David Rolfe Comments on Starbucks
- By Holly LaFon
We have established a new position in Starbucks (NASDAQ:SBUX) and made an addition to the position during the quarter, as well. We see a variety of avenues for sales and earnings growth over the next several years, through store expansion, modest growth in sales at existing stores, improving operating margins, and significant returns of capital to shareholders. While there are no undiscovered gems in the eleventh year of a historic bull market, we believe Starbucks represents an attractive, improving business which we were able to purchase at a reasonable valuation.
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The intrinsic value of SBUX
While Starbucks has stores all over the world, it has decided to focus on the U.S. and Chinese markets for the majority of its store expansion. These are two very different markets; the U.S. is the Company's largest market and is also a very mature market in terms of coffee consumption and competition; China potentially is a much larger market that is early in its development, and the market penetration for both Starbucks and competitors is extremely low. We see new stores in China as a high-return use of capital, as we expect margins and lease costs to be better than the corporate average. Also, on the store expansion front, we are fans of the decision by the Company's new CEO, Kevin Johnson, to limit the Company's investment in "Roasteries," as we had viewed these large-scale locations as extremely expensive long-term advertisements, and we are pleased to see the capital investment behind them curtailed.
In addition to growth from new stores, we believe Starbucks will be able to generate modest sales growth from its existing stores. While there have been, and will continue to be, temporary blips, we believe regular price increases, the continuation of greater food penetration as a percentage of total Company sales, the expansion of the Company's loyalty program, and constant product innovation all will contribute to modest same-store sales growth over time. In China, the Company also should benefit from the long-term expansion of coffee consumption per capita.
On the profitability front, we believe margins are bottoming (albeit at very attractive levels themselves) at the moment and expect profitability to begin to improve over the next several quarters. In the U.S. market, the Company soon will be lapping investments it made in store labor and diversity training; in China, margins have been higher than the corporate average until very recently, when the Company bought out one of its regional distributors, the short-term effect of which was to bring all the distribution costs on to the Company's P&L. Once we lap this acquisition in China, and comparisons are back to an apples-to-apples basis, we expect to see Chinese margins improving again, as well.
Starbucks began a significant capital return program last fiscal year, using its healthy free cash flow, along with a modest increase in debt, to fund an increased dividend (by roughly $300 million per year) and a significantly higher level of share repurchase (from roughly $2 billion per year in both fiscal years 2016 and 2017 to over $7 billion in repurchases in fiscal 2018). We think the Company's commitment to divert more of its excess cash to share repurchases will contribute modestly to earnings growth, giving us greater comfort in the Company's ability to generate sustainable double-digit percentage earnings growth.
Finally, looking at valuation, while the stock has had a nice bounce from multi-year lows seen last summer, we see valuation as reasonable in comparison to the Company's own historical ranges, and in relation to the broad large-cap growth market. We see fundamental results bottoming and inflecting positively, while P/E and EV/EBITDA valuations are sitting in the middle of the Company's historical range, and the stock is trading at a very attractive price in relation to free cash flow.
From David Rolfe (Trades, Portfolio)'s first-quarter 2019 Wedgewood Partners client letter.
This article first appeared on GuruFocus.
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The intrinsic value of SBUX
