Inelastic Coffee Demand Coupled With Domestic and Foreign Growth Will Increase Revenues and Earnings

Key Takeaways

• Coffee consumption is still growing, and demand is inelastic 
• Its brand strength means it can pass on higher costs to consumers
• SBUX will continue performing well domestically and globally
• Margins will slightly improve, despite pressure from cost increases
• The new CEO can stay on top of the risks of elevated debt, unionization issues, and foreign expansions.

Catalysts

Brand Strength and Inflationary Resilience Will Help Keep Revenue Predictable

Since the stock market peaked, Starbucks scored six consecutive strong quarters showing minimal inflationary impact on its customer base in the core market (North America). 

While the company raised menu prices by as much as 5% during FY 2022 and average ticket (cost per bill) by 8%,  global comparable store sales rose by 7%.

Starbucks Revenue Growth - Simply Wall St

This development shows that coffee consumption has an inflexible demand and that Starbucks' brand strength kept even lower-income customers. Finally, the company is flexible enough to adjust to consumer behavior quickly. In 2023, the company reported that cold drinks now represent 75% of their US sales since cold brew products surged in popularity post-2020.

Successful and Growing Loyalty Program Has Many Benefits

Loyalty programs are not a novelty, but a successful one can make a big positive difference to a company's balance sheet, as demonstrated by companies like Costco.

The Starbucks Rewards program reached 31.4 million members in Q2 2023 since launching in 2008, growing 15% year-over-year.

The Starbucks Rewards program allows customers to earn “stars” by spending money in-store, but they earn twice as many stars if they pre-load the cards (i.e. spend the money in advance). 

This preloaded money, which totals to around $1.8bn, is available to the company in the form of “stored value card liability and current portion of deferred revenue”, which is essentially an interest-free loan that it can use as it pleases.

They can reinvest this money, or simply earn interest on it (which is great in a high-interest rate environment), because they don’t have to pay back the money, they simply need to deliver a coffee or food item whenever the user wants what they’ve already paid for (which some people often forget about). 

While these programs help retain users for their daily dose of caffeine, a change made on Feb 13th 2023, to double the points cost of free items, and as you’d expect, this angered many users.  Despite the watered-down rewards, the member count is still increasing so it seems like a perfect example of inelastic demand - price increases with a consequential demand decrease.

New Expansion Potential In India Should Help With Growth

In October 2022, Starbucks appointed a new CEO. The choice was Laxman Narasimhan, former PepsiCo CCO, who succeeded the founder Howard Schultz. Narasimhan's Indian origin might be a strong card for expanding into one of the fastest global markets. India's expected growth could make it the third-largest economy by 2030.

Starbucks: International vs. Domestic Locations

Starbucks has been in India for over a decade, but its growth has recently accelerated. Operating under a 50:50 joint venture with Tata Consumer Products, Tata Starbucks added 120 out of its 341 stores within the last 2 years, while its revenue rose 71% in FY2023 compared to FY2022.

Reliable and Growing Dividend Appeals To Income Investors

Starbucks has been paying the dividend for 12 years, which by the dividend longevity standard isn't great but isn't terrible. They pay a 2.2% dividend which might not seem impressive, but it is actually above the industry average.

Starbucks dividend history - Simply Wall St

The dividend growth rate has been impressive, scoring almost 20% over the last 10 years, and it is a trend that is expected to continue. The company typically increases the dividend in November; thus, the yield forecast in 3 years stands at 2.6%.

Industry Catalysts

Stable Industry Growth Outlook Will Help 

The global coffee market was valued at $126 billion in 2022 and is expected to grow at approximately 6% over the next 5 years to reach over $170bn by 2028. 

Coffee consumption is growing, with analysis by the US-based National Coffee Association showing that 66% of Americans consume coffee daily. This consumption even exceeds any other beverage, including tap water!

Since 2021, coffee consumption has grown by nearly 14%, fully recovering from the COVID-19 pandemic losses. The demand appears inelastic and growing, so Starbucks' core revenue streams seem pretty dependable. 

Rising but Manageable Price of Coffee Won’t Be a Large Issue

Although coffee prices have fallen to 2-year lows, this decrease will likely reverse slowly. The US dollar has been weakening against the Brazilian Real, supporting the thesis of coffee prices moving higher. Since coffee trades in US Dollars, a weaker dollar results in lower returns for exporters.

A strong Real disincentivizes coffee producers to sell in international markets as they wait for higher prices, which in turn restrains the supply. However, due to available supplies, coffee exports for 2023/2024 are expected to rise by 26%, negating this risk, at least in the short term.

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Most importantly, I think Starbucks will be in a position where it can leverage its size to negotiate better terms with suppliers, and then pass on most if not all of the price increases to consumers using their brand power. 

Assumptions

• I expect Starbucks to continue growing its revenues but slightly slow down as it starts growing its presence in foreign markets. I expect its revenues will grow at 8% per year (over the next five years), driven by rising and inelastic domestic demand combined with a successful foreign expansion.
• I anticipate that expansion might result in an elevated capex, in the $2.5-3b range per year, instead of $2b as the company anticipates. This cost might delay the net margin recovery, which I expect to average around 12.5% from 2023-2028.
• I expect coffee prices to rise by 6% annually, driven by demand and producer currency pressures.
• I believe unionization will cause fewer issues than in other companies (like UPS) because it is a comparatively less skilled job. I believe the labor market has seen a through in the unemployment rate and that a higher unemployment rate further decreases unionization risks.
• I believe that a potential U.S. recession won't have a significant influence on coffee demand, and 
• With the company announcing a value return program of $20b over 3 years, deducting the growing dividends, I expect the company to average $4b per year in buybacks.

Risks

Rising Cost of Labor and Union Problems

Starbucks has been in a prolonged battle with unionization attempts. Although the company has been accused of deploying typical anti-labor tactics like shuttering some union stronghold cafes, they blame other factors, such as crime.

However, it is hard to deny that Starbucks has been exceptionally good in stalling tactics, delaying and avoiding the unionization negotiations. Furthermore, as reported by The New York Times, they've marginalized union advocates while rewarding the un-unionized locations.

With nearly 300 locations voting for unionization since December 2021, it is evident that the company won't be able to delay this process perpetually. Eventually, it will show up as a higher labor cost and potentially depress the gross margin if the company can't pass these costs on to consumers.

Dependency on China Provides Upside, With Risks

Coffee is a growing industry in China, with an expected annual growth of 7.6% between 2023 and 2028, which is well above the global average. Compared to 16,000 U.S.-based stores, Starbucks operates only 6,200 stores in China – with a plan to increase this number to 9,000 by FY 2025.

So far, Chinese sales contributed to approx. 9% of revenues, but if this expansion goes as planned, this number could reach as high as 20%. The company can charge premium prices since Starbucks is positioned as a premium brand in the Chinese market. 

However, dependence on the Chinese market for growth could be an issue due to growing political risks, including trade tariffs or outright bans on certain brands and products.

Burdening Long-Term Debt

Over the last 5 years, Starbucks accumulated a significant amount of debt, currently sitting at $15bn. Although it has declined since Q1 2021, this debt still amounts to over $15b, and its decline has been rather slow.

Starbucks Debt-to-Equity Analysis - Simply Wall St

While the company has been paying off debt, it seems to be simply issuing new notes to pay off expiring notes, rather than using free cash flow to reduce total debt. Repayments of long term debt amounted to $1bn in the 2022FY, yet it issued $1.5bn in long term debt in that same period (page 44 of the 2022 10-k). 

So its indebtedness remains roughly the same, and it appears intent on remaining this leveraged.  

As for the remaining $15bn in debt, the table below outlines that about 26% of that (~$4bn) expires in the next 3 years to 2025. As for the $11bn expiring in 2026 and thereafter, page 68 of the 2022 10-K shows that those different notes have interest rates ranging from 2% to 4.5%.  

If the company chooses to pay off the notes expiring in 2023-2025 by issuing new notes again, the indebtedness level will not reduce, and, all else being equal, it will still leave shareholders with negative equity in the business. 

Additionally the interest rates on the new notes will likely be higher than the current notes given SBUX’s current BBB credit rating and the fact that the risk free rate has increased plenty over the last 12-18 months. This could put pressure on its ability to service its debt.