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The Science of Hitting
The Science of Hitting
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Starbucks: Heading Back in the Right Direction

A look at the coffee company's third quarter results

July 30, 2020 | About:

Coffee giant Starbucks (SBUX) recently reported results for its third quarter of fiscal 2020.

As expected, it was a difficult quarter, with revenues down 38% to $4.2 billion. This reflects the impact of the pandemic, with the majority of the stores in the United States – Starbucks' most important market – closed at the start of the quarter. Today, 96% of the U.S. stores are open again. Globally, comparable store sales declined by 40%, with comps in the U.S. and China down 40% and 19%, respectively. The difference between comps and revenues was attributable to mid-single digit growth in units, with the company ending the quarter with 32,180 locations globally.

The good news is that there’s been a meaningful improvement in the comps over the past few months. At the trough in April, U.S. comps were down 65%. By quarter end, this had improved by 50 points (-16%). In addition, for the 3,100 stores that were open throughout the entire quarter, comps have actually moved back into positive territory in July (+2%).

Improving the trend has been depedent upon serving customers without them walking into a Starbucks and placing an order. As noted on the conference call, “Almost 90% of sales volume in the quarter flowed through the combination of drive-thru’s and Mobile Order & Pay.” Much like at Chipotle (CMG), Starbucks has benefited from its investments in digital. They are also helped by a strong brand and a large base of recurring customers, with more than 16 million Starbucks Rewards members in the U.S. at the end of the third quarter.

In my mind, these are the seemingly small things that may nudge a consumer to place their next order with Starbucks as opposed to a local coffee shop. Simply put, it's easier. Starbucks is also making real estate decisions to further address the growing need for on-the-go consumption. For example, it will open 50 Starbucks Pickup locations over the next 12-18 months. For those reason, while the results are clearly challenged in the short-term, I think there’s reason to believe that Starbucks will emerge from this crisis in a strong position relative to its competitors.

As I noted last quarter, the vast majority of Starbucks locations in China were open at the end of the second quarter (albeit with modified schedules and limited seating). Despite this, comps still declined 19% in the region. This points to a reality that I think we’ll see in other parts of the world as well, and which is supported by the guidance on the call: just because stores reopen does not mean consumers will immediately return to the routines and spending habits that existed before Covid-19.

As a result of the material sales deleverage experienced around the world, as well as the continuation of salary and benefits for some employees despite extensive store closures and temporary support to franchises through royalty relief, operating margins declined by more than 3,000 basis points to -13%. For the quarter, Starbucks reported a non-GAAP operating loss of $530 million compared to $1.25 billion in operating income in the year ago period.

As I’ve noted in the past, the company’s per share financial results have benefited in recent years from sizable share repurchases. As shown below, the company spent more than $19 billion on repurchases in the three years through the second quarter of fiscal 2020.

The activity in the past twelve months continues to have an impact, with the diluted share count down by nearly 5% in the quarter. However, between the combination of the pandemic and the aggressive capital returns in recent years, Starbucks is a bit stretched; as a result, the company did not repurchase any shares in the third quarter, and is unlikely to do in a material way for a year or longer. As a result of the aggressive capital returns in the past few years, Starbucks now has roughly $12 billion in net debt - compared to a net cash position three years ago. As a result, the company has much less financial flexibility than they did in 2017 or 2018.

Conclusion

At $77 per share, Starbucks trades at a high-20’s multiple on trailing earnings. On 2020 earnings, which management has forecasted will be less than $1 per share, the stock has a forward price-to-earnings (P/E) ratio of more than 80 times. The issue for investors, as management discussed on the call, is that earnings are unlikely to return to their 2019 levels anytime soon. The company believes sales in China and the U.S. will not return to their previous levels until the first half of 2021. In addition, they expect profit margins to lag the recovery in sales by “about two quarters.” Said differently, management does not expect the company’s most important regions to return to their pre-Covid levels of profitability for at least a year. In addition, the previous tailwind from outsized capital returns has been removed from the equation (for now). In my mind, that suggests the business may not exceed $3 per share in earnings for 2-3 years. Relative to today’s stock price, that does not strike me as a bargain – especially if you have doubts about the potential long-term impacts that may arise as a result of work from home trends (which I believe is a major concern in the near and intermediate term) and / or further headwinds from the pandemic (as management noted on the call, they are currently facing business pressure in China due to a resurgence of cases in Beijing).

As always, I have no idea what the stock price will do in the short-term. I would love to own Starbucks at a more attractive price. For now, I don’t think we’re there.

Disclosure: None

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About the author:

The Science of Hitting
I desire to own high-quality businesses for the long-term. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio, with the top five positions accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

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