- Starbucks may seem overvalued but its fundamentals remain extremely attractive.
- Margins continue to expand and multiple growth avenues still exist for Starbucks.
- For investors wary of the downside, selling a long term put option in the money will net far more income than the present 1.3% yield.
Starbucks (NASDAQ:SBUX) is certainly a stock with excellent fundamentals. However with the stock trading at just over $61 a share which gives a present earnings multiple of 37, some analysts believe it is trading at fair value (or even overvalued) despite the chain's excellent growth prospects. Furthermore, the present dividend yield is only 1.3% so dividend investors are unlikely to be interested in this stock either, for obvious purposes.
However (even for income purposes), my opinion is that when doing your due diligence on stock selection fundamentals and the pay-out ratio should always trump the dividend yield. For example, in Starbuck's last fiscal year, it did $2.76B in net income and paid out $928 million which gives us a pay-out ratio of less than 34%. This should be your first step as it illustrates that Starbuck's dividend is very safe at these levels especially considering that earnings grew by almost $700 million in 2015 whereas dividends only increased by around $145 million. This stock should be a serious income candidate in your portfolio. Let's first understand why by going through the fundamentals and then explain how you can boost your annual yield over the next 12 months.
Here is how the stock's fundamentals hold up over the last 10 years.
|Years Of Dividend Increases||6 Years - Pass|
|Free Cash Flow||$2.6 billion (10-Year Trend Is Up) - Pass (Very Important For Dividend Investors - Dividend Currently Is 1.3%)|
|Revenues||$19.7 billion (10-Year Trend Is Up) - Pass|
|Profit Margins||12% - (10-Year Trend Is Up) - Pass|
|Price History of the stock||Up 223% in the last 10 years excluding dividends - Pass|
|Healthy balance sheet||Total assets = $12.9 billion (10-Year Trend Is Up) - Pass|
|Resistant to recessions?||Both Earnings and the Share Price dropped sharply in the great recession - Fail|
The one fundamental metric that fails is the company's recession performance which makes sense for a premium brand such as Starbucks. Earnings per share went from $0.44 in 2007 to $0.22 in 2008. Furthermore, the share price dropped 53% in 2008 so we are definitely not dealing with a recession proof stock here. Nevertheless, the stock has been on the rampage since 2009 and with the Fed maintaining its dovish stance, I don't foresee a recession in the US in the near future. In fact, if the S&P500 breaks out to new highs, Starbucks stock should outperform as it has done so since 2009.
The reasons I like Starbucks are multiple. Firstly, despite being the market leading retailer of specialized coffee in the US, growth is nowhere near being topped out at present. Why? Well, there is major scope for more units (such as drive thru's, smaller express stores and beverage trucks) and more menu listings but the main reason is that Starbucks's numbers of late have been excellent compared to the general restaurant and retailing industries. Yes, earnings could fall in a recession but investors should remember that the company's brand is much stronger now than in 2008 which should keep profits elevated.
Furthermore, Starbucks's new loyalty program definitely seems to have more advantages than drawbacks as customers who previously put through low priced transactions just to avail of stars for the loyalty program will now have to spend more as the new layout means that stars are based on every dollar spent. The new loyalty program will reward its best customers even more which should over time strengthen its brand even further so I expect attrition to be minimal long term.
I like also the "Ultra Premium Starbucks Reserve" initiative where the company plans to roll out 500 reserve stores across all of its markets where specialized coffee will be served along with premium leaf loose tea. Starbucks's aim here is the "experience". It knows it has huge amounts of customers who have no problem paying premium prices and the premium initiative will attempt to get more out of their pockets.
Furthermore, the subscription model will definitely serve new customers and existing customers who are temporarily away from their regular stores and should increase EBITDA margins over time (see below). All these measures (along with huge growth in China) illustrate to me that top line growth will remain elevated going forward.
So here is how you play Starbucks if you are worried that it may be presently overvalued. Instead of buying the stock outright (100 shares) which would give you less than $100 over a 12 month period on a 100 share investment, you could sell the January-2017-$57.50 put for $370 which means you enter into a contract to buy 100 shares of the stock if Starbucks were to drop to $57.50 by expiration. You are getting far more income this way plus the opportunity to load up on the stock at a cheaper price. The strategy definitely makes sense for the investor who likes Starbucks fundamentals but is worried it may be overvalued.
To sum up, I wouldn't dismiss Starbucks stock at present despite its earnings multiple being above historical averages. Last quarter, margins continued to expand and the online channel plus the premium initiative should act as a tailwind for both margins and top-line growth going forward. Selling the $57.50 January 2017 put option makes sense for investors who are conscious of downside risk.