Will China Again Drive Growth For Starbucks In The Second Quarter?

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Starbucks (NASDAQ: SBUX) is scheduled to report its second quarter (three months ended March 2018) earnings on April 26, wherein a rise in both revenues and earnings is anticipated. While the revenue growth is expected to be boosted as a result of the company’s impressive performance in China, as well as the addition of new restaurants, these factors, together with a lowering of the corporate tax rate, should also result in a rise in the earnings. In the previous quarter, the company fell short of consensus revenue expectations, reporting a 6% year on year growth in revenues, against the expected 8%. Comparable sales growth remained at 2% (in line with the numbers in 2017) despite strong comparable sales of 6% reported in China. The low comps in the Americas were blamed on disappointing holiday sales  (holiday merchandise and limited time offers) and negative mall store comps. However, the company stated that it has a clear understanding of this issue and is working on several initiatives to drive sales including food and beverage innovation. Consequently, the company’s performance in this segment will be one to keep a close watch on.

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Key Factors That Will Impact The Results

1. Positive Industry Environment:  The overall restaurant industry environment has been positive for the quarter ended March 2018. While comparable traffic declined, comparable sales have been positive on the back of higher average checks. In March, same-store sales growth was 0.8 percent, the second-best month for restaurant industry sales growth over the last two years. While fine dining and upscale casual restaurants have consistently shown sales growth, casual dining and fast casual struggled heavily in 2017. This trend seems to be reversing, as this segment has shown signs of recovery this year, recording positive sales in the first quarter of 2018. This should benefit Starbucks.

2. Growth in China: China was again the fastest growing market for the company in the first quarter, with 6% comps growth and 30% revenue growth. It continues to remain a long term growth driver for the company, as its GDP, projected to exceed $15 trillion by 2021 from $11 trillion in 2014, is expected to fuel a massive increase in its middle class. Shanghai was chosen as the location for the first international Roastery, and this decision has paid off as it has driven significant customer engagement and revenue. Starbucks’ partnership with Alipay and WeChat in China and its recent East China acquisition are likely to aid the company in taking advantage of the growing middle class in the country – which is its major customer base. The East China business will be reflected in Starbucks’ financials from Q2 2018. The company expects this transaction to be neutral or slightly accretive in 2018 and expects to see a more positive impact of this transaction in 2019.

3. Innovation in Food and Beverage: Mercato fresh food menu was launched in Seattle and Chicago last year, and continues to perform well. Keeping this in mind, the company is planning to deploy Mercato in at least six new markets in fiscal 2018. Starbucks also has a tremendous opportunity to leverage its core beverage platforms, particularly in ice coffee, tea, cold brew, and draft beverages. In response to strong customer demand, the company is accelerating the rollout of Nitro Cold Brew from 1,300 stores currently to 2,300 stores in the U.S. by the end of the year. Starbucks has noted approximately 1 point of additional comp growth in stores offering Nitro Cold Brew during 2017.

4. Change in Tax Rate: The changes in the U.S. tax laws are likely to impact Starbucks positively. The company expects the effective tax rate to be 7 points below its earlier guidance, at 26% for 2018, leading to a slightly higher EPS.

5. Margin Contraction: Given the poor performance in the first quarter, Starbucks is removing over 200 SKUs from its U.S. retail stores, representing over 30% of total lobbied items. While this simplification effort increases the focus of the company and reduces operational complexity in its stores, it will pressure the margins given the high write-offs associated with these products. Moreover, the consolidation of the East China business is expected to have a negative impact on the operating margins. Another factor that will pressure the margins is the digital investments the company is undertaking in the Americas. Given these factors, the coffee giant projects a moderate operating margin decrease for the year.

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