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Starbucks: Buy at the High?

By Jeremy Bowman – Nov 28, 2018 at 10:15PM

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Shares of the coffee chain have surged recently. Is there still room to go higher?

The last couple of months have been rough for stocks. The S&P 500 has lost 8.7% thus far in the fourth quarter, and the tech-heavy Nasdaq is down 11.8% as concerns about rising interest rates, trade tensions with China, and an aging bull market combined to send the market swooning.

While nearly every sector has taken a hit, one stock that has surged over the last two months is Starbucks (SBUX 1.72%), up 19%. Shares of the global coffee giant jumped 10% on its fourth-quarter earnings report in October and have since continued to move higher. Today, Starbucks is trading within a hair of its all-time high at $68.98. After its recent rally, is the stock a buy? 

A female Starbucks employee standing in the middle of a store dining room and laughing with her eyes closed.

Image source: Starbucks.

A cup on every corner 

2018 has been a bizarre year for the cafe chain. Just five months ago, investors were panicking about Starbucks stock after the company said it would close 150 stores this year, triple its normal annual closures, slow its store opening pace next year, and slashed its quarterly guidance.  That news sent shares down 9% in a single session, and they slipped over the subsequent weeks to hit a three-year low at $47.37. 

What's changed since then? Surprisingly, not much, even though the stock is up about 40% in that time.

Starbucks' most recent earnings report topped expectations, but it didn't show the company had overcome the challenges highlighted five months ago. Instead, shares jumped as the company reported a 3% jump in same-store sales, an acceleration from 1% in the previous quarter, which beat expectations, but that figure glossed over some underlying problems. Traffic was still down globally and in the U.S., falling 1% in both markets, and comparable sales in China, which the company sees as its most important market, were up just 1%.

Instead of growing its customer base, Starbucks pumped up its growth with higher prices, as it hiked prices by 5% in the U.S., but that's not a sustainable strategy for growing sales as it can only raise prices so often. Starbucks isn't alone in this predicament. Traffic has fallen at U.S. fast-food restaurants for three years straight as the industry seems to be saturated, retail traffic especially in malls is declining, and easy app-based delivery has been disrupting the traditional fast-food model. 

Starbucks has a plan to boost traffic as the company is attempting to automate more tasks in order to free up employees for customer service, but slow traffic has plagued the coffee chain for some time and there doesn't seem to be an easy solution.

Where Starbucks is headed

Starbucks is still pinning its future on three key initiatives: China, premiumization, and digital. The company plans to open 500 stores a year in China through 2021, and envisions it as its biggest market one day. However, the slowdown in comparable sales and the deceleration in China's economic growth raises some concerns about that strategy. Starbucks is also focused on premiumization, with the opening of 20 to 30 Reserve Roasteries around the world and expansion of its high-end chain of Reserve stores, which offer Princi baked goods, small-lot coffee, and immersive experiences. Starbucks plans to eventually have 1,000 Reserve stores and Reserve bars in 20% of its stores. Its Reserve Roasteries have been well received, drawing record traffic, and the Seattle Roastery has become the second-biggest tourist attraction in Seattle after the Space Needle.

Finally, on the digital front, Starbucks is seeking to ramp its Rewards program, and Mobile Order & Pay, which may represent its best chance at returning to traffic growth. Though the company has had some challenges executing Mobile Order & Pay in stores, it continues to grow, increasing from 10% to 14% of transactions in the U.S. over the past year. Meanwhile, Starbucks Rewards membership increased 15% last year to 15.3 million. 

Is it a buy?

Beyond the traffic challenges, there are some other concerns for Starbucks investors. The company is under new management after longtime CEO Howard Schultz stepped down earlier this year, leaving Kevin Johnson in charge. Schultz led Starbucks from a handful of stores to the global giant it is today, and the last time he relinquished the leadership role, performance slipped and he eventually had to return to get the company back on the track. Johnson may have more success, but it's a risk that Starbucks investors wouldn't have to worry about if Schultz were still at the helm.

After the stock's surge over the past few months, valuation is also a concern. Non-GAAP operating income was flat in the recent quarter, despite cheers about same-store sales growth, and the P/E ratio has risen to 27, which is higher than most restaurant stocks and the S&P 500 average at 22.

I own shares of Starbucks, but right now, I wouldn't buy more. I'd like to see the company grow into that valuation, deliver traffic growth, and better comparable sales growth in China. If Starbucks can't execute on the last two goals, investors should look skeptically at any further appreciation in the stock at this point. Its brand helps give the company a sustainable competitive advantage, but between the current challenges it faces and its valuation, the stock doesn't look like a buy today.

Jeremy Bowman owns shares of Starbucks. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool has a disclosure policy.

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