One of my favorite John Maynard Keynes quotes goes like this:

“Markets can stay irrational longer than you can stay solvent.”

This COVID-19 crisis has made that quote never more prescient, as global markets are now in turmoil.

Indeed, this virus can stay alive longer than some businesses can stay solvent.

That’s why it’s more important than ever to focus on quality.

There are businesses far and wide that might become insolvent before the virus halts its progress and the economy reopens.

Only the highest-quality companies are fit to come out relatively unscathed. 

Well, companies with the longest track records of dividend raises just so happen to be some of the highest-quality companies in the world.

Many of these world-class companies can be found on the Dividend Champions, Contenders, and Challengers list.

After all, you can’t write ever-larger checks to your shareholders without bringing in ever-larger profits.

And you can’t bring in ever-larger profits without providing the products and/or services the world demands and is willing to pay up for.

This is what dividend growth investing is all about.

Jason Fieber's Dividend Growth PortfolioI’ve personally used this strategy to great effect.

By living below my means and investing in high-quality dividend growth stocks, I’ve built the FIRE Fund.

That’s my real-money portfolio, and it generates enough five-figure passive dividend income for me to live off of in my 30s.

As I lay out in my Early Retirement Blueprint, this strategy allowed me to retire at just 33 years old!

Investing in high-quality companies that pay reliable and rising cash dividends is almost a surefire way to not only survive but thrive during this COVID-19 crisis.

However, companies are not all created equal. Even among those paying reliable and rising cash dividends.

And not every stock is a good buy, even after the drubbing the US stock market has taken.

Fundamental analysis and valuation are as vital as ever.

That latter part – valuation – is especially critical in this time of risk management.

A stock’s price is only half the story.

Price is what a stock costs, but value is what a stock is worth.

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

This is relative to what the same stock might otherwise provide 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 correlates to greater long-term total return potential.

This is because total return is simply the total income earned from an investment – capital gain plus investment income – over a period of time.

Prospective investment income is boosted by the higher yield.

But capital gain is also given a possible boost via the “upside” between a lower price paid and higher estimated intrinsic value.

And that’s on top of whatever capital gain would ordinarily come about as a quality company naturally becomes worth more over time.

These dynamics should reduce risk.

Undervaluation introduces a margin of safety.

This is a “buffer” that protects the investor against unforeseen issues that could detrimentally lessen a company’s fair value.

It’s protection against the possible downside.

Investing in the highest-quality companies at the best possible valuations allows you to sleep well at night now, while also positioning you for excellent long-term investment results.

I have good news for you in this regard.

The valuation process is not as difficult as it might seem.

Fellow contributor Dave Van Knapp has produced an excellent valuation guide that you can apply to almost any dividend growth stock out there.

That guide is Lesson 11: Valuation, which is part of a comprehensive series of “lessons” on dividend growth investing.

With all of this in mind, let’s take a look at a high-quality dividend growth stock that appears to be undervalued right now…

Starbucks Corporation (SBUX)

Starbucks Corporation (SBUX) is the world’s leading retailer of high-quality, specialty coffee products. These products are sold in 31,000 stores across 80 different markets, in addition to multi-channel retail.

Company-owned stores accounted for approximately 81% of FY 2019 revenue, while licensed stores accounted for approximately 11% of FY 2019 revenue. The remainder was made up of Other sales.

The company splits its revenue across two primary geographical segments: Americas, ~69% of FY 2019 revenue; and International, ~23%. Channel Development (retail CPG) and Corporate and Other accounted for the remainder of revenue.

Today’s article is all about quality.

And that’s why I’m focusing on Starbucks.

This company oozes quality, from their coffee to their customer service. It’s one of the most recognized brands on the planet.

Millions of customers around the world flock to their stores because of the consistent quality in their bevy of drinks.

A latte is a cheap and attainable luxury for everyone.

Another aspect of their quality (which has been temporarily rendered less effective) is their stores. These lounges feature quality furnishings and a relaxing environment.

Again, cheap and attainable luxury.

Combining the coffee with the in-store experience means Starbucks is one of the rare companies that offers both a product and a service that people around the world enjoy.

Many of their lounges are currently temporarily closed. That’s because of COVID-19.

This does reduce the company’s experiential value proposition.

That’s not going to hurt Starbucks over the long run, though.

Their relentless focus on customer service put them way ahead of the curve.

They have drive-through options, mobile ordering, and delivery. The company’s use of technology has never been more important as they find new ways to get their products in customers’ hands.

In addition, they put together a $7.15 billion licensing deal that saw Nestle SA (NSRGY) pay Starbucks for the right to exclusively sell the chain’s packaged coffees and teas around the world.

Starbucks now has Nestle’s global distribution might working for them, and it means that consumers everywhere are able to bypass the store closure issue and still get their coffee fix.

Keep in mind, too, that the store closure issue is regional and temporary. And it’s been a rolling problem – the virus has moved from east to west. Most, if not all, of their stores in China have already been reopened.

The way the stock has dropped in price, you’d think a large percentage of their stores were permanently destroyed.

That’s simply not true.

However, the overreaction of the stock market has presented a great long-term opportunity on one of the highest-quality companies you could possibly find.

That quality carries over to the dividend, too.

Dividend Growth, Growth Rate, Payout Ratio and Yield

Starbucks brews up a dividend that’s as robust as their coffee.

And it’s growing like clockwork.

They’ve increased their dividend for 10 consecutive years.

What’s really impressive about the dividend growth, though, is the rate at which they’re increasing the dividend.

The five-year dividend growth rate is a stout 22.1%.

That growth comes on top of a 2.62% yield.

This yield is more than 100 basis points higher than the stock’s own five-year average yield.

It’s emblematic of undervaluation leading to a higher yield.

And this is one of the safer dividends in this environment.

The payout ratio is 53.8%, which is pretty close to a “perfect” payout ratio of 50% that exactly balances dividends and retained earnings in harmony.

While the payout ratio is backward-looking and using data that is sure to be materially impacted by the pandemic, Starbucks isn’t an airline or hotel company that’s been essentially shut down completely. They’re still slinging coffee. And they have the financial wherewithal to withstand this short-term storm.

Revenue and Earnings Growth

Let’s now discuss that financial wherewithal.

I’m first going to show you what kind of growth Starbucks is producing, going over their 10-year top-line and bottom-line growth.

Then I’ll compare that to a near-term professional prognostication of profit growth.

Combining the proven past with a future forecast in this manner should allow us to extrapolate out growth and sensibly estimate a growth trajectory for the business, which will later help us value the stock.

Starbucks grew its revenue from $10.707 billion in FY 2010 to $26.508 billion in FY 2019.

This is a compound annual growth rate of 10.60%.

I tend to look for mid-single-digit top-line growth from a mature business.

Starbucks did much, much better than this. On the other hand, their larger store count and higher revenue base will make it more difficult to repeat this feat over the next 10 years.

Earnings per share increased from $0.62 to $2.92 over this same period, which is a CAGR of 18.79%.

Really incredible.

The growth is spectacular, which supports my thesis regarding the quality of this business.

A lot of the excess bottom-line growth was driven by impressive margin expansion.

Share buybacks also helped. The outstanding share count is down by more than 19% over the last decade.

The comp story is also remarkable. Global comparable store sales were up an amazing 5% for FY 2019. And that’s in a year in which they opened almost 2,000 new stores.

2020 will no doubt be tough for comps, margins, and just about every other metric.

However, long-term investors should be thinking in terms of decades, not individual years.

Looking forward, CFRA believes Starbucks will compound its EPS at an annual rate of 14% over the next three years.

This forecast appears to have been provided in January. That’s before the COVID-19 pandemic became global. I think it’s fair to say that we should pull our expectations way back.

Still, the long-term story here is intact. If anything, it’s possible that this pandemic will make Starbucks even more formidable than they were before. Lesser competition might not be able to make it through the crisis.

CFRA cites global store expansion, growing digital sales, increasing foot traffic, and efficiency gains from supply chain initiatives as tailwinds.

The company’s use of digital tools, including their rewards program, is particularly forward-thinking in terms of keeping a sticky customer base. And this has positioned them well in today’s environment.

Headwinds include digital investing, marketing spend, rising labor costs, and a new threat from specialty purveyors (especially in convenience offerings). Luckin Coffee (LK), a Chinese coffeehouse chain that focuses on convenient and cheap pick-up and delivery coffee, is a good example of the new competition.

The COVID-19 pandemic is obviously a headwind, but that’s more temporary in nature.

Speaking of temporary, Starbucks is already back to business in China. And China is a massive growth market for the company. Starbucks is one of the few Western companies to achieve widespread success in China.

They acquired the remaining shares of East China Joint Venture in July 2017, allowing the company to operate all Starbucks stores in mainland China.

With almost 1.4 billion people and a rising middle class, China’s consumer base is hugely attractive.

Starbucks is adapting to local trends adeptly, including the need for speed in urban centers.

In July 2019, the company opened its first Starbucks Now store in Beijing. It’s an express store format that integrates mobile ordering and delivery seamlessly.

Now, I would temper our expectations here. That 14% near-term growth rate looks aggressive, especially in light of the spreading pandemic.

However, Starbucks doesn’t need to grow at 14% in order to provide big dividend raises and an appealing rate of return.

The numbers will be stunted over the short term. But I think the company stands to continue growing in the low-double-digit range over the long haul.

And that’s enough to comfortably provide high-single-digit dividend raises for years to come, which is plenty of growth when paired with a yield near 3%.

Financial Position

Moving over to the balance sheet, the company has a strong financial position.

The negative common equity belies this, meaning there’s no long-term debt/equity ratio to rely on.

With a bit over $11 billion in long-term debt on a $73 billion market cap, Starbucks has no issues with debt.

Furthermore, their interest coverage ratio, at over 14, shows that the company is easily covering its ongoing interest obligations.

However, I will say that I’m slightly disappointed with recent deterioration.

The company used to have a fortress balance sheet, but they’ve taken on debt for a variety of purposes. Their balance sheet is still very solid, but I’d like to see them refrain from reducing the strength of their financial position any further.

Profitability is robust at the company, which isn’t a surprise for a quality enterprise like this.

Over the last five years, the firm has averaged annual net margin of 14.47%. Return on equity has become inapplicable due to negative common equity.

To add color to the margin story, net margin was hovering around 10% a decade ago. There has been a meaningful improvement here.

Overall, there’s so much to like about Starbucks as a long-term investment.

I acknowledge and will advise you that the short term will likely be bumpy, but this company has the long-term legs to be an amazing investment.

Their durable competitive advantages should give you further comfort in this regard.

They have immense scale, first. This is something every other competitor trails on.

And their brand power is off the charts, conferring unique pricing power that allows them to charge a premium for their in-demand products.

I think their brand power is evidenced by the fact that they’ve been able to successfully penetrate the Chinese market, which is a market that has baffled and stymied almost every other company out there.

Of course, there are risks to consider.

Competition, regulation, and litigation are omnipresent risks in every industry.

They’re heavily exposed to input costs, primarily in the form of labor and raw materials.

Being a global company, they’re exposed to macroeconomic issues and broad economic slowdowns. The current pandemic is an acute reminder of this.

Perhaps the biggest risk is the nature of the company itself. Their massive size means they’re bumping up against the law of large numbers, putting a ceiling on their future growth.

Even with these risks, this appears to be one of the best ideas out there.

At the right valuation, it could be a phenomenal long-term investment.

Now down 30% YTD, the stock looks very attractively valued…

Stock Price Valuation

The stock is trading hands for a P/E ratio of 20.45.

That might look high at first glance, but this is a stock that has averaged a P/E ratio of 28.7 over the last five years.

It typically commands a large premium for its quality, but that big premium has all but disappeared.

The sales multiple is at 2.8, which is much lower than the stock’s five-year average P/S ratio of 4.0.

And the yield, as shown earlier, is significantly higher than its recent historical average.

So the stock does look cheap based on basic valuation metrics. But how cheap might it be? What would a reasonable estimate of intrinsic value look like? 

I valued shares using a dividend discount model analysis.

I factored in a 10% discount rate and a long-term dividend growth rate of 8%.

This DGR is at the top end of what I allow for when I use a DDM analysis.

If there’s any company that deserves it, it’s Starbucks.

The payout ratio is moderate, their commitment to dividend growth is clear, and they’re supporting that dividend growth with amazing EPS growth.

The COVID-19 pandemic is a bump in the road, but the 30% haircut on the stock seems overdone when 30% of the store base isn’t being wiped out.

There are few brands stronger or more recognized globally than Starbucks. That bodes well for the long term.

The DDM analysis gives me a fair value of $88.56.

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.

I think this stock is cheap, and my DDM analysis backs that view up.

But we’ll now compare that valuation with where two professional stock analysis firms have come out at.

This adds balance, depth, and perspective to our conclusion.

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 $86.00.

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 12-month target price of $90.00.

We have a tight consensus here. Averaging the three numbers out gives us a final valuation of $88.18, which would indicate the stock is possibly 41% undervalued.

Bottom line: Starbucks Corporation (SBUX) is a high-quality company with one of the most recognized brands in the world. Because of their relentless focus on customer service and prior technology initiatives, they’ve positioned themselves incredibly well to deal with the pandemic and come out relatively unscathed. With a 2.6% yield, a “near-perfect” payout ratio, double-digit long-term dividend growth, 10 consecutive years of dividend raises, and the potential that shares are 41% undervalued, this might be one of the best long-term investments available in this market right now.

-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 67. 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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