This is One of the Best Dividend Growth Stocks in the Market

Since its founding in Seattle in 1985, Starbucks (SBUX) has grown into the world’s largest coffee empire and the 67th most valuable brand on earth. Along the way, Starbucks’ amazing growth story has made countless investors amazingly rich.

For example, $10,000 invested in Starbucks 20 years ago would today be worth $283,520.03 compared to just $44,044.43 invested in the S&P 500.

That’s annual total compound returns of 18.1% and 7.7%, respectively, showing just how well founder, CEO, and Chairman Howard Schultz has been at generating long-term wealth for his shareholders.

Of course past performance is no guarantee of future success, and one must always invest with an eye towards future growth, not just past glories (see seven other effective habits of dividend investors here).

However, when you dig deep into Starbucks’ business model and factor in management’s growth plans, the company’s best days could still lie ahead of it.

Let’s take a closer look at this business for consideration in our Long-term Dividend Growth portfolio to see if dividend growth investors should climb on board the Starbucks Espresso train.

Business Description
Starbucks is the world’s largest coffee purveyor with just over 24,000 stores in 72 countries, where it sells not just premium coffee but also tea, packaged coffee, juices, bottled water, pastries, and various lunch items.

In addition, the company licenses several of its products, which are available in supermarkets and stores, and operates other up and coming fast casual restaurant brands such as Teavana, Tazo, Seattle’s Best Coffee, Evolution Fresh, La Boulange, and Ethos.

In its most recent quarter, the vast majority of its sales came from the company’s namesake, company owned stores.

captureBy geography, Starbucks generated 69% of its revenue last year in the Americas (U.S., Canada, Latin America); 13% in China / Asia Pacific; and 6% in Europe, Middle East, and Africa. The remaining 12% of revenue was related to channel sales of Starbucks’ products and other business segments.

Business Analysis
Despite its already massive size, Starbucks has been able to generate impressive sales, earnings, and free cash flow (FCF) growth over the last few years.

This strong growth is largely due to Starbucks’ ability to continue bringing in more foot traffic to its stores and raise prices consistently thanks to its strong brand, which gives it a solid moat against rivals such as Dunkin Brands (DNKN).

Even more impressive than its solid top line growth however, is Starbuck’s ability to grow its bottom line earnings and FCF per share, which funds the growing dividend, even faster.

In fact, thanks to increased cost efficiencies made possible from its vast economies of scale and hyper efficient supply chain, Starbucks was able to grow FCF per share, one of the most important dividend metrics, by an astounding 65.5% year-over-year last quarter.

captureThis continues the company’s amazing record of not just maintaining its margins over time, but substantially growing them as well. This just shows true power of Starbucks’ premium brand and the strong pricing power it commands.

This also explains how management was able to reward investors with a sensational 25% dividend increase and still lower the FCF payout ratio. That helps to not just make the current payout more secure (more on this later), but also increases the likelihood that the dividend will be able to keep growing quickly for years to come.

But as impressive as the company’s fast sales, and margin expansion has been, investors need to always ask themselves, “Where will continued growth come from?”

In Starbucks’ case, management has three pronged plan to keep the growth train humming.

First, the company continues to open and license new stores around the globe, especially in fast growing emerging markets such as China. In fact, over the next five years Starbucks plans to more than double its locations in the world’s most populous nation to over 5,000.

And lest you think that Starbucks is playing catch-up in China, as just another “me too” coffee shop, the fact is that Starbuck’s dominance in the Middle Kingdom is nearly as massive as its position in the US.

For example, thanks to its regional beverages tailored to unique Chinese tastes, Starbucks had a 74% market share in Chinese coffee shops, with McDonald’s (MCD) McCafes a distant second with just 9%.

The second growth strategy for the company is to continue boosting margins via the widening of its competitive moat. Specifically, this involves the company’s improving use of technology with its wildly successful loyalty card program, which saw membership grow 18% in the last quarter to 12.3 million.

Not only does this solid growth put to fear concerns that the company’s recent change to a dollar based rewards program from a transaction based one infuriated some loyal customers, but it will also help improve overall service. That’s because it eliminates line splitting in which customers would try to maximize rewards by paying for every item separately. Thus the new system means faster turnover, shorter waits, and more efficient (i.e. profitable) stores.

Better yet, the loyalty program is just part of the company’s ongoing experiments in innovation, designed to boost customer satisfaction, as well as efficiency and margins. For example, the loyalty program, which has evolved from decades of experimentation and data driven improvements, is integrated into the Starbucks mobile app.

This allows customers to preload their app with money, locate the nearest store, order online, and then quickly swing by the store to pick up the food and drink. In other words, Starbucks focuses on making it as easy as possible for customers to get their daily caffeine fix, and in the process cement a loyalty to the brand that makes them less price sensitive. And of course the ability to ring up sales without someone standing in line means stronger comps, and thus revenue growth.

Finally, Starbucks, which took premium coffee to an art form, continues to experiment with new formats and high end cafe brands, such its new “reserve” stores, which one yelp reviewer described as “Starbucks on crack”.

Source: Business Insider

The reviewer means that Starbucks Reserve is attempting to make coffee snobs of us all with its limited time, exotic, super premium blends that are “perfectly brewed…with exquisite balance, depth of flavor, and aroma.”

And with the company’s ever more impressive dedication to growing its dividend, even non-coffee drinkers can appreciate the fact that Starbucks has mastered the art of targeting specialty, niche tastes and delivering it as efficiently and profitably as possible.

Key Risks
There are four main risks to know before investing in Starbucks.

First, coffee shops are an incredibly competitive industry, especially during economic downturns. For example, McDonald’s has been making great strides in its own premium coffees, which sell for significantly less than Starbucks’.

Similarly, Dunkin Brands, which until recently was mostly an east coast chain, is now public and making a big expansion into the rest of the nation. This means that increased competition and market saturation could reduce the company’s sales growth rate and pace of new store openings.

This opens up the company to execution risk, in which, thanks to so many different growth projects going on simultaneously, Starbucks management might stretch itself too thin and end up failing to achieve traction with its new store concepts and brands.

That’s especially true when founder, CEO, and Chairman Howard Schultz eventually retires. Schultz already retired once, back in 2000, and was forced to return in 2008 because his company had spent eight years floundering with poorly executed rapid global expansion, and poor choice of foods introduced to its menus.

And while Schultz, who’s 63, may not retire for quite some time, nonetheless investors will understandably be worried about how the company might fair without the Steve Jobs of coffee at the helm.

Don’t forget that Starbucks’ earnings results are periodically negatively impacted by commodity price swings, mainly in the cost of coffee. While the company can, and does, increase prices during such times, it’s not always enough to prevent a temporary dip in margins.

In other words, if margins contract for a few quarters, don’t panic – the long-term investment thesis probably isn’t broken.

Finally, it’s worth mentioning that Starbucks’ biggest growth markets lie overseas, which exposes the company to currency fluctuations. Should interest rates move higher and take the US Dollar with it, Starbucks’ overseas sales would convert into few dollars and potentially hurt reported sales, earnings, and FCF growth.

Dividend Safety Analysis: Starbucks
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend. Starbuck’s dividend and fundamental data charts can all be seen by clicking here.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their track record has been, and how to use them for your portfolio here.

Starbucks has a Dividend Safety Score of 98, suggesting that the company’s dividend is extremely safe. That’s courtesy of the company’s low FCF payout ratio of 42%, which is helped by the fact that its business model isn’t very capital intensive.

This is important because free cash flow represents the excess money a company generates after paying for operations and investing in maintaining and growing its business. Warren Buffett describes FCF as “owner earnings,” and this is what ultimately funds a company’s capital return program, both buybacks and dividends.

Because Starbuck’s FCF payout ratio is so low, it should give income investors confidence that even during the next economic downturn when sales might slide a bit, Starbuck’s free cash flow should remain high enough to allow the company to continue paying and even growing the dividend.

Source: Simply Safe Dividends

Starbucks has only paid dividends for seven years, but the company’s strong fundamentals more than make up for its lack of dividend longevity when it comes to safety.

Starbucks’ growth has also been tremendous, providing plenty of money to fund and grow the dividend. Revenue and free cash flow per share have compounded by 12.3% and 14.3% per year, respectively, over the last five years.

Source: Simply Safe Dividends

The company also holds $2.3 billion in cash on its balance sheet, which more than doubles the amount of dividends paid last year. Starbucks’ balance sheet provides plenty of flexibility and shouldn’t hinder the company’s ability to continue paying safe, growing dividends.

Source: Simply Safe Dividends

Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

Starbuck’s Dividend Growth Score is 99, indicating very good chances that it will continue growing its payout at a rapid rate for years to come.

Starbucks began paying dividends in 2010 and has increased its payout every year since. The company’s dividend growth has been tremendous. For example, over the last three years, Starbucks’ dividend has grown by 23.6% per year. Most recently, Starbucks lifted its dividend by 25% in late 2015.

Source: Simply Safe Dividends

Starbucks can continue growing its dividend at a rapid pace going forward, but a dividend growth rate closer to 13-17% seems more likely. The company is still in investment mode, and management likely wants to keep the payout ratio not much higher than 40%, which is about where it sits today.

Therefore, future dividend growth will be driven by underlying earnings growth, which is expected to average about 15% annually over the next few years.

Given the company’s opportunities for expansion in international markets, continued share repurchases, expanding free cash flow margins (due to scale and technology advancements), and management’s long-term guidance below, the growth forecast doesn’t seem unreasonable.

Source: Starbucks Investor Presentation

Valuation
Despite falling 12% over the past year, from just looking at the forward P/E ratio (28x) or dividend yield (1.5%), you might not think that Starbucks looks undervalued.

After all, the current share price still represents a substantially higher valuation metric than the market’s P/E, and even accounting for the company’s excellent long-term growth investors can be forgiven for thinking that Starbucks is trading at lofty levels.

However, there are two things to consider. First, Starbucks has historically traded at a high premium due to the strength of its brand, the quality of its management, and its long growth runway.

In fact, the stock’s average P/E over the past 20 years has been over 40, implying that today’s valuation might not be as high as it seems.

As we’ve seen, Starbucks’ growth runway is still very long and, equally importantly for us, it has the potential for some truly sensational dividend growth in the coming years.

Growing dividends over time is very powerful. For example, Starbuck’s split adjusted cost basis 20 years ago was $2.06. This means that the current dividend represents a 31.6% yield on invested capital. Even adjusting for inflation that still comes to 20.5% and will only grow exponentially over time as Starbucks continues to reward patient, long-term investors.

In other words, while Starbucks may not seem like a screaming buy at today’s price, based on its historical valuations, and more importantly, its realistic forward earnings growth potential, the stock seems like a solid long-term core holding for any diversified dividend growth portfolio.

Even as large as Starbucks is today, it still has the potential to become one of the best performing dividend growth stocks of the next decade if it can achieve its long-term guidance. Essentially, owning Starbucks is a bet that the company’s store concept is not yet saturated but rather has a long runway for growth. If correct, the stock should deliver double-digit annual returns over time.

Conclusion
Despite the concerns over slowing global economic growth, Starbucks continues to fire on all cylinders. Its top notch management has a clear vision for how to continue impressive growth going forward, and that should mean great things for dividend growth investors if the plan is successful.

The stock doesn’t necessarily have a large margin for error at the current price, but its price is very reasonable if the company continues executing on management’s long-term growth plans. Overall, Starbucks looks like an appealing candidate for long-term dividend growth portfolios. That’s not to say the stock won’t suffer a correction with the rest of the market, but such dips merely represent more attractive buying opportunities for this supreme dividend growth stock.

Brian Bollinger
Simply Safe Dividends

Simply Safe Dividends provides a monthly newsletter and a comprehensive, easy-to-use suite of online research tools to help dividend investors increase current income, make better investment decisions, and avoid risk. Whether you are looking to find safe dividend stocks for retirement, track your dividend portfolio’s income, or receive guidance on potential stocks to buy, Simply Safe Dividends has you covered. Our service is rooted in integrity and filled with objective analysis. We are your one-stop shop for safe dividend investing. Brian Bollinger, CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm. Check us out today, with your free 10-day trial (no credit card required).

Source: Simply Safe Dividends



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