Undervalued Dividend Growth Stock of the Week: Starbucks Corporation (SBUX)

Every day is a gift and an opportunity.

That’s a motto in my life.

We’re never going to be younger than we are at this moment.

And once each day passes, it’s a day that you’ll never get back.

As such, carpe diem isn’t just a saying you should find on a bumper sticker; seizing every single day is something one should look forward to and aim for.

I’ve tried to make the most of my days by living below my means and investing in high-quality dividend growth stocks that reward me with a shower of increasing passive cash flow.

Great businesses can literally rain cash upon their owners by virtue of the increasing profit they generate as they sell more products and/or services.

Just look at the more than 800 stocks that can be found on David Fish’s Dividend Champions, Contenders, and Challengers list.

These are real-life businesses with real-life workers that are selling real-life products and/or services to real-life society.

And it’s real-life profit that’s generated, which results in the ability to pay shareholders real-life dividend income.

You’ll see food companies, manufacturers, utilities, and technology companies. So on and so forth.

Great businesses that make and sell things people want/need.

And by simply buying shares in these businesses, you get to participate in that economy.

By buying shares in a business, you get to own a slice of it. The workers work for you. And the cash the business generates is yours, which often ends up in a small slice of it coming your way.

I’ve simply saved and invested repetitively over the last seven years, to the point of building a six-figure stock portfolio that generates five-figure passive dividend income on my behalf.

This portfolio is real-life stuff here. And it’s life-changing stuff.

By buying shares in more than 100 different great businesses, I have a steady shower of cash being rained upon me.

And this shower of cash is so substantial that my basic expenses in life are now covered, rendering me financially independent.

So by seizing many days prior, I’m even more free to seize future days. It’s an amazing cycle that feeds into itself.

But it starts by putting capital to work, which is what today’s article is all about.

I’m going to highlight a wonderful business that right now appears to be an appealing long-term investment candidate based on fundamentals, competitive advantages, and valuation.

It’s that last part that’s particularly germane and critical, as paying too much for even the best business can really hamper one’s investment success, especially over the near term.

Price is what one pays for something; value is what one gets in return.

Value gives context to price. Without knowing value, price is practically meaningless.

Insofar as long-term investing goes, undervaluation (meaning the price of a stock is below intrinsic value) confers many benefits to the investor.

An undervalued dividend growth stock should offer a higher yield, greater long-term total return potential, and less risk.

This is all relative to what the same stock might offer if it were fairly valued or overvalued.

Price and yield are inversely correlated. All else equal, a lower price will result in a higher yield.

That higher yield obviously benefits one’s current and long-term income.

But it also benefits total return, as income (via dividends/distributions) is one of two components of total return.

In addition, total return is given a possible boost via the upside that exists between a lower price paid and the higher intrinsic value of an undervalued stock.

If one pays $50 for a stock worth $70, that gap exists as upside, which is a gap that tends to close over time as the market realizes fair value and reprices a stock more appropriately.

If/when this happens, that upside serves as capital gain, which is on top of whatever organic upside is available as the business becomes worth more over time as it sells more products and/or services.

And paying $50 for a stock worth $70 protects downside while maximizing upside, as that gap between price and value also serves to provide an investor a margin of safety – a “buffer” that limits downside in case the investment thesis is wrong or a business does something wrong.

With such benefits being possible when undervaluation is present, you’d think that it would be incredibly difficult to determine fair value and choose high-quality stocks when they’re undervalued.

But this isn’t necessarily so.

In fact, there are many tools and resources available that are designed to help investors estimate the fair value of just about any stock out there.

One such resource was put together by fellow contributor Dave Van Knapp, and it’s built specifically for dividend growth stocks.

Once you have a high-quality dividend growth stock picked out that appears to be undervalued, the only thing left is to seize the day by investing for the long haul.

To help you readers get closer to seizing your own day, I’m presenting what I think is a pretty compelling long-term idea.

Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality coffee products and services, sold across a global network of more than 24,000 stores, in addition to multi-channel retail.

Starbucks is a household name. It’s fast becoming a blue-chip company and stock that will likely produce and protect generational wealth.

In fact, I’m writing this very article from a Starbucks that’s very close to my humble abode.

Starbucks provides two things that are inextricably linked: a high-quality product and a high-quality experience.

Most companies provide one or the other. But Starbucks has become a global behemoth by linking the two together and providing both arguably better than anyone else on a grand scale.

There are the handcrafted coffee and tea drinks they provide in their stores and through multi-channel retail. These are drinks that people are willing to pay a premium for due to quality, consistency, and taste.

And Starbucks takes it a step further by producing and serving these drinks in an atmosphere that promotes gregarious conversation and relationship building.

In an era where more products are moving online, Starbucks has both insulated itself through the experience it provides, and accelerated its potential by also offering its products through multi-channel retail.

It’s truly the best of both worlds.

And their business prowess and profound potential shows up in the dividend.

The company has increased their dividend for seven consecutive years.

While a relatively short track record, I believe Starbucks is just beginning what will eventually be a very lengthy streak of dividend increases. The runway is still very long.

Nonetheless, they’ve gotten up to speed very quickly, with a five-year dividend growth rate of 24.9%.

I don’t anticipate that kind of dividend growth to continue on for much longer. However, the most recent dividend increase was 25%, so they obviously haven’t slowed quite yet in terms of dividend growth.

That said, the payout ratio has crept up as a result of such strong dividend growth, now sitting at 50.8%.

That’s what I consider a “perfect” balance between retaining earnings and paying shareholders their rightful share of profit.

Starbucks is essentially keeping half of what they earn in order to grow the business, but they’re also sending the other half to shareholders.

It’s a great harmony.

But the payout ratio has expanded quite a bit over the last five years, meaning dividend growth will have to roughly match earnings growth fairly soon. Said another way, an expanding payout ratio isn’t the available lever for outsized dividend growth that it once was.

What we’ll soon see, though, is that Starbucks is still growing as a business at a rather impressive clip, which means strong dividend growth should continue for the foreseeable future (even if it does slow a tad).

The only real drawback to the dividend metrics might be the yield.

At 1.80%, there’s certainly a lot to be desired from investors who desire more current income from their investments.

If I were an older investor nearing (or in) retirement, this stock probably wouldn’t make sense.

But if one has an investment time horizon of 10 years or more (before they need to live off of their investment income), this stock is a pretty good long-term candidate.

And this yield is notably 50 basis points higher than its five-year average, which ties into the undervaluation thesis (as discussed above).

In order to build those future income growth expectations, however, we must look at what Starbucks is doing as a company in terms of overall underlying revenue and profit growth.

And in order to paint that picture completely, we’ll first look at what the company’s top and bottom lines have done over the last 10 years, and we’ll then compare that to a near-term forecast for profit growth.

Combined, this should give us a pretty good idea as to what kind of earnings power Starbucks is demonstrating.

The company increased its revenue from $9.411 billion to $21.316 billion from fiscal years 2007 to 2016. That’s a compound annual growth rate of 9.51%.

Very strong revenue growth here. For mature companies, I like to look for mid-single-digit revenue growth. Yet Starbucks – this is a $79 billion company – is growing its top line at a pace near double digits.

Earnings per share grew from $0.44 (rounded up) to $1.90 over this same period, which is a CAGR of 17.65%.

So we see quite a bit of excess bottom-line growth relative to what the company did with revenue over the last decade, which can be largely explained by steadily increasing profitability.

Overall, the company’s growth is nothing short of extraordinary.

But we can also see that dividend growth has outstripped earnings growth (expanding the payout ratio), which is why I mentioned that the dividend growth moving forward will likely slow a bit.

CFRA believes Starbucks will compound its EPS at an annual rate of 18% over the next three years, which would be right in line with what’s transpired over the last 10 years. We’re looking at keeping the status quo here.

Global expansion is still a massive opportunity for Starbucks.

Toward that end, the company recently acquired the remaining shares of East China Joint Venture, allowing the company to operate all Starbucks stores in mainland China. It’s the largest single acquisition in company history, and this is a huge step forward for their international growth potential.

Starbucks recently showed that comparable store sales in China were up 7%, which is far in advance of their global average. So improving their footprint in China bodes well.

The company’s balance sheet exemplifies quality and offers additional flexibility.

The long-term debt/equity ratio is 0.54, while the interest coverage ratio is over 50.

This is a great balance sheet, especially considering how many companies have loaded up on debt over the last few years with interest rates being low. Starbucks has expanded significantly without putting its balance sheet in a precarious position.

Profitability is also outstanding.

Over the last five years, Starbucks has averaged net margin of 10.13% and return on equity of 35.12%.

These numbers are factoring in an anomaly in FY 2013. Net margin for last FY came in at over 13%. For perspective, net margin was sitting in the mid-single digits 7-10 years ago.

I actually think there’s further room for margin expansion, which is why I believe CFRA’s growth forecast above isn’t unreasonable at all. The most recent quarter for Starbucks showed impressive YOY non-GAAP margin expansion.

How can Starbucks continue to grow?

Let me count the ways.

Growing store count. Strong comp sales. Margin expansion. International development. Increasing multi-channel retail offerings/partnerships.

The list goes on.

I think the only thing that can really stop Starbucks is Starbucks. If they continue to execute properly, there’s no major evident crack in the armor. It’s a formidable business with multiple competitive advantages (scale, pricing power, brand recognition).

With that in mind, it would make sense for the stock to be priced at a major premium.

But I don’t think that’s the case at all. It appears perhaps expensive in absolute terms, but I think there’s value here relative to the growth potential of the business.

The stock is available for a P/E ratio of 28.22. That’s higher than the broader market, true. But this is one of the most successful and well-known businesses in the world, yet there’s not much of a premium there. Investors are paying less for the company’s sales compared to the five-year average. And the company’s cash flow is cheaper than what it’s recently been. Plus, the yield, as noted earlier, is 50 basis points higher than its recent historical average.

So the stock looks reasonable, if not undervalued. But what might be a good estimate of its intrinsic value?

I valued shares using a dividend discount model analysis.

A two-stage model was used to account for the low yield and high growth.

I factored in a 10% discount rate, a 10-year dividend growth rate of 14%, and a long-term dividend growth rate of 7.5%.

That near-term dividend growth rate is well below the 10-year demonstrated dividend growth rate, the long-term EPS growth rate, and the near-term forecast for earnings growth. But I try to err on the side of caution.

If anything, Starbucks could easily surpass these expectations.

The DDM analysis gives me a fair value of $73.69.

The reason I use a dividend discount model analysis is because a business is ultimately equal to the sum of all the future cash flow it can provide.

The DDM analysis is a tailored version of the discounted cash flow model analysis, as it simply substitutes dividends and dividend growth for cash flow and growth.

It then discounts those future dividends back to the present day, to account for the time value of money since a dollar tomorrow is not worth the same amount as a dollar today.

I find it to be a fairly accurate way to value dividend growth stocks.

My analysis and valuation shows that the stock should probably be selling for a much higher price, as it’s an outstanding business going for a valuation that’s just slightly higher than the broader average. But my perspective is but one of many, which is why I like to compare my number with what select professional analysts come up with.

Morningstar, a leading and well-respected stock analysis firm, rates stocks on a 5-star system.

1 star would mean a stock is substantially overvalued; 5 stars would mean a stock is substantially undervalued. 3 stars would indicate roughly fair value.

Morningstar rates SBUX as a 4-star stock, with a fair value estimate of $70.00.

CFRA is another professional analysis firm, and I like to compare my valuation opinion to theirs to see if I’m out of line.

They similarly rate stocks on a 1-5 star scale, with 1 star meaning a stock is a strong sell and 5 stars meaning a stock is a strong buy. 3 stars is a hold.

CFRA rates SBUX as a 3-star “HOLD”, with a fair value calculation of $51.30.

I came up with a number pretty close to what Morningstar has. But CFRA is far more bearish. However, that’s why I like to include multiple perspectives, which adds value and depth. Averaging the three numbers out gives us a final valuation of $65.00, which would mean the stock is potentially 17% undervalued.

Bottom line: Starbucks Corporation (SBUX) is one of the best businesses in the world. Excellent fundamentals, strong competitive advantages, and numerous growth levers all bode well for the company, its investors, and the dividend moving forward. With 17% upside on what’s truly an exceptional dividend growth stock, this could be one of the most compelling long-term ideas in the consumer space.

— Jason Fieber

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