I purchased stock in Starbucks (SBUX) last week when the stock was trading down about 5% following an earnings release that fell short of analyst expectations. I love it when short-term momentum traders bail on a great long-term story, creating an opportunity for us to buy. After an over 2 year hiatus, we’re back to partnering with one of the best management teams there is. Long time followers may remember I wrote a post over two years ago discussing long-term value investing and highlighted Starbucks in particular as an example of a stock that needed to cool off and would likely produce subpar returns for a while. The gist of it was that sometimes a stock’s price will outrun the growth in earning’s power of the underlying company, at which point the stock needs to cool down and wait while the actual company “catches up” over time. That turned out to be pretty accurate for Starbucks as the stock is essentially flat over the last two years.
But now we’re at the point where the stock is starting to look attractive again if you have the right mindset and patience. Starbucks has always been thought of as a high growth company and as such has always traded with a premium valuation multiple. They’re still expected to grow earnings at a pretty steady clip in the years ahead, with the vast majority of growth coming from Asia (China in particular), but the company is also turning into quite the dividend grower. They’ve boosted the dividend by an annual average clip of 24% over the last 7 years! The stock is now yielding over 2% which is oddly high for your typical “growth” company. I call these “hybrid” investments. The dividend isn’t large enough to buy it purely for income but it is enough that you can view the investment as more than just growth. It’s a nice combo and the profile looks similar to other dividend growers.
Companies can’t expand forever. For example, there are only so many stores that Starbucks can actually open in any given year so it’s natural for a company at this stage to begin sending excess cash flow (i.e. Free Cash Flow) back to shareholders in the form of dividends and share buybacks. Starbucks is now generating between $2.5 and $3.5 billion per year of Free Cash Flow and returning virtually all of it to shareholders. Apparently selling a cup of coffee for $4.50 is a pretty profitable business model. Who would have thought? So as an investor, I’m happy to have those profits sent into my account each year.
A Simple Way to View Investment Expectations – Dividend Growth Investing
I’m going to present a very simple way to look at Starbucks to discuss my return expectations moving forward by looking at the stock through the lens of Dividend Growth Investing (DGI). All we need to do is estimate the average annual dividend growth rate and what type of dividend yield we think a stock like SBUX would carry.
Here are the metrics today:
- Current dividend per year: $1.20
- Current stock price: $~57.50
- Current dividend yield: ~2.08%
As I mentioned above, Starbucks is returning FCF by growing the dividend at a very impressive rate each year. About 5 years ago, they were returning roughly 33% of FCF as dividends but today it stands around 50% so the growth rate of the dividend has outpaced the growth rate of FCF. This is something that can’t happen forever so it’s reasonable to assume the dividend growth rate will slow over the next 5-10 years. However, 1) the company is still growing, 2) they’re buying back stock each year which makes it easier for a company to boost the dividend per share since there are fewer shares, and 3) eventually Capital Expenditures will slow which should also support FCF. All of these give the company room to continue to increase the dividend per share each year. Not to mention that Starbucks has committed to returning $15 billion to shareholders from 2018-2020. That’s a lot of dough! So, to be conservative, let’s say the average annual dividend growth rate will slow to 15% over the next 5 years. This would mean that the annual dividend per share in 2023 would be $2.41.
Here are the estimated metrics for 5 years from now:
- Estimated dividend growth rate (2018-2023): 15%
- Estimated annual dividend per share: $2.41
- Yield at today’s stock price: ~4.2% ($2.41/$57.50)
- Future price if trading with a 3.0% dividend yield: $80.33
- Future price if trading with a 2.5% dividend yield: $96.40
- Future price if trading with a 2.0% dividend yield: $120.50
Once the company’s growth rate slows enough, the stock will start to trade more like a “mature” company with a higher dividend yield but I don’t expect this to occur for at least another decade. So my base case is that Starbucks will trade at no higher than a 2.5% dividend yield which would put the stock somewhere north of $96 per share. If things play out this way, we’re looking at a roughly 75% total return (including dividends) over the next 5 years. However, if Starbucks is able to grow the dividend at a rate greater than 15% per year or if the stock maintains its current valuation and dividend yield, the total return expectation easily exceeds 100%.
Key Takeaways
- Dividend Growth Investing is a great way to approach long-term investing that allows you to take advantage of compounding growth.
- By maintaining a long-term time horizon, you won’t get caught up in the short-term noise of pullbacks in the stock market or quarterly earnings that fall short of analyst expectations.
- This simple exercise could be done on the back of an envelope. Notice that I didn’t overcomplicate things by looking at how many stores I thought they would open each year, same-store sales comps, margins, etc. I do perform a much more detailed analysis of the company’s financials when researching potential investments but this is a way to distill investing down to some simple concepts.
If I think Starbucks will be somewhere north of $96/share 5 years from now, I’m not going to get concerned about anything the stock price does over the next 6 to 12 months. In fact, I will gladly add to the position if the stock price moves lower to drop our average purchase price. I purchased the stock just under $58 and will look to double down every time the stock drops 3 to 4 points from here.
Thanks for following!
-Nick
Starbucks (SBUX) – 5 year, weekly
As a reminder, this is not a recommendation to buy Starbucks. These are my personal opinions and things may not unfold as I’m estimating. Please read here for more.