While one should never blindly buy any stock a big hedge fund manager buys, it's still probably a good idea to pay attention to the moves of some of the market's most succesul investors. Recently, activist investor Bill Ackman made a very big bet -- worth roughly $900 million -- on Starbucks (NASDAQ:SBUX).
At a recent conference, Ackman outlined his case in a 43-slide presentation. In general, the investor's argument was similar to the case company management has been making to The Street, but there were a few new nuggets worth exploring.
Growth in China
Ackman's case, unsurprisingly, hinges on growth in China. He projects Starbucks' China earnings to grow 15% annually through 2022, while the U.S. will only grow 6%. Ackman sees Chinese units increasing from 3,500 units today to 6,000 in 2022, on the way to eventually achieving a store count in line with the U.S. -- over 14,400 locations.
As for the recent slowdown in China comp sales, Ackman counters with several arguments. For one, Starbucks has been in China for 20 years, already taking up prime locations in high-traffic areas. The company also has over 7 million active Rewards members in China, which it can leverage into upselling and personalized offers. Ackman also points to Starbucks' new partnership with Alibaba's (NYSE:BABA) Ele.me delivery service as a potential catalyst.
As far as upstart challenger Luckin Coffee, Ackman notes that Luckin has grown very fast in just one year with the help of venture funding, whereas Starbucks is a dominant global brand that doesn't need outside funding to grow and innovate.
Finally, Ackman applauded the recent hiring of new CFO Pat Grismer, formerly at Yum! Brands, a company that also found success in China with its KFC segment.
Can the U.S. turn around?
Despite all the China talk, Starbucks' U.S. segment still makes up two-thirds of the company's operating earnings. U.S. comp sales have recently been lackluster, dropping to 2% in the first nine months of 2018, the worst that figure has looked since 2009. Even worse, transaction volume has gone negative, with positive overall comps sustained by price increases.
Ackman believes this is due to three things: Frappuccino weakness, logjams created by mobile-order-and-pay, and the switch from transactions-based to dollar-based rewards. He also thinks all three are fixable. Once the hangover of the company's Rewards switch is in the rearview mirror, transactions will have easier comparisons. Starbucks has also taken steps to better manage mobile-order-and-pay, including a better app and more efficient labor scheduling.
Ackman also believes Starbucks can innovate with healthier options for the afternoon period to counteract declines in high-sugar Frappuccinos. The company's high-end roasteries and reserve bars should make for premium "labs" where this innovation takes place.
In contrast to some of his other investments -- such as Automatic Data Processing (NASDAQ:ADP), where he pushed for changes -- Ackman is passively invested in Starbucks. In fact, he even had high praise for management's recent moves.
In the past couple years, Starbucks closed its mall-based Teavana stories, sold its Tazo tea brand, and also sold its packaged coffee business to Nestle (OTC:NSRGY) for a cool $7.2 billion. Starbucks used that cash to buy out its East China joint venture, taking full control of its operations in the country, while increasing its capital return program. Ackman forecasts over $14 billion in buybacks over the next two years, or 18% of the company.
Other stunning stats
Based on company filings, Ackman estimates U.S. stores generate a 66% return on investment, while China stores produce an 86% return. Those are really huge numbers!
Another display of Starbucks' dominance? A stunning 46.2% market share of the out-of-home coffee category worldwide. The second-place company? McDonald's, with a mere 3.1% share.
Fun with numbers
Ackman thinks that Starbucks' stock can reach $93 per share by 2021, based on a base case of 25 times estimated 2022 EPS of $3.70. His bull case is $117 per share based on 27 times estimated 2022 EPS of $4.35. This compares with the stock's current forward P/E ratio of just 22.1.
While I believe the EPS growth story, I'm skeptical Starbucks can meaningfully expand its P/E ratio that much. As companies get bigger, the growth opportunity diminishes, which could limit the expansion Ackman is modeling for.
Still, a multiple of 22 times earnings on Ackman's base case of $3.70 in 2022 EPS would yield a price of $81.40 -- well above current levels. Add in a rising dividend, and Starbucks can still be a good investment here, even if not the double Ackman envisions.