The Flywheel Approach For Starbucks

| About: Starbucks Corporation (SBUX)

Flywheel (noun): A heavy revolving wheel in a machine that is used to increase the machine's momentum and thereby provide greater stability or a reserve of available power during interruptions in the delivery of power to the machine

While many may find it odd that a word normally reserved for industrial machines or automobiles be associated with the world's largest coffee company, CEO Howard Shultz mentioned it half a dozen times during the fiscal third quarter earnings call. However, when you look at what Starbucks (NASDAQ:SBUX) has become over the past few years following a wave of acquisitions and growth spurts, the word "flywheel" appears to be finely suited to this "coffee shop". Circle back and read that definition of a flywheel again. It is the perfect word to describe how the company is operating. With diversification away from simply caffeinated drinks, the massive wheel of Starbucks' is grabbing consumers looking for food, grocery items, tea, and smoothies.

This flywheel effect isn't just a result of selling more tangible items. Although selling physical goods is what ultimately drives revenue, what entices people to purchase those goods is a significant part of what keeps the flywheel spinning. The company spends vast sums of money and time investing in marketing, mainly through digital media and other innovative techniques. This drives consumers back into stores and explains the company's ability to continually exhibit strong same-store sales growth. A perfect example of how the flywheel at Starbucks' is able to reserve power during interruptions, was witnessed in the EMEA region (comprised mainly of Europe). For the first time in five quarters, the company posted positive same store sales in this region. Despite the slowdown in Europe over the past few years, the flywheel of Starbucks' kept spinning out record revenues. As further international expansion gears up, the successful growth story of North America will be implemented in foreign markets, keeping that flywheel spinning for shareholders.

Superior Loyalty

As Starbucks keeps expanding, the flywheel will need to provide a greater continuation of power. One way to keep that flywheel spinning is to focus on loyalty. Starbucks' has one of the strongest measurable loyalty programs of any company across the globe. The company updates us on various loyalty metrics each quarter and by simply tracking the flow of reload activity onto Starbuck's cards (essentially a re-loadable gift card) we can gauge repeat customers. Nearly 30% of all U.S. transactions are done with a Starbuck's card. 25% of all U.S. transactions are done through "loyalty", Starbucks' cards or smartphones which have been reloaded. The term "reload" refers to people receiving a gift card, and then physically going online to add more money for future use. In the chart below you can see the dollar value of reload transactions during each quarter. Just eight years ago reload activity was under $100 million per quarter, but has since ballooned and reached a record $681 million during FQ3. The number of people reloading their cards has grown substantially as well. During 2006 only 3 million people choose to add more funds, and during the most recent quarter that number grew 10x to 30.7 million.

(Click to enlarge)

Source: Starbuck's Investor Relations Website

Keep in mind that revenue is not booked from reloads until the customer actually utilizes the card in a store. This reload activity creates a "backlog" of deferred revenue for Starbucks. Typically we track order backlog for industrial companies to see what future demand may look like. It seems rather odd to look at Starbuck's with the same metrics as an industrial company, but consumers are essentially pre-paying for their coffee consumption and electing Starbucks as their preferred vendor. In the chart below I have divided the quarterly dollar value of reloads by quarterly revenue. As of the most recent quarter reload activity was just over 18% of revenue. This is substantial growth over the same period a few years prior. If this trend continues, we are likely to see Starbucks create a sustainable and predictable revenue stream.

(Click to enlarge)

Source: Starbucks' Investor Relations Website and SEC Filings

When you consider the fact that the loyalty program is only well established in North America, your mind has to wonder if these results are achievable in other foreign markets. If the company is able to implement the same marketing techniques and customer loyalty abroad, long term shareholders have the potential for tremendous returns. One of the most promising markets, China, is on track to have its 1,000th store opened by the end of this year. Management is projecting China to become the largest market outside the United States by 2014. As the flywheel continues to spin and the growth engine increase in size, earning are likely to expand.

Estimates for the Future

Starbucks' fiscal year ends on September 30th, and during the latest earnings call management provided updated guidance for the final quarter of FY13 in addition to full FY14 estimates. It appears the company is on track for another record year of top and bottom line performance, followed by a repeat performance in 2014. Given the impressive flywheel strategy thus far, I have updated my estimates for FY13 and FY14. Below are some relevant points which I factor into my estimates.

  • Given management's estimates for FQ4 growth, I have increased my full year revenue estimates from 12.25% to 13%. FY14 revenue estimates from management fall between 10%-13%, right in line with my estimate of 12%. Management is projecting similar same store sales growth as we witnessed in the first half of FY13.
  • Gross margin expansion as a result of lower coffee bean prices through the current and upcoming fiscal year. Management has confirmed that 80% of all green coffee bean purchases for FY14 have been locked in. (see chart below for coffee prices)
  • Management is projecting operating margin expansion of 100bps in Q4. For the full fiscal year '14 management is projecting operating margin expansion of 150-200 bps, my estimates are at the low end of this range, 166bps.
  • Management projections for earnings per share during FY13 is $2.22-$2.23, slightly above my estimate of $2.21. For FY14 management is projecting $2.55-$2.65, given the track record of management consistently outperforming their projections, I am estimating EPS at the high end, $2.65.

Please note that the estimates below are not guaranteeing any of the results will be met. These estimates are strictly based upon management's guidance, the company's SEC filings, press releases, and historical data. (CS=Common size, % of revenue)

(Click to enlarge)

Source: Starbucks' SEC Filings, Starbucks' Management Guidance, and my estimates based upon historical data and future expectations. Estimates given above are no guarantee of future results, please evaluate the company in greater detail before making investment decisions.

(Click to enlarge)

Source: CME Group

Closing Remarks

With shares of Starbucks trading at elevated price multiples (see charts below), investors may be hesitant to enter into positions at these elevated levels. Additionally in my last article I highlighted a pending lawsuit with Kraft (KRFT), which is anticipated to be resolved by the end of this year. Management did not spend much time speaking about the expected results of this lawsuit and the recently filed 10-Q had no material changes to the company's estimates regarding the outcome. I would still caution investors to review the results of this lawsuit before initiating a position in SBUX, although Kraft's claims of $2.9 billion may not fully materialize, I would be extremely surprised if Starbucks' walked away not paying a cent. Any negative results could cause selling in the stock and create favorable entry points for long term investors.

SBUX PE Ratio TTM Chart
(Click to enlarge)

SBUX PE Ratio TTM data by YCharts

SBUX Price / Sales Ratio TTM Chart
(Click to enlarge)

SBUX Price / Sales Ratio TTM data by YCharts

There are so many facets to this $55 billion company, it is challenging to touch on each of them in one article. The most important takeaway I would urge investors to consider is the flywheel which Starbucks is utilizing, think of it as the infrastructure which is being put in place not only to bring the benefits of North American growth elsewhere, but also to provide support if specific regions/segments begin to slow down. Given that we can find a Starbucks on every major corner in America, it sounds crazy to say we are in 4th-5th inning of this company's growth story. But with another 1,400 new stores expected to be built in FY14 and a rapidly growing consumer products group (K-cups and grocery store items), there is still plenty of real estate for this coffee company to occupy.

Consider your investment goals and objectives before initiating a position in Starbuck's and please remember that the value of investments in equity securities, like SBUX, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy.

Note: All data reported and graphed is pulled directly from Starbucks' SEC Filings and Press Releases.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Tagged: , , , Specialty Eateries
Problem with this article? Please tell us. Disagree with this article? .