Starbucks: What It’s Brewing May Be Going Stale

When it comes to a quality cup of coffee, Starbucks (SBUX) usually comes to mind for consumers. For many years, the same was true for Starbucks as an investment. However, as evident in Starbucks’ recent Q1 earnings report, future growth could be a concern with rising costs and decreasing sales in crucial markets such as China.

While Starbucks still enjoys near all-time high margins and respectable revenue growth, this news, along with the current volatility of the market due to employment and inflation concerns, has pushed Starbucks’ stock down ~20%, compared to a 7.6% decline in the S&P 500. A similar yet even more pronounced difference is apparent over the last year, with Starbucks’ return of -10% compared to a 12% gain of the market.

Trading below the 20-, 50-, and 200-day moving averages, this trend could certainly continue, though the RSI is nearing the 30 reference level, indicating the stock may potentially be oversold.

Starbucks recognizes these ongoing threats, with Kevin Johnson, President and CEO, commenting, “Although demand was strong [in Q1], this pandemic has not been linear, and the macro environment remains dynamic as we experienced higher-than-expected inflationary pressures, increased costs due to Omicron and a tight labor market.”

At the same time, SBUX is actively devising new strategies “that drive both top and bottom-line growth,” stated Johnson, but will it be successful?

Founded in 1971, Starbucks is committed to providing high-quality coffee that is ethically sourced. Operating more than 34,000 stores globally, Starbucks offers specialty coffees, lattes, teas, and small breakfast and dessert items.

I’m neutral on Starbucks.

Solid Financials, International Slowdown

There are plenty of positive aspects of Starbucks’ fundamentals to be considered.

Despite rising supply and labor costs, Starbucks’ operating and net margins are currently 16.2% and 14.5%, respectively. Similarly, its return on assets is 14.9%. In Q1, GAAP operating margin was 14.6% compared to 13.5% in the previous year, whereas non-GAAP operating margin fell from 15.4% in the prior year to 15.1%.

Maintaining these margins did come with a price, however, mainly paid by consumers. Pricing action has been taken multiple times already in Fiscal 2022, raising prices in October 2021 and January 2022, with additional pricing measures expected to ensue throughout the remainder of the year. While not ideal for consumers, Starbucks’ brand name and loyalty, as well as pricing power in an oligopolistic market, enable strong demand to continue regardless of price changes.

This sales leveraging also facilitated GAAP EPS growth of 30% year-over-year, resulting in Q1 EPS of $0.69.

While Starbucks’ three-year revenue growth is 11.4% and three-year EBITDA growth rate is a mere 6%, consolidated net revenues grew 19% to $8.1 billion in Q1 compared to the prior year. This can be attributed to global comparable store sales increasing 13%, supported by a 10% increase in comparable transactions and a 3% increase in average ticket.

Although this is fairly good news for the North American segment, international sales decreased 3%, with China comparable store sales decreasing 14%, resulting from a 9% decline in average ticket and 6% decline in transactions. Given China’s zero-COVID policy proliferating store closures and limited hours, this trend could certainly continue into the near future.

Lastly, Starbucks still boasts positive economic profit, or the difference between the return on invested capital and the weighted average cost of capital, though it was only 7% in 2021 compared to previous years in the 15% to 20% area.

Increasing Scope in Retail

In an effort to ensure growth through various channels, Starbucks has recently entered a completely new category to increase its scope: energy drinks.

In addition to Starbucks stores, Starbucks has been selling products in big-box retail stores for a number of years, from bottled and ground coffee to K-Cups for personal brewing machines. However, recently, Starbucks introduced an energy drink made with caffeine naturally found in the coffee fruit to its bottled and canned beverage portfolio. These drinks, produced in various fruit flavors, are sold in grocery stores, reaching customers through a different channel.

With strong brand loyalty secured, many may think that consumers will simply gravitate toward this energy drink over others solely because of the Starbucks name. While this is plausible and can certainly occur, it may not be as simple of a process.

To begin, just as Starbucks is entrenched in the coffee industry, there are entrenched competitors in the energy drink industry. Such companies, like Red Bull and Monster Beverage Corporation (MNST), already have customer bases of their own.

Moreover, these companies also have strong brand recognition through affiliations with sports teams and other notable individuals promoting the product. It could prove to be very difficult to not only attract but retain customers that previously purchased these brands.

This is especially true as Starbucks does not have a strong track record when entering new segments. In 2014, Starbucks attempted to transform into a night destination by serving beer and wine in its already-enjoyed atmosphere. However, this program failed soon after due to a lack of customer interest; ultimately, it seems that customers enjoy what Starbucks does best – its coffee – and perhaps it should focus on just that.

Evolving the “Third Place” Through Partnerships

The “third place” aspect of Starbucks is, of course, a crucial factor in its success, that is, allowing Starbucks locations to be the third destination for both work and leisure besides consumers’ homes and workplaces. Customers now had a place where they could socialize with others or perform tasks while enjoying their coffee, especially with the inclusion of Wi-Fi in its advent.

This model hasn’t undergone much change, however, prompting the question as to if there was any room for improvement or innovation. Addressing this concern, Starbucks recently announced a collaboration with Amazon Go (AMZN), laying the foundation for the modernized “third place” in a technology-driven era.

Through a combination of Starbucks Pickup and Amazon Go, customers can order ahead in the Starbucks app and enjoy a streamlined checkout experience through Amazon Go’s Just Walk Out technology. Along with a redesigned lounge containing individual workspaces and larger gathering tables, offerings from both Starbucks and the Amazon Go market can be purchased, adding salads and sandwiches to the menu, among other things.

While this initiative has promise, the concept has only been tested in one location in New York City, and its effectiveness in drawing additional customers has yet to be seen.

Wall Street’s Take

Turning to Wall Street, SBUX currently has a Moderate Buy consensus rating based on 13 Buys and 11 Hold ratings. The average Starbucks price target of $116.22 implies 24.1% upside potential, with a high price target of $136 and a low target of $100.

Conclusion

Starbucks has faced many headwinds due to the COVID-19 pandemic. Between rising costs and shortages of labor, Starbucks is depending heavily upon price hikes to maintain margins. While feasible in the short term, it is not necessarily sustainable, especially when international markets are already declining. While management has a positive long-term outlook, the success of new initiatives is questionable based on Starbucks’ precedent.

There was likely a lesson to be learned in Starbucks’ past failure to expand into different industries – focus on what is done best and what customers desire. It is evident that Starbucks has mastered making coffee and has a great deal of demand to do so.

One could hope that Starbucks will expend enough energy to sustain and grow its core business.

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