SBUX: Musings on 2021
(Starbucks Q4 2021 Earnings Review)
In September I shared a memo outlining my long-term thesis for Starbucks as a stalwart in the portfolio and my reasoning for trimming the position down 200bps to a more comfortable level. Nothing has wavered my conviction from that memo.
Like most companies in this industry, Starbucks has been a recovery story. Whilst there are pockets of their operations (China, Asia, Europe) that are recovering slower than their domestic operations, the overall recovery has been pleasing.
Today’s memo will focus on four key areas: (1) The Consolidated Business; (2) The Chinese business; (3) The Rewards Program; and (4) Liquidity and Cash Flow. For additional company-related commentary, please review my previous Starbucks memos (Portfolio Update 09/16/2021, Q3 Review: Starbucks Step Out of Recovery).
PDF Version Below
Starbucks is a position I currently hold in my portfolio (weighted at ~4%).
(1) The Consolidated Business
As of year-end, 2021, the Starbucks franchise is now home to 33,833 stores (+3.6%) and over 400,000 apron partners worldwide.
After guiding for $29.2B (mid-range), full-year revenues for the company came a touch shy of that at $29.06B (+23.5%), equating to 9.6% growth on a 2-year stack from 2019. Quarterly revenues of $8.14B (+31.3%) set a second successive record sales period for Starbucks, once again showing that the business is past the recovery stage on the consolidated level.
The North American ($5.8B/+27%) and International ($1.9B/+26%) segments both reported amicable revenue in Q4, largely driven by the sales leverage afforded by the increase in transactions (+18% and +6% respectively) and comparable-store sales (+22% and +3% respectively). North America reported a +3% comp on average ticket, whilst international average ticket fell 2%. As mobility has improved in these areas, and consumers are now purchasing more single-customer orders, the weakness in the average ticket is a byproduct, rather than a concern.
On the whole, the Starbucks business is looking healthy once again. Using 2019 as a base rate, gross profits ($8.4B/+19%), operating incomes ($4.6B/+19%), net earnings ($4.2B/+17%) and Earnings per share ($3.56/+21%) are all now aligned with where I would expect them to be under a typical operating environment.
The cash conversion cycle is now sitting at ~19.35 days (down 14.5 days YoY) with both inventory turnover and sales leverage ushering Starbucks back to pre-2020 efficiency.
Commentary from Kevin Johnson (CEO) suggests that, despite supply chain complications, the team are confident in their inventory levels heading into the festive season (which tends to be their best quarter). Anticipating that nearly $3 billion will be loaded onto Starbucks Cards this season ($1.59B, net, is currently loaded as of October 3rd), the adoption of Starbucks’s digital and out-of-store distribution methods (drive-through lanes) appear to be generating the desired shift in consumer behaviour.
Whilst in-store sales (excluding drive-through) are still a priority, rewards/cards members create customers with greater retention and propensity to spend, whilst fast-lane drive-throughs enable higher turnover. Both of which are margin accretive in the long run.
Operating Margins and Starbucks’ $1B Investment in Staff
Whilst we are on the topic of margins, Starbucks’ EBIT margin concluded the year at 16.18% after a 19.4% (+580bps) print in Q4. The company has a LT target of between 18% and 19%. Whilst 2021 was an obvious detraction from that target (more so about recovery), it would appear that 2022, guiding for ~100bps expansion, will bear some downward pressure on account of inflation, but most importantly a purposeful reinvestment into the workforce.
Come January 2022, Starbucks intend to raise the wages of their apron partners, granting full-time workers of 2Y+ a 5% increase in salary, with a 10% raise being granted to those who have worked for 5Y+ at the company. Hourly workers, starting next summer, will now also be paid an average rate of $17 per hour (range is $15 to $23).
This, alongside investments in training, and other employee benefits, will reportedly be a one-time step-up of $1B in annual wages and benefits. I will save the spiel on why this is for the betterment of the company, making Starbucks a “good place to work” to ensure happy employees, which equals happy customers, and so on. The tone from management is one that confidently asserts they are doing right by their apron partners, and that is worth the momentary setback in the margin, which they expect to offset during 2022 with sales leverage, pricing power, and return to 18% to 19% in 2023.
I think in light of the inflationary environment we are currently in, and the relative uncertainty as to how that will pan out, I can give Starbucks a pass here.
In their guidance for 2022, management suggested that the reinvestment in their workforce will cost them approximately 400bps of margin, whilst inflationary pressures are expected to amount to 200bps of contraction.
Operating margins across segments; North American 20.8% (+970bps), International 19.7% (+770bps), Channel Development 49.5% (+1,380bps), are all back to pre-covid levels, and there exists a number of avenues for margin expansion still left to squeeze across the coming decade.
Cold Beverage Attach: Whilst these beverages are typically seasonal, 75% of all beverage sales were from the cold brew lines this quarter (74% in Q3). These products typically have a higher mark-up (greater margin) than hot espresso.
Rewards Conversion: Greater numbers of rewards members equals a higher propensity to pay, greater retention, and higher repeat purchase rates. Whilst not incrementally material, a longer-term trend of higher SR conversion will result in increased sales leverage.
Technology: Through projects like Deep Brew which has the ability to create efficiencies in the supply chain, but also within stores via automation which inevitably lead to efficiencies in labour, Starbucks can both save expenses and increase throughput in stores.
Channel Development: Whilst a smaller portion of the business, channel development carries a significantly higher margin profile. Net revenues for this segment ($1.59B/-17%) were down on the year but still managed to grow operating income by 15% ($789M). The decline in revenue is transitory (related to the GCA restructuring), however. Packaged, ready-to-drink, products are still an attractive reinvestment runway for the Starbucks brand.
Pricing Power: Lastly, let us not forget that management believes the company has considerable pricing power. A tool they intend to use this year as the inflationary pressures persist.
In closing, despite margin pressure, I am confident Starbucks have the tools at their disposal to, initially, offset those pressures in 2022, before leveraging them to expand margin in 2023 and beyond.
(2) The Chinese Business
The Chinese business, despite operating for 20+ years, is still a great deal further behind on the S-curve than the rest of Starbucks’ operations. Representing one of Starbucks’ most attractive reinvestment runways, the overarching growth here comes from store count expansion and brand expansion.
2021 marked a landmark 5,000th store in the region, and now Starbucks have 5,360 total stores in China dispersed across 208 cities (of which there are still several hundred left untouched). The 225 net new stores in Q4 (654 in 2021) extend an impressive double-digit growth plan which has seen Starbucks grow Chinese store count by 14% YoY (4,706 in 2020), and 45% across the last 2 years (3,685 in 2019).
Rates of recovery in the Chinese region have been different from the West throughout covid. First, feeling the brunt of lockdowns much earlier, before emerging from the crisis ~1 quarter ahead of the West. During Q4, however, approximately 80% were affected by constrained consumer mobility at the peak in August, after some stores were fully closed (and others confined to mobile order only) after resurging cases swept the nation.
I would conclude that China is not yet back to full strength, with 2-year sales comparable sales down 10% (down 7% in Q4), which shows that on the restaurant level, there is still recovery left to be had. Both transactions (-2%) and average ticket (-5%) were also down from last year.
The Chinese business still managed to record $964M in revenues (+18%) for the quarter with the $3.64B generated in 2021 (+41%) marking a 27% growth rate from 2019 levels. In the face of negative comparable sales comps, I found it impressive that operating income was only down 1% on the year.
Whilst the business may still oscillate amongst the low-teens as a percentage of consolidated revenue (unchanged from last year), Chinese stores now represent 15.8% of the total store count (+140bps) and 31.3% of the company-operated store count (+300bps). I include company-operated stores here because Starbucks’ expansion strategy in China is absent of licensing.
As store count growth in the Chinese region continues to outpace domestic growth (which is approaching saturation) the catch-up effect will come into play. Of the 2,000 net new stores that Starbucks are guiding to open in 2022 (+6% growth in store count from 2021) approximately 75% of those stores will be outside of the United States.
(3) The Rewards Business
One of the slow-burning catalysts that I have identified in my Starbucks thesis is their increasing leveraging of technology. Through projects like the Starbucks Rewards program and the Deep Brew AI engine, Starbucks is now collecting more data on their consumers than ever before. That means more insight into spending habits, greater retention and propensity to spend, and visibility over a global network of coffee consumers.
The number of 90-Day Active Rewards members in the US increased to 24.8M (+30%) in Q4 with approximately 51% of all US tender (amongst company-operated stores) being generated from this small cohort of customers in Q4 (flat sequentially / +400bps YoY).
As a reminder to readers, management suggested back in Q2 that “the typical rewards member visits a store, or purchases an item, on average, 2 times to 3 times more often than a non-rewards customer.” Whilst Starbucks added an incremental 600,000 new members this quarter, Kevin Johnson’s LT goal of 40M+ Rewards members in the US is on the horizon.
In China, the 90-Day Active Reward members grew 5% sequentially (+33% YoY) and now stand at 17.9M members. In this region, the number of mobile orders as a percentage of revenues tends to sit in the low to mid-30s, compared to the US where mobile orders represented 24% of total transactions in Q4. China’s millennial/Gen-Z coffee consumer demographic is far more accustomed to using mobile for consumption than the West. As the presence of Starbucks in China continues to expand, I feel that experimentation and learnings from having a digital presence in this region will unlock hidden value that can then be trickled down into the domestic Starbucks app.
Candidly, whilst the growth of Starbucks Digital has been impressive (the company revamped their Stars program in Q3), it could be so much more. At present, a consumer can accumulate stars in their app for showing loyalty to the company. They can order ahead of time through the app for Starbucks pick-up. But besides that, there is a severe lack of ‘gamification’.
Whilst this lack of functionality has always been a source of potential ‘hidden’ value (or optionality) that can be unlocked at some stage, management has been slow to really innovate with the 42M+ combined members they have. I remarked last quarter that, through this program, Starbucks are essentially a bank, allowing billions of dollars of loaded funds to sit on the balance sheet (interest-free), from which they can leverage. More funds, equally more opportunity, so expanding the use and engagement of Starbucks Rewards with more compelling features seems like a no-brainer.
“Through blockchain or other innovative technologies, we are exploring how to tokenize Stars, create the ability for other merchants to connect their rewards program to Starbucks Rewards.” - Kevin Johnson, Q4 2021 Earnings Call
It appears that my wishes are being granted, to some extent. Starbucks will soon be unveiling more information on this initiative, but for now, have expressed that their intention is to open up the Starbucks Rewards and allow users to exchange those accumulated points of value with other brands. The first partnership of such being afforded to Air Canada.
More of these partnerships are to be expected this coming year, in a plan which Johnson quips will serve as the foundation for an “aspirational concept for new, modern payment rails that align payment expenses with the value received by customers and merchants.”
Starbucks has recently partnered with PayPal, allowing customers to load their cards with various cryptocurrencies (exchanged to fiat of course). Whilst the company appear to be experimenting with new methods of improving the value proposition of the Rewards program, the comments on “tokenising” stars piqued my interest mostly as this directly relates to my desire for gamification. It is from these incremental initiatives that new Rewards members originate. I am confident that Starbucks’ most attractive pool of potential new Rewards members is existing customers, so anything that assists with fattening the conversion margin will be worth trying.
(4) Liquidity and Cash Flow
Starbucks has implied that 2022 operating margins (17%) will be below the LT guide of 18% to 19% on account of their decision to reinvest heavily into their workforce. Frontloading this investment in the face of a still uncertain operating environment is something that may raise eyebrows. To appease concerns, management announced they would be returning $20B to shareholders over the next 3 years.
Around 2/3 of this sum will be distributed through share repurchases which, after completion, is approximately 15% of the current market capitalisation of the company. Including the share repurchases from 2018 onwards, this would equate to Starbucks buying back approximately 35% of the market capitalisation. Utilising the proceeds from the divestment of the Korea operations, it is expected that 2022’s repurchase will outweigh the following 2 years.
They aim to do this whilst simultaneously delivering on their double-digit EPS growth goal. To me, this shows confidence from the management team; that they can afford to distribute that level of capital, whilst continuing to reinvestment across the core tenants of the business.
The remaining 1/3 of the $20B outlay is expected to be returned to shareholders in the form of dividends with a ~50% payout ratio target. In support of that plan, the company intends to incrementally leverage the balance sheet, but at a level still below the <3x rent-adjusted EBITDA target.
As things stand, Starbucks’ current maturity structure implies just under 24% of their outstanding debt (~$2.5B) is due within the next 36 months. The company utilised additional leverage across 2018 to 2021 (with the latter half being to tide them over for covid), but with cash flowing back into the business, the outright reliance for additional financing now subsides.
Free cash flows for 2021 stand at $4.5B ($1B in Q4). The ~$500M per quarter dividend outlay now looks to be considerably safer than it did during 2020, which management continued to pay (tapping leverage to do so) to appease shareholders.
Despite margin pressure, I do expect earnings & operating cash flow to expand in 2022 as Starbucks exert full strength sales leverage. This gives me confidence in Starbucks’ ability to continue paying their dividend, and afford to ~$2B in 2022 CapEx they are guiding for to build the 2,000 net new stores.
It was noted on the call that they may look to utilise refinancing as a means to fuel the $20B promise to investors over the coming 3-years, so it feels as though next year will be a mixture of both free cash flow and modest debt issuance.
Now Starbucks are out of the woods, the foot appears to be pressed to the floor. Management is anticipating global sales comparable sales to reach high single digits in 2022 (still lapping poor results) alongside a full-year revenue guide of between $32.5B and $33B (+12% from 2021).
Whilst this revenue guide is above the 8% to 10% annual goal (LT target), if we claw back a little, the CAGR on revenue from 2017 through 2022 would be approximately 7.44% at the lower range of guidance.
Now that earnings are (partially) catching up on a TTM basis, Starbucks’ price to earnings sits in the low 30s. Whilst not cheap, they are now closer to pre-covid. Plans to repurchase 15% of the current market cap over the coming 3-years are great, but nothing to entice me to allocate more capital at these levels.
As readers know, I swung big in 2020, trimmed it back earlier in Q3, and am happy to sit on Starbucks at current valuations. My investment in Starbucks (initiated back in 2018) largely centres around a stalwart thesis. A strong brand, still growing, with margin expansion optionality, and ample space for reinvestment outside of dividends and share repurchases (China). Whilst that thesis is still in play, I am content. I believe that Starbucks can continue to expand in China for the next 5-years with little hesitation (barring external factors).
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