Starbucks (SBUX 0.18%) is the world's leading coffee retailer. Not surprisingly, the company had an exceptionally difficult year due to the pandemic; temporary store closures and social distancing measures caused revenue to drop over 11% in fiscal 2020, and earnings fell even further, down 73%. Yet Starbucks's stock is up 17% year to date, outperforming the S&P 500, and it recently hit a new all-time high, which may have investors thinking the stock is overvalued. Here's why they're wrong.
The impact of COVID-19
In response to the pandemic, Starbucks closed all of its stores in April, with the exception of drive-thrus. As a result, same-stores sales dropped 14% and total transactions dropped 22% in 2020. Despite this, operating expenses were roughly flat compared to 2019. In other words, even though the company closed stores and served fewer customers this year, it cost just as much to run the business.
This was primarily due to COVID-19, which introduced new expenses like catastrophe pay, wage increases, inventory write-offs because of product waste, and other costs necessary to provide customers and employees with a safe in-store experience. As a result, the company's operating margin dropped from 15.4% in 2019 to 6.6% in 2020, which in turn caused profitability to plummet.
Light at the end of the tunnel
Following the Starbucks's better-than-expected fourth-quarter results and management's strong guidance at the Investor Day in early December, shares hit a new high of $106. While the price has dropped a bit since then, the stock still trades at five times sales and 133 times earnings, the highest multiples shares have seen in over five years. But things aren't as bad as they look. These valuation metrics are misleading because they are backward-looking in nature. And in this case, that comparison doesn't work. I don't have a crystal ball, but I doubt we will see another pandemic in 2021. Instead, Starbucks's financial performance should rebound as stores reopen, social distancing measures subside, and consumer habits and spending return to normal.
Moreover, some of the pandemic-driven changes may actually help the company operate more efficiently in the future. For example, the new Starbucks Pickup option allows Starbucks Rewards members to order and pay through the mobile app, which means their order is ready when they arrive. As this format is introduced in new markets, the added convenience for customers should help grow revenue, and the increased efficiency associated with digital orders could increase the operating margin.
Additionally, Starbucks is adding artificial intelligence to certain digital drive-thru menus. This allows the menu to make product recommendations based on store location, weather, and time of day. Management expects this to both improve the customer experience and help better manage store inventory. If that pans out, it would boost revenue and improve cash flow, both of which could make the company more profitable.
Finally, in recent years Starbucks has invested heavily in its rewards program, which continued to gain traction throughout 2020. This looks encouraging both because it indicates increasing customer engagement and because customers typically spend more after joining Starbucks's loyalty program.
Management shares this optimistic outlook. At Starbucks's Investor Day, CEO Kevin Johnson said the company is stronger and more resilient than ever. He also indicated that Starbucks's premium brand and ability to quickly adapt to changing consumer preferences should give the company an advantage, helping it grow its share of the retail coffee market, which he estimated would reach $450 billion by 2023 -- over 19 times the company's trailing-12-month sales.
Additionally, CFO Patrick Grismer provided strong guidance for the coming years. While 2021 will be focused on recovery, Grismer estimated that non-GAAP EPS would jump more than 20% in 2022. He also projected that same-store sales growth would reach 4%-5% by 2023, driving revenue growth of 8%-10% through 2024. That would actually be a slight acceleration compared to pre-COVID growth rates. In other words, not only is there light at the end of the tunnel, but Starbucks may also be a stronger company now than it was prior to the pandemic.
A final word
Investors should watch Starbucks's recovery closely, looking for improvement in same-store sales and new store growth. These metrics underpin the company's ability grow revenue and earnings, and if they fall short of management's guidance, it could be a bad sign for the business.
However, Starbucks has a strong brand name and impressive global scale, both of which give the company a tremendous advantage. The company's colossal size means it generates more cash than smaller coffee retailers, and that cash can be reinvested into marketing, new technology, or product development, which reinforces the company's advantage.
Starbucks's stock is trading at a pricey valuation today, and that could certainly cause short-term volatility. But investors should look at the big picture. Given the company's strong competitive position, large market opportunity, and optimistic guidance, Starbucks is well positioned to grow its business.