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

I used to have this terrible enemy.

My enemy would follow me around everywhere I went, almost forcing me to make bad choices, only to feel great when I went and did the wrong thing(s) in life.

I would waste money on frivolous things. My enemy would feel great in the moment. And I would feel terrible later.

It took me years to finally shake this enemy and reclaim my life for myself.

You want to know who this enemy was?

The enemy was me.

I was getting in the way of myself. I didn’t believe in myself. I was making bad choices.

And I would feel guilty about all of it, only to repeat the process over and over again.

Once I realized it was me – not the government, the media, or anyone else – I was able to turn things around.

It’s easy to blame our troubles on others.

It’s much more difficult to actually take responsibility for our actions and make the necessary changes to avoid repeat mistakes.

But it’s the latter path that will yield amazing, long-lasting results that could positively change our lives.

Indeed, my choice to take latter path led me to make more intelligent moves with my money.

Routine saving and investing my hard-earned money eventually resulted in a six-figure, real-money dividend growth stock portfolio that generates the five-figure growing passive dividend income I need to sustain myself in life, rendering me financially independent in my 30s.

This portfolio is spread out across more than 100 different businesses.

And these aren’t just any businesses.

These are some of the best businesses in the world, as partly evidenced by the longstanding track record of growing dividends most of them have.

These are dividend growth stocks.

I built that portfolio – and went from broke to financially independent in about six years – by buying up high-quality dividend growth stocks like those you can find on David Fish’s Dividend Champions, Contenders, and Challengers list.

Mr. Fish tracks more than 800 US-listed stocks that have paid increasing dividends for at least the last five consecutive years.

If you take a moment to peruse the list, you’ll notice dozens of blue-chip stocks.

That’s because it takes a special kind of business to not only pay shareholders dividends, but to also increase the amount of those dividends year in and year out.

And so if you’re going to invest your money, shouldn’t you put it to work with some of the best companies on the planet? 

Well, that’s what today’s article is all about, as I’m going to highlight a high-quality dividend growth stock that looks like a compelling investment today.

But part of the reason it looks compelling is directly related to the possible presence of undervaluation.

See, price is only what you have to pay. But value is what you get in return for your money.

Price is what something costs, while value is what something is actually worth.

And it’s perhaps never more important to make that distinction than when investing in stocks.

This is because the price you pay for a stock, compared to its value, will have major consequences for an investor over the long haul.

If you’re able to buy a high-quality dividend growth stock when it’s undervalued (i.e., when its price is below its intrinsic value), this can confer numerous benefits to the long-term 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 otherwise offer if it were fairly valued or overvalued.

It’s easy to see how this plays out.

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

That higher yield directly and positively impacts potential long-term total return right from the start, due to yield being one of two components of total return.

The other component, capital gain, is also given a potential boost via the “upside” that exists between a lower price and higher intrinsic value.

While the market isn’t necessarily very good at recognizing fair value over the short term, price and value tend to more closely track one another over the long term.

But if one is able to capitalize on a mispricing in the short term, the correction of that concern over the long haul can lead to a lot of upside.

And that’s on top of whatever upside a stock naturally has as a quality business becomes worth more over time (which occurs as its profit increases due to selling more products and/or services to more people at higher prices).

This, of course, stands to reduce risk.

That’s because increasing upside simultaneously decreases downside, all while building in a margin of safety (a buffer) that protects an investor against ending up “upside down” on an investment.

Fortunately, it’s not terribly difficult to recognize undervalued high-quality dividend growth stocks and take advantage of these opportunities.

But one first needs to have a reasonable idea of fair value in the first place, which is where fellow contributor Dave Van Knapp’s lesson on dividend growth stock valuation comes in.

That lesson is part of an overarching series of lessons on dividend growth investing, educating investors on how the strategy works, why it’s so great, and how to successfully implement it.

Now that we see the power of dividend growth investing, and now that we see why an undervalued dividend growth stock can be such a compelling opportunity, let’s take a look at a high-quality dividend growth stock that appears to be undervalued…

Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality coffee products and services, sold across a global network of more than 25,000 stores, in addition to multi-channel retail.

Approximately half of the company’s stores are in the US, while the other half are international.

Revenue from company-operated stores accounted for just under 80% of fiscal year 2016 revenue.

A big buzzword these days is “experiences”.

People, especially young people (like millennials), are now choosing to spend a greater proportion of their money on experiences, rather than stuff.

This shift in the way people spend their time and money is important to recognize as a company and an investor.

Well, Starbucks recognized that trend many years ago, and they and their shareholders are benefiting from that foresight.

What’s really fantastic and even a bit unique about Starbucks is that they offer a product wrapped up within an experience.

As such, people don’t necessarily have to choose between an experience and a product – when you sit down in a plush chair at a Starbucks and sip your high-end customized coffee drink while chatting with a friend or reading the paper, you’re getting both an experience and a product. And you’re getting it for relatively little money.

Plus, they offer both the product and the experience at a level of quality and scale that nobody else has been able to match.

I like to invest when the odds are on my side.

Well, the odds that people are still consuming coffee 10 years from now are pretty close to 100%. And it seems just as likely that consumers will still enjoy consuming high-quality coffee in a high-quality environment.

Nobody wants a lower-quality product wrapped up within a lower-quality experience.

Starbucks is thus as entrenched and dominant as they ever have been.

This bodes well for the company’s ability to pay and increase its dividend for many years to come.

Indeed, the company has increased its dividend for eight consecutive years.

And I believe this is just the start of what will end up being decades of dividend increases.

While we wait for that lengthy track record to unfold, shareholders can console themselves with massive dividend growth: the five-year dividend growth rate stands at 23.9%.

That kind of dividend growth won’t continue forever. Whenever a company starts paying a dividend, there’s a lot of headroom for growth (as the payout ratio is coming off of 0%).

But for perspective on this, the most recent dividend increase from Starbucks (which was declared in November 2017) came in at 20%.

The payout ratio, at 56.9%, is higher than it was a few years ago, but there’s still plenty of room for continued dividend growth. (This payout ratio is looking at TTM EPS, factoring in adjusted Q1 FY 2018 EPS.)

The company is currently guiding for 12% or greater annual EPS growth, which should propel dividend growth at least in kind.

Consider, too, that the company announced, during the Q4 earnings conference call, the intention to return $15 billion to shareholders through dividends and repurchases over the next three years.

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

At 2.09%, investors who are in need of more current income might not be enticed by the stock here.

That yield, though, is almost 70 basis points higher than the stock’s own five-year average.

So when thinking about undervaluation leading to a higher yield, we can see that playing out right now.

And it’s hard to dislike a ~2% yield when it’s coupled with double-digit dividend growth, which is exactly what Starbucks is offering.

But in order to get a feel for what kind of dividend growth to expect moving forward, we’ll want to build an expectation for overall company growth (which will ultimately fuel dividend growth).

While we invest in where a company’s going, not where it’s been, it’s also important to look at what a company has done over the long term, as that allows an investor to build a foundation of supposition about a company’s trajectory.

We can then compare that past trajectory with a professional estimation for near-term future growth.

Blending the known past with the estimated future in this fashion should give us a reasonable idea as to what kind of growth the company should generate moving forward, which will also help us value the business and its stock.

Starbucks grew its revenue from $10.383 billion in fiscal year 2008 to $22.387 billion in FY 2017. That’s a compound annual growth rate of 8.91%.

That’s much higher than what I’d expect from a fairly mature company like this, as I usually like to see mid-single-digit revenue growth from a large, multinational business.

Meanwhile, the company increased its EPS from $0.21 to $1.97 over this period, which is a CAGR of 28.24%.

This is obviously incredible and very impressive, although the forward-looking guidance coming from the company shows us that this will slow (as one would surmise).

What happened here is, the company improved its profitability rather dramatically across the board. Net margin has quadrupled relative to where it was a decade ago. And the company has become substantially better at allocating its capital. It’s just a much better business today.

Looking out over the next three years, CFRA is predicting that Starbucks will compound its EPS at an annual rate of 17%.

This doesn’t seem outrageous to me. The company is guiding for 12% annual EPS growth at the minimum, so 17% is nothing more than an optimistic look at it.

The Tax Cuts and Jobs Act of 2017 should free up even more capital for Starbucks, while the acquisition of the remaining shares of East China Joint Venture (announced in July 2017) allows the company to operate all Starbucks stores in mainland China (a huge growth market for the company).

If the company was firing on all cylinders already, an extra cylinder or two basically just got added to the engine.

And so it doesn’t seem unreasonable that CFRA would look at the optimistic side of things.

Comprising another aspect of the company’s fundamentals, the balance sheet is in excellent condition.

It’s a balance sheet that’s particularly impressive when considering the growth they’ve managed over the last decade without loading up on debt, which is something that can’t be said for a lot of other companies out there.

The long-term debt/equity ratio is sitting at 0.72, while the interest coverage ratio is over 47.

It’s important to keep in mind, however, that Starbucks will gear itself a little more, as part of the aforementioned plan to return $15 billion to shareholders over the next three years includes additional leverage.

That said, the balance sheet is in such condition that I’m not particularly concerned. The interest coverage ratio could drop in half and still be great.

Profitability is extremely robust, especially compared to where it was just five or ten years ago, although it’s somewhat hard to compare it to industry metrics because Starbucks is more or less in a league of its own.

Over the last five years, the company has averaged annual net margin of 10.63% and annual return on equity of 38.27%.

Both numbers are thrown off by an anomalous FY 2013, but the numbers are nonetheless very strong.

Starbucks is a company that’s in control of its own destiny.

I don’t think anything can really stop this company, other than, perhaps, Starbucks itself (i.e., execution missteps).

But they have so many growth opportunities. The potential is nearly limitless.

There’s the growing store count, strong comps, international expansion, multi-channel retail, additional products within their stores, a larger move to franchising, roastery stores, expanding margins, and additional investment in their existing stores and employees.

They provide a unique platform where the product and experience are seamlessly yet inextricably linked, and they do it on scale that’s unmatched. Plus, they serve the masses while simultaneously catering to high-end tastes.

The stock could and probably should be priced rather expensively, but I’d actually argue the stock is undervalued right now…

Shares are trading hands for a P/E ratio of 27.27 right now, which might seem pricey. (The P/E ratio is looking at TTM EPS, but I’ve factored out special one-time gains for Q1 FY 2018 GAAP EPS.)

However, this is one of the best brands in the world here, yet the premium relative to the market isn’t that great. Moreover, a company growing at 17% annually (moving forward) implies a PEG ratio below 2 – and that’s on a world-class business.

Considering another angle, the current P/CF of 21.2 is below the 23.0 the stock has averaged over the last three years.

And the yield, as discussed earlier, is well above its recent historical average.

All in all, I think the stock looks appealing based on basic valuation metrics. But what might a rational estimate of its intrinsic value look like? 

I valued shares using a two-stage 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%.

The initial DGR is much lower than what’s transpired over the last five years; it’s also much lower than the most recent dividend increase.

Looking at company guidance and a professional estimate of near-term growth, international growth potential, and the company’s determination to return so much capital to shareholders, I think this is actually a pretty conservative look at things.

And the long-term DGR is more likely to exceed 7.5% than fall below it.

The DDM analysis gives me a fair value of $88.43.

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.

This stock is, in my view, one of the most obvious opportunities in the consumer space. I don’t believe my valuation was aggressive, yet the fair value estimate came out much higher than where the stock is priced at. But because my perspective is limited to my own biases and beliefs, let’s compare it to what professional analysts have 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 3-star stock, with a fair value estimate of $66.00.

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 $57.78.

The latter firm has a 12-month target price of $64.00, but I still came out with a high number here. Nonetheless, averaging the three numbers out gives us a final valuation of $70.74, which would indicate the stock is possibly 23% undervalued right now.

Bottom line: Starbucks Corporation (SBUX) is a world-class business with unrivaled scale, brand recognition, and pricing power. It’s perfectly positioned to take advantage of a paradigm shift where consumers look to spend more on experiences. With excellent fundamentals, incredible dividend growth, and the potential for 23% upside, this is a fantastic idea here for long-term dividend growth investors.

— Jason Fieber

Note from DTA: How safe is SBUX’s dividend? We ran the stock through Simply Safe Dividends, and as we go to press, its Dividend Safety Score is 72. Dividend Safety Scores range from 0 to 100. A score of 50 is average, 75 or higher is excellent, and 25 or lower is weak. With this in mind, SBUX’s dividend appears safe with an unlikely risk of being cut. Learn more about Dividend Safety Scores here.

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