Before we dive into all the reasons why I think you should stay away from Starbucks (SBUX 0.53%) stock, here's a strong disclaimer: I wrote an article saying the same thing two years ago. Since then, Starbucks shares have returned 52% for investors. The S&P 500? Up just 18%.
My call has been absolutely wrong. And it could be again. But I'll stand by my reasoning and back it up this time -- by putting my own skin in the game (more on that below).
Image source: Getty Images.
What's so bad about Starbucks?
You might think I hate the company; that's simply not true. I'm thoroughly impressed with the culture of coffee (and community) that Starbucks has helped foster in America. I'm equally impressed with how the company takes care of its employees. And while it's not my first choice, I don't mind visiting my local store.
My reticence is about the stock -- not the company. It can be broken down into three broad categories:
- Moat: The company's sustainable competitive advantages are shrinking.
- China: It won't be the panacea that the bulls are hoping for.
- Price: The stock is simply way too expensive given the above two points.
Let's break them down one at a time.
Got a moat?
In my investing world, moats come in four varieties.
- Network effects: Each additional customer makes the overall experience better for all customers, and thus makes the product more valuable.
- Low-cost production: When one company can make something for less than anyone else could.
- High switching costs: Current customers would find it painful, expensive, or otherwise challenging to change to a different provider.
- Intangible assets: These can include patents, government protection, and brand value.
Restaurants are notorious for their thin moats. Anyone can open up a store. While you might be able to keep your single location special enough that people frequent it, doing the same at scale is an entirely different thing.
That said, Starbucks has actually done a great job here. Forbes ranks it as the second-most valuable restaurant brand in the world, behind only McDonalds.
Starbucks' app and rewards program have proven quite popular. Customers clearly appreciate being able to order digitally, walk into the coffee shop, grab their beverages, and be on their way quickly. Those interactions with the app -- and the rewards points that build up from using it -- make patronizing Starbucks more "sticky" and add a mild degree of switching costs.
It could also be easily argued that because of its scale, Starbucks benefits from low-cost production.
And yet...
As I highlighted in my earlier article, millennials are becoming the most dominant demographic among consumers. And they (we) are looking for three things:
- Products produced locally.
- Products from small companies.
- Products that are organic.
While Starbucks can certainly offer organic beans, it is not local (unless you're in Seattle), nor is it small. There's evidence that this new demographic is willing to pay a little more for products that have those attributes. That could, of course, change -- but it substantially saps the value of Starbucks' powerful brand and lower-cost production.
How much luck will it have in China?
Much of the excitement around Starbucks has to do with the company's ambitions in China. It's hard not to get excited: There are over 800 million people living in its urban centers. American brands are popular there, and coffee is becoming more popular.
But there's a new kid on the block that could spoil everything: Luckin Coffee (LKNC.Y -1.52%). There were no Luckin shops in existence three years ago. This is what has happened in China since.
Chart by author. Data source: SEC filings and company investor relations.
Over the past year, Luckin has increased its footprint by 210%. "Sure," you might say, "anyone can grow fast by spending a lot of money. That doesn't mean Luckin will succeed!"
But consider the following:
- Average monthly customers grew 389% over the same period, faster than store openings, meaning existing locations are getting more customers.
- Average items sold rose 467% during this period, faster than the growth in customer count, meaning the average customer is buying more.
- Revenue is growing faster (520%) than items sold, meaning people are paying more for each item.
- Gross profit is growing faster than revenue, surging 822%, meaning Luckin has some financial leverage.
I'm not saying there won't be room for both Luckin and Starbucks in China. What I am saying is that Starbucks' long-term dominance in the Middle Kingdom is far from a foregone conclusion.
An expensive stock
So here's where I'm at: Starbucks is a quality company. But because of demographic shifts, I think its moat is narrowing. And because of the ascendance of a major competitor in China, I don't think it will be nearly as dominant there as it might have previously expected to be.
Those points alone don't make this a stock to avoid. The fact that Starbucks stock is trading for 36 times trailing free cash flow (P/FCF) and 32 times trailing earnings (P/E), is what really gives me pause. To put it in perspective, the average S&P 500 company trades today for 25 times earnings -- and even that is a historically high level. I just don't think such a large and mature company that isn't notably increasing traffic (much of its recent comp sales growth has come from price increases) deserves such a high valuation.
Putting my own skin in the game
I think having skin in the game is important. It forces us to hold ourselves accountable. I've already given Starbucks an underperform rating in my CAPS profile (a losing bet right now). I even briefly considered shorting the stock. But then my fellow Fool Daniel Sparks reminded me of something that's worth repeating here for all to see.
My take: One of the best privileges of investing is that you can have a negative view and remain on the sidelines. Shorting is more than being negative about a stock's long-term prospects. It's a bet it will go down.
— Daniel Sparks (@danielsparks) January 23, 2020
He's right. And this is an important behavior to model right here.
In its place, I offer this: I will take any money I get from writing this article and if -- three years from now -- Starbucks has outperformed the market, I will donate every cent to my local Boys & Girls Club.
You obviously don't have to follow suit. Staying on the sidelines is more than enough. There are better places for your money.
