Will The China Slowdown Impact Starbucks’ Third Quarter Performance?

Starbucks (NASDAQ: SBUX) is scheduled to report its third quarter (three months ended June 2018) earnings on July 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 addition of new restaurants, particularly in China, this factor, together with a lowering of the corporate tax rate and share buybacks, should also result in a rise in the earnings. While during the second quarter earnings release the company noted that the comps were gaining momentum, and should improve to 3% in the second half of the fiscal year, from 2% in the second quarter, in an update provided in June, SBUX stated it anticipates only a 1% growth in comps in Q3. This, coupled with the recent retirement of longtime CEO Howard Schulz and the pending retirement of CFO Scott Maw battered the company’s stock price, which fell as much as 15%. Consequently, we feel the stock is undervalued at its current price.

We have a $64 price estimate for Starbucks, which is significantly higher than the current market price. The charts have been made using our new, interactive platform. You can click here for our interactive dashboard on Starbucks’ second quarter performance to modify different drivers, and see their impact on the EPS and price estimate for Starbucks.

Key Factors That Will Impact The Results

1. Positive Industry Environment: According to insights provided by TDn2K’s Black Box Intelligence, year-over-year chain restaurant sales increased 1.1% in June, making it the fourth consecutive month of positive or flat comp sales. On the other hand, the guest count metric continued to be weak, with store traffic declining 1.7% during the month. For the quarter, same-store sales were up  0.8%, the third consecutive quarterly increase, reflecting a strengthening of the environment in the industry, while traffic was down 2%.

2. 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. While consumption levels in China may never be able to match those in the U.S., even attaining a small fraction of it will benefit the company immensely. Shanghai was chosen as the location for its 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 impact of the East China business is being reflected in Starbucks’ financials beginning Q2 2018. The company expects this transaction to be neutral or slightly accretive in 2018 and expects to see a more positive impact from this transaction in 2019.

A sudden slowdown in the country prompted the company to state that the same-store sales would be flat to slightly negative in its second biggest market in the April to June quarter. A sharp reduction in third-party orders, with which the company had no formal agreement, as a result of possible government measures, has been blamed for this. As a response to this, former CEO Howard Schulz hinted at a possible partnership with Alibaba to boost the company’s digital distribution in the country.

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 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.

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, SBUX projects a moderate operating margin decrease for the year. On the other hand, sliding valuations of the Brazilian Real and the Vietnamese Dong (Brazil and Vietnam are the two largest coffee producing nations in the world), should result in depressed coffee prices, which will be particularly beneficial for a coffee giant like Starbucks.

6. Anti-Racial Bias Education: SBUX closed its stores for racial-bias education on May 29, in the wake of the incident on April 12. During the second quarter results conference call, while the CEO had stated that the company had 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 Q3 revenues.

7. 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’s 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.

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