SBUX: Union, What Union?

(SBUX Q1 FY22 Earnings)

The last time I wrote about Starbucks (discussed in “Musings on 2021”), I spoke about how the business was beginning to emerge from covid. Despite mobility restrictions in Asia (particularly China), sales were accelerating and cash conversion cycles (the time it takes to receive payment from the sale of purchased inventory) had floated down from a peak of 45-days in Q3 2020 to 19-days by year-end 2021. I also spoke about the Chinese and Rewards businesses, and the self-induced setback to EBIT margins in light of management reinvesting $1B in staff & training. In doing so, they pushed the return of the LT 18% to 19% EBIT target out one additional year (to 2023). Let’s revisit all of that briefly before jumping to the most interesting topic; the unionist movement that appears to be brewing underneath Starbucks’ nose.

As it turns out, management now expects the return to LT EBIT margins to be extended out to 2024. Whilst revenue guidance ($32.5B to $33B) for 2022 has been reaffirmed, both EPS and EBIT expectations were tapered with an expected 200bps of incremental pressure headed their way from inflation, covid-related pay, new partner training costs, and uncertainty in consumer mobility (primarily in Asia). As such, we can expect EBIT to reach 16.5% in 2022 (a slight improvement on 2021), before expanding across both 2023/2024.

The tool for margin expansion over these next couple of years is apparently going to be sales leverage, sprinkled in with a modest amount of pricing actions, of which the company has taken two of in the last 6-months. There is this dichotomy of a business that is showing strength in their top-line, healthy rebounding demand for their products but hampered with the inflationary costs on the bottom line, squeezing margins. As such, the benefit of sales leverage is softened in 2022, and will hopefully become more pronounced thereafter.

Some notes:

• Record first-quarter revenue of $8.1B (+19%) with global same-store sales +13%. Despite strong sales recovery, cost pressure was deemed to be “extraordinary”, adding pressure to margins; most noticeably in higher staff-training costs, covid isolation pay, staffing shortages, and increase distribution & transport costs.

• Channel development revenue of $417M (+12%). The company also unveiled Starbucks Baya as part of its PepsiCo partnership. Whilst, not all PepsiCo partnership ideas have succeeded, the fruity energy drink places Starbucks into a promising high-growth product category.

The new energy drink is available in Mango Guava, Raspberry Lime and Pineapple Passionfruit. I am yet to sample any of the vitamin-infused beverages, but based on the amount of sugar they have (~23 grams) I don’t think I will be. This gives me all the vibes of Coca Cola Energy, a flop that was recalled last year after one year in markets.

• North America: Revenues of $5.7B (+23%), $3B in loaded card value, 21% growth in SR members (26.4M). Transactions up 12%, ticket up 6%, operating margins of 18.9%, comparable-store sales +18%, record food attach, which is now up 200bps over last 2 years as a % of sales. Drive through and digital account for 70% of US company-operated sales. A lot to like here.

• International: $1.9B revenues (+12%), 9% net new stores TTM, comparable same store sales -3%, transactions +2%, average ticket -5%. EBIT margins down 80bps to 16%. The UK was touted as a particularly strong market this quarter.

• China: Revenues of $897.2M (-2%) with -14% comparable-store sales, -6% transactions and -9% in ticket. Hit 5.5K+ stores.

China has been a sticky wicket this quarter. Hit with COVID mobility restrictions in Q1, the segment showed a decline in YoY revenues. It might surprise some that over the duration of this chart, Starbucks has grown their China store count by 50% (3,685 to 5,557). Whilst this market continues to lag behind the recovery of the remainder of the portfolio, I do believe there is some tension left to be released here as if it were some kind of coiled spring. Perhaps similar to what we saw with Kura Sushi after it emerged from almost 12 months of limited mobility with a greater number of stores.

I suspect this lack of mobility is part of the reason that Starbucks Rewards members in China are essentially flat QoQ, whilst North America has added 2.6M members YoY and 1.6M (+21% YoY) in the last 3-months. We know how important these SR members are (2-3x frequency rate compared to non-SR), but this is especially true in China where SR members drive ~75% of total sales in the region compared to ~50% in Northern America.

Around 3/4 of China’s store count came out of Q1 having “closures, dynamic store protocols or reduced operations”, which no doubt bleeds into Q2. However, it’s worth reminding oneself that ~1/5 of Starbucks’ entire fleet in China has been constructed during a pandemic. The results are far from ideal, but this is, and continues to be, a LT growth story for the company; a viable reinvestment runway. Still representing a fraction of China’s potential at 5.5K stores, I don’t find it hard to envision a future when China represents a $10B+ annual revenue opportunity for Starbucks. In order for that to happen, the company would need to optimise revenue per store back at pre-covid levels, and have ~15K stores. This is something I suspect could be plausible over the next 7-10 years. But again, this implies they continue to grow aggressively, the Chinese stores remain company-operated, and the return on investment continues to be favourable in the region.

Anyway, a fairly mundane quarter. Demand looks good, inflation looks to be beating up the bottom line. Nothing majorly concerning for me. What I really wanted to share a few cents on, is this big stinking union effort that is sweeping through Starbucks stores as we speak.

Union, what union?

If you were insulated from the outside world and just relied upon Starbucks’ SEC filings as a proxy for how the business is doing, you’d be unaware of brewing union tension. The word was mentioned exactly 0 times in the January earnings call. Starbucks has famously fended off union efforts for decades. After all, the business has long taken care of its green apron partners. They provide resources to go to college tuition-free, they pay living wages, they provide health and dental, and they give employees stock in the company. During covid, they ensured nobody would lose their job. Just last year they announced a $1B reinvestment into their own staff, at the expense of their LT EBIT margin target.

So what’s the beef?

There is a genuine outcry for partners’ voices to be heard. If you read this interview from October 2021 with members of the Buffalo store which eventually unionised (one of the first in the country), the overarching theme is simply that these workers want a ‘seat at the table’. They praise Starbucks a lot (oddly) but feel the working environment has been stressful over the covid period. They talk about supply chain issues, lack of personnel, all things that are not specific to Starbucks. It has an air of confusion about it, people becoming stressed working during covid, paired with commentary about how great Starbucks is as a job.

Pushing all that aside, I think the catalyst to these early innings of unionisation has been the company’s response, which some are calling “union-busting” behaviour. Nobody likes to see the little guy be squeezed by the big greedy coffee corporation. After two stores in Buffalo successfully unionised in December 2021, the company fired 7 Memphis partners (dubbed the “Memphis 7”) who had attempted to spur unionisation at their store.

Since then, 88 stores across 25 states (and counting) have now either filed for a vote to unionise or have announced intent to file. This can be tracked on this website or on the official Twitter account.

There, you can find the letters to Kevin Johnson that multiple new stores are signing up and sending each day. I have pasted one from an Atlanta store below. After having read through 30-40 of these letters, there appears to be an overwhelming amount of evidence that partners are not out to victimise Starbucks. On the contrary, many of them say just how much they love working there. But the consensus is that they want to be heard. Then there are some comical misunderstandings on how public entities work. One reads: “Starbucks as a company has continued to increase earnings during this pandemic, partners like us have not shared in the prosperity in turn”.

Indeed, that will be why earnings cratered 73% in 2020, and the company had to issue several billions in debt to remain liquid throughout the period when stores were closed. Debt which helped pay dividends to other stakeholders, continue to pay wages and keep the business, which you so love to work at, alive. What better idea than slapping reels of red tape around a business that already is constricted by red tape? It typically takes between 12-13 months for a maiden union contract to be agreed upon. Following that, the average duration of said contract is three years before one is then renegotiated.

But hey, the beef is on the table, the peppercorn sauce has been ladled over the meat and the plethora of triggered unionists are now writhing around in the sauce. The narrative is that big bad Johnson has some answers to provide and his team’s response, thus far, has not been great. Silently trying to shut them all down.

This is most definitely an unwelcome development for Starbucks. At present, the total spread represents less than 1% of the company’s company-operated North American stores. But like most infections, they spread fast, and this one is airborne. Unions inevitably pit employees against businesses. Whatever the outcome, the workforce is now going to be divided for the foreseeable future unless Starbucks conducts something miraculous to appease everyone.

I guess I find it interesting that management talked so frequently about how inflationary pressures and supply chain disruption is hampering EBIT margins but failed to mention the union effort in this line of discussion. Amongst others costs (both socially and monetarily) unions tend to increase the cost of labour for an organisation, which no doubt plays negatively on margins too. I remain fascinated as to how this turns out. Candidly, my hope is that the union gets ‘busted’, but I fear we may only be at the start of this journey.

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Concluding Remarks

It’s a tough spot to be in. I have only been a shareholder in Starbucks since early 2019, picking up shares at $76. When covid happened, I went hard, buying up a strong brand that I trusted would survive whatever was about to unfold, doubling up at $57 that month, and adding a touch more at $71 later in Q2. A year or so later, in September 2021, the share price had recovered, and I sold off the excess at $114.

On the one side, I definitely see the merit in owning a business that has a reputable brand amongst consumers, has attractive reinvestment runways (namely, China) for the next decade, shows the potential for margin expansion in the near term, and redistributes capital back to shareholders. Starbucks has repurchased around 23% of their outstanding shares since 2015, with an additional 31.1M being taken out of the market in Q1 alone ($3.5B). Last quarter we were told $20B would be returned to shareholders over 2022-2024, 2/3 of which would be via share repurchases.

Factoring in double-digit dividend per share increases each year, let’s call it $12B in share repurchases over that time. We were also told that much of that would be frontloaded into 2022. So far about 29% of that $12B has been redistributed in quarter 1 of 12. We were also told that “2022’s repurchase will outweigh the following 2 years”, for that to happen, they only need to repurchase an additional $2.51B in 2022.

That aside, the union troubles are concerning. Whilst I don’t think it will be entirely damning to the business, it does muddy the horizon with respect to visibility. As investors, we are left to sit tight and watch it play out. Do I think it will outperform the S&P 500 on a total return basis over the next 5-Years? Candidly, I don’t know, and I don’t really care either. Starbucks pays me ~3.1% of my cost basis each year in dividends. They have also shown a desire to repurchase a considerable amount of their outstanding shares over the next three years, whilst continuing to expand their footprint rapidly in China. I am not certain what kind of legacy Johnstone leaves, but if I had to hazard a guess, it could be the Chinese footprint.

I will admit, however, that I have contemplated selling down some Starbucks. I own it across two accounts; one which is “actively” managed, and the other which is more of a coffee can style basket. It certainly fits the bill for the latter, but in the former, where the goal is not optimising for yield, it has possibly overstayed its welcome as a re-opening beneficiary.

Regards,

Conor