Will Drive-Throughs at Starbucks Drive Up Returns?

A lot is happening at Starbucks (NASDAQ: SBUX), drawing investors’ attention lately. Year-to-date, shares of the global premier retailer of specialty coffee have been down almost 40%.

Amid unionization drives, the company is grappling with several issues, including cost and wage pressures, leading to compressed margins; a slump in sales in its second-largest market China due to lockdown; difficult macro environment; and rising inflation.

Despite the suspension of the financial outlook usually provided by the company, last week, Starbucks shares gained almost 10% after it posted better-than-expected Q2 sales.

Globally, comparable-store sales rose 7%, with 12% growth recorded in the U.S., offsetting the decline of 23% in China.

Investors also cheered the various strategic plans revealed by founder Howard Schultz, who took back the reigns for the third time as CEO effective April 4, 2022, following the retirement of Kevin Johnson.

The icing on the cake was Starbucks’ commitment of $1 billion in FY22 to uplift Starbucks partners and stores, with the main focus on areas including higher pay, improved training and collaboration, and store innovation.

In a bold move, however, Schultz chose to suspend its existing $20 billion share buyback program as he believes that reinvesting the cash back into the business will drive higher returns.

In contrast, under the leadership of former CEO Kevin Johnson, the company repurchased about a quarter of its shares outstanding since he took over in 2017. The repurchases strongly boosted its earnings-per-share growth over the same period.

Drive-through Locations

Interestingly, there are impending plans to install drive-throughs in 90% of new locations and machinery that will allow baristas to handle complex customer orders more efficiently.

Earlier, Starbucks management did not approve of the drive-through outlets as that would mean poor aesthetics for the luxury coffee chain.

However, with growing inflation tightening consumers’ speeding budgets as well as cost pressures, the company is forced to rehink how to retain the loyalty of customers by keeping its pricing in check.

The Unionization Efforts

Unionization efforts are on the rise recently with strong public support in the U.S. as the population has been severely impacted by various economic downturns and events for more than a decade now.

For Starbucks, over 240 Starbucks locations have filed election petitions as of May 5 that cover over 6,600 Starbucks employees who could potentially vote to unionize. According to National Labor Relations Board officials, the majority of those stores haven’t yet held or completed elections.

To combat the growing unrest, the company has announced an additional investment of $200 million in FY2022 to increase pay for store managers, increase training, and revitalize its “Coffee Master” program for baristas.

Furthermore, the company will launch an internal app to communicate directly with its 240,000 U.S. employees.

Effective August 1, Starbucks is moving all U.S. store partners to a minimum of $15/hour while also adding incremental increases and raises.

In addition, by late 2022, customers will be able to add tips to their credit and debit card purchases, as demanded by baristas at unionized stores in Buffalo, New York.

Wall Street’s take

Following the quarterly results, Stifel Nicolaus analyst Chris O`Cull reduced the price target on Starbucks to $84 (20.74% upside potential) from $112 and reiterated a Hold rating.

O`Cull chooses to remain on the sidelines despite attractive valuations as he sees some execution risks that could pose a risk to the investment returns.

The analyst points out that the move to add enhanced in-app tipping capability will surely boost partner pay, but it could tarnish customer’s value perception as well as the company’s pricing power.

However, the rest of the Wall Street community is cautiously optimistic about the stock, with a Moderate Buy consensus rating based on 13 Buys and nine Holds. The average Starbucks price target of $95.55 implies 39.05% upside potential to current levels.

Final Thoughts

Schultz has announced multiple growth initiatives intended to drive long-term shareholder value creation at Starbucks during his temporary stint as CEO, until the new CEO joins in, expectedly by the first quarter of FY2023.

SBUX should benefit from the volley of new plans combined with increased consumer spending that will continue to accelerate in a post-pandemic environment.

On the other hand, labor and supply-chain costs will continue to hurt margins in the near-term as price increases can only temporarily offset inflationary pressures.

In the meanwhile, investors will keep a close watch on the turn of events, seeking stabilization in China’s sales trends, better visibility on margin improvements amidst growing cost pressures, as well as an alleviation in unionization sentiments.

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