Starbucks Shares Fall Off A Cliff: 7 Things Investors Need To Know

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The cornerstone of my dividend growth retirement portfolio is to buy quality dividend growth stocks at beaten down prices. Specifically, I’m looking for well-run companies with strong business models, experienced management teams, and a good track record of steadily rising dividends over time.

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SBUX Total Return Price data by YCharts

Starbucks (SBUX) is one of the most successful long-term investments in US history, generating 1,643% total returns over the past 28 years. That equates to annual total returns of 20.0% compared to the S&P 500’s 9.1%.

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SBUX Total Return Price data by YCharts

However, in the past three years, Starbucks has badly underperformed the market thanks to concerns over slowing growth in its core US market. In addition, the retirement of legendary CEO Howard Schultz, first from the top job, and more recently from the Board of Directors, has rekindled fears that Starbucks has lost its way and is no longer a good growth stock. Many investors are even worried that Starbucks may be a “value trap”, meaning shares are likely to continue underperforming for the foreseeable future.

Let’s take a look at seven crucial facts all investors need to know about Starbucks today. First, we’ll look at the various short- and medium-term risks to the company’s growth efforts. But more importantly discover why Starbucks still has several key growth catalysts that lead me to believe that it has market crushing long-term potential. Finally, find out why at today’s depressed price I consider Starbucks a strong buy that is likely to make for a wonderful dividend growth investment over the coming years.

1. Slowing Growth Is Why Wall Street Hates Starbucks Right Now

Starbucks operates 28,209 stores in 76 countries around the world (500 opened in Q1 2018) and serves 900 million customers per year. Over 17,000 (about 60%) of those stores are in the US, which generates just over half of the company’s total sales. Starbucks has been struggling with weakening US comps for several years now, which continued in the first-quarter results.

(Source: earnings release)

While management started the year guiding for 3% to 5% same-store sales growth (comps), in the first quarter the results came in lighter than expected in all markets except China and Asia Pacific. China remained the one strong point, with 4% comps growth and now accounts for about 13% of total revenue. However, what had analysts worried is that the comps growth was purely driven by higher prices, with flat or negative customer traffic growth. In addition, China comps, while strong by industry standards, were half of what they were in Q4 of 2017. Starbucks says the weak China comps were caused by online delivery issues associated with its ongoing efforts to scale up its mobile ordering and delivery services in that country (a key driver of past China growth). By the end of the year, it expects the kinks to get worked out and China comps should reaccelerate.

Part of the problem in the US was changing consumer tastes, including a large decline in chilled beverages such as Starbuck’s famous and sugar packed Frappuccino. Starbucks had believed that cold beverage choices might help to expand its market base, but since 2015, Frappuccino sales are down 15%, including 3% in the past year. According to CEO Kevin Johnson, this is an industry wide trend caused by more health conscious consumers.

Metric

Q1 2018 Results

Revenue Growth

14%

EPS Growth

4%

Adjusted EPS Growth

18%

TTM Free Cash Flow Growth

-6%

TTM FCF/Share Growth

-2%

Dividend Growth (YOY)

44%

(Source: earnings release, Gurufocus)

In fairness to the company, it did manage to post impressive top line growth of 14%. 3% of that was from the July 2017, $1.3 billion buyout of its East China joint venture, which gave it full control of 1,300 Chinese stores. However, thanks to large restructuring expenses, the company’s bottom line growth was far less impressive. EPS grew only 4%, all due to a 4% share count reduction over the past year. Meanwhile, free cash flow, what ultimately funds the dividend, actually decreased 6%. On the plus side, adjusted EPS (which exclude restructuring costs which are temporary) rose 18% and management still thinks it can achieve 17% adjusted EPS growth this year.

The other bit of good news for Starbucks was that management hiked the dividend 20%, for the second time in the past 12 months. This means a 44% YOY increase in the payout, part of the recently announced $25 billion capital return program that will run through the end of 2020.

But the downside of that announcement is that it also came at the same time that Starbucks lowered its comps guidance for the next quarter, to just 1%, its slowest growth in nine years. Worse yet, comps in China are expected to be flat to negative due to ongoing online delivery distribution issues. Kevin Johnson, the company’s CEO, even went so far to say “our recent performance does not reflect the potential of our exceptional brand and is not acceptable.” Given that it means that Starbucks is unlikely to hit the low end of its previous guidance (3% to 5% comps in 2018), and might even miss its full-year Adjusted EPS guidance for the full year (already reduced by 4%), it’s hard to argue with that assessment.

However, the trouble for Starbucks extends beyond just weakening comps growth in recent years.

2. Recent Management Changes Have The Market Bearish As Well

One of the big fears investors have is that Starbucks without Howard Schultz won’t be able to grow over the long term. That’s an understandable concern given that the last time Shultz retired, replacement CEO Jim Donald “watered down the brand“, according to a 2007 Schultz memo.

By overextending Starbucks locations, and losing focus on the company’s core branding (as a home away from home), rivals like McDonald’s (MCD) were able to make big inroads into the premium coffee market and steal market share. Under Donald, Starbucks also became bloated with much higher operating and administrative costs that Schultz had to turn around via $581 million in cost cuts when he retook the CEO role in 2008.

Losing Schultz as CEO in April 2017 brought back a lot of bad memories for long time Starbucks investors. Their anxiety was only heightened when Schultz announced that he was stepping down as Chairman of the board on June 26th. His replacement, Mike Ullman, formerly CEO of J.C. Penney (JCP), didn’t immediately fill investors with confidence given the long history of decline at that struggling retailer.

Then on June 28th, shares tumbled almost 3% on news that CFO Scott Maw would be retiring at the end of November, for unexplained reasons. Maw had been CFO for four years, and some investors probably feel that his sudden departure might be equivalent of rats fleeing a sinking ship.

And if struggling growth in the US, Europe, the Middle East, and Africa (EMEA), and significant management changes weren’t enough, Starbucks also faces other growth challenges that are baked into its core business model.

3. Core Risks To Business Model Aren’t Helping Either

In addition to all the challenges it faces with its core US market and recent management turnover, Starbucks also faces several challenges baked into its industry’s business model.

For example, there is the potential hit its brand can take from PR nightmares such as what recently happened in Philadelphia. Two African American men were arrested (and detained for nine hours) because they were sitting in a Starbucks without buying anything (they were waiting for a friend). They were arrested for trespassing, and Starbucks responded with closing 8,000 US company-owned stores on May 29th for racial bias training.

Howard Schultz, as one of his last acts as Chairman, announced a new company policy that stores would be open to everyone, even if they didn’t buy anything. However, this led to worries from both customers and analysts that it might lead to large amounts of loitering from drug users and the homeless. The company had to clarify in a statement in the Wall Street Journal that “disruptive behaviors like smoking, drug use, sleeping, and inappropriate use of the restroom are not allowed.” Of course, it will be up to the management of each store to use good judgement to balance this new policy and maintain the cozy store atmosphere that has been such a core component of the company’s earlier success. That being said, according to Fortune Magazine, Starbucks is the world’s 5th most admired company, and I expect that this scandal will not affect the company’s long-term growth.

In addition, we can’t forget that while Starbucks has a lot of pricing power, its margins will still be affected by raw material costs, especially coffee prices. Its commodity sensitivity is lower than most of its rivals due to the world’s largest and most diversified supply chain. However, at the end of the day, even specialized coffee is a commodity over whose price management has no power.

Next we can’t forget that with almost half of revenue from outside the US (and growing fast thanks to China), Starbucks has a lot of currency risk.

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^DXY data by YCharts

When the US dollar appreciates against local currencies (as its doing right now), Starbucks foreign sales translate into fewer US dollars, creating growth headwinds. As US interest rates continue rising faster than those in the EU, UK, and Japan, it’s possible the dollar might continue to strengthen. How much of an impact can currency fluctuations have? Well, for example, in the company’s Europe, Middle East and Africa or EMEA segment, revenues in Q1 2018 were up 15% in local currency but negative currency translation lowered that to 4% in US dollars.

Finally, if the US and China do end up in a full blown trade war, then Starbucks could be hit hard. That’s because it’s possible that anti-American sentiment in Starbucks’ most important growth market (more on this in a bit) could cause its Asian comps to continue to weaken for as long as the trade conflict lasts.

And even if we avoid a trade war, increasing competition is always a concern. That’s especially true if Starbucks ends up seeing slower or even flat comps growth in China going forward. That’s because when you have 75% market share, it’s hard to build on that. Indeed, the success Starbucks has had in China has spurred increased competition, including from an army of smaller premium coffee establishments. Meanwhile, in the US, increased competition from a resurgent McDonald’s and an expanding Dunkin’ Brands (DNKN) means that Starbucks also risks losing market share and potentially having new stores cannibalize each other. That’s especially true if its strong brand takes a hit, and US customers decide they aren’t willing to pay the 38% higher prices Starbucks charges, on average, compared to its US rivals.

4. Starbucks Has A Solid Turnaround Plan For The US And A Great Management Team To Execute On It

Ultimately the key to long-term investing success comes down to a quality management team. After all, running a global corporation is monstrously difficult. In addition, as we’re seeing now, adapting to changing industry conditions isn’t easy, and so takes skilled leadership. With Schultz now gone for good, investors need to trust that Starbucks is in good hands. Fortunately, I am confident that CEO Kevin Johnson and new chairman Mike Ullman are the right people to lead Starbucks into a brighter future.

Mike Ullman’s track record at J.C. Penney is actually excellent. When he took over from failed CEO Ron Johnson, he proved that he is willing to abandon failed strategies and make large strategic shifts. In other words, Ullman is a proven turnaround veteran in the world of retail, exactly the kind of chairman the company needs right now.

Meanwhile, Kevin Johnson, Starbucks’ CEO, served as a director for seven years, and COO for two years, before Schultz retired from the top spot. He was instrumental in executing on Schultz’s international expansion efforts, including in China. In addition, Johnson has a lot of experience in tech, having spent 21 years as a top executive at both Microsoft (MSFT), and Juniper Networks (NYSE:JNPR). Why does this matter? Because management has a four-step turnaround plan. One that is heavily focused on good integration of technology.

(Source: Starbucks investor presentation)

The first step in the turnaround is better utilizing its strong digital applications to improve throughput, and same-store sales. For example via its digital flywheel initiative (use of apps and rewards programs), Starbucks has grown its My Starbucks Rewards program by 13% over the past year to 15 million members. This program involves prepaid Starbucks gift cards and the company’s popular and well received mobile app. One that allows customers to locate, order, and pay for orders online, and pick up at the store without having to wait in line. Going forward, management plans to roll out three additional digital initiatives via this platform. This includes using existing user buying habits to tailor advertising to each individual user. In other words, more specific marketing of new offerings and deals that should boost sales.

The success of the Starbucks Loyalty Reward Program (integrated with Mobile Order & Pay functionality) can be seen by the fact that its members account for just 12% of transactions, but generated 39% of sales, indicating higher average transaction volumes per member. Management believes that by doubling down on this digital platform they can boost 2019 US comps by 1% to 2%.

(Source: Starbucks investor presentation)

To help boost sales from non-rewards members, Starbucks has begun gathering emails from its more occasional US visitors who make up about 60% of sales in this country. Some have pointed out that Starbucks’ complicated menu options could be hurting it with these customers. In the past 90 days, Starbucks has obtained 5 million non-rewards member emails and expects that figure to grow rapidly. According to Rosalind Brewer, the company’s COO, in the past 12 months, just 25% of non-reward members were aware of new product offerings or promotions. That’s compared to 50% for rewards members.

Since non-rewards members make up over 50% of afternoon traffic (the company’s weakest sales time), management believes that more personalized marketing to these customers is a core strategy to boosting US comps growth. That includes by offering detailed digital menus that help less regular customers better understand its product offerings. Basically, Starbucks’ US turnaround hinges largely on increased convenience and personalization (such as with one-time coupons and personalized happy hour) of its customer experience.

(Source: Starbucks investor presentation)

Part of that personalization strategy will focus on expanded healthy drink and food offerings, such as teas, which continue to grow very strongly. Or to put another way, Starbucks is shifting with the times to get “on trend” with greater consumer demand for healthier food & drink.

The second part of the turnaround involves doubling down on what made it famous, a premium experience that customers are willing to pay extra for. For example, Starbucks plans to expand to 30 super premium roasteries in the coming years, which will feature Princi boutique bakery and cafes. These will focus on high-end baked goods from master baker Rocco Princi.

The exterior of the Starbucks Reserve Roastery and Tasting Room in Seattle

A new Starbucks Princi cafe at its Roastery

(Source: Starbucks)

Now it should be noted that this isn’t the company’s first push into bakeries. It spent $100 million in 2012 to acquire La Boulange, and then closed all the stores in 2015. However, as Darren Tristano, executive vice president of restaurant consulting firm Technomic, explained with an interview in Adweek:

“But if you look back to the beginning, it didn’t really sound like we were going to see them growing La Boulange. It seemed like they were going to learn from it.” – Darren Tristano

Indeed, Starbucks has a rich history of experimenting with new concepts, including Howard Schultz’s 2010 Starbucks Evening concept, which included: premium beers, fine foods, and wine offerings. While that ultimately didn’t work out, each time Starbucks experiments with premium concepts, it learns what works and what doesn’t. And it appears that Starbucks has indeed cracked the code in terms of super premium concepts. For example, the original Seattle Roastery store, opened in 2016, has an average ticket price that’s four times that of the average Starbucks store.

Baristas make drinks for customers in the middle of the new Starbucks Reserve Roastery in Shanghai.

(Source: Starbucks)

In late 2017, Starbucks opened its second Roastery in Shanghai (were it has over 600 stores in total). It offers not just super premium coffees but also Princi baked goods and a tea bar, tailored to Chinese cultural tastes. Starbucks is reporting multi-hour long lines out the door for this store, with average ticket prices about three times that of normal Chinese Starbucks location.

Then there’s the company’s other high end concept, the Reserve Bar. This will be where Starbucks offers super premium small batch coffees brewed with special techniques that often retail for $10 to $12 per 12 oz serving.

Starbucks Reserve coffee bar

(Source: Starbucks)

Now Starbucks is taking a very gradual approach to both Roasteries and Reserve bars. For example, there are just two Roasteries open today with another four to open in 2019. The company plans for the Roastery concept to represent global flagship stores with about 20 to 30 opening in the long term. There is just 1 Reserve store open right now with another six to 10 set to open in 2018. Management plans to carefully analyze best principles in each before rolling them out more broadly in coming years. This means that we won’t likely see any major top line growth from these concepts for several years.

However, the company does plan to open eventually about 1,000 Reserve Cafes, which include Princi baked goods, in the coming years. This will help Starbucks to diversify away from premium coffees, and strengthen its food business, which accounts for about 22% of US sales right now and about 1% of comps. Of course, there is no guarantee that these new concepts will work. That’s because, while Starbucks has proven itself highly willing to experiment in the past with non-coffee based concepts, its track record isn’t that great. For example: Evolution Fresh juices, La Boulange bakeries, and Teavana tea houses, all ended up failing. But given that Business Insider estimates that the average Reserve Cafe generates $3 million in annual sales, over double that of regular stores, it does appear as if this new, highly scalable concept appears to be a success. At least in the 185 current locations currently open around the world (150 of those in China).

Next there’s the third leg of Starbucks’ US turnaround, which is a strong focus on controlling costs. For one thing, Starbucks has admitted that its US market is highly concentrated. This is why it plans to triple the amount of US store closures (least profitable ones), from 50 per year to 150. That means that Starbucks will try to avoid store cannibalization by closing about 1% of its worst performing operations each year. Note, however, that Starbucks doesn’t believe America is saturated, as it plans to increase its overall US store count 5% in 2018 and 3% in 2019 (slower growth due to store closings).

(Source: Starbucks investor presentation)

In other words, the company’s plan for US store count is to streamline and optimize, while still achieving positive growth. The key will be focusing on US markets that are less densely packed with existing Starbucks locations, to minimize the risk of cannibalizing sales from existing stores.

(Source: Starbucks investor presentation)

The company also plans to greatly cut its general & administration costs. That means streamlining its workforce as well as its supply chain. In 2018, the company plans to reduce its annual operating costs by $280 million per year. As just one example of how Starbucks plans to double down on lean operations, the company estimates that food waste costs it about $500 million per year. In the next 18 months, management plans to reduce that by 15%, and then continue lowering it over the coming years. Starbucks is also hiring an external consulting firm to boost these cost savings figures in the coming years and in the next quarter’s conference will provide more detailed information.

In addition, management says it plans to potentially franchise (license) some select stores, meaning sell them to third party operators who will be in charge of covering the general expenses of day to day operations. This would greatly lower Starbucks’ fixed costs, which would be replaced with a much higher margin stream of royalty revenue. While such a move might mean a decline in overall revenue, it’s the approach McDonald’s has made to great effect over the past few years. However, Starbucks plans to be highly selective in its licensed store approach. Specifically, it plans to retain ownership of locations in its largest markets, because those are four times as profitable and licensed locations, due to its ability to retain all the profits.

(Source: Starbucks investor presentation)

Company

Gross Margin

Operating Margin

Net Margin

FCF Margin

ROIC

Starbucks

58.3%

14.2%

10.9%

11.7%

34.7%

Industry Average

56.6%

5.1%

2.8%

NA

7.5%

(Sources: Morningstar, Gurufocus, CSImarketing)

But we can’t forget that even with restructuring costs taking a 4.9% bite out of its operating margin in the past quarter, Starbucks remains one of the most profitable companies in its industry. For example, the company’s operating margin (which analysts expect to reach 21% to 22% in coming years) is already three times the industry average, even with high restructuring costs. Meanwhile, the net margin (not adjusted for restructuring) is over three times those of its peers. And if you wonder about the quality of the management team then consider the return on invested capital or ROIC. This is a good proxy for capital allocation and Starbuck’s sky-high figure indicates that the c-suite is allocating shareholder capital very well indeed. In other words, Starbucks’ global supply chain and enormous economies of scale will give it plenty of dry powder to fund this turnaround effort.

The fourth and final part of the turnaround plan is the $7.2 billion licensing deal with Nestle (OTCPK:NSRGY) which Starbucks calls its Global Coffee Alliance. This will give Nestle the exclusive global rights to market, sell, and distribute the Starbucks, Teavana, VIA, and other Starbucks brands. Starbucks will continue to supply these products, creating a recurring revenue stream that will offset the small immediate hit to revenue. This deal is meant to help the company focus more on its core locations, rather than dilute its efforts with trying to peddle branded products in grocery stores.

However, the strategic benefits of this deal fit perfectly with management’s long-term international growth strategy. That’s because, according to Kevin Johnson, consumer goods sales are a brand amplifier. Nestle sells consumer packaged goods in 189 countries around the world, nearly triple the reach of Starbucks. In fact, the Global Coffee Alliance deal means that Starbucks branded products will increase their distribution points of sale by five million within a few months.

This potentially means that as Nestle expands its sales of Starbucks branded products overseas, Starbucks will get the equivalent of free advertising as it continues to expand overseas. That might translate into higher comps in its current EMEA market, which has been a tough nut to crack for the company. In fact, management expects this deal to become accretive to EPS by the end of 2020 (fiscal year 2021). That’s partially because Starbucks expects to net about $5 billion from the deal and plans to use the proceeds to fund part of its ambitious $25 billion capital return program through 2020.

Overall, thanks to its strategic turnaround plan, management remains confident in its long-term growth targets of:

  • 3% to 5% annual global same-store comps
  • High single-digit revenue growth
  • Double-digit earnings and free cash flow per share growth

As part of that long-term plan, Starbucks plans to continue opening lots of new stores, including 2,300 in 2018. This shows that while the US market expansion may be limited, the rest of the world still provides a long growth runway for the company.

If management can hit those targets over the coming years, then Starbucks investors are set to benefit from both fast dividend growth as well as significant share price appreciation. And thanks to the company’s strongest growth driver of all, China, there is good reason to believe that Starbucks will hit those long-term growth objectives.

5. China Is The Main Growth Catalyst

China’s middle class is expected to double in the next five years to about 600 million, which is nearly twice the overall US population.

(Source: Starbucks investor presentation)

For years now, China has been the company’s fastest growing market, with management saying it’s cracked the code for ongoing long-term growth. In fact, Starbucks’ market share in Chinese coffee is about 75%, compared to McDonald’s second place 10%. Today, Starbucks has 3,200 stores open in China’s largest 141 cities. In the latest quarter, Chinese sales grew 54% and 13% backing out the 2017 Chinese store acquisition. The key to Starbucks’ success in China, which it entered nearly 20 years ago, is a combination of: strong brand focus, tailoring its products to local tastes, and very well executed uses of technology.

For example, in China, Starbucks’ loyalty program has over 6 million members and is growing fast. Its Chinese mobile app is integrated with mobile payment platforms WePay and AliPay. However, unlike in the US, in China mobile delivery, which involves partnering with third-party shippers, is a major growth component as well. This too is integrated into the company’s mobile app, and allows the company to post stronger comps growth than in any other market. That’s because in the US, Latin America, and the Middle East, and Europe, Starbucks sales are constrained by physical stores (which can only sell so many products). In contrast, online ordering and delivery means that each Chinese store can be leveraged as a central distribution hub to service a much larger client base and generate more revenue. And given that Chinese coffee consumption per capita is about 600 times less than in the US, to say that Starbucks has just scratched the surface of this growth market would be an understatement.

(Source: Starbucks investor presentation)

Starbucks plans to increase its Chinese store count to 6,000 by 2022, including 600 opening in 2018. In other words, over the next five years, Starbucks plans to almost double its China store base which will make China responsible for over 20% of the company’s total sales. However, management has said that it believes China’s enormous population, fast growing middle class, and rising coffee per capita consumption, could eventually support more stores than it has in the US (18,000+). That alone is a strong growth driver that makes Starbucks worth owning, and likely means management will be able to achieve its long-term EPS growth target of 10+%. Which in turns spells great things for the company’s dividend growth and total return prospects in the coming years.

6. Dividend Profile: Starbucks Is Still Capable Of Market Beating Total Returns

Company

Yield

TTM FCF Payout Ratio

10 Year Projected Dividend Growth

10 Year Potential CAGR Total Return

Starbucks

3.0%

57%

10.0% to 14.7%

13.0% to 17.7%

S&P 500

1.8%

40%

6.2%

8.0%

(Source: management guidance, FastGraphs, Gurufocus, Yardeni Research, Multpl)

The most important aspect to any income investment is the dividend profile which consists of three parts: yield, dividend safety, and long-term growth potential.

Starbucks’ yield is now at an all-time high, and nicely above both its average peer (1.6% yield), and the S&P 500. More importantly, its dividend is well covered by its free cash flow. Of course, there is more to a safe dividend then just a decent payout ratio. Debt levels are also important, especially for a company that plans to increase its store count by over 10,000 over the next five years.

Company

Debt/EBITDA

Interest Coverage Ratio

Debt/Capital

S&P Credit Rating

Avg Interest Rate

Starbucks

0.9

68.1

42%

BBB+

1.6%

Industry Average

2.3

23.6

59%

NA

NA

(Source: FastGraphs, Gurufocus, Morningstar, CSImarketing)

Fortunately, Starbucks has a very healthy balance sheet, with a much lower leverage ratio than its peers. Its interest coverage ratio is almost nearly three times the industry average. That’s thanks to two main factors. The first is the strong investment grade credit rating which allows it to borrow at very low cost in US dollars. The second is that Starbucks, being an international company, is able to borrow in foreign currency, including EU and Japanese bonds that have much lower yields than in the US. This is why Starbucks’ average interest rate, despite 95% of its debt being long-term, fixed rate bonds, is about half that of the US Treasury.

Now, let’s get down to brass tacks, Starbucks’ growth rate. The forward FCF payout ratio is 74% due to the second 20% dividend hike in the past year. This is likely as high as it can safely rise meaning that going forward the company’s dividend is likely to grow in line with the company’s FCF/share. Analysts are lowering their growth projects after management lowered its guidance, but the 10-year growth consensus is still for 14.7% EPS growth.

Even Morningstar analysts like R.J Hottovy, who are notorious for their conservative growth assumptions, believe that Starbucks will be able to grow its free cash flow in the low to mid-teens over the next decade. This is ultimately because most analysts believe that Starbucks, far from being a dying brand, is in the same place McDonald’s was three years ago. That was before it made its own strategic turnaround and rekindled its comps growth.

Now in this case, while I have confidence in management’s plan, I’d like to err on the side of caution a bit. That’s because Starbucks’ growth plan, while reasonable, still needs good execution. In other words, I’m in a “show me the results” mindset. Thus, I’m personally assuming that Starbucks’ dividend will grow at the lower end of the projected range, about 10%. This is likely to be slightly slower than the FCF/share growth rate, but management is going to want to lower that payout ratio to boost the dividend’s safety buffer.

That being said, even with 10% dividend growth Starbucks is likely to make a great long-term income investment. That’s not only due to the current 3% yield, which pays you to wait for management to execute on its growth plan, but also because the company’s total returns are likely to track not the dividend but its EPS and FCF/share growth. In addition, Starbucks’ current valuation is likely compressed out of fears that its growth will continue declining permanently.

There are three factors affecting total returns: yield, EPS/FCF growth (which drives dividend increases), and changes in valuation multiples. Even assuming no changes in valuation, Starbucks should be able to achieve about 15% total returns over the next decade. That’s roughly double what the S&P 500 is likely to generate from its current valuations.

In other words, Starbucks is now offering much better than market average income, along with long-term double digit dividend growth, AND market crushing total return potential.

7. Valuation: Best Time In Years To Buy This Beaten Down Blue Chip

Chart

SBUX Total Return Price data by YCharts

It’s been a rough year for Starbucks shareholders, with the company underperforming the broader market by about 30%. In fact, thanks to the recent selloff, Starbucks is trading at its lowest share price since August of 2015. That’s despite continued growth in its fundamentals, most notably its EPS, FCF/share, and dividend (which has now increased for eight consecutive years). In other words, it’s literally the best time in three years to buy this dividend growth blue chip.

Now it should be pointed out that there are dozens of ways to value a stock, both in a backwards looking, and forwards looking manner. There is no objectively 100% correct approach because all valuation metrics have their inherent limitations. Backwards looking ones assume that past growth will continue. Forwards looking ones are based on an uncertain future, and even the gold standard discounted cash flow analysis is only as good as the assumptions you use. This is why I personally use a multi-metric approach to valuing a stock. This means using multiple valuation methods to build a robust model that minimizes the chances that I’ll overpay for a company.

The first screen I use is the total return potential from the dividend profile. I want any company I recommend (or own) to at least be able to match the market over the coming decade. And to own it myself, I personally have a 10+% total return potential hurdle rate. Starbucks easily passes this first screen, thanks to its approximate 15% total return potential.

The second approach I use is to compare a stock’s forward PE to its historical PE, and estimate what long-term EPS growth rate is baked into the share price. I do this for two reasons. First, PE ratios are usually mean reverting over time. In other words, they tend to fluctuate around a relatively fixed point that approximates fair value. Meanwhile, knowing roughly what growth rate is baked into a stock allows you to approximate the chances that a company’s growth can beat to the upside and thus result in multiple expansion in the future.

Forward PE Ratio

Implied 10 Year EPS Growth Rate

20 Year Average PE

Yield

Historical Yield (Since 2010)

18.4

5.0%

38.9

3.0%

1.3%

(Source: Gurufocus, FastGraphs, Benjamin Graham)

Currently, Starbucks is trading at 18.4 times forward earnings, which is less than half its average PE over the past 20 years. Now I’ll grant you that its growth rate has slowed significantly, and so some of this is justified. Gone are the days of 5% to 7% comps growth year after year, so we can’t assume Starbucks is ever going to trade for nearly 40 times earnings again.

However, the company’s valuation has now fallen so low that shares are baking in about 5% long-term EPS and FCF/share growth. That’s about two to three times less than management and analysts believe the company can realistically achieve once its turnaround plan is firing on all cylinders. Or to put another way, Starbucks has a very low bar to clear in order to achieve multiple expansion and a significantly higher share price.

The next valuation screen I use is comparing the yield to its historical yield, both on a five-year average basis, and a longer-term median one. I do this for two reasons. First, as a dividend focused investor, yield is the most relevant valuation metric to me and my readers. Second, like with the PE ratio, yields tend to be mean reverting over time and so can approximate fair value.

(Source: Simply Safe Dividends)

Now again, we need to use some common sense here. In the past, Starbucks’ yield was based on its past, much faster growth rate, one that isn’t likely to repeat. So we can’t actually assume that the company’s yield will ever be as low as 1.3% or 1.5% again. However, the point is that with its yield being over 100% above its historical norms (and at all-time highs) Starbucks is now looking like a very attractive income investment. Especially since it’s likely to continue growing the payout at double digits for the foreseeable future.

Finally, when possible, I’ll consider a long-term, fundamentals driven, three stage discounted cash flow model, such as provided by Morningstar. Now it’s important to note that a DCF model, which estimates a company’s intrinsic value based on the present value of future cash flow, should never be the single metric used to determine an investment decision. That’s because it has several key assumptions and relies on long-term smoothed out growth rates that are educated guesstimates. That being said, I consider Morningstar a great way to augment my valuation model for two main reasons.

First, its analysts are purely fundamental driven, and always use long-term (10+ year) time horizons. In addition, they tend to be wonderfully conservative, often assuming growth rates lower than event management guidance. For example, in this case, Morningstar is modeling 2% long-term global comps growth.

That’s below management’s long-term guidance and personally I think 3% to 4% is more likely. But the point is that if Morningstar says a stock is undervalued, then it is almost certainly offering a wonderful margin of safety. Or to put another way the Morningstar Fair Value typically serves as a good low end fair value estimate.

Morningstar Fair Value Estimate

Discount To Fair Value

$64

24%

(Source: Morningstar)

In this case, even the conservative Morningstar thinks Starbucks is 24% undervalued. That’s even accounting for much slower long-term growth, that management should be able to easily beat even with imperfect execution on its strategic turnaround plan.

Putting together all these valuation methods, I estimate Starbucks’ intrinsic value to be about $70.

My Estimated Fair Value

Discount To Fair Value

$70

31%

(Source: Gurufocus, FastGraphs, Benjamin Graham, Morningstar, management guidance)

That means I estimate Starbucks to be about 31% undervalued today. For a blue chip dividend stock with double-digit payout growth and market beating total return potential, that is a fantastic deal. Which is why I consider Starbucks to be a “strong buy” at this time for anyone comfortable with its risk profile. In fact, I plan to add to my position as soon as I can get the cash together.

Bottom Line: Starbucks Is Where McDonald’s Was Three Years Ago And Will Probably Make A Great Long-Term Dividend Growth Investment

Don’t get me wrong, I’m not predicting that Starbucks has necessarily bottomed at this point. In the short term, there is no way to know how the fickle market will react to the company’s ongoing growth challenges, which might take several quarters to address.

What I do know is that Starbucks is a fundamentally healthy company with a: strong brand, a solid turnaround strategy, and good long-term growth catalysts. That should allow it to continue double-digit dividend growth for the foreseeable future, making it a potentially great low risk income growth investment. And at today’s rock bottom valuations, the stock is very likely to provide market crushing total returns over the next decade. This makes Starbucks a strong buy for anyone comfortable with its risk profile.

Disclosure: I am/we are long SBUX.

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.

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