Starbucks (SBUX) is the largest coffee chain in the world, with systemwide sales of roughly $35 billion. The company has more than 28,000 locations in 75 countries. Over the past 5-10 years, sales have increased by ~10% per year (CAGR) due to a combination of new unit growth and mid-single digit comp store sales. Combined with significant margin expansion (helped by mix shift towards licensed stores), a lower diluted share count and a declining tax rate, earnings per share have more than quintupled over the past decade (a mid-teens CAGR). The stock price has followed suit.
But while the long-term has been kind to shareholders, the ride has been a bit bumpy as of late. The stock reached $61 per share back in November 2015. Nearly three years later, it's in the low $50s.
This reflects concern among investors around weak comparable store sales in Starbucks' two most important markets, the U.S. and China. Largely due to results in these regions, the company’s consolidated comps declined from above 7% in 2015 to above 3% in 2017. In the most recent quarter (third quarter of fiscal 2018), comparable store sales only increased 1%. If this becomes the “new normal” for Starbucks, then the days of mid-teens earnings per share growth are behind them.
So, what is the company doing to try to get back to the solid results of 2010 to 2016?
Under CEO Kevin Johnson, the company has narrowed its strategic focus to three key areas.
First, Starbucks is adjusting its retail market structure. In places like Germany, Singapore, Taiwan and Brazil, where the company generates lower returns on invested capital and there’s less upside for new unit growth, it has aggressively pursued licensing. This enables the company to focus its efforts on key markets like the U.S. and China where it generates outsized return on invested capital and there is an opportunity to add thousands of new units over time. Most notably on this front, Starbucks bought out its partner in the East China JV for $1.3 billion in 2017, which gives the company 100% ownership in the region (it completed a similar transaction in Japan in 2014).
Second, management is simplifying the business by divesting or shuttering non-core assets. For example, it sold the Tazo tea brand to Unilever in 2017 to focus on its core tea brand, Teavana. In addition, it decided to close 379 underperforming Teavana retail locations in the U.S. and Canada (the company sells Teavana tea at its Starbucks stores).
Finally, the May 2018 global license agreement with Nestle (NSRGY) is an important evolution for the company. Under the deal, Nestle is now responsible for Starbucks’ CPG and Foodservice businesses. As part of the agreement, Nestle made an upfront payment to Starbucks of $7.15 billion; in addition, Starbucks will receive ongoing royalties and product fees.
The structure of the deal speaks to the value of the Starbucks brand around the globe. As Johnson recently noted, this agreement is a significant long-term opportunity for the company:
“Candidly, we’re in 76 countries around the world – and having had CPG and foodservice success in the U.S. and Canada, that means there are 74 other markets where we have established the brand, but either the CPG or the foodservice business is nascent or nonexistent. This global license agreement with Nestle allows us to continue to control our brand and at the same time Nestle will leverage their massive scale and capabilities for global distribution [including more exposure to the Nespresso and Dolce Gusto platforms, which have an installed base around the world that is meaningfully larger than Keurig in the United States].”
Beyond strategic and operational considerations, management has also announced material changes in capital allocation. Starbucks has committed to $25 billion of capital returns by 2020. After accounting for dividends, that implies about $19 billion of share repurchases over the next three years (they’ve already started) – equal to roughly 27% of its current market cap. This will lead to a significant reduction in the share count by 2020.
With that behind us, let’s return to the beginning of this discussion: Should we be worried by recent comp store sales trends in the U.S. and China? After doing some research, my conclusion is that this is likely a temporary issue for Starbucks. With time, this will likely end up similarly to the U.S. comp store sales concerns that McDonald’s (MCD) dealt with a few years ago. Said differently, the Starbucks brand is quite strong, and the business remains on solid footing.
Starting with the U.S., I think low-single digit comps are an attainable long term target. Half of the business is the morning daypart, and a large percentage (40%) is from My Starbucks Rewards members (by my math, MSR members spend approximately $1,000 a year at Starbucks). Considering the product, I’m willing to assume these are sticky customers who will keep coming to Starbucks for their morning cup of coffee. In addition, the company is working to improve the afternoon daypart, and will use its digital relationships (Rewards members and other customers they’ve identified through mobile ordering or in-store Wi-Fi) to try and mitigate pressure from lower Frappuccino sales. Finally, the real estate and store format strategy in the U.S. makes sense (drive-throughs and Starbucks Reserve stores), with potential upside from new food offerings. In terms of competition, there’s Dunkin’ (DNKN) and McDonald’s at one end of the spectrum and Intelligentsia, Blue Bottle and local coffee shops at the other end. Starbucks fits nicely in the middle (in terms of price, throughput, product quality, menu offerings and so forth).
As Starbucks approaches its 21st anniversary in China, Starbucks has built up a base of more than 3,400 stores across 140 cities. The store count has nearly tripled in four years, with revenues and operating income increasing at a 30% and 40% CAGR, respectively, over that period. According to Euromonitor, Starbucks accounts for 80% of the premium coffee market in China. Management is keeping its foot on the gas. The company expects to have 6,000 locations by 2022, which will require 600 new units a year (at which point China should be generating well over $1 billion a year in operating income). As founder Howard Schultz said at the 2016 Investor Day, he believes the company’s China business will eventually be larger than its U.S. business.
Competitors have taken notice of Starbucks' success in China. The most notable example is a local company, Luckin Coffee, which launched earlier this year. The company already has more than 800 locations throughout China and is targeting 2,000 stores by year-end (it recently raised $200 million from investors at a valuation of $1 billion). As noted in a Reuters article, Luckin has competed by focusing on low prices and quick delivery:
“Luckin’s customers can order coffee via an app, watch a livestream of their coffee being made, and have it delivered to their door in an average of 18 minutes, the company says. A regular latte, roughly the size of a Starbucks grande, costs 24 yuan plus 6 yuan for delivery (free delivery for orders of more than 35 yuan) but can be half price after promotions. A grande latte at Starbucks costs 31 yuan.”
While it took some time, Starbucks is responding: At the end of July, the company announced a partnership with Alibaba’s food-delivery unit (Ele.me) that will enable the company to offer delivery in Beijing and Shanghai, with plans to expand the service elsewhere in China in 2019.
While Luckin’s rapid ascent is eye-opening, it’s a manageable competitive threat. As in other regions around the world, Starbucks will have competitors in China. The question is whether Starbucks will earn its fair share of the market over the long run. Considering the advantages that Starbucks brings to the table relative to emerging competitors, that’s probably a safe bet. I agree with Starbucks' China CEO Belinda Wong:
“While recent coffee market entrants have chosen to capitalize on delivery, combined with heavily discounted offers, there are significant compromises at play in terms of quality, experience and business sustainability. These will prove to be short-lived.”
Conclusion
Based on my model, which does not assume anything heroic on comps, new unit growth or margins, the current valuation is reasonable. For context, that model assumes earnings per share growth of less than 10% per annum, compared to management’s long-term guidance of annual earnings per share growth of 12% or greater. If the shares remain under pressure and fall into the low-to-mid $40s, I would be interested in buying a lot of Starbucks stock. This business has a bright future.
Disclosure: None.
