Shares of Starbucks (SBUX -0.08%) surged earlier this week, after activist investor Bill Ackman touted the Seattle-based coffee titan at an investment conference. Ackman's Pershing Square hedge fund recently accumulated a roughly 1.1% stake in the company, currently worth more than $800 million.
In his recent presentation, Ackman predicted that Starbucks stock could roughly double within three years. That projection is probably too ambitious. Nevertheless, the shares do have a ton of upside, particularly for long-term investors.
Why Bill Ackman likes Starbucks stock
Looking back over the past decade, Starbucks stock has had an incredible run, delivering gains of more than 900% -- without even counting dividends. However, the stock has actually lost value over the past three years.
Investors have some legitimate concerns. Growth has slowed dramatically in the U.S., driven in part by the broader upheaval that has weighed on retail traffic. Furthermore, while China had been a bright spot for most of the past few years, Starbucks ran into trouble there earlier this year, due in part to a government crackdown on third-party delivery services. Competitors are also entering that market at a rapid pace.
Ackman noted in his presentation that Starbucks cafes still have incredible unit economics. He also believes that Starbucks will successfully address its growth challenges in the U.S. and China during the next few years.
First, Ackman highlighted Starbucks' massive long-term growth opportunity in China as coffee consumption increases there. He pointed to the company's first-mover advantage, premium positioning, and the impending rollout of delivery services through Alibaba's Ele.me platform.
Second, he praised Starbucks' actions to reinvigorate domestic growth. Improved food and beverage offerings and better execution in Starbucks' traditional cafes should drive better sales results. On top of that, Ackman sees significant promise in the company's investments in digital engagement/personalization and the super-premium Starbucks Reserve brand.
Finally, Ackman's presentation highlighted Starbucks' plan to spend about $14 billion on share buybacks over the next two years. (That includes a $5 billion accelerated share-repurchase agreement that Starbucks executed earlier this month.) The net result is that earnings per share could grow to around $3.70 -- or $4.35 in a best-case scenario -- by fiscal 2022, up from around $2.40 in fiscal 2018. Based on the company's historical valuation range, this could make Starbucks stock worth $93 to $117 by late 2021.
But the next few years could be bumpy
If the external environment cooperates, the combination of delivery in China, the expansion of Starbucks Reserve, and new digital capabilities should enable Starbucks to deliver strong EPS growth over the next few years. However, the company faces several potential pitfalls.
In the U.S., the economy has been growing for nearly a decade, but it wouldn't be surprising to have a recession in the next few years. That would likely drive a pullback in consumer spending. Given the saturation of the domestic coffee market today, a recession could cause outright comp sales declines at Starbucks in the U.S.
Meanwhile, growing trade tensions between the U.S. and China could lead to a backlash against American brands in China. That could quickly undermine Starbucks' growth there.
It also may be unrealistic to expect Starbucks stock to return to its historical valuation level of 25 times forward earnings or more. Rising interest rates will likely reduce earnings multiples across the stock market. Additionally, Starbucks circa 2021 will be growing more slowly and have more debt compared to a few years ago, when the stock's valuation peaked.
Starbucks stock still looks cheap
Despite the factors listed above, Starbucks stock has plenty of upside in the next three years and beyond. For example, while there's a good chance that Starbucks will face either a recession in the U.S. or a trade-related backlash in China (or both) within the next few years, the effects would likely be temporary, eventually giving way to a new period of growth.
Thus, Starbucks may or may not deliver EPS growth on the schedule projected by Pershing Square. However, it doesn't matter much for long-term investors, as long as Ackman's underlying thesis about the strength of the Starbucks brand and the company's long-term growth potential is sound -- which it probably is.
Starbucks shares trade at a very reasonable 21 times forward earnings. Furthermore, the company's aggressive share-repurchase plan should allow it to capitalize on any dips in the stock price if Starbucks stumbles in the next couple of years. Given the coffee giant's impressive track record, superior digital capabilities, and sterling reputation, the upside for long-term investors appears to far outweigh the potential downside in Starbucks stock.