Shares of Starbucks Corp. (SBUX, Financial) have fallen 24% this year amid the company’s struggles with slowing demand in China and wage inflation. However, the company recently reported higher-than-expected earnings, aided by strong demand for cold drinks in the U.S.
Despite the current macroeconomic challenges, the Seattle-based coffee chain continues to open new locations at a faster-than-expected pace. The company opened 318 stores in the fiscal third quarter that ended in June, bringing its total global restaurant count to 34,948. It hopes to operate 55,000 stores by 2030.
Although Starbucks is no longer the growth machine it used to be, value investors may want to have a closer look at the company on the back of recent price weakness in the market.
The coffeehouse giant continues to benefit from higher spending on cold drinks
Starbucks reported fiscal third-quarter financial results on Aug. 2, which, unlike other restaurant chains, showed strengthening profits as customers continued to spend on cold drinks and coffees. Adjusted earnings per share came to 84 cents compared to 75 cents expected by analysts. Revenue for the June quarter was up 9% year over year to $8.15 billion, driven primarily by higher prices for popular products.
Digital operations are another important factor that is becoming increasingly significant for restaurants' growth. This is not surprising given how online shopping has changed consumer buying behavior over the last two years. This trend will continue to play an important role in the growth strategies of all businesses. Enabling digital ordering saves money and increases customer engagement and loyalty. Mobile Order & Pay, drive-through and delivery drove 72% of Starbucks’ U.S. revenue in the recent quarter. The loyalty program also provides Starbucks with a competitive advantage by increasing switching costs for customers and driving higher member spending. The number of active rewards members increased 13% year over year to 27.4 million, which is an early indication of how Starbucks is positioning itself to be more resilient to future economic shocks by building a strong community around its brand.
The company reported a 3% increase in global same-store sales in the June quarter, driven by a strong performance in the U.S. but partially offset by a decline in the Chinese market. Starbucks' same-store sales increased 9% in the U.S., largely driven by an 8% increase in average ticket values and the return of morning customers who accounted for about half of sales as people resumed their pre-pandemic routines.
Starbucks also noted that customer demand for specifically customized cold coffee beverages is high, accounting for approximately 75% of total beverage sales in company-operated stores in the U.S. Iced Shaken Espresso, which was introduced just a year ago, is popular with Gen Z customers, a key demographic for the coffee chain, and has become the fastest-growing product category in its home market.
The company's operating income dropped from $1.4 billion to $1.19 billion in the June quarter due to labor shortages and higher wages for baristas. According to the company, hourly wages have been raised to $17 and training hours for new baristas have been significantly increased.
Starbucks' current challenges appear to be temporary, and its massive brand image and pricing power may help it to deliver strong results even amid expected macroeconomic challenges in the coming quarters. Further, as Covid restrictions ease, the situation in China should improve. The company plans to open 6,000 new stores in the country by the end of the year.
Business in China remains volatile
The coffee giant has a strong presence in China, its second-largest market, with over 5,700 stores. Aggressive Covid-19 lockdowns have created a dent in sales over the last few months. As a result, comparable store sales in China fell 44% year over year in the fiscal third quarter, bringing total international comparable store sales down 18% year over year. Shanghai, the company’s largest market in China with more than 940 stores, was completely locked down for approximately two-thirds of the quarter. The company continues to experience periodic short-term closures and hence, operations in China remain risky.
Starbucks benefited from the booming Chinese economy in the last decade, and the company may find it difficult to grow at the same pace it did in recent years as the country’s economy is expected to enter a phase of slow and steady growth. Economic growth in China remains weak by historical standards, and people are likely to reduce their spending on premium coffees and shift to local competitors who are lowering prices amid these challenges. China has already become a difficult market for the coffee giant, and increased prices have resulted in customer complaints in recent months as well. These complaints could attract the eyes of Chinese regulators, which would not be an ideal situation for Starbucks shareholders.
Starbucks has also been the subject of food safety controversy. Food safety issues were discovered in two Starbucks stores in Wuxi, China in December 2021, where employees were accused of using expired ingredients. In addition, the company had previously received an administrative penalty for selling expired mooncakes.
Food-related issues have continued this year, with one of the stores being exposed in March after a customer claimed to find a live cockroach in their drink. Starbucks was also subject to paying the penalty for expired coffee powder on June 6. These subsequent incidents have had a significant impact on the company's China business.
As the relationship between the U.S. and Chinese governments have been rocky lately, American companies with operations in China cannot afford to overlook serious issues that could compromise their brand image. Starbucks' recent struggles to keep food safety up to the expected standards may lead to an erosion of brand value in the country.
On the positive side, Starbucks' International segment excluding China reported a 33% year-over-year increase in revenue in the June quarter with comparable sales in Japan, its third-largest market, reaching a new high.
Starbucks has suspended its financial guidance for the remainder of this fiscal year due to the unpredictability of China's pandemic restrictions. According to Chief Financial Officer Rachel Ruggeri, the company expects margins and profits to be lower in the fourth quarter due to a slow recovery in China, increased investment and one-time tax items.
Thoughts on valuation
The lackluster performance of Starbucks' stock this year has contracted the price-earnings multiple to around 30, which is considerably lower than the five-year average of 47.30. The company may not be able to grow at the same pace it did in the last decade, but the company still has a long runway for growth internationally in populous markets such as Latin America as well as Southeast and South Asia.
The success of its loyalty program is also a testament to the brand value associated with Starbucks, and the company seems well-positioned to enjoy competitive advantages in the long run stemming from the strength of its brand assets. Although the company is likely to face hurdles in the short run, it still has room to grow, which makes the stock attractive to potential investors at the current valuation.
Takeaway
Starbucks’ earnings exceeded Wall Street expectations thanks in large part to strong domestic demand, as American consumers are not cutting back on coffee spending despite inflation. Furthermore, higher prices helped to compensate for lower traffic and sluggishness in China, where zero-Covid measures have severely reduced the demand for coffee.
However, higher prices, combined with recent controversies, may hurt its business in China. Despite its strong market presence, the company also faces stiff competition from new entrants and the growing tea industry. While it has performed well in the domestic market in the face of high inflation, consumer spending on non-essential items is expected to slow, thereby making life difficult for Starbucks in the coming quarters.
Amid all these challenges, Starbucks continues to invest in improving the value of its brand assets, which is a strategy that could pay handsome rewards in the long run.
