Starbucks v1.0: America's Topless Siren in China
$SBUX: Earnings in Five days and Under the Hood
From McDonald’s to Starbucks: Sentiment Dumpster Diving
On January 19, the University of Michigan’s Survey of Consumers showed a reading of 78.8 for January, its highest level since July 2021. On a two-month basis, sentiment showed its largest increase since 1991. This news boded well for the market – except for Starbucks.
I’ve been adding to SBUX since last December amid horrid sentiment surrounding the “boycott” misdirection, union troubles, and a slowing China growth story. It’s certainly not for everyone to go long on a stock that “seems” to be dealing with a deteriorating brand image. However, I’ve found that my most successful options trades have been betting on the thin line between the probability of an ameliorating sentiment gap and nullified IV on call options. See McDonald’s in October ‘23.
The Familiar Support and Resistance Zone since 2019
There is nothing to marvel at when examining the weekly chart, which seems to be stuck in purgatory as it heads into Q1 ER on January 30th. In my view, this is merely illustrative of the perceived fundamental problems playing out on the weekly chart. Nonetheless, this marks a pivotal support-and-resistance area going back more than four years, a low risk area to add.
Though technical analysis generally takes precedence over fundamentals in short-term trades, particularly with options, I believe much of the trade hinges on the CEO and the management’s commentary during the earnings call regarding its expansion efforts in China and on its attempt to soothe the tension between the company and its employees’ union. It needs a positive spin that drizzles Bloomberg Terminal with a series of headline grabs.
This cup of latte is getting quite cheap, sans the extra syrup pump
One interesting factoid is that today’s Daily Price/Normalized EPS is hovering around 31, a ratio last seen in July 2022. Daily Forward P/E is exhibiting similar relative value, though I should mention that its industry has an average Forward P/E of 17.95, which means Starbucks is trading at a premium to the group at 22.76.
I’m also in the valuation camp that the more “expensive” names have reasons for their premium valuation within their industry. In this case, it’s the brand moat outside the U.S. territory, simply having to pay more for quality. More importantly, it is relatively cheap to its own historical valuation.
“Low” ratios, however, are often just headline grabs on Bloomberg Terminal and in the financial news circuit, especially given my short-term trade with call contracts expiring in March. Fundamental ratios are generally forward-looking, and their implications are already priced into the current stock price. Therefore, I won’t dip too deep into its valuation.
Blame the Sell-side Analysts for the Drawdown This Past Quarter
As for the recent downdraft, I believe it’s attributable to analysts from JPMorgan, TD Cowen, and others who forecast U.S. comparable sales growth to be around 4% instead of 6%, with sales of $9.7B vs. the estimated $9.88B for the same quarter YoY in Q1. In my view, they're giving too much weight to the boycotts impacting its comparable sales. Certainly, there are some stores affected by these issues, e.g., vandalism, threats, etc., but the impact seems to be overblown based on my visits to numerous stores. Yes, I’m a Lynch acolyte.
All in all, the sell-side’s hesitancy to recommend the stock seems to arise from the lower comparable sales. However, I'd argue that most Americans do not care about the company’s lack of a political stance; they just want their quick caffeine injection every morning.
What’s in Store for ‘24 Q1 Earnings
China
As of October 1, 2023, there were 6,804 company-operated stores and plans to expand further while other U.S. companies cannot seem leave this key demographic market soon enough. By 2025, Starbucks will have expanded to have 9,000 stores in that market.
My conclusions are based on my own travels to Beijing and to Shanghai on work matters. Some personal anecdotes from my travels. The locals in China tend to gather and socialize at coffee shops and stripmalls during extreme weathers, both hot and cold, for valid reasons. Heck, I even recall having the most important business meeting of my legal career in a packed Reserve in Shanghai.
On a side note, have I mention that it recently broke a “seven-decade cold weather record” in Beijing and in its nearby cities? I’m sure some locals spent some time at their Starbucks this winter. And why not convert the tea drinkers to coffee?
India
Starbucks plans to operate 1,000 stores in India by 2028, essentially opening one new store every three days. It also expects to double its workforce in India to about 8,600 employees. It currently has more than 390 stores across 54 cities in India through a JV with local partner Tata Starbucks. Reinforcing this news during the Q&A section could rejuvenate institutional bulls who questioned its growth strategy.
I personally want to hear more about this expansion effort.
Union Tension
The Strategic Organizing Center (SOC) sent a letter to its fellow shareholders outlining why enhanced oversight and proven human capital management expertise are needed on the Starbucks Board and nominated their members.
Drawing on my experience as an in-house counsel for a public company, I'm quite familiar with this area. In my opinion, I believe HQ was not prepared for the unionizing tsunami, which caught them off-guard, and they are now shooting from the hip. How the management decide to pivot their narrative could be a harbinger for inflow in the coming weeks after the earnings.
The Supreme Court also granted Starbucks' petition to consider creating a level playing field for U.S. employers on January 16. This could be an interesting turn of events if the Supreme Court finds in favor of Starbucks, denying injunctions under Section 10(j) of the National Labor Relations Act before the merits of an unfair labor practice case are fully evaluated.
Boycotts
As for the publicity surrounding boycotts, Narasimhan is likely to reiterate the memo he released to employees on December 20:
Many of our stores have experienced incidents of vandalism. We see protestors influenced by misrepresentation on social media of what we stand for.
My take is this shall pass.
Top and Bottom lines
This is where I’m seeing more mixed bag on EPS and Revenue estimates. As I’ve mentioned above the sell-side estimates have been putting much weight to the impact of boycotts on sales stemming from the Middle East unrest. The Narasimhan’s memo likely also confirmed their bias on slight subdued comparable sales.
The market expects that Starbucks will report quarterly EPS of $0.93 in its upcoming release, pointing to a YoY increase of 24%. It is anticipated that revenues will amount to $9.59B, an increase of 10% compared to the quarter a year ago. I’m in the camp that comparable sales growth for Q1 to be above 5% vs. JPM’s 4%.
The company missed EPS estimates for the last two Q1 ERs, explaining the sell-side’s reluctance to upgrade prior to this Q1 ER. As of January 26, there are 7 Buy ratings and 11 Holds. What is significant in these analysts’ recommendations is that, because Starbucks is heavily owned by institutions, it has a consequential impact on short-term swing traders like myself, let alone options traders. I’d argue that their analysis is meaningless and inconsequential in a span of more than six months.
However, it's critical to remember that options premiums move based on implied volatility, meaning that a “surprise” to those issuing recommendations is what drives Vega to surge or nullify.
At the moment, the implied volatility for my contract premiums is hovering in the mid-20s. The premiums are cheap because they have been staying in this range for weeks.
The “Secret Sauce” to Starbucks Trade
For a name that’s heavily owned by institutions, it matters where they peg their price targets at, as illustrated above.
Historically, Starbucks has rarely passed above its daily target price, i.e., when to sell, yet below Low CIQ PTs in the past have generally yielded good areas to add.
Here, it has been hovering below the Low CIQ PT on the daily chart for weeks, one of the primary reasons why I’ve been adding to my March call positions since last December to cover the upcoming ER and its (possible) subsequent move towards CIQ’s Daily Target Price of $110. It’s an ambitious bet as it currently trades at $92.61; however, it does not even have to be in-the-money for the trade to be profitable.
This is an arbitrage trade on market sentiment and cheap premium on a strong American brand name that is trading cheaply compared to its historical valuation.
Did I also mention that its short interest has been rising significantly since the boycott and union news plaguing the newscycle? A decent earnings next week will take care of them, quite quickly.
All in all, it’s worth the risk in my view
For the foregoing reasons, I’ve been adding to my Starbucks position in March calls. The implied volatility could crush at a moment's notice, but that's part of the trade: understanding why the premiums crumble despite the stagnant underlying price action. It’s merely a paper loss before the key event.
Theoretical options pricing is often not calibrated correctly for OTM calls when the stock tends to trade sideways for weeks. Many assume it's Theta decaying, but more often than not, it's just a lack of volume with low Open Interest.
In a few days, we will know if all the bad news, including its top and bottom line estimates, has been priced in.
Disclaimer: I have Starbucks ‘24 March OTM calls in my portfolio. Enter at your own risk. This is not for boy scouts, nor is it financial advice.
great coverage you legend :), thank you, cheers!