Starbucks (NASDAQ:SBUX) is a high-growth stock that is quite popular in the investment community thanks to its straightforward business and its exceptional performance. However, it is considered quite risky by many investors due to its premium valuation, particularly now that the broad market is in a correction phase and the global economy seems to be losing steam. Therefore, the big question is whether the stock is likely to compensate its prospect shareholders despite its seemingly rich valuation.
First of all, the growth of Starbucks is nothing short of exceptional. To be sure, the company has grown its revenue and its earnings per share [EPS] at a compounded annual rate of 13% and 21%, respectively, in the last 3 years. In addition, it is expecting to achieve EPS growth 20% this year while it has a long-term target growth rate of about 15%.
The management also plans to open 500 new stores in China every year until 2021, as it believes that the demand for coffee will explode in the second-largest economy of the world. Even better, the company is present only in 70 countries, as opposed to most of the other well-known multinationals, which are present in almost 200 countries. Moreover, it is still in its very early stages in many of these 70 countries. Therefore, it has ample room for growth for many years or even decades as long as it maintains its perfect execution.
While there are high growth expectations from China, Starbucks is different from the other popular multinational companies, such as Coca-Cola (NYSE:KO), Pepsico (NYSE:PEP) and General Mills (NYSE:GIS), in that it has not reached a saturation phase in the US. More specifically, its same-store sales in the US increased 9% in the last quarter and hence the domestic segment of the company was the one with the best performance. Even better, there is still ample room for future growth in the US. To be sure, the company has not rested in the laurels of its more mature coffee market and has put great emphasis in diversifying its product mix. Consequently, while its morning transactions per US store have increased 22% in the last 5 years, its lunch transactions have climbed 30% and its afternoon/evening transactions have increased 19%. Clearly the company is trying to maximize its benefit from every store during the whole day.
Some investors are afraid that the recent excellent performance has resulted to a great extent from the depressed coffee prices. Indeed the operating margin of the company increased from 19.1% to 19.7% in the last quarter thanks to the lower cost of milk and coffee. Nevertheless, it should be noted that the price of coffee was twice as much in 2014 as it is now and the performance of the company was nothing short of exceptional even that year, as it achieved EPS growth 22%. Therefore, the management has proved that it efficiently hedges its input costs so that the earnings do not depend heavily on the commodity prices.
It is also worth noting that the company significantly benefits from the current environment of depressed oil prices. As consumers have received a great tax cut thanks to the bear market of oil, they spend a larger portion of their income in the coffee stores and elsewhere. Even better for Starbucks, the bear market of oil has proved much lengthier than initially expected and the supply glut is not likely to disappear this year. Moreover, whenever the price of oil rebounds, it seems that the numerous shale oil producers will put a cap of about $60-$70 on its price, as many producers will start raising their output at these levels. All in all, Starbucks is likely to keep benefiting from this essential tax cut of consumers for the foreseeable future.
While all the above are great features of the company, its most precious asset is probably its current management. Investors should not underestimate the importance of this attribute, as the history of the company has clearly demonstrated this. As long as Howard Schultz remains at the helm, the shareholders of the company have very little to be afraid of thanks to the above mentioned potential for future growth. On the other hand, as the history of the company has shown, if another management takes over and attempts to expand at an extremely fast pace without the required due diligence, the company may enter rough waters once again. All in all, the shareholders should keep a close eye on the succession plans of the management.
Finally, the major point of concern for most investors is the rich valuation of the stock. More specifically, while the stock is 10% off its recent peak, it is still trading at a forward P/E=30. There is a rule of thumb that a stock should not be purchased if its P/E is much greater than its growth rate (20%) so many investors will claim that the stock is not attractive right now. However, all the investors who have been waiting for a much cheaper valuation of this premium stock have missed its great rally. Moreover, investors should always remember the wise words of Peter Lynch; high-growth stocks compensate their shareholders particularly fast for the premium price they initially pay. More specifically, if Starbucks meets the analysts' estimates, its P/E will fall to 24 in one year and to approximately 20-21 in two years. Therefore, the stock is likely to return to a more reasonable valuation soon thanks to its significant growth. Of course, even better, as long as the growth prospects of the company remain exciting, the stock is likely to maintain its premium valuation and hence investors will probably reap profits that will be proportionally related to the EPS growth rate.
Nevertheless, the prospect shareholders should keep in mind that the stock may incur a steep correction to a more normal P/E ratio at any time. Thus they should be able to tolerate even a 33% temporary correction, from a P/E=30 to a P/E=20, if the broad market dives. Only those who can invest in the stock with a long-term horizon, without paying any attention to the short-term gyrations of the market, are eligible for purchasing this stock. Those who do not have a strong enough stomach to see their portfolio temporarily bleeding should stay away from this stock.
To sum up, while Starbucks has a very rich valuation at the moment, its high growth rate is likely to keep compensating investors for the premium price they pay. The company has excellent growth prospects for many years ahead and its management has proven its excellence in implementing its strategy. The only risk factor is a possible change of management in the next few years. As long as the current management remains at the helm, investors should stay the course and ignore the short-term fluctuation of the stock.
Disclosure: I/we 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.