Starbucks Corporation: The Coffee Empire Remains A Great Long-Term Investment

Starbucks Corporation (NASDAQ:SBUX) is an international food and beverage retail chain, with the main focus on premier roaster and retailer of speciality coffee. Through a global chain of over 28,000 company-owned and licensed stores, Starbucks sells beverages (coffee, espresso, teas and cold-blended drinks), food and accessories (e.g. mugs and tumblers) across 76 markets in 3 main geographical regions: the Americas (United States, Canada and Latin America), China/Asia Pacific (CAP) and Europe, Middle-East and Africa (EMEA).

In partnership with Nestle, Starbucks distributes packaged (including single-serve capsules) coffee and tea through various distribution channels (Starbucks stores, grocery-store chains, etc.) under brands like Starbucks and Teavana. Starbucks also sells ready-to-drink (RTD) bottled beverages (coffee, tea and juices) through other partnerships.

Starbucks derives its revenues from three major segments: Company-Operated Stores, Licensed Stores and Consumer Packaged Goods (CPG), Foodservice and others (Chart 1).

Chart 1: Starbucks’ Revenue Breakdown By Business And Geographical Segments

1. Growing Demand For Specialty Coffee In US

US has the world’s largest population of coffee drinkers, with average annual consumption rate of 300 cups per capita. Alongside increased coffee consumption, the taste and preferences of US coffee drinkers are also growing more sophisticated, with more coffee drinkers shifting towards specialty coffee, which many consider better tasting than non-specialty ones. Specialty coffee accounted for about 59% of all coffee consumed in the US in 2017, a stark contrast from 2010, when the percentage was only 40% (Chart 2).

Chart 2: Market Share of Specialty Coffee On The Rise

Not only are adult coffee drinkers in the US drinking more specialty coffee, they are also becoming more habitual. Over the last 18 years, the percentage of daily drinkers has increased sharply from just 9% of adults in 1999 to 41% in 2017. Specialty drinkers consumed on average 2.97 cups of coffee per day in 2017, as compared to 2.24 cups in 2001 (Chart 3).

Chart 3: US Adults Are Drinking More Coffee More Frequently

As one of the leading US specialty coffeehouses, Starbucks will stand to benefit from the growing demand for more and better tasting coffee.

2. Revenue Growth And Cost Reduction Strategies To Drive Profitability

While the 3-year revenue CAGR for Starbucks still remains healthy at 10.9%, same-store sales growth in its retail stores has began to show signs of slowing (6% in FY16 to 3% in FY17). However, we think it is only temporary – a reversal of the trend is in the horizon.

Having partnered with Nestle for its CPG business, we believe that Starbucks can now focus its efforts back on its brick-and-mortar beverage business. The management has recently outlined three key strategies that we think will be essential in driving profitability for the next few years.

Firstly, Starbucks aims to improve same-store sales growth by increasing both customer traffic and average spending per transaction. With its afternoon sales (3pm-5pm) being the weakest, Starbucks is putting more emphasis on marketing in the afternoon, with initiatives such as ‘Happy Hour’ deals offered digitally to targeted Starbucks customers and attractive discounts on newer products.

Starbucks is also aiming to raise customer spending within its stores by placing emphasis on its premium beverage innovations. These craft coffee are typically priced 2-4 times higher than its usual menu items and have higher profit margins. The Nitro Cold Brew drink is one successful example. Developed in early 2016, this popular drink has since been rolled out to more than 1,000 Starbucks stores globally. We are positive Starbucks can continue the momentum in increasing its average customer spending and overall same-store sales.

Figure 1: Starbucks’ Menu of Cold Craft Coffee Beverages

Secondly, Starbucks aims to further extend its outreach by launching more stores around the globe. The management’s target for its store unit growth is at 5% per year. Initiated in 2016, Starbucks plans to open around 12,000 stores worldwide by 2021 – 4,700 in the Americas, 5,000 in CAP and 2,300 in EMEA. This is especially important in key markets like China, where demand for Starbucks coffee is going strong.

Lastly, Starbucks intends to implement a series of cost reduction strategies, which include the reduction of inventory costs by cutting its stock keeping units (SKU) by one-third and streamlining its global supply chain, to drive profitability. We are also positive that Starbucks can yield significant cost savings over time by focusing efforts on ceasing its unprofitable operations.

We believe that the two-pronged approach of driving revenue growth and prudent cost management will allow Starbucks to improve its future profitability.

3. Tapping Into China’s Booming Coffee Market For Long-Term Growth

As the second-largest and the fastest-growing market, China is critically important for Starbucks. As the US market matures, comparable-sales growth in China has started to outpace that of the US. In the previous four quarters, China stores posted an average of 6% quarter-on-quarter increase in same-store sales, double the more modest 2-3% gain in US stores (Chart 4).

Chart 4: Same-Stores Sales Growth for Starbucks stores in the US and China (2015-2018)

While China has historically been a tea-drinking nation, coffee has become increasingly popular in China, particularly among younger city-dwellers. According to International Coffee Organisation, total coffee consumption in China has been growing at an average annual rate of 16% over the past 10 years. The consumption rate is also picking up quickly, having nearly tripled in the past four years. China’s massive and rapid urbanisation, alongside a burgeoning middle class, are among key factors contributing to the boom in China’s coffee drinking culture.

More importantly, Starbucks has a strong foothold in China. Starbucks held a 54.8% market share of China’s 25.2 billion yuan (USD 3.9 billion) specialty coffee market last year, far ahead of rivals like McDonald’s Corp’s McCafe (9%) and Whitbread Plc’s Costa Coffee (9%). Starbucks aims to retain that dominance by extending its store count in China from the current 3,300 to 6,000 by 2022 – nearly 600 new stores a year.

Chart 5: Tremendous Potential of the China’s Coffee Culture

China’s coffee market has ample room for growth. Chinese consumers on average still only drank 0.4 cups of coffee annually in 2016, compared to an average of 300 cups annually in the US (Chart 5). As Chinese rapid-expanding middle-class continue to adopt coffee as lifestyle habit, Starbucks is well-positioned to capture the growth.

4. Starbucks’ Strong Branding As A Premium Coffeehouse

Arguably the most important element, Starbucks has a strong branding as the coffee specialist, yet at a price point still largely appealing to the masses. According to Forbes, Starbucks is the second most valuable restaurant brand in the US, with its brand valued at USD 23.2 billion. It is also among the most popular food brand among US youngsters, in a survey of 5,500 teens conducted by Piper Jaffray on restaurant preferences. (Table 1)

Table 1: Top US Restaurant Brands Preferred by US Teens

A strong branding is essential for Starbucks: it enables greater control over the pricing of its product. The stronger a company’s brand, the less commoditised its products will appear to consumers and thus greater the ability to charge a higher price. Starbucks has been hiking its prices by 2-4% per quarter in recent quarters with great success, having seen little impact on its overall comparable sales figure.

With growing demand for premium artisanal coffee, Starbucks aims to elevate its branding a notch further into ‘Premium’ territory through its Reserve and Roastery brands. Positioned as Starbucks’ quintessential concept stores, customers get to experience the world of premium artisanal coffee through experimental beverages, wide variety of brewing methods and coffee bean variants. We are positive that Starbucks’ brand image will continue to resonate well with the masses as the experts in coffee.

5. Investment Risks

A. Souring US-China Trade Relations May Weigh On Starbucks’ Expansion Plans

Starbucks could potentially see a backlash (boycott by the Chinese consumers) if anti-US sentiment were to rise in China. It will be detrimental to Starbuck’s expansionary plans in China, considering how ambitiously Starbucks is investing in China. However, considering that Starbucks currently has a strong foothold and reputation in China, we think that the impact would be less severe that many would expect.

B. Intensity In Competition To Pick Up As Coffee Consumption Increases

Key rivals like McDonald’s Corp and Yum Brands have shifted their strategies to dollar deals menu. The results have been positive for them so far. The shift towards dollar menu in the fast-food restaurants, especially cheaper coffee, can create a challenging operating environment for Starbucks. Starbucks may be compelled to offer more discounts and deals to entice customers to visit their stores, which could further compress Starbuck’s margins.

C. Push Towards Premium May Backfire

While demand and pricing for gourmet coffee has ascended steadily, one unique selling point of Starbucks is its relatively affordable pricing. If the push towards high-end gets too aggressive (alongside Starbucks’ beverage prices), we think that the company could risk alienating some of its customers, especially in a competitive environment where other major players are offering low-priced specialty coffee to capture greater market share.

6. Fair Valuations

We value Starbucks at USD 66.80, based on a P/E ratio of 26.3X and our estimated 2018E earnings-per-share (EPS) of USD 2.54. This implies an upside potential of 18.2%, based on its last traded price of USD 56.48 (as of 13-June-18).

The P/E ratio is in-line with average 2018E P/E ratio of Starbucks’ peers. We estimate the forward 3-year 2018-20E EPS CAGR at 14.4%.

We have identified Starbucks’ main competitors as restaurant chains offering coffee services (Table 2):

Table 2: Starbucks’ Peers Comparison

Starbucks: A Good Long-Term Investment

While Starbucks have recently released its 2Q 2018 earnings report with modest growth in comparable sales, we think that the ‘Global Coffee Alliance’ with Nestle will enable Starbucks to pivot its attention back to its core brick-and-mortar operations. Through a two-pronged approach of various growth drivers (store expansions, increasing customer spending through premium beverages, etc.) and cost optimisation strategies, we are positive that the company has the potential to generate strong earnings and cash flow to command higher price multiples moving forward.

Hence, we believe that Starbucks remains a great long-term investment choice for investors!

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.

The Research Team is part of iFAST Financial Pte Ltd.