RECENT BUY: Starbucks Corp. [SBUX]

  • Decelerating growth and recent events surrounding the company have contributed to a drop in the stock price
  • Strategic initiatives will drive growth in revenues and cash flows moving forward
  • Attractive dividend yield of 2.5% and latest dividend hike of 20%

Starbucks Corporation [SBUX] has been on my radar for a while now and its stock price has finally reached levels that make it an attractive investment for my portfolio. The business of selling coffee seems to be investor friendly and I have admired the growth Starbucks has seen over the years. The coffee industry is the family-friendly version of a “sin stock” (tobacco, alcohol, etc.) and produces a very stable business model with strong margins. Like the so called “sin stocks” coffee is addicting and like many others, I look forward to a cup to jump-start my day. However, due to the popularity of the company I have not seen much value in buying their stock for my portfolio since I started building it in 2015. I would have paid a premium for a piece of the growth and the downside looked too great and all too possible. Sure enough, the stock is down 11% since the beginning of the year and about 12% over the last twelve months and has made its way on to my watchlist. This begs the questions, are recent events and media coverage affecting investor behavior and creating negative pressure on the stock price? Is there potential value for an investment? I have decided to take a further look.

Why did the stock price plunge?

First is the departure of the visionary and leader, Howard Shultz, as well as the retirement of the CFO Scott Maw, which has shaken up the management team. The company also announced that they’re closing 150 stores in FY 2019 as they look to reduce exposure to urban areas citing high rent and labor costs. This doesn’t worry me, in fact, I think it’s prudent given that the company has a store count in the US greater than that of McDonalds. Truth be told, it is extremely difficult for SBUX (or any company) to continue with 15 year, 10 year, and 5 year compound annual growth rates in revenue of 14%, 9%, and 11%, respectively. Eventually the market becomes saturated, growth slows, and the company needs to shift growth to new markets, develop new products, engage in M&A, strictly manage expenses, and/or return cash to shareholders. Having saturated the North American Market, this is exactly where SBUX finds themselves today. Here is a look at the top line dating back to 2000 and the downward trend has become fairly obvious.SBUX sales

But things aren’t actually all that bad and the business is still strong. Here are the Q2 highlights:

  • Net revenue + 14% to $6 billion
  • Americas revenue + 8% to $4 billion
  • Chinese revenues + 54% to $1.2 billion
  • EMEA revenues +15% to $34 million
  • Organic comparable store sales +2-3%

However, the company is seeing margin pressure with operating margins decreasing over 400 basis points. This is due to investments in growth markets, as well as restructuring and impairment charges. I expect margins to normalize in the medium term as management optimizes their sales mix in the US and immerses their business in international growth markets.

What is driving growth moving forward?

The largest driver of growth will be the company’s big expansion plans in China/Asia Pacific (CAP). In December of 2017 SBUX acquired the remaining 50% interest in East China joint venture and now owns over 7,500 stores in 15 countries throughout CAP. In 2017 revenues from CAP increased 10% to $3.2 billion representing only 14% of revenue. Also, operating margins (23.6%) are about 500 basis points better than that of the Americas business. China is known for its tea culture, but its people have begun to “wake up and smell the coffee”. The market is seeing double digit growth rates that look similar to Japan throughout the 60’s and 70’s. Japan is currently the 4th largest consumer of coffee. There is a vast amount of untapped potential as tea sales outnumber coffee sales 10-1 and with an estimated 450-600 million of people expected to join the middle class by 2022, SBUX only needs to grab a fragment of total market share in order to see significant growth in revenues. SBUX is also looking to improve growth in the US through their new partnership with Nestle to form a “Global Coffee Alliance”. This is an effort to expand the consumer packed goods segment, aka packaged Starbucks coffee for your home. This segment has seen its revenues increase by roughly 5% over the last year. The company also has a notably strong loyalty program that drives same store comparable sales. The rewards program membership rose 12% in 2017 and now accounts for 40% of same store sales in the US. According to their 10Q, management expects these strategic initiatives to boost revenue growth to 9-11% in FY 2018.

Cash Flow and Dividends

I expect my portfolio to pay me each and every month and for that income stream to grow. This can only be sustained if the company can turn revenues into cash flow in order to reward shareholders and invest in growth. SBUX has increased its Free Cash Flow (FCF) by 24.2%, annually, over the last decade. This has allowed SBUX to significantly increase its dividend, just recently raising it by 20% and showing a five year growth rate of 23%. The dividend is very healthy too, with an earnings payout ratio of only 40% and a dividend yield of 2.5%. Strong cash flow production is important because as growth eventually slows over the long-term, SBUX will have the ability to invest, buy back shares and boost the dividend to further drive returns. Here is a look at the dividend in relation to earnings and cash flow in the last few years.

SBUX Per Share

Is SBUX Undervalued?

SBUX is currently sporting a higher earnings yield and dividend yield than any previous point in the last decade, at 6.3% and 2.5% respectively.

SBUX yields

Furthermore, the company’s Price-to-Earnings and Price-to-Cash Flow ratios are below their 10 year averages (normalized) of 19.4x and 16.8x at 15.7x and 15.6x, respectively. This is down significantly from their 3 year average ratios of 29.9x and 20.2x. If these ratios revert to their 10 year averages then there could be share price growth somewhere in the 10-25% range, due to multiple expansion.

Continuing to attempt to value the company’s shares, I used the H-Model (DDM) and assumed that next year’s dividends would grow by 20%, then decelerate linearly over the following 10 years. Assuming I require a 9% return and the long-term growth rate is 4%, I reach a fair value estimation of $49.44. This shows the stock to be roughly fairly valued. As an avid follower of Warren Buffet, I am more than happy to buy shares of wonderful companies at fair value. However, I think that this is a very conservative estimate because it does not account for the potential growth rates that could be seen internationally, nor for any growth in the dividend payout ratio.

In order to be consistent with my thoughts on the company’s future I wanted to get an idea of potential upside. I ran a DDM with the assumption that cash flow will grow at 15% over the next 5 years, in which case it will drop to a steady long-term rate of 4%. I then made the assumption that the payout ratio increased linearly from 50-65% over the next 5 years, at which case it would level off at 70% of cash flow, as the business matures. Given a required return of 9%, I calculated fair value at roughly $62. This represents a margin of safety of 23.6%.

There are obviously many ways to model out a company to determine what price is fair value. The array of possible assumptions that fit one’s idea of what will happen to the company are essentially endless, but after completing my analysis and creating some perspective on the stock price, I have come to the conclusion that SBUX is slightly undervalued. I don’t see much downside from here considering the vast amount of people that are going to get up and head to Starbucks on their way to work tomorrow. I have decided to initiate a position in SBUX at $50.19. This is a quality company that should be able to provide my portfolio with strong returns and dividend income for many years to come. SBUX will now represent just shy of 3% of my portfolio and I will look to add more over the coming quarters if the stock continues to drop and/or future quarterly reports describe an even better story.

What do you think of the purchase?


Deep Value via Hidden Land Assets

Disclosure: The author has no position in any securities mentioned in the below article.

Finding a company with a net property value (market value of property – total liabilities) greater than the market cap of a company should be a screaming buy… but there are a few issues that come along with finding this type of hidden gem that the investor should be wary of. Land assets are deemed “hidden” because they are held at cost on the balance sheet. If an older company has held land for decades, chances are that land is worth significantly more than is reflected on the balance sheet.

The first problem with these types of investments is that the balance sheet simply reflects a snapshot in time. Best case scenario, the company liquidates all of its assets and pays off all of its debts and you are left with a hefty profit… but most companies are a going concern. Their balance sheet and fundamentals could and should change over time. A good management team will monetize the property to fund profitable capital projects, which leads to the next issue.

The second problem is the management. Why is the company’s share price depressed below its liquidation value? Why hasn’t the management borrowed against the property to fund capital projects? Are there even profitable opportunities to undertake? Are the managers really acting in the best interest of shareholders given these questions? Probably not.

Third, as with any value investment, is timing. If you happen to find a company like this, the timing is unknown as to when the actual value of the property will be reflected in the market price of the stock. Given that the market is forward-looking and the balance sheet is simply a snap shot in time, perhaps the market believes that the company is likely to borrow against the value of the property (which they should do if profitable projects exist), which will decrease the total net property value of the company. If the company does borrow against the property, you (as am equity holder) are now in the back of the line when it comes to liquidation.

However, these opportunities do arise and sometimes with even the right prospects in place. For example, Caloway’s Nursery (CLWY), a small retail gardening chain based out of Texas, recently went through this type of situation. The company was experiencing a management shakeout due to activist investor Peter Kamin of 3K. Management was giving themselves bloated benefits due to a serious agency problem. The management was essentially reporting to a board comprised of themselves! This resulted in excessive salaries and favorable insider stock purchase plans to the detriment of current shareholders. The company was trading underneath its net property value in 2016 for a few months before this value was realized in the market price.

If you find a company trading for less than its net property value, then you are essentially getting the business for free. Just be aware that it may take time for that value to be realized, and you will likely need good temperament and patience to bear through several periods with bad management.

  • Porcupine

2018 Market Outlook: Part I

As the New Year begins I like to take a look at the general landscape of the market as we embark on a new year of investing. As mentioned in my bio, my portfolio is diversified on an asset-class level and my strategic asset allocation decisions are based on my risk tolerance, time horizon and liquidity needs. Prevailing asset valuations will drive my tactical asset allocation decisions and where I invest fresh capital. Because of this, I like to make an annual macro assessment to help me create a picture of the current investment environment.

I am not an economist and I do not have the time, nor energy, to look at every fundamental market driver, so my macro-approach is very simple. I will let the quants crunch the numbers and make predictions while I just want to develop context and get a feel for the market sentiment that I am investing in. There will be many that disagree with my assessment and can lay out a very insightful argument to the contrary. I invite disagreement and discussion and think it is healthy to hear many perspectives. By no means am I an expert in predicting the best return drivers or where the largest risks lie in the current market. However, I believe that having a somewhat clear view of the market landscape will help me stay honest with capital decisions and avoid making un-educated investments. I expect that staying invested over many years, holding a diversified portfolio, and investing with a margin of safety will allow me to avoid excess exposure to tail-risks.

In 2017 the fed continued to stay the course on a rate-tightening cycle, the republicans passed a new tax bill, corporate share repurchases and IPOs continued to demonstrate strong volume, the yield curve has flattened, credit spreads tightened, volatility and inflation remained minimal and assets in general seem, at least at first glance, to be fully valued. Since I look to create alpha with my active investments in the US Equity markets, I will begin my assessment with the S&P 500.

US Equity Markets – Running of the Bulls

The U.S. economic outlook remains healthy according to many key economic indicators. GDP is expected to remain somewhere between 2-3%, coming in around 2.5% in 2017 with the same forecast for 2018 based on the most recent release at the Federal Open Market Committee meeting on December 13, 2017. Unemployment is expected to continue to drop to about 4%, and a successful Republican tax overhaul is expected to bring down corporate tax rates and improve earnings throughout 2018. Furthermore, low interest rates have left investors seeking higher yields outside of the fixed income markets (more on this in another post) and have encouraged investors to search for higher returns and yield in the stock market.

Last year was good for equities as the S&P returned about 21% (includes a 2% dividend yield). With most of the returns coming from price appreciation I think it’s important to ask the question – did valuations stretch further or did earnings keep up with the price appreciation? Earnings growth was 17.6%, thus returns by stocks this year were mostly led by earnings growth, which is a sign that the stock market appears healthy.

2018 Market Outlook - Yields

The P/E ratio increased slightly (earnings yield decreased by 19bps) and the dividend yield decreased 15bps but maintains a healthy payout ratio of 39.80%. Let’s see how some of these numbers stack up in a historical context:

2018 Market Outlook - Historical Graph

Looking at data going back to 1960 (57 years) it looks to me like stocks in the S&P 500 are bit on the expensive side. Both the earnings yield and dividend yield are sitting at the low end of the data series, while the PE ratio is becoming stretched – though not reaching the astronomical levels seen during the tech bubble. This concerns me a little bit as returns moving forward may be soft, however, we have been hearing a similar tune from the likes of many market professionals for quite some time now and if you have been sitting on the sidelines during this bull market I’m sure you not happy with the results.

My investment philosophy for my active equity allocation is mainly built around liquidity and safety of principal. As a result, most of my holdings are mid to large cap companies that have a competitive advantage in their industry and pay dividends. One way I like to measure dividend health is by analyzing cash produced by my potential investment in a company and ensure that cash flow is being sustained at a healthy level. I like to see companies use their cash flow to invest back in the business while also providing dividend growth to shareholders without being forced to tap the capital markets to raise funds. Here is a look at net income, free cash flow to equity, and cash returned to investors in the form of dividends and buybacks. These numbers are in millions.

2018 Market Outlook - Cash Return

Cash returned to shareholders as a percent of net income and free cash flow to equity is 87% and 98%, respectively. Anything over 100% is unsustainable, so it good to see cash returns below net income, and even better to see cash returns below free cash flow.

After comparing some basic fundamentals to historical numbers and getting idea of cash being returned to investors, I wanted to generate a forward looking estimate of the growth being priced into the current S&P 500 share price. Considering the US market is a developed and fairly stable economy, not currently experiencing an economic boom, I used the Gordon Constant Growth Model to back into an implied growth rate. Using the price and dividend at the end of 2017 (Price = $2,723.39 / Div. = $49.93) and a discount rate of 9% (average required return I use on my individual stock analysis), I get an implied growth rate of dividends of 7%. Does the growth rate justify the price? Well, there’s the obvious argument that if GDP is only growing at 3%-4% per year – than a 7% growth rate in dividends is unsustainable. You also must keep in mind there are inherent flaws in the GGM method as well as the fact that there is room left for the payout ratio (39%) to grow. The average annual growth rate in dividends going back to 1960 is about 6% -so we’re not that far off. Perhaps tax reform and the fiscal growth promised by politicians, combined with a year of healthy fundamental growth has left investors feeling good about future earnings growth. But you can make the argument that even though valuations are lifted in a historical context, investors aren’t pricing the S&P 500 at a euphoric level. (FANG stocks might be a different story!)

Currently, while somewhat healthy, US equities are not providing a sensational margin of safety. It seems like growth and risk are priced in and the market is fairly valued to slightly overvalued. However, I don’t think it makes much sense to look at the stock market in a vacuum and not take a look at what the credit markets are signaling. In Part II I will take a look at the equity risk premium and the prevailing interest rates to further develop context of the environment in which I am investing.

Comments or questions let me know…



Contra-Index Portfolio

It is December 1st, 2017. Tax loss harvesting season is almost upon us and has got me thinking a lot about forced selling and the types of situations that can force an investor to sell. The most obvious answer to that question is a stressed liquidity event (e.g, recessions), where an investor would be forced to sell his securities to fund current consumption. One problem: we’re not in a recession (at least according to government numbers).

So, I asked myself: Is there anything right now (aside from tax loss harvesting) that could potentially bring about a value opportunity? …One where an institution is forced to sell a security? Then it hit me. With the rise of passive investing, any constituent security that was booted from an index would force the ETFs that try to replicate that index to sell (assuming no tilt).

Due to the increased popularity of ETFs, when a constituent security is dropped from the S&P 500, forced selling from ETFs and index funds could potentially send the price per share of a company below its intrinsic value.

Over the next few weeks I will be examining this hypothesis by collecting data and back testing returns.

  • Porcupine

P.S. I’ve been told that this is a strategy that has been used by Baupost and I’m sure by numerous other asset managers (Who wouldn’t try to implement a strategy followed by Seth Klarman?). I intend to keep my thoughts original, and therefore am not looking into any of their thoughts on this strategy due to the fact that they may influence my analysis.


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