Starbucks: Remains A Great Opportunity Despite Analyst Downgrades

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

For the first time in quite a while Starbucks has reported growth in comp traffic on a consolidated basis.

Shares traded down briefly after earnings due to numerous downgrades from analysts citing unsustainability in the numbers and overvaluation of the shares.

While I will not comment on the valuation, I do believe that the comp growth and margin expansion is sustainable through multiple methods developed by management.

Investment Thesis

Starbucks delivered on the comp growth and margin expansion objectives in their key markets. It's exactly what analysts were looking for, but after reporting these impressive numbers, the stock has received numerous downgrades. Analysts believe that the comps and margin expansion are unsustainable and that the shares have become overvalued. I argue that these numbers are sustainable and believe that Starbucks remains a buy in the long-term.

The Numbers And Where They Came From

During the Q3 FY19 earnings call, management were happy to report that comps were up by ~6%. Included in this was 3% comp traffic growth, which is very impressive considering that in Q1 and Q2, transactions growth was flat leaving sales comps to be predominately driven by higher average ticket growth.

Breaking this down into areas, the US saw transaction comp growth of 3% compared to flat growth for the past two quarters. This growth was helped by weaker performance in Q3 of last year, which is important to note in relation to sustainability suspicions. In China, we saw transaction comp of 2% compared to flat growth for the past two quarters.

I believe that the company achieved this transaction comp growth by way of three levers, both in-store and out, which are under complete control by management:

  1. The delivery business,
  2. The company's digital platform, and;
  3. Events

1) Starbucks Delivers

The delivery service is now available in the US from 2700 stores across 11 markets via the partnership with Uber (NYSE:UBER) Eats, with plans of going nationwide in 2020. In China, it's available from 2900 stores across nearly 80 cities.

We know, from previous calls and analyst days, that delivery often has higher average tickets than in-store and that the mix is predominantly beverage led. Obviously this is positive for sales comps, but does nothing particularly for transactions. Interestingly however, during the Q3 earnings call, we heard that delivery in China is presenting a few different trends. In fact, Starbucks was actually seeing delivery bring in an incremental transaction lift. More strange was the fact that orders have a higher food attach, particularly in the morning and lunch daypart.

This is in stark contrast from what we saw at the very beginning, when the program was rolled out to much fewer cities. Management cited the program's advantages as being higher margin, particularly as it was observed as being beverage-led (higher margin than food). A reason for this could be that the 'pilot' program was held in the US, which has different consumer trends and tastes. Nonetheless, we know that delivery did contribute to transaction comps in China, so more on Starbucks Delivers later on.

2) The Digital Platform

During Q3, management let investors know that digital was creating relationships with customers that have resulted in: More frequent occasions, increased spend, improved retention and marketing efficiency.

The company's loyalty program might only have a couple million members, but in the US these members accounted for ~42% of tender. Seeing this figure impressed me quite a bit and shows just how strange the loyalty of customers can affect results. In China, the number of active rewards members rose to 9.1 million.

During Q3, digital efforts contributed ~2 points of comp. Unfortunately, management haven't broken this down further to let us know exactly how much of it came from increased average tickets and how much from transactions. It does show us however, that this loyalty program is becoming increasingly valuable to the company as a method of driving value to both customers and shareholders.

3) Events

Starbucks is primarily a coffee chain, even though they offer foods, this is what they will always be viewed as. In recent years, as the company has come under pressure to maintain, or even boost growth rates, this has become one of their primary problems.

They operate much like a restaurant, they are open the entire day and not just in the morning daypart when you stop there for your daily coffee fix. We know that the company has mornings under lock and key, as it has become ritualistic for consumers to get their daily dose of coffee each morning at their local Starbucks.

The problem is that consumers don't return afterwards, leaving the highly valuable afternoon daypart free for the taking. Management have implemented various strategies to combat this, including freeing up time for employees to interact with customers by streamlining their tasks. While this will undoubtedly contribute, it's not going to miraculously increase traffic. No, for that Starbucks uses events.

Research from placer.ai has shown that Starbucks are artificially creating sales boosts through hosting events such as: Reusable Cup Day and December Happy Hour. The numbers show that this strategy is definitely working. As an example, the December Happy hour event alone, drove an 8.1% increase in traffic compared to the same Saturday and Sunday a year before.

All Three Together Is The Key

What's important to note is that while these three are powerful on their own, they are most advantageous when combined with each other. It's the combination of the three that I believe contributed to the amazing comps that Starbucks have reported in Q3.

The Fuss About Margin

Why are these comps important anyway? In my previous article, titled: "Starbucks: Good Short Term, Great Long Term", I mentioned that analysts from Morgan Stanley were demanding margin expansion and an increase in traffic from Starbucks (SBUX). They cited that FY19 is seen as a "transitional" year for the company, one in which investors have a heavy focus on margins and traffic.

In response to that statement I said:

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.

The thing is that these two often go hand in hand. Meaning that higher comps with some transaction comp growth will result in margin expansion. More specifically, also mentioned in my previous article, to drive margin expansion we heard that Starbucks needed either:

  1. Growth in comp sales of 3% with at least some transaction comp growth, or;
  2. Growth in comp sales of at least 4%

Q3 numbers show that the company delivered the required comps for margin expansion and then some.

So why did margins contract during the third quarter?

That's the thing: on a consolidated basis, margins did contract, but it was by a mere 10 basis points, literally 0.1% YoY to 16.4%. Important to note is that this was inclusive of restructuring and impairment charges, primarily due to employee investments in the US, licensing of CPG and foodservices business to Nestle (OTCPK:NSRGY), product mix and higher inventory reserves. It was offset, at least partially, by sales leverage, cost savings initiatives and the adoption of new revenue recognition accounting for stored value card breakage.

Breaking the margins down by region, we see even more positive news. That being that in both key regions, the Americas and CAP, the operating margin actually increased YoY.

We found the following in the company's most recent 10-Q filing:

In the Americas,

  • Cost of sales including occupancy costs as a percentage of total net revenues decreased 80 basis points.

  • Store operating expenses as a percentage of total net revenues increased 30 basis points.

  • Other operating expenses increased $5 million.

  • General and administrative expenses decreased $26 million.

  • Restructuring and impairment expenses decreased $3 million.

The combination of these changes resulted in an overall increase in operating margin of 130 basis points.

In the second largest region for Starbucks, China/Asia Pacific,

  • Cost of sales including occupancy costs as a percentage of total net revenues decreased 10 basis points.

  • Store operating expenses as a percentage of total net revenues increased 80 basis points for the third quarter of fiscal 2019 . As a percentage of company-operated store revenues, store operating expenses increased 100 basis points.

  • Depreciation and amortization expenses as a percentage of total net revenues decreased 90 basis points.

  • Income from equity investees increased $4 million.

The combination of these changes resulted in an overall increase in operating margin of 120 basis points for the third quarter of fiscal 2019 .

The problem, which forced consolidated operating margins lower, was the EMEA segment:

  • Cost of sales including occupancy costs as a percentage of total net revenues increased 80 basis points for the third quarter of fiscal 2019.

  • Store operating expenses as a percentage of total net revenues decreased 540 basis points for the third quarter of fiscal 2019 . As a percentage of company-operated store revenues, store operating expenses decreased 400 basis points.

  • Depreciation and amortization expenses as a percentage of total net revenues decreased 80 basis points.

  • Restructuring and impairment expenses increased $17 million.

The combination of these changes resulted in an overall decrease in operating margin of 400 basis points for the third quarter of fiscal 2019.

Verdict

From what we observe above, it can be stated that there would've been at least some margin expansion if it wasn't for the EMEA segment. Which, by the way, is an area that is undergoing significant restructuring. Including the shifting of stores in the region to licensed models, such as in the Netherlands and France during Q2 and, also, the closure of multiple company-operated stores.

We can therefore assume that methods being used to drive the comp sales and traffic growth are working as expected and will more than likely lead to margin expansion in the near future.

What Analysts Think

BAML's analyst team said:

We raise our price objective to $103 (from $100), or 31x CY’20 P/E. This is a step-up from our prior 30x to reflect better than expected comps. SBUX has historically traded in an 18x-31x forward P/E multiple range and we expect the stock to trade towards the higher end of this range.

The J.P. Morgan team however, said:

Valuation has become beyond a stretch. Plus, being very late cycle often means continued rising labor costs matched with difficulties of generating sustained increases in same-store traffic.

So, obviously a bit of mixed signals from analysts. On the one hand we have BAML maintaining ratings and boosting their target price. On the other hand we have JPM downgrading the stock citing difficulties related to sustainable traffic growth.

Why The Comp Growth And Subsequent Margin Expansion Are Sustainable

There are three main reasons why the numbers are sustainable. It's the three levers mentioned above.

Let's go through each:

1. The sustainability of the first lever, Starbucks Delivers, is very much intact, considering that it isn't even available from all the existing stores across China. That's not even taking into account the new stores that the company are planning. Of course, the more stores that delivery is available from, the better it will be from a comps perspective.

2. The second lever, which is the digital platform, is also believed to be extremely sustainable. The company is adding members to their loyalty program every quarter. This growth is translating into those increased store visits mentioned earlier. It's especially valuable when considering how much of the tender is derived from these members.

3. The underlying strength of the third lever, events, is that the company can use them, potentially in combination with their digital platforms, to increase traffic, and therefore sales, in quiet periods such as the afternoon daypart. This is a big opportunity as, according the the latest estimates I've seen, the afternoon daypart makes up just 23% of Starbucks' traffic compared to 59% in the morning. It's also potentially the most sustainable of the three as the company can utilize anywhere that they identify a quiet period and this can be done at virtually any time.

By utilizing these three levers collectively, I believe that we could see the company move into a trend of sustainable positive comps growth and subsequent margin expansion for the short to medium term.

In Conclusion

We can assume that the levers mentioned above that are utilized by management to grow comps and traffic are sufficient to drive margin expansion based what we've seen in the company's key regions.

Due to the three levers mentioned being completely at the disposal of management, we can also assume that they are a sustainable way of growing the comps and traffic, and therefore expanding margins. The events, for example, can increase traffic in traditionally quiet periods as the company identifies them. The number of loyalty memberships will continue to grow. Finally, we already know of the plans to roll out Starbucks Delivers to more locations across China.

This means that the company are meeting the objectives expected from it by analysts. It also means that they will continue meeting these expectations in the foreseeable future.

So, while valuations are becoming stretched, investors in it for the long run can take solace in the fact that the company is doing more than what is expected from it to support, and grow, current valuations to levels past where the stock is currently trading. Therefore, Starbucks remains a long-term buy.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in SBUX over 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.