I Sold Starbucks, Here is Why...☕

Only fools stay same in the face of changing events. Starbucks still have good fundamentals but something is broken...

This picture changed the coffee shop industry forever:

This is Howard Schultz on his trip to Italy in 1983.

After he returned to the US, he turned Starbucks into the first truly global coffee shop chain.

What made Starbucks so big?

I think the answer to this question is the investment thesis itself for Starbucks.

Literally, think about it. Starbucks was not the first coffee shop in the world. The industry is so old but it has always been dominated by local businesses.

So, I think we have to go back to Schultz's trip and ask the question this way: What did Schultz see in his trip that would later help him make Starbucks so big?

It’s pretty simple actually.

He saw that the coffee shops were an integral part of the social life in Italy. People were visiting coffee shops at any time within the day, and coffee wasn’t a take-away item for them, they were talking and socializing in many different ways. It was an experience.

This is what Schultz saw in Italy: People sitting in a coffee shop, talking & socializing.

This is how Starbucks took over the world. It understood that it was an experience business.

This was also the core of my thesis when I started buying in April around $85 per share. Then I kept buying as it plummeted following the earnings, pulling my cost basis to $78.

I recently sold the bulk of my position and got back my initial investment. I will let the profits run for good.

Here is why I bought it in the first place and what changed:

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📝Starbucks Investment Thesis

When I am evaluating the potential investments, I ask the following questions in order:

1. Do I understand the business?

2. Does the business have a moat?

3. What’s the story?

4. Are the fundamentals strong?

5. Is the valuation attractive?

In my eyes, these questions are not five independent questions, they are chained together.

If I get a negative answer at one step, the whole process ends.

If the business doesn’t have a moat, I don’t look at the financials, because I know it’s just looking at numbers that can change unexpectedly. If you are operating in an unstable environment, there is no way you can make dependable predictions. First, you have to make sure that the environment is stable.

In April, I could finish the process as follows:

• Do I understand the business?

Yes.

The core business of Starbucks is selling coffee and other soft drinks. It also generates revenue through allocating the capital accumulated in loyalty programs and it also generates small revenue by selling Starbucks branded items like cups, water bottles etc…

• Does the business have a moat?

Starbucks has a giant moat in the form of economies of scale and brand recognition.

It is the largest coffee shop chain in the world. More than 80% of the US population live within 15 miles of a Starbucks. Given the size of the country, this is an incredible network of stores and it’s near impossible to match for any competitor in the next decade.

It also has one of the most recognizable brands in the world. Just look at the social media and you will instantly find millions of people posing with their Starbucks cups.

• What’s the story?

Starbucks is selling the experience, not coffee.

Just go out in your neighborhood and take a quick walk, most of you will find a smaller coffee shop that serves considerably better coffee than Starbucks.

If anything, Starbucks’ coffee is just average.

However, very high quality coffee was never the goal. You can’t sell premium coffee at scale, if that scale means 38,000 stores worldwide.

Howard Schultz envisioned Starbucks as a place where people would come together, socialize and drink their coffee. In Schultz’s model, coffee was the connector and the experience was what people were paying up for. This is how Starbucks could get away with mediocre coffee and premium prices.

People socializing in Starbucks

Though most of the developed world is now saturated, there are still plenty of growth opportunities in China and India. Starbucks could keep growing the revenue around 10% annually for the next 5 to 10 years. People have no reason not to keep choosing Starbucks as their preferred place to socialize.

• Are the fundamentals strong?

Starbucks has way more debt than equity.

This is normally unacceptable. However, if you look at the companies like Coca-Cola and Pepsi, you will see that they also have more debt than equity.

This is a distinct situation where the company can afford to operate with little equity pool or even with negative equity.

The reason is simple: The earnings of these companies are so predictable that they need a way smaller safety cushion than other operations.

Think about tech businesses, they are all under the threat of disruption.

There is no threat of disruption for Coca-Cola, Pepsi and Starbucks. AI won’t change how people drink Coca-Cola.

So, given the little risk of the business and high predictability of earnings, Starbucks stands at a solid financial ground despite the negative equity.

• Is the valuation attractive?

Valuing the story above, Starbucks will generate $59 billion in revenue in 2029.

If you assume that the profit margin will remain stable at 10% levels, we will get $5.9 billion net profit.

In the last 10 years, Starbucks’ median PE was 29. Even if we act conservatively and attach 25 times earnings, we will get roughly a $150 billion company.

You may ask, the growth will be much slower at that point so how come it can take 25 PE?

This is the magic with exceptional companies. Market doesn’t attach a premium just for growth. Market position, predictability of the earnings, amount of risk in the business are all factors. Coca-Cola still gets 30 PE at 7% average annual growth guidance because its earnings are extremely predictable.

It gets the premium for being the leader in the market, being safe, and being predictable. If it doesn’t get the premium, it will become a takeover target.

The reason for this premium is so simple: Nobody sells.

If you bought Coca-Cola in 2020, you are about to double your money in 5 years. You have an extremely safe investment that slightly outperforms the market. Why would you sell? Remember, it’s one of the favorite stocks for huge retirement funds. They don’t sell too so the P/E goes up. Newcomers have to pay a high price.

Starbucks, in theory, should get it too.

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🚨What Changed?

What happened is actually not specific to Starbucks.

There are many other companies that lost their soul after the visionary leader retired and the CEO position is filled with a professional CEO.

After Schultz stepped down from the CEO role in 2000, he had to come back 2 times to fix problems and hire a new CEO.

Starbucks CEOs turned out to be “not great” picks.

Maybe this is not on them, maybe they are correctly following the book to maximize the sales of Starbucks, but it doesn’t work.

Because they are not passionate. They don’t understand it.

Take Laxham Narasimhan for example. This is his attitude:

He had 0 passion about the business so he didn’t understand it. He never understood what made Starbucks so big.

After the disappointing the Q1 results, what do you think was the playbook Narasimhan came up with:

• Load up on the loyalty problem.

• Expand the product offerings.

• Reduce indoor seating.

• Increase promotions.

Totally useless.

There is a limit people will deposit to their rewards accounts, there is no point in expanding the menu if the same customers will choose one instead of another, promotions are only a short term solution.

Instead of these, he should have focused on one thing: Make the Starbucks experience better so people will come more often.

The most crucially negative data for me was this:

Same store sales were down both in China, the US and globally.

During the quarter, foot traffic was weak, with a 5% decline globally and a sharper 6% drop in the United States.

The problem is simple. It’s not promotions, rewards or the menu… It’s the experience.

People don’t go to Starbucks as often as they used to because the experience is getting worse and worse and the CEO, by deciding to reduce indoor seating, made it even worse.

The problem is not that 8% price hike. If you can provide people with a pleasant space where they can socialize with their friends comfortably for 2 hours, they will pay that additional 50 cents. No problem.

Now that Starbucks took experience out of the equation, why would people pay the premium price for a barely average coffee?

You just lost your ability to charge that premium but you are still pushing it.

Result? People don’t come as often.

For the past few months, I have been in the US, Germany, Turkey and Bulgaria and Italy.

Here is what I observed: There is a huge difference in experience between experiences. I have seen some of the best stores in Germany and Turkey and some of the worst in Italy and the US.

However, this general rule applies: Starbucks stores are getting smaller and smaller.

If I am not going to be able to sit comfortably for a 30 minute chat with my friends while I drink my coffee, I am not buying coffee from that store. I will simply go get it somewhere else where I can sit.

Nobody wants to search for a place to sit with a big, hot Starbucks cup at hand. Simple.

I am currently living in Florence, Italy and there only two Starbucks stores in my city. They have no outside seating, not enough inside seating, no wide enough tables to open your laptop, people are waiting in the line more than 10 minutes.

I can’t accept this.

For those who don’t know, Florence has only 350,000 inhabitants but it attracts 10-16 million tourists every year. This is one of the most profitable stores in the whole Starbucks network and it’s not good. I have been in the city for a month now and I haven’t bought anything from Starbucks so far. It feels like a torture rather than a good experience.

This store should have been one of their flagships in terms of experience but instead it’s selling coffee as a commodity.

Selling coffee as a commodity is not a game that Starbucks can win.

If one of the flagship stores is this bad, most stores should be much worse.

I am convinced that the current level of customer experience is not good enough to drive around 10% annual revenue growth in the next 5-10 years.

Starbucks TTM revenue currently stands at $36.4 billion.

If I reduce my revenue growth expectation to 6%, and keep the profit margin stable at 10%, we will get $4.8 billion net profit in 2029.

Even if we attach 25 times earnings to that, we will get a $120 billion business. It’s already valued at $100 billion. It’s basically promising nothing for retail investors right now.

This is why I decided to sell the bulk of my position to get my cost basis back after the stock skyrocketed when Brian Niccol was announced as the new CEO.

I love Brian Niccol and I believe that he will see the problem and correct it.

I just don’t want to gamble on his ability to steer the ship in the right direction. I am a retail investor, not an activist.

I left my profit inside to run because I trust in Niccol, but I won’t risk my principal.

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🏁 Conclusion

Is Starbucks uninvestable?

No, of course not.

If it was trading between $50-$60, I would jump on it even with the grim outlook I provided above. That would have been a perfect value investor play.

Plus, I really think Brian Niccol will make some difference, I just don’t know whether he can double the revenue growth. It’s so hard and I don’t want to gamble on it.

This is why I got my principal out and put it in SOFI.

I really think SOFI is a gift at this level, nothing else. Great growth, great company, great management.

HIMS is also amazingly attractive at these levels.

In the worst case, we have Amazon.

I just don’t want to bet on a turnaround while there are many great opportunities available in the market.

Let me know what you think about Starbucks right now!

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That’s all friends!

Thanks for reading Capitalist-Letters!

Please let me know your thoughts in the comments below.

👋🏽👋🏽See you in the next issue!