With stocks sitting near all-time highs, it is increasingly difficult to find stocks trading at attractive valuations, to the frustration of many value investors. However, there are definitely some stocks that are worth buying today, and UBS Research thinks it found one, upgrading Starbucks (NASDAQ:SBUX) to a buy on Thursday. In its note (details available here), UBS upgraded earnings estimates and raised its price target to $87. This upgrade sent shares rallying 2% to $77, though they are still below the 52 week high of $82. While the valuation is not particularly cheap, I believe SBUX has further upside and will reach $90 within 12 months.
Under CEO Howard Schultz, Starbucks has been a relentless growth machine and continues to enjoy same-store sales growth of 5-8%. Even with bad weather last quarter, U.S. same store sales growth was 6% (all financial and operating data available here). Starbucks is more than a U.S. story as it has aggressively invested in China and the Asia Pacific, which accounts for nearly 10% of the company's revenue. Importantly, none of its markets are near saturation, which is why Starbucks continues to aggressively open new stores. As a consequence, revenue growth continues to outpace same-store sales growth.
In the last quarter, Starbucks opened 335 net new stores bringing its global store count to 20,519. In the year ago quarter, SBUX added 590 stores, but this includes its purchase of 337 stores in the Teavana acquisition. Normalizing for this, Starbucks actually opened 82 more stores this quarter than it did a year ago. Even though the company is getting larger, it is finding even more growth opportunities. Importantly, these new stores are opening around the world. Starbucks opened 128 locations in the Americas, 32 in EMEA, and 174 in China and Asia Pacific. Starbucks is accelerating its expansion, and same-store sales growth continues to hold above 5%. In other words, Starbucks' growth story is far from over.
As a consequence, I expect Starbucks to maintain its pace of 18%+ EPS growth and 10% sales growth. In the current fiscal year, that translates to about $2.67-$2.75 while UBS is predicting $2.67 and translates to roughly $3.20 next year compared to UBS's $3.16 estimate. SBUX is trading 28.5x this year's earnings, which is not that expensive compared to its 20% earnings growth. Importantly, there are additional growth levers that can accelerate earnings and revenue growth in coming years.
Current growth is mainly coming from the Starbucks and its traditional projects. In specific markets, Starbucks is adding alcoholic beverages in the evening and lunch foods as well. Bringing consumers during non-traditional hours could dramatically increase profits as fixed expenses like rent are unchanged. The incremental gross margin will flow almost entirely to the bottom line, which will increase operating margins and help earnings growth outpace revenue growth.
Additionally, Starbucks is still a coffee play, but tea is actually a larger global market. As mentioned above, Starbucks acquired Teavana, but it accounts for less than 3% of all locations. If Starbucks can do for tea what it did for coffee, growth could be absolutely explosive. That is far from certain and there are definitely operational risks, but Schultz has proven it costly to bet against him. Even if Teavana doesn't take off like Starbucks has, there is ample room for growth, and its store count will certainly hit several thousand before the end of the decade, which will provide Starbucks with a very long growth runway.
This week, Starbucks also announced it would pay college tuition of employees who take online classes at Arizona State, one of the first retailers to offer such a program (details available here). This plan was announced to much fanfare, including CEO Howard Schultz appearing on The Daily Show with John Stewart. In reality, this programs serves as a great marketing vehicle and morale booster. It further develops Starbucks' brand as being socially conscious, which many of its customers appreciate. At the same time, it should lower employee churn and increase the quality of employees, thereby cutting training expenses. Even if 3% of employees took advantage of this program every year, the cost would be $50 million. Given the advantages of this program and Starbucks's $58 billion market capitalization, it really won't materially impact results and shouldn't concern investors. Being employee friendly is not necessarily unfriendly to shareholders.
Starbucks is a great company, and while shares aren't particularly cheap, I agree with the UBS call. Based on current operations alone, Starbucks should trade into the $80's within 12 month. Add the growth from Teavana and new products, and I expect Starbucks to trade $90 next years, which translates to a PEG (price to earnings over the earnings growth rate) of 1.5x. For a company with this level of execution and growth, that is a reasonable valuation. While I can understanding waiting for a pullback given the recent pop, Starbucks is a buy.
Disclosure: The author is long SBUX. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.