- Starbucks stock is facing headwinds on growth concerns.
- Starbucks continues to generate healthy economic profits.
- Analysts price target indicates more than 17% upside in stock price.
Yesterday, on August 29th, the Seattle based US coffee chain house, Starbucks (NSDQ:SBUX), opened its first store in Trinidad and Tobago, its 74th international market. Starbucks is under pressure to find new markets to continue its revenue growth, as same store sales growth, mainly in US, have slowed down. For any growth stock, the most important factor which determines the stock price is the growth potential. And any perceived slowdown could spell trouble for the stock.
The same happened with Starbucks stock, which was down 4.5%, after the company posted a good second quarter earnings, but showed a slowdown in US same store sales. Starbucks stock has since recovered most of its losses. While there might be some growth concerns, the long term growth story is still good with China playing a key part. More than half of the new stores in next few quarters will be outside the US, mainly in China/APAC. This region has shown healthy growth in the latest quarter. Here are three reasons why Starbucks stock still remains a buy.
Starbucks Profits Are Healthy
Starbucks has managed to grow its profits over the last five years while maintaining healthy margins. Net income has grown from $940 million in 2010 to $2.76 billion in 2016, a CAGR of 24%. Starbucks operating margin(ttm) currently stands at a healthy 19% while net margin is at 13%. In the latest quarter, while revenue saw a slight slowdown, EPS continued to grow at a fast pace. The latest quarter EPS growth came in at 24% YoY. And profit growth is likely to continue. According to yahoo finance, analysts estimate Starbucks earnings to grow at a healthy CAGR of 18.7% over the next five years.
But more importantly, Starbucks has continued to generate strong economic profit. Economic profit is the surplus generated after covering the cost of capital and is a measure of competitive strength enjoyed by the company. With WACC in the range of 7% and return on invested capital around 37% the Economic profit generated is huge.
Strong Cash Flows And Dividend Growth
Another parameter on which Starbucks has consistently delivered is cash flows, often regarded as the main parameter for judging a company's financial health. In the first nine months of FY2016, Starbucks has generated operating cash flows of $3.27 billion, 18% higher than $2.8 billion the company had generated in the first nine months of last year. Operating cash flows have increased from $1.7 billion in FY2010 to $3.75 billion in FY 2015. And FY 2016 cash flows are set to be even higher. In the latest quarter earnings call, while the company marginally lowered its revenue targets, cash flow targets remained unchanged.
The strong cash flows will allow Starbucks to keep its dividend increases going. While the current dividend yield of 1.4% is not very attractive, the fact that dividend has grown at a CAGR of 30% in last five years should interest income investors. With growing profits and a current pay out ratio at 44.6%, the company has enough room to increase its dividend.
Starbucks Stock Performance And Upside Potential
Strong growth and healthy profits had translated into a strong performance by the stock. Over the years Starbucks stock has generated strong returns for investors. In the last five years, Starbucks stock has generated almost close to 200% return. In the same period, the Nasdaq Composite (INDX:COMPX) has delivered 104% returns while S&P 500 (INDX:SPAL) has delivered close to 80% return. But in the last one year, while Starbucks stock has generated close to 5% returns, while S&P 500 and Nasdaq have returned close to 10% return.
However, going forward Starbucks stock is likely to generate healthy returns. The average 1 year price target by 37 analysts is $66.43, an upside of around 17% from yesterday's (29th August) closing price of $56.8. And if you include the dividend yield of 1.4%, the total return over next one year comes to 18.4%, not bad for any company, especially for a less volatile, "boring" company like Starbucks. Starbucks has a very low beta of 0.8, indicating a low risk attached to the stock (rare for a fast growing company). Using the risk-free rate of 1.46% and equity risk premium of 6.12%, we arrive at a cost of equity of 6.35% (1.46%+(0.8*6.12%)). The likely return in next one year for a Starbucks investor is almost three times the cost of equity, which is good by any standard. Also, Starbucks' return on equity (ttm) of 46% is more than seven times higher than its cost of equity.
While the slow down in US same store sales growth is definitely a cause for concern, the long term growth prospects, with the help of China, remain fairly strong. Starbucks has generated strong economic profits in the past and will continue to remain healthy going forward. The dividend yield, while not very attractive currently will continue to grow on the back of growing profits and strong cash flows. With an average price target of $66.43, and a dividend yield of 1.4%, Starbucks stock is likely to return more than 18% in the next one year. The stock enjoys a buy rating from wall street with no sell recommendations.