Loyalty Program Changes Positive for Starbucks

While we acknowledge the possibility of disruption as

There is no change to our $65 fair value estimate as a result of this update, and we continue to view Starbucks as one of the more attractive opportunities in the restaurant space today. We believe the updated program's positive impact on the average transaction size will outweigh any traffic disruption among lower-ticket customers who will not accrue stars as fast under the new system. We think attrition will be minimal, given the strength of the Starbucks brand and other loyalty program benefits like Mobile Order & Pay and Spotify integration. We're also intrigued by lowering the unit cost of a star, which should create new opportunities for Starbucks products at the grocery store, as well as new star program partnerships. Taken together, we believe these moves will strengthen wide-moat Starbucks' brand moat source while also establishing a budding network effect.

The loyalty program changes combined with the global rollout of Mobile Order & Pay reinforce our 2016 outlook, which includes 7% global comp growth (8% in the Americas region), adjusted operating margins of approximately 20% in fiscal 2016 (versus 19.1% in 2015), and adjusted earnings per share of $1.90 (a penny ahead of guidance for $1.87-$1.89). Over the next 10 years, we continue to anticipate average annual revenue growth of 10%--driven by comp growth in the mid-single-digit range, new sales channels, geographic expansion, and licensed store openings--and adjusted operating margins around 24% through expense leverage, wholesale penetration, improved channel development margins, and new licensing arrangements.

Meaningful Growth Potential Exists We view Starbucks as one of the most compelling growth stories in the global consumer space today, positioned for top-line growth and margin expansion through menu innovations, sustainable cost advantages, and an ongoing evolution into a diversified retail and consumer packaged goods platform. Although it is already the leading specialty coffee retailer in the United States, we believe Starbucks still has meaningful domestic growth potential via new store formats (smaller-format express stores, drive-thrus, beverage trucks, and square footage reallocation for the premium Starbucks Reserve subbrand), greater peak hour capacity, expanded food offerings, lunch/evening daypart expansion, game-changing Mobile Order & Pay and delivery platforms, and loyalty program usage. At a time when most restaurant and retailers are struggling to stimulate traffic growth, Starbucks' recent transaction gains suggest that it remains a key consumer destination, validating the significance of its brand intangible asset.

Starbucks is much more than retail story, however, and we believe the company is just starting to scratch the surface of its longer-term channel, brand, geographic, and technological growth potential. Many of Starbucks' core retail competencies should facilitate these efforts, putting the firm in a unique position to capture retail and wholesale market share. Platforms like Via and K-Cups should support channel diversification efforts over the medium term, with nascent brands like Teavana becoming greater cash flow contributors over an extended horizon. We're also optimistic about mobile, digital, and loyalty program synergies across the various business lines and through new partnerships including Spotify, The New York Times, and Lyft. Starbucks' international opportunities are undeniable--particularly in China, India, Japan, and Brazil--and we believe best practices from the U.S. can be applied to these regions to accelerate growth across channels. Competitive threats exist in both the retail and wholesale channels, but a wide moat built on strong brand equity, bargaining clout with suppliers of all kinds, and a leverageable model will help to stave off rivals.

Strong Brand and Scale Advantages Contribute to Wide Moat Nonexistent switching costs, intense industry competition, and low barriers to entry make it difficult for restaurants and specialty retailers to establish durable competitive advantages, but with its wide economic moat based on a brand intangible asset that commands premium pricing and meaningful scale advantages, we expect Starbucks to maintain its specialty coffee leadership while successfully penetrating new growth avenues. Our confidence is supported by Starbucks' innovative mobile/digital/loyalty offerings, channel development efforts, geographic market expansion opportunities, complementary brand portfolio (Teavana, La Boulange, and Evolution Fresh), and employee investments that have driven down attrition levels. Although there are execution and brand saturation risks tied to management's loaded agenda, we believe Starbucks' initiatives, if executed properly, could fortify its already wide economic moat.

With more than 12,500 company-owned and licensed locations in the U.S., Starbucks maintains a sizable lead over direct domestic rivals, including Dunkin' Donuts (8,300 U.S. points of distribution), Caribou Coffee, and Peet's Coffee (the last two chains, which account for a few hundred locations, are now owned by the Joh. A. Benckiser Group). With cafe-like environments and a brand that evokes a high-quality customer experience, Starbucks enjoys pricing power advantages over most specialty coffee peers, which we believe will only be augmented by the incubation of the Starbucks Reserve subbrand to distribute exclusive, higher-end coffee blends. New product platforms such as smoothies and tea as well as a revamped food program have added diversity to the menu, allowing the firm to broaden its target audience, increase its average transaction size, and expand more into the lunch and evening daypart. Starbucks also wields considerable influence over arabica coffee bean suppliers, ensuring access to raw materials at competitive prices.

In addition, retail landlords often grant Starbucks exclusive leases to prominent locations rife with consumer traffic, and we believe the company has a significant longer-term opportunity through the use of alternative store formats, including smaller-format express stores (400-600 limited service locations in high-foot-traffic locations), stand-alone drive-thrus, beverage trucks (which have been tested on college campuses), and kiosk locations. The company's strong landlord relationships and square footage creativity could accelerate the global growth aspirations of Starbucks' more nascent retail concepts over the next decade and make it more difficult for rivals to compete.

Many of Starbucks' competitive advantages also apply to international markets, which we view as a critical growth engine over the next several decades. With a widely recognized brand, Starbucks is among the few retail concepts to be successfully replicated across the globe. As such, we believe the firm will eventually exceed its domestic store count overseas. The chain has more than 10,500 units outside the U.S. in more than 60 countries, including some well-established cafe cultures. Emerging-market prospects are also intriguing, including opportunities in markets such as mainland China (which already has over 1,800 units, on its way to 3,400 by 2019 and possibly 10,000 over a longer horizon), as well as Brazil and India (which offer potential for at least a thousand units apiece over the next decade, in our view). We like Starbucks' 2014 decision to buy the remaining 60.5% stake of Starbucks Japan that it didn't own, as full ownership should help to accelerate inroads into new channels (with emphasis on the underpenetrated ready-to-drink market but also other licensing and food-service opportunities), roll out new brands (Teavana, in particular), and accelerate mobile/digital/loyalty efforts, which should help to build on Starbucks Japan's already strong store-level profit metrics (low to mid-20s).

Starbucks' channel development aspirations underscore the power of its brand intangible asset. We view the company as one of the few food-service operators that could evolve into a world-class consumer packaged goods company due to its ability to connect with grocery and mass-channel customers through licensed on-premise stores. With its already strong bargaining clout with national retailers like Costco, Kroger, Whole Foods, and Trader Joe's, we expect Starbucks to develop national distribution of its entire consumer product portfolio over the next few years. With consumer packaged goods penetration in 40 countries (which has more than doubled the past three years), Starbucks should also have ample opportunities to expand its presence on grocery and mass-channel shelves across the globe. We've been impressed by Starbucks' efforts to expand its distribution beyond traditional outlets, including other restaurant chains, hotels, and airlines.

Continued market share gains in the $8 billion-plus premium single-serve coffee category, including Via and the company's K-Cup partnership with Keurig Green Mountain, will likely be the key near-term driver for the channel development segment (the partnership runs through 2018, at which point we expect Starbucks to distribute K-Cup products independent of Keurig Green Mountain with little to no impact on segment profitability). However, with Starbucks Refreshers energy drinks, cold carbonated Fizzio drinks, and the long-term potential of new food, juice, and tea products stemming from La Boulange, Evolution Fresh, and Teavana, respectively, we remain comfortable forecasting low-double-digit collective average annual revenue growth for channel development and other segments over the next five years, especially when factoring in the distribution infrastructure already in place. More important, we anticipate that the channel development segment will become an increasingly important free cash flow contributor. Even with the marketing and labor costs necessary to support new product launches, we anticipate that this segment will continue to see margin expansion in the years to come, with our model calling for gradual segment margins exceeding 40% by fiscal 2018.

Competition Increasing Starbucks faces increased competition on several fronts, including Dunkin' Brands' DNKN ambitious growth plans, McDonald's MCD emphasis on the coffee and other beverage categories, intensified rivalry from Jacobs Douwe Egberts (which combines the coffee assets of Mondelez, D.E Master Blenders, Peet's, Caribou Coffee, Einstein Noah Restaurant Group, and Keurig Green Mountain under the Joh. A. Benckiser Group umbrella), and an influx of specialty coffee programs at quick-service and fast-casual restaurant chains. Given its position as a more affluent consumer brand, discretionary spending cyclicality can periodically create periods of top-line unevenness. Coffee and dairy commodity cost volatility, as well as labor and occupancy cost inflation, can influence profitability. Starbucks faces heightened economic, legal, and political risk associated with its international expansion efforts. The company has also taken on multiple layers of execution risk, including the further development of Via instant coffee and K-Cup platforms; integration and further development of the Teavana, La Boulange, and Evolution Fresh brands; and the rollout of Mobile Order & Pay and delivery initiatives.

Stewardship Is Exemplary Chairman Howard Schultz returned to the role of CEO in January 2008. Although we typically prefer the roles of chairman and CEO to be split for corporate-governance purposes, we believe the presence of Schultz, who previously served as CEO from 1987 to 2000, has helped reinvigorate the firm. In fiscal 2015, Schultz received $1.5 million in base salary, which seems reasonable given the firm's impressive operating performance the past several years. However, Schultz also was given stock awards, option awards, and nonequity incentive plan compensation of $18.6 million, which strikes us as moderately excessive even after factoring in the company's outperformance relative to industry peers. With 3% of Starbucks' common shares, Schultz has sufficient incentive to increase shareholder value, in our opinion. Although we disapprove of certain takeover defenses, we assign Starbucks an Exemplary stewardship rating. We remain impressed that, unlike many consumer cyclical companies, Starbucks has shown a willingness to invest in high-growth potential projects and the purchase of the remaining 60.5% stake of Starbucks Japan that it didn't own while still returning cash to shareholders through dividends and buybacks.

Kevin Johnson, board member and former CEO of Juniper Networks, assumed the roles of president and COO in 2015. We're optimistic about his ability to support the company's current growth projects. In particular, we're encouraged by his consumer technology background, which we view as a key asset in expanding the company's already-leading digital platform across channels and geographies in the years to come. We view Starbucks as having one of the deepest executive benches in the consumer space, with several innovative leaders capable of pushing forth the company's strategic priorities in the years to come.