We’re going to flip a coin one time.
If the coin lands on heads then you win $200. But it the coin lands on tails you lose $100.
Are you willing to play this game?
If you’re like most people you would say “No”. But the rational answer is yes.
You have a 50% chance to win $200 and 50% chance to lose $100. You’re expected to walk away $50 richer.
Don’t worry even highly educated mathematically inclined MIT professors refused to play this game. Paul Samuelson a Nobel Prize winning Economist would offer this game to his MIT colleagues during the 1960s and the majority of them would decline.
Why do you and the MIT professors fail to make the rational choice?
Loss Aversion
You would feel the pain of losing of the $100 more than you would enjoy the gain of $200.
Loss aversion is based on fear.
Loss Aversion & Suboptimal Behavior
Researchers ran a variation of the coin flip contest with three groups of people¹. One group had brain damage in the amygdala that prevented them from feeling fear. The second group was everyday normal people without brain damage. The third group also had brain damage that prevented them from processing any emotion.
The test involved 20 rounds of flipping a coin. Each participant was given $20. They could play a round or sit a round out. To play a participant would hand over $1. If the coined showed heads the participant won $2.50. If the coin showed tails then they lost $1. At the end of their testing session a participant would walk away with whatever money they had left.
The participants that could not feel fear did the best. On average this group played in every round 84% of the time. The normal/control group on average played in every round 54% of the time. The third group played every round 60% on average.
The group that didn’t feel fear really excelled after losing the previous round. On average 85% of the time this group played the very next round. This is the optimal behavior. Each round is independent of the previous round. If they play every round the odds favor them walking away with more than $20.
The worst performing group after losing the previous round was the control group, aka you and me. Only 40% of the time would the control group play the next round after losing the previous round. Losing a dollar created enough fear that they were unwilling to play the next round. They were afraid of losing more. This is suboptimal behavior. By sitting out a round they were giving too much weight to the remaining rounds and reducing their overall chances of success.
This game was set up to simulate investing and it does a good job.
Pre-Commitments and Optimal Behavior
One big difference is when you “lose” in the equity market – a stock market correction or bear market – your potential future return has increased (the lower the price paid, the higher expected return). In the coin flip the odds are the same, but when the stock market sells off and things get cheaper you’re potential long-term returns increase. Like the coin flip test you have to be ready to play the next round even after a loss. This is really hard so what can you do?
The best way to fight loss aversion is develop the right plan that will help you achieve your long-term investment goals. You must build a system of pre-commitments to say invested. So when the inevitable bear market occurs and stocks get cheaper you will be ready to invest and play the next round instead of siting it out.
One of the core pillars at American Money Management is asset allocation is a key driver of your returns. It is also a plan. A pre-commitment to stay invested at a certain percentage of your assets so that you will choose the optimal behavior at the right time.
Sincerely,
Your Portfolio Management Team
Dividend Stock in Focus
Starbucks (SBUX): $70.51
Price as of the close February 13, 2019
The Starbucks you know today wasn’t always Starbucks. It originally was Il Giornale.
The original Starbucks was a coffee roaster. Its main focus was selling high end roasted coffee beans. Howard Schultz was a general manager for Hammarplast, a Swedish drip coffee maker. Curious as to why this fledgling coffee roaster was buying so many cone filters, Howard Schultz made a point to visit the store. So impressed with the company, its coffee, and its founders, Howard kept in touch and eventually became its Director of Marketing. Reminiscent of Ray Kroc and his fateful visit to a high use mix master milk shake customer, McDonald’s.
Then during a coffee buying trip in Italy Howard fell in love with the Italian coffee shops that served up delicious espresso based drinks and acted as a cultural meeting place. Howard wanted to bring the Italian coffee house tradition to the United States.
The Starbucks owners allowed Howard to set up a small espresso station within their Seattle store. It was a success. But the original owners did not want to roll it out to all its stores. They wanted to remain coffee roasters and not become a “restaurant”.
Howard went out on his own. He raised $400,000 and opened his first Il Giornale coffee house. Despite its terrible name, Il Giornale continued to grow. Meanwhile the owners of Starbucks bought Peet’s Coffee, Tea and Spices. Peet’s coffee roasting business was doing much better than Starbucks and the owners decided to focus solely on Peet’s and sell Starbucks.
Howard Schultz, the former employee, heard about the pending sale and bought Starbucks for $3.8 million; taking on considerable debt to do so. Howard rebranded his Il Giornale stores as Starbucks, and redesigned his stores to be the “third place”, a place where the community can get together.
At the time of its IPO in 1992, Starbucks had 140 total stores. Today Starbucks has 29,324 stores globally sometimes on opposite corners from each other.
Starbucks still has room to grow but not as fast as it used to. Because each store produces tremendous returns on on investment, Starbucks ends up with more capital than they can use. In 2010 Starbucks started returning this excess capital to shareholders in the form of a dividend and the dividend has been growing at above average rate since.
Dividend History
We classify Starbucks as a New Dividend Payer. The company started paying a dividend in 2010. The first quarterly dividend was $0.05 per share. Last quarter Starbucks paid a quarterly dividend of $0.36 per share, a compound annual growth rate of 24.53%.
Click image to enlarge
Management is targeting a payout ratio of 50% to produce a dividend yield around 2%. Starbucks’ current payout ratio is 38%. This allows management to grow the dividend at an above average rate and above its rate of earnings growth.
Catalysts for Price Appreciation & Dividend Growth
Unit Store Economics
What if you could invest your money and generate 30+% cash return in the first year, return your entire investment to you within 3 years, and then continue to generate 30+% cash returns for the next 10, 15, 20 years?
You would beg, borrow, and steal to put as much money as you possibly can into this investment right? We would.
Starbucks has this wonderful investment. As of today on average each Starbucks’ store that is built costs $680,000, generates $1.5 million in sales, and generates about $450,000 in profits. This is a 32% profit margin and a 66% return on investment. The average return on investment for a fast casual store is 40%.
McDonald’s data from 2016 Franchise Disclosure Document. Taco Bell data from Pershing Square Presentation “Doppio”. Starbucks and Dunkin Donuts Pre-tax returns are from recent Investor Day presentations.
To realize these strong unit economics Starbucks needs to make sure that each store has high sales per square foot. There are two ways to produce higher sales per square foot 1) increase foot traffic 2) increase the average ticket size per customer.
China
China is Starbucks largest growth opportunity right now. Starbucks can achieve both pillars of growth in China, increasing foot traffic and average ticket size.
Starbucks is currently on pace to open a new store every day in China. Starbucks’ strategy is to build out the major cosmopolitan cities first. These cities are more globalized and most likely have previous exposure to Starbucks. The next step is to build stores in the second tier cities and then eventually into third tier cities that are very localized. Each growth stage expands Starbucks brand awareness. With an expanding brand awareness customer loyalty increases and average ticket size increases.
China is predominantly a tea drinking nation. But luckily for Starbucks caffeine is an addictive stimulant. Like all drugs, we tend to gravitate to the delivery method that gives us the biggest hit and the quickest high. A cup of tea on average has half the caffeine than Coffee (95-165 mg of Caffeine in a Cup of coffee versus 25-48 mg in a cup of Black Tea²). If you need a stronger pick me up which would you choose? England was a predominantly tea drinking nation but as of 2016 the English drink two and a half more cups of coffee than tea³.
The novelty of espresso based drinks, the low consumption of coffee based drinks, and the large Chinese population, gives Starbucks a long runway to expand brand awareness and increase foot traffic to its China based stores. With expanding brand awareness customer loyalty increases and larger average ticket sizes soon follow.
As Belinda just announced, we will bring this same experience and approach to another 100 new cities by 2022. And let me remind you with another important fact. The majority of these new cities are home of an average of 4 million people, approximately equivalent to the size of Los Angeles.
Everyone, what this means is that we are going to be introducing the Starbucks experience to a population nearly 100x of Los Angeles in the next 5 years. Now, how can I not be excited about this amazing runway of growth ahead of us? [emphasis added]
From Starbucks 2018 China Investor Day.
Mature Market Growth
In the U.S. Starbucks is a known entity. Significantly increasing foot traffic in the U.S. to drive more sales is highly unlikely. Growth needs to come from higher average ticket sales. The following sections address how Starbucks plans to increase its average ticket size per customer in mature markets.
Operational Efficiency
You poke your head into your local Starbucks store on your way to work in the morning. You see a very long line. You’re tight on time. Do you stay or do you go to another coffee store? You probably go to another coffee store or just skip it. Starbucks loses foot traffic and a sale.
If Starbucks can reduce wait time than you are more likely to stay, buy your coffee, and if the line is moving quick enough maybe you’ll add a breakfast sandwich or pastry to your order. Boosting the average ticket per customer.
Inefficiencies were compounded recently with the big push into mobile ordering. Mobile ordering as we’ll talk further about below is very important to increasing the average ticket size but the increased orders swamped the Baristas increasing wait times that drove foot traffic away during peak hours.
Kevin Johnson, the new CEO of Starbucks, is an operations guy. His main focus right now is improving the operational efficiency of each store and reducing wait times. The focus is workflow. Shifting maintenance and other tasks that take Baristas away from serving the customer to other parts of the day. Automating repetitive tasks like inventory management that distract Baristas from focusing on the customers. Remodeling stores to better handle mobile ordering. The goal is to get drinks and food orders completed as fast as possible and to accommodate the increased order load from mobile orders.
Mobile Ordering
When we place orders face to face with another person a psychological trick happens, we think we’re being judged. When we order food or drinks online, through an app, or at a digital kiosk the fear of being judged is gone. We’ll add that extra treat or two to our order. The average ticket per customer made through Starbucks mobile app is higher than an in-person order. Also, when you place your order through the app you don’t have the added pressure of holding up the line behind you with your complicated drink. The app allows you to order all the extra shots, additions, and substitutions you want driving up the average ticket size.
Customer Data
Starbucks’ app is already one the largest payment apps out there⁴. Everything about your order is a data goldmine for Starbucks. Starbucks is feeding all this data into its AI and machine learning programs to determine the best ways to get you to the store more often and at different parts of the day.
By collecting your order data Starbucks can learn to tailor the right email/digital marketing campaign and promotions to get you to come back in the afternoon.
This is why Starbucks changed its free in-store Wi-Fi policy. It’s still free but you have to enter your name and email to access it. This is the top of Starbucks digital sales funnel. The goal is to get you to download the Starbucks app if you haven’t done so already.
Delivery
Starbucks is partnering with UberEats to test delivery. An initial test that ran in one city is expanding to a few more cities for further testing.
Delivery orders are placed through the Starbucks app, more data for Starbucks and a higher average ticket. You shed the fear of being judged and holding up the line but you also feel pressure to add to your order. You have to justify the delivery order.
Delivery can also boost the average ticket per customer and sales per square foot in several ways. One is the standard morning coffee run at the office means one person (the most junior) collects all orders, heads to the store, places the order, waits for the order, and then returns as quickly as possible. This is a long and inefficient process.
Delivery with mobile ordering improves this. One phone gets passed around and everyone adds their drink or food order and then the order is delivered. No one has to leave the office disrupting work.
Delivery also helps with increasing sales during the later part of the day. Biologically, the two best times to have coffee if you wake up around 6:30 am are between 9-11am and 1:30-5pm.
The problem for Starbucks is that its customers may want a triple-shot-double-pump-vanilla-soy-latte but that means they would have to leave work. With delivery, they get their drink of choice without affecting their work and Starbucks increases sales during the latter part of the day.
Delivery reduces the barriers for people to get Starbucks when they want it.
Pre-Mortem
China
China is a blessing and a curse.
Starbucks first priority in China is/was building out its stores in China’s major cities. These tier 1 cities are the most cosmopolitan and highly globalized and most likely had previous exposure to Starbucks.
The second and third tier cities pose more of a problem. Starbucks needs to overcome localized tastes and the desire to support Chinese businesses over a western one. Especially now that China has its own coffee darling Luckin Coffee.
Luckin Coffee
Luckin Coffee wants to open 2,500 stores in China this year and overtake Starbucks as the largest coffee house chain in China⁵. Luckin coffee is barely a year old and it has pursued rapid expansion. Its focus is on better technology and speed.
Starbucks is extremely profitable. Luckin Coffee is not. Luckin is operating at a tremendous loss and spending itself deeper into a whole to expand as rapidly as possible. Usually, this spells disaster but Luckin is backed by deep-pocketed investors, the Singapore sovereign wealth fund and China International Capital Corp⁵. Luckin is also reported to be looking to do an IPO in the U.S. that would bring in more capital to fuel its growth⁶.
China Slow Down & Trade War
China is also facing an economic slowdown. The nascent trade war with the U.S. is exacerbating the issue too. Any Chinese economic slowdown and/or recession will slow the pace of Starbucks expansion and its returns. Escalation of the trade war might lead the Chinese Government to implement all sorts of measures to hamper U.S. businesses in China.
An ongoing trade war and government propaganda could lead Chinese consumers to abandon and revolt against western brands including Starbucks.
Maybe Howard Schultz found a way to protect the Starbucks brand in China.
Starbucks’ U.S. business is a mature business. Starbucks’ ability to reinvest excess capital into new stores that can generate 66% pre-tax return on investment in the U.S. is limited. Continued reinvestment in the U.S. would be into lesser stores driving Starbucks return on incremental invested capital down.
But in China Starbucks has a large opportunity to reinvest into new stores that maintain its current high return on investment rate. If increased competition, an inability to crack local preferences, or increased pressure from the Chinese government occur then Starbucks’ loses its growth and high reinvestment opportunity and Starbuck’s intrinsic value is less than we think it is.
Valuation
We’ve followed Starbucks for a while. During that time the price of Starbucks was always above our estimate of fair value. Other market participants had expected growth rates that were too high in our opinion for Starbucks. Then Starbucks reported slowing same-store-U.S.-sales last year, growth expectations came down and sentiment turned negative on Starbucks. Its stock price sold off below our estimate of its intrinsic value and we started buying. Other larger investors took notice of the decline too. Pershing Square led by Bill Ackman announced a large investment shortly after we started buying⁷. The announcement sparked a shift in sentiment along with better sales numbers. Today Starbucks is trading slightly above our estimate of fair value of $67 per share. We will take advantage of any future price weakness to add more shares or if/when our estimate of fair value increases.
¹B. Shiv, G. Lowenstein, A. Bechara, H. Damasio, and A. Damasio, “Investment Behavior and the Negative Side of Emotion,” Psychological Science 16 (2005): 435-439
²Mayo Clinic Staff. “Caffeine Content for coffee, tea, soda and more” mayoclinic.org
https://www.mayoclinic.org/healthy-lifestyle/nutrition-and-healthy-eating/in-depth/caffeine/art-20049372
³Poulter, Sean. “We drink twice as much coffee as tea: the nation’s favourite drink is under threat as tea consumption falls 19 percent since 2010” Dailymail.com
https://www.dailymail.co.uk/news/article-3538880/We-drink-twice-coffee-tea-nation-s-favourite-drink-threat-tea-consumption-fallen-19-cent-2010.html
⁴Moila, Rani. “Starbucks’s mobile payment system is so popular in the U.S., it has more users than Apple’s or Google’s Recode.net
https://www.recode.net/2018/5/22/17377234/starbucks-mobile-payments-users-apple-pay-google
⁵Jourdan, Adam; Li, Pei. “Coffee startup Luckin plans to overtake Starbucks in China this year” Reuters.com
https://www.reuters.com/article/us-china-coffee-luckin/coffee-startup-luckin-plans-to-overtake-starbucks-in-china-this-year-idUSKCN1OX0BY
⁶Chan, Vinicy; Tse, Crystal “Chinese Starbucks Rival Luckin Coffee Starts Work on U.S. IPO” Bloomberg.com
https://www.bloomberg.com/news/articles/2019-02-01/chinese-starbucks-rival-luckin-is-said-to-start-work-on-u-s-ipo
⁷You can read their full presentation on Starbucks here “Doppio“
