Starbucks & Growth: Embracing China’s Multi-Billion Dollar Market

  • Starbucks created the “coffee experience” which was their economic moat in the beginning and has deteriorated over time for numerous reasons
  • Howard Schultz (Founder and Former CEO) & Scott Maw (CFO) leaving will create temporary headwinds and investor concern
  • Success in China is necessary for the success of the company

SBUX is America’s favorite drink – the one that costs a little bit more than we would like, but is addicting. Coffee is a staple of most American’s mornings – wake up, grab a cup, and go to work. SBUX has made it into a “Starbucks Experience”, creating the stores into a place where you can go to catch up with friends, a job interview site, and a place to study for finals, fueled purely by caffeine.

It’s a “third place – the place between work and home”. SBUX is designed to be a stopping point, not just a place to breeze through after you grab your coffee. It is known as one of the best places to work in the world (paid family leave, “Bean Stock”, and online classes through the University of Arizona are just some of the perks that they offer employees). The stock has performed well over the years – since January 1st of 2010, it has returned almost 400%. A lot of that performance is due to Howard Schultz.

sbux1

Source: Yahoo Finance

Howard Schultz: The Mocha Mastermind

“We’re not in the coffee business serving people, we’re in the people business servicing coffee” – Howard Schultz

You can’t have Starbucks without Howard Schultz.

A grad of Northern Michigan University, he started his coffee career at Hammarplast, a Swedish Coffee manufacturer. One of the clients of that Swedish Coffee Manufacturer was Starbucks. Schultz liked what the guys over at Starbucks were doing, and became their Director of Marketing in 1982.

Schultz then traveled over to Italy, where he noticed various coffee bars serving espresso and pastries but also serving as meeting places (a novel idea at the time). Schultz took that concept back to the US with him, presented it to the Starbucks owners, who were disinterested. So like all good start-up stories, Schultz left, created Il Giornale, and by 1988, Schultz bought the original Starbucks from the original owners for $3.8M.

The company went public in 1992. Schultz was a growth-oriented CEO, pushing the company onto street corners to the point of ubiquity. He stepped down in 2000, before returning again as CEO in 2008 to pull the company out of the Recession.

He completely overhauled the company during that time, introducing more technology, the Rewards Card, and a focus on true, organic growth. He stepped down again at the end of 2016, and announced that he was completely exiting the company on June 4th of 2018, with whispers of political ambition for President of the United States surrounding his decision.

Schultz’s Exit: What Does it Mean For the Company?

A lot of company are defined by their founders. Elon Musk and Tesla are inseparable in the public eye (for better or for worse). Steve Jobs and Apple. Bill Gates and Microsoft. Warren Buffet and Berkshire Hathaway. Mark Zuckerberg and Facebook. Colonel Sanders and Kentucky Fried Chicken.

It’s always a tricky transition from Founder to New CEO, especially from Howard Schultz, who has been there for 33 years and became the face of the company over that time.

Kevin Johnson, an external hire with a background at Microsoft and Juniper Network, is now leading this $70b coffee company as CEO. He is backed by a Board of Directors headed by the former JC Penney CEO, Myron Ullman (he definitely has the ability to make painful decisions quickly). Management has several fresh faces, including Roz Brewer, the COO, who will celebrate her first year anniversary in October 2018. Scott Maw, the CFO, is retiring at the age of 50.

That’s the point of concern – so not only is Schultz leaving, but Maw is too. At fifty years old and with four years in the role, his early retirement is creating speculation that maybe the decision wasn’t quite voluntary.

On the announcement, shares dropped 2.6% on the day to $48.54 and are down 23.6% from last year’s highs of $63.61. Maw’s departure isn’t the only thing plaguing the company – they closed 150 stores over the course of FY 2017, which is 3x their normal amount. They are currently relying on growth from simply opening up new stores, rather than facilitating same-stores sales growth. They took out debt to finance a share buyback, resulting in a credit downgrade from both Moody’s and S&P. Their revenue is coming from an increase in ticket price, rather than an increase in the number of transactions.

They might have invented the coffee industry, but their economic moat is shrinking over time for 3 reasons:

  1. Local coffee shops are starting to do the same thing. Come in, sit down, and enjoy the experience.
  2. They’ve created their own competition. With a store on every street corner, they’ve going created some store-on-store loss.
  3. They have to adjust to new leadership and a new style of growth that balances new store openings with same stores sales.

China: The New Growth Catalyst

How does SBUX plan to combat the 3 headwinds above? By doing what almost every other company is doing – going to China.

chimerica graphics ENGLISH - population and area - NEU

Source: CIA World Factbook

Starbucks plans dominate the Chinese market. They bought out their entire East Asia market this year, and have a new store opening up every 15 hours, with a goal to add 600 new stores per year by 2021 (5,000 stores; 200 cities). Despite those lofty goals, China isn’t really going that well at the moment. China store sales declined 2% in Q3 2017, with the whole Chinese-Asia Pacfic area declining 1% in sales growth and 3% in the number of transactions.

sbux q3

Source: Company Filings

China used to have a tea culture, which has been replaced by coffee, evidenced by consumption growing 3x over the past four years. The market size of China is almost 1.4billion people, versus the USA’s 3.24 million. The US represents 23% of China’s population. If SBUX can replicate what they did here, and with an 80% coffee market share already, continued strategic growth could be astounding.

china consumption

Source: Business Insider

SBUX has also made two key business decisions that will compound their growth overseas:

  1. Distribution Agreement with Nestle
    • The deal allows Nestle to distribute SBUX goods
    • SBUX dominates the RTD (Ready-to-Drink) market, with 88% market share in North America
    • A partnership with Nestle will allow exposure to the company’s 189 country footprint (2.5x times the footprint of SBUX)
    • It also got them a $7b up-front payment, which is going towards a 20% hike in the dividend and a $10b increase in share buybacks
  2. Partnership with Alibaba
    • Partnership will begin in September of 2018, at 150 locations in China’s most populous cities, Shanghai and Beijing
    • BABA will be utilizing Ele.me, a food delivery company that they acquired in May
    • With plans to spend $1b in promotion for 3 months up until the September debut, BABA has lofty goals
      • By expanding marketing, they have more access to more consumer data allow them to execute those lofty goals
    • SBUX is the catalyst for the opportunity to expand their delivery services, tapping into the $585b Chinese food market. Beyond that, BABA is a force to be reckoned with in China
    • The SBUX partnership with BABA is like joining the 1996 Chicago Bull’s team: you’re probably going to win

Will China Be Enough?

Johnson plans for more “series of verticals” partnerships like these, which could be a wise business choice. Why build out your own infrastructure when there is already someone doing it better? SBUX has had successful partnerships in the past, notably those with Apple and PepsiCo (not so notably, the one with Kraft Foods).

SBUX is trying to make the stock as attractive as possible for investors, which ironically resulted in a credit downgrade. They are giving back $25b (a $10b boost from November) in share buybacks, which represents 35% of their market capitalization. Their dividend has increased 44% since 2017. They spent $1.3b to buy back East China from licensees. They are using the proceeds from the tax cut to reinvest in their employees, providing store grants and raises.

tiers

Source: Investor Presentation

They have other plans for the US, including high end Roasteries and Reserve Stores that further enhance the high-end feel of their stores (and the high-end prices – and subsequently, high-end ticket sales). There’s room in the Americas for afternoon sales to increase and growth in their already-successful mobile ordering. Starbucks Rewards also has room for continued performance, as the partnership with Chase’s Prepaid Visa grew 14% in Q3 2018, accounting for 40% of all US sales.

prepaidSource: E Marketer

But SBUX knows that China is going to be the tipping point. It has to be.

Conclusion

SBUX has some solid growth strategies lined up, both in the Americas and in China. They are actively searching out effective partnerships in a “least effort, most return” mindset (my words, not theirs). The exit of Schultz will be a test for the company. The company is in an economic environment where they should be growing, but they have some headwinds, such as self-saturation and the growth of local shops. They carry that brand-name but so did the 52% of Fortune 500 companies that went extinct over the past 15 years (Blockbuster, Kodak, Borders).

SBUX doesn’t suffer from the same headwinds that the above companies did, of course – SBUX is looking for innovation and partnerships in every corner, and is using mobile to their utmost advantage.

But China is a BIG market that a lot of companies are going into. It is important that SBUX plans for the long-term when making decisions – not saturating the market like they did here for short term revenue growth. They also need to continue to facilitate a strong and empowered China management team, which is currently led by Belinda Wong, who heavily invests in employees and has been with the company for 18 years.

The company is relatively inexpensive (16.18 PE ratio), EPS are expected to increase into the future, and their allocation to share buybacks should allow them to maintain the stock price in the short term. I expect them to have an adjustment period of 2-3 years as they adapt to the Chinese market (although Alibaba could accelerate that) and modify their American game plan, but they are maintaining a growth mindset, investing heavily in employees, and refusing to settle.

stock price

Source: Yahoo Finance

Trade Ideas

Straddle: If you think that the company has a upward trajectory, but don’t expect the stock price to move too much in the next few months, the Sep 21 52.5 Put/Call Straddle is trading for with 55% probability of profit and $2.77 of theta with a max profit of $228 and breakevens between $50.22 and $54.78.

straddle

Iron Fly: If you’re a little more risk averse, you can add some protection on either side. I bought a 48 put and a 57.5 call on either side, for a max profit of $206 and a max risk of $294 for $1.67 of theta and a 50% probability of profit.

ics

Finally, if you do expect growth in the future, think about buying the stock at a price you think is reasonable and sell some calls against it to reduce that cost-basis and improve your overall probability of profit.

Disclaimer: These views are not investment advice, and should not be interpreted as such. These views are my own, and do not represent my employer. Trading has risk. Big risk. Make sure that you can balance your risk/reward, and trade small, and trade often.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s