In a previous article, I asked a straightforward question: "How Much Should You Pay For Starbucks (NASDAQ:SBUX)?" The answer wasn't so straightforward; this depends greatly on your underlying growth, valuation and discount rate assumptions. With this in mind, I wanted to approach the topic from a slightly different angle.
Let's start with some history. Here's a look at how the business and investment has progressed dating back to fiscal year 2006:
On the top line you can see very strong growth. Total revenues of $7.8 billion in 2006 turned into $19.1 billion by 2015 - compounding at an average rate of 10.5% per annum. That's a solid start, but things were about to get a lot better.
As a result of an expanding net profit margin, company-wide earnings grew much faster than total revenue growth. Total earnings went from $580 million to $2.4 billion - growing by 17% per year. In addition, the share count was reduced slightly, allowing for earnings-per-share growth of about 17.5% per annum.
If the valuation remains the same at the beginning and end of the period, you'll see share price capital appreciation that is in line with EPS growth. With Starbucks you had a bit of P/E compression during this period. So 17.5% EPS growth turned into "just" 14.3% annual share price appreciation. Investors were anticipating solid growth - hence the high starting multiple - and the company has delivered.
In addition, Starbucks initiated a dividend, which bumped up the overall gain a bit. In total investors would have seen average compound returns on the magnitude of nearly 15% per annum. As a point of reference, that's the sort of thing that would turn a $10,000 starting investment into almost $35,000 after nine years.
Clearly the past results of long-term Starbucks shareholders have been quite solid. (And by the way, owning shares over this entire period would have required "enduring" an 80% price decline moving through the recession.)
Of course all of that is in the past. Today's shareholder, or prospective shareholder, is more likely concerned about the future. Naturally this is unknown, but we can work with some scenarios to give you a better feel for the process. I'll provide three examples - optimistic, baseline and pessimistic - to see how Starbucks future returns might play out. Let's start with stars in our eyes.
I actually found it difficult to put in these inputs (mentally not physically). I generally prefer to remain cautious in my assumptions, so this sort of expectation doesn't exactly give me a "warm and fuzzy" feeling.
The middle column provides the same historical information as above. The right-hand column provides a hypothetical scenario over the next 10 years. I used 12% annual revenue growth, an increase in the profit margin up to 18% and a slight reduction in share count to get to 17% annual EPS growth. This is what an optimistic scenario looks like to me.
Interestingly, when I look up intermediate-term growth rate estimates I often see analysts expecting something in the 16% to 20% range. So even though I personally consider the above to be optimistic, the EPS growth at least is in line with what many are actually anticipating.
Which, by the way, if this happens to be your view I'd stop reading this article now and go find a way to get your hands on more shares of Starbucks. At a 17% EPS growth rate, even substantial P/E compression would lead to solid gains. In our above example, a constant earnings multiple leads to an annual gain assumption of nearly 18% per year. Yet even if the multiple dropped all the way down to 18, in this scenario, you'd see be looking at double-digit gains.
Personally I prefer a slightly more pessimistic view - better to be pleasantly surprised instead of needing excellent assumptions to support an investment thesis. Here's a look at what a more subdued set of assumptions might look like:
Starbucks has the ability to grow on the top-line; I don't doubt that - you have a dominating force and willing consumers that lead to pricing power for the business owners. Yet I believe that replicating the growth of the past decade could be a bit difficult. The store count is now 70% higher than it was back in 2006. Thus the starting base is now much higher as well.
The above assumptions puts together a reasonable set of metrics, leading to 9% annual earnings-per-share growth. With many expecting 16% to 20% per year, surely this would be disappointing, but I'd also contend it's a more prudent starting point. It's easy to adjust upward; it becomes more and more difficult to justify an investment thesis when you're adjusting downward.
For most companies, this sort of performance would be quite solid. For Starbucks, this sort of thing lends itself to a problem in the way of an above average starting valuation. Instead of double-digit gains should this type of performance come from say JPMorgan (NYSE:JPM); you'd likely "only" expect mid-single digit returns - in this case about 7% per annum. That's still enough to double your investment, but a far cry from what was previously achieved.
Finally, let's look at a somewhat downbeat set of circumstances:
Here you still have reasonable growth - it's not like we've entered negative territory - but the valuation weighs heavy in this scenario. Should Starbucks grow earnings-per-share by close to 6% per year, but later trade at "just" 20 times earnings the share price appreciation would basically be nonexistent. The business would be humming along, but shareholders would not share in that at this level of growth and valuation.
Once you add in the dividend the returns are just above zero - apt to be in line with inflation, but not much more.
Put together, these scenarios offer an interesting take. And whether or not the security looks interesting to you personally depends on which alternative you lean toward most.
In the first scenario, you can see that if you're anticipating anything close to 15% or 20% EPS growth, Starbucks could be an excellent investment in the coming years. Many are expecting just that.
This is certainly conceivable, but this also moves away from the idea of prudent expectations. For Starbucks to achieve those results the company suddenly has to grow even faster off of a much, much larger base. You currently have 70% more stores turning out 150% more profits and 300% more earnings. And even back a decade the business was growing at a slower rate than what is now anticipated. Sure this could accelerate, but it's not a cautious view.
A more subdued look - lower revenue, earnings and valuation expectations - still allows for solid company results. And shareholders could stand to gain and build wealth nicely under this scenario - not to the same extent as in the past, but building nonetheless.
The problem for Starbucks, in my view, is if you believe that the business will perform only marginally (or worse) in the coming decade. For a lot of companies 5% annual revenue growth would turn out just fine. For Starbucks you have an expectations problem whereby that sort of growth could lead to severe valuation compression. The company probably isn't "priced for perfection" - you can do well in an average scenario - but you ought to be cognizant of the relationship between valuation and the resulting expectations as well.
Disclosure: I am/we are long JPM.
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.