Saul Sterman

Starbucks: Accept The Addiction

pop john,

Thanks for taking the time for writing you're carefully worded comment.

The bottom line is that you are requesting the numbers behind Mark Bashan's (S&P analyst) figures as to how he derives at a 17% revenue growth for U.S. and more perplexing to you is the 21% international figure for revenue growth in FY2008.

You are correct in stating that current margins from non U.S. operations are lower than U.S. margins for the past several years. SBUX management also confirms this and states as well that this will continue for some time though the spread will narrow over time.

Once you are convinced that the revenue growth will occur as projected by both analysts (S&P, CrossProfit and even Goldman Sachs, though the latter has a slightly lower target resulting in a $26 target price), you will see that an investment opportunity like now doesn't come along every day.

Before I knock your socks off with a one paragraph explanation of Bashan's numbers, first let's talk about the larger picture and how history tends to repeat itself though few rarely see it in the making and kick themselves in the pants when hindsight is visible to all.

For our history lesson we will use another (less) addictive beverage. Coca Cola (KO) is a global goliath. Today, KO has so many competitors that the combined sales of all of its competitors easily outsell KO on both volume and a revenue comparison. One competitor in particular has gained global market-share, but even with Pepsi at its current size, Coke is still king. At one time Coke had the opportunity of buying out Pepsi for a song and probably regrets today not acting on the opportunity. In the end of the day, there is only one company in the cola business that sets the tone for the rest. All the rest, until today, measure themselves as to how they are doing against Coke (KO).

Overseas, there are countries where not only the local brands sell for HALF of what Coke sells for, but Pepsi as well, in order to compete sells in line with local competition. In these countries Coke may not be the largest bottler but more often than not, Coke is the most profitable. When a brand can command a 50% premium and sometimes 100% premium over the local competition and still make the numbers work, then you know that you have dominated the marketplace.

SBUX is nowhere near reaching the KO global status in coffee. People who want a cola will ask for a "coke" even though they are pointing to a Pepsi bottle. When people who want a coffee ask for a Starbucks at the restaurant and everyone knows that it just means a coffee, this is when SBUX can change from its growth/domination strategy and work on the same retention/marketing approach as KO. Even after this happens, the total sales from competitors will far outstrip SBUX's revenue. The only difference is that just like with cola, there will be a clear global leader that sets the comparison benchmark.
When KO was building its global imprint there were times that margins contracted and there were times that margins expanded. This did not derail them from their basic strategy. From an investor's point of view, the KO story is very similar to SBUX. There were times that KO retracted 50% from recent highs only to present a second chance to get on board. It didn't happen very often, but those who looked at the bigger picture realized that this was an opportunity and not a long term derailment from the business model.

Likewise now, net growth is coming down for the next year or two to 17/18% from 22+%. Revenue growth has/will slowdown a bit. Yes, milk products have gone up and may go up further hurting margins a bit more etc. Big deal…the questions you should be asking yourself is;
1) Has Pepsi (McDonald's) delivered a knock out - no!
2) Can Pepsi (McDonald's) with all their might deliver a knock-out over the next year or so - no!
3) Will Pepsi (McDonald's) by introducing a 'me too' product take away business and if so how much, or will they just end up adding customers to the overall segment, growing the business primarily for themselves however there will be growth fallout for the competitors as well?

The answer to this is just look at what happened to all the stand alone coffee shops with the advent of SBUX. They are all doing better today in comparison with the timeframe prior to the SBUX phenomena.

When the cola wars erupted in the U.S., this was when the market had reached saturation. First, we are nowhere near saturation. Second, on a global basis the untapped source for coffee addiction is still in its infancy. Today, more British drink coffee than tea but this is still not the case in Asia. In other words we are still years away from an all out coffee war and SBUX is poised to be one of the goliaths that will partake in this endeavor when the time comes. McDonald's is now positioning itself to be a player when the war starts, but still has a long way to go both in the U.S. and overseas to match SBUX revenue in coffee.

SBUX is growing the business for itself and as always there has been fallout for competitors. Had it not been for SBUX, MCD would not be as successful in premium coffees. This is a two way street and it takes a lot of time for any one player to declare victory.

The 17% Growth Rate

Mark Bashan's revenue growth analysis to put it simply is straightforward. Take 15,000 stores; add 2,400 and you get 16%. (2400 divided by 15,000 = 16%). Take the worst quarter possible where same store total 'unit' sales growth (not total revenue growth which was higher) was only 1% and you get 17%! For overseas, add in exchange rate differences, improving economy of scale and in some countries throw in vertical integration and you get at least another 4% on those outlets. Also, overseas you are starting with a lower margin basis (as you mentioned) and improving traffic conditions. This works as a positive for year over year growth comparisons. Now remember that 2,400 stores are below the anticipated 2,500 so there is plenty of room for any error! The analysis is based on worse case scenario, not best! Still have your socks on?

What If?

What happens if SBUX doesn't use the 100 store reserve and FY2008 growth is back up to 22%? Then the S&P $34 target price doesn't look high at all. I say that they will use some or all of the reserve and still grow at 17%, hence the $29 target price. Also the S&P analysis assumes that there will not be any price increases in FY2008. This may be true in the U.S. but may not be the case in other countries where the local currency doesn't appreciate sufficiently against the dollar. Where it does appreciate sufficiently, this constitutes a price increase on its own.

I said 'only one paragraph' so I won't go on but you should know that it gets better as you look deeper into the overseas growth story. Essentially SBUX is grabbing prime store locations in every major population center on earth. They are focused on expanding at an achievable rate of 2,500 to 3,000 locations per year. In order to do so, many will have to be lower margin franchises at first and there is nothing wrong with this approach. KO did exactly the same at this stage of its global expansion; franchises make sense. As in the case of KO, when the time is right, some local franchises that meet specific metrics will be bought out. The franchise owners are counting on this as well. Everyone in this game knows the rules. Besides, if you didn't notice, MCD has a higher franchise percentage than SBUX, but that is about to even out over the next few years.