Starbucks Makes A Great Latte, But Is It A Great Business?

April 13, 2018

Starbucks Makes A Great Latte, But Is It A Great Business?

  • The key is to determine whether SBUX is a great business and if there is more room for growth.
  • SBUX might be the best low risk way to invest in China.
  • A recession is something to keep in mind, plus there are other risks.
  • A look at the price tells a lot about the stock here.



Introduction

I still remember very well how I was looking for stocks to buy and contemplating whether to buy McDonalds (NYSE: MCD) at $19 in September 2002. I was happy I didn’t buy as the stock dropped below $13 by December of the same year on the first announced loss, profit warnings, broken growth story, the CEO leaving, and restructuring costs.

It wasn’t a great picture for MCD at that moment. Fast forward 16 years, and you are looking at a 10-bagger investment with amazing dividends where the current dividend is almost 25% of the $19 price where I was watching MCD at.

Figure 1: MCD long term stock price. Source: MCD.



Fortunately for me, I did find some better investments at the time but MCD was still a really great investment as it had a great brand, strong customer base, and addictive products which were a healthy base for the restructuring process that delivered the seen growth.

A company that might be in a similar situation now is Starbucks (NASDAQ: SBUX) which I want to focus on today. I’ll try to estimate where the company will be in 10 and 20 years to see whether it’s a good investment now or if it’s at least a stock to watch.

We all know the company is still growing, the business model is proven, and it might just be a great business. When you find a great business, the price doesn’t really matter in the long run, just as was the case for MCD at $19. SBUX isn’t in much better shape than MCD was in 2002.

SBUX – How Much Room For Growth Is Left?

SBUX grew revenue at 6% in Q1 2018, and 2% comparable growth in the U.S. which isn’t something Wall Street is thrilled about. However, the U.S. is just half of Starbucks as almost 50% of the company’s business is outside of the U.S. The key to SBUX’s international growth is China.

SBUX has 3,200 stores in China today and plans to have 5,000 by 2020. Comparable sales growth in China is 6% which shows that SBUX is gaining traction there and the trends SBUX is focusing on are the increased middle class and a western lifestyle where coffee is a substitute for tea.

Figure 2: SBUX’s China offensive. Source: SBUX.

It’s difficult to put a number on the above figure, but let’s just estimate that the growth will continue over the next decade as has been the case in the last few years. This leads us to SBUX’s long term targets which see earnings per share growth at 12% or more and a return on invested capital at 25% or higher.

Figure 3: SBUX’s long term growth estimations. Source: SBUX.



Let’s be a bit conservative and put an 8% growth rate on SBUX’s current earnings as there will be a recession sooner or later, China will inevitably slow down, and Europe will have its issues as well.

SBUX’s Long Term Earnings

SBUX’s estimated earnings for 2018 are in the range of $3.32 and $3.36 giving a 2018 forward PE ratio of 17.75 which isn’t that high for such a growth story. The 2018 earnings would represent growth of 10% on the 2017 earnings which is above my conservative estimate. The company expects to have a return on invested capital of above 25% which is one of the most important metrics Charlie Munger likes to use because if a company can continue to keep such high ROIC metrics, it’s bound to deliver good returns to the shareholder.

Given the PE ratio of 17.75 and the growth of 10%, as long as SBUX grows at that rate, you can expect a 10% return on your investment as earnings will probably double in 7.2 years and if the valuation remains the same, the stock price should double too. Let’s take a look at what could go wrong.

The Risks Of Investing In SBUX

The main risk for SBUX is a continuation in the U.S. slowdown where the company doesn’t manage to rebrand itself and achieve further growth. There are two ways you can look at it, as a disaster and what I have learned from various examples of which one is Skechers, analysts have an overweight focus on what is going on in the U.S. even though it’s just 50% of revenue. If SBUX manages to remain as profitable as it is now and keeps earning money, it might be still extremely good at the current valuation.

The second risk is that the Chinese story doesn’t turn out that well.  SBUX has about 14,000 stores in the U.S. which makes one store per 23,000 inhabitants. The ratio in China is currently at one store per 445,000 inhabitants. However, if you put that into an economic purchasing power perspective, the Chinese market could be just 15% of the U.S. market for a while where there wouldn’t be much to expect over the short to medium term.



The Global Picture

The U.S., which most analysts are focused on, is just 5% of the global population while SBUX is becoming a global brand. There will be competition, there will be up and down years based on successful or unsuccessful product launches, but the company should manage to grow earnings at let’s take a rate of 7% over the next 10 years, which should be possible given that the world is big and there is much more room to grow, even if comps remain flat.

What I see with SBUX is a stable growth at a fair price business with high returns on capital and high cash flows for a long time to come. Will it be a 10-bagger in the next 20 years like MCD was? Well, it’s possible if earnings continue to grow at 10% over the next 20 years and after that, there is a 25 valuation. However, to be more realistic, the risk that SBUX is below the current price in 10 years is fairly low which is something I value in this market.

If valuations stay the same and earnings do grow at 10%, the stock price should double in 7 years which is a good result for a lot of people. If there is a recession but SBUX still manages to remain cash flow positive, profitable, and pays a dividend, you know that with the next leg up, you will have a big winner.

The fact that the stock price remained stable over the last few years shows how it was perhaps overhyped in 2015, but the fundamentals kept improving and the company kept growing. Sooner or later, the price will again be in correlation with fundamentals.

Figure 4: 5-year SBUX chart. Source: Seeking Alpha..

See how this fits your portfolio. Sometimes the best investments are just below our noses and smell like coffee.



By Sven Carlin Investiv Daily Starbucks Sunday Edition Share: