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International Store Growth To Sustain Revenue Growth Despite Labour Headwinds

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Goran_DamchevskiNot Invested
Equity Analyst

Published

February 01 2024

Updated

September 19 2024

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Announcement on 20 August, 2024

Starbucks Reverts To Intrinsic Value As Investors Restore Confidence With New Management

Starbucks has announced the appointment of Brian Niccol as CEO, replacing Laxman Narasimhan. Niccol was the CEO of Chipotle from 2018, and has a positive track record of more than doubling the company revenues under his leadership. Niccol successfully managed Chipotle’s digital transformation, resulting in more than 40% of Chipotle’s orders to come digitally. 

The previous CEO was also an external hire and didn’t manage to stabilize the performance of the company. The public's awareness of management's underperformance heightened when Howard Schultz released a LinkedIn post providing guidance to management on the company's priorities.

In its Q3 earnings release, the company noted a drop in sales driven by a drop in the number of transactions. While the consolidated revenue dropped by only 1%, the trend was concerning for investors. It seemed that the company was unable to revitalize sales, and investors started a top-down change.

Starbucks is experiencing further pressures from activist investors Starboard Value and Elliott, who have taken a stake in the company. These activist investors are known for pressuring companies to restructure and increase returns. In this case, the presence of activist investors may have been a good opportunity to implement larger changes which are starting with the change of the recently appointed CEO Laxman Narasimhan. The activists may decide to push for further changes, and stick around until the business shows signs of changing course.

The new CEO will also have to face the unionization issue, but I expect the unionization wave to tone down due to a general worsening of economic conditions.

Management, Software, Workflow, Equipment: Starbucks Is Ramping On All Fronts

Mobile App

Starbucks’ mobile app processes roughly one third of orders, however the experience has been less than optimal for customers and staff, as waiting times are a drag on the overall experience. The company is facing an increase in these wait times and the app isn’t leveraging its full potential in streamlining the process. This is one of the issues that the new CEO Niccol will have to address, and his success with Chipotle in this front is part of the reason why he was chosen.

App reviews indicate that there are multiple stakeholders clogging the software for customers. While progress has been made, it seems that there isn’t productive communication between executive, marketing, and development teams, all of which have different priorities. This sometimes happens in larger organizations where the goal is to cover a team’s KPIs instead of focusing on the larger picture of what the product needs to become. The reviews indicate that updates sometimes break core functionality, introduce friction and confusion (e.g. users can’t see prices next to items). This isn’t normally expected from an application with years in development and an enterprise-grade budget.

To me, it seems that management will need to prioritize one focus point, this could be reducing friction for users, which will diminish its ability to upsell additional items, but would make for shorter wait times and better user experience. Alternatively, management could focus on optimizing returns by pushing marketing campaigns and upselling items.

Given that management has recently opened the app to non-reward members, it seems that they are moving towards increasing sales, which would put additional pressure on waiting times.

Workflow

Starbucks also initiated the Siren Craft System, a project aimed at improving operational efficiency and customer service. It involves reorganizing production sequences, prioritizing hot and cold drink orders, adding a "play caller" role to manage jams, and providing baristas with more control. The goal is to reduce bottlenecks, and enhance the overall customer experience, especially during peak times.

Equipment

Besides the workflow changes, the company is integrating new equipment, including a custom ice dispenser, milk-dispenser, faster blenders, etc. However, implementing these systems will take multiple years and 40% of North American locations are expected to have the new systems by 2026. The combination of the workflow and equipment upgrades is expected to cut service times in half, solving most of the peak-time problems.

Management

From a financial point of view, this is not a capital expenditures problem, as the company has enough capacity to raise funds and invest in streamlining projects. Rather, thus far the problem seems to be execution, likely bottlenecked by conflicting interests from multiple stakeholders. In this regard, the leadership change makes sense, especially if the new CEO manages to discipline and rally the team behind clear goals.

Addressing The China Expansion

The North America segment has the highest priority given that it brings 74.6% of the revenue and higher dollar value per store. However, activists and general investors are interested in a turnaround story in China. 

The expansion in China is threatened by a weakened consumer base and a competitive landscape where Starbucks' brand relevance may be lower compared to North America. Starbucks ended Q3 with 7,306 stores in China, and addressing the returns in this market will become exceedingly important as the company expands. Despite the lower revenues per store internationally, the company still has room to grow outside of North America and may opt to focus on optimization once the growth curve peaks.

While international markets, and especially China carries with it risks such as: culture, brand name strength, competitive and regulatory landscapes, I still expect Starbucks to continue its store expansion.

Valuation Implications

Multiple forces are now rallied in order to increase Starbucks’ operations, and consequently its financial performance. Most importantly these forces are not allowing the company’s management to fall into a stagnation comfort zone, as it is sometimes the case with large companies.

I expect some of the company's issues to be resolved over time, and anticipate seeing the amplification effects of new management after at least one year of operations. For these reasons I expect Starbucks to recover from the stagnation and am maintaining my valuation estimate for the company.

I view the price reaction to the change of management as a catalyst that brought the stock to where it needed to be under normal circumstances. In that regard, I don’t view Starbucks entering a bull scenario just yet, but affirming my base case.

Key Takeaways

  • Store growth plans to increase by 74% internationally, but only 12% in the US.
  • Coffee demand is expected to be a tailwind for revenues longer term, growing at a stable 4.2%.
  • Unionization and new competition risks can be offset with store and product offering growth.
  • International stores aren’t as lucrative as U.S. stores, so ROI will likely decrease
  • Competition from alternative caffeine sources pose a risk to its revenue growth prospects 

Catalysts

Starbucks’s Revenue Growth Dynamics Are Solid

Starbucks has announced a long-term growth strategy called "Triple Shot Reinvention with Two Pumps" to elevate the brand, strengthen digital capabilities, and increase global presence. The company will reformat stores, deliver product innovation, increase digital capabilities, and keep expanding globally with a 56K store target by 2030.

Stores And Expansion Plans

The 17,931 US store count is slated to grow around 4% with an aspiration to reach 20,000 over the long term, while the global target is 56K stores. This means that the long-term expected store mix for Starbucks is 36%/64% US to global stores. The company opened 549 net new stores in Q1 '24, ending the period with 38,587 stores: 51% of which are company-operated and 49% licensed.

 

Visual Capitalist: Top Starbucks Stores By Country

 

US Stores Make 4x More Than International Stores

In Q1 '24 Starbucks made $7.120B in revenue (75.5%) from its 17,931 US stores, and $1.846B in revenue (19.6%) from its 20,656 international stores – 6,975 (33%) of which are in China.

 

10Q: Starbucks’ Revenue Breakdown By Geography

Breaking down these values on a per store average and on an annualized basis, we get a $1.6M average per US store, $357K per international store, and a global average of $944K. This indicates that US-based stores, where the market is close to saturation, are making some 4.4x more than international stores.

This being the case, I expect that as international expansion continues, we’ll start seeing returns on invested capital trend downwards in the name of store growth. Then, over time, they’ll attempt to improve the profitability of these international stores. 

 

Investments in Tech, New Products and Store Formats To Offset Margin headwinds

Starbucks is making investments in different areas to improve store margins and offset headwinds.

With regard to product development, it will increase its food offering, and offer all-day breakfast and snacks. Opening new specialized pick-up, and drive-thru stores, also represent an opportunity for sales growth as management has noticed a market need to deliver the product closer to clients with a lower delay.

As for technological capabilities, it will be experimenting with Amazon’s contactless payment processing platform One, as well as their “Just walk out” technology. These can help increase efficiency by simplifying the checkout process, and reduce the current costs related with the more manual checkout process.

These seem to have been helping. In Q1’24 operating margins increased to 15.7% from 14.4% YoY. The company cites operational efficiencies and sales leverage as the primary drivers. So while international stores might have lower revenue figures as mentioned above, if they can have better margins that’ll offset some of the lower sales.  

However, its margins are being offset from partner (employee) wages and benefits, and higher general and administrative expenses. This means that should partner wages keep increasing, profitability is going to be under pressure. 

Ideally, the company finds a way to increase wages while driving efficiency in stores, resulting in a net uptick in margins. The company’s investment into specialized pick-up and drive-through stores could allow them to maintain similar sales figures per store but with lower overheads.  Unfortunately, management has been reluctant to issue specific guidance on margins, which is fair enough, but I believe the investments mentioned above should be enough to offset the headwinds they’re facing.  

Market Demand And Supply Are Stable With A Positive Outlook

Another way to gauge Starbucks’ growth potential is analyzing market trends.

On the supply side, prices are stabilizing as output increases.

A headwind impacting coffee prices is the 150% rise in freight costs as shipping containers move around Africa to avoid the Red Sea route, as they are threatened by Houthi attacks. This is also causing supply-chain delays of up to three weeks from major producers from Vietnam and Indonesia.

Despite freight adjustments, supply remains strong and the ICO projects that 2023-2024 global coffee production would increase 5.8% YoY to 178 million bags with an estimated 1 million bags of surplus (0.56%).

 

Trading Economics: Historical Coffee Price Chart

Long-term prices are normalizing after peak 2022 levels, but may remain elevated compared to 2019 as inflation remains priced-in. This is already reflected in end-product prices which consumers have absorbed.

 

Statista: Coffee Exports 2022

Brazil remains the largest producer and exporter of coffee with 3.2 million bags exported in 2022, followed by Vietnam with 2.8 million bags. 

Needless to say, with supply conditions somewhat normalizing, and costs able to be passed on to consumers, the supply challenges faced over the last few years aren’t expected to persist, which helps the likes of Starbucks.  

Demand: Stable Industry Growth Continues

Consumers love their cup of coffee, and more are getting on board. The global coffee market made about $138B in 2023, and is expected to grow at a CAGR of 6.4% between 2024 and 2032, reaching a value of $237B. 

According to the NCA 63% of Americans drink coffee, with cold-brew experiencing a surge in popularity by 45% since January 2023, and 400% since 2016. This trend is something Starbucks is benefiting from as people associate cold brew with the Starbucks brand.

 

Statista: Coffee Shop Market

Coffee shops are also a good indicator for expansion potential, and estimates indicate that the spend in coffee shops will increase 39% by 2030, from $166B to $230B. This results in a 4.2% yearly growth for coffee shop revenues, which is a natural industry tailwind for Starbucks.

Unionization Pressure May Not Pose A Huge Threat 

The company is currently in the midst of a call for unionization and personnel reform.

This has attracted the attention of an investor group that has nominated three names for seats on the board of directors with the hopes of improving labor conditions for Starbucks employees. In the meantime, Starbucks has diluted the board's power by increasing the directors’ seats from 8 to 11, possibly as a precaution to effects from outside influence. 

It is unclear how shareholders will benefit from the company swinging in either direction, however, the turbulence itself poses a risk to the stock. Investors have thus far reacted negatively to activism news, which indicates that they may not want to partake in the shake-up.

Looking at the company structure, it is expected that Starbucks has a relatively younger workforce that increases the employee turnover rate, this may make it harder to make a consolidated unionization attempt. So for now, I’m not expecting a huge impact on margins from this catalyst.

Assumptions

Revenue to grow from new stores, products and price increases 
  • As the company is expected to reach 20K US stores, and 36K international stores by 2030, assuming comparative revenue levels per store, I estimate that the company makes sales of $32B from US stores and $13B from international stores – summing up to a total of $45B by 2029 from store sales alone.
  • The company will also drive growth from product expansion with food, as well as efficiency from technological improvements such as better SG&A management tools and the Starbucks app. I estimate that the combined drivers will grow revenue by 7.5% per year, where 4.2% stems from new stores, 2% from product line expansion and 1.3% from price increases and implementing efficiencies. 
  • By adding on these factors, I expect Starbucks to make around $52B revenues in 2029.
Profits Margins To Maintain Historical Average
  • I am assuming a stable profit margin of 13% close to historical averages. While I believe that Starbucks will straighten partner wages and benefits, I assume that productivity gains and food offerings will drive up net profitability. The 13% profit margin results in $6.7B in 2029 earnings.
Earnings Multiple To Reduce As Growth Slows: 
  • I assume that as Starbucks builds new stores and saturates its market capacity, the PE ratio will converge to 22x reflecting the future growth limitation.
Buybacks To Continue Reducing Share Count 
  • I expect buybacks to continue in the future as workforce issues get settled. This will leave around $4B for buybacks per year. The company has 1.13B in outstanding shares, and I expect that to drop by 1% p.a. as a consequence of reinstated share repurchases to 1.07 billion shares.

Risks

  • The company may experience a weaker consumer preference for premium coffee, as a possible stagnation in wages decreases discretionary spend. 
  • A higher portion of people may continue working from home - diminishing Starbucks’ store edge and forcing it to compete for deliveries with cheaper coffee providers.
  • Customers may find alternative trends appealing and a substitute for status and caffeine. This may further limit the Starbucks market share. Things like Coffee subscription services, Canned and bottled coffee from the supermarket, Coffee infused with vitamins and minerals, Alternative coffee and affordability all pose risks to Starbucks expansion.
  • Expanding into emerging markets will involve taking on categorical risk, which is difficult to quantify in a valuation. I expect returns on capital and profitability to diminish in these regions, but they may diminish even more than I already expect if the store rollout hits any hurdles, or if market penetration is harder in different cultures.
  • The restaurant industry hasn’t had a new and exciting brand pop up recently. While this doesn’t mean that one is just around the corner, in a competitive market like hospitality, there is a possibility that a new brand that emerges and entices younger generations, thus harming Starbucks's brand and sales. Alternatively, the “new and exciting” competitor doesn’t necessarily need to be a coffee shop, it may appear as an alternative status symbol or a caffeine substitute. An example of this can be seen in the high-growth energy drinks company Celsius Holdings (CELH), which signals status by staying away from sweeteners and artificial colors in their brand, and substitutes coffee with a selection of energy drinks. Starbucks may counter this by coming up with their own store brand energy drinks, and leverage its large network of 38K stores to protect its market leadership position.

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Disclaimer

Simply Wall St analyst Goran_Damchevski holds no position in NasdaqGS:SBUX. Simply Wall St has no position in the company(s) mentioned. This narrative is general in nature and explores scenarios and estimates created by the author. These scenarios are not indicative of the company's future performance and are exploratory in the ideas they cover. The fair value estimate's are estimations only, and does not constitute a recommendation to buy or sell any stock, and they do not take account of your objectives, or your financial situation. Note that the author's analysis may not factor in the latest price-sensitive company announcements or qualitative material.

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