More Bang for Your Starbucks?

Starbucks (SBUX) owns/operates and licenses stores in the US and international markets. It positions itself as a “third place“, after home and work, for meeting or hanging out.

In FY 2017, the revenue mix was 58% beverages, 17% food items, 13% packaged and single-serve coffee and teas, and 12% other (including ready-to-serve beverages, coffee cups and coffee-making equipment).

Investment Thesis

It is a growing company with a reasonable runway for future growth. Growth can come organically from increasing same store sales, or expanding into new geographies (China) or other categories categories (food, non-coffee beverages).

Revenue growth in the US is in the high single to low double digits. EPS growth rate exceeds sales growth (12-15%) due to improvements in operating margins (13% – 16%), and a modest decline in the number of shares (1546M to 1438M) over the past five years.

Management has ambitious growth targets, especially in China. It plans to increase its store count nearly 30% by 2021. At that point, SBUX will as ubiquitous as McDonald’s is today. Management also plans to double the food business by 2021.

It is amazingly profitable. As Scuttlebutt investor points out, the unit economics are compelling. A new SBUX earns back its original investment in two years. Thus, growth comes relatively cheap. Stores have proliferated without seriously compromising the ROIC or ROE (~25%).

Habits around coffee consumption tend to be regular and predictable. In some ways this is not different from addictive products like tobacco and cigarettes, where people get into a routine and get the same fix everyday. Digital initiatives and the loyalty program create powerful lock-in effects. One can almost think of SBUX as running a daily subscription business model.

Its brand value is strong. When I travel to other countries, I know what to expect when I enter a Starbucks. Its gift cards are perennial favorites at graduations, Christmas, etc. At many gatherings, it is not uncommon to serve SBUX coffee, when the tastes of the audience are not clearly known.

Generally speaking, the company is good to its employees and other stakeholders. In the US, it spends more on employee healthcare than on coffee bean purchases. It is the largest purchaser of fair-trade coffee in the world, and is committed to sustainability. At current prices it pays a nearly 3% dividend.

Negatives

  • Business is not recession resistant, even though SBUX remained FCF positive throughout the 2008-09 recession
  • It’s M&A track record isn’t exactly inspiring
  • SSS are declining from over 5% to less than 3%, currently
  • Management plans to lever up the balance sheet. Currently the debt is easily covered by cash flow (Debt/EBITDA ~ 1), but debt is on its way up.
  • If the China expansion misfires for some reason, piling on debt can limit their strategic options considerably. It will certainly crimp their growth ambitions.
  • Cheaper alternatives from McDonald’s (which I actually prefer) and Dunkin Donuts
  • Insiders have been selling on average for a while. Counterpoint: People sell for many reasons, but buy on the open market for only one – because stock is cheap. Howard Schultz seems to think so.

Valuation

Growth is an important part of valuing SBUX. If EPS continues to grow at a slower pace (8-10%) down from mid-teens in recent years, a multiple of 25-30 can be justified using, say Graham formula (8.5 + 2*g). Given an FCF/share of $2.30-$2.50, we get a somewhat wide range of $57-$75. A more careful DCF yields a estimate of $65-70, with the following range of plausible outcomes.

DCF

Resources

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An Interesting Week

Last week was unusually eventful.

Just last week I wrote about Walgreens Boots Alliance (WBA). I argued that the stock might be worth north of $90. On Monday, the stock drifted below $65, and I wrote a bunch of puts (1 7/13 $67.50 , and 2 6/22 $65) to pocket a premium of $550. We then learned that WBA had replaced GE in the DJIA. This bumped the stock above $67, and I closed the $65 weeklies. The $67.50 put is still open, and I will figure out what to do about it in July.

ALJJ, which has caused me a fair amount of heart burn, by falling over 60% from a 52-week high of $3.75 to a 52-week low of $1.42, finally seems to have turned a corner sometime two weeks ago. Last week, it put on a couple of impressive gains on strong volume, following more insider buying in the $1.50-$1.60 range. At the end of the week it had rallied over 35% from the low to end at $1.94. Six months to a year out, it is not hard to see this near $3.

Finally, GME confirmed rumors of a buyout, which pushed the stock above $15, a gain of about 20%. GME’s current cash flow is over $3/share. With a conservative 7-8x multiple given the less than stellar future business prospects, we could easily see a buyout over $20. With about 40% short interest, it is possible that GME will finally catch a thermal lift.

The stock has been battered over the past year, falling from $22 in August 2017 to nearly $12.50 in late March. Since then, it has rattled between $12.50 and $14. In my last update, I figured GME was still worth between $12 (bear case) and $25 (base case), and it is quite possible that the take out price will be closer to the base case than the bear case.

I have a small (1.5%) position in GME, accumulated at an average price of $15.80 after accounting for the dividends, and options written. I wrote ATM calls on about half my position, to hedge my bets and sell the enhanced implied volatility.

Walgreens Boots Alliance

I am looking at Walgreens Boots Alliance (WBA), and it seems interesting.

Investment Thesis

  • WBA is a large ($125B sales), growing (5-10%), and reasonably profitable company (ROE: 10-15%).
  • financially and operationally conservative: Its current (debt + liabilities)/EBITDA = 1.5 – 2.5x, depending on how you deal with leases. It pays a consistently growing dividend.
  • operationally conservative: It has avoided the acquisitive path of CVS (where debt/EBITDA is closer to 4-5x), choosing instead, to partner and collaborate. This strategy may attract “partners” wary of the CVS’s ecosystem.
  • horizontal and vertical integration: Consolidation is underway in the industry. WBA is iterative, and works in small steps. It bought a slice of Rite Aid stores, and a quarter of drug distributor Amerisource Bergen. In 2014, Walgreens bought Boots Alliance, which brought in a new CEO.
  • owner operator: CEO Pessina is a well regarded operator, with skin in the game. He bought a chunk when share price was in the $80s.
  • recession resistant, WBA was cash flow positive through the Great recession; plus their balance sheet is conservative.
  • risks are regulatory (can adapt), and Amazon (probably overblown given the complexity and low margins)

Quick Valuation

FCF/sales is steady and approximately 4%. Over periods of time, FCF exceeds net income by about 25%. This is especially so, if you normalize recent flurry of M&A.

Using a growth rate of 5%, discount rate of 12% and FCF of $6-6.5 gives a value of $90-$100/share using a terminal growth model.

It is cheap relative to its past P/S: 0.5 (historical 0.75), EV/EBIT 13.5 (historical 16.5), P/E 16.5 (historical 20). If they mean revert, they all imply a target price close to $100.

Tidbits

  • Comparison with other retailers: Walmart – $505B, Amazon – $193B, Costco – $140B, CVS – $185B, TGT – $72B.
  • Sales growth at Walmart and Target has trickled down to the 0-2% range, while that at CVS and WBA has been steady in the high single to low teens.
  • Rewards Program has about 90M members. This is valuable data.
  • Founded in 1909, invented milkshakes, and popularized soda fountains in the middle of the store.

Resources

  • RGA Investment Advisors slide deck on WBA, and Elliot Turner‘s twitter posts, were helpful in understanding the game WBA is choosing to play, compared to CVS.

 

Some Updates

This has been an interesting year so far. Despite being 30% in cash, I am down about 1.5%, which is more than the market.

Two relatively large positions are down significantly YTD. LUK is down nearly 20% ($26.50 to $22), and CFX is down nearly 25-30% ($40 to $30).

LUK made quite a few changes including changing its name and ticker to JEF, selling a large part of National Beef and all of Garcadia, and bought back nearly half a billion dollars in stock. For a $8B market cap company that is nearly 6%. While LUK or JEF has been a frustrating stock to hold, I can’t help thinking management is trying to do the best they can. I still think this is a stock worth north of $30, and am happy to hold on.

CFX expects to earn between $2.05 – $2.20/share (slide 20 on Q1 2018 presentation, link) for 2018. It seems like it is getting itself back on track. At a 18x multiple, they should be worth $36-40/share. Plus, it is a cyclical business that gets better with time, and it seems like a lot of its end markets are improving.

My most frustrating holding has been ALJJ. 2018 has been absolutely disappointing for reasons outlined in my last post on the company. Since then an additional “meh” quarter has gone by. The stock has halved from $3.15 at year end to $1.50-$1.60 last week. The company issued updated guidance calling for adj. EBITDA of $31-34m compared to $36-39m at the start of the year. If I assume interest, capex and tax to be on the higher end of previous guidance ($10m, $9m, and $1.5m), and divide by number of shares (37.9m), I still come up with a FCF/share of 28c – 35c. At 10x FCF, the stock could be worth twice its current price! The valuation was too compelling to pass up. I held my nose, and increased my position by 40%. I currently own 7000 shares at an average price of $2.81.

If the price of Under Armour holds steady, I will have escaped another holding full of drama with a small profit (5%). I started chasing UA to teach myself some options trading, and ended up buying at $20 and $16.50. The stock got halved from $20 to $10 over 2017, and has now jumped back to near $20. I think it is easily worth $15-$20, and might, with good execution, be a worth several times more. However, with the market getting choppy, I thinking there are more lower risk propositions available than last year.

Communications about Charter

Given the recent swoon in Charter Communications (CHTR) and Comcast (CMCSA), they both appear attractive. The economics of the cable business are predictable and compelling.

If you suspect that the market has over-reacted to the loss of (lower-margin) video-subscribers, and that these cable companies will adapt and position themselves as the dominant arteries for the flow of data(i.e. 5G etc. will be a complement, not a substitute), then now appears to be a fantastic time to take a substantial position in these companies.

I’ve taken a nearly 4% position in CHTR, and have significant exposure to CMCSA through options. If prices stabilize or go down further over the next couple of weeks, I plan on making a 10% allocation to cable.

Here are some useful links in chronological order:

  • June 2015: Oracle of Omaha after the announced merger with Time-Warner Cable when CHTR was trading around $170/share
  • September 2015: Punchcard Research did his characteristic deep dive
  • Andrew Walker continues to offer informed commentary on CHTR. He looked at it in June and October 2017.
  • There are numerous writeups on VIC. Here is a recent one (November 2017) by MarAzul.
  • Value Seeker did a deep dive in December 2017. He looked at the cable industry in general and both CMCSA and CHTR in particular.

 

Monte Carlo and Us

This, by Corey  Hoffstein, is the most insightful thing I read yesterday.

You are not a Monte Carlo Simulation” (click title for link)

It presents a simple but profound idea. It helped me pull together and contextualize several “gut feelings”.

  • The average experience of a population (ensemble average) can be very different from the experience of the average person (median)
  • This is especially true when the lower bound is zero and the upper bound is infinity. Income is a classic example
  • It helps understand why we are risk averse: why we feel the loss of $1 to be twice as painful as the gain of $1. The log-scale provides an appropriate measuring tape
  • Our lives are a single replica multi-period game, not multiple replicas of a single game

Check it out!

 

ALJJ: From Gray to Black and White

Last year, I took a 3% position in ALJ Regional holdings at about $3.20 (and wrote about it here and here). Today the stock trades below $2, and I have lost nearly 40% of my invested capital.

The central question is: should I hold on, or cut my losses?

The investment case for ALJJ has morphed over 2018 from something that could take years to play out to something that might take only a few quarters. In less than a year, it is conceivable that ALJJ goes bankrupt, or doubles from here!

The bear case is straightforward:

  • Q1 2018 results were a disaster! Two of the three operating segments are becoming an increasing drag!
  • the company is highly levered, and is uncomfortably close to breaching its debt covenants. Bankruptcy is on the table.
  • the CEO is accused of sexual harassment by a former colleague, and may be distracted

On the other hand, the bull case is:

  • The company is dirt cheap on a cash flow basis! On the Q4 2017 earnings call (Jan 8) about a month before the Q1 2018 results came out, the company projected about $18M in FCF for 2018 (FCF = EBITDA ($36-39M) – CapEx ($7-9M) – interest ($8-10M) – tax ($1-1.5M)). For a $72M market cap company, this translates to $18/$72 = 25% FCF yield!
  • The CEO increased his already large ownership in the stock by 3.7% after the debacle in the stock price (he paid ~$2.25/share). He comes from a distressed debt background, and probably has a more sophisticated understanding of how to navigate the covenants.
  • Dave Waters of Alluvial Capital summarized the bull case pretty effectively.

Because of the binary nature of the payoff, I haven’t added to my holdings. My plan is to hold on to my shares for a quarter or two more, and see which way the wind blows stronger.

Subjectively, I think the risk of bankruptcy is elevated but not overwhelming (if I had to pull a number from my ass, I would guess something like 1/3).

Currently, the expected 2018 FCF/share $18M divided by 37.6M shares is over $0.45/share. If the debt fears go away (perhaps as incremental FCF is directed towards debt reduction), the company might deserve a 10x FCF multiple or be worth $4.50/share. The expected value is then $3 (2/3 * $4.50), which is 50% above the current price.

Thus, while the position has a lot of hair, a lot of the bad news is more than baked in, and I plan on holding until 2Q or 3Q 2018.