Did you hear that? That was the world’s largest company, Apple (NASDAQ:AAPL), firing a warning shot about slowing growth in the world’s hottest economy, China. Everyone heard the shot when it was first fired on January 2. Stocks across the board dropped. But now, less than two weeks later, everyone has seemingly forgotten about that warning shot, and stocks are in rally mode.
That’s fair. Stocks, by and large, are undervalued, and other risk factors are improving, such as the Fed becoming more dovish and U.S.-China trade talks progressing nicely. But, China’s economy is still cooling, and that’s bad news for companies with broad exposure to China, regardless of how other risk factors are playing out.
One such company is retail coffee giant Starbucks (NASDAQ:SBUX). For all intents and purposes, due to dried up growth everywhere else, the Starbucks stock growth narrative is entirely centered around China. Given Apple’s warning shot, that’s a worrisome position to be in. Indeed, Goldman Sachs recently downgraded Starbucks stock to Neutral due to the company’s broad exposure to the slowing China economy. Goldman actually warns that Starbucks could issue a warning like Apple about slowing growth in the near future.
Goldman hit the nail on the head with this downgrade. To warrant its current valuation, Starbucks stock needs everything to go right. But, because of Apple’s warning, we know everything isn’t going right in the most important region for the coffee giant.
Thus, the current valuation seems due for compression based on weakening growth trends, and that’s reason enough to stay away from Starbucks stock in the near term.
Worrisome Exposure To China
The core of the near-term bear thesis on Starbucks stock is that the company has a worrisome level of exposure to China, and that if growth in China falls apart, SBUX’s long-term growth narrative will substantially weaken, causing the stock to drop meaningfully.
It’s not all bad news in China, though. This is still a 6%-plus growth economy. And, while Apple recently issued a big warning about slowing growth in China, Nike (NYSE:NKE) announced two weeks prior that its China business was red hot.
My fear, however, is that Starbucks is on the Apple path in China, not the Nike path.
Over the past several quarters, Nike’s business has been heating up globally. Apple’s business has been cooling. So has Starbucks’ business. Thus, Nike’s ability to maintain strong growth in China is more a function of outstanding operational momentum than anything else. Starbucks doesn’t have that. Instead, Starbucks is more comparable to Apple in that growth is positive, but slowing from its multi-year trend.
From this perspective, the present situation for Starbucks in China is most likely one defined by slowing growth. That’s a big problem. Growth everywhere else is all dried up due to rising competition and saturation. Comparable sales growth in the U.S. has dropped from 5% and up a few years back, to 2% last year, with transaction volume actually down year-over-year. Europe, Middle East, and Africa comps have followed a similar trajectory, also with negative transaction volume growth last year.
Thus, the SBUX growth narrative is all about China. If China falls apart, so does this growth narrative, meaning that if China numbers are weak next quarter (as they should be), then Starbucks stock will drop meaningfully.
Valuation Has Room To Fall
In relation to what is likely substantial sales pressure in China, the valuation on Starbucks stock is a tough pill to swallow.
Starbucks stock trades at 24x forward earnings. That’s below the stock’s five-year forward multiple of 25. But, the company is also growing much less quickly today than it has over the past five years. Thus, a lower valuation is warranted.
With respect to its peers, that 24 forward multiple actually seems stretched. The forward P/E multiple across the whole restaurant industry hovers right around 22. McDonald’s (NYSE:MCD) trades at 22x forward earnings. Dunkin’ (NYSE:DNKN) trades at 23x forward earnings. Yum (NYSE:YUM), Jack In The Box (NASDAQ:JACK), and El Pollo Loco (NASDAQ:LOCO) all trade around 18 to 23x forward earnings.
Thus, relative to other mid-to-large cap restaurant names with fairly slow but stable growth, Starbucks stock still trades at a premium — despite worrisome exposure to China. That means that if China’s numbers do come in below expectations, SBUX stock could get hit by sizable valuation compression.
Bottom Line on SBUX Stock
Starbucks stock is a solid long-term holding given the company’s staying power in a stable growth global retail coffee industry. But, at the present moment, the valuation seems overstretched with sizable operational risks on the horizon. That means the near to medium term outlook for this stock skews bearish, despite stable long term fundamentals.
As of this writing, Luke Lango was long AAPL and NKE.
