All Quiet on the Eastern Front
All Quiet on the Eastern Front
Starbucks revises China guidance and introduces olive oil coffee
Starbucks’ consolidated business continues to be running at different temperatures throughout. As though it were a leftover steak pie being reheated in the microwave. The upper crust and outer pastry are plenty hot, but the all-important centre, the gravy & steak filling, is still cold to the touch. The last time1 I wrote about Starbucks was at the conclusion of its 2022 financial year. It was showing strength in its domestic market (record sales of $23.4 billion) and signs of promise from the international segment which, excluding China, grew revenues by 11% (30% in constant currency). Meanwhile, China, Starbucks’ second largest market, shed an incremental $690 million from its topline. Naturally, I decided to focus that memo on China. The latest news on that front has been the removal of China’s zero-covid policy. Just this morning, the manufacturing PMI index put out the fastest expansion in over a decade.
Across the country, both supply & demand expanded in February, the employment sector picked up, delivery times improved, and business confidence is at a two-year high2. By all accounts, this is the data Starbucks has been waiting on. Rewind a month, and the headlines from the Starbucks report sounded promising, touting a potential recovery in China for the back half of 2023. But the quarter ended up being a real nothingburger; a wait-and-see story. Management saw “meaningful, sequential improvement” in sales & traffic in January. But when push came to shove, Ruggeri admits it’s all still up in the air. The company arguably has the greatest clarity they have had on the region in over 2 years and, as a result, reduced China’s expected contribution to EBIT during 2023. However, domestic strength and international recovery (ex-China) mean overall guidance remains unchanged. More on this later.
During the call back in early February, Schultz would allude to a “transformative new category and platform for the company”. Just recently, we found out what that was; a supplementary offering for Starbucks’ modifiers3 business that will stand as a parting gift for the exiting CEO4. Today I will touch on this new offering, as well as the discombobulation in Starbucks’ Chinese recovery.
Daily per-store transactions are still lower than in 2019
But first, a little closer to home. Just how far will the American consumer go to get a hold of a Starbucks? Apparently, quite far. Bringing in 75% ($6.5 billion) of the quarter’s revenue ($8.7 billion) the North American division grew sales by 14% in the first quarter, driven by +10% same-store sales on the back of a 9% increase in average ticket and 1% growth in the volume of transactions. This came with modest margin suppression (40bps YoY) as they endure a reinvestment cycle. Consumers are obviously willing to soak up the inflationary menu prices at Starbucks, revenues are at all-time highs, but don’t be fooled.
Transactions per store per day, a measure of health for the business, are still below pre-pandemic levels. In fact, they are slightly lower than they were last year. Things are improving, Ruggeri claims. But something that ought to be remembered, customers are still consuming differently than they would pre-pandemic. When you begin to utilise drive-thrus more often, for example, it’s more often the case that you are ordering for multiple acquaintances. In these circumstances, the basket size is greater. So while it looks like Starbucks is simply growing through pricing (and they certainly are to some extent), it’s not the whole picture. On the consolidated level, Starbucks put up +5% same-store comps, with average ticket up 7% and transactions falling by 2%. But again, China, where volumes were down 28%, has a large part to play here. We are not yet at the stage where Starbucks is wringing out the towel for extra beads of sweat. Elsewhere, the international segment which has been hurting for so long is back. Excluding China, the region put up revenue growth of 25% and double-digit same-store comps. There were various other callouts in the call5; you can read the footnote if you wish.
In other news, the rewards membership base, now spanning ~10% of the American population, continues to grow in adoption and importance. These rewards accounts typically represent ~$2 billion of pending spend in stores. Nothing to be scoffed at. A record of $3.3 billion was loaded onto cards during the festive quarter. No shit, prices are going up, so the card load should too. More interesting, to me at least, is the continued share of tender that Rewards members make up for; now totalling 56%, up 6% from the beginning of 2021. To beat a dead horse, rewards members spend more, they visit more, and they are a higher calibre of customer. The Starbucks Odyssey6 system, the supposed “next phase” for the rewards pipeline, has been out in the wild for a few months now. When Schultz began talking about merging NFTs and rewards back in 2022 I felt nauseous. I still do. It felt like a futile attempt to connect with younger audiences. For now, members are told they can collect "stamps" by doing various things on the platform like answering quizzes and buying bags of whole-bean coffee. Come April, the company will unveil the benefits of the stamps and varying tiers of points collection. This comes at a time when Starbucks has increased the hurdle rate (the number of stars needed) to earn a free coffee in the original rewards app7. The intelligent thing about these stamps is that they expire8; creating a sense of urgency that mimics the non-permanent gold member status of the traditional rewards system. The jury is still out on what level of success Odyssey will have as it continues to be rolled out.
Share Repurchases are Back
The first decision Schultz made when returning for his third stint as CEO was to axe share repurchases in favour of shoring up liquidity. Until then, Starbucks had repurchased ~25% of the company’s outstanding shares over the prior decade. I expressed at the time this was sensible. Shareholders are so used to dividends at this point cutting those would have been met with disdain. The company was also in a precarious position with cash flows constricted and a daunting maturity structure9. The move was met with praise10 from credit rating agencies. One of his last decisions, before retreating into a board role, is reinstating share repurchases. The $191 million repurchases in Q1 seem paltry when you consider that Starbucks reclaimed $17.3 billion in stock in the two years prior to the pandemic. But this comes with a renewed11 promise of returning $20 billion to shareholders through (primarily) share repurchases and dividends by 2025. Rating agencies are once again convinced of the strength of the company's liquidity; they feel12 that "Starbucks' credit profile reflects strong liquidity that provides it with the support to be able to manage through the current difficult global operating environment”. This is despite the fact that margins continue to face an uphill battle in the face of a flaccid Chinese market and inflationary headwinds.
Starbucks’ EBIT margins are earmarked to eventually return to the 18% to 19% level over the medium term. Although, Ruggeri no longer provides a timeline for this. If they can get there, 400bps of upside to EBIT is a big deal. But there are still a few levers that need to be pulled first.
All Quiet on the Eastern Front
One of which is China. The quarter proved to be a mixed bag; not to be quite as exciting as the headlines suggested. While the end of the zero covid policy is a great thing for business, it ultimatley led to an outbreak of covid cases in the quarter. Revenues, as a result, were less than impressive at $622 million (-32%). Same-store sales declined 29%, about four times worse than management had expected, largely led by a 28% decline in transactions and a 1% decline in ticket. The greater-than-anticipated same-store sales amounted to a surprise $0.06 additional loss on EPS (which was $0.75 for the quarter).
Starbucks is essentially a lamb negotiating with a butcher’s knife here. They are at the mercy of the Chinese government and the economy. All they can do is build more stores, wait, and hopefully be rewarded with an eventual recovery of traffic that ought to see this business pump out a minimum of $1 billion in quarterly sales. But, this journey is non-linear and there may be more cobbles ahead. On the positive side, clarity is improving; the fog is slowly rising. Management cautiously suggested the end of zero covid will result in “renewed consumer activity in China and recovery in the back half of fiscal 2023” and resumption of pre-pandemic levels of consumer, social, and economic growth. Early data from January was positive. Comps were only down 15% compared to December’s 42% decline. But we’ve heard this all before. It remains a show-me story. Thankfully, Starbucks, now backed with stronger liquidity, have the resources to bide its time. But while they have been biding their time, the resuscitated Luckin Coffee has been busy, carving out a considerable lead in store count across China.
It’s not as though Starbucks have this market to itself. When normality resumes, so too will the ground war. Luckin, for better or worse, has an advantage in scaling; currently, ~32% of their stores operate under partnerships, up 4% in the last 12 months. Contrast this to Starbucks which is 100% company-operated. Starbucks does, however, have the advantage of operating a greater capitalised business on the whole. Moreover, the typical Starbucks store generates ~2x more revenue in a given quarter than a Luckin store does. There are various puts and takes here; sacrificing quality control for scale, weaker unit economics, etc. But I will be candid and say I haven’t dug into Luckin since they were caught fabricating financial performance back in 2020. I am led to believe that their turnaround has been quite miraculous, but will have to do the work to draw my own conclusions, perhaps in a future memo.
All said and done, Starbucks are not out of the woods yet. It would be overly optimistic to expect anything significant to come from China in 2023. I would settle for robust signs of recovery in the back half and remain convinced that China continues to be an attractive market for Starbucks that will, in due course, assist with the return to high teen margins when sales leverage kicks in.
You’re putting what in the coffee?
Remember that mysterious “alchemy” comment from the call? As though he was presenting this decade’s iPhone, Schultz stated that Starbucks would "introduce something much bigger than any new promotion or beverage” in the coming month. Something he claims would be a “transformative new category and platform” and “a game changer” before telling analysts on the call he’d have to kill them if he divulged more.