What Are The Challenges Facing Starbucks And How Can It Overcome Them?

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Starbucks is the strongest there is in the waning restaurant industry right now. Although comparable sales were below its historical average for the first two quarters of the year, in the third quarter Starbucks’ comparable sales growth met expectations. Further, its revenue has consistently grown at an impressive rate in the year. However, all the positives haven’t really helped the company’s stock price, which has been stagnating at approximately $55-$60 per share. While we at Trefis are bullish on the company, by approximately 13%, primarily due to its resistance given the difficult market environment and its success in China (Read more about “Why We Are Bullish On Starbucks?“), the market’s perception isn’t as positive. In this article we talk about the challenges ahead for the company and how it could potentially overcome them.

Starbucks Stock Price (Dec’15-Dec’16)

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Increasing Prices Of Its Products

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Starbucks has been leveraging its consumer loyalty and lack of elasticity among its consumers by continuously passing on increases in costs, due to wages and coffee prices, to its customers. As a result, in the period between 2014-2016 we have seen four price hikes on its products, two of which were in 2016 alone. The rise in prices has been mainly aimed at protecting the company’s operating margins. In the financial year ended September 2016, Starbucks was able to expand its margin by 80 bps to 21.5%, and earnings by 17% y-o-y to $1.85 per share.

Having said that, there is a very serious concern about how long before consumers decide to choose one of the many upcoming coffee shops in favor of Starbucks, if it continues to increase its prices at this pace. However, the problem may not be as serious as one may think. The main attraction of a Starbucks store, is its inviting and premium atmosphere. The company has become a popular place to have casual meetings related to work or even study while having coffee. The coffee giant has, and continues to pull out all the stops, when it comes to establishing its brand presence and value. One example is the introduction of new concept stores, such as reserve stores and roastery. These concept stores aim to offer a highly customized and elevated experience, targeted at premium customers, such as uber-rich and coffee connoisseurs. The company is looking at potentially 10 Roasteries, offering different types of coffee experiences: pour-over, siphon, clover, specifically roasted Reserve coffees on-site that you are able to buy from a scoop bar, and interactive experience with bars and baristas. Furthermore, Starbucks has consistently seen its Reward program grow, despite the change in structure. As a result, we believe that while there may be some loss of customers due to higher prices, it will be more than offset by optimal customer retention and increasing customer acquisitions.

Higher Wage Payment

As mentioned previously, the increase in prices of end product is propelled due to higher cost of raw material and labor. It is argued that an increase in the federal minimum wage will adversely impact the company and its already thin margins, especially at licensed stores. However, the argument fails to consider that labor costs are the smallest portion of the company’s operating expenses. While the company doesn’t report expenditure on wages separately, but as a part of general and administrative expenses, we can see that there hasn’t been much increment in the amount over the 2015-2016 period. Furthermore, the company already pays wages much higher than the stipulated minimum, and is popular as employees’ choice. Consequently, we believe that a hike in federal minimum wages will only go on to help Starbucks, by impacting its competitors adversely.

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Rising Prices Of Coffee Beans

Coffee prices, after being on a slump for a while, have started rising again. The primary contributor towards the rise in prices of coffee beans is the drought in Brazil and Vietnam, the largest producers of coffee beans. Further, the increased demand for coffee has led to a reduction in the inventory levels of coffee beans for the past twelve consecutive quarters. According to ICO, this is the longest such streak since the organization began collecting data in 1995. As a result, we have seen a spike in the prices of the commodity. Since coffee is the main raw material used, a hike in the coffee bean prices, coupled with supply shortage, is likely to affect Starbucks margins negatively. However, the company has taken measures by passing on the hike to its customers. As per Starbucks’ management, the recent hikes in prices at the stores were focused mainly on cold beverage and bakery menu items. The company expects it to add 0.5% in average ticket price.

As previously discussed, the sticky nature of demand of Starbucks’ product will help the company retain customers even as the prices of its products rise. In addition, the improving sentiment of consumer spending and rising household income, will further help customers absorb price increases that will likely continue into the future.

Trump Effect

During the election period, President-Elect Trump asked his supporters to boycott Starbucks. This was in line with his anti-globalization stand. He accused Starbucks of exporting jobs to outsiders and not contributing to the U.S. economy. As a result of this campaign, the stock price of Starbucks was seen on a continuous downtrend. Furthermore, even now incidents can be heard of where long time loyal customers throw tantrums or create a scene at the stores. This is a big threat to the company in the near future. If Starbucks is not able to woo the current government, we may see it have difficulties. On the positive side, the demand for coffee is as strong as ever. This is likely to give Starbucks, the largest coffee brand in the world, an upside.

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Replacement Of The Current CEO Schultz

On the 1st of December, Starbucks’ management announced that it will be replacing its CEO Howard Schultz with Kevin Johnson. The announcement left many investors worried (approx. -4% drop in SBUX price), as Schultz is solely held accountable for Starbucks’ immense success and stellar performance. However, it is important to note that Schultz doesn’t leave the company, but stays on to work on its new concept stores, Starbucks Reserve Roastery. Coming to the new CEO Johnson, who is known for his experience in technology, we can expect mobile app and payment to play a much bigger role going forward, which is the next step in the increasingly digitizing world.

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Have more questions on Starbucks? See the links below.

Notes:

1) The purpose of these analyses is to help readers focus on a few important things. We hope such lean communication sparks thinking, and encourages readers to comment and ask questions on the comment section, or email content@trefis.com
2) Figures mentioned are approximate values to help our readers remember the key concepts more intuitively. For precise figures, please refer to our complete analysis for Starbucks

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