Starbucks Is Set for Growth

We believe Starbucks’ SBUX recently reported fiscal third quarter will mark a turning point in the investment narrative, where the market shifts its focus to how customer experience, menu innovation, and digital initiatives solidify the company’s wide economic moat and position it for future growth. The key highlight from the quarter was comparable growth of 7% in the United States (4% ticket, 3% transaction) and 6% in China (4% ticket, 2% transaction), indicating that Starbucks is working through the experience and innovation issues we’ve called out in the past and validating why this stock was our top pick heading into the year.

We think Starbucks can maintain its current growth trajectory for several reasons. Our discussions with personnel at legacy and remodeled locations indicate that simplified operations and labor reallocation efforts are unlocking meaningful throughput capacity and improving speed of service. While the recently announced Brightloom partnership is meant to assist international licensed partners in developing a digital flywheel, we believe it can also lead to experience refinements and new convenience-focused Starbucks formats (similar to Starbucks Now in China). In addition, Starbucks’ innovation pipeline is strong: The Nitro Cold Brew platform will continue to be a key sales contributor as it is rolled out nationwide, international consumer packaged goods products have been well received in new markets via the Global Coffee Alliance, and replacing Mercato with a new fresh food program should have a positive impact in 2020. With loyalty member acceleration and increased delivery footprints in the U.S. (which will have national coverage through Uber Eats in early 2020) and China, we see 4%-5% global comps as realistic in the next two to four years.

We’ve raised our fair value estimate to $90 per share from $80 to reflect our greater optimism regarding Starbucks’ medium-term revenue growth and margin expansion potential. While we’d prefer a wider margin of safety before investing, we still view Starbucks as one of the more dynamic growth and income stories among large-cap consumer stocks.

While Starbucks’ valuation looks less compelling than it did at the beginning of the year--the shares are up 52% year to date compared with 20% for the S&P 500 and now trade at 30 times our preliminary earnings per share outlook for fiscal 2020--we see very little risk to the company’s updated fiscal 2019 guidance. This includes 2,000 net new stores (down from 2,100 because of a slower pace of openings in the Europe, Middle East, and Africa region--300 versus 400 in prior guidance--but still assuming 1,100 in China/Asia-Pacific and 600-plus in the Americas region), global comps of 4%, revenue growth of 7% (including a 2-point hit due to operational streamline-related activities), a slight decrease in adjusted operating income growth (excluding the impact of its consumer packaged goods partnership with Nestle) due to employee and technology investments, adjusted EPS of $2.80-$2.82 (versus previous guidance of $2.75-$2.79 due to strong year-to-date results), and $2 billion of capital expenditures.

With 2019 likely to yield few downside surprises, we believe the more important question facing Starbucks investors is what longer-term sales and margin assumptions to base valuation assumptions upon. Over the next five years, we now believe it’s reasonable to anticipate average annual revenue growth of 9%, up from earlier projections of 8%. Our model assumes 7% annual unit growth (aided by the prospect of new restaurant formats in both domestic and international markets) as well as 4%-5% global comps (versus ongoing guidance of 3%-4%) driven by mobile order and pay and other digital initiatives, delivery (where we believe the company can exceed the 1.5-2.5 ticket average that most restaurants experience with delivery orders due to large group orders), beverage and food innovations, and ongoing restaurant throughput refinements. Over the same period, we project annual operating income growth around 10% as the sales leverage tied to increased comps is partly offset by store operations investments, new retail configurations and equipment to better address evolving consumer preferences, and technology enhancements, but with five-year margins coming in just above the high end of management’s ongoing guidance (17%-18%). Over a longer horizon, we anticipate adjusted operating margins exceeding 20%, driven by sales leverage from streamlined store operations and technology initiatives, international scale improvements, and contribution from the Global Coffee Alliance.