Starbucks Valuation: When To Catch This Falling Knife

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About: Starbucks Corporation (SBUX), Includes: AAPL, MCD
by: Cory Cramer
Summary

Starbucks is in transition and management is, at least publicly, in denial.

I view Starbucks' stock as a cross between Apple and McDonald's.

It attracts the same sort of investors that Apple does and also sells a higher-end product like Apple, but it has the branding and global restaurant footprint of McDonald's.

Thinking about the cycles that Apple and McDonald's have gone through, and comparing them with Starbucks' historical cycles can provide a guideline for investors.

Based on history, Starbucks stock could fall farther, but it will be a solid investment opportunity if and when that happens. I list the prices I'll be buying Starbucks at.

Introduction

It doesn't happen very often, but every now and then, finicky investors over-react and send a well-followed large-cap stock to the bargain bin. And while there is something to be said for "investing in what you know," I've found that in cases where persistent negative narratives around a shifting growth profile of a great company push the stock price down, having some distance between both the company and the stock can help provide a degree of detached clarity for investors.

It helps, in these cases, for a potential investor to put themselves in the shoes of recent shareholders as best they can and try to estimate what their motivations might have been for buying the stock. We can never be perfectly accurate when trying to ascertain what other investors are thinking and there is no metric that we can examine that will tell us that. But understanding investor sentiment can be a particularly helpful exercise after we've seen a widely followed large-cap stock like Starbucks (SBUX) fall 20%, because, every now and then, group behavior can get overly irrational, especially if the media is helping fan the flames.

I've never been in a Starbucks store nor do I own the stock yet, but I see a lot of similarities in shifting investor sentiment that I saw with Apple (AAPL) stock in 2013. That ended up being a great investment opportunity for me even though I wasn't an Apple 'fan' at the time. This article will examine some of the similarities I see between Starbucks and Apple stock, as well as some of the differences, and how investors might use these comparisons to determine the best entry point for the stock.

Starbucks Similarities to Apple circa 2013

I have never owned a single Apple product, and I still don't own a smartphone. Until 2013, I never owned or followed Apple stock. I was as detached from Apple the company as anyone could be. And I think from an investing standpoint that ended up being a good thing.

Chart AAPL Total Return Price data by YCharts

From the March 2009 bottom until September of 2012 Apple stock rose nearly 750%. A great deal of that rise came during the first 2/3rds of 2012 alone. One has to ask themselves: what type of investors was gobbling up the stock during that 2012 period? My view is that after Apple rose 125% per year for three years straight, and iPhones were continuously flying off the shelves, a large group of investors assumed that Apple sales would move in a straight line, upward, exponentially, forever. Another group probably saw the great performance the past few years, loved Apple's products, and saw an opportunity to get rich quickly.

While I can't say for sure what motivated every investor, what I can say for sure is that they were very finicky. They expected Apple's earnings and stock price to rise largely in a straight line. So, when earnings contracted a little bit, lots of these investors sold when their unrealistic expectations were not immediately met. At the time, the media and a variety of analysts piled on, one after another predicting that Apple had reached peak iPhone growth etc. In addition to this, stories were running about how Apple was employing slave labor in China to make its products and nets had been installed to prevent workers from jumping to their deaths out of factory dormitory windows because working conditions were so bad.

These stories are important because Apple produces 'feel good' premium products. I believe there is a sense of pride and belonging for many Apple consumers that is derived from using Apple products. There are other companies that produce less expensive products that are fairly similar to Apple's, but that fact is, these competing products don't produce the same feelings among their users that Apple's do. Those feelings, however, can become undermined when owner/users start thinking about the Chinese slave labor that went into producing those products.

There are certain stocks that benefit from a cult-like consumer following. In these cases, I think consumers first fall in love with the products, then the company, then the stock. And if the stock price keeps rising, it reinforces this cycle and these feelings. There is no better company than one you can feel good about using their products, supporting their company, and getting rich from their stock, all at the same time. But companies with these dynamics can crack in different ways than other stocks, and if a perfect storm comes along that undermines all these supports at the same time, then it can be disastrous for the price of a stock. And that's what happened to Apple in 2013.

By 2013, Apple had gone a while without putting out a new iPhone or other blockbuster product, Steve Jobs had been retired for over a year, earnings had fallen a bit, competition was getting better, the news media had made Apple out to be both an exporter of US jobs and user of slave labor. By the summer of 2013, the stock price had fallen over 40%. At this point in time, Apple was trading at a P/E of 9 and so oversold that even someone as disconnected from Apple as me could see it was a great value.

Chart AAPL data by YCharts

The chart above is from the calendar year 2013, and at mid-summer, I was able to buy Apple for my daughter's account at a cost basis of $59.93. The stock has done very well since then:

Chart AAPL Total Return Price data by YCharts

At this point, you may be asking what does this have to do with Starbucks? And my answer to that is I think Starbucks and Apple attract a similar profile of investor. Starbucks offers a premium product around the world just like Apple does. I think many Starbucks shareholders enjoy Starbucks' products and the experience they have in the stores and it makes them feel good being associated with the company. Starbucks has a strong association with its founder Howard Schultz just like Apple does with its celebrity founder Steve Jobs. And frankly, these are some of the few corporations that left-leaning Americans seem to like owning the stock of. Schultz has been a master of public relations as much as he has been a great businessman when it comes to making Starbucks a 'likable' company.

Unfortunately for Starbucks shareholders, Schultz left the company this month, right on the heels of a public relations fiasco, and just as Starbucks' growth appears to be waning. To make matters potentially worse, Schultz may be considering entering the political area, which could unnecessarily politicize Starbucks even more than it already is. So, much like Apple in 2013, Starbucks is seeing cracks in the virtuous circle with shareholders it has built since the Great Recession. When Starbucks customers think about the Philadelphia incident, they may no longer feel as good about their purchases; when the founder of the company is leaving, shareholders may no longer feel as confident about its future; when growth is slowing they may no longer think of Starbucks as a long-term growth stock; and when the price falls nearly 20%, they may no longer think Starbucks can make them rich.

Similarities to McDonald's

Quite often in the comments section of various articles, I'll see commenters compare Starbucks' stock to McDonald's (MCD). And, I think there is some validity in doing so. There are few global restaurants/eateries that have the ability to scale globally like McDonald's has done, and Starbucks is one of those few. Additionally, many investors remember how McDonald's stock was left for dead in the early 2000s, and they also remember McDonald's stock slump from 2012 to 2015 where for three years the stock price went nowhere while the rest of the market rose. The tone of these comments that compare Starbucks to McDonald's is generally one of optimism for the future of Starbucks' stock price. And I think part of that has to do with the fact McDonald's stock has risen over 25% per year since it broke out in October of 2015:

Chart MCD Total Return Price data by YCharts

The general feeling is that Starbucks has the same potential and that structurally it faces the same sort of challenges that McDonald's has faced over the years.

All that said, I think those optimistic about Starbucks' future stock price might be overlooking important differences between both Starbucks and Apple, and Starbucks and McDonald's. And those differences, combined with Starbucks's historical price fluctuations, make Starbucks's stock look much less attractive at current prices than one might initially think.

Key Differences

The key difference between Apple circa 2013 and Starbucks circa 2018 are the stock multiples. Even though I think the general investing dynamics behind Apple's 2013 price drop and Starbucks's 2018 price drop are similar, in the summer of 2013 Apple was trading at a P/E under 10. Depending on what method of P/E you prefer to use, Starbucks is trading between 16.8 TTM and 22.1 blended P/E right now.

Anyway that one wants to measure it, Apple stock was trading at a valuation around 50% less in 2013 than Starbucks is now. And I don't think those who think China is going to provide significant future growth for Starbucks can argue that Starbucks' potential growth in China is greater than what Apple's growth potential in China was in 2013. The fact is, Apple was a no-brainer value in 2013, and that simply is not the case with Starbucks here, even if we value it using a 17 P/E multiple. So, even though both Apple and Starbucks sell higher-end products and Starbucks is going through similar investor sentiment that Apple did in 2013, it isn't clear to me that Starbucks' stock at its current price offers the same value that Apple's did.

With regard to comparisons to McDonald's, I think optimistic investors are cherry-picking what they want to see regarding this comparison. They want to see a mature global restaurant company that was once left for dead, and once traded sideways, that is now trading at a relatively high valuation and assume the same thing could happen to Starbucks. There are two key differences these investors don't appear to be taking into account, though. The first, is once again, valuation. The second is the type of customers each of these companies caters to.

With regard to valuation, it's important to point out that during McDonald's sideways move from 2012 to 2015 it traded with a multiple between 15 and 20:

Chart MCD P/E Ratio (TTM) data by YCharts

And most of MCD's price movement since then has been multiple expansion up into the mid-20s. The Starbucks optimists see this sort of multiple on a mature company like MCD with a similar global footprint and ask Why not Starbucks? But when Starbucks traded sideways, it did so at a much higher multiple than McDonald's did:

Chart SBUX data by YCharts

From mid-2015 until the January 2018 Starbucks was fairly range-bound, trading in between $50 and $60 per share, while the P/E ranged from 27-37, roughly double the multiple McDonald's was trading at when it went through a similar sideways trading pattern a few years earlier.

So, once again, like the comparison with Apple, we see that Starbucks' sideways move occurred with a much higher valuation than McDonald's did.

The McDonald's comparison we should be making

There was a time in McDonald's history when it did carry the same sort of ultra-premium valuation that Starbucks recently has, and I think that time period is instructive for potential Starbucks investors to look at.

Chart MCD P/E Ratio (TTM) data by YCharts

From mid-1998 until 2000 McDonald's stock traded at a very similar multiple premium as Starbucks has recently (in the upper 20s to upper 30s), then, from its peak in 1999 until 2002 the multiple contracted back down to historic norms in between 15 and 20. Here is how MCD stock performed during that contraction:

Chart MCD data by YCharts

Yes, that's an over 70% drop in McDonald's stock over the course of about four years. And if Starbucks' stagnation carries into the next recession then this sort of decline for Starbucks' stock is a very real possibility.

Starbucks' Historical Cyclicality

I have three main factors I use when trying to determine good entry points for stocks: historical price cyclicality, historical P/E ratios, and where I think we are in the business cycle. There are many more factors I consider before actually buying a stock, but when it comes to estimating price, these three factors really help narrow my research down to a handful of potential purchases. Thus far, I've mostly discussed historic P/E ratios and how they relate to similar companies. Now, since Starbucks has been around for a few decades, I'm going to take a look what kind of price cycles Starbucks itself has experienced in the past in order to use those as a potential guide for the future.

Those readers familiar with my research will recognize the table below. It contains historical data on all of the downturns deeper than 30% Starbucks' stock has experienced since it was a publicly traded company. The table shows the approximate year the downturn started, how long the stock took to bottom, how long the entire downturn lasted before the stock fully recovered, and how deep the drawdown was from peak to trough. While it's important to keep in mind that companies change over time, I've found that past price cyclicality, when placed in the proper context, can be a good guide for what to expect in the future. At the very least, it lets investors know what sort of downside is possible for a stock.

~Year ~Time Until Bottom ~Duration ~Depth
1998 3 months 12 months 47%
1999 3 months 12 months 48%
2000 2 months 7 months 37%
2001 10 months 18 months 43%
2007 2 years 4 years 78%

Starbucks has mostly been a high growth stock, and during the late 1990s and early 2000s it experienced some moderate volatility during a time when the market was experiencing a downturn and the economy was in recession. While the volatility was high-frequency in nature, it wasn't particularly deep given the macroeconomic environment and the high multiple at which Starbucks was trading at the time. What's more interesting is the 2007 decline. As we saw earlier with McDonald's, when Starbucks experienced multiple contraction at the same time the economy was experiencing a recession, the stock saw a decline in value of over 70%. If an economic slowdown started tomorrow, I would expect this sort of decline again. So the stock could have much further to fall than the 20% we've seen so far.

CEO Intangibles

As a general rule, I don't usually let my opinion about management and media coverage take center stage in my analysis. While I try to avoid incompetent or corrupt managers I focus most of my attention on factors that are more quantitative rather than qualitative. That said, Starbucks is a situation where I feel it is necessary to give an even-handed analysis that cuts through some of the media's coverage of Starbucks during this recent decline, as well as Starbucks' convoluted response.

By the time this article is published, celebrity CEO Howard Schultz will have fully left Starbucks. It won't be the first time. He left in the year 2000, only to return in 2008 after Starbucks stock had tanked over 75%. Last year, he turned over the CEO job to Kevin Johnson, but remained on as chairman for this past year. There has been some speculation that Schultz will enter the political arena, perhaps running for President.

With that brief context in mind we turn to Starbucks's recently lowered growth projections and Kevin Johnson's disastrous interview with David Faber and Jim Cramer on CNBC last week. The interview is 15 minutes long and can be watched in its entirety here, but I'm going to take you through my interpretation of some of the interview because it was quite telling when seen through the correct lens.

David's first question to Kevin Johnson was "Is Starbucks a mature company?" The context for this question was that same-store sales were only projected to grow 1% near-term. Now, folks, this is a simple question with a simple answer, and the answer is: Yes! Starbucks is a mature company with 28,000 stores around the world, but like many mature companies, it can still find ways to innovate and grow for many more years.

That's my answer. It's both honest and optimistic. Here's Kevin Johnson's answer:

What we talked about yesterday was really something we have been working on this last year, which is fundamentally streamlining this company over this last year so that we could focus on the most important priorities. And those priorities are going to allow us to transition into a phase that I call growth at scale.

Okay, let's stop right here for a moment. First, Johnson dodges a very simple question about whether Starbucks is a mature company. Then he claims he has been "fundamentally streamlining" the company. What does that mean? Fewer products? Fewer employees? Fewer stores? Who knows? At one point, later on, he talks about how they have made the barista's job a little easier, but that was the only reference to any real "streamlining", and those types of efficiency results are something that should have already moved to Starbucks' bottom line and been reflected in its earnings. So this is mostly a meaningless statement. Then he follows it up with a "phase" he calls "growth at scale." What on earth does that mean? It should be obvious to anyone that with a company the size of Starbucks anything that it does is going to have to be done "at scale." Duh. Putting the term growth in front of "at scale" actually makes the term non-sensical at worst, and utterly obvious at best. Any sort of growth at that occurs at Starbucks is going to have to be "at scale" and any growth that has ever happened at Starbucks during the past two decades of the company has been "at scale." Mr. Johnson continues:

Starbucks was founded in 1971. So over the last 47 years we have built an iconic global brand, 77 countries 28,00 stores around the world serving nearly 100 million customers a week. And so now at our scale we've got to be much more disciplined in setting our priorities. We have to be more data-driven in how we are allocating resources and tuning the model. And we have to be more agile as innovators. And so what we did yesterday was set the stage for that transition to a company that's really focused on growth at scale.

At this point, David does a great job of trying to get a definition of the nonsensical term "growth at scale", and asks "Does growth at scale mean not the growth that Starbucks and Starbucks investors have come to expect previously?"

I won't quote Johnson's long, convoluted response to this extremely simple question, but basically, it involved the fact that they were still planning to open several hundred more stores, especially in China. I don't know why opening up new stores in China requires a nonsensical term like "growth at scale" and a whole "new phase" for Starbucks other than to mask the fact that Starbucks is indeed a mature company. Which, honestly, anyone who can do basic math should be able to figure out. As David pointed out in the interview, there are more Starbucks stores than there are McDonald's. Starbucks is a mature company with a great brand and it should be valued as such by investors.

After a couple more questions from David, Jim Cramer chimed in with some 'questions.' Here is the first one:

Okay, good morning. Stock's down two bucks, gotta take a little bit different narrative here. You came in in April of 2017. There have been four quarters that you have been presiding over. On three of those four quarters you have cut your forecast. You're from Juniper. You understand technology. You know this isn't right. Kevin how could you be three out four cutting your forecast. Kevin you would be furious at yourself. I don't hear you even being upset.

There is a reason I rarely watch the news, except to get a feeling for what current narratives are being tossed around in the media. Jim Cramer's almost incomprehensible statement isn't even a question, but if it was rephrased it would be "Why aren't you upset you've had to lower your growth forecasts?" The real answer to this would be 'Schultz set expectations far higher than we could actually achieve and set me up to disappoint shareholders.' But, come on, we can't expect Johnson to get on CNBC and badmouth Schultz, even if it would have been the truth, so he gives another meaningless answer. Then we get this from Cramer:

Okay, Kevin, one of the things I want to see more than anyone in the world other than maybe you and Howard is a bottom in this stock. I am not asking a question. I am giving a statement and you can refute it. How can you reach a bottom in this stock when you maintain a long-term growth rate of 3-5% which now seems unrealistic because of cannibalism and because of a slowdown in China. Why not just say we are scrapping that long-term? We can't get a bottom until you do that. You and I go way back. That's what we know about stocks!

Once again, Jim gives us a ridiculous question, and I suspect Jim's frustration comes from him buying into Schultz's high growth forever narrative and recommending buying Starbucks stock on his show. When Jim interviews Howard and then tells people Starbucks is a 'buy, buy, buy!' he looks stupid when the stock tanks. But the fact is, the stock performance is not Kevin Johnson's problem. His job is to run the company. It's not his fault investors overpaid for Starbucks' stock under Schultz's reign because they bought into the high-growth-forever narrative and bought Starbucks' stock at a 35 multiple. But, of course, Johnson doesn't say that because he isn't in a position to talk-down the company's stock price.

To make this whole exchange even worse, after Starbucks' stock tanked even more than it already had, Schultz took the time to e-mail Jim Cramer the next day and talk up the prospects of Starbucks' future and defend his successor. It was sort of like a child's parents going into the principal's office to defend them from some transgression their school had accused them of.

So, why is all this important?

The main reason why this is important for potential investors is that we have to realize that 1) Starbucks is a mature company, 2) The stock has been carrying a 'Schultz' premium with regard to its recent valuation, and 3) Nobody at the company is going to openly admit this because it would drive the stock price down and they have strong personal incentives not to do that.

Putting this all together

If we accept that Starbucks is a mature business with a strong brand then the simplest way to value the company is by using the long-term historical average valuation for these types of companies which is a P/E multiple of 15. Buying a company like Starbucks at 15 multiple should produce good long-term results that are at least in line with the broader market. If Starbucks comes up with a hot new product or steps up their use of technology, it could outperform, and if it experiences more Philadelphia-like issues, then it could underperform. But I think a 15 multiple is a solid reference point for purchasing the stock.

I used Y-Charts and a TTM P/E previously in the article because their data goes back a little farther than my preferred P/E calculation, which is the blended P/E used by F.A.S.T. Graphs. The blended P/E takes into account the most recent actual earnings results and blends them with analysts' near-term expectations. So it's a blend of both solid backward-looking numbers and forward-looking numbers. I like it because it smooths out the ratio a bit. Currently, there is a big discrepancy between the TTM of 16.8 and the blended P/E of 22.1:

This F.A.S.T. Graph can be very informative in Starbucks' case because we can see the relatively high 'normal' P/E of 30.9 Starbucks has averaged the past couple of decades represented by the blue line on the graph. This is the multiple of a high growth stock. The orange line tracks where the stock would have traded if it traded at a multiple more indicative of a mature company of 17.3 (a bit higher than my estimate of 15). As we can see, the black line representing the price of the stock has started to move from the blue-line-trend, toward the orange line, a move that is what we might expect from a maturing company where growth is slowing. Also note, the price has a lot farther to fall before it touches the orange line. At current earnings, it would need to be priced at $41.62 to hit that 17.3 blended P/E ratio. Excluding the Great Recession, previously Starbucks experienced several price declines in the 37-48% range. If it were to experience that sort of decline again, the price would range from $32 to $39 per share. If we use a more traditional 15 blended P/E we would be looking at a price around $36.

So assuming we get a full shift of investor sentiment that values Starbucks as a mature, but strong business, I think a fair price range to expect is $32-42 per share. I would be inclined to make my first purchase of the stock at the high end of this range around $42 per share, provided the stock hits that price while the overall economy is still strong. Starbucks will continue to buy back shares and pay a good, and growing dividend, which could prop up the price some. And I actually like that Kevin Johnson plans to focus on running an efficient, data-driven business. Despite his inability to announce Starbucks is a mature company, operationally, he is treating it as such, which is a good thing. He'll never be as good of a stock promoter as Schultz and we can't expect him to produce the sort of multiple premium Schultz was able to produce. But as long as we buy the stock at a good price, we don't need Johnson to do that. We just need him to do a good job running Starbucks, and to keep his commitment of returning value to shareholders via buybacks and dividends. But in order for this to be a good value from an investor's standpoint, I believe the price of the stock needs to come down first.

Now, the above estimates assume there isn't an economic downturn occurring. If there is, it's important to recognize another important difference between Starbucks and McDonald's. In Kevin Johnson's interview, he stressed his focus on the higher-end consumer and essentially that he was not interested in pursuing the lower end. That approach is fine, but investors must realize that along with that approach comes much more volatility during times of economic distress. During the Great Recession, Starbucks' stock lost over 70% of its value and its earnings fell, while McDonald's stock and earnings did exactly the opposite. McDonald's has the potential to do that because they are selling lower-priced products. If we have another recession (and I think we probably will within the next 2-3 years) then we can expect Starbucks' share price to fall much farther than $42 per share. I think there is a very high probability that during an average recession we could have an opportunity to buy Starbucks' stock at $25 per share.

Those readers who have read my previous work know that I like to have two potential entry points for stocks. Those entry points for Starbucks are $42 and $25 per share.

Conclusion

Starbucks stock should be expected to lose both its 'Howard Schultz premium' and its 'growth stock premium.' The new CEO Kevin Johnson seems to understand this and is taking reasonable actions to run Starbucks like a mature company even if he can't publicly admit he is doing so. Using historical estimates of other mature companies and examining previous Starbucks' drawdowns, I think $42 is a solid entry point for medium-term investors. If we experience a recession or serious economic stagnation, I think there is a good chance Starbucks stock could see $25 per share and I would buy additional shares at that price.

Essentially, what I expect to see from Starbucks is a big turnover in the type of investor who owns the shares. I expect to see short-term investors, Howard Schultz admirers, and growth-oriented investors exit the stock over the next couple years. But eventually, when the price gets low enough, we'll see value investors, income investors, and long-term business-oriented investors take their place. That is what we have seen with Apple over the past five years. Just because a company is mature doesn't mean the stock can't be a good investment, and once the price is right, Starbucks' stock will attract better shareholders and hopefully that will allow Kevin Johnson to be able to focus on running his company, rather than trying to prop up the stock price the way his predecessor did.

Disclosure: I am/we are long AAPL. 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.