Starbucks may need caffeine boost from activist, sector advisors say

Starbucks’ [NASDAQ: SBUX] excessive spending, underlevered balance sheet and carve-out opportunities make the coffee retailer a potential activist target, two sector advisors and an activist investor said.

Only a handful of funds can pull the trigger against the Seattle, Washington-based group given its size, these sources agreed. The investor estimated that, in order to have an impact, an activist would need to buy around 3% of the company, accounting for an investment of roughly USD 2.4bn.

Starbucks has a market cap of USD 82.5bn.

The exclusive roster includes Elliott Management, Third Point, Trian Partners and Pershing Square, they said. One of them did not rule out other well-established names like Carl Icahn, Jana Partners, Starboard Value and ValueAct Capital.

Pershing Square was close to launching a campaign against Starbucks a decade ago when shares were at 7 USD, in a different investment environment, a source familiar with the fund said.

Any activist doing work on Starbucks today should study the white paper Pershing Square published on McDonald’s [NYSE:MCD] in 2005, the first advisor said. The New York-based fund declined to comment.

A focus on costs and balance sheet

Starbucks could use an activist to help put its costs under control, the investor said.

The company does not disclose total system sales, a key metric to calculate spending efficiency, the investor noted. But he said he calculated G&A as a percentage of total system sales using an estimate for the denominator and it comes significantly higher than the average of a peer group. The first advisor said that his model also highlights a subpar performance on this metric by the company.

On the more standard formula of G&A as a percentage of net revenues, which does not take into account sales going to licensed partners, Starbucks went from 6% in 2014 to 6.7% in the last quarter.

The operating margins erosion in the Americas driven by higher partner and content investments, and the around USD 1bn in unallocated corporate overhead costs, deserve attention on the spending front, the investor said.

The opportunity for Starbucks to lever up could be another topic of discussion if a dissident showed up, the advisors and investor said. The company has USD 1.25bn of debt on USD 4.95bn of TTM EBITDA as of its latest disclosure.

The investor said that Starbucks could take its leverage up to 3x and use the roughly USD 15bn it raises for a buyback of around 15% of the company.

Last week, the company said it returned USD 2bn to shareholders via buyback and dividends in the last quarter and has authorizations for repurchasing an additional 52 million shares. The amount returned to investors in the quarter is not going to move the needle for a company of this size, the first advisor said.

Low-returning projects

An activist could argue that Starbucks should stop investing its money in low-returning projects and return more capital to investors instead, this advisor said. Acquisitions, new openings in developed markets and partnerships on new store concepts have not produced strong returns as of late, he said.

The company’s return on invested capital (ROIC), a measurement of optimal capital allocation, has steadily declined each year for the past four years to the current 25.2%. Starbucks reported 27.2% ROIC in 2014, data pulled by this news service shows.

The company’s founder, Howard Schultz, supports a culture of “reinvesting in people” that is more suitable to a start-up than a mature business, the investor said. Schultz is executive chairman of the company and owns 3.06% of Starbucks shares.

An activist could target the board to promote a change in mentality toward value creation for shareholders, the investor said. The average tenure of the 14 board members is 10 years. Shareholders can nominate board candidates between 22 October and 21 November.

Starbucks operates in a growing but highly competitive industry, a second activist investor familiar with the sector said. The US market is saturated and new openings can cannibalize traffic from nearby locations, this investor and the second advisor agreed. Meanwhile, the expansion strategy in Europe produced a mixed bag of results and China represents the only growth platform, the investor said.

A look toward Asia

Starbucks has a plan in place to grow in China from the current 3,200 stores to more than 5,000 stores by 2021. In the China/Asia Pacific region, revenue grew 54% yoy in the second quarter of this fiscal year, to USD 1.19bn.

An agitator could push for a spin-off of the Chinese operations and the Global Consumer Products (CPG) business to see them trade at much higher multiple on a standalone basis, the first investor said. He said that while spinning-off these assets seems “hard to do at this stage,” an activist could try to convince the company to unlock their value by selling part of them or considering partial splits.

This investor said he was not clear if those operations would be profitable on a standalone basis after accounting for the costs to run them.

Starbucks faces an important test this quarter as it performed well in the same period last year, the first investor said. If it disappoints when it reports earnings this summer, and the stock falls down to the mid-to-low USD 50s, some shareholders could start showing signs of frustration, he said.

Same-stores sales were up 5%, 2% and 7% in US, EMEA and China, respectively in the third quarter of fiscal 2017.

This investor said that Starbucks’ valuation multiple is still above its peer group but the relative premium has come down. Shares trade at about 22x forward EPS, the lower end of the 21x – 36x three-year range, according to Barclays.

Last year, activists started emerging in so called large and mega-caps like Procter & Gamble [NYSE:PG], Automatic Data Processing [NASDAQ: ADP] and General Motors [NYSE:GM]. This marked the end of an era in which large corporations were using size to keep agitators at bay.

A third industry advisor said an M&A angle could emerge for the company if an activist came in play. The first advisor, investor and an industry source said 3G Capital could buy the group and put it on a strict diet as it did with other companies, they said. One of them cautioned that Coca-Cola [NYSE: KO] might be a better fit for the Brazilian private equity.

The first investor said that Starbucks can be seen as a larger Costa Coffee, the UK-based coffee chain that will be spun-off by its parent, Whitbread [LON:WTB], after two activists called for the separation.

Starbucks and Costa are market leaders, they could be operated more efficiently, they have large operations in China and they are slow-moving entities in a fast-changing industry, the second investor said. But scale is an important difference as Starbucks is a global leader while Costa is more of a regional player, the first advisor said.

Starbucks did not respond to a request for comment.

by David Carnevali, with analytics by Kevin Ketcham and Justin Zacks