Starbucks (SBUX)

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WHAT HAS CHANGED?

Latest Earnings

Starbucks reported a strong Q2 of its financial year, noting a 6.9% growth in revenues year on year and 3% improvement in comparable sales in Q2, driven by 4% Comp Growth in the U.S. and 3% Comp Growth in China. Operating margins improved in three geographic segments – Americas 80 basis points, China/Asia-Pacific 80 basis points and EMEA by 310 basis points. These positive results are encouraging after a strong start to FY 2019. Starbucks is continuing to focus on accelerating its improvement in long-term growth markets of the U.S. and China, and focusing on the Global Coffee Alliance created with Nestle. For FY 2019, the company is expecting roughly 3-4% comps growth, 2,100 net new stores, driven by China/Asia Pacific, 5% to 7% revenue increase, moderate decline in operating margin, and 8% to 10% improvement in the EPS.

Growth in China

Although China has been the fastest growing market for Starbucks, the growth has been driven by the increase in store count. But this factor also caused cannibalization, which together with a sharp reduction in third-party orders resulted in a weak third quarter. As a response to this, the coffee giant has partnered with Alibaba to boost the company's delivery services in the country. The company has also converted Mainland China into a wholly company-operated market, placing it in a strong position for long-term expansion. As a result of its efforts, Starbucks was rewarded with 1% improvement in comps in the quarter. The company has also expanded delivery to all its stores in Shanghai, Beijing, and 11 other cities in China, with an intention to expand to 2,000 stores by the end of FY 2019. Moreover, SBUX remains on track to add 600 net new stores per year and to achieve its goal of 6,000 stores in 230 cities across Mainland China by the end of fiscal 2022.

China 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.

Innovation in Food and Beverage

As consumer trends evolve, SBUX intends to stay ahead of the market with new and innovative products. Mercato fresh food menu was launched in Seattle and Chicago last year, and continues to perform well. Keeping this in mind, the company has deployed Mercato in nearly 1,800 stores across six markets. The company sees substantial accretive growth from Draft, Refreshers, Tea, and Cold Brew platforms, and noted that consumer demand for cold beverages has grown from 37% of sales five years ago to over 50% of sales today. There's also strong demand for customization, including Blonde Espresso as an alternative to its bolder signature roasts, and the inclusion of plant-based milk and cold foam for its cold coffee and tea beverages.

Deal With Nestle

Starbucks and Nestle announced plans for a $7.2 billion license deal that would allow the latter to market, sell, and distribute the coffee giant's brands in Consumer Packaged Goods (CPG) and Foodservice. This global coffee alliance, which brings together the world's leading coffee brand and retailer, and the biggest food and beverage company globally, gives Nestle a stronger footing in its fight against JAB Holdings, the world's second largest player in the coffee space. For Starbucks, on the other hand, this deal paves the way for expansion into markets where the company has no CPG presence. Starbucks will also be supplying the coffee to both the Nespresso and Dulce Gusto machine platforms, opening its access to the addressable, single-serve coffee market. While the deal will hamper revenue and EPS growth for Starbucks in the short term (expected to have a negative impact of one to two points in FY 2019), it should become accretive to the EPS in FY 2020, earlier than FY 2021 stated previously.

BUSINESS SUMMARY

Starbucks is the world’s leading roaster and retailer of specialty coffee. Through its global network of owned and franchised coffee retail outlets, Starbucks offers a wide range of products like high-quality whole bean coffees, freshly brewed coffees, Italian-style espresso beverages, cold blended beverages, food items like sandwiches, premium teas, and coffee making equipment.

Starbucks' own stores are located near offices and residential areas and are larger in size, compared to its licensed stores that are much smaller and mostly located at airports and supermarkets.

Starbucks also sells its packaged coffee and tea through retail channels such as grocery stores, warehouse clubs, convenience stores, and US foodservice accounts.

SOURCES OF VALUE

The Company-Operated Stores division is more valuable than the Franchise Stores division for Starbucks because of the following two reasons:

Company operated stores generate more revenues than franchised stores

Starbucks makes money through its company-owned stores as well as through franchise fees and royalties from franchised stores. Starbucks earns higher profit margins from franchised stores compared to company-owned stores because there are no operational and employee costs involved with franchised stores, hence Starbucks gets to keep the entire royalty & rent fee without paying for any costs.

Revenues earned from Starbucks' company-owned stores are much higher than the franchised stores. This is because, although there are costs involved, Starbucks owns 100% of the revenues from its own restaurants, while it gets a percentage of the revenues (in the form of royalty fees) from its franchised restaurants.

Number of company-owned stores comparable to franchised stores

Food & beverage companies, in general, increase their reach and profits by having a large base of franchised stores. For example, McDonald's has four times more franchised restaurants than company-owned restaurants, making the franchise business more valuable to its stock. However, Starbucks has almost an equal number of company-owned stores and franchised stores. As of March 31, 2019, Starbucks had 15,655 company-owned stores and 14,529 franchised stores making a total of 30,184 stores.

KEY TRENDS

International expansion fueling growth

Most of the new restaurants the company plans to open are in China/Asia Pacific. The number of Starbucks outlets in these countries are still much less than the number in the U.S. New outlets opened will be a mix of company-operated and franchised restaurants. SBUX remains on track to add 600 net new stores per year and to achieve its goal of 6,000 stores in 230 cities across Mainland China by the end of fiscal 2022.

Focus On Drive-Thrus

SBUX intends to open a majority of its new U.S. restaurants in middle America and the south, with over 80% of stores built in the year being drive-thrus. The company states that their research has indicated significant opportunities for store expansion in higher growth, lower cost markets, particularly when considering rising wages and occupancy costs, and hence, this will be a key focus in FY 2019. In the U.S., the company is also focusing on its digital initiatives, since it now has 15.3 million active Starbucks Rewards members, up 15% y-o-y. Additionally, drive-thru, out-the-window, and Mobile Order and Pay combined grew to more than 50% of customer orders, up more than 10 percentage points in just two years.

Improving Customer Connection

Starbucks is working on improving its customer image, and in this regard, it set itself an ambitious target of cutting up to 50% of current in-store administrative tasks by the end of FY 2019, in a bid to unlock up to two to three hours daily for partners to focus on customer connections.

Deal With Nestle

Starbucks and Nestle announced plans for a $7.2 billion license deal that would allow the latter to market, sell, and distribute the coffee giant's brands in Consumer Packaged Goods (CPG) and Foodservice. This global coffee alliance, which brings together the world's leading coffee brand and retailer, and the biggest food and beverage company globally, gives Nestle a stronger footing in its fight against JAB Holdings, the world's second largest player in the coffee space. For Starbucks, on the other hand, this deal paves the way for expansion into markets where the company has no CPG presence. Starbucks will also be supplying the coffee to both the Nespresso and Dulce Gusto machine platforms, opening its access to the addressable, single-serve coffee market. While the deal will hamper revenue and EPS growth for Starbucks in the short term (expected to have a negative impact of one to two points in FY 2019), it should become accretive to the EPS in FY 2020, earlier than FY 2021 stated previously.

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