Starbucks (SBUX) shares have been mild laggards thus far in 2014, in what is shaping up to be a choppy year for the U.S. equity market. But we attribute the relative underperformance to investors’ profit-taking, rather than to any deterioration in the company’s fundamentals. On the contrary, Starbucks looks to be back in a strong growth mode after struggling a bit (by its lofty standards) during the 2007-2009 recession. And prospects remain bright, with share net now set to climb 19% in each of the next two years, to $2.68 and $3.20, respectively. (Fiscal years end on the Sunday closest to September 30th.) Should investors take advantage of the current entry point to build positions in this unique, well-run restaurant outfit? Or is the issue still too expensive to get excited about? In this article, we will attempt to address these questions by taking a brief look at Starbucks’ business and performing an easy-to-follow SWOT analysis of the company, evaluating its Strengths, Weaknesses, Opportunities, and Threats.
Starbucks, founded in 1971 and based in Seattle, Washington, is the largest coffee retailer in the world, with over 20,500 locations in 62 countries, about half of which are company-owned and half of which are licensed. The restaurant chain also sells a variety of coffee and tea products, and licenses its trademarks, through other distribution channels, including grocery and foodservice accounts. Apart from the recognizable Starbucks label, products are marketed under the Teavana, Tazo, Seattle’s Best Coffee, Starbucks Via, Starbucks Refreshers, Evolution Fresh, La Boulange, and Verismo brand names.
Industry Leading Comps: Starbucks’ greatest strength, we think, is its ability to deliver robust (and consistent) same-store sales growth, even against a sometimes-challenging consumer spending backdrop. This is especially true in the core U.S. market, where comps advanced a better-than-expected 6% in the March interim. We see the momentum persisting well into the future, too, as the company focuses on product innovation, and leverages its digital payment/advertising capabilities and customer loyalty programs. New products, partially aimed at boosting traffic during slower daytime parts (e.g., evenings), are apt to include hot meals, new teas and carbonated beverages, and select beer and wine offerings. A further national rollout of La Boulange baked goods, which have been very well received, is also planned. And an extension of the Evolution Fresh juice brand, acquired in 2011, is also in the works.
Excellent Finances: The company, thanks to those impressive comps and an effective leveraging of fixed overhead costs, like rent and labor, maintains robust free cash flow and a first-rate balance sheet. This supports product development and aggressive unit expansion, both at home and abroad. It also enables Starbucks to pay a modest dividend, with the yield typically hovering around the 1.5% area.
Big Investment Spending: The company spends a lot of money to develop new products, build out its infrastructure abroad, and penetrate new distribution channels. This has not been a notable problem during past years, but it means that a profit squeeze would be quick to materialize if same-store sales growth slows considerably. The high spending levels may also explain why Starbucks does not pay shareholders a heftier quarterly dividend.
Uneven International Profitability: Some of the company’s overseas territories have yet to reach critical mass, and are not nearly as profitable as the core domestic market. Starbucks has also had some struggles in Europe, where the sovereign debt crisis and ensuing belt-tightening measures have taken a toll on sales.
New Distribution Channels: While the retail business is humming along, Starbucks is endeavoring to leverage its brand and push deeper into new distribution channels by expanding its consumer packaged goods (CPG) operations. In particular, the company is getting a lift from brisk K-cup growth, which is helping it gain ground in the booming single-serve coffee segment. (K-cup single-serve brewing machines are the main product line of Keurig Green Mountain (GMCR).) Starbucks is also benefiting from an acceleration in packaged coffee sales, something that has been noticeable since the company took control of that business from Mondelez International (MDLZ) -- then Kraft Foods -- in 2010.
Overseas Expansion: Starbucks still has plenty of room to grow at home, though its current development pace is not as rapid as it was before the recession, when site selection appeared to get a bit sloppy. That said, the international opportunity is the more attractive one at this point. And we believe that Starbucks could eventually have a global scale on par with fast-food heavyweight McDonald’s (MCD - Free McDonald's Stock Report), which has a base of over 35,000 locations worldwide. Much of the growth we envision will likely be in China, given its vast population, burgeoning middle class, and healthy appetite for foreign brands. Starbucks has been successful in China, where it’s been fairly active since the late 1990s, by adding a little local flavor to its beverages, such as with its red bean frappuccinos. It’s also opened more large-format stores in that country, since, more so than on-the-go Americans, Chinese consumers tend to prefer wide open spaces where they can sit and relax.
Heightened Competition: The coffee wars have been heating up in recent years, with Starbucks’ most significant rivals being McDonald’s and Dunkin’ Donuts (DNKN). Those outfits, both relatively aggressive on the price and advertising fronts, are scoring some points with price-conscious consumers, which seem to have increased in rank since the recession. Starbucks does not appear to be losing market share, however, as evidenced by its solid comp trends. And the company maintains good pricing power, a testament, we believe, to its high brand equity and effort to sell customers an entire “experience,” rather than just individual food and beverage items.
Commodity Pressures: Coffee costs, a major input for Starbucks, have been a welcome tailwind of late. But they look set to rise before too long, because of “coffee rust” (a disease that makes coffee trees less productive) and severe weather conditions that have hampered coffee crops in Central and South America. This will likely weigh on the bottom line, perhaps as early as 2015. And other commodity headwinds may well emerge, especially with the company adding more food items to its menu.
In sum, we believe that there are many chapters yet to come in Starbucks’ compelling growth story. The equity, while not a steal at recent levels, seems appealing relative to its prospects, too, trading at about 25 times forward share earnings. With this in mind, we think that long-term investors with an eye toward 2017-2019 would do well to accumulate the stock. The recent share-price malaise will likely prove to be a blessing in disguise.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.