Return of Schultz Sweetens Starbucks but Investors Could Still Get Burnt

A long-time solid performer, the stock of the coffee retailer Starbucks (SBUX) has recently thrived as a result of the efficiencies brought on by digital ordering. Alas, the abrupt management change and suspension of a major stock buyback raise concerns about Starbucks' near-term future. Although the shares are well off recent highs, down over 25% year-to-date, given the red flags that have emerged, the shares ought to be avoided at the current level in the mid-$80s.

The return of Howard Schultz as interim CEO, replacing Kevin Johnson who departed after five years as CEO, ought to be a confidence booster to Wall Street. Starbucks thrived with Schultz as CEO from 1986 to 2000. In 2008, during his first return, he enacted bold leadership steps to restore growth during the financial crisis. Upon his return in 2022, he is again effecting strong measures to right the ship. On his first day back, Schultz suspended a $20 billion share buyback, sending a signal of serious underlying challenges that need to be addressed, especially since Johnson's resignation came unexpectedly. Part of the problem for Wall Street is that it was unaware the ship had sailed off-course.

Schultz faces an altered company from the one he handed over to Johnson in 2017. In recent years, Starbucks had been reliant on debt-funded buybacks to grow earnings and prop up the stock; consequently, net debt has exploded from $1.3 billion in 2017 to $20 billion at the end of 2021. While the share count has been reduced by 20% over the five years, the suspended buyback seems prudent in light of the balance sheet deterioration and higher interest rates to fund debt.

Schultz has indicated these buybacks also came at the expense of investing in stores and employees during his absence.

"This decision [to suspend the buyback] will allow us to invest more profit into our people and our store - the only way to create long-term value for stakeholders," Schultz wrote.

Starbucks may start feeling some additional pressure from competition. Dutch Bros (BROS) is expanding rapidly, with plans for 4,000 domestic locations, up from just over 500. Although Dutch Bros. currently produces only a fraction of Starbucks' sales, they attract an important younger demographic. I wrote in February about the highly unattractive valuation of BROS at around $60, yet the nationwide expansion is undeniably gathering steam.

Wedbush downgraded Starbucks to neutral on Tuesday, surprised by the suspended buyback. The firm sees a lack of catalysts on the horizon and trimmed earnings per share estimates, lowered the price target to $91 - representing about 25-times fiscal year 2023 estimates.

Weakness likely emerges in China from the Covid-related shutdown. China accounts for about 12% of revenue. The shutdown will likely pose only a shorter-term sales slowdown, but it also offers another reason to stay on the sidelines.

Howard Schultz is one of the all-time great CEOs, and he's willing to make hard choices as he returns to Starbucks. For now, this indicates pleasing investors will take a back seat as the focus turns to employee retention, capital investments, and balance sheet improvement. For the balance of 2021, the stock is dead money, at best, until investors have more certainty Schultz has addressed the list of challenges the company faces.

At the time of publication, Ginesin had no position in any security mentioned.