Description

Starbucks is a high-quality business with a long runway to compound earnings per share at 12-15% through a combination of unit growth of ~5%, same store sales growth of 5-8%, margin expansion of 1-2%, and share repurchases of 2-3%. A 25x multiple on $4/share of earnings power in 2022 results in a $100 stock. For reference—a table from the Pershing Square Presentation on SBUX (October 9,2018--https://assets.pershingsquareholdings.com/2014/09/09140753/Doppio.pdf)

1-3 Year average P/E: 25.9x

2-5 Year Average: 26.7x

3-10 average was 24.4x

The foundational assets at SBUX, namely the irreplaceable real estate portfolio (with a growing drive-through presence), the digital ecosystem, the brand, the CPG product portfolio (VIA/RTD Bottled Frappuccino/Ground/Roast Coffee/Single-Serve) and the unique third-place model create a durable and profitable business model that can thrive as long as people desire some combination of high-quality coffee and tea-based beverages, convenience and social interaction. The Chinese business, which has the potential to be larger than the U.S. business over time, provides valuable optionality; net of the value of the U.S. business, the CPG business, and Asia ex-China (namely South Korea and Japan), I do not believe that an investor is paying much for China’s growth today. I believe that SBUX is going to be immensely successful in China due to its third-place model, digital assets, and careful and thoughtful localization of product, supply chain, and SBUX China business culture that it has invested in and nurtured for over 20 years in China.

            Kevin Johnson, the new CEO who took over for legendary founder Howard Schultz is 2017 is a highly underrated leader with a unique combination of strategic, operational and financial capabilities. He cut his teeth at the highest levels of Microsoft and as CEO of Juniper Networks. Howard Schultz was a rare retail genius, but in some ways Johnson may be the better leader for the time given his analytical approach and technology background.  

            Not unlike what Roberto Goizueta did at another iconic beverage brand, Coke, Mr. Johnson is making serious structural changes to SBUX business model that will create a leaner, more focused, more profitable and more durable enterprise. Mr. Johnson’s major moves were already starting to bear fruit with the strongest holiday quarter in the Company’s history in Q1 2020, as well as U.S. comps that were up 8% through March 11 (led by a healthy 4% transaction growth) (strongest topline performance in 4 years) before Coronavirus derailed the progress. I believe the challenges for coronavirus for SBUX’s business are transitory; SBUX will emerge from the crisis in good shape, well-positioned to expand and deepen its relationship with customers through an improving mix of high-quality beverages and growing convenience in payments, loyalty and order fulfillment.

             Under Mr. Johnson, SBUX has made major structural changes that focus its business model around the retail sales of coffee and beverage, building a world-class digital platform with an industry leading mobile order and pay, rewards, and digital gifting functionality, and investments in AI. Since 2017, SBUX has also optimized its international portfolio by licensing non-core markets that were previously company-owned, taking ownership of its East China JV giving SBUX total control of the highest growth market in the world, selling Tazo tea to Unilever, and closing Teavana retail stores. The biggest move was in In 2018 when Mr. Johnson sold a broad suite of SBUX’s packaged coffee rights to Nestle for $7B, representing the third largest M&A deal in Nestlé’s history, a remarkable data point considering Nestlé’s size and the fact that Nestle did not buy control of the brand. Coffee is a key business for Nestle around the world, especially given that coffee is one of the few attractive growth categories in CPG. SBUX gives Nestle scale and brand power in the premium end of the at-home packaged/single serve coffee market in the U.S., as well as a large opportunity to expand its single-serve and instant coffee business internationally. The deal also allows SBUX to focus solely on retail operation. It would not surprise if one day Nestle made a bid to acquire SBUX in its entirety, given that almost every large branded coffee business has been acquired over the last ten years (Costa by Coke/; Tim Horton’s by 3G/; Caribou-Stumptown-Intelligentsia-Krispy Kreme—Keurig/JAB; part of Blue Bottle/Nestle). I think it is pretty incredible that 3G/Burger King paid about $11B for control of Tim Horton’s—and Nestle paid about $7B for perpetual rights to a subset of SBUX CPG rights with ongoing royalties.

            In 2018, Mr. Johnson opened an innovation center (Tryer Center) with an aim of expediting SBUX’s innovation lead-time from concept to commercialization from 180 days-100 days. Strategically, Mr. Johnson had focused building market differentiated beverage platforms that can support line extensions, category innovation and customer loyalty, rather than one-off beverages that drive traffic but not repeat business (i.e. Unicorn Frappuccino).

            The cold beverage platform anchored by cold brew and refreshers, has been runaway success; cold beverages now represents nearly 50% of SBUX sales, up from 30% a few years ago years ago. The cold beverage platform is a key strategic advantage because it opens up the afternoon daypart, particularly in warm weather, creates a sticky morning offering for customers who want a refreshing beverage on the way to work, and is generally hard to substitute with in-home coffee. I am personally a SBUX cold-brew addict and have not found any substitute cold brew that I like as much as SBUX. Starbucks is leveraging the cold platform with great innovation: cold foam/salted crème cold brew/pumpkin cold brew/nitro cold brew. I believe that long term, the cold beverage platform will drive sustained customer loyalty, store productivity (i.e. install a nitro cold brew tap and leveraged fixed cost), and optionality in the packaged goods channel (Pepsi, SBUX’s RTD license partner in the U.S., is expanding its RTD cold beverage offering at retail).

            Mr. Johnson has also changed capital allocation in a big way, buying back large amounts of stock with a combination of free cash flow and leverage. The balance sheet is a bit weaker than it was, but with nearly $80B in equity value, $2.5B in cash and equivalents, and ~$11B of long-term debt (ex. operating leases), the Debt/Capital is reasonable for this business. Mr. Johnson has made appearances on CNBC, sometimes referencing the stock price. I am under the impression that he cares about the stock price.

            At a high level, scaled branded beverage is a great category of CPG. Customers are loyal, taste and brand matter, private label substitution is low, and the gross margins are very high due to lower and more predictable inputs costs than food-based CPG. Within branded beverage, coffee is particularly attractive because it can be consumed in/out of home, has many form factors (roast/ground/ready-to-drink/single-serve) is a daily essential for a lot of people often multiple times per day, can be sold cold or hot which expands the addressable market, and does not have some of the negative trends around health and wellness faced by carbonated soft-drinks/high sugar content products.

            The Starbucks business model is spectacular. Store level unit economics include a <2 year payback, 30% store level EBITDA margins, and format flexibility due to the lack of kitchen capital equipment the use cases for coffee across broad demographics, and the coffee-focused model (i.e. the smell of SBUX does not detract form the experience at Target/Kroger/Publix—all locations for SBUX stores etc). SBUX occupies a particularly special place in restaurant retail as the “third place”—the stop that many consumers make before work or home, or a spot to meet, study, socialize or date. This third-place positioning, combined with SBUX capability to localize the aesthetic through décor and design, gives many stores a local, community atmosphere. The concerted push to open more drive-through (80% of new U.S. units will have drive-through) should fundamentally improve the store productivity because drive-through generate higher AUV.

            I think SBUX is essentially a subscription business, absent the recurring subscriber fee paid in advance. The combination of an addictive product, a routine/habit-based purchase, an increasingly sticky value proposition through the mobile experience (both payments and rewards-40% of the transactions in the US are now coming through mobile-based loyalty program), and the most convenient store locations build deep loyalty and repeat business among a recurring base of customers. Evidence of this is the fact that SBUX has 100mm customer visits per week and spends almost no money on marketing—and anecdotal evidence of this is my daily visit to SBUX at 5:30-6am in the morning that often involves waiting in a long-line for a drive-through (which is starting to move at brisker pace). Some of this has always been true about SBUX: but now management is focused on deepening the core advantages on the business; SBUX has ample room to improve all aspects of the consumer experience: SBUX can take friction out of ordering/drive-through/payments, as well as improve personalization and direct marketing through its app, product innovation on top of its new platforms, store productivity through automating scheduling, enhancing the gift-giving ecosystem through the app, and improving CPG economics as Nestle grows the SBUX brand around the world and the product portfolio expands.

            There are more exciting ideas out there. But I think this one of the only stocks that I know where there is a combination of durability built on strong sustainable competitive advantages, improving economics through digital, and a wonderful (relatively) new management team that seems committed to making the business better. There is a low-risk of technological obsolescence hurting the competitive position, the unit economics degrading, or consumer taste and preference shifting away from the core product offerings. Therefore, I think the business deserves to trade at high multiple reflective of the quality, durability, and relative predictability of earnings growth.

            The two biggest near-term risks are a slow-down in consumer spending related to COVID-19 hurting SBUX sales as consumers trade down/buy fewer products/indulge less. The other biggest risk is that the intangible value of the third-place model is impaired because the idea of sitting around/waiting in a crowded SBUX is not appealing in the wake of Coronavirus.

            Both risks to me are not fatal. I think the combination of convenience (drive-through/digital pay), rewards program, improved product offering, and the general addictiveness of coffee mean that SBUX will not lose meaningful share in downturn. The business is a much healthier position from a product and real estate standpoint that it was on 2010-2011 (which was a bad period for the company). On the second risk, I would expect that it will be a headwind near-medium term. But humans are social animals and once it is safe to go out, I believe SBUX stores will be full again and the intrinsic value of a convenient local community gathering spot anchored by coffee will shine through.

Catalyst

1-improved execution

2-growth in China

3-rebound in 2021