- Buying quality businesses should be the focus of every investor
- We will take a look at what the business does
- There are many factors that contribute to the growth of Starbucks and will continue to do so
- The company’s robust financials should give investors enough confidence in the business
- Potential risks will also be explored
If you are a follower of Warren Buffett and the way that he sees investing, then you should be familiar with what he said about having a punch card with 20 holes in them. Every time you make an investment decision, you would fill up 1 hole. And when you have made 20 investment decisions, you are done. In that context, I am certain that you would consider very carefully before deploying your capital into any business.
Given that scenario, one stock that I would definitely add to my portfolio would be the coffee giant, Starbucks (NASDAQ: SBUX).
Since its Initial Public Offering (IPO) back in 1992, the stock price has increased by more than a 150 fold which equates to more than 20% per annum, tidily outperforming the S&P 500 index.
Should we still be excited about a company that has heavily rewarded its early investors? If there is still more growth left in the business, of course!
2. Business Overview
Founded in Seattle in 1971, Starbucks has grown into the world’s largest coffee business (approximately 15,300 stores in the U.S.) which sells specialty coffee through company-owned and licensed stores and other various channels. Today, it has expanded its product offerings into teas, juices and a variety of fresh food items.
Overall, the mechanics of the business isn’t complex; it’s just food and beverage products after all. Can a business with such a simple business expand and strive for world domination? Let’s explore the opportunities that lie ahead.
3. What Is There to Like About Starbucks?
- A Huge Membership Base Which Signal Brand Loyalty
One thing that can be said of Starbucks is that it isn’t simply just a store that provides its customers with a caffeine fix; it is a business that is evolving into a full-fledge lifestyle brand.
A metric that is used to measure the company’s brand loyalty is the growth in membership base. In 2014, the membership count in the company’s Starbucks Rewards loyalty program has a total of 8 million active members. In the latest quarter, it has hit a record 12.3 million active loyalty members in the U.S. alone.
Brand loyalty can be considered to be an economic moat for the company. Over the years, Starbucks has been able to increase the price of the products that it sells without losing its customers. And the growing membership base is prove. A price increase translates to higher revenues, higher profits and ultimately, greater shareholder value.
- Stronger Distribution Channels
The company’s Channel Development segment has grown tremendously. The business provides roasted beans, ground coffee, teas, and ready-to-drink beverages to grocery stores, warehouse clubs, convenience stores, and other retailers.
During its most recent quarterly earnings, this segment of the business grew by 10% to hit $441 million in revenue and $188 million in operating income. Supermarkets and convenient stores in Singapore have started to carry some of these products. Investors, being consumers as well, will be able to observe and see if these products remain on the shelves here. If so, the Channel Development segment will keep the growth story intact for some years to come.
- Greenfield Opportunities in International Market
Besides having pricing power, which is the ability to raise prices on goods and services without losing its customer base, Starbucks is one of those companies with plenty of opportunities ahead of it.
The brand is being welcomed by many new markets that it enters. Currently, it has 24,395 stores in 74 countries with more than 300,000 employees.
Here is a quick breakdown on the number of stores by the region:
What should get investors excited about Starbucks is that its plan to open more stores continues to materialise. Also, China is playing a huge part in the company’s growth. It estimates that it will be able to open 500 new stores in China every year, for the next 5 years! While China is the second largest market, I believe that it will very soon take over the U.S. as the largest market.
- Competent Management
Howard Schultz, an entrepreneur whom I admire, left Starbucks in 2000. Jim Donald took the reigns as CEO and it seemed that he would do a great job in building one of the finest brands in American history.
Well, not quite.
In 2006, same-store sales were down despite generating higher revenues. By 2008, the stock price had been cut in half and Schultz returned to lead (He even documented the entire experience in his book, Onward).
Schultz had turned Starbucks into more than just a place to get coffee; he turned it into a place where people come together to meet. A place where people meet for work, studies and even dates.
With Schultz at the helm, I am confident that the business will continue scaling to new heights.
4. A Look at the Financials
Another attractive aspect of Starbucks is its financials. Over the years, the company has been disciplined in how it allocated capital and managed resources.
The result? A profitable and growing company with a rock-solid balance sheet.
- Growing Revenue and Profits
Over the last 3 years, the company’s revenue and net income has been compounding at rate of 8.4% and 17.8% respectively. This is important as it is a reflection of the company’s pricing power and also shows that its expansion plans and initiatives have yielded fruit.
In 2013, Starbucks was involved in a lawsuit which has caused it $2 billion. As such, the net income for 2013 has been almost entirely wiped out. In the years ahead, Starbucks quickly rebounded and continued to grow.
Over the next 5 years, most of the growth would be focused on China and other emerging markets. With the ability to raise prices and expand their product offerings, I expect revenue and profit growth to remain at the current rate for the next 5 years.
- Steady Returns on Invested Capital
For every company that we invest in, the Return on Invested Capital (ROIC) has to be greater than the Weighted Average Cost of Capital (WACC). That simply means that the returns on using long-term debt and equity is greater than the interest payments due on the debt and shareholder’s expected return. Starbucks has demonstrated to shareholders, year after year, that it has fantastic capital allocation chops.
From the chart, ROIC has been above 40% since 2014 (2013 had been a tough time for Starbucks as mentioned above) while WACC has been declining. By being efficient with the use of capital, the company’s management is making sure that growth will remain sustainable for years to come.
- Venti-Sized Dividends
Lastly, the company has been able to grow dividends year over year. What’s even more exciting is that the growth rate of the dividend is far greater than the rate of inflation while the pay-out ratio remains very conservative (it is currently at 43% of net income).
In 2013, the dividend per share is $0.42 and this year, it has grown to $0.80 per share, almost doubling from 3 years ago.
5. Potential Risk
- Key-Man Risk
No brand is above being tarnished and Starbucks is proof. While the Schultz-led turnaround has been a success, keeping up the momentum will require unflagging focus and attention.
Although he is showing no signs of leaving yet, his eventual departure is arguably the largest risk shareholders face. When Jim Donald took the reigns as the CEO back in 2000, the company crumbled. I think that investors should keep an eye on whether the company has taken succession planning into account.
- Volatility in Commodity Prices
Starbucks is subject to coffee and dairy commodity price swings. This means that the cost of goods tend to be relatively unpredictable. The good news is that the company has taken steps to hedge those costs.
Additionally, there are also other cost to consider. If interest rates were to rise, interest expense will also increase and this will add pressure on the company’s margins. Securing real estate to open up new stores will also be more expensive and could perhaps slow down the company’s expansion plans. While I am impressed with how resources has been allocated to grow the business, shareholders should not turn a blind eye to these potential risks.
- Competition from Smaller Players
I have heard this from people around me almost a hundred times:
“Why would you spend $8 on a cup of coffee?”
Well, it’s a valid question. But it also raises some red flags for shareholders. It means that consumers have plenty of alternatives to choose from. Be it the $1 coffee at your local coffee shop to $2.50 coffee at Toast Box to the $6.50 coffee from boutiques, the alternatives are endless.
Furthermore, Starbucks is priced at a premium in comparison to most alternatives. While the company has managed to maintain its pricing power, if consumer discretionary spending falls, Starbucks could be at risk of losing market share, especially to less expensive competitors.
There are few companies positioned for the future as well as Starbucks is today. As a shareholder, I am excited about a company that is on a mission to continuously outperform its status quo. On top of that, having a repeat-purchase business model makes its long-term growth prospects that much more appealing.
If I was given a ticket with 20 punch holes in them, Starbucks would be a company that requires me to use 1 of it.
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Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.