The Most Confusing Thing About Starbucks
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If you’ve been following my channel or newsletter for a while, you probably know that Starbucks (SBUX) is one of my favorite companies. Recently, after a fast and furious rise in its share price, it has also become the largest position in my portfolio.
One of the most common questions I get about Starbucks is why a company as successful as this one reports negative shareholders' equity. It’s a legitimate concern, especially when we’re used to thinking of equity as a key measure of a company’s financial well-being.
In simple terms, shareholders' equity represents the difference between a company’s assets and liabilities. When equity is positive, it means the company owns more than it owes, which is obviously what you’d want to see.
But when a company’s liabilities become greater than its assets, equity turns negative, which can be a signal of potential financial issues. Essentially, this means that if the company liquidated all of its assets to pay off its debts, there would be nothing left for shareholders.
Several factors can lead to negative shareholders’ equity:
Accumulated Losses
Consistently poor earnings can erode a company's equity over time. While Starbucks is far from being a company with poor earnings (aside from 2020, their net income has consistently grown), their retained earnings are negative.
Retained earnings represent the portion of a company's cumulative profits that haven’t been paid out as dividends or used in share buybacks. When companies like Starbucks engage in aggressive share repurchase programs, they’re effectively returning a significant portion of earnings to shareholders, which can lead to negative retained earnings.
This is more so a strategic decision, often made by companies with strong cash flows and growth prospects, rather than a sign of financial weakness.
Excessive Dividend Payments and Buybacks
When companies pay out excessive dividends or engage in substantial share buybacks, it can reduce retained earnings, which, once again, can push shareholders’ equity into negative territory.
This is exactly what has happened with Starbucks—they allocate a substantial portion of their net income to dividends and share buybacks, leading to negative retained earnings. While this might sound alarming at first, it's important to understand that this is a deliberate capital allocation strategy designed to return value to shareholders.
High Levels of Debt
Taking on a large amount of debt will dramatically increase the liabilities on the balance sheet. Without a corresponding increase in assets, this can lead to negative shareholders’ equity.
Some of these factors are currently at play with Starbucks. However, their negative shareholders' equity and increase in liabilities as a result of these things isn’t as alarming as it might seem.
Let’s break down their major liabilities to understand why:
The most significant liability is their long-term debt, which currently stands at around $15.6 billion—up from $2.0 billion a decade ago. This increase in debt is a result of their strategy to aggressively open up new stores, which the company justifies by the strong returns they see on those new stores.
For example, a recent press release noted that new company-operated stores in the U.S. are averaging unit volumes of around $2 million with returns on investment (ROI) of about 50%. I think we can all agree that’s no small return. Since the company is able to make their money back on their investment into new stores so quickly, why stop?
With that said, their debt maturities are well spaced out (stretched out until 2050) and the interest expense to service their rising debt is still manageable. Over the past 12 months, Starbucks had to pay $528 million in interest expenses, which is well-covered by its earnings before interest and taxes (EBIT) of $5.5 billion.
Another major liability is deferred revenue. This comes primarily from a deal they have with Nestlé as part of the Global Coffee Alliance established in 2018.
Nestlé paid Starbucks an upfront royalty of $6.7 billion to market, sell, and distribute Starbucks consumer packaged goods, and this deferred revenue will be gradually recognized over 40 years.
Deferred revenue represents cash received for goods or services not yet delivered, which is why it's recorded as a liability. As time goes on, this liability will decrease, and Starbucks will recognize the revenue on their income statement.
While it’s technically a liability, deferred revenue is different from debt and doesn’t carry the same level of risk.
Starbucks also has deferred revenue in the form of unredeemed gift cards and unredeemed loyalty points associated with its rewards program. As of their last report, these deferred revenues totaled about $6 billion.
The next key contributor to Starbucks’ total liabilities is the company’s operating leases. Starbucks leases many different properties around the world, including retail stores, roasting facilities, distribution centers, and office spaces, making up about $8.3 billion in long-term operating lease liabilities.
However, given that Starbucks operates nearly 40,000 stores globally, this figure is manageable and is more a reflection of the business model than a financial concern.
SOME MORE Context
What’s interesting about all of this is that Starbucks is not the only restaurant to show a negative shareholders’ equity. This is actually pretty common with restaurants, especially those in quick-service-restaurant (QSR) segment.
For example, Domino’s (DPZ), Yum Brands (YUM), and McDonald’s (MCD) all report negative shareholders' equity, and for reasons largely the same as what we discussed with Starbucks. Like with Starbucks, these companies generate enough cash flow to sustain their debt levels, making negative equity less of a concern for investors than it might be in other industries.
Overall, while negative equity is usually a red flag, in the case of Starbucks (and other restaurants), it’s more a reflection of strategic financial decisions rather than operational weakness. Starbucks and its peers in the industry use these strategies to maximize shareholder returns, and (at least for now) they have the cash flows to support them.
However, it’s important to keep an eye on the sustainability of these financial strategies. The fact that this is a common trend in the restaurant industry doesn't eliminate the risks, but it is an important reminder that every industry has its nuances, and it’s crucial to spend time understanding what they are.
With that said, I want to hear from you: what are some of the key financial red flags you look out for with your investments? Write to me here and let me know.
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DIVIDENDS
No dividends this week 😢
Weekly Total: $0
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Annual Total: $1,722.07
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"Do you have any companies in your portfolio that you think you think are so solid that you'll keep buying them forever?? (Unless something big changed about it)."
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Ideally, I’d like to hold onto all the stocks in my portfolio indefinitely.
That’s the essence of dividend investing: it's a buy-and-hold strategy where you simply buy stocks, sit back, and collect the cash flow. The simplicity of this strategy is one of the things I really love about it.
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HOT TAKES 🔥
Last week, I asked readers about their missed opportunities in the stock market. Here are some of the responses:
Bartosz said: For sure UNH but then I decided to invest in other good stocks (ADC, VICI, MCD, and JNJ). I tell myself that you have to be patient and opportunities will come but we must also remember that we will never have enough money to buy all the stocks we want.
Deepa said: About 11 years ago, I was working at a major tech company in their finance group and kept hearing about AI and NVDA/AMD being buzzed about. I looked into them and ultimately bought both. About $1k in NVDA and $250 in AMD. Well, I was switching companies, bla bla bla. So I sold my stake in them. My stake in Nvidia would be worth ~$250k today!
Danny said: My bad decision of the year was buying PLTR at 9 and selling at 16 because I wanted to grow my position in VOO and PLTR does not have dividends. PLTR sits at almost $30 today.
Pat said: A stock I missed was Broadcom (AVGO) in early November 2023. The stock market in general was bottoming and I'd been following the rumors of Broadcom purchasing VMware, which I figured was going to be a great move in relation to Nvidia, AMD, and the AI froth. I almost pulled the trigger at $750 in early November but it was so expensive! The purchase happened, the stock popped on its earnings report on December 7th, and AVGO split on July 15th for 10:1. I estimate I would be up over 100% based on today's price.
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