Starbucks' Weakness Only Temporary

We've trimmed our fair value estimate for

Starbucks’ softer-than-expected U.S. comparable sales (which increased 4% versus market expectations in the mid-5% range) were the clear story of the third quarter and indicate that the company is not immune to the more cautious consumer environment weighing on much of the domestic restaurant industry. Even with prior caution that the shift to a transaction-based loyalty program could create some noise in the quarter, we believed that other drivers such as Mobile Order & Pay and new beverage and food innovations would cancel out these disruptions. However, we weren’t counting on the loyalty program shift affecting other promotional efforts (including the Frappuccino Happy Hour event) nor the extent of slowing traffic across the restaurant industry (and probably the broader retail sector) over the past few months.

We see two main takeaways from the quarter. First, this is not the first time Starbucks has faced an uneven consumer environment in the United States over the past several years, and each time traffic was pressured, the firm found ways to adjust. While the current weakness may extend over the next few quarters, we believe management’s implied goal of returning to 5% comparable sales growth is doable in the fourth quarter as we move past the loyalty program transition and as other technology and menu drivers contribute more. Second, and perhaps more important, despite the softer domestic top-line results, management left much of its full-year guidance intact, validating components of our wide economic moat rating and long-term cash flow assumptions, including geographic expansion (most notably China) and channel diversification efforts.

Although flat comparable transaction growth in the U.S. represents the lowest point since the first quarter of 2010 (also flat transaction growth) when Starbucks was just coming out of the Great Recession, we remain confident that the company is well positioned to weather a period of uncertain consumer sentiment. First and foremost, we see several signs that the Starbucks’ brand intangible asset--the primary source behind our wide moat rating--remains intact, evidenced by continued increases in the My Starbucks Rewards member base (12.3 million active members at quarter-end) and management comments about seeing little change in loyalty member behavior, even among those who are traditionally low-price-point consumers. Second, we believe Mobile Order & Pay, which accounted for 5% of all transactions during the quarter and 20% of all mobile transactions, will remain a positive driver for transaction growth in the months to come, especially as the revamped loyalty program enables greater personalized marketing and promotional activity. Finally, we anticipate that a rebound in blended beverage sales (which posted a 1% comparable sales decline amid the loyalty program changes during the quarter) coupled with continued success of food product sales (which added 1 point to Americas comparable sales growth, led by strength in breakfast sandwiches) will help to bring comparable sales growth to around 5% in the fourth quarter.

Even if we’ve overestimated Starbucks’ ability to rebound from the current consumer environment or its own executional missteps in the U.S., its channel diversification, geographic and brand extensions, and global technological innovations make the company less dependent on the U.S. than in past periods. We estimate that Starbucks has packaged goods penetration in almost 45 countries today, but we believe the upcoming partnership with Nespresso (the dominant single-serve player in Europe, with around 70% market share according to Euromonitor) will help to accelerate the company’s presence on grocery and mass-channel shelves across the globe. We remain comfortable forecasting high-single-digit annual revenue growth for the channel development segment over the next five years, consistent with the company’s fiscal 2019 channel development revenue target of $2.5 billion, especially when factoring in the distribution infrastructure already in place. More important, we anticipate that the channel development segment will become an increasingly important contributor to free cash flow. Even with the marketing and labor costs necessary to support new product launches, we expect this segment to continue seeing margin expansion in the years to come, with margins exceeding 40% by fiscal 2018. This would put the company on track to reach its goal of approximately $1.1 billion in operating income by fiscal 2019, representing operating margins in the low to mid-40s.

Additionally, we continue to see evidence that Starbucks’ competitive advantages in the U.S. apply to international markets as well. Most notably, we were encouraged by 7% comparable sales growth from Starbucks’ China operations during the quarter, demonstrating the relevancy of its brand intangible asset in the region and increasing our comfort with a longer-term outlook of 10,000 units in China. Coupling this with prudent local supply chain infrastructure, personnel recruitment, and site-development investments, we continue to view management’s fiscal 2019 China/Asia Pacific segment goals--revenue of more than $3 billion (excluding the impact of the recent Starbucks Japan acquisition) and operating income of more than $1 billion--as realistic, if not conservative. This is particularly true if the company is able to build upon its learnings from Teavana and other channel-expansion efforts and unlock its global growth potential, which we view as probable.

Moat Is Wide and Could Get Wider Nonexistent switching costs, intense industry competition, and low barriers to entry make it challenging for restaurants and specialty retailers to establish long-lasting 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, and loyalty offerings, channel development efforts (VIA, K-Cups, Nespresso-compatible products, and other consumer packaged goods), geographic market expansion opportunities (China, India, Japan, and Brazil in particular), a complementary brand portfolio (mainly Teavana, but also La Boulange, and Evolution Fresh), and employee investments that have driven down attrition levels. In our view, each of these factors provide greater support for our estimates calling for average annual revenue growth of almost 10% and cash flow growth in the mid- to high teens over the next decade. 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 12,900 company-owned and licensed locations in the U.S., Starbucks maintains a sizable lead over direct domestic rivals, including Dunkin’ Donuts DNKN (8,600 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 cafelike 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 dayparts. 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 with heavy 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 11,500 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 almost 2,200 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 view Starbucks’ 2014 decision to buy the remaining 60.5% stake of Starbucks Japan that it didn’t own favorably, 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, and loyalty efforts, which should help to build on Starbucks Japan’s already strong store-level profit metrics.

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 approaching 45 countries (more than doubling the past three years), Starbucks should also have ample opportunities to expand its presence on grocery and mass-channel shelves across the globe, aided by plans to sell Starbucks-branded products for Nestle’s Nespresso machines in Europe and other markets. We’ve been impressed by Starbucks’ efforts to expand its distribution beyond traditional outlets, including other restaurant chains, hotels, airlines, universities, and offices.

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 probably be the key near-term driver for the channel development segment. The amended relationship with Keurig Green Mountain--which offers Starbucks better economics, expanded product diversity and access to high-margin channels like offices, food service, and universities--will only solidify this important competitive advantage. The company’s single-serve platform, coupled with Starbucks Refreshers energy drinks, cold carbonated Fizzio drinks, and the long-term potential of new food, juice, tea, and products from La Boulange, Evolution Fresh, and Teavana, respectively, give us confidence forecasting low-double-digit collective average annual revenue growth for the 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.