This is a very big ship, forced to navigate a continuing turbulent, competitive consumer spending environment. Growth in sales and earnings has slowed, and we doubt that EPS growth can be re-ignited, in large part due to the law of large numbers. To some extent, SBUX has become a “cash cow”, very profitable, generating still very high returns on capital, even if the base is growing more slowly. The shareholder base is transitioning to include long term value, and dividend, oriented, investors. In fact, SBUX has been in a trading range from the mid-50s to the low 60s over the last two years, with the stock’s valuation mirroring the slowdown in earnings (and EPS) growth. The corporate initiatives described below, further described by management on their conference call, are all necessary for further progress. Collectively, they can maintain corporate progress, and even move the growth rate by a few points, but we suspect that the days of high single digit comps (in the US) and 20% or better EPS gains are in the rear view mirror. There are now a large number of operational moving parts, not all of which will proceed smoothly. Furthermore, the business model is evolving, with possible unintended consequences, as discussed in our report of 8/22/17. Earnings reports in 2018, as predicted by management, will be muddied by one time transactions, so “adjusted earnings” will be a feature of their reports. Analysts and investors may not care much, if the current forgiving stock market environment continues, but tolerance for lots of adjustments will not be as high if the general market runs out of steam. A revised food menu is in the works but, even if food sales increase, non-coffee margins are lower, so earnings may not “leverage”. Starbucks is a great company, and will remain so, admirable in many ways, a great brand building example. The Company is one thing, the stock another. Investors can, and will, decide for themselves, what valuation is appropriate.
COMPANY OVERVIEW (2017 10-K):
Starbucks is the premier roaster, marketer and retailer of specialty coffee in the world, operating and licensing over 27,339 locations in 75 countries. They employ over 300,000 employees generating $22,386 billion in sales.
In addition to selling products under the flagship Starbucks Coffee brand, they sell goods and services under the following brands: Teavana, Tazo, Seattle’s Best Coffee, Evolution Fresh, La Boulange, Ethos and Princi (an Italian bakery concept recently added to their portfolio).
Starbucks purchases and roasts high quality coffees that they sell along with hand crafted coffees, teas and other beverages, and a variety of high quality food items including snack offerings through company owned stores. Starbucks also sells a variety of coffee and tea products and license their trademarks through other channels such as licensed stores, grocery and food service accounts.
Starbucks is considered the main representative of “second move coffee”, initially distinguishing itself from other coffees – serving venues in the U.S. by taste, quality and customer experiences while popularizing darkly roasted coffee.
The first Starbucks opened in Seattle, WA March 1971. Originally the company only sold whole coffee beans and did not brew to sell. In 1987 the original owners sold Starbucks chain to Howard Schultz. It was under Mr. Schultz’s leadership the company developed into today’s concept.
SOURCES OF REVENUE (2017 10-K):
The company operations are organized into four principle segments.
- Americas which is inclusive of the U.S., Canada and Latin America;
- China / Asia Pacific (CAP);
- Europe, Middle East and Africa (EMEA); and
- Channel Development which functions primarily as a wholesaler of branded Consumer Packaged Goods (CPG). Such products as single-serve Starbucks Coffee K-Cups, ready to drink bottled coffee, etc. to grocers, warehouse clubs, specialty retailers, convenience stores and U.S. food accounts. The remaining operations are grouped together under the heading – all other segments which include the retail operations of their smaller brands: Teavana, Seattle’s Best Coffee, Evolution Fresh, Reserve Roastery Tasting Rooms.
*UNIT LEVEL ECONOMICS:
Starbucks utilizes a wide variety of sites, types and sizes to meet its market penetration objectives. Depending on urban vs. suburban location, types and sizes include traditional and nontraditional mall locations, inside big box retailers, college campuses, hospitals, airports, hotels, resorts, etc. A typical Starbucks free standing unit ranges from 1900-2100 square feet.
Starbucks does not franchise; however, it does grant licenses to operate a Starbucks under certain restrictions to select retail or hospitality operators – such as Marriott hotels, Target Retail Stores and airports to name a few. Average costs to open a license location is $315,000.
One of Starbucks essential attributes is its Return On Investment Capital (ROIC) at the store level performance. See table which reflects unit level economics as disclosed by the company for 3 of its principal markets at its 2016 analyst day in December 2016. While the performance of all stores in each country are industry leading, the returns of the stores opened in FY16 are especially impressive as they are even more profitable than their country-wide averages though they have lower or the same AUV’s. It is also notable that in the 2 years since the last investor day, year 1unit level EBITDA margins and cash ROI’s were up 1400 bps and 3300 bps, respectively, in the U.S. and up 900 bps and 1100 bps, respectively in China. In Japan year 1 metrics were down in the two-year period (EBITDA% -200 bps, ROI% – 1700 bps), likely transitional effects resulting from the buyout of the company’s JV partner in Japan. Still, though the Japanese metrics compare unfavorably with their counterparts in the U.S. and China, their unit level economics surpass most peers.
An equally important attribute of the company’s performance (but less quantifiable) is the culture instilled throughout the organization by Howard Schultz.
- Employees are partners
- Commitment to the environment
- Provide great work environment
- Create a third place
- Never compromise the quality of the coffee
- Complete guest experience: focus on details, people oriented, team gratification, aggressiveness and stability.
Mr. Schultz handed off leadership to Kevin Johnson in April 2017. This is the second time he will have stepped away. The first time (he remained non-executive chairman) it is worth remembering how the “romance and theater” of coffee preparation and service was lost in pursuit of speeding service and increasing efficiency. This led to “watering down the Starbucks experience” and “commoditizing the brand” per the diagnosis of SBUX’s underperformance sent to top management by Howard Schultz in February 2007. It is also worth remembering that the turn around and the renewed growth and margin expansion noted above dates from his return to the CEO role a year later in 2008 with the initiatives summarized in this letter. Clearly, Mr. Schultz has put a great deal of effort in selecting and grooming Kevin Johnson, his new successor, so relinquishing his executive role will hopefully be more successful this time. Mr. Schultz will remain as non-executive chairman and will supervise the development of the Roastery and Reserve concepts. Mr. Johnson first came to SBUX as a board member in 2009 when he was a top executive with Microsoft and later with Jupiter Networks. Mr. Schultz convinced him to join management in 2015 where he became steeped in the operations and led the development of the digital flywheel which Mr. Schultz determined several years ago would be instrumental in the next phase of SBUX’s corporate life.
LONG-TERM BUSINESS STRATEGIES (Biennial Investor Conference 12/7/16):
- Transforming the Premium Coffee Experience
Since opening two years ago, the Starbucks Reserve® Roastery in Seattle has become recognized as the most dynamic and immersive coffee forward retail experience in the world, delivering an unprecedented level of premiumization to the coffee category and fueling the next wave of transformation that is elevating the Starbucks Experience globally.
Each Roastery will serve as the foundation for Starbucks Reserve® stores – a new retail format that will integrate the theatre and romance of the Roastery with the unique culinary experience of the company’s new Italian food partner, Princi.
- Premiumization Strategy to Drive Innovative New Customer Experiences
Starbucks Reserve® Roasteries will serve as an innovation pipeline that will elevate the brand and contribute a “halo” to the entire Starbucks Experience. This includes new product breakthroughs that will contribute to the growth of the company’s ecosystem, segmented strategically across all Starbucks® stores.
Starbucks is simultaneously innovating and expanding its food menu with products customers have been looking for convenient breakfast; the spring launch of a Certified Gluten-Free Breakfast Sandwich; the expansion of the successful Bistro Box platform; as well as a regional rollout of delicious organic soups. Relevant innovation has become fundamental to unlocking the lunch daypart and building on existing breakfast daypart momentum, giving the company the ability to realize additional profitability and incremental sales.
- Extending the Digital Flywheel
Starbucks offers the largest and most robust mobile ecosystem of any retailer in the world, with more than 12 million Starbucks Rewards™ members (up 18 percent year on year). Today, Starbucks will unveil an innovative conversational ordering system, My Starbucks® Barista, powered by groundbreaking Artificial Intelligence (AI) for the Starbucks® Mobile App.
Starbucks digital flywheel has also continued to gain momentum with the launch of true one-to-one personalization. While still early in the evolution of this service, Starbucks hyper-personalized email reward offerings – with more than 400,000 variations – have more than doubled customer response rates over previous segmented email campaigns, translating into increased customer engagement and, importantly, accelerated spend. Starbucks has delivered personalized offers to customers directly on the front screen of the mobile app. By early 2017.
- Unlocking High-Value Opportunities in China
Customers in China have continued to embrace the Starbucks brand, with some of the company’s most innovative, efficient and profitable stores producing record revenue and strong same-store sales growth in FY16. Starbucks newest class of stores in China are delivering the highest AUVs, ROI and profitability of any store class in the company’s 17-year history in the market. Starbucks now operates approximately 2,500 stores in 118 cities in China and employs more than 30,000 partners (employees), opening over a store a day – a growth rate that will continue to accelerate well into the future.
- Expanding Global Leadership Position in At-Home Coffee and Ready-to-Drink
Over the next five years, Starbucks expects its Channel Development segment, which includes its Consumer Packaged Goods (CPG) portfolio, Branded Solutions (licensed stores and foodservice), and Ready-to-Drink (RTD) segments, will generate an incremental $1 billion in revenue, grow operating income by 75 percent, and double its RTD business outside of the U.S. The company is the industry leader in premium single serve, premium packaged roast and ground coffee, and Ready-to-Drink products, and is well positioned to grow its share of these markets both in the U.S. and globally. The company’s more than 20-year partnership with PepsiCo to create the North America Coffee Partnership (NACP) is a more than $2 billion business and has approximately 97 percent share of the RTD coffee category. The NACP continues to bring to the market highly relevant, new and innovative coffee and energy products to meet the needs of customers looking for premium, on-the-go coffee offerings.
- Creating Long-Term Opportunities for Partners
From being among the first to offer comprehensive health benefits and equity in the form of stock for partners who work 20 hours or more a week, to providing them with the opportunity for full tuition reimbursement for a bachelor’s degree from Arizona State University through the innovative Starbucks College Achievement Plan, Starbucks has continued to invest in and innovate around the partner experience while balancing the needs of its customers, shareholders and the marketplace. Starbucks has now matched $78 million in 401K savings in the U.S. with a total fund balance of $1.3 billion as of FY16. The company also recently announced it will add an enhancement to the program in 2017.
Starbucks is finding that these incremental investments in both wages and benefits have helped support and elevate its partners, attract and retain the best talent, provide measured improvement in service to customers and deliver outsized returns to shareholders.
Starbucks has returned $10 billion of cash to shareholders in the last five years, through dividends and share repurchase. $15 billion more is scheduled over the next three years, indicated to be modestly front loaded to early 2018 . The dividend was recently increased 20% to $0.30 quarterly, so the stock now yields a little over 2%. As noted above, the stock has been in a relatively narrow trading range in the last two years. It is worth noting that Starbucks also invested, in 2016, for operating “partners”, $322 million in healthcare and other benefits, $15M in the Starbucks College Achievement Plan, and $221.6 million in Bean Stock. No doubt, these benefits have been an important contributor to the Starbucks operating “culture”, the best we have ever seen for a food service company of this size.
Source = Starbucks Annual Meeting March 2017
Recent Developments, Per Q4’17 Press Release, Per Q4 Conf. Call Transcript
The fourth quarter was relatively strong, especially in terms of sales, for SBUX, especially considering the challenges within the restaurant landscape. As Indicated above, US comp sales were up 2%, with a 1% increase in traffic, excluding the impact of Hurricanes Harvey and Irma. Comp sales in China were especially impressive, up 8% with transactions up 7%.
Q4’17 had 12 weeks, versus 13 in Q4’16, obviously affecting the YTY earnings comparisons. GAAP results were also affected materially by “strategic actions….as it focuses on accelerating growth in high-returning businesses and streamlining its operations”. From a revenue standpoint, the consolidated flat revenues would have been 8% higher with the extra week, as indicated in the Q4 release. Be that as it may, Q4 GAAP operating income was down 16.7%, and non-GAAP operating income was up 2.8%. GAAP operating margin declined 360 bp to 17.9%, non-GAAP operating margin declined 90 bp to 20.0%. GAAP EPS was flat at $0.54, non-GAAP EPS grew 10.0% to $0.55 per share.
More details are available within the Q4 release, but it seems noteworthy to us that while consolidated operating margin was down 360 bp, this consisted of a decline of 470 bp in the Americas segment, a decline of 410 bp in the EMEA segment, offset only nominally by 80 bp of improvement in Channel Development and 60 bp improvement in China/Asia. “All Other Segments”, including Teavana stores, Seattle’s Best, and Starbucks’ Reserve lost $46.1M vs. a $10.1M loss QTQ, primarily due to closing Teavana retail stores.
Other Q4 highlights included 603 new store openings globally, Starbucks Rewards’ growth up 11% to 13.3M active members in the US, representing 36% of US sales, and Mobile Order & Pay reaching 10% of US transactions. Long term financial targets were provided, with global comp sales of 3-5%, annual consolidated revenue growth in high single digits, annual EPS growth of 12% or better, and annual ROIC of at least 25%. The dividend was increased by 20% to $0.30 quarterly, 15.1M shares were bought back, and a new commitment was announced to “return $15B to shareholders” over the next 3 years through dividends and share repurchases.
Further highlights of the year and quarter were discussed on the call. 550 new stores were added in fiscal ’17, bringing the total there to nearly 3,000 locations, heading for 10,000 within 10 years. Starbucks Rewards and Mobile Order & Pay platforms continue to be enhanced, drawing more revenues per customer and more participants. New financial products will be offered, in partnership with Chase bank, using Starbucks “currency” at other retailers. (A lot better than Bitcoin, in our opinion, though harder to launder a lot of money one cup of coffee at a time. Starbucks Roastery is a continued focus, and a new Princi Italian Bakery has opened within the Seattle location.
Management pointed out on the conference call that GAAP EPS growth will be above 40% in 2018, with over $0.50 of the gain from the purchase of ownership interest in East China and the sale of TAZO. These transactions, as well as the exit from Teavana stores, licensing Taiwan and Singapore, will affect non-GAAP EPS modestly, if at all (“flat to slightly accretive”) in 2018, then become more meaningfully accretive to EPS growth in late fiscal 2018 and into 2019. It was also indicated that the 12-13% non-GAAP EPS growth will be “back loaded” in fiscal 2018, aided by stock buybacks as well as operational improvements.
There are numerous ongoing growth opportunities for this premier worldwide consumer brand, many of them discussed on the conference call, and we encourage our readers who are interested to read the entire transcript. For our purposes, most of the “needle moving” initiatives have been discussed above.
Conclusion: Stated at the Beginning of this Corporate Writeup