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Why Starbucks Stock Dropped But I Still Like It (NASDAQ:SBUX)

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Investment thesis

Starbucks is a leading brand with a wide moat. The company has sufficient capacity to pass on cost increases to customers. She faces key challenges — COVID-related restrictions in China, organizing efforts, CEO transition — but the company can maneuver beyond these. It is these challenges that explain the stock’s fall more sharply than that of the market this year. So the stock has fallen to attractive levels and, of course, there are reasons for the fall.

I think the stock should bounce back once the issues are resolved.

An overview of operations

Starbucks Company (NASDAQ: SBUX) is a leading specialty coffee roaster, distributor and retailer, with operations in 84 markets. Revenue from company-operated stores accounted for 85% and licensed stores accounted for 9% of total net revenue in fiscal 2021. Under a licensing agreement, Starbucks receives a margin on branded products and supplies sold to the licensed store operator, as well as a retail royalty. Sales. Licensees are responsible for operating costs and capital investments.

Store mix bar chart

Starbucks

In North America, Starbucks has more company-operated stores than licensed stores, while most of its stores are licensed in international markets. The company expects 75% of net new stores in fiscal 2022 to be outside the United States

Coffee consumption is booming in the United States

Coffee consumption trends in the United States support companies like Starbucks. According to a March 2022 report by the National Coffee Association USA, coffee consumption has reached a two-decade high in the United States. The report further states that specialty coffee consumption hit a five-year high in March.

Coffee, an integral part of the morning routine, will see healthy growth in the years to come with more people returning to work and thus taking their coffee outside the home at places such as Starbucks.

China presents a huge opportunity

Outside of the United States, China presents a huge opportunity for Starbucks growth. According Statistical, the value of out-of-home coffee consumption in China is expected to increase from 49 billion yuan in 2020 to 160 billion yuan in 2024, with a CAGR of 34.4%. Starbucks is well positioned to take advantage of this growth, as China is the company’s second largest market.

In addition, in 2021, roasted coffee generated the most revenue, about $9.4 billion, in the coffee market in China. According to Statista Market Outlook estimates, this is expected to reach around $13.25 billion in 2025.

finance

During the 2017-2021 period, Starbucks showed decent growth. Revenue from corporate stores increased at a CAGR of 8.7%, while revenue from licensed stores increased at a CAGR of 3.3%. Total revenue increased 6.7% CAGR.

Total operating expenses over this period grew CAGR of 7.1%. Operating profit during this period recorded a CAGR growth of 4.2%. Net income also saw a healthy CAGR growth of 9.8%.

In the second quarter of fiscal 2022, total net revenues increased by 14.5%, mainly due to higher revenues from company-operated stores. Company-operated store revenue growth was driven by an increase in average ticket as well as an increase in same-store transactions.

However, inflationary pressure resulted in a 110 basis point increase for the quarter in product and distribution costs as a percentage of total revenue. At the same time, store operating expenses as a percentage of total net income also rose 110 basis points. As a result, operating profit for the quarter fell to $948.9 million from $987.6 million in the comparable quarter last year, showing a decline of 3.9%.

Speaking of the downfall, Starbucks CEO Howard Schultz noted that:

“Even so, inflationary pressures outpaced our price increases, causing several points of near-term margin compression and costing us more than 200 basis points in the first half of the fiscal year. In the second quarter, we were able to absorb the additional costs while meeting our EPS expectations. »

Schultz also noted that “well over $1 billion is loaded onto Starbucks cards waiting to be spent” at the company’s stores. The company will recognize this revenue when customers use it. This highlights customer loyalty for Starbucks.

Risks

  • The rising cost of high-quality Arabica coffee beans can impact a company’s finances. High quality arabica coffee usually trades at a higher price than “C” coffee. World coffee prices have been rising over the past 5 years as shown in the graph below.

Coffee price over 5 years

St. Louis Fed

If this trend continues, Starbucks’ cost of sales will increase, which will hurt profitability. According StatisticalArabica coffee was selling for $2.93/kg in 2018 and its price is expected to increase to $4.28/kg in 2025.

However, Starbucks management brags about the inelastic demand for its products. The company has over $1 billion in Starbucks cards, indicating customer commitment to the brand. Over the past year, the company has faced inflationary pressures and raised prices several times. Still, the company experienced negligible customer loss.

  • China is the fastest growing market for Starbucks. It is also the second largest market for the company. Recently, major cities in China have seen new outbreaks of COVID-19. The Chinese government had imposed restrictions to control the outbreak. Starbucks management said it was unable to predict the company’s performance in China in the second half. Due to the uncertainty in China, accelerating inflation and large investments planned by the company, management has suspended guidance for the third and fourth quarters.
  • Starbucks is one of the top companies to see unionization in the United States. Unionization could lead to increased costs for the company. Indeed, companies often try to discourage union organizing efforts by spending more on benefits.
  • There are concerns Schultz has been recalled as Starbucks struggles to find a suitable replacement for Kevin Johnson. The performance of the new CEO, once appointed, remains to be seen.

Notably, Schultz had also been recalled in times of crisis earlier, such as in 2008. Current labor pressures as well as the COVID situation in China signal tough times for Starbucks in the near term. This may have prompted management to put Schultz back in charge. He has experience in handling employee unrest in the past and was the one who started the company’s operations in China. His appointment should help quickly resolve some of the company’s pressing issues.

Evaluation

The stock is trading at a discount to its median 5-year P/E ratio. His current P/E ratio of around 21 seems reasonable.

Chart
Data by YCharts

Alpha Seeking’s proprietary quantitative ratings rate Starbucks as “hold.” The stock is rated low on valuation and earnings revisions and high on profitability.

Conclusion

The coffee market is set to grow in the years to come. Starbucks being in the premium category will benefit from the increased market for coffee drinkers as well as a general increase in per capita disposable income. The stock is trading at a decent valuation relative to its 5-year median.

China, Starbuck’s second-largest market, although recently stalled by the pandemic, has strong growth potential in the coming years. Even though the company is facing issues with unionization in stores, these issues are not expected to affect the company’s financial results and stock market performance in the long term, provided the company’s fundamentals remain strong. Overall, Starbucks stock looks like a good buy at current price levels.