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Starbucks' Secret Weapon

March 19, 2013 | About:
As many have wondered, how can Starbucks (SBUX) continue to grow if it's on every street corner in America? The answer lies in Asia. Try finding a Starbucks in Asia outside the major shopping malls and the major cities. It's very difficult, most likely impossible, to find one on every street corner like in the U.S.

Meanwhile, China has not been treating the likes of McDonald's (MCD) and Yum! Brands (YUM) very well. Chicken supply and food safety concerns have pressured both companies. China's state television CCTV reported that two poultry farms that supply chickens to Yum!'s KFC had fed chickens with unapproved levels of antibiotics. Although the issue really only impacted KFC, the pressure extended to McDonald's as consumer confidence in food quality at many restaurants was brought into question.

Yum! remains unsure about how long it will take to recover sales at KFC in China. Management expects continued weakness in China sales during the first quarter, with an expected drop of 25% in same store sales for the period. Yum! has taken steps to monitor its poultry suppliers in China and cut ties to questionable companies.

China still holds the key to both McDonald's and Yum's overseas expansion plans. For Yum, its China segment accounts for more than double its U.S. revenues, and the company has double the stores in China versus the U.S. However, McDonald's still has room to grow, with only 1,500 China-base stores, versus its 18,000 U.S. locations. McDonald's has increased its store openings in China, and Yum plans to continue opening stores. But with increased store openings comes margin compression. However, Starbucks is already enjoying 30% operating margins in China, versus the company-wide average of just over 11%.

But Don't Most People in Asia Prefer Tea over Coffee?

Typically the average drinker in Asia preferred tea over coffee. But as incomes have risen and palettes have changed, the transition is being made to coffee. Starbucks believes that China will be its second-largest market by 2014. In China alone, an estimated one-third of the population is now drinking coffee. That's 443 million people! For those that prefer tea, Starbucks last quarter completed the acquisition of Teavana for $620 million. Starbucks is going after the tea drinkers as well and wants to capture that segment of the market that it has been missing. The company will add this line to its existing Tazo tea products.

The Growth Is Evidenced by the Numbers

Last quarter Starbucks reported global revenues of $3.8 billion, a rise of over 11%. Inside those numbers was revenue of $214.1 million from the Asia-Pacific region, a jump of 28% from the previous year. These revenue numbers come from having only 700 stores in China. Compare that to over 11,000 in the U.S. and you get the picture of the growth potential for Starbucks in Asia.

In terms of employee headcount, Starbucks employs over 200,000 on a global basis. Of that, roughly 10%, or 19,500, are based in Asia. The best part about Starbucks is that it doesn't discount. The prices in China are the same as they are in the U.S., but margins are better because employee costs are much lower in the Asia Pacific region than in the U.S.

Growth Beyond China

India Is Next

At least the Chinese have over 700 Starbucks for their 1.34 billion people. People in India have a total of seven for their 1.24 billion people. Starbucks has been slow getting into India because it didn't have the right partners. Now Starbucks has a 50/50 joint venture with Tata Global Beverages to build stores in India. The first one opened in October 2012 and six more have followed.

Starbucks Opens Its First Store in Vietnam

Vietnam is the world's second largest coffee producer after Brazil. Vietnam grows the robusta variety of coffee, which is sweeter than the Arabica variety. Arabica is the type of coffee used by Starbucks in its coffee. If Vietnam coffee drinkers are used to a sweeter type of coffee, isn't that a bad sign for Starbucks? Wrong! Starbucks opened its first store in Ho Chi Minh City last month and people lined up for more than two hours to get their first Starbucks coffee. The aura of the Starbucks brand is seen in Asia as being sophisticated and appeals to the growing population with more disposable income.

Attractive Valuation

Compared to other major peers, Starbucks also has the best (lowest) PEG ratio:

  • Starbucks 1.6
  • McDonald's 2.0
  • Yum! 1.7
Compared to these other companies, Starbucks also has the best balance sheet, with a debt to capital ratio of 10%, compared to McDonald's 45% and Yum 55%.

Starbucks currently has a forward P/E of 21. This is extremely attractive for a company still in the growth phase. The company's current operating margin of 13.6% looks set to improve further as the company benefits from the weakness in coffee prices. Coffee was the worst-performing commodity last year. That greatly benefited Starbucks as the prices dropped. Starbucks is able to use last year's weakness to negotiate better fixed prices with its leading suppliers.

Further helping Starbucks with its coffee purchases is the outlook for the 2013 to 2014 crop. Brazil is the world's largest coffee producer and it produces the Arabica variety that Starbucks uses. The outlook for the Brazil crop is looking extremely favorable as weather has helped the crop and coffee growers invested in new seedlings and fertilizer. Production in Colombia, Mexico and other Central American producers looks strong as well.

Be sure to check out our detailed stock analysis (click here).

About the author:

Investment adviser and startup striver.

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