Starbucks (NASDAQ:SBUX) has given its investors a jolt. SBUX stock has advanced 30% in recent months. But Starbucks is getting ahead of itself, and it’s time for investors to take profits before the coffee company gets spilled.
What’s the issue? For one, the company is meaningfully overvalued following the recent run in the share price. And secondly, much of the company’s future success, should it occur, would be based on highly uncertain growth prospects out of China. It’s not a bet that most investors should be willing to take.
The Bullish Argument for SBUX Stock
Obviously, with Starbucks’ recent move, the bulls are having a field day. Here’s the arguments they are making, starting with the most recent earnings report.
The company managed 3% overall same store sales growth out of its North American division. This unit has been lagging, so it’s quite the encouragement to see it picking up some steam this quarter.
Starbucks also is focusing on boosting profitability. It has several plans in the works for accomplishing this. First off, it is cutting five percent of corporate staff. The company also is working on upping its digital customer outreach programs to boost repeat sales in an affordable manner. It also has more customer engagement programs in progress in China, such as home delivery.
Analysts have taken a favorable eye to the quarterly results and Starbucks further efforts. Mizuho boosted SBUX stock from Neutral to a Buy with a $75 target. Goldman Sachs took its price target from $69 to $76. Wells Fargo lifted their estimate, but only slightly, from $64 to $66. Meanwhile, Morgan Stanley was unimpressed, leaving its rating at neutral with a $64 outlook.
Growth By Price Hikes
Yes, the earnings report was strong. But dig into the numbers a little more closely, and you’ll see some problem signs. For one, overall transactions actually went down by 1%. They gained 4% in revenues from larger orders and price increases. The problem is that you can’t hike your prices to infinity. Starbucks already costs more than the local competition in some cases.
With coffee beans near many year trading lows, there is little excuse for Starbucks to be hiking prices so aggressively outside of the U.S., where, admittedly, labor costs are a concern.
Needless to say, other chains don’t necessarily have to raise prices so quickly, and can represent an even stronger value proposition. Bulls can say that people will go to Starbucks no matter what, but things change. Don’t forget that SBUX stock plummeted 75% during the financial crisis doing far worse than the stock market as a whole.
China Is The Future, and That’s a Bad Thing
Besides declining customer visits, Starbucks has another big problem. They are opening stores at an insane rate in China. On the latest conference call, Starbucks stated:
“In China, we exceeded our plan and opened 585 net new stores and entered 17 new cities during the fiscal year. For the quarter, we opened 139 stores and entered five new cities, expanding our presence to over 3,500 stores across 148 cities on the mainland.”
That’s a spectacular amount of growth. More than 500 stores in a year. They are already up to 3,500 stores, and it’s their second largest market. It’s worth remembering, however, that Chinese consumers are not accustomed to drinking coffee.
One recent analysis suggests that the average Chinese person drinks fewer than five cups of coffee per year. Per year! That’s in comparison to 400 cups per person per year in North America and Europe.
The report says that Chinese people living in Tier 1 cities consume 20 cups of coffee a day, giving Starbucks a slightly better market. But they are already in 148 Chinese cities. How many more good opportunities are there for the firm in China?
This madcap expansion reminds me of 2005, when Starbucks was opening stores at a frantic rate in the U.S. only to have to shut them shortly thereafter when the recession hit.
In the most recent earnings report, same store sales from China grew by just 1%. They grew at a significantly better rate in both the United States and the rest of the world excluding Asia. Starbucks is making a worrisome bet on a region that doesn’t like their main product and is showing anemic sales growth already.
SBUX Stock: Steep Valuation for an Uncertain Future
Starbucks stock is now trading at about 23x forward earnings. Ignore the 20x trailing PE ratio, as it includes one-time benefits and would be significantly higher otherwise. The stock also sells for 3.4x price/sales, which is quite high for a restaurant.
For what it’s worth, both McDonald’s (NYSE:MCD) and Dunkin Brands (NASDAQ:DNKN) trade around the same PE ratios as SBUX stock. A Starbucks bull can argue that the company has better prospects than the other two. But McDonald’s brand packs as solid an international punch as Starbucks does and the business is much more recession-proof.
In the case of Dunkin Donuts, they have way more growth opportunities left in wealthier markets. In my opinion, all three stocks are overvalued now.
Starbucks stock could certainly go up more in 2019 if they manage to get better sales results in China and get passenger traffic back up in North America. But those are both pretty tall asks. If Starbucks can’t deliver, their lofty PE ratio may come in, bringing the stock back down toward $55 where it has long been trading.
At the time of this writing, Ian Bezek owned none of the aforementioned securities. You can reach him on Twitter at @irbezek.