Bill Ackman (Trades, Portfolio) at Pershing Square (PSHZF, Financial) is making a comeback in 2018. NAV per share is up 9.7% while the S&P 500 index (SPY, Financial)'s year-to-date performance is only 3.5%.
In his latest letter to investors Ackman detailed a number of investment cases. I have picked out the $900 million Starbucks (SBUX, Financial) investment as the most interesting one to highlight. Direct quotes are clearly marked as such and followed up by my commentary and potentially illuminating context.
Starbucks is up about 35% since Pershing's initial investment. It is a fairly typical investment for Pershing. The firm has historically done exceedingly well within the "restaurant" category. Starbucks is somewhat of an odd duck within that category, but it is close enough that we will see Pershing's skills translate well.
Pershing believes Starbucks has a strong competive advantage:
"Starbucks is the category killer with a wide competitive moat, underpinned by quality and innovation advantages over low-cost coffee and quick service restaurant (QSR) players, with convenience, technological, and cost advantages compared with higher-end, boutique coffee shops."
I definitely w ill not argue against Starbucks' competitive advantage but will add that it is unlikely to be "a secret," which implies the market will have incorporated its competitive advantage into its price.
"New Starbucks stores have industry-leading unit economics, which we estimate generate a pretax return on investment of ~65% in the U.S. and ~85% in China in their first full year of operations. Starbucks is one of the rare mega-cap businesses with a long runway for reinvesting free cash flow at exceptionally high rates of return, as we estimate that every dollar the company spends on building a new store in one of its major markets is worth $10 to $15 after the store opens."
Pershing has also done well by identifying restaurants with strong growth potential and if they are correct about these types of growth rates, Starbucks could be a strong investment. But these types of returns are hard to come by and should incite additional competition.
"We believe that the company should continue to grow its global store count at a high-single-digit rate for the foreseeable future driven by underpenetrated markets such as China where per capita coffee consumption is less than 1% of U.S. levels."
Note that this is a very high growth rate because the company is sitting on a huge installed base of stores. Starbucks views China as its second home market and is indeed taking expansion there extremely seriously. The two countries together account for 80% of earnings.
This past quarter was the first in which CEO Kevin Johnson, who assumed the role in April 2017, led the company without the active involvement of founder Howard Schultz, who stepped down as executive chairman in June of this year. We are impressed by the bold actions that Johnson and his team have taken to date to simplify the business in order to drive accelerated growth and shareholder returns.
Among other things, the management team sold its consumer packaged goods division to Nestle (NSRGY, Financial), who are experts on that front. In return they received cash but more importantly an ongoing sales royalty. This is incredibly important because even if Nestle manages to drive the packaged goods division to great heights, the sale will have been beneficial to Starbucks. Meanwhile it does not take any attention away from managmenet. The return on headache is exceedingly high.
Management also sold its Tazo tea brand to Unilever (UL, Financial), which is less important but also chips away at mangement diversion.
But Pershing points out other beneficial actions as well:
"Management is reducing overhead expenses as a percentage of systemwide sales by ~22% net of reinvestment over the next three years, with the goal of increasing the pace of innovation through faster decision making."
These actions all point towards a leaner and meaner Starbucks and are a positive surprise. Usually you'd expect the opposite as a company transitions away from a founder-led operation.
"Management is acutely aware of the stock’s undervaluation and has implemented a large three-year share buyback program of nearly $20 billion, shrinking the share count by 7% this past fiscal year and a further ~13% over the next two years. We are pleased with the stock’s increase of 32% versus our average cost and continue to believe that Starbucks remains undervalued, and should generate highly attractive returns from current levels over the next several years."
If Starbucks can take out 20% of the sharecount in the next two years, that is immensely beneficial and by itself accounts for 10% returns per year. Of couse this is magnified greatly as the company manages to grow same-store sales and store count over the same period. Starbucks trades at only 6.5x free cash flow. But that is a deceiving metric because of asset sales. On an EV/Ebitda basis it trades around 15x, which is attractive if the company manages to hit its growth targets as expected.
I tend to prefer more deep-value situations, but Pershing has historically been very succesful with its restaurant investments. And Starbucks could very well be further confirmation of this trend.
Disclosure: no positions.
