Starbucks: Good Perspectives Do Not Make It A Good Investment Now

| About: Starbucks Corporation (SBUX)

Summary

Starbucks has shown excellent growth and operating results over the past five years (and in the last year, particularly).

However, the stock is in the stratosphere. Buying now means that you believe in the success of its Chinese expansion.

I am not a believer - I am an analyst and an investor. My DCF, zero-growth, and comparative analyses show that the stock is overvalued by 9% at least.

Hence, I recommend selling Starbucks’s shares, if you have any. If you are a risk-lover, you can open a put option position.

During the last year, I paid special attention to stocks that are both defensive (such as companies in the Food & Beverage, Apparel, Footwear, etc. industries) and seem to show good growth perspectives. There were two reasons for doing this:

  1. First - to build a defensive portfolio after the Chinese market crash and amid the recession talks.
  2. Second - to find interesting opportunities for long positions and, if the high price for some stocks is too high, short them using put options.

starbucks Starbucks (NASDAQ:SBUX) is a company that has been on my radar for a while.

First of all, it has diversified operations worldwide and has a leading position in the coffee business.

Secondly, despite its close connection to coffee prices, its fiscal 2014 revenue growth results were much better than the ones my regression analysis shows (for an average coffee price of $5 per lb. sales should have been at a level of $13B, while the factual result is much higher - about $16.5B). Moreover, fiscal 2015 demonstrated a decline in commodities, whereas Starbucks's revenue has increased by more than 17% as per the latest 10-K. Despite the Starbucks Japan acquisition, the company has shown good natural growth, as well.

Finally, Starbucks has a very liquid stock. Hence, its calculated beta is quite reliable and can be precisely used in calculations.

Diagram 1

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Source: Data - Morningstar.com, International Coffee Organization, infographics by author

Now let us talk about a few trends.

First of all, I would like to say that SBUX has Napoleon plans on the Chinese market. In the next five years, the company wants to open more than 2500 locations in order to bring the store count to a total of 4500 stores by 2020. It means that China can become the second largest Starbucks's market after the US.

However, the strong bet on Chinese growth is rather risky. I do not want to repeat the several thousand analysts' words about the "slowing growth" and the "devaluation risks" but I think that a 125% increase in presence in a five-year period (more than 17% per year on average) is a bit too much for this market. Whatever the Chinese authorities say, it does not seem obvious that the middle class will be a key growth driver in the future. Moreover, even a successful implementation of the plan does not mean that Starbucks will not face rivalry. Costa Coffee, U.B.C. Coffee, and the well-known McCafe - they all will fight for the same consumer. New local competitors may emerge.

Secondly, as I have mentioned before, the company has been showing good growth during the past five years. Its revenue CAGR has been in excess of 13%, while the net income CAGR was a little bit lower than 22%. The free cash flow to firm has been growing at a 9% CAGR, which allowed the company to pay rich dividends. The dividends per share ratio has increased from $0.25 in fiscal 2011 to $0.61 in fiscal 2015, showing a 25% CAGR in the meantime. Also, the company performed a series of buybacks - one of the reasons why EPS and DPS have rocketed.

Thirdly, the company made a decent recovery in its operating metrics after the problems it faced in 2013 (just to remind you: in that year, Starbucks was forced to pay about $2.76B to Kraft; you can read more about this story here). Moreover, as you can see in Diagram 2, the company's margins have even increased. Diagram 3 also shows that its operating metrics are much higher than industry averages. The operating margin of 18.8% and the net profit margin of 14.4% have caused its ROE to climb to a stunning level of 50%. If Starbucks did not pay dividends, its book value would double every two years. Moreover, this all has been achieved by using a fairly low financial leverage: the D/E ratio is 4.5x lower than the industry's average. This means that the company has a lot of extra debt capacity.

Diagram 2

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Source: Data - Morningstar.com, infographics by author

Diagram 3

Source: Data - Morningstar.com, infographics by author

However, there are a few points of concern. Of course, Starbucks seems to be a "safety lagoon" for investors who are uncertain about the future perspectives of the Chinese, American, and global markets. Nevertheless, the company is trading at its historical highs now. Over the past year, the stock price has increased by more than 40%, and the company has paid dividends yielding a 1% annual return. Diagram 4 shows that, if you had invested $10K in Starbucks in 2010, you would have had about $60K at the present time. I congratulate the people who made this investment. However, I am not sure it will play out as well in the future as it did before. I question the company's future growth.

A good investment is not buying the best company for a high price. The best investment is paying a reasonable price for a company with good perspectives. If the investment has a good margin of safety, it is a plus. I have a feeling that Starbucks may be the first choice.

Diagram 4

Source: Morningstar.com

DCF analysis

My DCF model is presented in Diagram 5. In Diagram 6, you can see how different metrics of Starbucks are expected to change during this period. I have made several assumptions, which can be easily seen in the "Assumptions" tab of my Excel file. Pay special attention - they are very optimistic. The forecasted 7-year revenue CAGR is set to be at a 17% level, while the previous five-year CAGR is 13%. The forecasted seven-year CAGR in free cash flows is about 16%, which already includes the effect of increasing dividends, while the historical five-year CAGR is less than 10%. Moreover, the operating metrics are set to be stable.

My model shows that, after subtracting the market value of debt, minority interest and adding back cash and investments, the market value of equity is around $81.1B in the Base scenario. Consequently, the fair value per share is around $54 per share. It is more than 7% lower than the current price ($59 per share).

Diagram 5.

Click to enlarge

Source: Data - Morningstar.com, DCF model by author

Diagram 6.

Click to enlarge

Source: Data - Morningstar.com, infographics by author

Sensitivity Analysis

The sensitivity analysis is presented in Diagram 7. According to the Base scenario and the assumptions for the EV/EBITDA multiple and WACC, the price range is estimated to be between $49 and $59 per share. This price range represents a -17%-0% downside risk for the stock.

Diagram 7.

Click to enlarge

Source: Data - Morningstar.com, model by author

Zero-growth Analysis

The Zero-growth analysis has been described in one of my articles. You can read more about it here.

According to this analysis, the current stock price shows no margin of safety. The valuation gives a fair market value of equity of $44B, which transforms into a fair price per share of $29.12. This price level is 51% lower than the current level. If we only used net income in the calculations, the result would be a fair value per share of only $21.76. It is 63% lower than the current price. Hence, we can definitely say that the stock has no margin of safety at current price levels.

Comparative Analysis

My comparative analysis is based on three key ratios: P/E, P/S, and P/BV (see Diagram 8). All ratios show that the stock price is extremely overvalued. However, these ratios do not include the effect of the changing capital structure and the growth perspectives of the company. Nevertheless, these ratios are still quite high. The current EV/EBITDA multiple is 18.3x, while the industry's average is 12.7x (according to the updated Damodaran data tables). Therefore, the company is definitely overvalued.

Diagram 8.

Click to enlarge

Source: Data - Morningstar.com, infographics by author

Opinion

Starbucks shows good growth trends. The Chinese expansion may be a factor that will boost revenue even higher than what I expect. However, I am not a believer, I want to be sure that my investments are worth doing and I will not lose money in the same manner Skechers's (NYSE:SKX) investors already have. This is why I recommend staying away from this stock and SELL your position, if you have one. Risk-lovers may short this stock by using put options. According to Yahoo Finance, the cost of the options is quite low - about $1.26 on a $50 strike expiring on June 17, 2016 (according to the ask prices).

My target price range is $49-$54 per share, which translates into a 7%-15% downside risk.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.