Can This Coffee Stock Extend Its Activist-Driven Rally?

Key Points

• An activist investor has initiated a sizeable stake in Starbucks stock, and investors wonder if there's any further upside left.
• While the short answer is yes, examining the fundamental trends supporting this belief would be beneficial.
• These are the same trends that are backing Wall Street analysts' decisions to boost price targets and expect above-industry EPS growth.

Most of the market had grown worried about the fate of consumer discretionary stocks, especially after realizing that the U.S. consumer is now suffering more and more from stickier inflation rates. While this may have some traction, fear is often not real when it comes to a certain group of stocks within this space, with more than just sound financial momentum behind them.

What’s termed a brand ‘moat’ is more critical in today’s market and even more so inside the consumer discretionary space. Brands like Coca-Cola Co. NYSE: KO are not really exposed to the business cycle, and that’s because no matter whether the economy is booming or busting, people will likely make room in their budgets for Coca-Cola products. The same can be said for the brand behind Starbucks Co. NASDAQ: SBUX.

After falling to a near 52-week low, shares of Starbucks rallied over 12% in one week. The move that had started as simply bullish price action came to show its true colors by the end of the week. Elliott Management, a known activist fund that invests in cheap quality businesses, initiated a sizeable (undisclosed) stake in Starbucks stock; here’s how investors can reverse engineer this decision to invest.

Why Investing in Starbucks Stock Can Help You Navigate the Business Cycle

Now that the market is going through a new rotation into small caps and bonds, investors can minimize risk by focusing on companies unaffected by such trends, like Starbucks.

Its strong brand presence, epitomized by the recognizable Starbucks logo, serves as a sort of social currency, distinguishing it significantly from competitors like Dunkin' Donuts. This unique branding contributes to Starbucks' stable investment profile amidst market fluctuations.

With this status comes pricing power and market penetration, two characteristics that show up on Starbucks’ financials. Pricing power results in gross margin rates of 27.7%, and the company’s ability to retain and reinvest this much capital from each sale might have attracted Elliott’s team in the first place.

Return on invested capital (ROIC) rates of up to 25.9% pinpoint the company’s potential to compound capital above market rates. This is why, over 20 years, Starbucks stock has compounded enough to deliver a 1,200% rally.

Chances are it will do similarly well over the next 20 years, as every company that can compound at these rates does. That may be why Wall Street has taken an optimistic view toward the stock in recent quarters.

What Wall Street Thinks About Starbucks Stock

Earnings are one of the main drivers behind any stock’s valuation in the market. Wall Street analysts now forecast up to 12.3% earnings per share (EPS) growth for Starbucks stock in the next 12 months, compared to only 8.2% growth for McDonald’s Co. NYSE: MCD.

Leaning on these EPS projections, Morgan Stanley decided to place a price target of $98 a share on Starbucks stock, daring it to rally by an additional 23.6% from where the stock trades today. However, these analysts haven’t been the only ones to show their bullish opinions of Starbucks recently.

Those at Raymond James decided to boost their stakes in the company by 8.4% as of July 2024, bringing the asset manager’s net investment up to $125.4 million today. Even with this projected upside, investors have one more thing to consider when watching this company.

Through robust financials, management is able to pay investors a $2.28 share payout, which would translate into an annual 2.9% dividend yield, beating forecasted U.S. GDP growth and above the Federal Reserve’s inflation targets of 2%.

Closing the Valuation Gap: How Coffee Prices Impact Starbucks Stock

Recently, coffee futures have reached a ten-year high price. Of course, rising coffee prices will directly impact Starbucks’s gross margins. Yet, because of management resilience, they have not.

Margins remain strong because management loaded up on inventory during the third and fourth quarters of 2023 when coffee prices were nearly half what they are today.

Following simple economics, the cheap inventory the company bought, which will be sold at wider margins now that ticket prices have risen by 4% in the U.S. (according to quarterly earnings), could potentially close the gap in Starbucks stock’s discount valuation today.

On a price-to-earnings (P/E) basis, Starbucks stock trades at a 21.8x multiple. At the same time, the average for the eating and drinking places industry stands at a much richer 42.8x valuation today. A discount of over 50% reflects the – unjustified – worries in the market stemming from more expensive coffee prices.

However, as investors know, Elliott Management has spotted a potential discount. This opportunity could pay off as soon as the following earnings announcement when the profits from cheaply bought inventories start to show on the financials.