Why Starbucks Stock Has Limited Upside

Starbucks stock - Why Starbucks Stock Has Limited Upside

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Once upon a time, Starbucks (NASDAQ:SBUX) was an untouchable retail coffee giant. Thanks to its premium branding and second-to-none convenience, the company was able to smash competitive threats, making Starbucks stock a decent investment.

Starbucks’ strength also enabled it to generate 5%-plus comparable sales growth and consistently increase its margins. But the era of Starbucks’ domination ended in 2016. Competition heated up. Starbucks cooled down and so did Starbucks stock. From mid-2015 to mid-2018, while the S&P 500 rallied  about 50%, SBUX stock went nowhere.

That trend, however,  reversed in the second half of 2018. From its early July bottom, Starbucks stock rallied more than 30% to close out 2018 at levels just shy of its all-time highs.

If you just look at the recent rally of SBUX stock, you’d assume that SBUX must have figured out how to beat its competition and is back to dominating the retail coffee sector.

But that isn’t the case. Starbucks’ competition is still hot, and it’s only getting hotter. Meanwhile, the company’s growth is still weak, and it looks poised to remain weak for the foreseeable future. Also, Starbucks’ margins aren’t expected to start expanding again anytime soon.

All in all, the fundamentals underlying Starbucks stock remain troubled.

To be sure, this is still a stable and globally recognized brand with staying power and double-digit earnings growth potential. Those fundamentals inherently make  Starbucks stock a long-term winner. But the near-to-medium term upside of Starbucks stock is limited by its still-extended valuation and the persistently slowing growth of SBUX.

Overall, Starbucks stock is worthwhile for passive investors. But for investors looking to generate alpha in 2019, there are much better options than SBUX.

Solid Growth

The big-picture growth outlook of SBUX is: solid, but not too exciting. Moreover, there are some reasons to be concerned about its growth outlook.

It’s solid because this is Starbucks, the global-retail-coffee brand  that has locations everywhere. The company’s premium branding and second-to-none convenience have resulted in consistently positive comparable sales growth over the past decade. Even over the past three years, as SBUX’s growth has meaningfully slowed, its comparable sales growth globally, in the U.S., and in China have all remained positive. The company’s margins have also been relatively stable.

That is expected to remain true for the foreseeable future. Management’s long-term targets include 3%-4% comparable sales growth globally and in the U.S., 1%-3% comparable sales growth in China and stabilized operating margins in the 17%-18% range. Putting all that together, management believes 10%-plus annualized earnings growth is achievable in the long run. That’s pretty solid.

But Nothing To Write Home About

But the company’s outlook also isn’t too exciting. Earlier this decade, SBUX was posting 5%-plus comparable sales growth, and its margins were consistently rising. Now its comparable sales growth is stubbornly stuck below 5%, while its margins are actually dropping. Thus, while the company’s growth is positive and its margins are expected to stabilize, that’s a far cry from what SBUX has done over the past several years.

Over the past three years, Starbucks has seen its growth outlook  weaken meaningfully due to rising competition from casual players like McDonald’s (NYSE:MCD), and from indie coffee shop companies like Peet’s. These threats aren’t going away any time soon. If anything, McDonald’s is only getting more aggressive on the breakfast drinks and snack fronts, while indie-coffee-shop culture is booming. As these threats continue to rise, Starbucks’ growth could continue to slow.

Moreover, China is expected to generate a big part of Starbucks’ growth, and the country is supposed to be a major positive catalyst for Starbucks stock. The company’s management continually touts its huge opportunity in China.

But the company’s comparable sales growth in China has fallen from 22% in 2011 to 1% last year, and China’s economy is cooling rapidly at a time when Starbucks is expanding quickly in the country. That isn’t a recipe for success, especially since Starbucks is starting to feel competition from casual coffee outlets in China, too, both from McDonald’s and the nascent but rapidly growing Luckin Coffee.

The Valuation of Starbucks Stock Doesn’t Fully Account for Its Risks

Starbucks looks poised to post results over the next five years which are  not as impressive as the results it reported over the past five years. Furthermore, if the company’s growth outlook in China gets derailed and/or its domestic growth continues to be hurt by intensifying competition, then Starbucks ‘ results over the next five years could be far worse than the results the company has posted over the past five years.

Thus, the base case for SBUX going forward  is subpar growth, and the bear case is extremely weak growth.

The valuation of Starbucks stock doesn’t reflect subpar growth. Instead, SBUX stock still trades at 24 times the company’s forward earnings, which is just a hair below its five-year average forward multiple of 25. That means the market is paying a historically average price for Starbucks stock, at a time when its growth will, at best, be below the historical norm. That doesn’t seem like a good deal for owners of Starbucks stock.

In all likelihood, Starbucks’ revenue will grow by  mid-to-high-single-digit percentage levels over the next five years. That top-line growth, alongside stable margins and healthy buybacks of Starbucks stock, should increase the company’s earnings per share to $5 by fiscal 2024.

A more normal, McDonald’s-like forward multiple of 20 for SBUX stock implies a fiscal 2023 price target of $100. Discounted back by 10% per year, that equates to a fiscal 2019 price target of $68. That implies  upside of about 5% this year.

The Bottom Line on Starbucks Stock

In the long run, Starbucks stock will trend gradually higher. But at current levels, its stretched valuation limits its near-to-medium term upside, especially considering the operational risks it faces from competition and slowing global growth.

If SBUX stock continues to drop towards and perhaps below $60, its near-to-medium-term upside will look compelling. But with Starbucks stock around $64, the best place for investors to hang out is on the sidelines.

As of this writing, Luke Lango did not hold a position in any of the aforementioned securities. 

Article printed from InvestorPlace Media, https://investorplace.com/2019/01/all-not-well-starbucks-kingdom/.

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