We bought the Financials right as it was about to v-bottom. Not a time to get piggy. Book the tidy 3.2% risk-managed gain. That's the TRADE. We remain bullish on the Financials from a TREND perspective.
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.
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.
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.
Bear Case: Valuation, Sentiment, Portfolio Pitfall, Personnel Changes, EMEA, Brewer Growing Pains
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
Slot volume is the metric we watch closely - and growth is accelerating
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Takeaway: Recent policy developments call attention to the systemic risks facing China’s banking system. Additionally, MAY growth data came in soft.
PBOC, CBRC RAISING EYEBROWS (OURS AT LEAST)
This morning, we learned that the PBOC was out confirming that a deposit insurance system is ready to be launched after gathering much-needed political consensus. According to the central bank, the insurance system will help "increase the flexibility of commercial banks in terms of financial business innovation and risk control". Moreover, China’s regulation on the standardization of commercial bank bankruptcy – which has been deliberated on for five years – is expected to be submitted to the State Council in 2H13.
So let’s get this straight: Chinese authorities are A) implementing a deposit insurance scheme and B) finalizing regulations to facilitate commercial bank bankruptcies. Are we missing something or is Beijing preparing for some meaningful banking system headwinds over the intermediate-to-long-term?
In the context of the PBOC likely scrapping the deposit rate ceiling over the intermediate term, there have been concerns that smaller banks would be uncompetitive in a competing cost-of-funds environment. They would ultimately lose deposits and creditor faith as their ability to generate earnings growth declined amid slower or potentially negative financing growth.
The commensurate tightening of interbank liquidity is something we’ve been keeping an eye on; last week there was a rumor of a mid-sized bank failing to repay an interbank loan. Expect more to come on that front as we inch closer to the implementation of interest rate liberalization in China. Consensus has been celebrating/bidding up headlines on that front in the YTD, but we continue to hold a far less sanguine view:
As a reminder, we’ll be hosting a flash conference call this Wednesday at 11AM EST to discuss Chinese financial system risks in greater detail, having added CHIX (Global X China Financials ETF) to our Best Ideas list on the short side. We look forward to your participation and questions then.
RATTY MAY DATA
This weekend brought us some pretty ratty growth data out of China for the month of MAY. Perhaps the largest callout would be export growth slowing from +14.7% YoY in APR to +1% YoY in MAY, which is what we were calling for post the regulatory crackdown on fake invoicing. Back in line with reality, the MAY export growth figures may arouse global growth fears (exports to the US slowed to -1.6% YoY; exports to the EU slowed to -9.7% YoY).
In the context of slower capital flows stemming from a reduction in “fexports” (i.e. fake exports) and tighter interbank liquidity, the MAY credit growth data was also pretty subdued: total social financing growth slowed to +CNY1.19 trillion MoM from +CNY1.75 trillion prior as new loans ticked down to +CNY667.4 billion MoM from +CNY792.9 billion prior. That is unsupportive for fixed assets investment and industrial production growth, the both of which ticked down marginally.
All told, the sluggish MAY growth figures are in line with what we saw out of China’s recent PMI readings on both the manufacturing and non-manufacturing fronts and we continue to warn of A) incremental tightening (macroprudential or blunt instrument, if necessary) to stem rampant property price appreciation and B) a 2H13 slowdown in Chinese growth as conditions for credit growth deteriorate.
While certainly hard to know for sure, it is our view that much of the equity market upside stemming from positive sentiment surrounding the various avenues for reform (economic, financial, fiscal and social) was priced in during the recent rally.
For our latest thoughts on the Chinese economy and its banking system, please refer to the research notes hyperlinked at the bottom of this note.
Takeaway: The case for shorting Chinese financials stocks, frontier markets and EM LC and USD debt is becoming stronger by the minute.
This note was originally published June 07, 2013 at 11:44 in Macro
Normally, we aim to provide more lead time to get our Black Books and conference calls into your respective calendars, but the recent volatility across Global Macro markets has provided us with a strategic opportunity to expand upon our #EmergingOutflows theme. To that tune, the $5.5B in EM equity fund outflows per the most recent week of data was the largest weekly withdrawal since AUG ’11!
Specifically, we are now adding the following four ideas to our Best Ideas list and we will detail exactly why on next week’s call:
As an aside, we like to use ETFs in order to #TimeStamp our positions, but for those of you whose funds are larger in size and require additional liquidity, we encourage you to express these views at the asset class level as well.
In addition to these latest editions to our Best Ideas list, we are content to “book” the gain in our EEM short call. The ETF is down -2.6% since we introduced the idea on our 4/23 conference call titled: “Emerging Market Crises: Identifying, Contextualizing and Navigating Key Risks in the Next Cycle”.
While 260bps may not seem like all that much, we were able to extract a considerable amount of alpha from the position – particularly relative to our favorite equity market (USA); the EEM ETF has underperformed the SPY by a whopping 693bps since we introduced the thesis. While we still think there is room for this spread to widen, we are focusing our sights on the aforementioned new tickers, as we seek out more “juice” amid rising conviction in our views (see: Stanley Druckenmiller’s mantra on “spreading your wings”).
Lastly, if you're getting bear'd up here, don't lazily join the consensus crowd that has been getting squeezed trying to short US equities throughout the YTD. Short stuff like Emerging Markets that A) have a legitimate bear case and B) will actually decline in value for more than 1-3 days.
Have a great weekend,
Strong headline numbers belie the fact that promotional activity around new product introductions and trading day benefits masked the real issues at McDonald's in May. We continue to believe it will not be until July that we see what MCD normalized trends look like. Adjusted for the calendar/trading day impact, global comps actually registered a sequential deceleration in the two-year average trend.
MCD reported May global same-store sales growth of 2.6% versus 3.3% last year.
All the regional results showed positive same-store sales growth with the U.S. up 2.4% versus 4.4%; Europe up 2% versus 2.9%; and APMEA up 0.9% versus 1.7%.
The results benefitted from positive trade day variances of approximately 1% for the global business and between 0.6% and 1.4% for the balance of the regions.
The positive takeaway for the month is Europe, which reversed a string of 5 consecutive months of declining same-store sales. The strength in the U.K., and to a lesser degree Russia, continues to offset weakness in France and Germany as the comps become very difficult in June for many European markets.
U.S. same-store sales were better than our estimate, helped by the significant promotions following the introduction of the new Egg White Delight and, to a lesser degree, the McWrap.
APMEA posted slightly positive comps of 0.5%. Positive same-store sales were achieved on the back of better sales in Japan, offsetting declining sales in China, where Avian flu issues persist, and Australia.