SBUX: WELL CAFFEINATED

Takeaway: Despite SBUX trading at the high end of its historical consensus forward earnings and cash flow multiples, we believe there's more upside.

This note was originally published June 06, 2013 at 22:40 in Restaurants

Our CEO Keith McCullough likes to frame sentiment as being bullish, bearish, or not enough of one or the other. The investment community is not bullish enough on Starbucks. The bear case does not scare us when it comes to Starbucks. We decided to run through some bull and bear points to refresh clients on our thesis.

 

SBUX: WELL CAFFEINATED - sbux

 

Summary


We remain bullish on Starbucks at current levels. Despite the stock trading at the high end of its historical consensus forward earnings and cash flow multiples, we believe more upside is in store. Bullish factors we are focused on include rapid unit growth in China, expansion into new segments of the global food and beverage industry, and a commodity tailwind that only seems to be getting stronger.

 

Below, we go through the bear and bull cases for SBUX and offer our thoughts on each sub-point.

 

 

Performance

 

Starbucks has been a favorite name of ours for virtually all of the last four years. Aside from a period in 3Q12, when our research process suggested a more cautious stance was necessary, we have been bullish on the stock as it has taken share from competitors in existing businesses and grown its touch points in tangent areas of the food and beverage industries. Despite strong outperformance and plenty of bearish arguments to the contrary, we are reiterating our bullish stance today as we believe that the investment community is bullish, but not bullish enough, at this price.

 

As the quantitative levels, below, indicate, SBUX is in bullish formation with the immediate-term risk range at $62.63-$64.56 and TREND level support at $59.57.

 

SBUX: WELL CAFFEINATED - sbux levels 66

 

 

Bear Case: Valuation, Sentiment, Portfolio Pitfall, Personnel Changes, EMEA, Brewer Growing Pains

 

Valuation

 

Valuation is a factor we consider when formulating all investment theses but is not, in itself, a thesis. It’s impossible to know if Starbucks’ stock is cheap or expensive at current levels unless one knows the forward earnings of the company. What would make the stock cheap to us is if the future growth potential of the company was being overestimated by the investment community. We do not believe that it is.

 

SBUX: WELL CAFFEINATED - sbux valuation cahnge

 

SBUX: WELL CAFFEINATED - sbux eeg FY13

 

 

Sentiment

 

The investment community has become more bullish on Starbucks over the past year as the stock price has risen and visibility on the company’s future growth strategies has increased. Casual dining has seen sentiment rise more than quick service as investors have sought exposure to more discretionary niches of the consumer space. We believe that the stock has further to run over the intermediate TREND and long-term TAIL durations. Our CEO Keith McCullough likes to frame sentiment as being bullish, bearish, or not enough of one or the other. The investment community is not bullish enough on Starbucks.

 

SBUX: WELL CAFFEINATED - sbux sentiment historical

 

 

Portfolio Pitfalls & Growing Pains

 

The history of the restaurant industry is littered with anecdotes of management teams that thought they could grow forever at an ever-increasing rate. Executive compensation structures more closely tied to unit growth targets than returns typified the folly of so many quick service and casual dining companies. Many companies have reaped the negative rewards of growing too fast and/or adding too many concepts to the company’s structure.

 

With respect to growth, Starbucks has not been perfect throughout its history. Between 2005 and 2009, Starbucks almost doubled its number of locations, to almost 17,000. In 2007, Howard Schultz flagged changes in the consumer experience to then-CEO Jim Donald as counter-productive initiatives.  Examples included “flavor-locked packaging” and complicated espresso machines that eroded the degree to which visiting Starbucks resonated with consumers.

 

Perhaps the most acute risk we see in Starbucks’ future trajectory is the growing number of ventures under the auspices of the current management team. We expressed this on 6/5/12 in a note titled “ONE MOVE TOO MANY?”, writing  that the company seemed to be embarking on an investment phase implied added risk to the share price. Managing five concepts, we wrote, seemed to be a departure from the returns-focused strategy had added value to the company in recent years.

The best argument against the idea that Starbucks will begin to destroy value by overstretching its shareholders’ capital is the current management team’s leadership.  Schultz’ emphasis on discipline and rigor in his team’s approach to making capital allocation decisions differs greatly from other, less effective, executives in the industry.

 

 

Executive Changes

 

As Starbucks becomes larger, and a greater number of individuals assume leadership positions, the potential for executives to leave to pursue alternative paths could increase. Michelle Gass leaving the company for Kohl’s Corp. is a blow, with CEO Howard Schultz having praised her impact on several key areas of the business including a key role in the turnaround of 2008/2009.

 

What Gass’ departure means for the stock is difficult to know. The pessimist may infer that her departure represents, in part, a lack of confidence in Starbucks’ future trajectory as she had, just one month ago, been called back from her role leading the EMEA division to work in an undefined leadership role under Schultz focusing on making the “pieces” of Starbucks work together, according to The Wall Street Journal. Gass worked for Stabucks for 16 years and, in time, may have been a candidate to assume a leadership role in the company’s C-Suite.

 

We believe that Gass’ departure from the company is a negative but, given her focus on the EMEA division over the past couple of years, it is clear that the company has many other talented individuals that have helped drive important areas of the enterprise forward. If we were to speculate, we would guess that the incentive of almost $10 million over the next four years likely had more of an impact than unease in her role at Starbucks.

 

 

EMEA

 

The weakness of Europe’s economies poses a risk to all global companies but we believe that Starbucks is relatively well-prepared to weather the storm. The company derives a very small proportion of its earnings, or less than 2% of total consolidated operating income, from EMEA which offers shareholders peace of mind as Europe continues to struggle to find economic momentum. Even with such a low degree of exposure, the company is taking a proactive approach to mitigating the risk of further economic turbulence in EMEA by increasing the proportion of licensed to company-owned stores.

 

SBUX: WELL CAFFEINATED - sbux emea pod1

 

SBUX: WELL CAFFEINATED - yum mcd sbux opinc

 

 

Bull Case: Strong Dollar, Growth Runway, Commodity Costs, Mgmt Team, ROIIC

 

Strong Dollar, Strong America, Strong Consumption

 

In November 2012, our Macro team turned positive on U.S. growth, which is 71% consumption, as the strengthening U.S. Dollar gave consumers a food and energy price cut. With the U.S. economy continuing to improve, we believe that Starbucks is one of the best ways to play a strengthening consumer. Jobless Claims, in particular, are an important metric for Starbucks’ Americas business as, in the most basic terms possible, more people going to work translates very closely into more people buying coffee as part of their daily routine.

 

SBUX: WELL CAFFEINATED - sbux americas pod1

 

 

Growth Runway

 

The strength of Starbucks’ Americas retail business is well-appreciated. Additional growth over the long-term TAIL will be largely driven by other segments of the business such as CPG, China, India, K-Cups, single-serve, home brewers, tea ($40 billion category), juice, and food among others. With management aiming to double the China unit count to 1,500 from 700 by the end of 2015 and viewing the CPG business as potentially becoming as large as the U.S. retail business, we believe that Starbucks is far from the end of the growth phase of its maturity curve.

 

 

Coffee Costs

 

Favorable coffee costs, coinciding with strong top-line growth, have resulted in strong earnings and cash flow generation. This tailwind is likely to continue through the end of the year and beyond, with management expecting a $100 million tailwind from coffee in 2014.

 

SBUX: WELL CAFFEINATED - coffee chart

 

 

Management Team

 

This is not a quantifiable factor but for anyone that has been following the restaurant space for any significant period of time, it is evident that a management team’s aptitude is often evident in their communications with the investor communities. Starbucks, over the last five or six years, has demonstrated a consistency in its message and its commitment to prudent growth that has set is apart from most of its competitors. Starbucks’ brand is one of the best-recognized in the world as the company has taken proactive steps to build an industry-leading loyalty program and an unrivalled social media presence, which has manifested in strong organic growth.

 

 

ROIIC

 

Last, but certainly not least, the ROIIC metric indicates that management is walking the walk. This chart is a key component of our process on all restaurant names – particularly those growing units – and Starbucks is better than most at sustaining a disciplined approach to expanding its business operations.

 

SBUX: WELL CAFFEINATED - sbux roiic

 

 

Howard Penney

Managing Director

HPenney@hedgeye.com

646.455.0992

 

Rory Green

Analyst

RGreen@hedgeye.com

646.455.0992

 


Did the US Economy Just “Collapse”? "Worst Personal Spending Since 2009"?

This is a brief note written by Hedgeye U.S. Macro analyst Christian Drake on 4/28 dispelling media reporting that “US GDP collapses to 0.7%, the lowest number in three years with the worst personal spending since 2009.”

read more

7 Tweets Summing Up What You Need to Know About Today's GDP Report

"There's a tremendous opportunity to educate people in our profession on how GDP is stated and projected," Hedgeye CEO Keith McCullough wrote today. Here's everything you need to know about today's GDP report.

read more

Cartoon of the Day: Crash Test Bear

In the past six months, U.S. stock indices are up between +12% and +18%.

read more

GOLD: A Deep Dive on What’s Next with a Top Commodities Strategist

“If you saved in gold over the past 20 to 25 years rather than any currency anywhere in the world, gold has outperformed all these currencies,” says Stefan Wieler, Vice President of Goldmoney in this edition of Real Conversations.

read more

Exact Sciences Up +24% This Week... What's Next? | $EXAS

We remain long Exact Sciences in the Hedgeye Healthcare Position Monitor.

read more

Inside the Atlanta Fed's Flawed GDP Tracker

"The Atlanta Fed’s GDPNowcast model, while useful at amalgamating investor consensus on one singular GDP estimate for any given quarter, is certainly not the end-all-be-all of forecasting U.S. GDP," writes Hedgeye Senior Macro analyst Darius Dale.

read more

Cartoon of the Day: Acrophobia

"Most people who are making a ton of money right now are focused on growth companies seeing accelerations," Hedgeye CEO Keith McCullough wrote in today's Early Look. "That’s what happens in Quad 1."

read more

People's Bank of China Spins China’s Bad-Loan Data

PBoC Deputy Governor Yi says China's non-performing loan problem has “pretty much stabilized." "Yi is spinning. China’s bad-debt problem remains serious," write Benn Steil and Emma Smith, Council on Foreign Relations.

read more

UnderArmour: 'I Am Much More Bearish Than I Was 3 Hours Ago'

“The consumer has a short memory.” Yes, Plank actually said this," writes Hedgeye Retail analyst Brian McGough. "Last time I heard such arrogance was Ron Johnson."

read more

Buffalo Wild Wings: Complacency & Lack of Leadership (by Howard Penney)

"Buffalo Wild Wings has been plagued by complacency and a continued lack of adequate leadership," writes Hedgeye Restaurants analyst Howard Penney.

read more

Todd Jordan on Las Vegas Sands Earnings

"The quarter actually beat lowered expectations. Overall, the mass segment performed well although base mass lagging is a concern," writes Hedgeye Gaming, Lodging & Leisure analyst Todd Jordan on Las Vegas Sands.

read more

An Update on Defense Spending by Lt. Gen Emo Gardner

"Congress' FY17 omnibus appropriation will fully fund the Pentagon's original budget request plus $15B of its $30B supplemental request," writes Hedgeye Potomac Defense Policy analyst Lt. Gen Emerson "Emo" Gardner USMC Ret.

read more