Why I’m Drinking the Kool-Aid on Starbucks

starbucksWhy I’m Drinking the Kool-Aid on Starbucks

Starbucks (SBUX) is one of the top holdings in my core portfolio. Taking a page from Warren Buffet, Starbucks is one of my forever stocks because, if I went away from the market for 10-20 years and came back, I would be very confident that my investment in Starbucks would not only hold its value, but would increase in value significantly. This is the kind of stock around which I want to build my core portfolio.

Personally, I want to see if a company has a great business and is in a big and growing market first before I evaluate the financials. And I do believe that Starbucks is a great business. These are the main points of my investment thesis:

  1. Coffee is the new “Coke”. Unlike all other restaurants that are traditionally built around food, Starbucks is centered around a beverage. Being a beverage, coffee is something you can and do drink every day, just like Coca-Cola. On the other hand, you’d get pretty tired of eating a burrito or a Big Mac every day. Personally, I think the fact that people go to Starbucks multiple times per week/month is the key reason why the Starbucks loyalty program and other digital initiatives are far and away more successful than those of other restaurant. If you go to Chipotle only a one or two times per month, you may never get that free burrito. In addition, the higher the frequency, the stronger the habit. It also doesn’t hurt that caffeine is addictive.
  2. Starbucks is the new “smoke break”–that’s the term I used when I described my investment thesis to my kids. Many years ago, people used to go on “smoke breaks” to break up the monotony of the work day. Now, if you want to take five from the office, you go to Starbucks for a coffee and gossip/vent about your work day. I will oftentimes meet potential clients to discuss projects at Starbucks. Beyond work, it’s so much more convenient and less expensive to “meet for coffee” than “do lunch”. Got a first date, or a blind date? It’s less of a commitment to grab a coffee than suffer through a meal if things aren’t working out. Anyways, this is my take on how Starbucks wants to and is successfully becoming everybody’s “third” place (the place you most frequent after home and work).
  3. Starbucks is an affordable luxury that plays well into the trend towards premium everything (e.g., craft beers, etc.). It’s also at a price point where almost everyone can treat themselves at least once in a while.
  4. Starbucks is truly a one-of-a-kind restaurant concept. There are plenty of burger joints, pizzerias, taquerias, and sandwich shops, but there is only one global coffee brand. Dunkin Donuts (DNKN) is a donut seller that is making a bigger push into coffee, but it’s core is really more of the “blue-collar” market, so it’s competing more directly with McDonald’s McCafe offerings (MCD). Starbucks really only competes with smaller regional chains or mom-and-pop specialty shops.
  5. Starbucks is cool with kids. Walk into any Starbucks and it’s full of teens getting their frap fix on. Starbucks is perennially the #1 restaurant preferred by teens in Piper Jaffray’s semi-annual surveys. I think it is critical to know that a new generation of consumers is waiting in the wings to help drive growth.
  6. Starbucks is in a big and growing market. In addition to US expansion, the international growth potential is huge, especially in China, India and other non-traditional coffee regions. China’s older generation drinks tea, but the younger gen are starting to drink coffee. If they start making it into a daily habit like here in the US, the upside is enormous. This is supported by the growth forecasts for global consumption of coffee to increase 25% between 2015 and 2020. In addition, the global non-alcoholic beverage market is expected to grow at a compound annual growth rate (CAGR) of 4.3% from $1.4 trillion in 2013 to $1.9 trillion in 2020.

Topline Growth and Bottomline Profits

By any financial metric, Starbucks is stellar. Topline sales are growing at a CAGR of 12.3% over the past five years.

This has been driven by both the growth in store count, which has grown 6.5%/year, and comp store sales growth of 6-8% over the past five years. They are adding 1,600-1,700 new stores every year, primarily in the Americas and in Asia, with plans to grow the store count to 30,000 and revenue to $30 billion by 2019.

Starbucks is very profitable. Gross margin is almost 60% and net income is over 12% of sales. Not only is it highly profitable, all of these profitability metrics have increased over time. Earnings per share has been growing at a CAGR of over 24% due in part to its increasing profits as well as stock buybacks.

Generates Tons of Cash

Personally, I think free cash flow (FCF) is one of the most important financials to look at when evaluating a company. If it’s in a more mature growth stage, you want to see that the company is actually generating cash from all of their investments. For a quick look, I just go to Yahoo Finance or Google Finance and take the total of operating cashflow minus capex.

In 2015, Starbucks generated FCF of $2.4 billion ($3.7 billion operating cashflow minus $1.3 billion capex). In other words, it generated $3.7 billion of cash from its store operations, spent $1.3 billion primarily on new store expansion (1,700 stores it added the past year), and had $2.4 billion of extra cash left over.

Starbucks returned most of that cash in the form of dividends ($928 million) and stock buybacks ($1.2 billion). In terms of dividends, we’re interested in what it’s paying now, but we really want to focus on how fast it will grow those dividends. One good indication is the payout ratio, which is dividends divided by the cashflow. In this case, Starbucks had a payout ratio of only 38% on the $2.4 billion cashflow, which means that it has plenty of room to grow its dividend. This has been the case as Starbucks has increased its dividends by 20%+ per year since it started paying dividends in 2010. So, I expect Starbucks to double its dividend over the next 5 years by increasing its dividend at a healthy rate (maybe not 20%, but in the double digits) even while continuing to open plenty of new stores to drive additional earnings and cashflow growth.

Balance Sheet Is Solid

Starbucks generates a ton of cash so its balance sheet is solid. It only has net debt of $0.4 billion on equity of $5.8 billion, or a debt to equity ratio of only 7.3%. I think it’s important to point out that its asset base is growing at 14.3% CAGR, which means the company is growing much bigger by the year. It’s also important to point out that its equity is growing at a healthy clip of 9.6% CAGR, and that this is driven by retained earnings growth (i.e., profits), as opposed to new capital raises. I think a big reason is that Starbucks has an incredible return on invested capital (ROIC) of 42%, which is a superior return above its cost of capital of 6.58% (source: GuruFocus). In other words, Starbucks continues to achieve superior returns with every new store it opens.

Other Restaurants Pale in Comparison

The main complaint that you’ll see about Starbucks is that it has a rich valuation. But it’s expensive for a reason–it has a rare combination of size (second only to McDonald’s), consistency (years and years of profitability), and growth (double digits despite its enormous size). If you look at this list of restaurant stocks (not an exhaustive list), there’s not a better one than Starbucks, in my opinion. Nobody else has all of these qualities and many are even more pricey.

Some key valuation metrics for Starbucks:

  • Starbucks’ P/E of 29.56x is near the median of this group and in a similar range as Yum, Buffalo Wild Wings, Papa John’s, Panera, and Dunkin’ Donuts. It’s higher than McDonald’s 21.24x.
  • Starbucks’ 5 year earnings growth rate of 13% is similar to that same set. It’s also twice as high as McDonald’s 6.3% growth.
  • The PEG ratio (price to earning growth) is a good metric that combines both of these factors. Starbucks’ PEG of 2.24 is still rich (PEG of 1 is cheap) but is at the lower range of this high growth subset. When compared to McDonald’s 3.40 PEG, Starbucks does look cheap.
  • Starbucks’ ROIC of 42% is only exceeded by Domino’s and Yum Brands, both of which are much more heavily franchised.
  • What’s impressive is that Starbucks has a high growth rate despite being the second largest restaurant operator only behind McDonald’s.

Investing, Not Trading

I’m investing in Starbucks for the long term; not trading the stock. Holding period = forever. I’ve done my own discounted cashflow (DCF) model and I value the company around $70 on the low side. Now that I have built up a core position in Starbucks, I’m just buying on dips and adding to it. I just purchased some more for my kids’ accounts yesterday with Starbucks trading around $53, near the low of its 52-week range of $52.59-$64.00.

Summary

As mentioned, I think Starbucks has that rare combination of size, consistency, and growth. I believe kool-aidStarbucks will continue to grow beyond its 30,000 store plan and do so very profitably. It is uniquely positioned as a beverage purveying restaurant and has ingrained itself as a hard to kick habit into our daily. It is the new “Coke” and the new “smoke break” of ours and our kids’ generation. In my opinion, I think it has plenty of room to grow for a long time. And all the while it’s making lots of money. That’s why Starbucks is a corner piece in my core portfolio.

Yup. I’m drinking the Kool-Aid, I mean coffee on Starbucks.

 

Other Articles

Why I Just Bought Starbucks Stock and 3 Stocks I’m Never Selling. A couple articles on Motley Fool that just came out.

Warren Buffett’s Co-Pilot Loves This Kind of Company

Starbucks Is Maintaining Its Competitive Edge

Starbucks charts by Trefis. Kind of a cool set of analysis that this company Trefis did to show off their wares.

Why is China the center piece of Starbucks growth story. Another one by Trefis.

 

Disclosure: The author is long SBUX. Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation. The views expressed in the article are the author and the author’s alone.