Starbucks - Growth Now, Income Later

| About: Starbucks Corporation (SBUX)

Although Starbucks (NASDAQ:SBUX) has regained a bit of momentum in the last couple of weeks, it remains nearly $11/share off its 52-week high of $62 at the time of this writing. There is no question it has been weighed down by a variety of factors, including higher commodity costs (namely coffee) throughout fiscal year 2012 and increased competition in the coffee market from brands such as McDonald's (NYSE:MCD) and Dunkin' Brands (NASDAQ:DNKN).

An additional issue worrying investors is probably the difficulty Starbucks is having in turning its European, Middle Eastern, and Africa (EMEA) segment into a profitable component of the business. However, I believe the market is currently underestimating Starbucks' growth potential in the next several years and, furthermore, neglecting to realize how an investment in this company could lead to income down the road for the long-term investor.

Growth Now

Let's first take a look at the most recent quarter, Q3 of fiscal year 2012. Here are a few highlights of the results:

  • Net revenues are up 13% to $3.3 billion.
  • Worldwide comparable-store sales growth of 6%, including a 7% increase in the America's division and 12% in the Chinese, Asia, Pacific (CAP) segments.
  • Diluted EPS growth of 19% to $0.43/share, despite what the company describes as continued pressure from commodity costs that negatively impacted operating income by $38 million.
  • Unfortunate difficulties in profitizing the EMEA segment, though management was very vocal on recent conference call regarding its confidence in a European segment turnaround in the works.

Starbucks also provided a compelling case for fiscal 2013 guidance:

  • 1,200 net new stores opening: 600 in the Americas segment, 500 in the China/Asia-Pacific (slightly more than half in China) segment, and 100 from the European segment.
  • EPS growth of 15%-20% over fiscal 2012.
  • Comparable same-store sales growth in the mid-single digits again.
  • Management specifically notes that high coffee costs that have served as a headwind recently will become a tailwind in 2013.
  • Additional targeted goal of 1,500 total stores in China by 2015 (currently there are just over 600).

So, aside from new store openings and same-store sales growth, are there any other potential needle-movers for Starbucks? In my mind, the answer to this question is yes, certainly.

First, the company has made its first move into the reportedly $8 billion energy drink category with its "Starbucks Refreshers," which are available in more than 10,800 stores in the U.S. and 15 international markets. Second, the company has made an acquisition of "Evolution Fresh," which produces ready-to-drink juices. According to the most recent conference call, these are now offered in over 800 stores primarily in Seattle, Los Angeles, and San Diego. The company mentions plans to double that number in the coming months, stating that sales of this product have exceeded internal expectations.

Starbucks management also notes that one-third of all transactions are now accompanied by a food purchase. The acquisition of La Boulange has now been completed to add a fresh bakery aspect to Starbucks stores, which should further supplement this trend and add an additional revenue line.

These are all theoretically great additional revenue lines, but the one I am most excited about is the pending introduction of the Verismo single-cup system by the winter holiday season. This is an interesting product as it is the only single-serve machine that uses pods made from real milk, an effort to increase quality in this category. Starbucks is already claiming to be the second-largest player in the premium single-cup market thanks to K-cup products, and should look to gain market share in this revenue field with the introduction of the Verismo System. Management seems very excited about this product, and I believe investors should be as well. The following quote regarding the Verismo system from Starbucks' earnings call transcript should support this thesis: "Commitments and initial orders from retailers for the holiday season have exceeded even our most optimistic expectations."

Allow me to summarize my growth potential thesis for Starbucks in a brief list:

  1. Enormous growth potential in the CAP (primarily China) division; plans are already in the works to increase Chinese store counts to 1,500 by 2015, up from current levels of 600 stores. This in a geography that is currently enjoying comparable-stores sales growth of 12% and enjoyed increased revenues of 31% in the third quarter year over year. This is a geography that management specifically notes "offers high store margins and current penetration rate is low given the size of the country." The CAP division currently contributes 13% of Starbucks' profit, up from 9% two years ago, a trend that looks ready to continue.
  2. A more diversified future revenue outlook with the addition of Juice, Energy Drink, and Bakery products, as well as packaged coffees that have fared well.
  3. Potential turnaround in the EMEA segment (Europe) that would greatly add to potential income.
  4. Starbucks intends to open its first store in India this year. India is another hugely populated country and emerging market, and if Starbucks can show viable growth in this region it will have major potential impact on earnings in the future.

I recognize that these are all "ifs" and "maybes" at this point, but the path for the company's potential growth is fairly transparent. Which brings me to my next argument.

Income Later

Starbucks currently pays a yearly dividend of $0.68 on guided 2012 EPS of $2.04-$2.14. This yields a payout ratio of 32.5% of earnings for next year. Contrast this with other industry leaders and competitors such as McDonald's, Dunkin' Brands, and Coca-Cola (NYSE:KO).

Company and payout ratio based on trailing 12 months numbers from Yahoo Finance:

  • MCD: 52%
  • DNK: 48%
  • KO: 54%

While not an exact science, one can speculate as to the room Starbucks has and will have to continue raising dividend payouts in the future to enhance investor return. If it was to simply match the rough average payout ratio of 50% of the companies above, this would create an estimated dividend of $1.05 for 2013, for a yield of 2% at current stock prices (keeping in mind the large growth potential outlined above for continued share price appreciation and future dividend hikes).

I'm not saying management will implement such a drastic dividend hike in a year's time (in fact, I am quite certain it won't) -- I am simply outlining the potential for increased dividends in the future as the company matures and the income base these may provide. I think more realistic expectations are of modest annual dividend hikes that total up to a substantial amount over the longer term.

My Bottom Line

Starbucks' management has done a nice job of outlining its plans for growth in emerging markets such as China and potentially India in the future, and has taken strides to somewhat diversify revenue streams. Few would argue with the nice job management has done in creating a great Americas segment, and there are experienced personnel in place in European markets with high hopes of a turnaround in that segment. The growth potential is quite good, if not exceptional.

The company also has demonstrated consistent earnings growth and expects this to continue. Starbucks is currently paying a dividend at a much lower ratio than established companies such as McDonald's and other competitors and peers, and it has the ability to increase this payout in future years to become an income investment down the road.

Valuations are not through the roof for a company with the prospects ahead of it that Starbucks has. A current P/E of 28 and high-end estimated EPS growth of 20% yields a PEG ratio of 1.4, a level at which many growth investors are willing to invest.

I think this would be a quite intriguing company for working-age individuals looking to boost retirement funds, as well as be prepared for the need for continued income in the eventual retirement years. I would, of course, encourage investors to assess their own portfolio needs and preferences and to do their own homework and due diligence on any potential investments. This article is intended only to stimulate thought and highlight a few reasons I personally have become quite interested in Starbucks at current levels. I welcome all comments from even the most bullish or bearish sides of this topic in the spirit of promoting a well-balanced decision-making process.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SBUX over 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.