STARBUCKS (SBUX) – Great company still, but operating earnings are flat, and stock is expensive. Always has been expensive, but growth in earnings and cash flow is not what it was.
We have written a number of articles over the last two year, with excerpts provided below. We have consistently expressed our admiration for this worldwide brand, at the same time pointing out that the “easy money” has been made. We think it is no accident that the stock has done nothing since late 2015,in a trading range from the low 50s to the low 60s. While adjusted EPS increased from $1.58 in the year ending 9/30/2015 to $1.91 in fiscal 2016 and $2.06 in ’17. It is timely to re-examine our thesis, as the stock trades toward the high end of its two year trading range, during which it has underperformed the market, we believe with good reason.
Most Recent Results Support Conclusion
The following is a very brief summary. See our full writeup,
for more detail.
Fiscal Year ending 9/30/17 included consolidated net revenues up 7% (adjusted for the extra week in ’16), global comp sales up 3%, GAAP operating income down 0.9%, non-GAAP operating income up 7.8%. GAAP EPS grew 3.7% while non-GAAP EPS (which the Company and analyts prefer to use) grew 11.4% to $2.06 per share. Without reviewing all the multi-year trends, the growth in revenues has slowed 17% in fiscal 2015 to 11% in 2016, and of course much higher rates of growth prior to 2015. It is worth noting that China/Asia Pacific has built revenues at a 42% rate over the last three years (vs 9% in the Americas) and will continue to grow rapidly, but represents only about 14-15% of total revenues. With ’17 completed, management provided long term financial targets which included annual comp growth of 3-5%, annual net revenue growth in high single digits, annual EPS growth of 12% or greater.
After the first quarter, ending 12/31/17, was reported, showing consolidated revenue growth of 6%, consolidated same store sales growth of 2% (flat traffic), GAAP operating Income down 1%, and GAAP Operating Margin down 140 bp to 18.4%, the Company updated their fiscal ’18 guidance. They continue to expect 3-5% global comp growth, near the low end of the range and, and (with Q1 at 2%), obviously back loaded. Consolidated revenue growth will be in the high single digits (they say “consistent with long term guidance”). The HSD works out to 7-9% because they say that the 9-11% total expectation includes 2% from the acquisition of East China and other streamlining activities. Non-GAAP EPS is expected to be $2.48 to $2.53, vs. $2.06, which includes the effect of lower taxes (we estimate $0.25-$0.30) and stock buybacks. Subtracting $0.29 of tax effect from $$2.51 (the midpoints) leaves $2.22 vs $2.06 (up 7.7%), a large portion of which would be due to fewer shares outstanding. Suffice to say, therefore, that pretax earnings, and EBITDA, growth, will be modest, at best, and the most recent guidance, in total, implies short term growth at the low end of long term targets.
We have written a number of articles describing Starbucks over the last two years, describing the high valuation of the stock and the changing fundamentals, not all of which are necessarily positive.
Late in calendar ’15, we wrote “At 33x estimated forward earnings…… I view SBUX as priced close to perfection. As great as the year (’15) was, as great as a 9% same store sales comp in Q4 was, a slight slowing, which the company is indicating for the first quarter, and inevitable at some point anyway undermines new buying enthusiasm. Guidance has not been boosted, which is normally necessary for an upside run from this kind of valuation. Having said all that, strange things can happen in this market. My fundamental view is that the stock is “efficiently valued”, not a bargain…
On November 1, 2016, we wrote: “My observation, as a Starbucks customer and corporate fan, is that business is, if anything, slower than in the past. Nothing I hear or see indicates that the quarter ending 9/30 (’15) will encompass a positive Q3 surprise, or increased guidance going forward. The unforgiving environment can affect even a “best of breed” (by far) operator such as Starbucks. Almost any chart analyst would view the situation negatively, foreseeing a price breakdown. Combined with my fundamental view, I see no reason to be a hero here.”
On August 2, 2017, I wrote an article describing the changing business model at Starbucks, including the possibility of unintended consequences.
THE TIMES THEY ARE A’CHANGIN’
BARRON’S MAGAZINE this morning has a front cover entitled THE FUTURE OF COFFEE (AND RETAIL). The subtitle reads “Starbucks has succeeded where Silicon Valley hasn’t: changing the way consumers pay. The behavioral shift holds big promise for the coffee giant and its stock”.
Not exactly, in my opinion. It is not just about “the law of large numbers”, and the difficulty of satisfying investors by building on profit margins that are well above peers. The business model has changed, and the question becomes whether the new model will match the original. It’s well known that a new loyalty program bothered some customers and also that an increasing number of customers are ordering and paying online, often in advance of entering the store. In the most recent quarter, 30% of US transactions were paid using the smartphone app, up from 25% a year earlier and 20% two years ago. More important, to my view, is that 9% of US orders were ordered and paid for in advance. The company has been discussing the store level congestion for several quarters now, as mobile orders slow down service for customers going through the line. Perhaps it’s just me, but I am put off somewhat when the line at the register (where I like the human contact) is short, but I have to wait while eight or ten orders are pumped out ahead of my own.
MILLENIALS, WHO ARE THE SPENDERS, DON’T VALUE HUMAN CONTACT (AS MUCH)
It’s not so long ago that pundits dismissed the internet as a retail venue. The public was not expected to give out their credit card information, and certainly was not going to buy “touchy, feely” products like apparel or shoes through online channels. The public is not only ordering “everything” through Amazon and others, but relationships are maintained through Facebook and other social channels. As a corollary, customers are increasingly seeking “experiential” retail situations, rather than visit the malls, with their undifferentiated stores and restaurants, most often staffed with poorly trained employees.
WHAT’S IT ALL MEAN TO EMPLOYEES, AND CUSTOMERS?
Relative to Starbucks, their leadership with mobile order and pay, increasingly in advance of the store visit, may well be appropriate and necessary, but the business model has changed. It’s become a production challenge, not a relationship driven enterprise. The employed “people person” who was the star of the previous model, is not going to be as easily satisfied, because most of the employees, for most of their time, are busy pumping out product. It’s going to be harder to find someone as described above who says that Starbucks “is making me a better person”. From the customer side, there are 27,000 stores already existing that are already tightly configured and can’t be reconfigured too much to handle a lot more production. From a customer standpoint, some, like myself (perhaps in the minority these days), who value the human contact, may decide that the local independent shop, or even the home or office kitchen, can provide an adequate cup of coffee at a competitive price without the “tumult”.
I remember when Howard Schultz said that food will never be a material part of Starbucks’ sales. Today, it represents 30% of revenues. Schultz originally envisioned his coffee shops as a “third place”, to hang out other than home or office. That’s a little hard today, in a small busy shop, but we can call this an “unintended consequence” of building one of the still growing premier worldwide brands. Comps and traffic have slowed in recent years, due to the “law of large numbers”, the natural limitations of small stores that were not originally built to handle today’s volumes, and the evolving environment that every successful retailer must adjust to. Starbucks is one of the most successful retailers ever created, and we don’t doubt that they will continue to succeed in a major way. We caution however, that the rate of progress demonstrated in the past, already slowing, will be increasingly difficult to replicate. The business model has evolved. Starbucks was a retail “disrupter” but their previous approach may not be quite as successful. Accordingly, valuation parameters that have applied to SBUX equity in the past may not apply in the future. The stock chart that has languished over the last couple of years may well be reflecting the most likely future business model; still good, just not quite as great.
Lastly, on January 4, 2018, we wrote:
This is a very big ship, forced to navigate a continuing turbulent, competitive consumer spending environment. Growth in sales and earnings has slowed, and we doubt that EPS growth can be re-ignited, in large part due to the law of large numbers. To some extent, SBUX has become a “cash cow”, very profitable, generating still very high returns on capital, even if the base is growing more slowly. The shareholder base is transitioning to include long term value, and dividend, oriented, investors. In fact, SBUX has been in a trading range from the mid-50s to the low 60s over the last two years, with the stock’s valuation mirroring the slowdown in earnings (and EPS) growth. The corporate initiatives described below, further described by management on their conference call, are all necessary for further progress. Collectively, they can maintain corporate progress, and even move the growth rate by a few points, but we suspect that the days of high single digit comps (in the US) and 20% or better EPS gains are in the rear view mirror. There are now a large number of operational moving parts, not all of which will proceed smoothly. Furthermore, the business model is evolving, with possible unintended consequences, as discussed in our report of 8/22/17. Earnings reports in 2018, as predicted by management, will be muddied by one time transactions, so “adjusted earnings” will be a feature of their reports. Analysts and investors may not care much, if the current forgiving stock market environment continues, but tolerance for lots of adjustments will not be as high if the general market runs out of steam. A revised food menu is in the works but, even if food sales increase, non-coffee margins are lower, so earnings may not “leverage”. Starbucks is a great company, and will remain so, admirable in many ways, a great brand building example. The Company is one thing, the stock another. Investors can, and will, decide for themselves, what valuation is appropriate.