Starbucks Stock: Are Silly Incentives Burning Shareholders? (w/ @HamishHodder)

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Hey guys, welcome back to the channel. We're continuing on with the new money advent calendar for yet another episode and yet another collaboration. This time I've got someone that you guys would be very familiar with, and that is of course Hamish Hodder. Hamish, how you doing mate?

Hey, I'm doing well. I'm very excited. Been looking forward to this for a couple of weeks now.

Yeah, um, so where the reason behind this video is that you reached out to me on Facebook recently, um, and told me this crazy story. Well, I didn't get the full story, but you told me a little bit about some management doing some dodgy things. So yeah, in this video, we're going to talk about, you know, the management team, their role, and also what can go wrong when it comes to company management.

Of course, if you don't know much about the value investing kind of approach, that Warren Buffett approach, management team, you know, and assessing the management team is very, very important to that process. Of course, you've got to understand the business, you find the competitive advantage, but the third key pillar is to make sure the management team operates with skill and integrity. And then the fourth key pillar is of course making sure you're buying a margin of safety, fair valuations, etc.

Um, so it does form a key pillar of that approach, and a lot of people kind of skip over the management side of things I think, but it's important to remember that these are the people, the guys and girls, that are literally running the company that you're invested in. So the decisions that they make are going to have an impact on the business and thus on the business value and thus on your investment.

So the first thing I wanted to ask you is, well, what do you even kind of look at when it comes to assessing the management team?

Yeah, and I mean, there's a fair few different things that I want to look at, and they kind of fall into the different categories when we're assessing management. So as you mentioned, we kind of care about where the management's values are aligned with ours and there's a number of different ways that you could go about assessing that. Listening to conference calls and just kind of getting a subjective feel for whether you trust how the management team is speaking, how the CEO is speaking.

Yeah, um, looking and reading through the letters to the shareholders can give you a good insight as to whether the CEO is the kind of person who kind of just shares what is happening in the business truthfully, whether it's good or bad, or whether they're kind of giving you a sales pitch and kind of only talking about the good metrics. And maybe one year they talk about a metric, but in the next year they don't just remove that metric because it wasn't as good as the previous year.

So those are some of the things that we can look at and, um, I guess management compensation is probably one of the biggest ones. And we'll talk about Starbucks as an example of management's compensation and how that can kind of go wrong or how I think that that can go wrong.

Um, so those are some of the things in terms of looking at management and making sure their values are aligned with ours. Um, but then of course that's just one part of management. There's so many different things. We want to look at their ability to invest within the business is super important. Like how skillful are they at making internal decisions?

Um, and then decisions such as like capital allocation. So how much debt are they taking on? Um, and how are they managing that risk for shareholders? I remember you were the person that taught me the two overarching steps which I've always kind of kept clinging on to, which is just when you look at the management team, when you look at the management team, it's skill and then it's integrity.

And I guess in this video, yes, while skill is very important, like what you're talking about, we're going to focus a little bit more on integrity and specifically talking about CEO compensation, which should be very interesting because, um, you know, it's quite, it's, it's still quite common that you do hit companies these days where the management team quite simply just doesn't hold up in terms of their integrity. And as we're just discussing before, we're kind of dancing around the issue. You recently found an example of exactly that in Starbucks. So I'm interested to hear what you actually found out about that company and the management.

Yeah, so I think Starbucks is a really good example of a really, really great company that has had a change in management recently. Yeah, and I think in the past couple of years there is a significant disalignment between the management's values, what they care about doing in the business, and long-term shareholders, people who are wanting to invest in the business over the long term.

Okay, um, and I think before we get into sort of some of the things we're going to talk about, um, I want to be clear there's a lot of good things to like about Starbucks. It's not as if I'm coming out here saying it's a terrible service or it's a terrible product or anything like that. Um, they clearly have some key characteristics that make it a great business, um, outside of management.

So things like competitive advantages, for example, I think they have a very, very powerful and I think many people would argue the case that they have a powerful competitive advantage in terms of branding. Um, so providing a unique coffee experience and what they've been able to do in the coffee shop market, especially in the U.S., is kind of incredible when you think about it because historically it's been a very fragmented market.

And that makes sense, right? You have a whole lot of different individual coffee shop owners, and you have some chains, but you wouldn't expect that a chain could grow to the size that Starbucks has where I think they have about 30% market share.

Wow.

Of the number of coffee shops in the U.S. which is kind of crazy if you look at any other sort of similar market, like the restaurant industry, for example, highly fragmented, uh, McDonald's is obviously the biggest player, but even McDonald's in the restaurant industry has four percent market share.

So what Starbucks has done in the coffee shop industry, particularly in the U.S., is kind of incredible. Um, and they have a number of other advantages as well that I mean they have a very consistent and excellent return on invested capital that's above 25.

So, okay, in terms of management skill, um, you know, you could still argue that it's very, very good, but, uh, I think in 2018 there was a clear change that happened that, um, misaligned management with the shareholders.

So what did you find?

Yes, so basically in 2017 a new CEO came into power. This guy is called Kevin Johnson. Um, and prior to that, to sort of understand Starbucks history, there were three founders, but they're not really credited for the success of Starbucks because they quickly sold the business after about 10 years to Howard Schultz, which is who everyone credits for the success of Starbucks.

And, um, he was at the business from 1986 to 2000. He then left, but then came back in 2008 until 2017. So for most of the life of Starbucks, uh, Howard Schultz was running the company and he is credited to a significant amount of its success.

Um, and that kind of changed in 2017 where we had a new management team come into power. Um, and, uh, basically there were some new compensation set up, some new plans were put in place, and I think that's where the misalignment sort of started to happen for Starbucks.

Right. So this new person that comes in and for investors that means, you know, a new contract to look at and new compensation plans to make sure that, you know, we as investors feel comfortable with.

Um, so I guess what we would look at for this guy running the company, first of all, how is he getting paid?

Yeah, so there's first a couple of things I want to look at. The first is the ownership of the CEO. So how much stock does he own? Is he a shareholder himself? And then the compensation itself.

So right, okay. In terms of his stock, the first thing you'll notice is he holds 182 million dollars worth of stock, which is an outrageous amount of stock.

Um, and you might immediately think, well, that's really great, right? Like he's clearly incentivized to grow the business long term, skin in the game then if...

Yeah. And then if you dig a little bit deeper, you see that 92% of that is in stock options. So he doesn't actually directly own most of that money. It's that he has right to buy contracts. Um, only 15 million dollars is directly owned. And again, you might think, well, 15 million is still a lot. Like how do you determine that 15 million is not enough?

Um, or like how have I reached that conclusion? Um, and the way that I do is I compare it to compensation because ultimately I want the CEO to be benefiting mostly from growing their ownership in the business from growing the business long term versus meeting their short-term incentives that earn them their compensation.

So that's how I'm, I'm sort of assessing that it's not enough.

Right, okay. Um, in 2019, Kevin Johnson, the CEO, earned 19.2 million in compensation. So, um, basically he earned more compensation than stock he owns.

Oh, okay.

Which means he is personally incentivized to meet his compensation package, his requirements versus just growing the underlying business. And of course there'll be a bit of crossover, right? Because the compensation pack ideally will be incentivizing the CEO to make good decisions long term.

Uh, but there's one component of the compensation pack at the moment or that at least has been in place over the past three years that I think has, uh, significantly led the CEO to make some bad decisions.

Well, let's talk about that. So we covered, yes, he owns a little bit of stock, but a lot of the interest for him is tied up in his ongoing compensation. So what's the deal with this compensation package?

Yeah, so I want to talk about one very specific part of the compensation pack. Um, so he learned cash, he'll own bonuses, stock options, and stock awards. So it's very varied, and these will be in a combination of short-term incentives which, uh, looking at performance over one year, and also long-term incentives.

And most of their compensation is tied to long-term compensation, our long-term variable incentives. So that basically means they set some goals, some three-year targets, and if they meet those targets, they earn the maximum compensation. If they half meet them, they'll earn a little bit less.

And one of the long-term incentives that was set in 2018, which was six months after the new CEO came in, was that management wanted to return 25 billion dollars to shareholders over the next three years.

So through 2018, 19, and 20...

And right, um, what they mean by return 25 billion, they basically mean dividends and share buybacks.

Right, so in total over that three-year period, uh, they want to be spending 25 billion dollars on a combination of dividends and share buybacks, right? To return value to their shareholders.

So I'm not talking about the share price going up. We're just talking about the company making an effort to return that, like literally give that money back to their investors in some way, whether it be through a dividend or through a buyback, right?

Yes, exactly right. And there are many other metrics that go into their compensation. This is just one of them, but I think it is probably one that led management to make a lot of the decisions that they did in terms of how many share buybacks to do and how to allocate capital over that three-year period that I think it is significant.

Um, and I mean immediately you might think, well, that sounds great, right? It sounds great because the management's compensation is tied to how much money the shareholders get.

Yeah, and on the surface that does seem good. The part where it's not good is where that, where the amount of money that they're promising to deliver is more than the profit that the business is actually producing, is actually capable of producing.

And I'm guessing the next thing you're going to say is that that is exactly the case with Starbucks?

Yeah, that is exactly not the case with Starbucks.

Yeah, so they basically decided that they were going to have this 25 billion plan and there was absolutely no way that over that three-year period Starbucks was going to be able to produce 25 billion in profit.

Right.

Um, so this is how their profits went over those three years. In 2018 they produced 10 billion in profit, but 7 billion was a one-time royalty to Nestle. They basically gave Nestle the rights to use the Starbucks logo on their products.

Um, so we'll include that seven billion, but it's not a recurring thing that's coming out.

2019 they produced about 3.3 billion in profit, and in 2020 they produced basically nothing. They were pretty much break-even because of the pandemic.

So all of that included, even if we include that one-time royalty, meant that they produced about 13.3 billion dollars in profit over that period.

Right. And they want to give 25 billion back to shareholders?

Yes, you might wonder, well, how can they do that? And even that in of itself is not necessarily a red flag because if you think of something like a Facebook or a Google or a Berkshire Hathaway, for example, where they have a lot of cash on their books, it's reasonable to expect that they could distribute more than they produce.

Right.

Say Facebook makes 10 billion in profit, but they have 50 billion in cash on the balance sheet, they could distribute 20 billion dollars a year and it would be fine, right? They'd still distribute all of their profit, they'd distribute a bit of the cash off their balance sheet, but they still have cash around, right?

So it's not destroying the business, it's just excess money that they have.

Um, but Starbucks was not in that position. They had to take on debt in order to do this.

Right, so they took on debt to be able to hit for the CEO to be able to return 25 billion dollars to shareholders over three years?

Correct, yes.

So pretty much perfectly the difference between the profits they made and the 25 billion they took on in debt.

So their debt increased from four billion dollars to 15 billion dollars over that three-year period to the point now where the company went from having a significant amount of shareholder equity on the book, on, uh, in their balance sheet to now having negative equity.

They now run a deficit, um, which means that they are heavily reliant on the future profits of the business to pay for those debts.

Wow, okay.

So, so just because the management team's salary, or this guy, the CEO, wanted to get his bonus, he has made sure that they hit this 25 billion of buybacks or dividends by taking on debt and thus putting the company into a much riskier financial situation?

Yeah, and I mean it's not all negative. I shouldn't be all negative Nancy here, but, um, you know, during that process of delivering 25 billion dollars to shareholders, shareholders of Starbucks throughout that period and still now have benefited substantially.

So we shouldn't avoid that as if nothing has gone back to shareholders.

Um, during that period, uh, five billion dollars in dividends were paid to shareholders, uh, they did 18.7 billion dollars in share buybacks, and as a result, the stock is up 70% since 2018, and prior to that, stock actually hadn't moved for a number of years. It would, it had kind of stagnated; it was kind of out of love from shareholders on average.

So, right, um, there's been a significant contribution to existing shareholders, people who held the stock.

Um, that's, there's nothing sort of um to say about that, but in terms of people who want to be shareholders now and hold it over the long term, there is a significant negative consequence, and that is that the business is now running in a far worse balance sheet, much more risky, and there's significant amounts of debts that need to be paid in the future, and those are going to come out of the cash flows that the business produces.

Right, the way to think about debt is it's kind of like bringing profits forward because you're bringing money forward now and delivering it to shareholders, but that money still needs to be paid with profits at some point in the future.

So even though shareholders over the past three years, people who've held the stock have been able to receive more cash than the business produced, that is at the expense of shareholders in the future who will have to receive less, right, than profits?

Less than the profits that the business produces.

Makes sense because they'll be repaying that debt.

Exactly right, yeah, and I mean you could argue that they just won't need to pay that debt, they can always refinance that debt, but um, that's always a risky position to have, and considering interest rates are very, very low, it's likely the interest payments on those debts when they need to be refinanced will likely go up in the future, right?

And that's going to be a higher and even higher cost to future shareholders, right? So even though in the short term, if you just look at what investors have gotten out of it, it looks like maybe it wasn't so bad after all if we think about, well hang on, if we are long-term investors in a company like Starbucks and where we want to hold the shares over the next 10, 20 years, then this situation, which has basically arisen because the management team has agreed to this compensation deal where they, where they're incentivized to get more money back to shareholders, it's actually this whole situation has just put their long-term shareholders potentially in a maybe not a worse position but in a riskier position, and they've played around with the financial positioning of the company essentially so that they can return this money and so the CEO can pocket a couple million bucks.

Yeah, and I mean the way that I think about it is if you wanted to sell Starbucks or if you wanted to sell any business, for example, you would want them to squeeze every little last bit of cash out of that business before you sold it.

So and that's basically what Starbucks is doing right now, right? If you had a business and you wanted to squeeze every last bit of profit, then you would take on debt and deliver cash to you, and then you sell the business because you don't really care.

Yeah, like it doesn't matter to you; you just want as much cash as possible.

So if you're looking to sell the business now and get out, um, I think it's probably the best thing management could have done. But it's someone who is looking to invest in a business that has a really strong balance sheet and that's supposed to be delivering me significant cash flows in the future, it doesn't look very good.

Um, and it does just make it that little bit worse that it was in management's compensation pack to the point where they, even if it was in the best interest of shareholders not to take on that debt, and I would argue that it's pretty obvious that it probably wasn't.

Yeah, um, even if it was in their best interest not to take on debt and deliver extra cash flow, of course they're going to do it because otherwise they're not getting their maximum compensation, and that just makes it certain that they were going to do that regardless of how damaging it was to the business long term.

Yeah, right. Well, thanks very much for coming onto the channel and running us through that example. I remember when you highlighted that to me on Facebook, I was like, well, what the heck? But this is a perfect example of, you know, management compensation and how, you know, things that maybe even at face value seem good in reality, once you actually play that situation out with the company, it turns out that maybe that's not the best thing for the company going forward.

So anyway, thanks very much for joining me, Hamish.

And Ryan, thanks for having me!

Yeah, through the example. Of course, most of you guys already know Hamish's channel, but I'm going to leave it linked in the description as well, so go and subscribe to Hamish as well and follow our efforts on the Young Investors podcast.

Uh, with a funny story, we've recorded two episodes of the Young Investors podcast today, and now a long day. It's been a long day, and we're going back to back to back and now recording this collab as well.

So, um, thanks for joining me today, Hamish!

Thank you!

Thanks for having me. I appreciate it.

Thanks for having me, and, uh, definitely go and check out Hamish's channel. As I was just saying, leave a like on the video if you enjoyed, but that'll do us for today, guys. We'll see you guys in the next video.

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You.