Starbucks: People Are Expecting Too Much; The Big Growth Days Are Over

Summary

• The brutal truth is that Starbucks has reached a mature stature within the US market and will probably struggle to ever gain back the massive sales growth of the past.
• Sales estimates are being unrealistic regarding this issue, and in turn, shareholders are progressively being disappointed.
• Starbucks' growth seems extremely reliant on China and faces staunch competition at home.
• In what I view as the final lap in the Starbucks story, these overseas markets will be the final jolt for the stock. Without them, it seems unlikely that the company will ever live up to the earnings expectations being placed upon it.
• When you consider the current tensions between China and the United States, this overseas dependence for growth is rather concerning.

Starbucks (NASDAQ:SBUX) stock took a big slip following first quarter results that underwhelmed analyst expectations. Revenue growth wasn't what Wall Street wanted, and store traffic in the United States is rather stagnant.

It's not like this is a big shocker. Starbucks has over 14,000 locations in the United States. How much bigger can you get? There's not much room left to grow. On top of that, there's a growing sentiment in the US to support smaller establishments. Perhaps it stems from the craft beer craze, but people are definitely trending toward supporting local establishments versus corporate conglomerates.

A renewed emphasis on "craft" is pervasive throughout the market, and it's carrying over into coffee. All of the "hipsters" (no offense meant) that used to be all about sitting in Starbucks are choosing to do that at new places. They're going to places where you can say hi to the actual owner when you buy your coffee from them.

The effects of this type of shift are not without precedent. Look at Boston Beer Co. (SAM). Once the father of the craft beer revolution, Boston Beer's Samuel Adams lineup has faced mounting pressure for years from the onslaught of small startups; looking to snatch up market share in their local areas. Cowen and Co.'s analyst Andrew Charles has altered his price targets for Starbucks after finding similar trends in coffee shops. Independent/collective coffee shops are growing at more than double the rate that Starbucks is.

With small pieces of market share being taken by these small independent players, Starbucks faces a bitter conflict in the United States. So where does the future growth come from? The answer is China. Nowhere is this more prevalent than the company's first quarter (fiscal Q2) results.

Net earnings of $660.1 million mark a very lax 1.1% increase from last year. The 4.4% increase in earnings to $0.47 a share had more to do with share buybacks rather than higher net income. In fact, the company announced an additional 100 million shares that have been approved for the share repurchase program. This is likely intended to strengthen the share price, and to aid in driving earnings per share as the share count declines.

Asian expansion, tepid US growth

Asia reported a 4% increase in comparable store sales. With the addition of 29 new locations and the buyout of their franchise system in Eastern China, the Asian region reported a 54% increase in revenues to $1.186 billion, with a 16% increase in operating income of $204.6 million. That's a stark contrast to the Americas, where revenues grew 8% but operating income fell 3% to $801.3 million. Comparable store sales growth in the Americas increased 2%. A large portion of that is coming from 3% increases in average ticket (the amount someone spends on their order).

The US market is one where Starbucks is having to squeeze out sales gains. China is a market yielding large organic revenue growth. Make no mistake, Starbucks is no longer an American firm. They're an international conglomerate. The company's stock price is at the mercy of Chinese expansion. Things like the "largest Starbucks in the world" and the big untapped potential of the country are essential to the stock's performance.

In case you haven't noticed, we keep going back and forth with hostile trade sentiment against China. I'm not necessarily saying it's a bad thing. Our manufacturing base is far more vital to the country than whether or not Starbucks shareholders can keep reeking out gains from overseas expansion. But retaliatory measures from China regarding things like coffee and tech could be disastrous for companies like Starbucks.

It has happened before. Google (GOOGL) doesn't have a big presence in China due to restrictions and the countries own protective policies. I don't necessarily feel bad for Google. They're big enough already. And I won't necessarily feel bad for Starbucks. I'm 100% small business when it comes to things like coffee. I will feel bad for investors that take a hit to their positions.

My conclusive thesis on Starbucks is this. They've over matured in the United States, and homegrown competitors are starting to eat at their sales growth. They're reliant on the Asian region to spur growth for shareholders, and it's a region that the United States as a whole is not super keen on playing nice with. It's a risky setup for investors. Bear in mind we're assuming that comparable store sales for the US remain positive.

If things should slow even further, Starbucks would be even more hard pressed to counter the slowdown with growth overseas. The EMEA segment (meaning most of Europe, Middle East, and Africa) is taking losses. Fiscal Q2 had a negative operating margin of 1.6%. I personally predict Europe to be a progressive underperformer for the company. Europeans take their coffee seriously and enjoy independent shops. Their "other segments", which include things like their coffee brand, Starbucks reserve, and roasteries, as well as Teavana, delivered negative operating income from restructuring efforts. Remember that awful Teavana purchase? Yeah, that bit them in the butt. So, at the end of the day, Starbucks is currently almost wholly reliant on China for its continued growth.

Because of this, I'm taking a negative sentiment on the stock price. I do not see the point of buying more shares in a company that's only economic avenue is a nation where we're currently implementing economically repressive policies. Make no mistake, China's economy will slow without outlets for excess steel and aluminum capacity. They're also planning to pull back on their own budget in order to reduce deficit spending. This, in turn, will slow growth, even if they provide their population a tax cut. These factors could slow the economy, and therefore, consumer spending.

In summation, this is becoming a dangerous game. If one piece of the puzzle falls out of place, they'll have a problem. Forecast non-GAAP earnings have a high of $2.53. That's a tough price to earnings setup at the $60 range; as it is already trading at over 20 times the projected 2018 earnings forecast.

Analyst’s Disclosure: I/we 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.