Starbucks Expands into the Land of Tea

by Charles Sizemore, CFA
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Submitted by Charles Sizemore at Sizemore Investment Letter as part of our contributors program

If there has been one recurring theme in my investment recommendations over the past two years, it is this: If you want growth, you have to look to emerging markets.  With the United States, Europe and Japan burdened with high levels of debt and aging demographics, growth in the developed world will be hard to come by.  But in markets like China, Brazil and Turkey, living standards are rising and a new middle class is rising.  This is a long-term investment theme that is ripe for the picking.

There are different ways to skin this cat, of course.  You can buy the shares of individual emerging market stocks (see Charles Sizemore’s top emerging market stock for 2012), or you can buy the shares of American and European companies that get a large and growing percentage of their revenues from emerging markets.  This latter theme has been a specialty of the Sizemore Investment Letter and the source of some of our biggest investment successes in recent years.

Today, let’s consider the case of an American icon: Starbucks (Nasdaq: $SBUX). Starbucks is a well-run company that also happened to be at the right place at the right time.  Starbucks exploded in popularity in the 1990s, a time when incomes and lifestyles were on the rise in the United States.  The company benefitted from what financial writer David Brooks called the rise of the Bobos,” or bourgeois bohemians: white-collar knowledge workers who shun the trappings of wealth yet think nothing of spending $300 for a pair of rugged hiking boots or $5 on a cup of coffee.

See the full Trefis Analysis for Starbucks

Starbucks is one of the great American success stories of the past 20 years.  But it’s also a company that now faces a saturated market.  Starbucks gets 70 percent of its revenues from the United States, and virtually every corner of every street in every major city in America already has a Starbucks or a competing coffee shop.

Not surprisingly, Starbucks has had to get creative in searching for new ways to grow.  The company has begun experimenting with beer and wine sales in select markets, effectively transforming itself from an American coffee shop to something more resembling a European café.

For Starbucks shareholders, this should be welcome news.  The transformation turns a saturated market into a growth market again, at least for a while.  But if Starbucks wants to enjoy sustained growth, it’s going to have to look outside U.S. borders, and that is exactly what the company is doing with its partnership with India’s Tata Coffee (see “Starbucks, Tata Coffee Closing in on Retail Deal”).

Starbucks is finalizing its retail partnership with India’s Tata Coffee Ltd, a subsidiary of the Tata Group, one of India’s largest conglomerates, to expand Starbuck’s retail presence in the country.  For Starbucks, India will be a tough nut to crack. India is not traditionally a coffee-drinking country; but it is one of the world’s largest producers and consumers of tea.  Tea is served with breakfast and throughout the day, usually with milk and sugar. The iconic Tetley Brand, formerly British and one of the largest, is now owned by Tata Coffee’s sister company, Tata Tea Limited.

For Starbucks, success in India will mean creating a market for coffee where none previously existed.  It’s hard to compete with centuries of tradition, and Starbuck’s Indian venture may or may not work out.  Only time will tell.

But regardless of what happens in India, Starbucks has the right idea.  The company is planning to expand its presence in China from 470 shops as of late last year to 1,500 by 2015.  It similarly plans to roughly double its stores in South Korea.  And, on an anecdotal note, I wrote a recent InvestorPlace article from a Starbucks shop in Trujillo, Peru of all places.

Starbucks is currently priced a bit richly for my liking; it trades for 21 times estimated 2013 earnings and yields just 1.4 percent.  That’s a bit expensive for a company that gets 70 percent of its revenues from a saturated market.

Still, the stock warrants watching.  If its transformation to a full-fledged café is successful and its emerging market expansion plans work out as expected, earnings growth could take a lot of investors by surprise in the years ahead.

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