I will admit to having a love-hate relationship with Starbucks (SBUX). On the one hand I can’t understand why people stand in line for overpriced, burnt coffee (only my opinion so please hold the emails). However, over the last few months I have become obsessed by those little brown Starbucks ‘Doubleshot’ cans of cold espresso and cream sold next to the energy drinks and sodas.
In fact, I get so frustrated when the cans are sold out (a fairly regular occurrence) that I decided to take a little informal survey of convenience store clerks on a recent road-trip to Las Vegas. The response was generally along the lines of “we can’t keep these in stock.” These little cans belong to a product segment called Consumer Packaged Goods (CPG) and got me thinking about growth prospects for SBUX in general.
My experimental survey was just anecdotes and shouldn’t be taken as data but it matches up with SBUX’s recent filing where CPG grew 12%, and the company’s primary business of company-owned stores grew by 13% versus the same quarter last year. However, although growth is nice, profits are even nicer. On that front SBUX ran into a $2.7billion snag over the last year.
Due to a lawsuit with Kraft — now Mondelez (MDLZ) — over ending their retail partnership, SBUX recognized a litigation expense of more than $2.7 billion last year, which knocked net income down to nearly breakeven for the year. The company has the liquidity to the cover the expense and although this is a big penalty, it removes a major source of uncertainty about the company’s financial position.
Time to Focus on Growth
My argument for growth now that the lawsuit is over is very similar to the kind of calculation that would be used to estimate potential GDP growth. Economists estimate that growth is equal to the sum of expected growth of technology, labor and capital. Although SBUX has taken a hit to cash, their revenue generating assets continue to grow and their ability to borrow is very strong.
The company has grown labor efficiency from 11.3 transactions per labor hour to 11.7 per labor hour over the last three years. Multiply that across 1,700 new stores opened last year (more than 500 of those in China) and the boost from labor and technology improvements become material.
On the technology front the company is using mobile payments and rewards programs to boost sales and usage. Currently 11% of all transactions are done via mobile payments. If they can cut those lines a little more, even I might become a customer!
There is some risk that rising coffee prices could cause a problem for SBUX in the near term. Coffee prices have been dropping since 2011 but the effect of cheaper inputs lags quite a bit before hitting SBUX’s bottom line. However, if coffee prices were to rise, the impact is felt much more quickly. The old marketing truism of it being easier to lower than raise prices can create problems for a company dependent on the price of a volatile commodity. You can see in the next chart that coffee prices have hit a low equal to a consolidation range from the mid 2000’s where is could bounce.
However, barring an unexpected spike in input prices (which could trigger an exit from the trade) we think SBUX is undervalued. The removal of the lawsuit’s overhang has opened the doors for better shareholder payouts and more transparency into the company’s financials. Investors tend to over-discount those issues but the stock hasn’t broken out yet, which should give us an opportunity.
As you can see in the next chart, SBUX is forming a nice pennant or symmetrical triangle over the last month. Volume has been falling through the pattern, which is what we would like to see, but it has spiked on the big up days. This is a pattern we often observe when the big traders are working on accumulating the stock.
On a break above resistance, we would expect the stock to rally roughly equal to the distance of the move leading into the consolidation. In this case, that is $8-$9 per share for a price target in the $88 range. SBUX tends to move quickly to the upside but option traders would likely want to build in some extra time before expiration just in case the stock retests support. Stop losses should be set one average true range below support near $79 per share.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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