Starbucks: Bulls Vs. Bears

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About: Starbucks Corporation (SBUX)
by: SA Bulls & Bears

Summary

After much time in the doldrums, Starbucks' stock rallied this week when activist investor Pershing Square disclosed a stake worth $900 million along with a bullish outlook.

The sentiment is not shared by all Seeking Alpha authors, many of whom are skeptical about the company's growth prospects and view the stock as overvalued.

Much of the debate may hinge on Starbucks' prospects in China. Bulls are enthusiastic about the opportunity, but there have been a few missteps already.

Seeking Alpha's readership is, predictably, divided on the issue. The China question has attracted a lot of commentary.

Written by Nathaniel E. Baker, Seeking Alpha editor and contributor.

Starbucks Corporation (SBUX) shares received a much-needed jolt this week on news that Bill Ackman's Pershing Square Capital Management had invested $900 million in the coffee chain. Ackman called Starbucks "one of the greatest businesses in the world" when he revealed his stake at Grant's Fall 2018 Conference on Tuesday.

SBUX rallied more than 6% on the news, but Ackman's enthusiasm is not shared by everybody on Seeking Alpha. Indeed there is no shortage of bearish articles, making this a compelling entry in the Bulls vs. Bears series. In light of Ackman's call, let's take a look at the Pershing Square thesis first:

Bulls

  1. Starbucks has generated total shareholder returns of 26% the last 10 years, twice the S&P 500, but is trading at a "substantial discount" to its recent historical average, according to Pershing Square's presentation for Grant's conference. The company is a "category killer" in away-from-home coffee, has a loyal customer base, and is growing in all the right areas -- specifically, China. The value of the Chinese market "will become increasingly important" as it represents Starbucks' single-largest unit growth opportunity.
  2. There are three reasons that Big Ticket Fund Managers is optimistic about Starbucks, starting with the China story. Growth in the world's most populous country accounted for 8% of SBUX sales last year, with a 7% increase in transactions. The other reasons: the company is a leader in mobile technology (13% of total transactions are conducted over mobile, and that number is growing), and the dividend growth opportunity is compelling.
  3. The China market is also what has Nick Menard getting onboard with Starbucks. Revenues from China have tripled over the last five years and can be expected to grow 17% to 18% for the next five years. Management's efforts to improve net margins and focus on core markets -- as exemplified by selling the Tazo products line and closing Teavana stores -- should have a positive effect in the years to come. Finally, the company is committed to returning capital to shareholders through dividends and share buybacks.

Bears

  1. Recent gains in the stock price are unlikely to last, Mott Capital Management wrote on Oct. 4. Earnings and revenue estimates have been in decline since the start of 2018, same store growth is dwindling, and the stock is overvalued at a growth-adjusted PEG ratio of 1.36. Analysts have been cutting estimates and there will be more pressure to increase margins. "Starbucks has been a slowing growth story for years" and investors are "in denial."
  2. Starbucks "has been struggling with a balancing act that doesn't seem winnable," according to David Butler. The US market is stagnating and the Asia market is not yet big enough to offset these troubles. The overall trend in operating income portends more downside ahead -- to the tune of a share price south of $53 and as low as $45.
  3. SBUX has too many warning signs to warrant a premium multiple of 19 times forward EPS estimates, writes Stone Fox Capital. The exit of longtime CEO Howard Schultz is "a major problem" especially because the new CEO Kevin Johnson does not inspire confidence based on his track record. Starbucks "needs to be valued based on a suddenly questionable executive suite and not a premium brand with one of the best CEOs around," like when Schultz was in charge.

Conclusion

Bulls and bears agree the China story is key to the company's future growth. The most recent quarterly earnings report showed lower operating margins from China, a "concerning" sign for longtime SBUX bull Discount Fountain. "China is critical to Starbucks' success, and Starbucks has failed in the past when it comes to expanding into potentially lucrative markets," Discount Fountain writes, citing Australia as one example. "Ultimately, I would need to see a significant revival in operating margin from China to consider adding to my position in this stock."

Another bullish author, Faloh Investment, is also skeptical about the company's prospects in China. "I don't think Starbucks will have an easy time taking over the Coffee House business available in China like the company had taking over the U.S.," the author wrote in a comment. "Because everyone has seen Starbucks success and is trying to get a piece."

The "China question" captivates many readers. "I think I underestimated the differences/difficulties [in China] versus US market," admits David Harper. "I was surprised to hear SBUX China's CEO refer to cannibalization already in China [...] At a minimum, evidence suggests that China high accretion is maybe not a forgone conclusion."

One reader points to the parallel with Japan's process of becoming a coffee culture last century. "Business research on coffee has compared China’s import trends to those witnessed in Japan 50 years ago," writes StrategyDoc. While Japan now has an advanced coffee culture, "this process took 30 to 40 years in Japan, and China is still very much in the early stages of its coffee development."

Presumably, Ackman's research vindicates the China growth story for Starbucks. But the question remains what the near-term future might hold if and when China's economy cools in earnest.

Or maybe the China speculation is pointless? Are there other metrics that speak to SBUX's viability as an investment option? Have your say in the comments below.

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.