Starbucks Margins To Expand Further; Same-Store Sales To Remain Strong

Starbucks Corporation (NASDAQ:SBUX) is scheduled to announce its Q4 earnings on October 30.  It has been a great year for Starbucks with shares of the company gaining more than 40% year-to-date. Impressive same-store sales growth, aggressive expansion plans and diversification are the reasons why investors are being so bullish on the company.

During the third quarter earnings call, the management raised the full year earnings guidance to $2.22-2.23 per share, up from the previous estimate of $2.12-2.18 a share.

We  have a $67 price estimate for Starbucks, which is about 15% below the market price.

Margins To Expand Further

Through the first three quarters of the fiscal years, Starbucks’ reported operating margins have risen 130 basis points to 16.1%. ^[1] The company’s operating margins are rising primarily because of two reasons:

a) Lower coffee costs: Starbucks’ most important raw material – arabica coffee, is trading near a three and a half year low. Arabica prices aren’t expected to rebound anytime soon, so the company’s margins will remain firm in the near term. Weakness in Europe, the biggest consumer of arabica, is driving down the prices of the coffee. ^[2]

b) Higher proportion of licensed stores: Globally, Starbucks stores are either company operated or licensed to third party franchisees. Licensed stores usually have margins two to three times those of the company-operated stores since Starbucks does not have to incur operational expenses such as labor, occupancy, raw materials etc for these stores. In the recent years, Starbucks is opening a higher percentage of licensed stores than the historical average. A greater proportion of licensed stores will naturally push up the margins higher.

Furthermore, sales leverage is helping the margin expansion. During the third quarter, Starbucks stunned the markets with a same-store sales growth of 9%, helped by an 8% rise in the customer traffic. Starbucks’ bet on investing in technology to attract more customers seems to be paying off. ^[3]

Last year, Starbucks poured $25 million in a payment start up called Square, and is playing the technology game pretty well. More Americans are using smartphone technology to make purchases at their favorite restaurant chains. Ten percent of Starbucks’ payments in the previous quarter were made through smartphones. Paying through mobile phones allows customers to skip queues, the effect of which was evident on the traffic volume.

Additionally, the expanded food menu is also attracting more traffic. Starbucks acquired the San Francisco based bakery chain La Boulange last year for $100 million. By the end of the third quarter, La Boulange products were available in 1,076 of its company-operated stores across the U.S. By the end of 2013, the extended menu will be available in about 3,500 of the company-operated stores in the U.S., and by the end of next year, these will be rolled out in all of its company-operated stores across the country.

A word of caution though. Starbucks only reports the same-store sales of its company-operated stores, over which it has a greater control on the operations and which account for about half the total stores. For franchised stores, the same-store sales growth could be lower.

Same-store sales, or comparable sales, is an important parameter to gauge a restaurant chain’s performance since it excludes the effect of currency fluctuations and only includes the restaurants open for more than a year. The sales of newly opened restaurants could be unusually high or low and can distort the overall revenue/store figure.

Aggressive Store Expansion

Through the three quarters of fiscal 2013, the company has already opened 1,143 new stores, including the 350 Teavana stores purchased as a result of the acquisition. In fiscal 2014, Starbucks plans to add another 1,400 stores, about half of which will be in the Asia Pacific region. China, as expected, will be a key part of its global expansion as the company looks to grow the store count in the nation to 1,500 by the end of 2015. The world’s most populous nation will surpass Canada as the second most important market for the company in the next two years.

See our full analysis for Starbucks Corportion

Packaged Product Sales Should Continue To Rise

Sales of Starbucks’ channel development segment consist of packaged coffees and teas, K-cups and brewers that are available in grocery and retail stores. The segment is growing at a brisk pace and already accounts for about a tenth of the total sales. Through the first three quarters of the fiscal years, the segment’s sales have jumped 11.8%.

This segment is most sensitive to the cost of coffee since the raw material costs are higher (as a % of total costs) for packaged products (vs coffee sold at Starbucks stores). Due to the low coffee prices, the margins should witness a healthy improvement, on a year-over-year basis. In the first three quarters of the fiscal year, the reported operating margins are already up 230 basis points to 27.1%.

Overall, Starbucks sees a significant growth opportunity in the packaged product segment. A couple of months back, Starbucks formed an agreement with French giant Danone, which will see the company launch new specialty yogurt products (such as Greek yogurt) beginning next year. Earlier in the year, Starbucks announced the extension of its deal with Green Mountain as well. Starbucks also has ambitious plans of doubling its international footprint for this segment within the next two to three years. This division should continue to witness impressive growth as the company keeps expanding into new geographies and introduces new products.

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1. SBUX 10-Q [↩]
2. Goldman Sachs cuts Arabica Coffee price forecast by 7.7%, October 21, 2013, economictimes.com [↩]
3. SBUX 8-k [↩]