SBUX - Starbucks: Turning Tea Drinkers Into Coffee Drinkers And Reaping The Rewards

2023-10-11 02:25:00 ET

Summary

• Starbucks is expanding fast in China and India.
• The growth from expansion is further accelerated on an EPS level by share buybacks.
• These qualities together make SBUX an interesting growth play - albeit with some risks that are discussed in this analysis.

A Starbucks at every corner... in China

Some brands have come to represent the American way of life and globalism. Think McDonald's Corporation (NYSE: MCD ), think The Coca-Cola Company (NYSE: KO ). As much as coffee is a global beverage - grown mostly in South America, Asia, and Africa - and enjoyed by consumers everywhere, there's another silent trend of globalism taking place in how it's consumed.

The leader of this shift is Starbucks Corporation ( SBUX ). Starbucks is well known for operating more than 15,000 coffee shops in the US with a strong reach in several other Western countries. But several years ago - in 1999 to be exact - Starbucks opened its first coffee shop in China.

China has eventually grown to be Starbucks' second largest market only behind the US, with about a third of Starbucks' company-operated stores based in China . China brings in the bulk of Starbucks' international revenue.

This is a far cry from what many were expecting when Howard Schultz, then CEO of Starbucks, opened the first Starbucks in China. Back then, China was thought to be a nation of tea drinkers - with essentially no one enjoying coffee the way Starbucks envisioned : In the style of the Italian coffee shop, a place to enjoy premium coffee and hang out with friends and family.

Fast forward to today, China is now the leading growth driver of Starbucks. It's taking center stage in Starbucks' corporate strategy which includes efforts to expand even further. At one point in recent years, Starbucks opened a new store in China every 9 hours. The total store count has surpassed 6,000 and is expected to grow to 9,000 by 2025.

Starbucks is nurturing relationships with its customer base in China. One interesting statistic is that of the number of rewards members per location:

As seen, a Chinese Starbucks location has almost twice as many reward members as one in the US. This speaks to the attractiveness of expanding in China. It's a place where once you've got the trust of consumers, they stick with you.

Expanding into China hasn't come without its challenges, though.

In 2017, Chinese company Luckin Coffee ( OTCPK:LKNCY ) entered the market. The company started to compete in the same segment as Starbucks and expanded at an extreme pace. Within a few years of its founding, it had opened more than 3,000 locations in China. Some analysts pointed to this as the end of Starbucks in China. However, in part because of over expanding and an accounting scandal, Luckin Coffee went bankrupt in 2021 . Luckin Coffee is still operating but to a much lesser degree. So as much as this was not the end of Starbucks in China, it does point to the dynamic character of the Chinese market: Something big can happen very quickly. And this is one of the risks involved in expansion into China as I will be discussing in more detail later.

But at the end of the day, Starbucks has never really taken a big hit in China. This is pretty unique as other major US brands have had issues in China one way or another in much of their time in the country. Starbucks now controls more than a third of the Chinese coffee market.

Some gloomy clouds are forming on the horizon. Chinese tea shop, Hey Tea , operates more than 1,000 tea stores in China that are aimed a premium offerings like Starbucks. This of course is an attempt on the part of the Chinese company to return Chinese consumers to mostly tea drinking now that premium tea is available to a great extent just like premium coffee. This is also somewhat different from the type of competition Starbucks faces in the US, where competitors typically are more price-focused than focused on beating Starbucks on quality (think Dunkin' Donuts).

It's up to Starbucks' new CEO, Laxman Narasimhan, to execute Starbucks' strategy in China which is key to keeping Starbucks growing. In that respect, I think 2025 is a milestone year, in part because of the ambition to reach 9,000 stores.

What turning tea drinkers into coffee drinkers at a global scale is worth to investors

In valuing Starbucks, I think there are three main value drivers:

1. The growth from expansion, particularly in China
2. The features of Starbucks' cash program
3. The capital allocation policy of Starbucks

The first main value driver I see is one that I've already touched upon: The expansion in China. Starbucks trades at a P/E ratio of ~27, so the market is expecting a lot of growth. That growth is probably mainly going to come from China - and from Starbucks' more recent foray into India. In the fiscal year 2023, Starbucks added a net 71 new stores in India. With its vast population, India offers great room to grow - but as a nation of mostly tea drinkers, India also offers some of the same challenges as China did when Starbucks decided to expand there. And India also has several domestic startups that are competing - also something Starbucks has lots of experience with handling.

I think Starbucks' proven ability to expand in Asia alone makes it worthy of a "growth stock" status.

The second value driver I'd like to highlight is Starbucks' rewards program. As described earlier, Starbucks runs a rewards program, essentially a charge card to buy Starbucks products - one that is relatively more popular in China than in the US.

The rewards program essentially works as an interest free credit facility to Starbucks. When customers fund their cards, Starbucks gets the cash immediately and will only incur charges over time as customers buy products with the card. Often, some of the money in the rewards program is not used at all. In Spring 2023 , the Starbucks rewards program held almost $2 billion in unused cash - cash that Starbucks can use as financing for its expansion and other purposes.

The fact that these programs add free financing and that they are probably going to expand in the future should help drive value to shareholders for many years to come.

As mentioned, I regard Starbucks' capital allocation policy as its third driver of value. Starbucks pays a dividend that sits at ~2.5 % has been steadily increasing the dividend for several years.

Aside from the dividend, Starbucks is buying back shares aggressively. In June 2015, Starbucks had almost 1.5 billion shares outstanding. Now, this is down roughly a quarter to 1.15 billion shares. The strategy of buying back shares helps drive EPS growth and adds to the growth provided by expanding. If Starbucks had not bought back the shares mentioned, EPS would be considerably lower - and the growth from expansion therefore much less evident to shareholders.

So what do you pay for a stock that displays ample growth, has plenty of cash and a strong cash funnel, and an ability to distribute cash to shareholders directly and consistently in the form of dividends and buybacks? Starbucks trades at a forward P/E of ~27 which is already reflecting quite a lot of growth expectations (and higher than the S&P 500's average of ~24). Given this, in my opinion Starbucks trades at a price that is probably close to fair value. However, given the buybacks that are going to drive EPS growth going forward - coupled with extra cash flows from expanding - I believe the appropriate P/E to ascribe to Starbucks' current earnings could be somewhat higher than it currently, probably by around 10 %, which would put the Starbucks stock at a P/E of ~30.

The risks of Starbucks' expansion into China (and beyond)

As with any investment thesis, there are risks to consider. In terms of the investment thesis laid out here, I consider the geopolitical environment to be of the most imminent concern.

Tensions between the US and China have become evidently clear in recent years. Certain regulatory moves by China have raised concerns that in the event of a direct confrontation between the parties, private property rights could be voided. These regulatory moves include China's regulation from 2020 allowing government to seize private property (including enterprises). It's clear that any development in that direction could significantly hurt investors. Even if properties aren't actually seized, it's just as clear that being in a situation where Starbucks would have to make a judgment call - either leave China in the event of an escalation, as was seen with many corporations leaving Russia over the war in Ukraine - is just as hurtful to investors. Imagine Starbucks having to leave China and close all 6,000+ stores - potentially 9,000+ stores by then. Obviously, this would devastate revenue and earnings for a long time and not least sever the company's near-term growth prospects. I think it's key to keep this risk in mind when considering an investment in Starbucks.

In terms of the risks involved with Starbucks in other countries - their expansion in India, and their efforts to remain on top of the market in the US - I see the risks as being mainly operational in nature. That's not to say expanding in India is easy: But at least you don't have the kind of geopolitical tensions potentially working against you. And as for the domestic market, it's about keeping up with competition.

There's really no easy way to quantify these risks - it's up to the individual investor to determine whether to shy away from the investment because of the risks - or whether the upside is too attractive to stay away from.

Key takeaways

Starbucks is leading the charge in the shift in how the world in consuming coffee. It's done so in the United States, and it's becoming a truly global company.

Starbucks is a growth company with a main focus on expanding in China and India. Starbucks has done a great job of establishing itself in China and is now looking to replicate the success in India.

All in all, I see three main drivers of value in Starbucks: (1) The expansion efforts, particularly in Asia, (2) The rewards programs that generate lots of free funding, and (3) The capital allocation policy, which secures a steady cash income coupled with EPS growth from buybacks.

The combination of these value drivers makes me believe that Starbucks is slightly undervalued by the market with a fair price P/E of about 30.

I see the main risks associated with buying Starbucks stock to be the geopolitical tensions between the US and China and local competition from startups etc. in India. Each investor must weigh these risks against the potential upside. Personally, at this point in time I see the positives outweigh the negatives.

For the reasons stated above, I rate Starbucks a Buy.

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