Starbucks has positioned itself for solid top-line growth and margin expansion through product innovations, cost structure re-engineering, and evolution into a diversified retail and consumer packaged goods platform. Representing about a third of coffee cups sold at retail, and 4% of the 90 billion coffee cups brewed at home in the U.S., Starbucks still has meaningful domestic growth potential, driven by platforms like VIA single-serve coffee, K-Cup products, Verismo, Evolution Fresh, La Boulange, Teavana, and Seattle's Best Coffee. International expansion possibilities are also compelling, particularly in emerging markets like China, India, and Brazil.
Formidable threats exist in both the retail and wholesale specialty coffee channels, but we believe a wide moat founded on strong brand equity, bargaining clout with its suppliers, and a highly leverageable model will be enough for Starbucks to stave off rivals.
|Economic Moat||Fair value||Stewardship Rating|
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KEY INVESTMENT CONSIDERATIONS
- At our updated fair value of $60 (22 times fiscal 2014 EPS), shares appear slightly undervalued. Starbucks remains one of the more compelling growth and margin expansion stories among large-cap consumer stocks, and we would not require much margin of safety before taking a position.
- Starbucks' global growth, channel expansion, and brand diversification efforts provide more potential upside catalysts than most consumer cyclical names.
- Despite its growth plans, we believe Starbucks can sustain a 35% dividend payout ratio, implying at least high-teen dividend growth over the next decade.
- The company's three-pronged approach to the single-serve market (VIA for users who don't want an at-home brewer, K-Cups for basic brewed coffee, Verismo for more sophisticated users) makes a lot of sense. Market share gains in the $8 billion premium single-cup coffee category (of which half is espresso-based drinks, according to management) could potentially lead to upside in our fair value estimate.
- Having greater control of its own consumer product distribution should be accretive to free cash flow over the long haul. Higher marketing costs and product launch investments likely will weigh down near-term channel development segment operating margins, but we remain confident that segment operating margins can return to approximately 35% over the next five years by increasing penetration of existing channels and diversifying to new channels.
- A reinvigorated food menu, La Boulange pastry products, beer and wine sales in selective markets, store redesigns, increased usage of social media tools, and leveraging the My Starbucks Rewards program are part of heightened focus on improving the Starbucks customer experience, penetrating new dayparts, and boosting unit level productivity.
- The company remains in the early stage of an intriguing international growth story. By 2022, we expect Starbucks' international unit count will exceed the U.S., including approximately 2,500 China locations and several hundred units apiece from India and Brazil.
- Competition is intensifying in the specialty coffee industry. Because switching costs are minimal, there is little to prevent customers from trading to other specialty coffee providers or quick-service restaurant substitutes such as McDonald's. Joh. A. Benckiser Group's consolidation of Peet's, Caribou Coffee, and D.E Master Blenders could evolve into a more formidable specialty coffee rival over time.
- Aggressive store openings can water down the customer experience and dilute brand equity. A number of recent retail acquisitions (Evolution Fresh, La Boulange, and Teavana) could take management's attention from the core Starbucks brand and adds new layers of execution risk to management's already loaded agenda.
- Volatile labor costs and commodity prices could weigh on quarter-to-quarter operating results.
- Expectations are high for Starbucks' potential in the premium single-serve coffee market. Any material missteps in the company's channel diversification strategies could have an adverse impact on the market's long-term view of these business lines.
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