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The following segment was excerpted from this fund letter.
Starbucks (NASDAQ:SBUX)
We exited our position in Starbucks during the second quarter.
We do not mind admitting that there was a heated internal debate over this position, as there were several conflicting issues to weigh in our decision. Before the pandemic, we had been quite happy with the Company’s execution and the stock’s performance, and we were likewise happy with strategic decisions made during and immediately after the initial pandemic-related lockdowns in 2020, as we have written previously.
Despite our appreciation for the Company’s execution during this period, it was dealing with some concerning issues.
- First, as a business reliant upon stores being open, the Company faced continuing risks from rolling pandemic-related lockdowns, particularly in China, which is the Company’s second largest and fastest-growing market.
- A second and related issue was employee illness; even as stores were open, various pandemic waves (Omicron, for example) caused many employees to miss shifts, making it very difficult and expensive for Starbucks to keep its stores staffed properly.
The Company’s stock, like most of the U.S. stock market, enjoyed a healthy recovery from the pandemic beginning near the end of 2020 and into 2021; at times, we believed that recoveries in many portions of the stock market happened well ahead of recoveries in fundamentals, or that individual stocks often didn’t reflect still existing pandemic-related risks. Starbucks fit into this category for us at one point, and we would remind our investors that we earlier reduced our position in the stock for exactly that reason.
Then, at the end of October last year, when the Company reported its fourth quarter (ending September) results, it issued guidance for the new September 2022 fiscal year that included 400 basis points of margin pressure from additional “investment” in its employees, including pay, benefits, training, and additional hiring. While this weighed on projected earnings growth for the year, the Company still expected to deliver double-digit earnings growth, as its fundamentals continued to recover from the pandemic.
We viewed this as a rational – and not at all unprecedented in the history of Starbucks, for that matter – response to economic-wide realities, and we appreciated the Company being proactive about employee costs, rather than spending all fiscal year trying to catch up with higher costs. However, at this same time, some unionization efforts were underway at some of the company’s U.S. stores, and the market jumped all over this employee “investment” commentary in the Company’s fourth quarter earnings report and turned it into a major incident.
We would note that pretty much every Company in America, publicly traded or private, has been struggling with labor shortages during the post-pandemic era, and this has caused significant margin pressures on most or nearly all companies, whether that has been in the form of higher wages (planned or otherwise), higher benefits, greater turnover, and higher recruiting costs, etc. We believe that by proactively addressing the issue and telling the market about it, Starbucks inadvertently caused itself a problem by giving the market something over which to obsess.
We also note that the Company’s fiscal year ends in September, three months before most companies’ fiscal years, so Starbucks offered a view of 2022’s labor market three months before most companies; perhaps investors who hadn’t been paying much attention to inflation or labor market dynamics were surprised to hear about the potential for these pressures to continue into 2022. Those investors certainly have heard a lot more about it now from every corner of the economy.
In any case, most of us on the team believe the public discussion around Starbucks became more than a little irrationally focused on one issue, which definitely is not unique to the Company, after its initial fiscal year 2022 guidance commentary.
While, in a vacuum, pressures to unionize are not positive, it also could be argued that the unique labor conditions post-pandemic have created an ideal time for labor unions to make gains, after decades of irrelevance. Therefore, of course organized labor will try to make some noise, and not only at Starbucks. However, it still is not completely clear to us what meaningful changes, if any, a union may be able to influence at the Company. Starbucks has been well known for decades – since 1988 – among its labor pool for proactively offering health and other benefits to part-time employees, in an industry where any benefits at all are still uncommon.
As part of the Company’s response to this current labor debate, founder Howard Schultz has returned to the Company as a replacement for the retiring Kevin Johnson. We do believe this is a decent PR campaign, as Mr. Schultz, the executive who instituted the Company’s generous benefits program decades ago, should have a lot of credibility with the labor force. However, one genuine issue we have with the longer-term outlook for Starbucks is that we actually were big fans of the outgoing CEO, Mr. Johnson, and we agreed with basically every one of his strategic and capital priorities both before and after the pandemic.
So, we do put his loss in the negative column for the stock. His departure, as well as resulting potential changes to the Company’s stock buyback plan, is one of the factors that convinced the portion of the team that had been more reticent to sell the stock to exit our position, in the end.
On the labor front, we expect the Company to remain vocal about its commitment to its employees, and to continue to highlight the financial aspects of this commitment. While this is just good business, and while it isn’t much different from the Company’s normal behavior for decades, we expect the market to remain fixated on this for some time. We also would note that rolling COVID lockdowns in China, a phenomenon for which we see no end in sight at the moment, certainly remain unhelpful to the Company’s near-term fundamentals, considering China’s importance to the Company.
We certainly acknowledge the drag on the business from the Chinese government’s COVID policies; in fact, as mentioned above, we trimmed our Starbucks position in the second half of 2021, when it was apparent to us that the market was not factoring any COVID-related risks into the valuation of the stock.
All in all, we do not believe anything is broken about this Company’s long-term business model or its competitive position, and we still strongly believe the Company emerged from the pandemic in a better competitive position rather than a worse one. We believe the labor issue upon which the market is fixated to the exclusion of all else now is an issue being faced by pretty much every company in America. In general, the team believes the valuation of the stock has been driven to something at or near trough levels, which also made our decision to sell more difficult; however, the broad market sell-off we have seen this year has left many stocks trading at attractive valuations, as well.
In the end, as a team, we agreed to disagree about whether this was the ideal time to sell this one stock, in isolation. From a portfolio standpoint, though, and taking all the near-and intermediate-term possibilities we could foresee for both Starbucks and for potential replacements for our position, we agreed to allocate the funds in our Starbucks position into better expected returns elsewhere.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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