Starbucks: Underperforming Shares Have Long-Term Appeal

Summary

• Shares of Starbucks have traded down more than 20% year-to-date.
• COVID-related costs and inflationary pressures weighed on 1Q22 earnings and shares. However, these should be transitory, and SBUX's long-term investment thesis remains intact.
• Over the next 2 to 3 years, revenues should increase at or near the double-digit range on a combination of traffic growth, higher average ticket and unit expansion.
• This should drive earnings to the $4.65 range in FY24 from $3.40 this year. In turn, this supports a price target of $120, suggesting a total return of about 36%.

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Investment Thesis

Facing a handful of external issues, shares of Starbucks (NASDAQ:SBUX) have sharply underperformed the broader market in 2022, trading down more than 20% to their lowest levels since late-2020. Nonetheless, with the primary investment theses still intact, resulting in double-digit earnings growth driven by mid-single digits comparable store sales growth, Starbucks has plenty of long-term appeal. While investors may be facing a few quarters of turbulence as the company works through COVID-related labor challenges and supply chain issues that are weighing on margins and earnings, near-term pressures, especially as they relate to COVID, should result in post-pandemic margin and earnings opportunities. The stock currently trades at $91; we see significant upside to our $120 price target for investors who are willing to be patient.

Financials/Earnings

To better understand Starbucks' earnings opportunities, it's worth examining each of the earnings components, starting with revenues. The fact is, across most metrics, sales continue to trend quite strongly, and all indications suggest that Starbucks' top-line momentum should continue. First-quarter comparable store sales increased 13%, driven by 10% growth in traffic counts; North America comps posted an 18% increase on 12% traffic growth.

On the 2Q22 earnings call earlier this month, management reaffirmed FY22 total revenues in the range of $32.5 billion to $33 billion, on comparable-store sales growth in the high-single digits range. At the midpoint, this implies 12.7% growth year-over-year (and +39.3% over pandemic-influenced FY20 revenues). The company has plenty of levers to pull to meet its longer-term goals. Double-digit traffic growth is evidence that Starbucks has plenty of room to take additional pricing. And though the company has taken fairly aggressively pricing decisions in just the past three months, it is still favorably positioned relative to competitors. Moreover, there has been little, if any, pushback from customers to recent pricing actions. The Starbucks Rewards loyalty program, with more than 26 million members (up 21% year-over-year) driving 53% of U.S. sales in 1Q22, is reaping benefits, and current trends should continue. Beyond FY22, the combination of higher traffic counts and pricing should drive comps growth in the mid-single digits range or better.

Starbucks expects to add approximately 2,000 units in FY22, which, on a base of 33,833 stores at FY21 year-end, equates to unit growth of nearly 6%. Since 2Q19, SBUX has increased company-operated unit counts by more than 11% (and nearly 14% overall), suggesting a three-year CAGR of more than 3.5%. For a company of Starbucks' size, store growth on this scale is noteworthy - evidence that many of the markets in which it operates are still underpenetrated. China's unit economics remain strong as store expansion moves into lower-tier markets. This suggests that plenty of growth remains in that key market. International markets will account for the lion's share of unit expansion.

In summary, annual revenue growth approaching the 10% range would appear to be a reasonable assumption for at least the next two to three years, driven by mid-single digits - or better - comps growth (on a combination of higher traffic and average check) as well unit expansion in the low- to mid-single digits.

On the flip side, cost and margin pressures will be meaningful in FY22. But it is important to emphasize that many of the cost pressures are directly related to inflationary impacts as well as COVID-related issues (including sick pay/staffing shortages and higher training expenses). Indeed, management anticipates more than 200 basis points of margin pressure in FY22 from a combination of these factors. Thus, were it not for inflationary pressures and COVID, FY22 operating margin would be close to 19%, a nearly 90 bps improvement from 18.1% in FY21. As it is, inflationary pressures are likely to impact earnings beyond FY22. Again, SBUX's pricing power suggests that it is better positioned than many companies in the current inflationary environment, and pricing should mitigate some of these pressures, but not all. COVID-related cost pressures should begin to ebb in the coming quarters - although given the uncertainty surrounding the pandemic, the actual impact is difficult to predict. What does seem certain is that COVID-related expenses should be a relatively near-term issue, while inflation, though likely not a long-term impact, will take some time to work through.

For Starbucks, the bottom line is that margins are depressed and will likely remain so in FY22. But there is significant potential upside in FY23 and beyond. Earlier this month, management guided to an 18%-19% operating margin in FY24, which it pushed back from FY23 due to the aforementioned pressures. Assuming that COVID- and inflation-related margin pressures are in the 200 bps range in FY22, it seems quite likely that management's margin outlook is conservative and that margins could very well top 19% two years out - if, obviously, external cost pressures, including wage pressures, are more cooperative. If so, the combination of earnings growth and margin expansion should drive significant earnings growth at least through 2024 and likely beyond.

Valuation

We see Starbucks trading up to the $120 level within the next 18 to 24 months as EPS improves to $3.95 in FY23 and $4.65 in FY24. This represents a 32% upside from the current share price - or a 36% total return including the dividend (presently yielding about 2.1%). The target price is based on a multiple of 26x expected FY24 earnings, which is well within historic earnings multiples and shouldn't be a stretch, even if the current macro headwinds aren't fully resolved. Since 2017, SBUX shares have traded at an average multiple of approximately 37x current year earnings. Excluding 2020, when multiples were skewed higher by depressed EPS due to COVID shutdowns, that average is just under 30x, ranging from a low of 20x in 2018 to a high of 39x in 2021. Absent a prolonged period of inflationary pressures, including wage inflation, and/or global crises - which would also affect the broader markets - we are confident that Starbucks shares will trade at a multiple in the mid-20s range.

Peer Comparison

Starbucks faces plenty of competition in each of the markets in which it operates. But because its closest competitors are smaller, with limited geographic footprints, and mostly private, it has few direct, public company peers. That said, Starbucks' closest peers include restaurant chains McDonald's (MCD), Yum! Brands (YUM), and Chipotle Mexican Grill (CMG). SBUX, MCD and YUM each trade in the mid-20x range, approximately, as a multiple of 2022 earnings estimates. However, SBUX's earnings growth prospects over the next three years are arguably more attractive than either of its QSR peers. By comparison, CMG trades at a premium multiple - about 47x 2022 estimates - which, as a smaller company with a relatively less-penetrated store base, reflects its growth opportunities over the next several years.

Dividend

Starbucks initiated a $0.05 per share quarterly dividend in 2010 and has increased the payout every year since. The current quarterly dividend of $0.49 per share equates to a yield of about 2.2% and represents a payout of about 58% of our FY22 earnings estimate of $3.40, which is reasonable (and less than 50% of our FY23 estimate).

Risks

We would be wary of the global economy moves into a recession and inflationary pressures persist for an extended period. Efforts by store workers to unionize are a threat and could result in additional wage pressure. As always, the competitive landscape poses potential challenges. However, Starbucks is better positioned, financially (capitalization, scale) and operationally (pricing power, geographic diversity, management, product innovation), to face the challenges of the current environment than many of its competitors. But taking these potential risks into consideration, the risk/reward at $91 is attractive - arguably more so than at any point in the prior year or more.

Conclusion

Shares of Starbucks have recently traded lower on margin pressures, many of which should be transitory, including those specifically related to COVID. While inflationary pressures could linger, margins should improve over the next several quarters as sales continue to trend higher, driving double-digit EPS growth in FY23 and beyond. If so, SBUX should trade up to the $120 level, which implies a total return of around 36% over the next two years. And if shares trade lower due to COVID, inflation and/or global crises, the long-term opportunity should be that much more attractive. Based on the expected total return, shares of SBUX are a Buy at current levels.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.