Dividend Growth Stock of the Month for October 2016: Starbucks (SBUX)

October 7, 2016

Dividend Growth Stocks of the Month So Far in 2016

Here are the stocks that I have written up so far this year in the Dividend Growth Stock of the Month series.

Month, 2016 Company Ticker Article Link
January ExxonMobil XOM January 23
February PepsiCo PEP February 18
March Wal-Mart WMT March 16
April Ventas VTR April 8
May Southern SO May 3
June Cisco CSCO June 11
July Qualcomm QCOM July 11
August Boeing BA August 1
September Verizon VZ September 20

Last month’s stock, Verizon Communications (VZ), is a high-yield, slow-growth stock. This month’s choice, Starbucks (SBUX), is the opposite: It has a low yield (1.5%) but its dividend has been growing very fast, more than 20% per year for the past 5 years.

There is nothing inherently better or worse about either type of stock.

Different investors have different goals.

Some want a high yield right now and are willing to accept slower future growth to obtain it.

Others don’t care as much about current yield as they do about long-term growth potential.

Some dividend growth investors, such as myself, like to have a mixture of types in their portfolios: Some higher-yielding, others faster-growing. It is a form of diversification.

Normally, I would not consider a stock with a yield as low as Starbucks’ 1.5%.

My usual minimum is 2.7% for my public Dividend Growth Portfolio. However, the Starbucks story is so good that I am considering Starbucks for my wife’s and my personal dividend growth portfolio.

Disclosure: Practically every day, I go to Starbucks and order a Decaf Grande Non-fat No-whip Mocha. Nobody makes them like Starbucks. Their ability to keep selling the same things day after day to the same customers is at the heart of their business model.

Starbucks’ Dividend Picture

captureThe table clearly shows Starbucks’ nature as a low-yielding but fast-growing company.

• The yield of 1.5% trails both the S&P 500’s yield of 2.1% and the average yield of all 778 Dividend Champions, Contenders, and Challengers, which is 2.8%.
• On the other hand, the dividend growth record has been spectacular. Since 2010 when Starbucks initiated its dividend, its annual dividend increases have been 56%, 29%, 24%, 24%, and 24%. The average Dividend Champion, Contender, and Challenger has an annual 5-year dividend growth rate of 15% per year. Starbucks’ rate is double that.

Starbucks’ dividend safety gets top marks from both services that I track, Safety Net Pro and Simply Safe Dividends. For more on dividend safety, see DGI Lesson 17. Under both systems, the dividend is rated as extremely safe and very unlikely to be cut.

As you can see in the following chart, Starbucks’ price growth has more or less mirrored its dividend growth since the dividend was initiated in 2010. As always, the price signal is noisier than the dividend signal.

captureBusiness Model and Quality

Starbucks was founded in 1985 and is headquartered in Seattle, WA. It went public in 1992. One of its co-founders, Howard Schultz, is CEO.

From its beginnings as a single-location coffee roaster, Starbucks has grown into the world’s largest manufacturer, preparer, and seller of coffee, tea, related beverages, food items, and related merchandise.

The company operates through these segments: Americas; EMEA (Europe, Middle East, and Africa); CAP (China/Asia Pacific); Channel Development; and Other.

Starbucks sells through company-owned stores, franchised stores, and retail channels such as grocery stores, warehouse clubs, convenience stores, and US food service accounts.

Starbucks stores totaled about 24,400 at the end of its fiscal 3rd quarter in June. A significant part of Starbucks’ success is related to the “Starbucks Experience” for customers. Most of its stores are company-owned. It places great emphasis on developing its employees (“partners”) with above-market wages, training, comprehensive health coverage, tuition programs, and equity possibilities.

Starbucks’ products include the following:

• Coffee and tea: More than 30 blends and single-origin premium coffees. Whole bean and ground coffee (Starbucks and Seattle’s Best Coffee brands), Starbucks VIA Instant, Starbucks Coffee K-Cup pods, Starbucks and Teavana Verismo pods, Tazo teabags, and Tazo tea latte concentrates.
• Handcrafted Beverages: Fresh-brewed coffee, hot and iced espresso beverages, Frappuccino coffee and non-coffee blended beverages, Starbucks Refreshers beverages, smoothies, and teas.
• Merchandise: Coffee- and tea-brewing equipment, Verismo System, mugs and accessories, packaged goods, books and gifts.
• Fresh Food: Baked pastries, sandwiches, salads, salad and grain bowls, oatmeal, yogurt parfaits, and fruit cups.
• Ready-to-Drink: Starbucks bottled Frappuccino coffee drinks, Starbucks Discoveries chilled cup coffees and Iced Café Favorites, Starbucks Iced Coffee, Starbucks Doubleshot espresso and Energy Coffee drinks, Starbucks Refreshers beverages, Evolution Fresh bottled juices, Tazo bottled iced, and juiced teas.

Starbucks is a fast-growth company. This graph shows its EPS (earnings per share) growth trajectory over the past 10 years.

captureSome highlights from its 3rd-quarter (June) earnings report were:

• Global comparable store sales increased 4%
• Consolidated net revenues grew 7% to a Q3 record $5.2 billion
• Consolidated GAAP operating income increased 9% to a Q3 record $1.0 billion
• GAAP EPS increased 24% to a Q3 record $0.51 per share

The company opened 474 net new stores globally in Q3, and 1876 in the prior 12 months, bringing total stores to 24,395 in 74 countries worldwide. Mobile Order and Pay usage reached 5% of U.S. transactions, up from 4% in the previous quarter. And membership in the company’s Starbucks Rewards loyalty program increased 18% year-over-year to 12.3 million active loyalty members in the U.S.

Another source of growth is improvement in operating margins. Much of this comes from annual price increases. Starbucks’ wide moat and brand strength give it pricing power. Starbucks’ brand strength is ranked #45 on Forbes‘ World’s Most Valuable Brands.

Growth strategies include the opening of new outlets, particularly in China. The company now has almost 2,300 stores in over 100 cities in China. Net revenues for the China/Asia Pacific segment grew 18% in Q3 2016 compared to the same quarter in 2015, primarily driven by incremental revenues from 888 net new store openings over the past 12 months.

For the full fiscal year, Starbucks now expects about 1,900 net new store openings across all regions:

• Americas: approximately 750 new stores, half licensed
• China/Asia Pacific: approximately 900, two-thirds licensed
• EMEA: approximately 250, most licensed

This graph from Trefis shows the sources of Starbucks’ value:

captureMorningstar gives Starbucks a wide-moat rating (its highest), based on its strong brand that evokes high quality, advantages of scale, café-like experience, innovations in mobile order and payment systems, popular rewards program, product breadth, and employee relations.

captureStarbucks’ Financials

Starbucks has a very high ROE (return on equity) of 47%. I usually consider anything around 12%-15% to be attractive. High margins are often a hallmark of a company with a wide moat (sustainable competitive advantages).

Sometimes, though, a high ROE is created by high debt. We saw that last month with Verizon. But that’s not the case with Starbucks. Its D/E (debt to equity) level is 0.6. In other words, in SBUX’s capital structure, debt accounts for 60% of the capital compared to the level of equity.

Nowadays, that practically qualifies as low-debt. For comparison, the average D/E ratio for all Dividend Champions, Contenders, and Challengers is 1.04.

You can see both ROE and D/E metrics on the following chart.

captureStarbucks’ earnings per share (EPS) growth over the past 5 years has been 24% per year, which indicates that it is a fast-growth company. You can see the long-term annual increase in EPS here (this display is drawn from FASTGraphs):

captureThis is an excellent record of growth. If you look year-by-year, the only year of negative profit growth was 2008. Every other year shows positive growth in double digits.

Analyst consensus estimates of 3-5 year forward earnings growth stand at about 19% per year, in line with the past few years.

Overall, Starbucks’ financial picture is quite positive, matching its strong business model and story from above.

captureVerizon’s Stock Valuation

My 4-step process for valuing companies is described in Dividend Growth Investing Lesson 11: Valuation.

Step 1: FASTGraphs Default. The first step is to compare the stock’s current price to FASTGraphs’ basic estimate of its fair value.

That is usually based on a price-to-earnings ratio (P/E) of 15, which is the long-term average P/E of the stock market as a whole.

However, FASTGraph’s estimate of the next two years’ earnings growth just 16.2% per year. Therefore, the software draws the fair-value line at that same rate, namely 16.2. That is the orange line on the following chart.

captureThat turns out not to matter. At a current P/E of 28.3, Starbucks is far overvalued.

By comparing those two valuation ratios, we discover that, by this first method of appraising valuation, SBUX appears to be 75% overvalued. That suggests a fair price of $30 per share, far below the current price shown by the black line.

Step 2: FASTGraphs Normalized. The second valuation step is to compare Starbuck’s price to its own long-term average P/E ratio. This lets us adjust for the fact that some stocks always seem to have a high valuation, while others always seem to have have a low valuation.

captureStarbucks is one of those companies that always seems to be overvalued. Its 10-year average P/E ratio is 28.5, which is nearly identical to its current value of 28.3.

Using the ratio of P/Es, I calculate a fair value of $54.

Step 3: Morningstar Star Rating. Morningstar uses a comprehensive discounted cash flow (DCF) process for valuation. Many investors consider this approach to be the best method of assessing fair valuations.

Morningstar makes a projection of all the company’s future profits. The sum of all those profits is discounted back to the present to reflect the time value of money. The resulting net present value of all future earnings is considered to be the fair price for the stock today.

captureOn Morningstar’s 5-star system, Starbucks gets 4 stars. That means that they believe the company is undervalued. They calculate a fair value of $63.

Step 4: Current Yield vs. Historical Yield.

Finally, we compare the stock’s current yield to its historical yield. This is an indirect way of calculating fair value. It is better for a stock’s yield to be near the top of its historical range than near the bottom.

captureThe display above is from Morningstar. It shows Starbucks’ current yield of 1.5% vs. its 5-year average of 1.2%. In other words, SBUX’s yield is 25% above its 5-year average.

To be conservative, I cut off valuation estimates at 20% when using this method. So the bottom line is that this approach suggests that Starbucks’ fair price is $64.

Valuation Summary:
Using the 4 approaches just described, our valuation summary for Starbucks looks like this:

captureFor a reality check, I also looked at S&P Capital IQ’s valuation analysis. Their 12-month price target for Verizon is $68, and they have a 4-star “buy” rating on the stock.

Miscellaneous Factors
There are some factors that do not fall into the earlier categories.

captureBeta measures a stock’s price volatility relative to the market as a whole (represented by the S&P 500). Most dividend growth investors like to own stocks with low volatility, because then you are less likely to become emotional about them when the market drops.

Starbucks’ beta of 0.8 suggests that the stock has been 20% less volatile than the market.

I consider this a minor plus-factor for Starbucks.

The analysts’ recommendations come from S&P Capital IQ.

Their most recent report on Starbucks shows the opinions of 33 analysts.

Their average recommendation is 4.5 on a 5-point scale, where 4.0 = Buy and 5.0 = Strong Buy.

In other words, their average recommendation is well into the “buy” range. Another minor plus-factor.

This chart shows SBUX’s share count over the past 10 years.

capture[Source: Simply Safe Dividends]

The graph does not show the steadily declining share count that we normally prefer, but it does not show constant issuance of new shares either. The trend is basically flat. I consider this a neutral factor for Starbucks.

Bottom Line

Here are Starbucks’ positives:

• Fast dividend growth rate at 20%+ over the past several years (offset by low yield).
• Strong dividend safety, protected by very good cash flow.
• Stock is fairly valued.
• Fast-growing company with strong brand and excellent reputation.
• Good growth prospects in China, Brazil, and India.
• Growth prospects also via pricing power and introduction of new products.
• Good financials, including high return on equity, moderate debt, and steady double-digit earnings growth.
• Below-market price volatility.
• Strong analyst support.

Here are Starbucks’ negatives:

• Low yield (offset by fast growth).
• One valuation method suggests that price is far above fair value.

As always, do your own due diligence, and please do not take this article as a recommendation to buy or hold Starbucks. Instead, use it to inspire your own research. Give particular attention to whether a low-yield, high-growth company fits your own investing goals.

– Dave Van Knapp

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