Starbucks Still Too Expensive For Me

Summary

• Starbucks reported a decent quarter, but not enough in my opinion to justify the high multiple shares fetch.
• The brand deserves a premium valuation but should still trade at a reasonable level given growth expectations.
• We find what is a fair price for shares using DCF method.

Source:

Starbucks (NASDAQ:SBUX) has had a dismal few years. With slowing same store sales growth, multiple executive departures, and a maturing North American market, its shares have been under pressure. At some point, every great company begins to see its growth slow and its multiple compress. While I believe Starbucks is a great company and will have a great future, we need to find what a fair price for the shares are. We also should look for when might be the time to start a position based on fundamentals. Despite a strong quarter recently reported, this is the first in a while and needs to uphold as a trend for the shares to continue to move higher.

Starbucks Slows Down

The law of large numbers has taken its toll on Starbucks. We have seen what appears to be the maturation of the company in the past several quarters. While growth is still present, it is not at the levels it once was. Below was see a snapshot from the recent 10-Q.

A few positive notes first, revenue growth was 13.2%, shares outstanding decreased 12.5%, and a dividend increase of 20%, were all recognized year over year. While earnings growth was present, it was not that great of a change as operating expenses rose just as fast as revenue.

Deep within the 10-Q we find why operating costs have risen. Cost of sales as a percentage of total net revenues increased 400 basis points for the first quarter due to a food-related mix shift. Because food made up 18% of overall company sales up 1% year over year, they recognized higher costs. Also the licensing of the "Consumer Product Goods" division and "Food Service" division led to increased costs. What is interesting is that they continue to expand their food offerings to drive revenue growth, but overall this is reducing profit margin.

They also noted store operating expenses as a percentage of company-operated store revenues increased 60 basis points, due to increased wage expenses. While raising wages for employees is great, they tried to reduce operating expenses by lowering marketing spend 60 basis points. I would like to see a company with limited revenue growth continue to spend on marketing for a return, alongside increased wages. While it may be a well-known name, this has never stopped any company with brand recognition from continuing marketing efforts.

Overall Starbucks' net revenue grew 9% to $6.6 billion in the first quarter of 2019. This sounds great until we realize that 7% of the sales growth came from the 1,889 new stores Starbucks opened. The rest came from strong comparable store sales and the change in ownership of the stores in Asia. Operating margin declined 310 basis points to 15.3%. This was primarily due to licensing the "CPG" and "Food Service" businesses to Nestlé (OTCPK:NSRGY) and the sale of the Tazo brand.

The Americas revenue grew by 8% to $4.6 billion, primarily driven by 807 new store openings, which was 5% of the growth recognized. Comparable store sales growth of 4% made up the rest. This is a positive as it was the first time in a while that Starbucks reported stronger than expected comps.

China/Asia Pacific total net revenues for the first quarter of 2019 increased $384 million, or 45%. This was due to higher revenue from company operated stores. The increase in company-operated store revenues was driven by the impact of the ownership change in East China, as well as the 443 net new company-operated store openings. A 3% increase in comparable store helped the rest however; this is not that exciting and could become a problem in the future. The company will only be able to open so many stores to drive growth before sales growth really slows.

EMEA total net revenues decreased $2 million to $266.3 million, or 1%, for the first quarter of 2019. This was primarily due to store closures and foreign exchange headwinds. This has been an ongoing issue however and it will be interesting to see how the company will execute and drive growth going forward.

Starbucks has stated that it's going to try and regain momentum in America and China. The company is trying to focus on ways to increase the average dollar per ticket as a means to increase sales. While the company continues to see strong growth in its digital customer growth, it does not actually mean it is acquiring new customers, rather it is transitioning them to the way in which they pay. Alongside this initiative, it announced it is also going to focus on shareholder returns. As a company matures, it generally finds itself less able to generate an attractive ROI, instead it sees that it is time to start returning more of the profits to shareholders. This is a sign the company recognizes it is starting to become the staple it always wanted to be and will no longer see the growth it once had.

Based on the forecast by Starbucks for low single-digit comp sales going forward, I believe it is important to start valuing the company like a mature consumer goods company. While it may have future growth out of China and other emerging markets, it surely will reach its maturation point quickly. With Starbucks increasing its store count rather quickly, it will not take long until it has reached its limits within markets like China.

Source: Starbucks 10-Q

We can see that as of 12/2018, Starbucks had 4,682 company-owned stores operating in "CAP." With a plan to reach 6,000 stores in the Asia Pacific region by 2021 in, it will be opening approximately 600 a year for the next 3.5 years going forward. While this is going to be a great source of growth, we should be cautious due to the Chinese consumer having a strong sense of pride in their nationalism. With the recent trade war tiff, we could see a boycott of Starbucks' most aspiring growth region. This is something we need to keep an eye on, but I believe should be resolved sooner rather than later.

Same store sales are growing at a faster clip in China than the U.S., and I believe it will be this way for quite some time as the middle class grows stronger. Also, as the partnership with Nestle expands its sales of consumer packaged goods, the Chinese may grow more loyal to the brand. This could cause higher traffic and brand awareness at the store level for a freshly made product. As long as the trade war issues subside, this could be the best positive momentum generator for Starbucks.

Strong Yield, Doesn't Mean Buy Yet

With greater focus on shareholder returns, Starbucks increased its dividend with a 20% raise. The company increased its quarterly dividend to $0.36 a share or $1.44 annually. For new investors, this means the forward yield they can expect is about 2.1%.

Source: Yieldchart.com

With an average yield of 1.5%, investors would recognize a higher yield than normal. Now, while I am a fan of capital return to shareholders, especially growing capital returns, we must keep in mind why this is happening. Starbucks is now seeing less optimal use of cash within its business and to ensure investors are attracted to the shares, they must offer an enticing return.

In addition to the increased dividend, Starbucks is increasing its share repurchase program to make for a total return to shareholders of $25 billion through 2020. It is hard to calculate what the exact amount expected to be spent on buybacks versus share repurchases due to share count being reduced each year alongside dividend increases.

With 1.24 billion shares outstanding and a dividend payout of $1.44 for the next 12 months, this is close to $2 billion. Assuming a 20% increase next year to $1.72 annually, and a 20% increase the following year to $2.06 annually, we would see a total payout of about $7 billion for the dividend. The number of remaining shares authorized for repurchase as of December 30, 2018 totaled 96.8 million or approximately 7.8% of the outstanding shares.

Competition Valuation

Next, we take a look at some financial metrics to see what valuation we get in return for our purchase should we make one.

Data by YCharts

Starbucks is trading at a forward ratio above 25x earnings. I find this to be a bit high considering the company is reliant upon new stores opening for almost all revenue growth. I also believe that it being higher than the average for the past few years makes it an expensive time to purchase shares. That being said, it is in line with some slow-growing staples such as PepsiCo (PEP), Coca-Cola (KO), and Dunkin' Brands (DNKN).

Data by YCharts

The company clearly yields the least and trades at the most expensive valuation. A while back shares could have been purchased at a discount but the recent run-up in price has now made shares the most expensive of its peers.

DCF Valuation

For the DCF valuation, I used the following values:

Source: Moneychimp

The earnings for the last 12 months were $2.52. I expect earnings to grow around 7% annually in the following 3 years. With the growth slowing down thereafter to 5% and a discount rate set to take into account a possible recession, I lowered the typical 11% return to 9%, as we can see this gives Starbucks' shares a DCF of $69.86. Meaning the current price of ~$68 per share is near the fair value.

Conclusion

Starbucks is a wonderful company, and its brand is synonymous with coffee. Shares have pulled back and are starting to become compelling to those looking to start a position. There could be a better entry point down the road but currently shares seem expensive. If Starbucks doesn't start meeting or exceeding growth expectations then shares may start to fall back to earth. With a strong buyback helping the underlying stock and growing dividend prospects, Starbucks will become the next capital return giant.

Growth in the American market may be limited going forward, but I expect the Chinese market to help ensure there is revenue growth. With a valuation higher than average, higher than peers, and this lofty, investors need to see great results for the shares to stay up at current levels. A price pullback to the mid $50s would offer a great entry point in my opinion.

Analyst’s 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.