A darker view of Starbucks

(Fortune Magazine) -- If you think there's already a Starbucks on every corner, chairman Howard Schultz has news for you: He's just warming up. In October the head of the world's largest coffee-shop chain said he plans to more than triple the number of stores, to 40,000, with half in the U.S. and half overseas. The target supplants Schultz's previous goal of 30,000 stores as he tries to challenge Yum Brands (Charts) and McDonald's (Charts) as the world's largest restaurant chain.

Schultz, with his usual flair, also gave investors a peek into the company's pipeline. No longer a mere Java joint, Starbucks (Charts) is increasingly looking to become an arbiter of culture. Starbucks executives announced that the company had reached an agreement with Apple (Charts) that will give consumers the ability to preview, buy and download a variety of Starbucks' Hear Music titles from the iTunes store.

Ubiquitous: The chain wants to hit 40,000 stores.

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And for the coming holiday season, Starbucks will begin selling a specially packaged DVD of "White Christmas" at its coffee shops this month. Investors can expect Schultz to unveil even more goodies when Starbucks reports its fiscal 2006 financial results on Nov. 16.

News of the amped-up expansion plans certainly impressed Wall Street, as the company's stock jumped 8 percent, registering the biggest one-day gain in nearly a year. In fact, Starbucks shares now sell for a staggering 52 times the company's earnings for the past 12 months, according to Baseline. That makes the stock slightly more expensive than Google (Charts), which trades at 51 times trailing earnings.

The lofty P/E indicates that investors are highly enthusiastic about the stock, but not everyone is so perky about Starbucks' prospects. One skeptic is David Trainer, founder of New Constructs, an independent equity research firm based in Nashville. Trainer, a former auditor at Arthur Andersen, makes a living poring over financial statements looking for holes. He says that Starbucks will have to achieve extraordinary growth to justify its current valuation. And he contends that investors are drastically overestimating Starbucks' profitability, largely because they're overlooking billions of dollars in off-balance-sheet debt.

Like many chain stores, Starbucks classifies the leases on its shops as "operating leases." In accordance with accounting rules, it doesn't have to reflect the cost of those leases on its balance sheet; it simply books the rent expense on its income statement.

But the lease obligations are still debt to Starbucks. How much? Digging through the footnotes from the company's financials at the end of its last fiscal year, Trainer estimates that the present value of the company's future lease liabilities is a hefty $2.7 billion, roughly 10 percent of the company's market value. Once he includes that as part of the company's debt, Trainer calculates that Starbucks' return on capital - a key measure of profitability - plunges from a stellar 15.6 percent to a mediocre 8.6 percent.

A Starbucks spokeswoman would not comment except to say that the company is simply following generally accepted accounting principles in the way it deals with leases. That's true, but if the company wanted to be more transparent, says Ed Ketz, an accounting professor at Pennsylvania State University, Starbucks could also report its leases as if they were "capital leases," which would require it to reflect the assets and corresponding liabilities on the balance sheet. "Clearly, Starbucks is leveraged more than it admits," says Ketz.

As Trainer sees it, the bigger problem is the lofty valuation. He estimates that Starbucks would have to boost revenues nearly 25 percent a year for the next ten years and improve returns on capital by 30 percent to justify its current stock price.

Is that doable? Sure - just as long as more consumers are willing to pay up for premium-priced coffee. But Trainer, for one, says he isn't betting on it: "People who play in these popular stocks where expectations are so high are playing a fool's game."

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