The Drop in Starbucks Stock Doesn’t Look Like a Buying Opportunity


Starbucks stock - The Drop in Starbucks Stock Doesn’t Look Like a Buying Opportunity

Source: Adrianna Calvo via Stock Snap

Investors have been waiting for Starbucks Corporation (NASDAQ:SBUX) stock to break out of its tight trading range for about three years now. It’s finally happened, but Starbucks stock didn’t move in the direction shareholders were hoping.

Instead, SBUX plunged last week, falling 9% after cutting expectations for its fiscal third quarter and the full fiscal year. The company is closing 150 underperforming stores in the U.S. as well.

After the plunge, Starbucks stock now trades at at its lowest levels in almost three years.

There’s a case that the decline represents a buying opportunity. On this site, Nicholas Chahine made that argument, and recommended selling puts on Starbucks stock.

While I see the logic of a hedged entry into Starbucks, I’m more inclined to agree with James Brumley, who cited real risks to Starbucks’ long-term growth.

Indeed, I’ve been skeptical toward Starbucks stock for some time – and a 10% pullback doesn’t change the argument here.

Growth is decelerating, the opportunity in China looks tenuous, and Starbucks stock still isn’t that cheap. Indeed, Starbucks still is priced for growth – but management itself seems to be signaling that growth is at or near an end.

Starbucks’ Growth

The core issue here is that Starbucks stock still is priced for a reasonable amount of growth. At Monday’s close near $51, Starbucks still trades at 21x the midpoint of updated FY18 EPS guidance of $2.39-$2.43.

But the question is the same as it was in April, and last September, and indeed for the past three years: from where is that growth coming?

Global comparable-store sales growth is decelerating to 3% or so, including a ~1% print in Q3. In the US, the news may be even worse.

Labor costs are rising, thanks to wage increases at companies like McDonald’s Corporation (NYSE:MCD), Target Corporation (NYSE:TGT), and Walmart Inc (NYSE:WMT), among many others.

There’s essentially zero room left for expansion: net store growth is guided to roughly 3% next year, down from 6% last year.

And just as is happening everywhere else in the consumer industry, whether in restaurants, retail, or consumer products manufacturers, customers increasingly are choosing small, local, and unique.

Add to that pressure in sugary drinks like frappucinos, and there are multiple headwinds toward the U.S. business.

And so that leaves Asia. The company bought out its joint venture partner in Japan in 2014, and did the same in China last year.

Almost a quarter of the company’s stores are located in China and that figure only is going to rise.

For the company as a whole to increase profit enough to support the current price, China needs to be a big growth driver and in fact the big growth driver. Right now, that looks like a huge problem.

The China Problem

Starbucks said last week that it was planning to accelerate its store opening strategy in China, targeting 6,000 stores by fiscal 2022, up from 3,070 at the end of last year.

That likely would mean the market easily would account for one-third of the company’s global footprint.

Starbucks believes in a huge long-term opportunity. A growing middle class should support Starbucks traffic.

The average Chinese adult drinks one-half cup of coffee per year, according to company figures, against ~300 cups annually in the U.S. But in the near- to mid-term, there are a number of obvious challenges.

A trade war could pressure growth in the country, as Will Ashworth pointed out, whether through government intervention or rising anti-American sentiment. Same-store sales have been solid – but slowed markedly in fiscal Q3.

Even the 4% level seen in the first half of the year isn’t that great, considering margin pressure and weakness elsewhere in the portfolio.

Again, this is a stock trading at 21x EPS – and one still pricing in the company’s long-term targets of 3-5% global comp growth.

That figure isn’t going to be hit if the US is stagnant and China is growing 3-4%. Growth has to accelerate – but it’s not clear how that will happen.

Starbucks Stock and Management

It’s worth noting as well that Starbucks management isn’t acting as if there’s a ton of growth left here.

It has shut down the online store. The packaged goods business has been sold to Nestle (OTCMKTS:NSRGY). And Starbucks is pouring ever-greater amount of capital into shareholder returns rather than growing the business.

That’s not necessarily a poor strategy. Starbucks’ dividend yield now is nearing 3% after another hike to 36 cents quarterly. Buybacks could boost EPS and provide some demand for the stock over the next few years.

But it’s also a strategy that befits a mature company. The decision to ramp up shareholder returns is an admission by management that the cash is better utilized by shareholders than by Starbucks itself.

In essence, it’s a sign that even Starbucks itself knows its growth phase is nearing the end. And if that’s the case, I’m not sure why investors should pay an above-market multiple for Starbucks stock.

As of this writing, Vince Martin has no positions in any securities mentioned.

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