Starbucks: Good Short Term, Great Long Term

|
About: Starbucks Corporation (SBUX)
by: Gavin Fourie
Summary

Short-term: Analysts are demanding margin expansion and an increase in traffic from management. The emergence of some competition in China isn't helping.

To meet these demands, management will have to juggle many moving parts and align them just right in order to deliver. It's a daunting and unreasonable task.

Long-term: Starbucks is a great company and they might have quite a bit of underlying strength that will pay off for investors in the future.

The short-term play

I think Starbucks (SBUX) is a great company, with numerous competitive advantages and a well put-together management team. It has all the attributes of a successful company as reflected in the chart above. Over the past five years, shares have risen ~150%. But based on recent comments from management, expectations from analysts and competitive factors, I'm not interested in a position in the short term. On a longer timeline, things get a lot more interesting.

My short-term skepticism started in Q4 of FY18, when an analyst from Morgan Stanley said: "FY19 is seen as a "transitional" year with a heavy focus from investors on margins and traffic." To me, this means that in order for shares, which generally act very responsively to analyst recommendations, to continue trending upwards, analysts will have to maintain their current ratings. These ratings, in turn, will only be maintained if analysts see margin expansion and/or traffic growth.

Margin expansion

The first thing analysts want to see is margin expansion. How can that be achieved? Well, management have given us a few clues. Most notably, during the Q4 earnings call, management stated that in order to see margin expansion in the US, the company would need 3% comp growth with at least some transaction growth within.

The investor day transcript from last December also gave us some insights. Patrick Gismer, CFO, told investors: "So we do expect sales leverage from that range of 3% to 4% but we need something closer to 4% to see a sustained margin expansion from sales leverage as against some of the offsetting pressures." According to this, as long as comp sales increase by at least 4%, irrespective of what is driving it, we can expect margin expansion.

This leaves us with two different methods of driving margin expansion in the US, irrespective of dilutive factors such as wages, product mix and strategic investments. Those methods are:

  1. Grow comp sales 3% with some transaction comp growth, or;
  2. Grow comp sales at least 4% consistently.

So far, the company is delivering on #2 in the US, evident by the table below:

q2_comps

Source: Starbucks Q2 FY19 10-Q Filing

Since the US is the company's largest segment and accounted for ~70% of revenue in the most recent quarter, I feel confident in applying the same formula for margin expansion to the consolidated results. Unfortunately, this is where the image gets a little gloom. In the most recent quarter, comp sales was only up 3% while comp transactions remained flat. Which means that the company hasn't met either of the two criteria necessary for margin expansion on a consolidated basis.

In China, the company's second largest and also target market, the picture is even more gloom. Same-store comps have fallen massively over the past few quarters.

china_sales_comps

Source: Starbucks and CNBC

If management are unable to get comp sales back up over the next 2 quarters, the full-year comps might not meet analysts' expectations. That might equate to target price cuts or even slight downgrades.

We know for a fact that management can't rely on the comp sales growth of 3% with some transaction comp growth criteria to boost margins. Roz Brewer mentioned the company's struggle to get transactions up during the Q4 call, saying: "Yet we realize there's still much work ahead, particularly as it relates to reversing our negative transaction trend."

This means that all management are left with is the second option of keeping comp sales at 4% or above. For this, the company is relying solely on average ticket increases.

That's not too discouraging as the company has a lot of methods of growing the average ticket. For example, we know, according to the Q1 call, that the average ticket through deliveries is a bit higher than in core stores and that the mix is more beverage led, which is of course higher margin for Starbucks. On top of that, management are seeing similar trends in China, during the 2018 Investor Day, it was revealed that deliveries tend to have a larger ticket than the average spending in-store.

With delivery capabilities being rolled out to 1 600 stores across US and 2 100 stores across China, it might make that objective easier to meet. Still I remain skeptical. The company was barely meeting one of the criteria, but during the most recent quarter hasn't met either of them. This is very discouraging.

Increasing traffic

The second thing analysts are expecting is an increase in traffic in stores. This is more than likely related to the estimated $27B in spending that's available to fast-food restaurants and coffee chains from the 5.4B people visiting between 2pm and 4pm each year.

The company have mentioned numerous times that getting more customers through its doors remains the primary challenge. Including, when they announced last November, that they would be laying off 5% of the global corporate workforce to become more nimble.

Unfortunately, especially in the US where this is important, traffic has been flat to negative over the past couple of years. While the company haven't cited any specific reason, analysts have concluded that it could be due to either competition or even cannibalization from the high amount of net new stores opened. Specifically along the West Coast, where the footprint is very dense, as evident in the picture below.

dense_locations_sbux Source: Starbucks

Increasing traffic is something I don't expect to see happening soon for Starbucks, simply due to the fact that it's an industry-wide problem. According to a TDn2K report released last November, the whole restaurant industry is relying on higher average spending to fuel growth as traffic continues declining. I feel Starbucks can't do much on this front currently and, therefore, I definitely do not see them giving analysts what they want on this objective.

Competition

Also, during the Investor Day in December, Kevin Johnson told analysts and investors: "In China, there are many more start-ups and a much more fragmented landscape of competition, and we expect to see that as well."

While competition doesn't have a big effect effect on Starbucks right now, with their strong business model and first-mover advantage, it is an unnecessary drag. The concerning part is that it directly affects both of the analyst expectations. It's diluting the already poor traffic figures and could also make getting comp sales up difficult, hitting Starbucks where it hurts.

One example would be Luckin Coffee. I've read numerous comments on this very site of readers and contributors talking the company down. I agree with them, to an extent. Luckin, with their 'booth' like stores are unlikely to compete directly with Starbucks. The fact remains that it will redirect some of the traffic away from Starbucks stores in China.

The primary reason for this shift will come from the lower middle class whom are more interested in price than taste or atmosphere. Of course Luckin will get these customers as it serves much cheaper coffee, often by taking a loss on each cup.

On the contrary, many analysts and even SA contributors will say that Luckin isn't close to being a threat. That's because the overall market is growing fast enough to support the rapid expansion of many competitors. Coffee consumption in China per capita is severely behind that observed in South Korea, Taiwan and Hong Kong. In fact, the Chinese coffee market is expected to grow 45% by 2022.

china_coffee_market_growth Source: Starbucks

Increased consumption doesn't necessarily translate into higher traffic though and that remains to be seen in my opinion.

In the US the picture is a bit darker. There are no emerging trends of competition, because they are already present! Dunkin Donuts, McDonald's and so many others. Starbucks face so many other competitors in their largest market everyday, that I believe increasing their traffic numbers is going to be increasingly difficult if they aren't even positive for the industry overall.

The long-term play

Starbucks is building a name for themselves quickly in China. Although they've been in the country for decades, the company is still growing their footprint rapidly. Over the past 12 months, they have opened 553 net new stores representing a 17% annual growth rate in China alone.

That number coming in just shy of their goal for 600 net new stores annually in order to reach 6 000 stores by fiscal '22. Keep in mind that these numbers are China only. On a consolidated basis, the company opened more than 800 stores globally over the past 2 quarters, bringing their grand total to 30 184 stores.

store_opening_data

Source: Starbucks

Readers not familiar with the company might be wondering why they are opening such an excessive amount of stores throughout China. There is one primary reason for this. China is the company's fastest-growing market as a company-operated market.

Furthermore, in Q1, it was mentioned that store growth underpins ~80% of the company's growth algorithm in China. The company is using new store expansion to fuel its impressive revenue growth numbers in the region. It's also a bit of a defensive play to get ahead of competition and maintain that first-mover advantage in China.

Cannibalizing volume and 0% transaction comp

As evident in the photo above, the same basically holds true for all regions except EMEA, which is of course mainly licensed stores. In the US, for example, we saw 83 net new stores being opened across the past 2 quarters. The problem, and opportunity, with that statement is that the company isn't relying on store expansion to drive growth in the US. Their footprint is already large and comps performance isn't too bad. Still they are building out their footprint at the same to a slightly faster pace as compared to fiscal '18.

These new stores are more than likely cannibalizing volume from existing stores. On its own, that sentence might not seem noteworthy. I can assure you that it is. In the image above titled "U.S. Growth Opportunity", investors can see that Starbucks stores are extremely concentrated along the West Coast. There is a very small population per store.

This is where the most promising aspect of Starbucks becomes evident. Which is that even though there are numerous net new stores being opened quarterly, transaction comps are holding steady. Yes, they aren't growing, I will admit. But the important thing is that they aren't declining either! This means that if we take the cannibalization into account, comp transactions could have actually been growing. What's keeping growth at bay is all the new stores being added to the comp base as the company expands.

So, as soon as net new store openings start to slow, investors will more than likely see transaction comps slightly improve. This will show the underlying strength held by Starbucks that will keep their momentum going and contribute to the company's long-term sustainability.

For now, investors have to be happy with beverage innovation and deliveries driving bigger tickets which, in turn, will drive comp sales. But, later on, we might see transaction comps once again making a bit of a contribution.

Conclusion

Analysts are expecting a lot of the management team at Starbucks in fiscal '19. While I have full faith in the company and the management team, I don't believe that the company will exceed or even match the full-year expectations. Margin expansion, for example, simply has too many moving parts at play that aren't currently on management's side. Traffic, also isn't going to improve.

These 'let downs' will drive some analysts to revise price targets or even, more severely, downgrade their ratings. I expect the overall market to follow their lead. This will knock shares lower and make the company trade at very attractive prices.

This needn't be the case as the company still has a lot of its potential and a very attractive business model. Long-term I think that Starbucks is a buy, but I will wait for better prices before opening a position.

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.