The Biggest Risks of Investing in Starbucks

Starbucks (SBUX) has the most recognizable coffee brand in the world. What started out as a small coffee shop that opened in Seattle's Pike Place Market in 1971 has now become an international conglomerate. The chain has over 36,000 locations across the world as of the second quarter of the 2023 fiscal year.

Initial investors were pessimistic about the company's long-term prospects, with the common argument being "people are not going to keep paying so much money for just a cup of coffee." But Starbucks continues to prove that it has staying power and impressive growth prospects.

Even though Starbucks' initial public offering (IPO) took place back in 1992, the period after 2010 saw its prices skyrocket. Unsurprisingly, the stock garnered a lot of positive press for its performance. However, there are some real risks facing the Starbucks brand in the future, including global competition, commodity prices, and changing dynamics in the retail market.

Starbucks' Stock Performance

We've all heard that saying before: "What goes up must come down." But does that apply to Starbucks? There is really no reason to believe that Starbucks will continue to grow or fall regardless of market trends and conditions. Instead, investors need to investigate whether a stock is a good buy based on expected future results—not on what has occurred in the past.

Future earnings growth depends on a number of factors, including consumer tastes, government regulations, corporate management, input prices, and others. These factors are present in any business, but every company interacts with them differently. Starbucks is no exception.

The company’s market valuations look relatively strong going in mid-2023. As of July 3, 2023, Starbucks shares sold for $99.06. Over the past ten years, it reports an annualized total return of 13.46% with a forward dividend yield of 2.14%. The company is well established in the market with a payout ratio of 65.87% and a trailing 12-month (TTM) free cash flow of $2.75 billion.

Starbucks had a price-to-earnings (P/E) ratio of 31.95. Combine that with its five-year monthly average beta of 0.95 and the risks look somewhat moderate in the near term. Having said that, consumer cyclical stocks are highly prone to certain risks as spending changes and consumer preferences can trend toward lower-cost options. Below are a few factors for investors to watch out for that could always undermine future earnings growth.

Starbucks' Competition

Competitors abound from all sides of the consumer cyclical restaurant and beverage industry. Starbucks competes with several other low-cost providers including Dunkin Donuts, McDonald's, and convenience store brands, not to mention the hot and cold beverage competition from companies like Coca-Cola and Pepsi, which are always looking for the newest emerging brand names.

Partnerships are also a variable for competition. Starbucks has locations inside many other retailers, such as Best Buy and Target stores in the United States. Keeping these partnerships and keeping the competition from aligning in these channels is also important. Operationally keeping its brand alive through partnerships with suppliers like Walmart, Target, and other retailers, including online retailers, is also critical.

Commodity Price Fluctuations

Starbucks openly admits it is vulnerable to commodity prices. The company spends an extraordinary amount of money on coffee beans, sugar, milk, and other commodities. It is not nakedly exposed to commodity fluctuations. Starbucks uses derivative contracts as a hedge just in case prices skyrocket. And there is evidence to suggest these measures are effective for their bottom line.

Market Risk

Investors know that the American stock market has taken some hits. But it has proven its resilience, rebounding back after some troubling times, including the lows of 2009 and 2020. Stocks in nearly every sector have been able to take advantage of this and most investment advisors are bullish on the future.

But the risks of a bear market still abound because of a number of factors, including the rise in interest rates and trading volatility. The beta of 0.95 for Starbucks limits these risks but bear markets each have their own catalysts and if combined with some other idiosyncratic risks it could be more severely harmful.

Underperformance in Emerging Markets

Many prime areas in the United States already have Starbucks locations, which means the market is becoming saturated. Comedian Lewis Black once joked he ran across two Starbucks cafes located directly across the street from each other in Texas. As such, the company began looking elsewhere, deploying significant capital to expand into international markets

Domestic saturation is not always the best driver for international expansion though and there is no guarantee that the international markets will have acceptance rates that mirror the U.S. The company made significant investments in China and India with Starbucks Coffee China and Asia Pacific, but these endeavors are still evolving.

Investors should pay particular attention to the performance of foreign-placed Starbucks cafes, particularly CAP. CAP has had some success, but competitor brands are also moving into the same emerging markets, including large franchises from Yum! Brands and McDonald's with the McCafe.

The Bottom Line

Some investors believe Starbucks could be peaking after prolonged market success. A potential impending bear market combined with economic and spending retractions could be a problem for Starbucks and its investors as luxury brands would take a hit in this scenario.

New global expansion is also a risk as international markets have different preferences and adoption levels. Expansion from developed markets to emerging markets can also have higher risks as spending psychologies can differ dramatically.

As with all equities and consumer cyclical stocks, it is especially important to monitor the systematic changes along with the idiosyncratic changes to stay ahead of any and all potential losses that can possibly be avoided or hedged with active investing.