Starbucks (SBUX)

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WHAT HAS CHANGED?

Latest Earnings

Starbucks had a mixed third quarter (three months ended June 2018), wherein it beat consensus expectations on revenue and earnings, but had a poor showing in China, its fastest growing market in recent times. The revenue growth was driven by the addition of new restaurants, particularly in China, and this factor, together with a lowering of the corporate tax rate and share buybacks, resulted in a rise in the earnings. The company reduced its full year EPS guidance to $2.40 to $2.42 vs. $2.48 to $2.53 earlier, much lower than our expectation of $2.52. This downgrade is a result of the $0.03 impact of anti-bias training for U.S. partners, as well as the sales for the year being near the lower end of its 3% to 5% growth guidance.

Growth in China

Although China was the fastest growing market for Starbucks, the growth was driven by the increase in store count. But this factor also caused cannibalization, resulting in a 2% decline in the comparable sales from the region. Another factor blamed for the poor performance is a sharp reduction in third-party orders, with which the company had no formal agreement, as a result of possible government measures. 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.

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. 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 company expects the impact of the East China business to be neutral or slightly accretive in 2018 and expects to see a more positive impact from this transaction in 2019. The company is also piloting delivery in Shanghai and Beijing this fall, with an intention to expand further in FY 2019. Moreover, despite the hiccup this quarter, 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.

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 is planning to deploy Mercato in nearly 1,800 stores across six markets by fiscal year end. 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.

Changes in U.S. Tax Laws Will Impact Starbucks Positively

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 FY 2018, leading to a slightly higher EPS.

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 food service 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 October 2017, Starbucks had 13,275 company-owned stores and 14,064 franchised stores making a total of 27,339 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 only a fraction of what they are in the U.S. New outlets opened will be a mix of company-operated and franchised restaurants. The company plans to take the store count in China to 3,400 by 2019. Shanghai alone has 320 Starbucks stores. Starbucks plans to double the store count in China & Asia-Pacific to 10,000 by 2019.

Ease and convenience of payment through mobile apps helping domestic sales

In Q4 2017, Starbucks' mobile order and pay reached 10% of transactions in its U.S. company operated stores. Consumers can load the money on to the app and then present a 2D bar code to pay at the register. With this app, it’s easy to pay with a phone, track purchases, and view one's My Starbucks Rewards Stars and rewards.

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 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 two to three points in FY 2019), it should become accretive to the EPS in three years or earlier.

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