Morningstar.com recently highlighted nine undervalued stocks with moats. One of those on the list is Starbucks (NASDAQ:SBUX), which Morningstar considers to have a wide moat and gives SBUX stock four out of five stars.
I, too, believe there are many reasons why Starbucks is worth owning despite the novel coronavirus pandemic. However, it is the company’s move to distance itself from the grocery-store aisles that could deliver unexpected rewards during the Covid-19 pandemic.
If you’re thinking the benefit has something to do with Luckin Coffee’s (NASDAQ:LK) fall from grace you’d be wrong. That said, Luckin is going to have a hard time recovering from the current fraud allegations, which leaves Starbucks as the undisputed champion of the Chinese coffee market.
And that’s nothing to sneeze about.
The Sale Heard ’Round the World
However, the benefit I’m speaking about requires that we go back to May 2018, when Starbucks sold the rights to its packaged coffee, tea and ready-to-drink products in the grocery store channel. Nestle (OTCMKTS:NSRGY) paid $7.2 billion for the licensing rights. Almost two years later, the global coffee alliance the two companies formed appears to be delivering on its potential.
That’s great news for both shareholders.
For Starbucks, CEO Kevin Johnson said at the time of the deal that it “will bring the Starbucks experience to the homes of millions more around the world.” What he didn’t say is that it would allow the company to focus on what it does best, while Nestle could do what it does best in the grocery store market. Also, Nestle got an additional global brand to sell right beside its Nespresso offerings. It was a case of one plus one equals three.
More importantly, the cash Starbucks received in August 2018 when the deal closed is helping the company deal with the downturn in its business in 2020.
Well, in the third quarter of 2018, Starbucks had $2 billion in cash and short-term investments on its balance sheet. At the end of its fiscal year, it had $8.9 billion in cash and short-term investments, almost five times as much liquidity. That liquidity enabled it to borrow more money to speed up its growth in China.
And now that Luckin looks to have shot itself in the foot, the bet is looking even smarter.
Where’s the Global Coffee Alliance Today?
In February, Nestle’s head of coffee, David Rennie, and Starbucks’ head of global channel development, John Culver — it includes consumer packaged goods, food service, and Evolution Fresh — held a joint telephone interview to discuss the launch of Starbucks-branded capsules for Nestle’s Nespresso and Dolce Gusto single-serve coffee brewers.
“We expect this business to continue to grow for the foreseeable future,” Rennie said. “We’ll be in 50 markets by the end of this quarter.”
Since Nestle acquired the rights to Starbucks products in the grocery store channel, it’s grown sales in the U.S. by 15% to $2.3 billion. Culver believes that the global coffee alliance has lots of growth available outside North America, so there’s no question Starbucks was wise to pass the baton to an organization that is deeply embedded in markets around the world.
Rennie suggested that Nestle had seen an increase in online orders in China as a result of the coronavirus. According to the International Coffee Organization’s report for the week ended April 18, the demand for coffee was way up. In France and Italy, coffee spending was up 35% and 30%, respectively.
While the surge in demand has pushed wholesale coffee prices higher to meet the demand, and that would put a crimp in gross margins for Nestle, the corresponding surge in sales should be music to the ears of Starbucks shareholders, because Nestle pays a royalty on sales, almost all of it Starbucks profit.
The Bottom Line on SBUX Stock
In March, I said SBUX stock was a good buy under $50; a very good buy under $40. It didn’t quite make it to $50. Now trading above $70, I’m reluctant to recommend it unless you plan to hold for five years or more.
However, I like the way China and its global coffee alliance are setting up for continued growth on both the top and bottom lines. If it falls into the mid-$60, I’d say go ahead.
In the meantime, I’d keep it on your watchlist.
Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.