Starbucks: Strong brand building but tepid profits growth

The company seems to have many of the hallmarks of a great business and of brand building in particular. However, its profits growth has been disappointing in recent years and has been flattered by share buybacks. 

This raises the question of whether Starbucks is the kind of business that can deliver for long-term investors.

The business

Starbucks is the leading roaster and retailer of speciality coffee in the world. It has more than 32,000 stores across the world selling coffee, tea, other hot and cold beverages and food. Just under half of its stores are owned and operated by the company but they produce over 80 per cent of total revenues. 

The remaining stores are licensed and operated by specialist retailers. Starbucks receives a margin on its branded products bought by the licensees as well as a royalty on retail sales. The licensees are responsible for all operating and investment costs of their stores. This means that Starbucks receives a lower gross profit margin but higher operating margin than it does from its company owned stores. 

The company’s business is dominated by its US operations and its business in China. These two areas are also the main focus for the company’s expansion plans, along with Japan. Starbucks has been closing stores in the UK and has moved its stores in Thailand to licences.

As well as selling coffee through its stores, the company sells it directly to supermarkets, warehouse clubs and speciality retailers. It has signed an agreement with Nestle which gives the Swiss giant the rights to market Starbucks’ packaged goods and foodservice products globally outside its chain of coffee shops.

It also partners with other beverage companies such as Pepsi in ready-made drinks and sells coffee and tea-making equipment and gifts.

Strategy and business performance

The company has been pursuing a fairly aggressive strategy of opening up new stores and has been doing a reasonably good job of selling more from its existing ones as well.

Store location and increasingly the type of format is key to the success of the roll-out of new stores. In recent years, they have been opened in shopping centres, office buildings, university campuses, roadside and drive-thrus.

What’s interesting to note is that since 2015, most of the company’s like-for-like sales growth has been coming from price increases rather than selling more products. Some of the price increase will be a reflection of sales mix such as cold drinks and selling drinks with plant-based milks (coconut or almond milk). That said, the lack of volume growth is not a great sign.

Starbucks: Components of LFL sales growth

Source: Annual report

The sales of coffee direct to consumers through supermarkets has also been going well. It has been helped by the Nestle agreement and also by a shift away from stores during the economic lockdown. This is a very profitable business and is improving the quality of the company’s earnings with operating profit margins of 35 per cent last year compared with its core US shops, which made margins of just over 20 per cent.

That said, the economic lockdown has hit Starbucks hard. With it having to close its shops the company’s profits have taken a hit in 2020. Its stores have lots of fixed costs which mean that it has a high drop through rate from falling revenues to profits. It will be hoping that this process will work in reverse as shops open up again.

However, this is a company  that has been very adaptable and it may be the case that its business model will enhance its competitive position once the economy gets through the Covid-19 crisis.

Around 80 per cent of its recent openings in the US have been drive-thrus, which have very good economics and have played a key part in allowing those that have recently started working at home to go out into their local neighbourhood and get their morning coffee fix. 

These outlets have higher sales volumes and, with the benefits of operating leverage, this feeds through to higher operating margins than it gets in stores. The cash payback on drive-thru investment is very impressive at around two years.

In urban areas the company has been focusing on pick-up stores where people order in advance. These stores tend to have lower sales than its cafes, but have higher margins due to lower labour costs and lower rents, which means that the return on capital is similar.

With or without a period of social distancing these formats look as if they are going to be able to  keep Starbucks a very profitable business.

Protecting its brand and competitive position

Brands can be very powerful and positive forces for a company. They generate long-term customer loyalty and can create a competitive edge. At the same time, they are a target for competition.

When it comes to coffee shops it’s difficult not to think that they are everywhere. It makes you think that there are too many outlets chasing too few customers. I definitely got that impression with Costa in the UK as its like-for-like sales stagnated in the years before Whitbread (WTB) sold it to Coca-Cola. 

It also might explain why Starbucks has reduced its presence in the UK market and has chosen to concentrate its growth efforts on its core US market and China.

Starbucks faces a lot of competition. As well as independent coffee shops, quick-service restaurants such as McDonald's have been putting a lot of effort into their coffee offer at a much lower selling price than Starbucks. Most people I speak to who have tried McDonald's’ coffee have been pleasantly surprised by how good it is. This does not seem to have stopped Starbucks from driving its sales growth with price increases though.

Starbucks’ store opening schedule means that it is filling up more places with one of its cafes but it has been working very hard to keep hold of its regular customers. It has had a loyalty card for a while where customers earn points that they can redeem for free coffees. It also has generated revenues by selling gift cards.

One of the gripes from customers has been that they have had to load cash onto a prepaid card in order to start collecting points. This is going to change and just registering a credit or debit card to it now will suffice.

As has been seen with businesses such as Tesco (TSCO) with its Clubcard scheme, loyalty cards serve a dual purpose. They generate repeat sales but also give a company a huge amount of data about its customers, which gives them an ability to personalise the customer experience.

Starbucks has been doing this following significant investment in its mobile phone app. Not only has this helped with mobile ordering in the lockdown, but it has opened up a world of personalised marketing and rewards. As a result more customers are signing up for the app. 

In US company-owned stores, close to 50 per cent of revenues are coming from customers signed up to the rewards scheme. This is a great example of one of Starbucks’ competitive edges bearing fruit.

One of the other hallmarks of a business with a competitive edge is an ability to innovate and Starbucks seems to be very good at this. It has done this in recent years with products such as the Frapucinno - a milkshake with ice cream and cappuccino coffee-, other cold drinks and products with specialised ingredients. 

A nice profitable business in normal times…

Starbucks’ business model stacks up from a financial performance point of view. It makes decent profit margins for a retailer and ROCE is very respectable even when its rented stores are put onto its balance sheet(this is shown in the TTM numbers but not before).

Starbucks: Key performance indicators

Source: Factset, annual reports & Investors Chronicle

...but its ability to grow is questionable

My concern with this business is its ability to grow. Even before the impact of the coronavirus lockdown hit, the company had been struggling to grow. Its non-GAAP operating profit (equivalent to pre-exceptional or adjusted profits for UK investors) has essentially made little progress since 2016.

I like the potential to roll out drive-thrus in the US and enter areas of the country where it is still unrepresented. The potential of China is somewhat uncertain given the current trade war between the US and China. This could escalate - even with a different president - and represents something of a cloud over Starbucks’ growth outlook in my view.

I also think Starbucks EPS growth has been essentially driven by buybacks rather than genuine profit growth and therefore is somewhat lower in quality.

Its non-GAAP earnings per share (EPS) numbers – the one people tend to focus on the most – has painted a much more favourable picture of the business. The company received a $7.1bn upfront cash payment from Nestle in 2018 and spent it all – and some more – on buying back its own shares. This has nicely boosted EPS growth, but has masked the fact that underlying net income growth was slowing at the end of 2019.

Starbucks: The effect of buybacks on EPS

Source: Annual reports/Investors Chronicle. Note: TTM shares bought figure is year to date and not a whole year

Juicing up EPS with buybacks has been a common theme with US companies in recent years. Since 2015, Starbucks has reduced its fully diluted shares in issue by 22 per cent and this has seen EPS increasing at a faster rate than net income. 2019 net income received a nice boost from the reduction in the US corporation tax rate but only increased by 3.4 per cent. EPS increased by 16.9 per cent.

Starbucks paid an average price of $72.23 to buy nearly 140m of its own shares in 2019 and an average of $84 in the year to date. This compares with a current share price of $72.73. This has done a job in terms of EPS but time will tell as to whether this represents money that has been well spent.

In my view, Starbucks is a very clear and relevant example of the financial engineering of EPS growth with buybacks that masks weaker underlying profit growth.

The company does generate free cash flow but this needs to be considered carefully. The $7.1bn inflow from Nestle in 2018 was a one-off and will not be repeated. The company has also benefits a little from cash being loaded onto pre-paid loyalty cards which may change with the switch to card registrations as discussed above. 

As I discussed a couple of weeks’ ago, many US company free cash flows are flattered by share based compensation (SBC) which is a real cost but is non cash. The impact at Starbucks is not as pronounced as it is with many tech firms but SBC accounted for 9.5 per cent of free cash flow in 2019 and 16 per cent during the past 12 months.

If we deduct SBC, then 2019 free cash flow per share – a pre-Covid-19 valuation base - was $2.38. This would give the shares a trailing free cash flow yield of 3.3 per cent. That’s not unreasonable for a high-quality business with a robust brand like Starbucks, but given the slowdown in growth before the lockdown, the possibility of further lockdowns and a cloud over long-term growth in China, investors may be better waiting for a cheaper buying opportunity.