Recent Stock performance
Since analyzing and purchasing Starbucks (“SBUX”) in July of 2018 the stock price of the coffee giant has exploded 51% to ~$78 (at time of writing). Given the run-up in the price I thought it would make sense to revisit my analysis. SBUX would make a great case study in how quick investor sentiment can change. It was only 8 months ago that the stock was selling off due to the change in management and uncertainty about the future. Sales were decelerating in the U.S. and investors we’re unsure about international prospects. The position currently makes up ~5% of my satellite portfolio.
In the most recent earnings call, management declared that they are “making meaningful progress against (their) three key strategic priorities, 1.) accelerating growth in (their) two long-term markets, the U.S. and China; 2.) expanding the global reach of the brand through the Global Coffee Alliance with Nestle; and 3.) increasing shareholder returns.” I briefly reviewed each of these to see if the story is unfolding how long-term investors have hoped. I find less than a year a bit quick to fully judge management execution but decided to take a look nonetheless.
Overall, total sales grew 4.5%
year over year. Excluding the impact of the Global Coffee Alliance and FX
translation, total organic revenue increased 9%. As of March 31, 2019, SBUX had
over 30,000 company-operated and licensed stores, an increase of 7% from the
prior year and the firm’s global comparable store sales grew 3%.
The Americas segment delivered 8% revenue growth in Q2, driven by net new store growth of 4% over the past year and comparable sales growth of 4%. Management highlighted beverage innovation as a driver of growth, citing the roll-out of nitro cold brew and the cloud macchiato as examples. However, as mentioned in my initial write-up, it has become evident over the last couple years that growth in the America’s has decelerated. SBUX has pretty much saturated the American market and the focus here has been on building efficiency and customer loyalty (more on this in a moment). These numbers are better than I had anticipated. The health of the business model looks to be in-tact. In my opinion, this speaks strongly to the brand. In fact, there’s a Starbucks just outside my office and there is always a line.
Investors have been watching the growth in China/ Asia Pacific (“CAP”) closely. Given that the region drinks a lot more tea than they do coffee investors have been skeptical about the growth opportunities in this region. There are also some known competitors in the space (i.e. Luckin’ Coffee) that are trying to increase their market share. This was a strong quarter for SBUX as they were able to demonstrate that they can continue to penetrate the Asian market effectively. If this trend can continue, this should bode well for the company’s growth. I believe most long-term shareholders tend to think the runway to further growth heavily resides in this region.
China delivered 9% revenue growth
in Q2 and, excluding the 4% FX translation, the growth was closer to 13%. This
was driven by 12% net new store growth over the past year and 2% comparable
sales growth for the quarter. Given the race for market share, SBUX has been
aggressively opening stores, with doors opening on 553 net new stores over the
past year, representing a 17% increase. Furthermore, as I discussed in my
original analysis, most people in the region are tea drinkers. However,
drinking coffee has been picking up steam adding a secular tailwind to the
Starbucks’ loyalty program continues to be an economic boon for the company. In the most recent quarter, over 40% of sales in the United States were from program members, while membership increased 13% to 16.8 million. Not only is the loyalty program good for its customers, but it’s beneficial for the company by allowing them to access a significant amount of data about its customers. This should help management improve product mix and directed advertising to their consumers. Clearly SBUX is doing a good job retaining their customer base in the U.S. If the U.S. can be any indication of how effective the company’s rewards program can be in China, then this should help SBUX integrate the economic moat we see here in the U.S. over in the pacific market. Since the launch of the rewards program in China less than a year ago, 90-day active Rewards members has increased 1 million during Q2 to a total of 8.3 million.
Management said on the conference call that this partnership with Nestlé has exceeded their expectations. However, I believe the jury is still out on this initiative. Late in fiscal Q2, Nestlé launched the first 24 Starbucks products across three platforms, Starbucks coffee by Nespresso, Starbucks coffee by Dolce Gusto, and Starbucks roasted brown and whole bean coffees. These products co-created by Starbucks and Nestlé are now being deployed to 16 global markets as part the initial rollout. This should in theory help produce global brand awareness and provide access to the SBUX brand for home brewers and I will be paying attention to how this develops over the coming quarters given that the project is still in its infancy. SBUX continues to produce the coffee products in North America, while Nestle is in charge of manufacturing throughout the rest of the world paying SBUX a percent of sales in royalties. Nestlé paid about $7 billion up-front in the agreement which SBUX has used (along with debt) to invest in CAP and provide returns to shareholders.
In March, SBUX initiated a $2 billion accelerated share repurchase program that is expected to be completed by the end of June. This puts the firm on pace to deliver about 80% of the expected $25 billion capital return commitment by the end of FY 2019. Additionally, the dividend yield sits at 1.8% with a 5-year growth rate of 24.5%, including an increase the dividend by 20% in August of 2018. In the latest quarter the payout ratio was a bit high at .68 but this should come back down as new initiatives hit the bottom line and debt is paid down. It’s important to note, however, that SBUX increased their debt load by ~$7 billion this year and now has a debt load over $9 billion. However, given that the firm produces healthy, growing, and predictable cash flows the elevated debt does not concern me. SBUX has a Debt/Asset ratio of .5 and an interest coverage ratio of 12x.
Guidance and Valuation
For fiscal year 2019 management anticipates
revenue growth to be 5-7% with global comparable store sales growth of 3-4% and
expects to add approximately 2,100 net new stores across the globe. EPS is expected
to be $2.40 to $2.44. If we assume the low end of guidance, we are left with a
forward P/E ratio of 33x. P/OCF sits at 8x and EV/EBITDA sits at 19x. These are
on the higher end of the historical trading range.
A strong cash flow producer with high returns on capital that is still growing rapidly deserves to trade at a premium, but I do not see myself adding to my position at these multiples. I believe that SBUX has the business model and proper brand recognition that allows the company to retain significant cash flow that can provide shareholder returns for years to come. I intend to let the story play out as a long-term shareholder and would look to add more shares if the price becomes attractive again.