The Biggest Risks of Investing in Starbucks (SBUX)

Starbucks Corporation (NASDAQ: SBUX) has the most recognizable coffee brand in the world. What started out as a small coffee shop in Pike Place Market is an international conglomerate with more than 28,218 locations as of 2018. Initial investors were pessimistic about the company's long-term prospects, with the common argument being "people are not going to keep paying $x.xx for just a cup of coffee," but Starbucks has proved it has staying power and impressive growth.

Even though Starbucks' initial public offering (IPO) took place back in 1992, the period after 2010 saw its prices skyrocket. Unsurprisingly, the stock garnered a lot of positive press for its performance. However, there are some real risks facing the Starbucks brand in the future, including global competition, commodity prices and changing dynamics in the retail market.

It is not necessarily true that "what goes up must come down," but there is also no reason to believe Starbucks will continue to grow regardless of market conditions. Investors need to investigate whether a stock is a good buy based on expected future results, not on what has occurred in the past.

Future earnings growth depends on consumer tastes, government regulations, corporate management, input prices and many other factors. These factors are present for any business, but every business interacts with them differently and Starbucks is no exception.

In 2018 the company’s market valuations look relatively strong. Shares sold for $57.07 as of October 15, 2018.  This is a 43% increase in five years. Over the past ten years, it reports an annualized total return of 26% with a forward dividend yield of 2.57%

The company is well established in the market and has a committed payout ratio of 36% with trailing twelve-month free cash flow of $2.6 billion. Its price to free cash flow over the past three years averages 22.

As of October 2018, the company has a price to earnings ratio of 17.66. This is at about the midpoint for S&P 100 companies. Its P/E is also one of the lowest in the S&P 100 consumer cyclicals which ranges from 146 to 5. Combine that with Starbuck’s three-year average beta of 0.63 and the risks look somewhat moderate in the near-term.

That said consumer cyclicals are highly prone to a number of risks and the restaurant industry especially as spending changes and consumer preferences can trend toward more lower cost options. Below are a few factors for investors to watch out for that could always undermine future earnings growth.

Competitors abound from all sides in the consumer cyclical restaurant and beverage industry. Starbucks competes with several other low-cost providers including Dunking Donuts, McDonalds and convenience store brands. This is not to mention the hot and cold beverage competition from companies like Coca-Cola and Pepsi, which are always looking of the newest emerging brand names. Thus, market trending products or acquisitions such as the Coca-Cola Costa deal could affect revenue negatively for Starbucks.

Partnerships are also a variable for competition. Starbucks has its locations inside many Barnes & Noble, Best Buy and Target stores. Keeping these partnerships and keeping the competition from aligning in these channels is also important. Operationally keeping its brand alive through partnerships with suppliers like Walmart, Target, and other retailers, including online retailers, is also critical.

Starbucks openly admits it is vulnerable to commodity prices. The company spends an extraordinary amount of money on coffee beans, sugar, milk and other commodities. It is not nakedly exposed to commodity fluctuations. Starbucks uses derivative contracts as a hedge just in case prices skyrocket. And there is evidence to suggest these measures are effective for their bottom line.

The American stock market has had a charmed climb since the lows of 2009 with the economy and stock market steadily gaining annually. Stocks in nearly every sector have been able to take advantage of this and most investment advisors are bullish on the future. However, with rising rate plans from the Federal Reserve, years of compounding gains and risk off trading volatility popping up more often, the bear market risks in 2018-2019 are increasing. The beta of 0.63 for Starbucks limits these risks but bear markets each have their own catalysts and if combined with some other idiosyncratic risks it could be more severely harmful.

Starbucks has deployed some significant amounts of capital to expand into international markets, partially because many prime locations in the United States already have Starbucks locations and the market is becoming saturated. Comedian Lewis Black once joked he ran across two Starbucks cafes located directly across the street from each other in Texas, and now there are three separate Starbucks cafes at the intersection of Shepherd and West Gray in Houston.

Domestic saturation is not always the best driver for international expansion though and there is no guarantee that the international markets will have acceptance rates that mirror the U.S. The company has made significant investments in China and India with Starbucks Coffee China and Asia Pacific (CAP), but these endeavors are still evolving. Investors should pay particular attention to the performance of foreign-placed Starbucks cafes, particularly CAP. CAP has had some success, but competitor brands are also moving into the same emerging markets, including large franchises from Yum! Brands and McDonald's with the McCafe.

Some investors believe Starbucks could be peaking after prolonged market success. A potential impending bear market combined with economic and spending retractions could be a problem for Starbucks and its investors as luxury brands would take a hit in this scenario. New global expansion is also a risk as international markets have different preferences and adoption levels. Expansion from development markets to emerging markets can also have higher risks as spending psychologies can differ dramatically. However, while there are risks, Starbucks’ three-year beta of 0.63 ultimately suggest that it would see less severe losses in a broad market downturn which is good for investors. As with all equities and consumer cyclicals especially it is important to monitor the systematic changes along with the idiosyncratic changes to stay ahead of any and all potential losses that can possibly be avoided or hedged with active investing.