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Starbucks: Brewing On All Cylinders

"Time is on your side when you own shares of superior companies," so wrote the Fidelity fund manager legend Peter Lynch. Starbucks (NASDAQ:SBUX) is a superior company and has plenty of growth prospects left to own its shares for the long-haul.

The economics of Starbucks' business is vast and contributes to organic growth unlike any other company of their magnitude in the marketplace today.

This article is one of a few highlighting key hallmarks of this organic growth and thus, forming a thesis on Starbucks as a long-term position, mostly based upon the economics of Starbucks' business and the strength of their strategy in China.

As you read through their recent 10-Q from July (filing), you gain a glimpse of a multi-national company which is building a sustaining system of growth with a widening moat. This in large part is due to all of the differing streams of revenue Starbucks has implemented which are further complimented by a reduction in operational costs due to the drop in coffee bean prices.

Beginning on page 19 and reading through the MD&A ending on page 25, there are a couple of words which are repeated more often than others: "growth" and "increase." The growth is coming at an alarming rate for any company and the increase is coming in their revenue. In the Americas alone, Starbucks showed revenue growth of 12% year over year. One important metric Starbucks tracks which also showed growth was their increase in average tickets which contributes to their comparable store sales growth. The average ticket increased 2% year over year. This is important to note for as Starbucks is primarily a beverage provider, they have been and are still modifying the experience they offer their customer with their food items. This year over year per-ticket growth is pointing to the fact that consumers are not only satisfying their thirst when they go to Starbucks, but now also their hunger. And why wouldn't they? Starbucks is following the trending niche of creating healthy products at affordable prices. The average item on Starbucks' menu is approximately $3.00. A ticket with a drink coupled by a food item and you're looking at an organically healthy order around $6 to $8. What they are discovering is their customers are willing to pay a slight premium for healthy and good tasting food.

Furthermore, while Starbucks is always improving their consumer experience in their retail stores, they are also seeing their efforts net higher revenues for them in their channel development segments (CDS). Starbucks' CDS would be their products which can be bought outside of a retail location. Revenues from their CDS grew 6% for the quarter to $336 million. This makes sense when you recall Starbucks' brands represent not only typical coffee grounds or whole bean bags, but also Tazo Tea brands, and also K-Cup portion packs. This strategy and accompanying figures give a glimpse of the growth in the Americas region alone. But that's not the only region where Starbucks showed growth during the third quarter - they showed growth in each of their regions. But the one most captivating would be their growth in China.

Starbucks + China = GROWTH

For the third quarter alone Starbucks brought in $52 million of revenues through their stores in China, a 29% increase year over year. This was in large part due to the efforts of 220 new company-operated stores. This highlights another important moat-forming metric and it would be the metric Starbucks uses to track their growth between licensed store revenue and company-operated store revenue. Growth is occurring in both per given region, but what is interesting about this metric for Starbucks in China is that they have not accelerated the growth of their licensed store operations yet. Starbucks typically enters a region naturally through their company-operated stores to build their presence, vendor-relations in the region, and of course their brand. Following this, they then begin to license out their stores. And by the way, you have to be a company grossing $1 billion EBIT to be qualified for a Starbucks store license. This is a core strategy for them as they only want their brand associated with other sustaining enterprises; hence, their ever widening moat. This is highlighted here because for all the growth they have been able to achieve in China in a few shorts years, it's only the beginning. Once they reach the proper milestone, one could expect they will begin to license out more and more stores to Chinese companies. This will not only sustain their revenue, but it will have the organic effect in China as it did in other regions: being more accessible to the consumer by being in more places the consumer accesses.

Critics will be quick to say "But I thought China a tea-drinking culture?" They are indeed and while Starbucks serves plenty of tea, China has steadily been increasing their coffee consumption in large part because of Starbucks' presence. In fact, data compiled by Euromonitor International shows China's retail coffee sales have seen an increase of 10% in the past 5 years (EI data). Other data compiled shows the global average growth rate is 3%. If these figures are not fascinating enough with regards to Starbucks' continued growth, try re-reading these figures in light of also knowing that further data compiled from Euromonitor International shows that coffee only accounts for less than 1% of China's hot-beverage market. Growth prospects abound in China for Starbucks.

Long-term Strategy

It's been said that companies in the West think in terms of decades, while companies in China think of business in terms of centuries. Starbucks shares China's perspective as they are strategically forming their base to dominate China's hot-beverage market for the long-term.

It's not merely about quantity of stores Starbucks is opening in China, but more so with the price per unit cup of coffee they are offering Chinese customers. Companies in China often reduce prices of their items to build market share while simultaneously hurting their operating costs. Over time their margins begin to compress hurting their both their top and bottom lines of revenue. Starbucks has taken the other side of this coin and has kept their coffee drinks at even a higher premium in China than in the West allowing for overall wider margins. There's a large psychological affect here as well: Starbucks, amongst the up and coming generation is seen as an item of status. This working nicely for Starbucks especially amongst up-and-coming middle class.

Starbucks' growth in China contributing to their bottom line really comes down to some simple math. They opened 500 stores last year an 200 more this year. With substantial year over year growth in their China store operations, while only tackling so far a minimal amount of the hot-beverage market. The compounding effect of Starbucks' growth in China is clear.

What Are The Risks?

As Starbucks' essential item comes from a commodity (coffee beans), the obvious risk would be a sharp rise in price per pound of coffee. This happens all the time in commodities. But the global trend over the last few years has been coffee beans per pound decreasing and not increasing. Right now coffee is trading at a multi-year low of approximately $1.14/lb. Starbucks' lowest priced bag of whole beans through their CDS channels is approximately $8. That's a wide margin which is leading to Starbucks' success in every region and contributing to their bottom line. The risk to be aware of would be the possibility of a bad year for coffee bean exporters causing a sharp rise in Starbucks' operating cost. But with more and more countries making coffee one of their top exports due to a global demands for beans, if one country has a bad year, another will not, allowing this risk to be mitigated.

With Starbucks set to report earnings just under a month from now, I expect them to beat the street. Should they miss earnings, I would see it only as a buying opportunity for a position to hold for the long-term.

Source: Starbucks Brewing On All Cylinders: A Long Thesis

Additional disclosure: I am considering going long November call spreads ahead of earnings.