Buying quality is always in style, but in the wake of Starbucks (SBUX 0.46%) stock's 15% decline over the last two months, the coffee giant looks even more worthy of serious consideration by investors. Whether one is looking for a way to supplement retirement income or looking for some portfolio growth in uncertain times makes no difference.
As a restaurant chain, Starbucks is sensitive to consumer discretionary spending, so it certainly wouldn't be immune to a severe economic slowdown -- and signs that such an event is imminent have dominated headlines as of late. (Indeed, recession fears are likely part of the reason for this share price drop.) However, over the long term, Starbucks has a clear path for continued growth.
China is still a massive growth opportunity
Though its brand is already well-entrenched in the American psyche, Starbucks has continued to grow in the U.S. through new store openings, investments in digital tools like its order-and-pay loyalty app, and menu experimentation. Also benefiting it is the trend toward more eating on the go; in fact, according to U.S. Census Bureau data, this year, spending at restaurants is set to exceed spending at grocery stores for the first time ever.
The real wind filling Starbucks' sails, though, is China. There's been a lot of negativity regarding its economy, especially in light of the ongoing trade war, but in the case of Starbucks' plans there, that misses the real story. It isn't simply a matter of betting on a growing Chinese middle class that's able to spend more money on coffee. It's also a story about growing coffee consumption in general. Tea is the caffeine of choice across the Pacific, and Starbucks' work there has only just begun to unlock its signature beverage's long-term potential.
Now, large-scale competition has popped up to ride the wave. Though it's just a couple years old, Luckin Coffee (NASDAQ: LK) is already doing a couple hundred million dollars worth of business annually; Yum China (NYSE: YUMC) -- exclusive licensee of KFC and Pizza Hut in the Middle Kingdom -- has also been promoting coffee at KFC and launched a new chain called COFFii & JOY. But Starbucks is a premium brand, so what's good for the new coffee entrants will ultimately be good for it. Case in point, despite all the worry about the economy, Starbucks' store count in China grew 16% year-over-year and comparable sales (foot traffic plus average transaction size) were up 6% during its fiscal third quarter, an acceleration from the sluggish numbers that have been posted the last couple years. Not too shabby at all.
Image source: Starbucks.
Rising profitability from streamlined operations
That growth is boosting the bottom line. Operating income was up 8% during fiscal Q3 (which ended June 30) as a result of the higher foot traffic numbers -- both in China and domestically. Starbucks has been making some changes to its business model to help boost this number, including selling its consumer goods business to Nestle (NSRGY 1.23%) last year, and more recently, transitioning its stores in Thailand from company-operated to fully licensed.
It's early to gauge the results of those moves, but free cash flow -- a more accurate measure of profitability, calculated as revenue minus operating and capital expenditures -- is on the rise. Subtracting the $7.15 billion Nestle paid Starbucks last year, trailing-12-month free cash flow was $2.81 billion after Q3 2018, compared with $3.37 billion now. That's a 20% year-over-year increase. Currently, the stock is valued at 30.0 times price to free cash (P/FCF) flow when backing out the one-time $7.15 billion amount earned from the Nestle deal.
Putting cash to work
Granted, that P/FCF doesn't scream value, especially for investors worried that an economic downturn is near. But bear in mind that Starbucks' mid- to high-single-digit percentage sales growth is fueling even more bottom-line expansion. Adjusted earnings per share (backing out non-recurring items) are expected to be up 16% this year -- a figure boosted by stock repurchases.
There's also the dividend, which currently yields 1.6%. Management has raised the payout by 125% over the last five years. No hike has been announced yet this year, but the company has a history of annual increases.
At the beginning of August, I wrote that it was time to book some profits on this stock, but the quick sell-off since then means it's time to start testing the waters again. The world's largest coffee chain keeps getting bigger, and investors are likely to keep getting rewarded -- no matter what direction the economy heads in the short term.
