Trouble Brewing for Starbucks in China

| About: Starbucks Corporation (SBUX)

I love Starbucks (NASDAQ:SBUX). I go there 3-4 times a week in the morning, as much for the service as the coffee – all the baristas know my family, my drink and are incredibly friendly. In a market like China, where the idea "service" is still evolving and inconsistent, Starbucks is a breath of fresh air. Starbucks' senior management should be applauded for being able to transfer the original way that made Starbucks popular to China with really top-flight training.

Unfortunately, based on research we have done in the last two months, Starbucks is getting hit really hard in China with the economic slowdown that is hitting the world. All three of their main target markets are cutting back on spending.

One of Starbucks' main core target markets is expatriate executives. Starbucks, like all foreign-focused restaurants, are getting hit hard as foreigners cut back spending in the face of declining stock portfolios. As one waiter of a top foreign-focused restaurant in Xintiandi told me, "The Chinese are spending the same if not more than before. The foreigners are just not coming anymore or, if they do, are cutting back spending." This has been a sentiment echoed in interviews we have conducted with dining establishments throughout China, from small restaurants to expensive hotel restaurants in a Starwood (HOT) or Marriott (NYSE:MAR).

Starbucks' second main target market is executives who arrange meetings in Starbucks. But with the drop of foreign executives flying to China and generally fewer domestic meetings too taking place, Starbucks is getting hit along with the travel industry in general, especially conferences and conventions which are seeing major drop in exhibitors and attendees.

Unlike in the US, where a huge percentage of sales comes from take-out, in China Starbucks is a de facto meeting place. Many people who do not have a physical office actually use Starbucks as their offices daily for meetings. The environment is comfortable, locations always great and even if the coffee is overpriced it is still cheaper than the high office rents in Shanghai. Consumers know that it will be clean with good air conditioning.

In recent years, Chinese too have been spending more and more in Starbucks, mostly senior managers in MNCs. This obviously is the main potential market for Starbucks long-term. However, the most pessimistic consumer segments in China (aside from ex-pats) that we have interviewed in the past few months are senior managers in MNCs that see budget cuts and hiring freezes … not so much because of weak China operations of these MNCs but because of the global malaise that is leaving many MNCs to, in my mind, disastrously implementing hiring freezes and budget controls to the point that throttle even profitable China operations.

These senior managers are the best long-term core target market for Starbucks and these Chinese are cutting back their discretionary spending. They are the ones who are no longer buying autos from companies like Buick (NYSE:GM) and they have stopped making the semi-regular trip to Starbucks.

Look for difficult times for companies from international schools to western restaurants in the coming months as more ex-pats get repatriated because of their out-sized compensation packages and as they fear for their plummeting stock portfolios back home and thus cut back discretionary spending. And look for the Chinese consumers at the senior manager level to cut back too. Brands that target the upper middle class will get hit while the low-middle class focused companies, such as the online game sector like a Shanda (NASDAQ:SNDA) or Netease (NASDAQ:NTES), will continue to do well.

Overall, we are cautiously optimistic on China's economy short-term, very optimistic long-term. However, certain sectors will be hit hard and Starbucks falls into one of those. Starbucks will have to make changes quickly to its business model – from introducing loyalty cards, free wireless internet, to smaller but cheap cups of java to weather the storm.