Starbucks (SBUX), it seems, is a "can't miss" stock these days. This much loved darling of the financial media is the talk of the town. The future is full of promise, and any dips are merely "buying opportunities". We here at the 99% will take the opposite view. Not only does it fit in with our contrarian nature, but also because we think the fundamentals don't support any near or medium-term moves higher.
A quick look at the Seeking Alpha SBUX articles show just about everyone is bullish. Well written articles by my fellow writers with titles like "pullback presents buying opportunities" "secrets for growth" and "fueling future growth" abound. Right away, before we even look at the fundamentals, this grabs our attention. As contrarian investors, we know that anytime too many people are either bullish (or bearish) on anything, it represents a good trading opportunity, a chance to make excellent profits. We must always be aware of the strength of trends however (even if we're eventually right, it's very easy to lose your shirt before one is proven right), so we must make sure the fundamentals support our contrarian position. So is the SBUX uptrend getting a little long in the tooth? We think so, and here's why:
1. Rising input costs
Coffee has been relentlessly beaten down the past few years, as the following chart shows. The selling has gone on for far below fair value of coffee: at its lowest price, farmers were getting $0.71/lb while production cost was 59% higher at $1.17/lb, an unsustainable trend which guaranteed higher prices. Even if the fundamentals of coffee hadn't changed, we were due for a strong technical bounce off the $1/lb support level. JO Click to enlarge
But the fundamentals of coffee did change. Instead of a brief technical bounce, Brazil suffered from one of the worst droughts in decades that decimated up to 30% of the Brazilian crop. While one might think "so what? It's only one country, coffee is produced everywhere" that is not the case. The price of global coffee is basically the price of Brazilian coffee, as we can see from this chart of global coffee production:
(source: US Dept of Agriculture)
30% of the Brazilian crop is a huge supportive factor in the fundamentals of coffee. Now, this article is not about the coffee price, we are just providing context, so we won't delve into this any further. Suffice it to say, given the strong technical and fundamental factors, as well as the high costs of coffee production, we think it's a fair assessment that coffee has a floor of $1.75/lb and could go up as $2.25 or higher in the coming years. The 2014 coffee crop is more or less decimated, we won't get any pressure on coffee prices until the 2015 crop is proven robust, which won't be known for 6-9 months from now.
The argument we often hear against this is "slow down cowboy. SBUX is fully hedged against coffee so the recent spike won't affect them. The CEO even says so."
Fair enough. Let's take a closer look at that. First of all, we don't think the company is quite as hedged as they say they are. Perusing the Q3 and Q4 2013 earnings statements, we find these statements:
"Adjusted operating margin increased 150 basis points to 16.4% driven by strong sales leverage and lower coffee costs."
"Operating margins expanded 260 basis points to 19.2%. Starbucks' margins are being helped by lower coffee costs"
So we can see that they clearly aren't fully hedged here. You can't have it both ways SBUX. You can't claim that low coffee prices are helping margins when coffee is cheap, and THEN claim that your margins are insulated from the recent spike in coffee prices. And this argument is supported if we look closer at the company's most recent Q-10 filing. The company states (emphasis ours):
"As of December 29, 2013, we had committed to purchasing green coffee totaling $519 million under fixed-price contracts and an estimated $264 million under price-to-be-fixed contracts. As of December 29, 2013, approximately $1 million of our price-to-be-fixed contracts were effectively fixed through the use of futures contracts. Price-to-be-fixed contracts are purchase commitments whereby the quality, quantity, delivery period, and other negotiated terms are agreed upon, but the date, and therefore the price, at which the base "C" coffee commodity price component will be fixed has not yet been established. For these types of contracts, either Starbucks or the seller has the option to "fix" the base "C" coffee commodity price prior to the delivery date. " (Page 13)
We're not professional hedgers, but from our point of view, any hedge that has not had a price fixed to it is not a hedge at all. It is just a purchase order. A way to guarantee supply and quality (both important) for sure, but not price. And since the "price to be fixed" orders account for 33% of total orders, we don't view this as a very effective hedge.
And on the company's most recent 10-K, we see this under 'risk factors':
"Increases in the cost of high-quality Arabica coffee beans or other commodities or decreases in the availability of high-quality Arabica coffee beans or other commodities could have an adverse impact on our business and financial results." (Page 11)
Funny thing for a company to say about a large input they are hedged against. We're not fully confident that SBUX is as insulated from the 75% YTD gain (and reaching as high as 100%) in coffee prices as they'd have us believe.
But let's ignore that and for one moment just assume that they were fully hedged. When we look at the hedging, it's really only in effect for 2014.
SBUX finance director Troy Alstead says here that "Starbucks is not meaningfully priced for 2015 at all yet" which - at the time - was a selling point. Coffee prices were very low and hedges were actually hurting Starbucks margins. So Mr. Alstead was trying to reassure investors that while 2014 was locked in, don't worry, because they're going to be able to lock in 2015 at these low prices. Whoops.
We hear this a lot from the analysts: "SBUX is hedged for 2014, and so doesn't need to worry about coffee prices until Q1 2015!!"
We're not sure if these analysts have checked a calendar lately, that's only 9 months away. And hedging is a complex series of financial maneuvers that - given the size SBUX needs to hedge - will need to be started months in advance. So SBUX will need to either a) start hedging for 2015 real soon or b) Just gamble that they can get lower prices if they wait.
We see neither option as being particularly attractive for SBUX. We think that given the fundamentals of coffee, the current price of $1.75 is going to provide extremely strong support. Even if SBUX hedges at that price, margins for 2015 will surely not be able to meet the company's very optimistic expectations of 19.7% margins:
And certainly the forward looking margin projections of 20%+ in the coming years looks impossible to reach, given that margins were at 7.5% as recently as 2008.
(4-traders.com via Thomson Reuters)
Remember, a huge part of SBUX's very high multiples is these very optimistic margin projections. The forward P/E of 24.20 is high EVEN IF Starbucks manages to meet its forward guidance. But we believe operating margins will come in substantially lower, no higher than 17% in 2015, which would make the forward P/E even more unattractive.
The other rebuttal I hear is that "coffee is not even Starbuck's biggest input costs." For this, we go right to the horse's mouth, CEO Howard Schultz:
In this recent interview Mr. Schultz tells us that "coffee accounts for less than 20 percent of our cost of goods" and also reminds us that dairy, not coffee, is the biggest input costs for the company.
First, to suggest that the price of coffee is a nonevent because it "only" accounts for 20% of the input costs is a little disingenuous. When your company is buying almost a billion dollars of it, that's significant. And how about that little tidbit about dairy being more important? "Surely milk prices are stable, right?" you might say to yourself. In a word, no:
"OK," you might say, "but how does that compare to the big picture? I mean, it's not like milk is at 10 year highs or anything, right? *nervous laughter*"
Milk is at 10 year highs.
And we notice Mr. Schultz has not been nearly so vocal about the hedging of milk, so we have to assume they are feeling some pain from this recent move.
2. Heavy insider selling:
To be clear, insider selling is not always a bearish signal. Many of these execs are merely financing their lives, using the options they are given as a piggy bank. Need $10 million? Exercise some options and sell some stock. However, heavy, sustained, one sided selling is often a sign that insiders see the top. The argument against this is invariably something like: "But they were given those options for nothing, it's basically free money, so why wouldn't they sell?."
The price they paid (or didn't pay) to get their options is irrelevant. Just because they were given free options, if they think the stock will appreciate another 25% or more, they are simply not going to sell in large numbers. Sure $100 million for free is nice. But not as nice as $125 million for free, and when we see large numbers of insiders selling in large amounts, that is a big warning sign for us. We've traded using this as a factor with great success over the years (note: insider should only be a cog in the machine. We would never trade on heavy insider selling alone).
So just how much insider selling has gone on? Lots.
One purchase of 3,300 shares vs. twenty-three sales of 4.29 million shares strikes us as significant. It also strikes us as significant that despite the very optimistic forward guidance, the largest seller has been Mr. Schultz himself. Now, as we said before, we don't begrudge insiders selling shares periodically to finance their life. With that said:
We DO feel that $335.8 million worth of stock sold over the past 15 months is a little extreme and certainly makes us skeptical of Mr. Schultz's true feelings about the upside of his company. In case you were wondering, this represents around 20% of Mr. Schultz's holdings, so it can't be considered an insignificant amount.
In summary, we feel:
- Starbucks' rising input costs (which we feel will impact margins significantly more than the company is leading us to believe).
- Massive insider selling.
- Extremely generous forward multiples than is basically pricing the company to perfection.
- 555% share price appreciation over the last 5 years.
- Our belief that the market showing strong signs of a top (which we mentioned in our article the other day "Is the VIX calling a top?"
- Too many bulls, not enough bears.
All these reasons add up to our overall bearish feeling of Starbucks. We feel this is dead money over the next 12-24 months and would not be buying at these levels. If you have a very long-term investment horizon and are already in, sure, keep holding. Why not? But if you'd like to buy, we suggest waiting a year or two for lower prices.
Please understand I'm not talking ill of the company. The company is very well run and Mr. Schultz is obviously very smart. What we don't like however is the valuation and the short-term fundamentals. We plan on trading this by sitting out until earnings next month and going short just before earnings. We strongly feel the stock will sell off based on our opinion on what the margins will look like as well as downward revised forward guidance.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours, but will be entering into a short position in mid-April. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.