Discover more from Investment Talk
Starbucks Opens its 6,000th Store in China
Starbucks pins their recovery on a strong domestic consumer and a China recovery
While the world moves on from the events of 2020 and the pandemic fades through the rear-view mirror, a cluster of fallout still clings to Starbucks, the world’s largest coffee retailer. The operational stress of the pandemic, as well as concerns over in-store safety, catalysed demand for unionisation in the company’s most integral market, the United States. Since the first store won its union vote in Buffalo, New York, in December 2021, over 330 stores in 38 states have filed for an election, yielding more than 250 successfully unionised stores. Union contagion is small in comparison to the 15,900 stores Starbucks operate & licence across the US, but the ripple effect is tangible; prompting the company to reinvest upwards of $1 billion in employee wages & training, as well as implementing a range of additional benefits as they look to appeal to green apron partners. Just two months ago, Starbucks unveiled a “Reinvention Plan” at their Investor Day which for all intents and purposes seeks to get partners back on their side and update the store operating model to reflect the changes in how consumers interact with Starbucks. The company’s second most important stakeholder, the consumer, doesn’t seem to be as conflicted. In North America, the company reported $23.4 billion in sales for the 2022 calendar year; a 14.3% improvement from last year. This is a record performance; as was the $32.3 billion (+13%) in revenue the company reported on a consolidated basis over the same period. Outside of domestic labour force troubles, Starbucks has been battling with a far greater byproduct of the pandemic; China’s reluctance to end its zero-covid policy. On the surface, Starbucks’ international business reported flat sales ($6.94 billion) in 2022 (+12% constant currency). Excluding China, the international business grew revenues by 11% (+30% constant currency), while the China segment lost an incremental $690 million (-19%) in revenue year-over-year. The purveying theme at Starbucks is a domestic business, thriving in spite of crippling levels of inflation, lugging the business forward like a steroid-infested sprinter tethered to a partner in a three-legged race that happens to be suffering from a broken leg.
Reinvesting In Darkness
Broken limbs have not prevented the company from reinvesting heavily in the Chinese market, their second-largest outside of North America, and where they are the nation’s largest coffee retailer. Starbucks is quite particular about which markets they like to run company-operated stores in, and in China every store is company-operated. This is in contrast to Starbucks’ licensing model, where the operating margins are higher (licensed stores are responsible for OpEx & CapEx) but the revenues (mainly royalties and margin on branded products) are smaller. Despite making up 49% of the global store count, licensed stores bring in just 11% of Starbucks’ revenues. Licensing tends to carry less immediate risk and offers a capital-light method of rapid expansion. Out of the 83 countries where you can find a Starbucks, just 8 have company-operated operated stores. Of those 8 markets (home to 18,250 stores), China accounts for 33% of the total; up from 23% just four years ago and is second only to the US (51%) and lightyears ahead of the third largest company-operated market, Japan (9%). Standing at 6,021 stores (as of Q4 2022), Starbucks has expanded their presence in China at a compounded annual rate of 25% over the last eleven years.
Outside of store count, Starbucks has also been investing in their Chinese supply chain; announcing earlier this year that it will be constructing the Starbucks China Coffee Innovation Park; a “next-generation facility that will revolutionalize copy roasting” through its state-of-the-art roasting plant that will “fulfil all aspects of the value chain from bean to cup”. Once complete in 2023, it will become the largest Starbucks roasting plant outside of the US, with a capacity to produce 135 million pounds per year (~58,967 tonnes). That’s the same weight as ~6 Eiffel Towers. This is being set in place to provide for the additional demand from the 9,000 stores that Starbucks wants to open in China by 2025. With every store in China being company-operated, and their expansion plans being so aggressive, you can appreciate how large of a bet Starbucks is taking on China. This aggressiveness continues, despite the plagued results from the segment across 2020-2022. So, why are they hell-bent?
We could dive into the history of Howard Schultz, Starbucks’ founder and three-time CEO, and his adoration of China but it might stretch outside of the parameters of this article. Instead, let me share three quotes from Schultz.
2005: “Starbucks expects the People’s Republic of China to be one of its largest markets outside of the United States”.
2006: “Much like China, India has traditionally been a tea culture, yet there is a growing coffee culture emerging, especially among the country’s young adults”.
2012: “We've been in the International business since 1996 and the core expansion for the company, the core target and prize is China. China remains a focal point of our international expansion efforts and last week, we opened our 500th store”.
Schultz was early to recognise the potential of a nation that had not yet adopted coffee culture, and where the aggregate wealth was climbing rapidly. At the time of that last quote, in 2012, the average Chinese citizen consumed between 3 cups of coffee, per year, accounting for <1% of global coffee sales. By 2025 it is expected to grow to 13 cups per year. While 333% growth in just over a decade seems impressive, consider that the average citizen of Japan consumes ~200 cups per year and their American cousins drink upwards of 380 cups.
As China’s rate of urbanisation grows and the middle class continues to expandthe nascent demand for premium coffee retailers like Starbucks is expected to ride on its coattails. The middle class in China accounts for more than 50% of the nation's population today (up from 3% in 2000). While wealth & living standards have grown for the average Chinese citizen, Starbucks' bet is more so reliant on the slow catalysation of a shift in consumer tastes toward coffee. The data suggests that things are trending in the direction and while the outright numbers may be small, it is the long-term tailwinds of China eventually becoming even a nation that consumes an average of 20, 30, 40, 50... cups per year that has Starbucks salivating. This is why they continue to invest heavily in China, despite the crippling performance of late.
Imagine I told you in November 2019 that in three years’ time Starbucks would build an additional 1,900 stores (+47%) across China, but report near identical revenue figures for the fourth quarter of 2022. That’s precisely what has happened. The initial collapse and recovery of revenue in early 2020 mirror that of many other companies. But whilst the domestic and international-ex China segments recovered in full and accelerated in 2022 following easier YoY comps, China languished. Starbucks would endure several quarters with more than a third of their stores shuttered due to zero covid policy.
After Starbucks, conveniently, stopped disclosing the number of 90-Day active rewards members in Chinafor several quarters (last known to be 17.9 million in 2021) they would report that the total now stands at 17 million (shedding 900,000 members YoY). The fact that this metric was up 29% sequentially tells us two things. First, it evidences just how severe mobility has impacted customer engagement with the brand. Second, and perhaps on a positive note, is that Starbucks may have found the bottom in China. While Q4 sales of $775 million are still far below where they ought to be, the 42% sequential growth outpaces the 6.5%, 30%, and 3.8% sequential growth seen over the last three years.
But let’s not get ahead of ourselves. After unrewarded optimism presented in past quarters, management took on a more conservative tone in their recent earnings call, citing that they believe China’s recovery will be “non-linear” and for the “uncertainty to continue” into the back half of 2023; “we expect China’s comp to be negative in the first quarter [of 2023] followed by outsized comp in the balance of the year”. On a more positive note, Schultz noted the strong correlation between Starbucks’ revenue growth and the relaxing of COVID mobility restrictions and that he was encouraged by the early signs of recovery in the fourth quarter. Leading onlookers to consider it a matter of “when” not “if” with respect to China’s recovery.
Elsewhere, Things are Holding Steady
The steroid-infested sprinter I mentioned earlier, he is doing okay. Starbucks, over the course of 2022, has increased prices by ~6%, meaning inflation is the primary driver of both revenues and average ticket. Importantly, the volume of transactions is not suffering as a result. Ruggeri, CFO, would cite that beverage and food volumes per store exceeded pre-pandemic levels with a 9% YoY increase in the number of unique customers in North America. The consumer is demonstrating their loyalty to Starbucks in spite of inflation, for now.
The company are also refusing to hold steady when it comes to expansion outside of China. Over the next 7 years, they intend to open 8 stores per day, amounting to goals of 45,000 stores worldwide by 2025, and 55,000 by 2030. Next year, with a guided 7% of annual store count growth, it is expected that 75% of that comes from outside of the US.
Margins? In this economy?
It’s no secret that margins at Starbucks have been struggling. Long gone are the days when Ruggeri would talk about returning to 19% EBIT margins circa 2023/24. A culmination of inflationary input costs, sales deleverage from international, and the significant reinvestment into the Reinvention Plan have tempered Starbucks’ margins over the last two years. But Ruggeri suggests there is light at the end of the tunnel, as she anticipates “solid margin expansion” next year, with the bulk of that being weighted towards the back half, as well as multiple years of expansion from here on out.
The obvious caveat is that the base from which that expansion occurs is… a low hurdle, at just 14.3% in 2022. But what’s baked into that margin expansion? It seems like Starbucks is pinning its 2023 performance on an unrelenting youthful customer base, the assumption that price inflation continues not to disrupt demand, and that China has a reasonable recovery by the back half of the year. They also believe the Reinvention plan will result in margin accretion once the reinvestment period is over, via labour and output efficiencies. As far as things stand, it remains a show-me-tell-me story. The recovery and eventual acceleration of China stand as Starbucks' largest catalyst today, but there is no telling when those consumers will normalise, even following a full re-opening of the economy. As the world teeters on the brink of recession, there is a reasonable concern in the medium term that Starbucks will once again be impeded in its progress, just as they start to get going again.
Thus far, the market seems to be buying the story. Starbucks’ share price has recovered by ~28% in the last six months, now trading at a similar valuation to February 2020, at 27 times forward earnings. In other news, shareholders may be pleased to know that share repurchases, halted earlier in the year as Howard Schultz stepped in as interim CEO, will be reinstated next year. At the time, Schultz cited an ROI-based rationale for stopping share repurchases, suggesting that the ROI on domestic store expansion was superior. This was given the vote of approval from the likes of Moody’s, the credit rating agency. In Mayof this year, I remarked that it was more likely a liquidity decision.
“Whilst the decision to pause share repurchases was garnished with an ROI narrative, I suspect it had as much to do with Starbucks’ balance sheet weakness. Interest is well covered by the company’s EBIT (~7.6x) and the business is a notorious cash flow producer, but with maturities looming, a $2.2B dividend to pay out each year, undergoing a reinvestment cycle during an inflationary environment, and the certainty of those cash flows diminishing in regions like China, halting Starbucks’ repurchases feels like the prudent move.”
Interest coverage is still strong, at 9.2x, but the general health of Starbucks’ balance sheet hasn’t vastly improved from Q2 2022 (when the repurchases were halted). There is evidence to suggest it has worsened. Nevertheless, CapEx is expected to reach $2.5 billion next year (35% greater than last year), dividends are a commitment (of a couple $ billion per annum) that Starbucks is sticking to, and they are now suggesting ~$12 billionin share repurchases over the coming three years. Looking at the maturity structure of their debt ($1.9 billion due within 12 months and $13.1 billion in long term), their reinstating of the repurchases feel a tad premature. Perhaps it would have been wiser to exercise patience considering the uncertainty that looms ahead with respect to potential softening demand in North America and the lack of clarity in the Chinese recovery. That said, while operating cash flows and earnings are down on the year, and provided the domestic market stays strong with an eventual Chinese recovery, there are a number of margin-accretive tailwinds in the distance for Starbucks that will bolster cash flow generation in the coming years; if everything goes to plan.
Thanks for reading,
Other Starbucks News
In 2022, global comparable store sales were up 8% (12% in North America) with a 6% expansion in the global store base.
In Q4 more than 60% of beverage units sold in the US company-operated business were customised, contributing to the $1 billion and growing annual net sales for modifiers representing growth of 2x since the first fiscal 2019.
Expected consolidated revenue growth to reach the range of 10% to 12% in the fiscal year 2023 (including a 3% FX headwind).
Reinstating buybacks. The fourth building block is capital allocation. We expect our CapEx in fiscal 2023 to be approximately $2.5 billion. As we shared during our Investor Day, we also expect to return approximately $20 billion to shareholders in the next three years between dividends and share buybacks. We remain committed to targeting an approximately 50% dividend payout ratio as reflected in the recently announced dividend increase and will also resume our buyback program in fiscal 2023.
In September, the company announced new financial benefits for partners, including My Starbucks Savings and a Student Loan Management Benefit, designed to help eligible partners manage student loan repayments and achieve greater financial stability. In October, additional well-being partner benefits were launched, including enhanced sick pay and mental health support, as well as updates to the family expansion reimbursement program.
Finally optimising store hardware for cold beverages, which accounts for 75% of beverage sales, is one example. The emphasis on these CapEx investments is increasing the efficiency of labour and decreasing turnaround times for beverage and food orders. Equipment such as the Starbucks Cold Brewer, Mastrena II espresso machines, and new warming ovens are expected to be fully rolled out across the US by the end of 2023.
After expressing interest to sell the remaining 318 company-owned stores in the UK, it’s soon to be 7
Pew Research shows that China’s middle class grew from 39.1 million people (3.1% of the population) in 2000 to more than 700 million (50.8% of the population) by 2018.
Rewards members are vital because the average SR member is likely to visit a store 3x more times than a non-SR member. SR members also relate to the shifting consumption patterns of consumers. Starbucks app payments and mobile orders account for an increasing share of total spending and transactions, with a trailing quarterly average of $2.6 billion in consumer funds sitting on the balance sheet from SR balances in a given quarter.
Management state that 51% of consumers are Gen Z or Millenial and that the customer cohort is becoming younger as time goes on. This was a prior fear of investors, that Starbucks would not appeal to upcoming generations. This may present a tailwind for the company, as management suggests “the younger you go, the colder the beverage” when talking about customer demographics. The younger consumer also tends to add more modifiers (syrup, alternative milk, etc) that are higher margin sales.
I assume that Starbucks’ annual dividend of $2.2 billion grows ~10% per year over the next three years. The company suggests $20 billion will be allocated to buybacks and dividends over the next three years. $20B - £8B = $12B.