Starbucks Reports Growth In Sales, But A Contraction In Margins In The Second Quarter

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Starbucks (NASDAQ: SBUX) reported its second quarter results on April 26, wherein earnings were in-line with consensus estimates, while revenues topped expectations. The revenue growth was driven by China, where comparable sales rose 4%, and it is this region on which the company has pinned its hopes. However, the margins contracted in the quarter, due to restructuring and impairment costs, East China business acquisition, and higher food costs. The company noted that comps are gaining momentum, and should improve to 3% in the second half of the fiscal year, from 2% in the second quarter.

We have a $65 price estimate for Starbucks, which is higher than the current market price. The charts have been made using our new, interactive platform. You can click here for our interactive dashboard to modify different drivers, and see their impact on the earnings and price estimate for Starbucks.

1. Growth in China: China was again the fastest growing market for the company in the second 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. Moreover, the per capita coffee consumption in China is about one-half of one cup per person per year compared to approximately 300 cups per person per year in the U.S.

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.

2. Margin Contraction: Given the poor performance in the first quarter, Starbucks decided to remove 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.

3. Focus on Afternoons: COO Rosalind Brewer stated that “occasional customers,” largely with whom the company doesn’t have any digital relationship, and who are not regularly aware of SBUX’ new offerings and key promotions, make up nearly 50% of the volume sold in the afternoon. These customers “are a material part” of the company’s current afternoon challenges. This is prompting a shift in the marketing initiatives, to focus more on these customers.

4. 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 nearly 1,800 stores across six markets by fiscal year end. 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 had noted approximately 1 point of additional comp growth in stores offering Nitro Cold Brew during 2017.

5. Anti-Racial Bias Education: SBUX is closing its stores for racial-bias education on May 29, in the wake of the incident on April 12. While the CEO said that the company has so far not seen any financial impact in the aftermath, it has been estimated that the losses for the company could range from $6 million to as high as $30 million in missed sales during the closure period alone. This move may have a negative impact on the Q2 revenues.

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