Starbucks: Bullish Thesis Confirmed

Thesis

I have previously argued that Starbucks (NASDAQ:SBUX) could deliver record performance in 2023. And following a Q4 report in line with my expectations, I feel comfortable to reiterate my bullish thesis. In fact, on the backdrop of a sharper-than-expected COVID reopening push in China, Starbucks’ second-largest market, and largest growth exposure, I slightly updated my EPS expectations for the world’s leading coffee brand owner through 2025. According to my residual earnings model, I now calculate a fair implied share price of $132.22/share and thus see a slightly more than 30% share price appreciation upside.

For reference, SBUX stock is up approximately 11% for the past 12 months, as compared to a loss of close to 10% for the S&P 500 (SPY).

Starbucks’ Q1 2023 Performance

Starbucks started the financial year 2023 with a solid Q1 performance, although slightly below analyst consensus estimates. During the period from October to the end of January, Starbucks generated total revenues of approximately $8.7 billion, which compares to $7.6 billion for the same period one year prior (14% year-over-year growth). With regard to profitability, the world’s leading coffee brand recorded year-over-year operating income growth of 6.4%, accumulating $1.25 billion of operating profits. GAAP earnings came in at $0.74/share, growing 7.2% year over year.

Although analysts had expected revenues of around $8.78 billion, and EPS close to 77 cents per share (a 3-cent miss), I argue that 14% YoY revenue and a 7% EPS expansion are enough to justify continued optimism.

Other highlights for Q1 2023 include:

• Global comparable store sales increased by 5%
• Starbucks opened 459 net new stores in Q1 2023, ending the quarter with 36,170 stores globally, of which 51% are company-operated and 49% licensed

Confident To Reiterate Bullish Thesis On China Reopening Tailwind

Starbucks has previously predicted to operate 9,000 stores in 300 cities in China by the end of 2025. The bold expansion has slowed during China’s COVID lockdowns and investors feared that the bet would likely turn out to be a failure, with comparable store sales in China falling as much as 16% in the fourth quarter. The sales slowdown was even worse in the Q1 2023 quarter, as comparable sales in China fell an additional 13 percentage points, to 29% year-over-year contraction. However, investors should consider that Q1 2023 was still pressured to a large extent by China’s zero-COVID policies, with reopening starting only in early/mid-December.

In my opinion, the situation is poised to shift quickly in Q2 2023, with the COVID lockdown headwind likely to become a COVID reopening tailwind. For reference, as compared to economic growth of only about 3.3% in 2022, Goldman Sachs sees China’s economy expand by 4.5% in 2023, and Morgan Stanley estimates GDP growth for 2023 at 5.4%. In that context, it’s worth pointing out that in the conference call with analysts, Starbucks China Chief Executive Officer Belinda Wong commented that traffic during the Lunar New Year holidays has been “fantastic.”

Moreover, with Starbucks pushing into China’s lower-tier cities, the world’s leading coffee brand is expanding to cover a larger economic potential in China – a strategy which I expect to pay off handsomely in 2023. In Q1 2023, Starbucks added 69 net new stores in China, bringing total locations to 6,090.

Target Price: Raise To $132.22

Expecting a sharp economic rebound in China, I estimate that SBUX’s EPS in 2023 will likely expand to somewhere between $3.7 and $3.9. Moreover, I also raise my EPS expectations for 2024 and 2025, to $4.55 and 5.0, respectively.

I continue to anchor on a 4.5% terminal growth rate (close to 2 percentage points higher than estimated nominal global GDP growth), as well as on an 8% cost of equity.

Given the EPS updates as highlighted below, I now calculate a fair implied share price of $132.22.

Below is also the updated sensitivity table.

Risks To My Thesis

As I see it, there has been no major risk-updated since I have last covered SBUX stock. Thus, I would like to highlight what I have written before.

… investors should monitor the following, arguably temporary, headwinds:

1) high wage inflation which has and could continue to pressure Starbucks’ profit margins.

2) Slowing consumer confidence due to inflation and other macro-economic challenges could pressure Starbucks customers to save on arguably non-essential and “overpriced” coffee.

3) China’s challenges with the COVID-19 epidemic, and consequently the country’s reopening, could take longer than expected. This in turn would impact Starbucks’ business operations in the country.

4) Much of Starbucks’ share price volatility is currently driven by investor sentiment toward risk and growth assets. Thus, investors should expect price volatility even though SBUX’s business outlook remains unchanged.

Conclusion

Reflecting on Starbucks’ Q1 2023 results, I continue to believe that Starbucks’ coffee franchise remains in a secular growth trend. Although the company’s Q1 results were slightly below market expectations, I do not consider the results as bad – on the contrary. In my opinion, a 14% YoY revenue and a 7% EPS expansion is enough to justify continued optimism. Moreover, investors should consider that the China COVID reopening tailwind will only start to materialize in Q2 2023 onwards.

I acknowledge that at an EV/EBIT of about x26 SBUX is valued richly. But considering a likely 15-20% EPS CAGR until 2025, I argue that there’s still upside for share price appreciation. Personally, I model a fair implied share price equal to $132.22. Reiterate “Buy” rating.