Starbucks Corporation – I am happily buying at these levels
After reporting Q3 results earlier this week, Starbucks shares remain attractively priced. I am buying.
With shares in this coffee giant down 21% YTD, significantly underperforming the S&P500 (up 14%), and now trading at a whopping 40% discount to the historical average valuation, it’s no surprise that many eyes were on Starbucks’s fiscal Q3 results and management’s commentary earlier this week.
Starbucks is going through one of the roughest times it has ever had to deal with due to a combination of a cautious consumer, a new management team, and a boycott headwind in relation to the Israel-Hamas war.
As a result, Starbucks reported its first YoY revenue decline in Q1 in over a decade, excluding 2020, which was impacted by COVID-19 lockdowns. Indeed, Starbucks hadn’t reported a single quarter of negative growth in over a decade, but this has now changed as the company might not be the growth stock it used to be and is facing a plethora of headwinds.
In the face of these recent headwinds, many believe the Starbucks growth story is finally over. The company allegedly does not have much room to grow, with an already impressive global presence. And whereas I agree with the skeptics in part, I am a firm believer that Starbucks has plenty of room to keep growing revenue at a respectable rate thanks to expansion in China, Europe, and other emerging parts of the world.
In addition, the company has plenty of other levers to pull, like better playing into changing consumer preferences and more extensive opening hours, which could increase traffic. It is also continuously working on expanding its food and beverage offerings and customer loyalty through loyalty programs.
Overall, I believe the current skepticism toward Starbucks is a bit overdone.
Whether you like and visit the Starbucks shops or not, millions of people still do so daily, and this number of daily visitors has continued to grow rapidly over recent years as the coffee brand remains as popular as ever. For reference, roughly 40% of its customers still visit on a daily basis.
We shouldn’t forget that Starbucks is still one of the highest-regarded brands globally. This year, it was named the #1 restaurant brand for the 7th year in a row, extending its lead over McDonald’s with a brand value of over $53 billion, up 17% YoY. A brand remains one of the largest moats for any business, and Starbucks is in the top bracket.
So, whether you like the company or not, it is here to stay. Even as it faces significant near-term headwinds, trust me, a business like this will re-emerge. It is simply too popular and strong not to.
Coffee is also growing in popularity, being the most consumed beverage item already. Especially in emerging markets such as the Asia Pacific, where disposable income is growing rapidly, coffee is still rapidly gaining in popularity.
Take from me that Starbucks’ popularity, also in these emerging regions, will continue to grow over time thanks to its brand name and global presence. In the end, Starbucks is best positioned to benefit.
So yes, the Starbucks growth story is still far from over, even as growth may be less impressive compared to the last two decades due to the rule of large numbers kicking in and the company having less and less room to expand.
Positively, on top of decent expected revenue growth, Starbucks’ bottom line should expand even faster thanks to efficiency gains through technology and improving operating leverage. In my view, Starbucks, in a normalized environment and assuming it manages to do the right things (which I am not yet overly confident about), should be able to grow its revenue at a high-single-digit rate, while the bottom line should grow by low-to-mid teens.
It will be clear by now that I remain bullish on Starbucks’ long-term growth story, even though the company is currently not operating quite as well. The new CEO still has quite a lot to prove, as he has to turn the business around now. Short-term developments remain critical for the company’s medium-term trajectory.
On that note, let’s examine the company's performance in the latest quarter to determine whether now might be a good time to buy Starbucks or not.
Starbucks really isn’t doing too bad.
Starbucks announced its fiscal Q3 results last Tuesday, and, well, the top-line numbers didn’t really impress. Starbucks didn’t manage to beat the already rather downbeat Wall Street consensus on top and bottom lines, reporting a revenue miss and EPS right in line with expectations.
However, diving deeper into the results and putting them into perspective shows that while far from great, they weren’t that bad at all, with data pointing in the right direction.
For fiscal Q3, Starbucks reported revenue of $9.1 billion, which represents a 1% YoY decline, although up 1% in constant currency. This suggests a bottom might already be in for Starbucks as the revenue decline doesn’t seem to continue, showing sequential growth of a couple of percentages and the YoY decline not worsening from a 2% decline in Q1.
While not great, it also isn’t too bad.
Comparable store sales did remain down 3% YoY, driven by a 2% decline in the U.S. and significant weakness in China, where comparable sales fell by 14% YoY. This was somewhat offset by a stronger performance in Japan and Latin America. Still, overall international store sales were down 7% YoY.
According to management, this is the result of headwinds in the Middle East and part of Europe, mainly due to brand misconceptions regarding the company’s stance toward the Israel-Hamas war. Positively, this weakness seems to be easing a bit as less frequent customers are returning. Still, cautious consumer spending continues to impact overall growth, with customers visiting less frequently.
In the U.S., this same headwind led to a 6% decline in comparable transactions, offsetting a 4% average ticket increase driven by pricing and multi-beverage orders. As a result, revenue growth remained negative at 2%.
For China, the extremely poor results were worse than anticipated and reflected a challenging operating environment for Starbucks with increasing competition and cautious consumer spending. While the weakness was no surprise, its magnitude was. The region remains a drag on overall company results, even as the growth opportunity remains significant in the long term.
Overall, the top-line results reflect continued consumer weakness and challenges for Starbucks. However, I am pleased to see the trend not weakening further, particularly in the U.S., and Starbucks seeing some return in traffic compared to Q1, which, according to management, is also thanks to the developments they have been implementing recently in the U.S.
To give you some examples, according to the most recent data, Starbucks has been able to reduce calls received via the customer center by 50% and improve delivery times by 99%, indicating improved customer satisfaction.
Now, this might not sound overly meaningful, but these changes drive not only customer traffic but also productivity gains. For example, some recent technology updates allow Starbucks to reduce the production time of an order by 10-20 seconds, which is good for a potential 1-1.5% comparable sales growth thanks to more customers being served during peak times and higher customer satisfaction.
As I said at the beginning of this post, Starbucks has plenty of levers to pull to improve its business, even if they might not seem too meaningful.
Meanwhile, Starbucks also continues to see solid adoption for its Starbucks Rewards program, with members growing 7% YoY to 33.8 million, up from 6% growth in Q1. Starbucks is seeing solid growth across all ages and a higher visit frequency.
Monitoring progress here remains important as it indicates solid demand for Starbucks products. It also provides a growing recurring revenue stream and growth driver as loyalty members tend to visit much more regularly and spend materially more on an annual basis.
Overall, considering current near-term headwinds, I don’t think the business is performing as badly as it might seem at times. As a shareholder, I am not disappointed by this quarter, so the 3% jump in share price aftermarket made sense.
Moving to the bottom line, we can see Starbucks is struggling a bit more, even though margins aren’t looking all that bad considering the weak top-line. In Q3, the operating margin declined by 70 bps to 16.7%, “primarily driven by increased promotional activities, investments in store partner wages and benefits as well as deleverage,” according to management.
Positively, Starbucks was able to offset this somewhat with pricing and a “continued execution against reinvention-related in-store operational efficiencies, as well as out-of-store efficiencies, which primarily center around our supply chain.”
These investments meant that G&A expenses rose to 7% of revenue, somewhat higher than usual, but these efforts amounted to nearly 300 basis points of margin improvement, offsetting a lot of the weakness Starbucks is experiencing. Management now expects it to be able to deliver above the initial goal of finding #3 billion in efficiencies, now aiming for closer to $4 billion, which represents some great execution here.
While these profitability gains might not be very visible today, once the operating environment improves and Starbucks returns to growth, I expect some solid margin gains as a result!
Finally, in Q3, EPS was down 6% to $0.93, representing a weak top line and minor margin decline. All in all not all too bad.
In terms of financial health, Starbucks leaves plenty to be desired. It currently holds $3.2 billion in cash and cash equivalents against long-term debt of $15.5 billion, resulting in a net debt position of $12.3 billion, up from $10 billion last year, reflecting somewhat depressed cash flows.
Starbucks still maintains a BBB+ credit rating, but I would like management to focus on keeping its debt under control. I expect the balance sheet to improve once cash flows return to normal, with Starbucks previously able to deliver FCF of around $4 billion. However, Capex will also remain high, so I wouldn’t expect much improvement here any time soon.
This will limit Starbucks’ financial flexibility, especially in terms of buybacks. However, the dividend remains well covered, sitting at a payout of 64% based on this year’s EPS expectation. I know this is somewhat elevated, but EPS should recover quickly in coming years, which should lower the payout ratio to closer to management’s targeted 50%.
Investors do currently receive a very compelling 3% yield. On top of this, the dividend has grown at a 9% CAGR for the last five years and has grown for 13 consecutive years. While dividend growth will most likely be very low in coming years to allow the payout ratio to normalize, I do think that long-term Starbucks remains a compelling dividend growth investment, especially with a starting yield of 3% today.
With that, let’s move to the outlook and medium-term expectations.
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Outlook & Valuation
After significantly lowering FY24 guidance last quarter, management now confirmed guidance and left this unchanged. This means management still guides for revenue growth of low single digits, driven by comparable sales flat to declining by low single digits and global net store growth of 6%.
The operating margin is expected to be flat YoY thanks to a somewhat stronger expectation for the second half of 2024 due to lower investments. Finally, EPS is still expected to be flat or up in the low single digits.
Overall, I don’t think the narrative has really changed after these Q3 results, apart from the fact that they are showing somewhat of an improvement and a likely bottom. We could possibly see growth turn positive again in Q4 and into fiscal FY25. That seems likely right now.
Nevertheless, I have slightly trimmed my FY24 and FY25 estimates to reflect some continued cautious spending behavior by the general consumer. I now project the following results through fiscal FY27
Based on these updated estimates, Starbucks shares now trade at just under 22x this year’s earnings, which is roughly a 40% discount from the long-term average. On a PEG basis, we are also looking at a 20% discount to historical averages.
Now, of course, there is a lot of uncertainty, and shares certainly aren’t as attractive as they have been over the last decade, with growth slowing down and the financial position of the company not looking its prettiest.
Therefore, a discount is most certainly justified. However, I do think this has been overdone by now based on overly skeptical sentiment. For now, sentiment toward the shares remains far from great as it has become a show-me story. Investors are waiting for the trend to reverse and management to prove the company still has plenty of growth ahead of it.
Once this positive trend becomes more obvious, Starbucks shares can rebound quickly, especially with the backing of Elliot Management. The activist shareholder took a sizeable stake in Starbucks last month in an effort to turn this investment into a great gain by helping management right the ship, which I view as a positive. Management could definitely use some experience on this front.
However, I am not waiting for this turnaround to materialize. I remain confident in Starbucks’ long-term growth thesis and am happy to add shares at current valuations, even as uncertainty persists. Looking at the growth ahead, this company still deserves to trade at a premium in the longer term. Therefore, I deem a long-term earnings multiple of 22x to offer enough downside protection.
Using this multiple, I calculate an end-of-fiscal 2026 target price of $105, reflecting the potential for annual returns exceeding 14%, which is more than enough to warrant a buy rating.
Even based on conservative 2025 estimates and a discounted multiple, Starbucks shares should still be able to easily beat global benchmarks in the medium term.
I am happily buying at these levels!
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