Caution Is Warranted for Starbucks Stock Ahead of Earnings

Starbucks stock - Caution Is Warranted for Starbucks Stock Ahead of Earnings

Source: Adrianna Calvo via Stock Snap

As the market has rallied the past few weeks, so have shares of retail coffee giant Starbucks (NASDAQ:SBUX). During this stretch, Starbucks stock is up 7%.

Things didn’t look as good at the beginning of 2019. To kick off the year, one of the world’s largest companies, Apple (NASDAQ:AAPL), fired a warning shot about rapidly slowing growth in China — the world’s hottest economy. Stocks broadly fell after that warning shot. But, it’s been nothing but up, up, and away for markets since then. Following the Apple-led market selloff in early January, the S&P 500 has rallied an impressive 8% in under three weeks.

But while Starbucks is up nearly that much, SBUX investors shouldn’t be forgetting the Apple warning shot so soon. To be frank, Starbucks stock should not have been part of the broad market rally in January. The reality is that Starbucks, much like Apple, is a company on a slowing growth trend with worrisome exposure to the slowing China economy. As such, first quarter numbers — due after the bell on Thursday, January 24 — won’t be very good, and they will likely include an Apple-like warning about slowing China growth going forward.

That negative update isn’t priced into Starbucks stock. Thus, not only could Starbucks fall after Q1 earnings, but it could also fall by quite a bit.

All together, while Starbucks is a long-term growth company that will ultimately head higher in a multi-year window, caution is warranted on Starbucks stock ahead of Q1 earnings.

The Numbers May Disappoint

Last quarter, Starbucks reported headline revenue and earnings beats with above-consensus comparable sales growth and a healthy guide. The theme of the conference call was that expansion in the China market would offset slowing growth in U.S. market, and reinvigorate the overall growth narrative. Investors rallied around that idea. Starbucks stock has done nothing but grind higher since then.

That puts Starbucks stock in a precarious position heading into Q1 earnings.

If anything has become clear since the last earnings report, it is that the Chinese economy is dramatically cooling off. Apple cut its quarterly guide in a big way due to slowing growth in China. China reported 6.6% GDP growth in 2018, the lowest annual pace in nearly 30 years. Q4 GDP growth was 6.4%, the slowest quarterly pace since the Financial Crisis. Other economic data coming out of China has been weak, including retail-sales growth rates hovering at 15 year lows.

This is all bad news for Starbucks stock. The core of the near term bull thesis on SBUX is that China growth is going to pave a brighter future for this company, which has struggled with slowing growth over the past several years.

But, that probably isn’t happening yet. It’s highly unlikely that Starbucks is bucking the broader China economic trend and putting up strong numbers in China. As such, China numbers this quarter will likely disappoint. If they do, the numbers globally will disappoint, too. Also, the tone on the conference call may be Apple-like, and include warnings about slowing growth going forward.

Overall, Starbucks is heading into an earnings report which has the potential to be pretty bad. That isn’t a favorable setup for Starbucks stock, especially at current valuation levels.

The Valuation Doesn’t Incorporate Disappointment

At the end of the day, it always comes down to numbers and valuation. For example, despite significant sales pressure in China, Apple stock is a buy here because it’s trading at just 12x forward earnings, and is priced for all the bad news.

That isn’t true for Starbucks stock. Despite facing significant sales pressure in China like Apple, Starbucks stock doesn’t trade at 12x forward earnings. Instead, it still trades at 25x forward earnings.

That is simply too big of a multiple for Starbucks stock. The whole restaurant industry trades at 22x forward earnings. Other major players in the quick service restaurant space like McDonald’s (NYSE:MCD), Dunkin’ (NYSE:DNKN), Yum(NYSE:YUM), Jack In The Box (NASDAQ:JACK) and El Pollo Loco (NASDAQ:LOCO) all trade around 18 to 23x forward earnings.

In the past, Starbucks stock warranted a premium valuation because of higher quality growth. That is no longer the case today. Comparable sales growth last quarter was just 3%. That is largely an industry average comparable sales growth rate (McDonald’s was up above 4% last quarter, and Yum was at 2%). Thus, this is no longer a higher quality growth company, meaning the stock no longer deserves its premium valuation. Compression to the norm valuation across the QSR space implies ~10% valuation downside risk.

Bottom Line on SBUX Stock

In the long term, Starbucks stock is a winner, powered by global brand leadership in the steady growth coffee retail industry. But, in the near term, Starbucks stock seems due for a correction as it rallies into an earnings report that will likely disappoint due to slowing China growth.

As such, near term caution is warranted. But, post-earnings pullbacks towards the $60 level could quickly turn into buying opportunities.

As of this writing, Luke Lango was long AAPL and MCD.

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