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Why Starbucks Is a ‘Hold’ before Its Q2 Earnings

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Amid the global sell-off due to COVID-19, Starbucks (NASDAQ:SBUX) fell to a low of $50.02 on March 18. Since then, the company’s stock price has made a significant recovery. As of Wednesday, the company was trading at $77.45, which represents an increase of 54.8% from its March 18 lows. On March 28, President Trump signed a $2 trillion stimulus package to boost the US economy. The company’s stock price rose due to optimism about the stimulus package and a decline in the infection rate. On April 21, Chipotle reported better-than-expected first-quarter performance. The impressive first-quarter performance and optimistic commentary from Chipotle’s management also contributed to the increase in Starbucks’s stock price.

So, should you consider buying Starbucks before its second-quarter earnings? The company will likely report its results for the second quarter of fiscal 2020 after the market closes on April 28. First, we’ll discuss analysts’ expectations for the quarter.

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Analysts’ revenue expectation for Starbucks

For the second quarter, analysts expect Starbucks to report revenue of $5.89 billion. The estimate represents a fall of 6.6% from $6.31 billion in the second quarter of 2019. The decline in the company’s SSSG (same-store sales growth) due to COVID-19 could drag its sales down. However, adding new restaurants could offset some of the declines.

China and the US to report negative SSSG

At the peak of the COVID-19 outbreak, Starbucks closed 80% of its restaurants in China. Starbucks’s SSSG fell by 78% in February due to temporary closures, reduced operation hours, and less customer traffic. In March, the situation started to improve. Starbucks had 95% of its restaurants open at the end of March. The company’s SSSG was down by 64% in March. Notably, the company reported a decline of 42% in the last week of the month. So, management expects the company’s SSSG in China to decline by 50% during the quarter. Earlier, management expected the company to report an SSSG of 3% in China.

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Moving to the US, Starbucks had an excellent quarter until March 11. The company’s SSSG rose 8% with traffic growth contributing 4%. On March 12, the company’s SSSG started to fall. Starbucks closed some restaurants temporarily. Other restaurants only offered drive-thru and delivery services in accordance with social distancing guidelines. By the last week of March, the company’s SSSG had stabilized at -60% to -70%. During that period, the company had opened 44% of its company-operated restaurants in the US. By the end of the second quarter, 58% of the company-owned restaurants were drive-thru restaurants. Among the restaurants, 76% were in operation. Meanwhile, 55% of the franchised restaurants were also open at the end of March. So, these issues could drag the company’s SSSG in the US by 3% for the quarter.

Starbucks’s EPS to decline by double-digits

On April 8, Starbucks announced that it expects its adjusted EPS for the second quarter to be $0.32. Analysts expect the company to post an adjusted EPS of $0.34, which represents a fall of 42.9% from $0.60 in the second quarter of fiscal 2019. The sales decline due to restaurant closures, an increase in employee wages and benefits, higher expenses associated with store operations, and other activities related to the COVID-19 outbreak could hurt the company’s second-quarter EPS. Also, analysts expect the company’s interest expenses to rise by 29.9% to $96.0 million. The effective tax rate could increase from 19.7% to 23.0% during the quarter. Increased expenses could also lower the company’s EPS.

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Valuation multiple

Since the beginning of this year, Starbucks has declined by 11.9%. Despite the decline, the company’s valuation has increased. As of April 22, the company was trading at a forward PE ratio of 31.0x compared to 28.0x at the beginning of this year. The decline in analysts’ EPS expectations for the next four quarters might have led to a rise in the company’s valuation multiple. Meanwhile, the company was trading at a premium compared to McDonald’s (NYSE:MCD) and Dunkin’ Brands (NASDAQ:DNKN). As of April 22, McDonald’s and Dunkin’ Brands were trading at forward PE ratios of 27.4x and 20.7x, respectively.

As of Wednesday, Starbucks was trading at 42.5x analysts’ fiscal 2020 EPS estimate of $1.82 and at 26.9x analysts’ fiscal 2021 EPS estimate of $2.88. The estimates represent a YoY fall of 35.6% in fiscal 2020 and a rise of 57.7% in fiscal 2021.

Analysts’ recommendations

Since the beginning of this month, many analysts have lowered their target prices. MKM Partners, Citigroup, UBS, Piper Sandler, JPMorgan Chase, Wedbush, Credit Suisse, and Oppenheimer have all cut their target prices for Starbucks. Also, JPMorgan Chase downgraded Starbucks from “overweight” to “neutral.” To learn more, read Starbucks Stock Rose despite JPMorgan’s Downgrade.

As of April 22, analysts’ consensus target price was $78.11. The target price represents a 12-month return potential of 0.9% from the closing price of $77.45 on April 22. Meanwhile, Wall Street favors a “hold” rating for the stock. Among the 34 analysts, 58.8% recommend a “hold,” 38.2% recommend a “buy,” and 2.9% recommend a “sell.”

YTD stock performance and my take on Starbucks

So far in 2020, Starbucks has lost 11.9% of its stock value. Despite the fall, the company has outperformed the broader equity market. The S&P 500 Index has declined by 13.4% during the same period. Meanwhile, McDonald’s and Dunkin’ Brands have fallen by 5.6% and 22.0% YTD, respectively.

Amid the social distancing guidelines, Starbucks has shifted to a “to-go” model. Earlier this month, the company announced that it will expand its plant-based offerings in China in association with Beyond Meat, Omnipork, and Oatly. Despite these initiatives, I think that Starbucks stock will be under pressure for some time. The rising unemployment rate could lower customers’ disposable income, which would reduce the traffic at Starbucks. Also, the company owns and operates over 50% of its restaurants. So, lower sales could severely impact the company’s margin compared to its peers, who operate a higher percentage of the restaurants through franchises. So, I think investors should avoid Starbucks stock for the near term. In the future, they might get better entry levels.

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