Starbucks is a high-quality business and my next dividend growth play

Starbucks (SBUX) is the newest addition to my Dividend Portfolio and in this post, I want to share why. I chose this stock despite its relatively low yield and various short-term uncertainties – but a few aspects of this business makes this one uniquely high quality and a great long-term holding.

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Starbucks as a brand

You may have mistaken me for a big coffee drinker but that is actually not true. I rarely drink coffee for enjoyment – Mostly in certain social settings or just to keep warm in the cold. Even when working or staying up late I prefer a caffeinated soft drink or energy drink above coffee. Whenever I do drink coffee I just take it black. Certainly, I am not the type to drop by the local coffee house and drop upwards of $10 (yes, really) on a single beverage. But many of my peers, including my girlfriend, study mates, or colleagues, do so as often as they can away with it. Starbucks has an incredible brand and huge mind share among the global population. They have managed to create an effective and unique experience and atmosphere for their customers somewhere in between the office and a private home. Friendly, neighborly, and cozy.

Every Starbucks coffee house is different and some are even entirely unique. Each store design aims to reflect the characteristics of their surrounding neighborhoods. Yet they still manage to stay familiar. Starbucks has an entire page dedicated to this design philosophy on its site.

The brand has become almost synonymous with coffee shops and anyone knows what to expect when walking through their doors: Hot or cold beverages & snacks at above-average prices, a warm wooden interior vibe, and readily available free Wi-Fi. Starbucks has retained the title of the world’s most valuable restaurant brand for five consecutive years and is the only non-fast food brand in the top 5. Its brand value is estimated to be between $13-38 billion as of last year. According to Forbes, It ranks 37 out of all global brands as well.

Starbucks on every corner

Starbucks was founded in 1971 and its first store opened at Pike Place Market in Seattle. I actually visited that store back in 2016, which is somewhat of a landmark tourist attraction now. But with Starbucks being a truly global brand, their stores can be found everywhere. There is a ton of coffee houses in Copenhagen where I have my day-to-day and even though local competition has sprung up over the last couple of years, Starbucks still dominates the market and prime locations. Even in China, their stores are everywhere and a market where they are accelerating store expansions. The company aims to operate 6.000 stores in China by the end of this year and had already managed to open just above 5.000 of those by mid-2021. As of January 2022, Starbucks operates 34.317 stores worldwide with 17.000 of those being in the US.

A picture I snapped of the first-ever Starbucks store at Pike Place Market in Seattle, Washington back in February of 2016. Certainly crowded.

“A Starbucks on every corner” has long been a saying and has now almost come true. Although that is not without its downsides as well –Cannibalization of their own local business with neighboring stores competing for the same crowd has hurt them in the past. And so in 2020, in the midst of the pandemic, the company announced plans to close 600 stores across North America. Primarily in dense metro areas with an already high concentration of stores, but with plans to open in new locations drive-throughs and to-go stores. The coffee maker has also upped its efforts in retail, offering more Coffee at home products than ever before – including several unique bean roasts, blends, instant coffee & to-go drinks, all in their own branding.

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Starbucks as a bank

One surprising aspect of Starbucks as a business you may not know of is that the business operates essentially like an unregulated bank. In many ways, Starbucks has embraced the increasing focus on technology and is now competing with players such as PayPal (PYPL) without the knowledge of their customers. A few years ago the Starbucks Card was introduced allowing customers to add money to their Starbucks Account in exchange for small rewards like free drinks. Today that card is widely used through the Starbucks app and is the most popular restaurant awards app out there. While this money eventually will be used to pay for their own offerings, in the meantime their customers are essentially offering Starbucks a small loan with no interest. The company can then use this money to fuel new ventures and open new stores in rising locations – which they historically have been very good at.

I got all the info on this particular topic from a great video made by PolyMatter in 2021. Well worth a watch! This video truly got me thinking about an investment in Starbucks.

Starbucks has the ability to find up-and-coming neighborhoods before the rest of the market revealed by how real estate property in close proximity to Starbucks stores has appreciated more than average. In total, about $1.6 billion is stored in Starbucks Accounts globally – and just to put that number into perspective, about 85% of US banks have less than $1 billion in total assets at any given time. On top of that around 10% of this number is never redeemed and lost or forgotten – known in the industry as “breakage”. Yet because money cannot be withdrawn and instead only traded for coffee, Starbucks is allowed to operate without a bank license, giving them many direct advantages over competitors in this space.

Starbucks in the short term

Starbucks falls into the sector of consumer discretionaries – meaning they sell non-essential goods. In contrast to this are consumer stables, selling the kind of things we all need no matter what. In a period of high inflation and growing fears of recession, there is a reason why Starbucks has fallen more than 30% year-to-date. So with big short-term risks facing the company, why have I not instead bought into consumer stable stocks like Costco (COST), PepsiCo (PEP), or Coca-Cola (KO)? The answer is fairly simple: I think they are fundamentally too expensive right now. All three are proven, quality businesses and therefore trading at fairly high multiples. The same could be said for Starbucks which over the last several years have traded at a high multiple of above 30 or very high 20s – but is now interestingly trading at only a Price to Earnings (P/E) of 21.

During the pandemic, the lockdowns resulted in a temporarily inflated P/E of almost 200, but historically the stock has traded at higher multiples than now.

If the doomsayers and pessimists are right about a recession though, it is likely that Starbucks will have a tough time for the next few quarters – if that turns out to be the case, I will attempt to buy more shares at a lower price, but overall I am pretty happy picking up such a high-quality business at a fair P/E or approximately $80 per share. But even as times are tough, Starbucks has shown that they are able to leverage their strong brand allowing them to raise prices in both October of last year and in January this year. Global supply chains are strained from the shipping shortage created by the pandemic and now by Putin’s war, meaning prices of the raw ingredients Starbucks need for their products are going up – but it seems at least for now they are able to not let that hurt their bottom line too much.

Lately, there has also been a lot of chatter about Starbucks employees pushing for unionization, which may eventually hurt the company short-term, but which I think on a fundamental level will only benefit them in the long term. Adding to this, I believe Starbucks will come out of the situation in Russia in much better shape than many of its competitors. McDonald’s (MCD) recently shared that their restaurant closures in the country will cost the chain an estimated $50 million a month. Coca-Cola and Pepsi also rely much heavier on Russian customers than Starbucks do. Like so many others, Starbucks has announced a total pullback from the Russian market. Alongside this, they announced a contribution of $500.000 by the Starbucks Foundation for humanitarian relief in Ukraine which I am also happy to see. But according to their CEO, Starbucks has only operated 130 locations in Russia and zero in Ukraine and even through a partner at that – resulting in only a 1% revenue loss in the short term.

Starbucks as a dividend growth play

Regular readers of my investment journal may be aware that Costco sits at the top of my Watch List and may still wonder why I did not pick that one over Starbucks. I would have loved to, had it not been so expensive and I hope to still be able to add it to my portfolio one day. One aspect however that these two businesses share is sustaining a high-quality business over the long term: Both focus on taking care of their employees and providing them with proper training and benefits. That results in less turnover and better service. Open positions are quickly filled and most workers report that they are happy to stay. One great example of this is how Starbucks has long offered all employees in the US working more than 20 hours a week, free online college through a partnership with Arizona State University.

The Starbucks College Achievement Plan.

Starbucks grows its revenue steadily and at a very consistent rate over the years, with the pandemic being the only exception. Their EBITA is at near all-time highs and in general, they are a very profitable company selling high margin products under a popular brand. They do have some debt, like so many other companies in the industry, but have also uniquely positioned themselves almost as a really successful bank. They have a well-covered and safe dividend, growing pretty significantly – having over doubled in just the past five years. The payout ratio sits just above 50% which is very manageable unless the world has to go through another pandemic type situation very soon. Up until then, they have also been great at issuing share buybacks and hope this trend will continue soon.

Starbucks quarterly revenue from 2009 to 2022.

They are positioned as a dealer of non-essential goods and because of this, they are sensitive to recessions and periods of economic downturn. But I believe the stock has been punished too hard for too long and that better times are ahead for the company. Regardless, their strong brand and innovative rapid growth strategy mark them as a solid business with huge upside potential for the long term. Their dividend yield currently sits at a little above 2%, which is lower than what I usually strive for in my dividend portfolio (3%+). But like with my other recent addition to this portfolio – Broadcom (AVGO) I believe they are in a position to grow into that fairly soon. As I have come to better understand value companies I have learned not to chase yield and instead focus on long-term healthy companies looking to reward their investors over the long term.

Disclaimer: I am not a financial advisor, the opinions expressed in this article are entirely my own – always invest at your own risk.

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