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Starbucks (SBUX)

The first Starbucks (SBUX) location opened in 1971, and the company has since grown to become the world’s largest coffee purveyor with over 29,000 stores in 78 countries. Starbucks stores sell not just premium coffee but also tea, packaged coffee, juices, bottled water, pastries, and various lunch items.

In addition, the company licenses several of its products, which are available in supermarkets and stores, and sells through other up-and-coming brands such as Teavana, Tazo, Seattle’s Best Coffee, Evolution Fresh, and Ethos.

In its most recent fiscal year, the vast majority of Starbucks' sales came from the company’s namesake, company-owned stores.

  • Company-owned stores: 80% of revenue
  • Licensed stores: 11% of revenue
  • Consumer packaged goods: 9% of revenue 

By geography, Starbucks generated 68% of its revenue last year in the Americas (U.S., Canada, Latin America); 18% in China / Asia Pacific; and 4% in Europe, Middle East, and Africa. The remaining 9% of revenue was related to channel sales of Starbucks’ products and other business segments.

Business Analysis
Starbucks' key to its long history of impressive sales and earnings growth has largely come down to its ability to differentiate its brand and often become a destination in its own right. 

Each location does its best to provide customers with a unique Starbucks Experience, which is built upon superior service, high-quality coffee, a seamless digital experience, and clean and well-maintained stores that reflect the personalities of the communities in which they operate.

The end result has been a high degree of customer loyalty in what is otherwise a very crowded coffee market, helping the company command strong pricing power and generate excellent profitability.

To put it another way, Starbucks' competitive advantages, including its substantial economies of scale, mean that this coffee chain generates unusually high margins for a brick-and-mortar business. That's a testament to the great job management has done creating a unique coffee experience that its core customers will continuously pay up for. 

However, Starbucks has seen its growth slow substantially in recent years. For example, in the final fiscal quarter of 2018, the company's same-store comps (sales growth recorded by stores open for at least a year) fell to just 3%, far below the company's historical 5+% rate.

               Starbucks Fiscal Q4 2018 Same-Store Comparable Sales
Source: Earnings Release

While Starbucks' sales in its core Americas market were strong, sales in China, where the company had previously said it had "cracked the code" on dominating that fast-growing coffee market, were up just 1% (in the past they had grown at 6+%). And all of the sales growth it managed to generate was due to higher ticket sales, with transaction volumes declining by 1% in nearly all of its important markets. 

In fiscal 2018 global comps were 2%, and in 2019 management expects to deliver just 3% same-store growth, the low end of its long-term guidance. Deceleration in China is a big reason behind the lower growth figures, as management's long-term plans now call for comps of just 1% to 3% per year in that region. Instead, new store openings are expected to drive most of the growth in China going forward.

Starbucks currently owns all of its Chinese stores, which number over 3,500. By the end of fiscal 2022 Starbucks plans to open another 2,300 locations in China (the company will have about 6,000 locations in 230 cities in total). 

And in the very long term, given China's population (1.4 billion people) and growing wealth, it's not out of the question that Starbucks' store count in that region could eventually approach the size of its U.S. company-owned store base, which exceeds 14,500 locations today.

Growing store counts are still a great way for Starbucks to drive strong top-line sales growth, especially since China's coffee market is expected to expand about 7% per year through 2022. For context, the global coffee market is growing about 6% per year.  

That's largely due to Chinese per capita coffee consumption being 800 times lower than in the U.S. according to Euromonitor. While comps in China were far weaker in 2018, Starbucks still managed to generate 38% revenue growth thanks to a large increase in its store base. In fact, thanks to that strong growth, just over half of the company's total revenue growth in 2018 (10%) came from Asia. It's a critical region for the firm's long-term future.

In order to turn things around and re-accelerate growth in China, the company is focusing on innovative use of technology and strategic partnerships. 

For example, in late 2018 Starbucks partnered with Alibaba (BABA)'s subsidiary Ele.me, China’s leading on-demand food delivery platform. Ele.me has 3 million registered delivery riders and Starbucks is rolling out store delivery from 2,000 locations in 30 cities. 

Starbuck's China strategy is to recreate its digital flywheel in the U.S. by tapping into Alibaba's entire ecosystem including Ele.me, Hema, Tmall, Taobao, and Alipay. These are the some of the most popular methods for China's consumers to buy products online and, combined with its Chinese loyalty program (over 6 million members), is a great way to continue driving modest sales growth from a fast-growing store base. 

In fact, management expects 80% of China's future revenue growth to come from new store openings, compared to 50% in the U.S. (50% growth from comps and 50% from new store/concept openings). 

Management also has a multi-pronged plan to address its stabilize U.S. sales and help it achieve its long-term growth targets of:

  • 3% to 4% global same-store comps (3% to 4% in the U.S., 1% to 3% in China)
  • 7% to 9% revenue growth (mid-teens in China)
  • 8% to 10% operating income growth
  • 17% to 18% operating margins (a return to its all-time highs seen in 2016)
  • At least 10% annual growth in adjusted EPS 

Note that in 2019 management is guiding for 5% to 7% revenue growth and 8% to 10% adjusted EPS growth but "at least 13%" EPS growth in 2020 and 2021. That faster growth in 2020 and 2021 is due largely to the large-scale buybacks that the company announced in mid-2018 ($25 billion in buybacks and dividends between 2018 and 2020). 

The long-term guidance above is for fiscal years 2022 and beyond. Due to expectations for a slower pace of same-store sales growth compared to the past, Starbucks is largely counting on expanding its global store count (by 2,100 in 2019) to help it achieve its high single-digits revenue growth targets. 

Management's earnings and cash flow growth targets seem achievable thanks to ongoing cost-cutting and efficiency initiatives that should boost its long-term operating margins from 15% to 18% over time.

Starbucks' changes to improve profitability in the U.S. include simplified store operations and more use of throughput-boosting technologies such as its popular app and increased use of mobile payments which speed up transaction times. 

The company also plans to continue the expansion of new offerings like the Mercato fresh foods menu, Blonde Espresso roast, and Nitro Cold Brew coffee offerings, all of which have proven big hits in recent years. 

More importantly, Starbucks is continuing to focus on its loyalty program and improving its in-store customer experience. For example, in the third quarter of 2018 the company announced an initiative to cut store administrative tasks by 50%, freeing up two to three hours per day for store managers to improve customer interactions. 

Starbucks is also betting big on its popular mobile app, which saw 18% U.S. member growth in 2016, and 11% growth in 2017. Today this program has 15.3 million U.S. members (15% growth in 2018), or close to 20% of the 75 million U.S. customers it serves each month. In 2018 Starbucks partnered with Chase/Visa to launch a co-branded credit card to further improve its loyalty program, which accounted for more than 40% of U.S. and Canadian sales in 2018. 

Starbucks says that digitally engaged customers buy two to three times more than non-engaged customers (mobile is just 12% of transactions but 40% of U.S. sales) which is why it's so focused on expanding the program to as many U.S. (and global) customers as possible. In 2016 the mobile app accounted for just 5% of transactions, a figure that has more than doubled over the past 24 months. 

Besides efforts to be a leader in digital engagement, new CEO Kevin Johnson, who took over for Founder and Chairman Howard Schultz in April 2017, is planning on rolling out new store concepts, both big and small, to improve results. 

For example, the company is experimenting with smaller-format express stores, more drive-thrus (now in 80% of U.S. stores), beverage trucks, and kiosks. In late 2018, Starbucks also announced it was partnering with Uber Eats to roll out a delivery service for 25% of its U.S. stores by  mid-2019. In 2018 these new formats (plus mobile app) accounted for 50% of total sales, up from 40% in 2016. 

And on the high end, the company is also opening more Starbucks Roasteries, super premium locations that have much higher-end offerings that some reviewers have called "Starbucks on crack." Currently, Starbucks has four global locations, Seattle, Milan, Shanghai, and New York City. Eventually, the company wants to have 20 to 30 of these stores operating globally. 

Prices for some of its select reserve coffees in these stores can sell for as much as $100 per pound. Roasteries are also coming with Princi bakeries, which offer premium artisanal baked goods.

                                           Starbucks Shanghai Roastery
Source: CNBC
In addition to super-premium coffee and baked goods, Roasteries are now going to be including high-margin alcohol as well. The New York roastery is the first to feature the company's new "Arriviamo Bar" which according to Starbucks is "where expert mixologists will serve coffee- and tea-infused cocktails."
Source: Starbucks

Roasteries serve not just as super high-end stores, but R&D facilities for the company where it can test out new product concepts. For example, according to CEO Kevin Johnson:

"Beverages such as Draft Nitro, Cold Foam, and the recently launched Juniper Latte all began at the Roastery and have since been introduced to Starbucks locations around the world." 

Roasteries, in addition to generating extremely high per store sales and launching new products for the company, are designed to be a distribution hub for the 1,000 Reserve stores the company plans to eventually open. Reserve stores will exclusively feature premium coffee and fresh-baked food from Princi.

Basically, Starbucks, which built its success on selling upscale coffee to the masses, is now doubling down on its strategy to shift its customer base even more upmarket. And while China's growth is definitely slowing and will likely never return to its former glory days of 6+% comps growth, management thinks that more stores will still make that country its best long-term growth market.

In fact, CEO Kevin Johnson has said that Starbucks eventually wants to have more stores in China than in the U.S. (implying over 15,000 locations compared to 3,500 today). In 2019 Starbucks expects 1,100 of its 2,100 new store openings to be in Asia, with 600 of those being in China. 

Overall, Starbucks has done a remarkable job in building itself a premium, enduring brand in a cutthroat industry characterized by minimal switching costs and low margins. While its future pace of growth faces some uncertainties, this business has impressive staying power and should remain a dividend-paying cash cow for years to come.

Key Risks
Starbucks is undoubtedly an impressive business, but it also faces some notable challenges going forward. This is likely why management's most recent long-term guidance calling for about 8% revenue growth and 10% earnings growth is down from its previous 9% sales growth and "at least" 12% earnings growth forecast. Same-store comps guidance of 3% to 4% has also edged lower from a previous target of 3% to 5%.

In addition, Starbucks' 17% to 18% operating margin guidance, while solid, is still below the near 20% level some analysts were expecting the company to deliver in the future. This is likely due to the company finding it more challenging than previously thought to find profitable new growth avenues now that it has saturated many of the easiest expansion opportunities.

One of the biggest challenges Starbucks now faces is its size. The company is so large that it is increasingly running into major competitors at all price levels in the coffee market. That includes McDonald's McCafe and Dunkin' Donuts at the low end, as well as Peet's, Caribou Coffee, and Panera at the upper end of the price market.

Management has said that globally Starbucks continues to gain market share (8% growth vs 6% growth for the coffee industry), but that might not always be the case, especially should the global economy weaken in the coming years which might make some consumers more price sensitive.

And while Starbucks's big push into ever higher market coffees and baked goods might be a new growth opportunity, the ultimate success of these efforts is far from certain. After all, there is only so much consumers are likely to pay for even the highest quality coffee and baked goods.

Meanwhile, in China management's new long-term guidance of 1% to 3% comps growth shows that, even with its bold tech initiatives and joint ventures with Alibaba, the company expects to face many of the same competition and cannibalization issues it's experiencing in the U.S.

Euromonitor estimates that Starbucks has about 80% share of coffee shops in China, making it by far the dominant name in coffee shops (McDonald's is a distant #2). However, while China's massive population and fast-growing middle class make it a potentially rich growth opportunity, Starbucks could have a hard time profitably increasing market share (or even maintaining it) from such dominant levels.

Finally, it should be pointed out that Starbucks is not generating enough operating cash flow ($4.8 billion in fiscal 2018) to fund its ambitious three-year $25 billion capital return program (that is largely a result of activist investor pressure). The company plans to fund much of its buybacks (which will boost EPS growth by 2% per year) with debt.

According to the company's CFO, that will increase the company's leverage ratio (net debt/EBITDA) from 1.8 to 3.0. That nearly doubling of debt will not put Starbucks' balance sheet at dangerous levels. However, taking on more leverage to fund buybacks is a potentially risky move, especially in a cyclical industry such as this.

At the end of the day, it appears likely that Starbucks' days of extremely strong earnings growth are permanently behind it, and investors need to have more modest earnings and dividend growth expectations going forward (along the lines of managements' 10% guidance).

Shares of Starbucks have long enjoyed a premium valuation multiple due to the company's impressive growth profile, so investors need to be particularly mindful of the price they are willing to pay if the company's long-term outlook for growth continues slowing.

Closing Thoughts on Starbucks
Starbucks has proven itself very good at building one of the world's most premium brands and quickly growing while adapting to various challenges over time. As a result, the innovative company appears to have a solid plan to continue rewarding income investors with double-digit dividend growth for the foreseeable future.

While the risks facing Starbucks' growth profile are very real, the management team is also very experienced and seems likely to continue finding success in expanding the company's global reach and store concepts. 

Just remember that for a blue-chip global giant of Starbucks' size, investors need to have realistic growth expectations and value the stock accordingly. 

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