Is Starbucks Your Cup of Money?

(source: Sheila Hawkins and Starbucks)

All of us know Starbucks. It is the brand that defines coolness and social status. It aims to be your third home, away from your home and office. A place where you socialise with your friends. Did you know there are more Starbucks than McDonald’s in USA? They have over 28k stores in 77 countries. It is a lifestyle brand.

Today is 26 June 2018! What day it is? For Starbucks, it means Howard Schultz, former chief executive and executive chairman, is leaving today. Mr. Schultz was the CEO from 1986 – 2000, and 2008-2017 before transiting into the executive chairman post. After leaving his post, he will assume the position of chairman emeritus.

(Howard Schultz on the left; Kevin Johnson on the right)

A year before, Mr. Schultz had already passed down the role of CEO to long-time executive Kevin Johnson. The office distance between Kevin Johnson and Howard Schultz’s offices was just a door apart. As a result, they worked very closely together. Starbucks’ five-year strategic plan was co-authored by them. Before his current role, Kevin was on Starbucks’ board of directors since 2009, then became the chief operating officer in 2015. He is no stranger.

Kevin was the instrumental person behind buying full control of Starbucks’s east China operations, selling the Tazo tea brand and closing hundreds of Teavana stores. All of which improved profitability and kept Starbucks simple. In my view, Kevin, with his previous experience in Microsoft, will drive Starbucks into a more technologically adept company.

(source: Starbucks presentation)

As for the newly vacant chairman role, Mike Ullman will take over.

On 19 June 2018, the company did a press release titled “Starbucks Announces Strategic Priorities and Operational Initiatives to Accelerate Growth and Create Long-Term Shareholder Value”. On the same day, the stock fell 9%. Wall Street obviously saw this as negative news.

The key details are:

1. Grow the tea and refreshment category, catering towards health and wellness trend. The trend has been shifting some of their customers to other competitors, so Starbucks is embracing it now.
2. Reduce licensed store growth, shut down underperforming company-operated stores and shifting focus to underpenetrated markets. The closure of stores would increase to 150 from a historical average of up to 50 annually, causing lower revenue growth.
3. Grow the digital relationships with current and new customers such as active Starbucks Rewards members. Gamify the process. This is to drive comparable sales.
4. Working with an external consultant, Starbucks will focus on G&A efficiency to drive speed and leverage best practices.

(source: Starbucks presentation)

In my view, Starbucks has overreached itself and probably eat into its own profits by having too many outlets situated closely together. This ubiquity reduced the brand into a somewhat commodity which Starbucks is trying to offset it by building their premium roasteries brands around the world. It is probably time for a refresh.

On 22 June 2018, CNBC released an email from Mr. Schultz to CNBC’s Cramer.

“Given Starbucks scale and global footprint it’s almost inevitable that we will face cyclical changes in the business,” Schultz said in the email. “Some self-induced (after all we’re all human) and others due to market forces. Yet, if you look at our history (26 years) as a public company we have always been a learning organization that is built on a foundation of growth and innovation, leading to superior financial performance. I can unequivocally promise you this time will be no different.”

“And, for those who have looked at Starbucks whenever there has been a glitch in US comp store sales, and determined the glass is half empty they are respectfully dead wrong,” he said. “With regard to China, it’s going to be bigger and more robust than the US ever was, full stop.”

“The stock (which in almost 40 years) I have rarely commented on is cheap and undervalued. Kevin [Johnson, CEO] with Roz [Brewer, the chief operating officer] and our leadership team will lead us to the promised land,” Schultz said. “We have built a great and enduring company. And, as my mother was so fond of saying, ‘this too shall pass.'”

What do I think about it?

I used to follow Jane Elfers, CEO of The Children’s Place. She joined the company in 2010. Since then, she embarked on key strategies such as [1] better product [2] digital transformation using technology and [3] closing stores that are not producing profits due to high rents. As a result, the company’s share price shot up more than 150% from 2010 to 2018. For example, for FY2017, the net sales increased by 3.4% while the Selling, General, and Administrative expenses fell by 3.4%. As a direct impact from stronger cost controls, the operating income jumped by 63.5%.

The formerly SGX-listed Auric Pacific also pulled off similar strategy to improve profitability. The management bit the bullet and took out the non-performers in the group so that overall group profitability would not be dragged down.

(source: Auric Pacific Q2 2016 results)

As you can see, despite 2.3% revenue drop in 9M 2016, the business increased its profits significantly. Why? Its cost of revenue, general & administration, and selling & marketing expenses fell further. More profits at the bottom-line. There are many more examples which include NYSE-listed Systemax.

Using my limited experience in analysing these businesses over the years and the content from Super Stocks, I’ve learnt that businesses will have cycles so it is inevitable to suffer from something called a sales glitch. It provides the opportunity for long-term due to short-term sell-off. I will offer an opposite view from Wall Street. Starbucks will see better days but not so soon.

The issue with Starbucks closing down stores and affecting comparable stores growth should be seen in another way.

We should never be focussed on revenue growth. Revenue growth that leads to lesser profits and more costs is detrimental to the company. However, reducing revenue which allowed the company to save far greater costs is always encouraged.

Companies should pursue a path of profitable growth and not reckless growth. Shareholders should be delighted by the plan laid out as profitability is expected to improve.

Here’s an illustration. You have two kinds of revenue – good revenue and bad revenue.

Let’s illustrate using the simplified yearly numbers of two stores:

Clearly, for BadBucks, it does not make financial sense to run a store like that. It loses $16,000 on a yearly basis. This is bad revenue. Perhaps, it is an iconic store operating in a prime, high-traffic area to build the brand awareness.

For GoodBucks, it makes total financial sense since there are profits to be earned.

However, I do not know how many Goodbucks or Badbucks are in Starbucks. As of 2Q FY2018, the company has 14,812 company-operated stores. Pruning 150 stores per year is equivalent to 1% of it. Due to this low percentage, the profitability will improve but not in a huge way. The profits would not see a drastic shift as compared to The Children’s Place or Auric Pacific. Furthermore, the management is targeting to close down stores that are located too closely, so the traffic and sales of a closed store get redirected to other stores.

Why Starbucks will survive? It’s the brand. The strength of the brand awareness to pull in crowds remains intact. Whichever country I go, I see a Starbucks and it is crowded. People are willing to stand in line for a cup of Starbucks. That is one key observation which provided confidence in the brand.

Starbucks reminded me of something McDonald’s announced in 2014. Their article “McDonald’s Announces 3-Year Total Cash Return Target”, here are the key points:

1. Return $18 to $20 billion to shareholders between 2014 and 2016 through a combination of dividends and share repurchases, representing a 10% to 20% increase over the amount of cash returned between 2011 and 2013;
2. Refranchise at least 1,500 restaurants by the end of 2016, primarily in Asia/Pacific, Middle East and Africa (APMEA) and Europe, reflecting a more than 50% increase in refranchising activity compared with the prior three-year period; and
3. Analyze G&A spending with the primary intent of reallocating resources to higher return initiatives and growth areas, including the development of the Company’s global digital capabilities

You see, McDonald’s and Starbucks have similar strategies. Their turnaround plan included driving digital initiatives, redesigning store experiences and reducing G&A significantly.

McDonald’s executed their first leg of their turnaround successfully. Using that as a reference, it may take up to 3 quarters for Starbucks to show some signs of improvement.

Here is what I would do to monitor Starbucks

• Analyse its cost under “General & Administration” expenses, it should come down as a percentage of revenue.
• See improvement in comparable sales growth due to the closure of non-performing stores.
• Continued membership growth from Rewards programme

There is potential in Starbucks’ business.

But… before any signs of the turnaround, I will just remain as a customer of Starbucks.

EDIT: A friend of min shared this link showing Luckin Coffee, a serious competitor to Starbucks in China.

Heading back to KL now!