Getting My Fix of Starbucks (SBUX)

by Scuttlebutt Investor


Happy Holidays

Happy holidays and happy new year! The pollyannas, the secret santas, the white elephant gift exchanges are all behind us.  Did you stop to look around though and take notice?  How many of those gifts that were exchanged were in some way related to Starbucks (SBUX)? Starbucks gift cards perhaps?  The work of the lazy, creativity-lacking gift giver, sure. But the ubiquity of that Starbucks gift card this holiday season and probably at least the last ~5 years is undeniable.  When you don’t know what to buy or give, it's the ultimate fallback option.  Surely the unknown recipient likes coffee or at least knows someone that does to whom they can re-gift it.  And it’s oh so easy to buy it at the Starbucks right down the street.

The Starbucks gift card is so popular in fact that the float on the Starbucks stored value program (the fancy word for prepaid gift cards) recently amounted to ~$1.3 billion (stored value card liability on B/S as of 10/1/17).  So large in fact that it rivals the deposits of some small banks.

In the grand scheme of things, this stored value float isn’t the crux to an investment thesis for Starbucks but it does demonstrate the important and central role that Starbucks plays in the lives of consumers across the US and the world.  Starbucks locations are ubiquitous, their gift cards and stored value are a form of currency and a Starbucks gift card won’t offend anyone and surely will make many of its loyal customers very happy.

Background

I have a confession to make.  I have lived in the San Francisco Bay Area for the last 6 years and living here has made me a big snob- a coffee snob to be exact. I never was much of a coffee drinker before I moved out to the Bay Area but once I did and I had my first taste of a Blue Bottle cappuccino, I was hooked. After that, I took on places like Ritual, Four Barrel, Verve, Stumptown, Sightglass and I was in love.  No one had ever told me that coffee could be so good if the beans were roasted at just the right level and everything was made with careful precision. These so called Third Wave coffee shops had all kinds of fancy equipment and baristas that looked more like craftsmen than baristas. This led me to take home brewing classes so I could make beautiful concoctions at home. To my wife's dismay, I plunked down all kinds of money to buy a chemex, moka, French press and various other equipment that may be unfamiliar to the uninitiated. Making the perfect cappuccino is still out of reach for me until I buy my $15,000 La Marzocco espresso machine.  I digress.

So what's a supposed coffee snob like me doing talking about Starbucks (SBUX)? Starbucks was the second wave.  Before Starbucks, mostly everyone in America drank coffee one way - black drip coffee. Howard Schultz came upon the idea that Americans might actually like coffee based drinks like the Italians and imported some of the recipes over to the US.  He singlehandedly changed Americans’ relationship with coffee. 

But even though I’m not a daily Starbucks customer and even though I wasn’t pining for the Starbucks gift card at my workplace secret santa, I have been there many a time partly because it’s a ubiquitous behemoth that sells a lot more than just coffee.  It offers a convenient meeting place (a “third place” as Howard Schultz coined it), a light lunch, a sweet treat, a cold drink and you likely already have a gift card in your wallet to pay for it.   

Company Overview

Starbucks (SBUX) has 27,000+ shops that sell a product (coffee) with incredibly high repeat behavior to a very loyal group of consumers around the world.  I would categorize SBUX in the bucket of reinvestment moat companies that can comfortably invest in their business to build out more stores in more locations to further “premiumize” the coffee experience.  By doing so, they can continue to deliver strong returns of ~25% Return on Invested Capital (ROIC) that they have delivered in recent years.  While concerns of slowing growth have weighed on the stock for some time, I continue to believe in SBUX’s ability to meaningfully increase free cash flow while making disciplined investments in Roasteries and Reserve stores to further elevate the coffee experience.  There’s a lot to like about Starbucks:

Investment Merits

Customers with high frequency, repeat behavior and strong loyalty
I have a certain predisposition for businesses with recurring revenue streams.  SBUX is not recurring the way a SAAS software company is, but coffee is a daily ritual for many- driving a reliable, repeating revenue stream.  SBUX has been successful engendering loyalty from its customers as well- Starbucks Rewards has 13.3mm members in the US and an incredible 36% of all dollars tendered in the stores is transacted through the loyalty program (US Company operated stores).  You would be hard pressed to find any other company loyalty program with this much engagement. 

Stellar Unit Economics
SBUX benefits from strong unit economics that are best in class among quick service restaurants and other peers.  In the US- the average new SBUX location generates revenue of $1.5mm (average unit volume or AUV) and generates a year 1 store profit margin of 34% or $510k.  Based on an average store investment of  $700k in the US, this results in an ROI of ~75%.  Compare this to a McDonalds with an ROI of ~30%, an average fast casual operator at ~40% or even Chipotle (at its peak before the food illness issues) at ~70%.  This means that the average SBUX store earns back its investment a third of the way into its second year – very compelling unit economics.  The math likely changes with higher investments in Reserve stores and premium Roasteries in the coming years but if these seek to elevate the overall SBUX experience and thus drive pricing power through the entire system, it’s the right move for the long term.

We look at the brand not as a piece of advertising, but everything we do communicates who Starbucks is. The place, the physical environment, really has become an extension of the brand and it’s very important to the success of the company.
— Howard Schultz

Strong Brand
SBUX’s moat or competitive advantage is derived primarily from its strong brand that is synonymous with premium coffee.  The brand ranks high on all traditional measures of brand strength including awareness and consideration and is one of the most recognized and respected brands in the world.  This brand strength is a powerful driver of pricing power – what enables the company to charge ~$4 or more for a coffee that consumers would have never paid more than a dollar for some years back.  More importantly – the brand isn’t only about coffee – it’s about an elevated experience (often called “the Starbucks experience”) that comes with the customer service and the ambiance of the store.  In fact, Starbucks devised the idea of the “third place” – a place for consumers to go between home and work. 

Smart management team making investments with a long-term focus
While Kevin Johnson (the current CEO) is relatively new and we’ve seen what’s happened before when Schultz left the helm, Johnson seems focused on the right things.  Management is focused on investing in the future and playing the long game in a few key ways: 1) Expanding the digital flywheel to increase digital relationships with customers by way of their loyalty program, which has been very successful; 2) Investing in meaningfully elevating the Starbucks experience through the Reserve stores across all markets and flagship Reserve Roasteries in major cities; 3) Investing in employees (partners) to increase wages/benefits that ultimately results in greater retention and thus drives a superior customer experience. 

Johnson is also committed to rewarding shareholders in the form of dividend increases and share buybacks.  In fiscal 2017, the Company returned $3.5bn to shareholders through repurchases and dividends and recently committed to returning $15bn (over 18% of the current market cap) over the next three years.

Multiple growth levers
Starbucks’ management team has set robust long term targets of growing revenue in the high single digits, comparable sales in the 3-5% range and EPS at 12%+.  Not too shabby for a company with 27,000+ stores.  SBUX has a few different growth levers it can pull on to get there: 

1) China and other geographic expansion – Growing the footprint of company owned stores in China is a major part of the story to get to a planned 37,000 locations by 2021.  Chinese consumers have demonstrated a thirst for Starbucks coffee at premium price points and 600 or ~25% of SBUX’s 2,300 new builds in 2018 will be in China.  And it’s important to remember that Starbucks isn’t a tech business like Google or Facebook that raises protectionist alarms for Chinese regulators. The government doesn’t necessarily favor homegrown businesses when it comes to an industry like coffee.

2) Diversify product mix to include more food.  Food comprises about 21% of total revenue but SBUX has ambitions to grow this to 25% by 2021.  While food is margin dilutive, it helps expand the daypart from morning and also helps drive absolute profits and FCF

3) Drive more throughput – SBUX can drive growth simply by ensuring they are appropriately matching capacity to demand. Demand for coffee and caffeinated beverages tends to be more concentrated to the morning daypart.  Expanding mobile order ahead and optimizing labor productivity are two ways that management intends to solve for this.  As of Q4 2017, mobile transactions represented 30% of all transactions and mobile order ahead represented 10% of all transactions, an increase from 21% and 3% respectively less than two years prior (Q1 FY16).

4) Elevate the experience and product to drive a higher ticket – Starbucks is continuing to invest in the right places to drive pricing power.  The investments in Princi (a premium Italian bakery that SBUX has partnered with), flagship Reserve Roastery in major cities, Reserve stores and Reserve bars in existing stores all seek to further premiumize and elevate the Starbucks coffee experience.  While these require capital expenditures where they build out these experiences, they halo to the entire brand, reinforce pricing power and drive consumer willingness to pay for the product.  

Source: Starbucks Investor Day Presentation 12/7/16; Growing and Elevating Our Stores-Andy Adams, SVP of Global Store Development

A tech savvy company that isn’t in tech
Starbucks’ has harnessed technology to meaningfully drive its business over the last few years.  The success of a well-designed app and order ahead functionality has helped drive throughput and a more positive consumer experience, which engenders loyalty.   Early on, order ahead was a victim of its own success as the physical operation wasn’t quite set up to handle the increased demand but SBUX will iron out these kinks over time.

While helped by technology, Starbucks isn’t at any risk of technological disruption.  Consumers have consumed coffee for hundreds of years and while per capita consumption has ebbed and flowed (actually has increased over the last ~20 years - especially specialty coffee)– I don’t see technology or anything else meaningfully changing the consumption of coffee.   

 

Risks and Considerations (i.e. Why I’m Wrong)

Slowing growth especially in the more mature US market
Comparable store sales growth between 2010 and 2016 ranged from 5% to 8% on a consolidated basis and between 6 and 8% in the America’s region.  As shown in the chart below, growth in 2017 slowed down meaningfully to 3% both in the America’s region and on a consolidated basis.  Guidance for the long term and 2018 pegs comparable sales growth for the Company between 3 and 5%.  Recessions and downturns in the business cycle will inevitably impact this in the intermediate term.    

Growth will be slower than years past given increasing saturation in the US and the law of large numbers but: 1) this conservative target should be more achievable and beatable; 2) while the topline will be softer, moderate operating leverage in the business should help drive stronger growth in operating income, free cash flow and EPS.

Source: Data from Starbucks Investor Relations site; Consolidated Company operated stores open 13 months or longer

The decline of brick and mortar retail
The general decline of brick and mortar retail is a threat to traffic especially at locations in malls and adjacent to retail stores.  SBUX depends on this retail foot traffic to drive traffic into its stores and it hasn’t been immune to the decline.  Long term though, they should fare ok as SBUX is often a destination in and of itself and they can shift out of leases to accommodate for shifting consumer trends in retail.  Furthermore, they have continued to build out alternate locations with drive through or other locations (e.g. theme parks) that don’t necessarily depend on retail traffic.

Store growth plans feel aggressive at first blush
Starbucks store growth plans do feel a bit aggressive with a plan to increase the store count to ~37,000 by 2021, a ~10,000 store increase over the current ~27,000 stores.  That means adding about 2,500 stores per year for the next 4 years.  To put that into context, that would put them close to the likes of McDonalds (~36,000 locations worldwide) and Subway (~45,000 locations worldwide).   A focus on growth at the expense of quality can be detrimental or dilutive to the brand and Starbucks has been down this path before.  The current management team is smarter and more experienced than the one that led to overgrowth some years ago.  When you consider a habitual product coupled with new untapped markets and efforts to expand daypart to lunch and even dinner, the growth feels much more reasonable and sustainable. 

Crux of the thesis highly predicated on China growth
I’m highly skeptical of any company where the crux of the thesis is “China”.  This isn’t the only growth lever in the case of Starbucks but it is a big part of the story.  I am comforted by that fact that Starbucks has been quite successful in the China/Asia Pacific (CAP) Region and more specifically, China.  Starbucks has nearly 3,000 company operated and licensed stores in China with roughly 600 more stores opening in 2018 including a premium flagship Reserve Roastery in Shanghai.  CAP operating margins are on par and in fact, slightly ahead of the Americas region at 23.6% for 2017.  Based on historical precedent and recent results, Starbucks seems to be well positioned to capture growth in China, especially as it repurchased its East China JV from a partner to make all of those properties company owned. 

Historic inability to integrate acquisitions
Starbucks’ growth has primarily been driven organically but it has made several acquisitions along the way – Evolution Fresh, Teavana, La Boulange bakery - for millions of dollars each only to shut all these other businesses down.  Maybe Starbucks’ strategy is to buy these businesses for the brands/products to integrate them into SBUX shops but it feels like an expensive approach.  Their inability to integrate acquisitions doesn’t worry me that much because I see little future growth being derived from acquisitions.  I believe that the Starbucks masterbrand has strong brand equity on its own that can be leveraged to launch new products and even services.     

Intensifying competition including oversaturation from existing players and consolidating “third wave” coffee players.  Low barriers to entry to open a coffee shop don’t help the situation.
Coffee has had a good run over the last several years as consumers shift away from products like caffeinated soft drinks that are perceived to be unhealthy.  As a result, large players and small players alike have continued to grow their retail store footprint.  Major players like JAB Holding Company have gone on a buying spree with Keurig Green Mountain, Peet’s, and third wave players like Stumptown and Intelligentsia.  Nestle more recently bought a majority stake in another third wave coffee shop – Blue Bottle.  And McDonald’s continues to increase its coffee offerings at the lower end of the price spectrum. 

Furthermore, the US seems to be pretty well saturated with 33,000 coffee shops, up 16% from five years ago as the chart below shows.  Starbucks represents about 14,000 of these 33,000 shops.  There exists some risk that Starbucks could get squeezed by more premium third wave shops at the high end and mass competitors like convenience stores and McDonald’s at the low end.  

Source: "Too Much Caffeine? Coffee Shops Face a Shakeout", Wall Street Journal (12/18/17)

The reality is that I am an outlier with my coffee snobbishness, and even with that, I often find my way into a Starbucks.  There’s a few things that provide some comfort here as the competition increases: 1) Starbucks is pushing into the super premium space with its Reserve stores and Roasteries to prevent it from getting squeezed from the top; 2) Starbucks is looking to diversify its revenue mix by increasing the proportion of food so it isn’t as reliant on only coffee; 3) Starbucks customers are a loyal bunch that enjoy its products with frequency with a very popular loyalty program (Starbucks Rewards) reinforcing this behavior.

Valuation

If Starbucks can deliver on somewhat aggressive store growth plans (37k stores by 2021) and drive operating leverage as it has described, the Company should be able to meaningfully increase free cash flow from ~$2.5bn currently to nearly $7bn over the next 10 years.  This is all while continuing to generously invest in the business at capital expenditure levels north of $2bn that will support its efforts to maintain its existing stores and elevate the coffee experience through new, more premium stores. 

While the valuation does appear to be on the rich side at 29x trailing earnings and 25x 2018 estimates, my DCF with more specific inputs on store growth and margin yields a valuation of $68 or about 19% upside from the current price ($57).  This doesn’t meet my hurdle for margin of safety at current prices.  However, SBUX has frequently traded down to the $50 territory over the last year or so.  If it revisits $50 or close to it in the near term, I would view this as an attractive entry point with 35%+ upside. 

 

The Net Net

Starbucks is a well-positioned company led by a smart management team playing “the long game”.  While store growth in more mature markets and continuing competition in premium coffee may be a drag to future growth, Starbucks benefits from a moat in the form of a strong brand and a loyal, repeat customer that can be extended into more markets and into more than just coffee.  And I believe that this moat is sustainable under the right leadership team that understands that Starbucks delivers an experience that extends far beyond just selling coffee.  The sustainability of the moat is predicated on continued investment to elevate the store experience and thus drive pricing power.  Management has demonstrated a willingness and enthusiasm to invest and has ample runway to do so while also rewarding shareholders with share repurchases.   

As with most retail and QSR companies that trade in a short sighted stock market where it’s all about “what comp sales have you done for me lately”, an earnings or comp sales miss will inevitably provide the opportunity to acquire SBUX shares at a price (~$50 or below) that provides a rich and “frothy” upside (couldn't resist!).  That’s the time to strike and even gets a third-wave coffee snob like me excited.

 

Disclosure: I am currently long SBUX.   I am not an investment advisor and this article presents my personal views.  While I have conducted a fair bit of research to write this, you should also do your own research and come to your own conclusions. 


Castle Protectors and Kingdom Builders - Empire Theory

by Scuttlebutt Investor


When pouring through Company 10-Ks is your idea of a good time like it is for me, you develop a certain type of familiarity with different business models and you start categorizing them in your mind.  And while there are a lot of different types of business models across various industries, the strategies that they employ aren't all that different.  We'll get to this but let's take just one step back to something a bit more fundamental.  A term that is often used by Warren Buffett to describe the type of businesses he invests in is "moat".  He describes many of the businesses that he invests in as benefitting from an economic moat and often a wide economic moat.  In other words, these businesses benefit from important competitive advantages that protect its business from competitors whether that be a wonderful brand like Coca-Cola or network effects like American Express. I'm not quite sure if Buffett coined the term but he has popularized it over the years.  At the recent 2017 Berkshire Hathaway Annual Meeting, he reinforced the point:

If you got a wonderful business - even if it’s a small one like See’s Candy-you basically have an economic castle.  In capitalism, people are going to try to take away that castle from you so you want a moat around it protecting it in various ways and you want a knight in the castle who is pretty darn good at warding off marauders. But there are going to be marauders and they’ll never go away
— Warren Buffett, 2017 Berkshire Hathaway Annual Meeting

So this got me thinking more about the different types of businesses model strategies and what I call Empire Theory.  I also thought it would be a great way to drive traffic to the site with the new season of Game of Thrones out!  The crux of Empire Theory is that many businesses fall into one of two major buckets.  There are Castle Protectors and there are Kingdom Builders.    

 

Castle Protectors

There are some companies out there that have a core high margin business or cash cow that they are trying to protect - what I would refer to as the castle. These castles are like printing presses and churn out vast sums of money so the company is highly motivated to do everything it can to protect this castle. Often, the companies will build innovations around this core business (moats) that don't necessarily generate revenue on their own but that rather seek to reinforce the core business in some meaningful way. The list of companies fall into this camp of castle protectors is long.  Google (GOOG) is a pretty good example of a castle protector. Google's core business of search ads generates the lion share of its revenue and profits and are much higher margin than YouTube ads for example. Sure, other businesses like self driving cars and internet balloons get a lot media attention but let that not distract you from the economic castle that is search ads. Google gets a lot of credit for being an innovative company (and I don't disagree) but many of these innovations are essentially different layers of moats that seek to protect the castle (search ads) that pays everyone's salaries and keeps the lights on in Mountain View.  

When Google realized that Microsoft could leverage its share leading Internet Explorer browser to push consumer usage of its own search engine over Google, Google quickly developed the Chrome browser as a defensive maneuver.  Not only did Chrome quickly overtake the other browsers as the dominant internet browser, but it helped further cement Google search as the de-facto search engine by reinforcing search behaviors in several critical ways (i.e. the address bar doubles as a search prompt for Google Search).     

When Apple introduced the iPhone way back in 2007, Google had already been working on a mobile operating system and smartphone.  But once they saw the revolutionary capabilities and UX of the iPhone, they knew they had to go back to the drawing board lest they be beholden to Apple for getting their products seamlessly to the end consumer.  Sure they would be fine as long as there was a negotiated agreement with Apple to embed Google as the default search engine on the device, but relying on Apple to be a gatekeeper to the cash cow is no way to protect the monopoly. Thus Google developed Android- an alternative mobile operating system - with none other than Google search embedded at its core.  

Chrome Browser, Android OS, Maps, Gmail, Chrome OS, News, the list goes on and on.  Yes, these are all wonderful consumer products on their own, but they also serve another important purpose - to put wider and wider moats around the castle (as shown in the pic above) or in other words, to protect and extend Google's cash cow of search ads. If you're searching for anything, anywhere, Google wants to be the one to monetize it and even if they don't monetize it (as with many of these products), they want to make sure that their direct linkage to the end consumer isn't abstracted by competitor products or devices. Not to mention a secondary benefit of serving up more relevant ads by tracking behavior across their various products.

This notion of protecting Google's castle becomes very interesting in the world of voice dictation. Amazon is the current market leader for smart speakers with the Amazon Echo, but if Amazon controls a future where consumers search for everything through voice commands, that leaves Google's castle of search ads vulnerable. Cue the music...introducing Google Home  - Google's smart speaker released last year and the outermost rung of the moat protecting the castle in the image above. And have no doubt, Google will continue to create new products and services that reinforce its dominant position in internet search ads anytime that position is threatened in any way.  This is what Castle Protectors are expected to do.  

You can't knock a company for being a castle protector.  As an investor, we should expect a company to vigorously protect outsized margins and returns. But recognizing that a company falls in this camp is important as there are some key implications of being a castle protector.  For castle protectors everything is interconnected so it can lead to slower decision making and in some cases, poor decision making.  Every Google product that is launched is likely vetted by someone that works on what I would expect is the very politically powerful search or search ads team.  And if it doesn't reinforce search or have some future path to do that, you can bet that it's a more difficult and lengthy internal sell.  Castle protectors can often struggle with providing their senior managers and leaders with autonomy - since many of the ancillary businesses are so interconnected to the cash cow, a lot of decisions quickly become about the cash cow and are deferred to the leadership of the cash cow or the most senior leaders in the company, like the CEO rather than the manager of the business unit.  This can become a problem.  If you've read The Outsiders (a wonderful book about successful CEOs), one of the recipes of success that is threaded across most of the eight CEO stories that generated incredible shareholder returns over many years, is this notion of decentralization and pushing down authority and providing autonomy to the general managers of business units. This level of autonomy and decentralization is often not possible with castle builders and so the persons most knowledgable about something aren't making the decision.  I've talked about this problem before in The Travails of a Businessman

A second critical implication of being a castle protector is that they can become so fixated on protecting the core with "innovation" that they might miss some important shift or a new competitor that comes from left field.  More often than not, it's a shift that they might have known about, but were unwilling to acknowledge or respond to because it would cannibalize the cash cow.  Kodak is a classic example.  Rochester was once the Silicon Valley of its day with both Kodak and Xerox thriving in its midst.  Kodak had a very lucrative, high margin business model of selling "razor blades" (film) to service both its own "razors" (cameras) and other companies' razors. But Kodak actually invented and patented the technology for digital photography well before anyone had even thought of the idea in the 1970s, but they buried it in some closet because of the threat it posed to the cash cow. There's a wonderful Marketplace podcast about it. 

Understanding and analyzing a company's orientation as a castle protector is helpful in analyzing the business' strategic decisions and overall prospects.  Google is just one example but there are a lot of other companies that could also be classified as a castle protector. Costco's (COST) castle is memberships and over the years, they have put a ton of benefits (rungs of the moat) around the membership like gas stations, optical, car buying, etc. I would argue that Amazon's castle is also memberships - memberships of Amazon Prime and similarly they have put a lot of benefits around it to protect it from marauders.  

 

Kingdom Builders

Kingdom Builders are another species in the classification of company business model strategies. Kingdom builders don't rely on one cash cow but rather many different cash cow businesses that can all exist independently of each other.  These individual cash cows (kingdoms) generate their own cash flow that is fed back up to the parent organization that can then decide if they want to use the cash to extend or shore up the moats of existing castles, acquire new castles or build new castles.  

There were a lot of examples that came to mind with Kingdom Builders but one that is near and dear to my heart is consumer packaged goods companies.  A company like Procter & Gamble (PG) is a perfect example of a Kingdom Builder.  P&G owns many wonderful businesses or brands as they would refer to them that could very well be independent companies and in some cases were independent companies.  P&G owns an entire kingdom of castles like Pampers, Gillette, Tide, and Crest to name a few. Each of these businesses has their own moat around it - in the case of P&G this is often a combination of a strong brand and strong R&D that leads to a product advantage. In some cases, P&G goes right out and builds massive new castles like Febreeze, which launched in 1996 and went on to become a billion dollar brand.   

In addition to the moats around each castle, P&G also has a moat or a massive ocean around its kingdom protecting its borders. Even though many of these brands are fundamentally different, operating under the umbrella of P&G brings unique competitive advantages like scale in sourcing and dealing with customers, capital, logistics expertise, etc.  

There are some inherent implications of being a Kingdom Builder as well. In contrast to Castle Protectors, Kingdom Builders can push down a fair bit of decision making and autonomy to the general managers of the businesses. While the business units are loosely connected under the parent, the decisions that are made within one business unit don't often impact other business units. All things being equal, this can lead to better decisions - the person most knowledgable about the business unit is making the key decisions.  Company and investment risk can often be significantly lower in Kingdom Builders as it is spread out over several different businesses versus Castle Protectors where the risk is concentrated into one business or profit center.  If a business like Crest toothpaste for examples loses its competitive edge and suffers financially, P&G can cut off the tentacles without impacting the core.  In the case of a Castle Protector though, if a competitor manages to traverse the deep moats surrounding the castle or profit center, there is not much that can be done to stem the loss and keep the company intact - it can't be severed because the core is everything- it's the cash cow and many of the other business units are dependent on it.

Kingdom Builders isn't all unicorns and rainbows though.  The very thing that makes Kingdom Builders less risky and more decentralized/autonomous also makes them less efficient.  Marketing dollars and other investments (e.g. manufacturing lines) have to be doled out individually to each castle and other castles don't typically benefit from the investment in one castle.  These competing priorities can become difficult to manage and challenge the capital allocation process. Kingdom builders can also often find themselves down the path of building businesses that are outside of their core competencies or circle of competence as Warren likes to say. This can be a destruction of value - when companies venture out from what they are good at and fail. 

Many companies in the consumer packaged goods space like Hershey, Nestle, Kraft Heinz fit the definition of Kingdom Builders but there are also others. Disney (DIS) is also a Kingdom Builder in some ways.  They build what I like to call creative franchises like Toy Story, Cars, The Avengers.  While they are monetized in similar ways through films, TV, merchandizing, live shows, etc., these creative franchises can stand on their own two feet.  

Starbucks is an interesting example of a company that thought it probably could be a Kingdom Builder only to realize that it is a Castle Protector.  Over the years, it has purchased many other QSR type retailers like Evolution Fresh, Teavana, La Boulange and it has gone on to close all the stores under these alternative banners.  They just announced the closure of Teavana in the last day.  While they still carry these alternative brands in Starbucks stores, it's clear that Starbucks is a Castle Protector very good at protecting the core Starbucks brand and concept but not so good at allocating capital and having the patience to see through the growth of some high potential alternative concepts.  

The reality is that not all businesses fall cleanly into the buckets of Castle Protectors or Kingdom Builders.  There are definitely companies that are hybrids and others where the framework doesn't provide much value.  However, for many companies I believe it does provide a good framework and starting point for analysis.  Next time you're analyzing a company's investment prospects, I would encourage you to think about what bucket they might fall in and the inherent implications of such.  Heck, maybe take out your colored pencils and draw it out like I did!


A Little Luv for the Airlines - 2017 Berkshire Hathaway Annual Meeting Part 2

by Scuttlebutt Investor


Two weeks ago I pontificated on Buffett's new found appreciation for tech. Another topic that captured my interest from this year's Berkshire annual meeting was the discussion on Buffett's recent investment in the airlines. Berkshire Hathaway now owns a piece of all four of the major US airlines - Southwest Airlines (LUV), Delta Airlines (DAL), United Airlines (UAL) and American Airlines (AAL).  We've known about these investments for some time as they were reported back in November 2016 and we've heard others speculate about the reasons behind them but for the first time, we heard the rationale straight from the horse's mouth.  

When I first heard about these new investments in the airlines, I was taken aback.  Another lifetime ago I was a young buy-side analyst that covered the airlines for the better part of two years and for the life of me, I could not find anything redeeming about the US airlines (at that time circa 2008/2009).  Over the long term the US airlines' cost of capital exceeded their return on capital, meaning that they had destroyed billions of dollars of value over the years.  Even in the case of Southwest (LUV) which had managed to eke out profits, while some of the other airlines were treading water, did so by being really good at hedging oil instead of being really great at airline operations (although they are better than their peers at the latter). The second reason I was so surprised was that Buffett had long ago sworn off airlines after an investment in US Airways in the 80's didn't go quite as planned.  In fact, he has said:

The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.
— Warren Buffett, 2007 Berkshire Hathaway Annual Letter

And Buffett has made comments very similar to these rebuking the airlines on several occasions-both in person and in his letters.  He's been bitter about airlines for the better part of 30 years and now he owns a significant stake in 4 of them.  What gives?  What changed?  Buffett elaborated on this a bit in response to a question from a shareholder at the meeting.  Having dipped my own toes into airlines a bit and learned the myriad of acronyms like RASM and RPM that only an airline analyst would know, I also have an additional thought that I didn't hear Buffett discuss, but that I think is also very important to the secular story on airlines and what seems to make them particularly attractive now.  

The airline industry is a peculiar industry.  To the casual observer, it would seem that it should be a wonderful industry that should benefit from rising passenger demand from now until the end of eternity and high barriers to entry driven by limited slotting at airports, stringent regulatory requirements and large capex outlays for aircraft.  However, ever since the airlines were deregulated in the 1970's, the case has been exactly the opposite.  The airlines have destroyed tremendous value by competing fiercely in providing an undifferentiated, commodity product. Buffett doesn't think that an investment in the airlines is a cinch, but he thinks a few fundamental things have changed that now make them a decent investment.

 

Industry consolidation has created an oligopoly that should result in more sensible competition.
Railroads were once a terrible industry until they went bankrupt and consolidated and gained some modicum of pricing power. Similarly, airlines have been guilty of over-competing to the brink of suicide. At even the hint of more passengers, airlines have historically increased capacity to the point where supply far outpaced passenger demand, resulting in downward pressure on pricing. Buffett believes that the airlines will be more sensible and disciplined in increasing capacity going in the future.  So far, this has mostly been the case, the airline majors have only increased capacity modestly over the last several years and seem to remain disciplined based on their plans for the upcoming year - flat to modestly up (0-1%) capacity growth- despite record demand.  This has resulted in record high load factors (Demand/Supply or Revenue Passenger Miles/Available Seat Miles) approaching the mid-80% versus the low to mid 70% area in years past. Buffett believes that these higher load factors will persist over the next 5-10 years and should drive better industry profitability.

Labor stability
Strikes and contentious labor relations were an issue for the airlines in the past, but Buffett believes that the conditions have improved as it relates to labor because they've been through bankruptcy and restructured a lot of their labor agreements.  Part of the airlines' folly was locking in higher pay during the good times that was then unsustainable during times of recession or high fuel prices.  Many of the new labor agreements allow for greater comp flexibility by way incentive based comp like profit sharing.  However, Buffett notes that there will likely be a shortage of pilots in the future.  

Earning decent Returns on Capital  
Buffett cites that the airlines are currently earning high returns on capital. Flipping through the financials of the airline majors (see below) proves out Buffett's point - the returns on capital have improved and are pretty solid. Also - it seems like most of the airlines are using ROIC as one of their key KPIs because many have started to report it out to shareholders - this is a good thing when airline management teams act rationally and manage towards a high ROIC.

US Airline Majors Return on Invested Capital % (ROIC) - 2016

Source: ROIC as reported by companies in respective financial statements; American Airlines does not report an ROIC number.

Share repurchases should driven returns
All the airline majors have been diverting their free cash flow to buy back shares at a hungry pace and thereby reduce their share count.  In 2016, Delta, United, Southwest and American spent $2.6bn, $2.6bn, $1.8bn and $4.5bn respectively on share repurchases and this was following record high share repurchases in 2015.  This is a significant sum that represents a considerable portion of the market cap of these companies. Many of the airlines have reduced their float by double digit percentages over the last few years. When companies buy back their stock at low PE multiples, this is a good for the existing shareholders.  Buffett makes the important point that they can make a lot of money through share repurchases even if the total value of the companies stays the same (the per share price will go up as the share count is reduced)

An Industry Bet
What hasn't changed is that the airlines are largely still selling an indistinguishable product as it compares to their peer airlines.  However, the number of peers has shrunk, thus making it easier to act sensible.  But this indistinguishability is also why Berkshire bought all four of the major airlines rather than just one. It's an industry bet and it's really hard to figure out who will do the best, but he believes that Revenue Passenger Miles (RPMs) will be much higher in ten years compared to now - despite some level of increasing competition from the low cost guys like Spirit and Allegiant.

My Theory - An Expectation of Low Oil Prices is Key to the Thesis
One area that Buffett didn't delve into was the price of oil, which is a major cost factor if you are running an airline.  Most airline's biggest expense line item after salaries is fuel.  It is a major driver of profitability and usually, losses and one that management can't control (other than locking in some price certainty through hedging). For many years, high fuel prices kept profitability in check as airlines had to absorb the high fuel costs but had trouble passing them onto consumers without significantly impacting demand.  But fuel prices have come down meaningfully (~$50/barrrel currently) and the thesis of an investment in airlines doesn't make much sense if you believe that fuel prices are going to go up meaningfully in the near term. Essentially, Buffett believes that low oil prices are here to stay for some time.  And we are seeing this play out in real time- the US with its new found shale oil has become  a swing producer and has been able to offset any cuts made by OPEC to more or less keep oil prices in check.  This is a win for the airlines.   

All in all, it seems like there have been some fundamental changes to the airline industry that make them a much more attractive investment than they have historically been. Although the numbers do look pretty good, I maintain a healthy dose of skepticism about airline management teams' ability to remain rational, sensible actors and disciplined about capacity growth if passenger demand declines due to the vagaries of the business cycle. While it seems like airlines have learned the lesson that growth is not always a good thing, a change in demand may be the only true test.  


Buffett's Man Crush on Jeff Bezos and the 2017 Berkshire Annual Meeting

by Scuttlebutt Investor


For the second year in a row, I got up extra early on a Saturday in May and tuned in to listen to the tag team duo of Buffett and Munger discuss topics galore at the Berkshire annual meeting (replay here). The Q&A session that often runs for several hours is a treasure trove of wisdom, on investing, politics and life in general, all with a touch of humor.  I imagine that some of you may have been there live and some may have listened in like me - halfly paying attention with my bluetooth headset glued to my right ear and my two year old son in tow, going about my usual routine of cooking breakfast, chores and a walk outside. Many of the same questions from previous years were rehashed for sure but an unwavering adherence to his philosophy is partly what makes the Oracle so good at what he does. And drilling the same sound ideas into our heads probably is the only way that some of us will remember them and internalize them.

While I can't do the entire meeting justice here (there are plenty of articles and blogs that probably can and already have), there were some themes and topics that especially stood out to me.  I'll cover the first one here and look to cover a few additional themes in subsequent weeks. As an aside, it's worth noting that the entire meeting was released as a podcast this year which was a week long treat for me to be able to listen back through the entire meeting a couple times.

 

A New Found Appreciation for Tech

I think we were smart enough to figure out Google—those ads worked so much better in the early days than anything else—so I would say that we failed you there.
— Charley Munger at 2017 Berkshire Annual Meeting

The 2017 meeting was very similar to meetings of past in many ways but it was also very different in one key way.  I heard the names of tech companies like Google (GOOG), Apple (AAPL), Amazon (AMZN) uttered numerous times and I heard words like cloud, artificial intelligence and self-driving cars mentioned more than once.  This was the year of tech in Omaha. This was partly driven by recent moves to sell part of BRK's stake in IBM and buy a large position in Apple (AAPL).  To say that Buffett has stayed away from tech in the past is an understatement.  He has avoided it like the plague - noting for a long time that he didn't really understand it because it is out of his circle of competence.  But something has changed in Buffett and we saw signs of this emerging in last year's meeting.  In the 2016 meeting Buffett said, "The ideal business is one that requires no capital but still grows."  He repeated this statement almost word for word this year - except it made a lot more sense in the context of his recent purchases of Apple - a company that designs beautiful technology products but doesn't touch manufacturing with a ten foot pole - i.e. it requires very little capital and churns out gobs of cash flow without much reinvestment.  

And Buffett and Munger also went on to sing the praises of Google and Amazon.  In the case of Google, they noted that they had the opportunity to understand that business very early on because Geico was paying $10 a click for Google search ads and it's a great business model when you can charge that amount without any incremental cost.  Furthermore, the founders of Google had come to Buffett to invest shortly after the IPO but he passed without really digging in given his general aversion to tech.  

And as it relates to Amazon, I would go so far as to say that Buffett and Munger may have a man crush on Jeff Bezos.  I don't blame them.  They praised Bezos' achievements in building two very successful but very different businesses (retail and Amazon Web Services) from a standing start. Buffett noted that he "always admired him as a business leader" but he was "too dumb to realize what was going to happen".  Munger noted that they missed Amazon because it was hard- which makes sense as succeeding in retail is definitely no easy task.  He recommended reading Bezos' first shareholder letter from 1997 (I have referenced it many a time) and his interview on Charlie Rose.

It's interesting when we break down this evolution in Munger and Buffett's philosophy but it's not surprising.  They've always said that they avoid tech because it's not within their circle of competence but I never quite bought this.  I'm sure railroads (BNSF) or payments (American Express) weren't in their circle of competence either until they took the time to really learn the industries and businesses.  More likely, I think they believed the competitive advantages of technology companies weren't sustainable.  And having been through the dotcom crash of the early 2000's, they were rightfully wary.  But I think what they have come to appreciate is that many of today's tech companies aren't on the bleeding edge of technology.  Rather, many of them are mature businesses with dominant market share in the verticals they occupy.  And many of them aren't too dissimilar from other great companies in other industries- they make wonderful products and services for a very loyal consumer base and that loyalty affords them a high degree of pricing power. In fact, Buffett noted that he didn't really evaluate Apple as a tech company at all but as a consumer products company with a loyal/sticky customer base.  In fact, he noted that he used the Scuttlebutt Method (Yes - I was elated!) in his evaluation - he went around Omaha asking his nieces and nephews about their devices to better understand their value to their loyal owners (smartphones are another appendage) and their loyalty to Apple (it's fervent).  Apple device owners overwhelmingly upgrade to new Apple devices!

And so yes - these tech companies are not that different from other great companies.  But they are different in one very big way that is super important.  These tech companies are incredibly scalable - growing them doesn't require large reinvestments of capital - they reinvest little and generate very high returns on the capital they do invest.  And it's very clear that Return on Invested Capital is a metric that Buffett cares a lot about. This very important metric was mentioned several times during the meeting in relation to new investments in airlines, their ownership of McLane (a distributor) and a few other times.  Buffett noted that the world has changed considerably from the capital consumptive steel mills of Andrew Carnegie's day to the capital light cash generators that now dominate the economy and that it's likely to continue. He went on to comment that the top five companies by market cap which comprise $2.5 trillion of market value are all tech companies (Apple, Alphabet, Microsoft, Amazon and Facebook).

I think that Buffett's views on tech are pretty accurate.  Many in the value investing world (Sequoia Fund) have owned companies like Google for some time - noting the scalability and durability.  Where I might modestly depart from Buffett (have you no respect Raj!) is in the degree of capital intensity of these businesses.  I agree that they are much lighter in capital requirements than old economy industrial businesses, but they are not completely capital deficient. Two things I would note here.  1) More and more, companies like Google, Facebook and Amazon are investing large sums (some is capitalized but some is operating leases) in building out data center infrastructure that they believe will provide them with competitive advantages. Now this can be done in an asset light way (by using Amazon web services) but the big players like Facebook and Google would never want the fox that is Amazon in the henhouse.  2) A lot of the investments these companies make in their product just aren't capitalized the way they are for traditional businesses. The investments run through the income statement because of traditional accounting rules around capitalization.  Nonetheless, the investments (whether capitalized or expensed) that they make relative to the earning streams is much "lighter" as compared to more traditional non-tech businesses given the scalability of the business models.  

Next up on themes from the 2017 Berkshire Annual Meeting: A little LUV for the Airlines