Starbucks Is Set to Adapt to an Evolving Industry

Heading into

With respect to the United States, we were encouraged by a back-to-basics approach to store operations and automated inventory, which should allow for greater customer engagement, and a beverage pipeline that should drive increased frequency. We are also encouraged by several new store layouts--including the new 23,000-square-foot New York Roastery but also drive-thru and express formats--that better isolate and address consumers’ “convenience versus experience” needs. China remains competitive, but we are optimistic about Starbucks’ long-term potential there due to the Alibaba partnership that unlocks new growth avenues and the brand’s ongoing connection with younger Chinese professionals. Management’s initiatives in the U.S. and China help to reinforce our wide economic moat rating.

Management’s updated long-term growth algorithms--comps of 3%-4% (including 3%-4% in the U.S. and 1%-3% in China), 6%-7% net new unit growth (3%-4% U.S., midteens China), 8%-10% operating income growth (suggesting 17%-18% operating margins), and EPS growth of “at least 10%”--warrant closer examination, as they represent a step down from previous estimates (comps of 3%-5%, net revenue growth in the high single digits, and annual EPS growth of 12% or more). Although the longer-term targets are a shade below our current longer-term discounted cash flow assumptions, we identify several paths for Starbucks to outperform while maintaining healthy shareholder returns. We are leaving our $74 fair value estimate unchanged and expect greater market appreciation as new initiatives materialize.

Despite the changes to management’s longer-term guidance, our longer-term projections are largely intact. Over the next 10 years, we anticipate average annual revenue growth of 8%, factoring in roughly 2-3 points of revenue growth impact from the Nestle partnership beginning in 2020, 6% average annual unit growth, and 4% global comps driven by Mobile Order & Pay and other digital initiatives, new beverage/food innovations, daypart expansion, streamlined restaurant operations, and contribution from delivery partnerships in key markets (including Alibaba in China and Uber Eats in the U.S.). We project operating income growth around 11% over the same time frame, implying operating margins around 20% longer term and averaging 18% over the next five years, roughly in line with management’s updated guidance.

Perhaps the most discussed component of management’s updated long-term guidance coming out of the event was the 3%-4% comp expectation in the U.S., which assumes 1-2 points from digital initiatives and transaction growth and 1-2 points from pricing. While this target may appear appropriate considering recent trends, we walked away from our discussions with management believing that this figure will eventually prove conservative absent a more pronounced economic downturn over the near future. Management’s comp outlook does not incorporate the expanded Uber Eats partnership, which will be rolled out to one fourth of Starbucks’ U.S. company-operated stores by the end of the second quarter with transaction sizes 2-3 times in-store transactions. We also believe the comp target probably understates the impact of innovation in beverage categories with more habitual consumers, such as cold beverages (including the introduction of Nitro to all U.S. company-operated stores by the end of fiscal 2019) and away from Frappuccinos. Management appeared to put less emphasis on food compared with previous investor day events, but we still believe this will be an important area of innovation that helps to drive average ticket and daypart expansion efforts in the years to come. We also believe the company’s new beverage and delivery efforts will stimulate greater digital engagement, resulting in loyalty program member growth in the low double digits over the foreseeable future.

While there was great deal of focus on the company’s store growth targets--including 3%-4% annual growth in the U.S. (implying 550 net new units) and midteens annual growth in China (implying 600 net new locations)--we believe the more important takeaway for investors is tangible evidence that the company is adjusting to consumers’ convenience and experience needs at the individual store level. Starbucks’ Roastery “experience” locations (which will expand to Tokyo and Chicago in 2019) are grabbing the headlines, but we may be equally impressed by the traction the company is seeing with drive-thru (which has outpaced traditional store comps by 4% the past several quarters) and express locations. Chief operating officer Roz Brewer also discussed exploring other small-format venues in the future--including Mobile Order & Pay only locations--which is something we’ve advocated to better address consumers’ focus on convenience. Of course, we don’t believe this unit growth would be possible without streamlined in-store operations, including the reallocation of non-consumer-facing tasks (such cleaning) to other parts of the day and automated inventory management, which should not only drive greater customer engagement but also be a positive for partner retention.

Despite lingering competition from Luckin Coffee and others and an uneven macro environment, we continue to see China as not only a tremendous growth opportunity for Starbucks--per capita coffee consumption is 0.4 cup annually in China versus 300 cups in the U.S.--but also in many ways a blueprint for the rest of the system. Management’s longer-term target of 1%-3% comps in the region appears conservative, though part of the softness can be explained by sales transfer to new store openings due to aggressive unit growth plans in the region. Management expects that 80% of top-line growth will be fueled by new stores over the coming years, with a goal of 6,000 units within the next four years, compared with 3,600 today. We believe the unit economics in China (average store investment of $300,000, average unit volume of $600,000, and cash-on-cash returns of 37%) and expectations that China’s coffee market could grow by 45% the next five years (from $4.5 billion today) suggest a long runway of growth. We now believe that 15,000-20,000 locations in China are possible over a longer horizon, putting Starbucks in the same echelon as Yum Brands. While there will certainly be competition from other local and Western brands in the region--and we believe the market is large enough for multiple competitors to succeed--we share management’s views that Starbucks is one of the chains best positioned to compete for market share. In fact, we believe its innovative partnership with Alibaba may be the most important differentiator between Starbucks and its competitors. Boasting more than 600 million active buyers across its various China marketplaces and almost 80 transactions per user, Alibaba will be an important driver of growth in the years to come, in our view. While Starbucks has been behind the delivery curve, we believe the nationwide rollout of delivery via Alibaba’s Ele.me in 2019 will help to bring China comps back to at least the low- to mid-single-digit range, in line with guidance.

Management also provided additional details about the Global Coffee Alliance, its partnership with Nestle. While this partnership will have a negative impact on 2019 results (hurting top-line growth by 2-3 points, operating income by 7-8 points, and EPS by 1-2 points after incorporating buybacks from the proceeds generated from the transaction), we continue to see it as the perfect marriage. This is another area where management’s guidance strikes us as conservative, as the company forecasts 4%-6% longer-term growth for the channel development segment (though acknowledging opportunities for acceleration beyond fiscal 2022) compared with Euromonitor’s specialty coffee growth rate of 6% for 2017-22. We believe the GCA’s goals--expanding Starbucks’ share of capsules on Nespresso/Dolce Gusto platforms, accelerating Starbucks’ North America leadership in the premium at-home coffee category, and expanding Starbucks’ reach globally--are reasonable and should position the channel development segment at the high end of guidance following this year’s transitional period. Additionally, we’re encouraged that the Nestle partnership appears to be ahead of schedule; management reiterated that it expects the partnership to be margin-accretive in fiscal 2020, a year ahead of previous expectations. It should be a high-margin vehicle to brand awareness and distribution across the globe, especially as rivals like JAB and Coke/Costa refine their consumer packaged goods strategies.

While we see several levers in the U.S. and China longer term, our model remains aligned with Starbucks’ fiscal 2019 guidance. We now expect comps in the upper half of the 3%-5% range after what appears to be a strong start to fiscal 2019 due to beverage innovation, digital engagement, delivery, and contribution from new store layouts opened in early fiscal 2018. Management’s other targets for fiscal 2019 continue to strike us as reasonable, including 2,100 net new stores (1,100 in China/Asia-Pacific, 600 in the Americas, and 400 in Europe, the Middle East, and Africa), revenue growth of 5%-7% (including a 2-point hit due to streamlining-related activities), a slight increase in adjusted operating income growth (excluding the impact of the GCA partnership with Nestle), some general and administrative expense leverage, adjusted EPS of $2.61-$2.66 (which also assumes 1-2 points of dilution to the Nestle partnership), and $2 billion of capital expenditures. We plan to adjust our model to incorporate EPS growth of at least 13% in fiscal 2020 and fiscal 2021, owing largely to the impact of the GCA.