There are core problems lurking at Starbucks, in our view, and the idea that the chain will triple the number of company-owned store closings in US markets in fiscal 2019, to 150 (from 50, on average, in prior years), is rather telling that something’s not quite right, regardless of whether it may be too-high of prices, changing consumer preferences (millennials), increasing competition (McDonald’s, Dunkin’ Donuts), oversaturation in densely-penetrated markets–or a combination of all of the above.
By Brian Nelson, CFA
On June 19, Starbucks (SBUX) reset investor expectations lower, just a couple weeks after former CEO and executive chairman Howard Schultz announced he is walking away from the business to pursue other personal interests, some speculating that it will be a 2020 US presidential run on a Democratic ticket. The news for Starbucks’ shareholders likely comes at no worse of a time, as the coffee giant’s pace of retail growth in the US continues to be challenged at the same time it is engaging in aggressive expansion endeavors in China. CEO Kevin Johnson and new Chairman Myron Ullman, who came over from J.C. Penney (JCP), will have their work cut out for them, especially to preserve brand image in the wake of social backlash.
The brand has always been a source of Starbucks’ “moaty” characteristics, and its ability to continue to price its beverages at a lofty premium depends on consumers’ willingness to pay up. Questions have started to come up as to whether millennials (MILN) may not want to pay for that $5 cup of joe, however, and with the chain raising prices 10-20 cents on most of its brewed coffee earlier this month, signs of stress may be showing. There is only so much consumers may be willing to pay for coffee and given the influx of competition from the likes of McDonald’s (MCD), which has successfully reinvented itself with all-day breakfast, and Dunkin’ Brands (DNKN), some consumers may just like the coffee at McDonald’s and Dunkin’ Donuts, no matter how savvy Starbucks’ brand/marketing endeavors may be.
In the same press release clarifying its strategic priorities and operational initiatives, Starbucks lowered its expectations regarding same-store sales expansion for the current quarter, which appears to be pacing at a modest 1% rate, despite considerable digital initiatives by the coffee retailer, and well below fiscal 2018 targets, released in late April, calling for comparable store sales to be in the 3%-5% range for the fiscal year, albeit at the low end. Not only are comps under pressure, but Starbucks also noted that it “anticipates lower net new store growth in the US for fiscal 2019.” The company seems to be struggling to achieve its goal to accelerate growth in the US and China, even if it may be able to increase cash returned to shareholders, which it now targets at $25 billion through fiscal 2020 (a $10 billion increase), a move that is related to the 20% increase in the quarterly dividend, to $0.36 per share ($1.44 annualized; ~2.7% dividend yield).
We’ve generally given Starbucks the benefit of the doubt given its brand strength and “status” symbol destination coffee shops that have kept loyal customers coming back, but it is growing possible that consumers are starting to balk at its prices, especially millennials. Harley-Davidson (HOG), for example, is dealing with a new wave of consumers that may not think hitting the open road on a roaring Harley is “cool” anymore, and similarly, Starbucks could be getting the initial wave of the coming generation that may not think it cool to drop $5 on a coffee every morning. When it comes to coffee, perhaps the sentiments of millennials are growing more like that of Shark Tank investor Kevin O’Leary that won’t even spend $2.50 on a cup of coffee, let alone $5 for a fancy “venti white mocha.”
There are core problems lurking at Starbucks, in our view, and the idea that the chain will triple the number of company-owned store closings in US markets in fiscal 2019, to 150 (from 50, on average, in prior years), is rather telling that something’s not quite right, regardless of whether it may be too-high of prices, changing consumer preferences (millennials), increasing competition (McDonald’s, Dunkin’ Donuts), oversaturation in densely-penetrated markets–or a combination of all of the above. Its dividend yield is starting to get more attractive as shares falter and management focuses on increasing the payout, but there may be further sledding ahead of shares. We value Starbucks about where the market does at the time of this writing (in the mid-$50s per share), but if current troubles turn out to be more permanent in nature, the low end of the fair value range may be more appropriate.
We’re not ready to jump into shares of Starbucks just yet, but for dividend growth investors, the company should definitely be on your radar. In the event things start to turn up again for Starbucks, do not be surprised if it makes it into the simulated Dividend Growth Newsletter portfolio. In the meantime, we’ll be watching it very closely.
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Brian Nelson does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.