SBUX: "We're Playing the Long Game"
Starbucks Q2 2022 (NASDAQ:SBUX)
Starbucks continues to demonstrate a robust recovery in its domestic territory, with International (Ex-China) playing catch up. The focal point of Q2 earnings, however, was the temporal deterioration of the China business. Plagued so badly by zero-covid policy closures, the contagion from the China arm of the business resulted in Starbucks withdrawing guidance for the remainder of the year. But fear not, the prodigal son has returned for a third stint as CEO. Schultz has long been a catalyst for the Starbucks China expansion, expressing his desire for 5,000 stores in the region by 2021 as far back as 2015, when there were fewer than 1,500 stores. Reaffirming that he believes China’s dismal performance is transitory he would go so far as to suggest he is "convinced Starbucks' business in China will be eventually larger than our business in the U.S."
If we imagine Starbucks is a pizza for a moment, with the thick doughy base being the core business. Sat atop of that base, are toppings like supply chain woes, inflationary cost environment, looming management transition, high employee attrition, and discombobulated global mobility. These are what the observer sees when staring at this pizza… I mean business. All very yummy, but it’s missing something. A sprinkle of je ne sais quoi (*gestures pinched fingers*). Oh yes, there is a raging union movement still percolating within Starbucks’ most important market. Thankfully, unlike his predecessor, Schultz mustered up the courage to say the word, “union”, in the earnings call. There is a lot going on at the world’s favourite java joint, so I want to stick to the crucial matters at hand today; recovery, china, and the union.
• North America is Strong: North America recovering well, with revenues +17%, bolstered by a 5% increase in transactions and a 7% increase in average ticket. Comparable sales were up 12%, and pricing increases were met with minimal attrition and sustained demand.
• China Hurting: Lampooned by China’s zero-covid policy, revenues fell 14%, with average ticket down 4%, transactions down 20%, and a 23% decline in comparable sales. 1/3 of stores remain closed heading into Q3, and company-wide guidance for 22’ has been withdrawn as a result of the uncertainty.
• NFT/Web3 Chatter: Schultz announces some hair-brained ideas to incorporate Web3 and NFTs into Starbucks’ digital and rewards businesses. It will be the “digital third place”, apparently.
• Union: Unionised store count has 10x’d since I last wrote about Starbucks in March, standing at 65 stores. Only 12% of votes resulted in rejection.
• Hefty Reinvestment Cycle Ahead: Starbucks are set to reinvest heavily into store optimisation, wages and benefits, and digital, in an effort to transform the business in the face of changing consumer behaviour. Share repurchases have been axed to free up capital to do so.
All things considered, North America is doing relatively well. Churning out $5.45B in revenues (+17%) during the quarter, the region was supported by a 12% growth in comparable sales, a 5% increase in transactions, and a 7% increase in average ticket. Starbucks has raised prices several times over the last year to offset inflationary pressure with “negligible customer attrition”. This is similarly exemplified through the fact that both average ticket and transaction volumes hold strong. Even so, price events were not enough to outpace inflationary expenditure, as demonstrated by the segment’s EBIT margins.
Sitting at 17.1%, down 220bps YoY, there was some lapping of government subsidies that should be taken into consideration, but supply chain costs, investment in labour, and enhanced store partner wages and training costs, are the primary culprits here. With the announcement of further wage increases (likely to combat the union), and the continuation of an inflationary environment, it might be some time before things crawl back to equilibrium.
I chose the title for this memo because Starbucks is seemingly at risk of an impasse after its 50-year history, which Schultz plans to navigate by transforming the business once again. Cold beverages, for instance, is a product category that equates to anywhere between 60% and 75% of total beverage sales in a given quarter. Yet, despite the insatiable demand, Starbucks stores are not optimised for cold beverage output. Naturally, Schultz plans to reinvest in this area, expanding cold beverage station capacity in stores. That’s just one example, but the reality is that Starbucks was once a “third place” for consumers to physically park their posterior and chill for an hour or two and it’s still built for that reality.
Today, increasingly complex cold beverage orders are a larger part of that equation. Mobile Order & Pay, a $4B business in its own right which has grown 4x over the last 5-years, drove over 70% of store volumes in the States alongside an increasing demand for drive-thru. Delivery, another $500M business, is one which has grown 30% YoY as consumers continue to favour Starbucks from their homes or office. Even the way customers engage with Starbucks has changed. With 26.7M active Rewards members in the United States (120M total members), an approximate $11B or so is spent at Starbucks stores each year, from pre-loaded cards.
It comes as no surprise that Starbucks needs to get with the times. Schultz appears to be ready to do just that:
“Given record demand and changes in customer behaviour we are accelerating our store growth plans, primarily adding high-returning drive-thrus, and accelerating renovation programs so we can better meet demand and serve our customers where they are.”
He later remarked that ~90% of all new store openings would be high-returning drive-throughs. So, a multi-year investment cycle which understandably has to take place, but one that is going to cost a pretty penny. This was no doubt on Schultz’s mind during his first action as CEO, to shut down the share repurchase program and preserve liquidity. I had imagined, at the time of the announcement, that this was mostly related to the balance sheet, as Starbucks’ leaves a lot to be desired. This was echoed in the call, but supplemented with a narrative that ROI is stronger when reinvested into new US stores, which are cited to exhibit a ~55% ROI compared to annualised buybacks that sit at a ~10% ROI each year. Put simply, “investments in our stores - have an outsized return relative to what we could do with buybacks”. As a shareholder, with a time horizon of longer than 2 weeks, I don’t hate this. Sure, EPS will suffer from no share repurchases, but dividends and heavy buybacks are oft signs that the company feels it has no other attractive avenues for reinvestment. To bemoan the assertion that management now feels it has a better way to use that capital is nonsensical.
Speaking of nonsensical, I sighed as I listened to Schultz, a 68-year old man, enthuse about NFTs and Web3. More specifically, talks of a “big breakthrough idea” related to the launch of a “unique platform for NFTs” from Adam Brotman, the architect of the Starbucks digital app. If his app design is anything to go by, I am not optimistic about what he does with NFTs. Having long expressed a desire for Starbucks to gamify its app and rewards program, this is not what I had intended. Talks of creating a “digital third place” with the ability to create incremental revenue unto itself as a separate business, feel very 2021 to me.
However, I must admit, that I am eager to see what they will do to rejuvenate the rewards program, whilst remaining sceptical about the means through which they plan to do so.
International Weighed Down by China
The international segment was notably weighed down by the China results. Excluding China, the segment grew comparable sales in double digits and management attests that the segment is recovering well, despite the larger supply chain disruption than the US has faced. In aggregate, the segment generated record revenue of $1.7B (+4% despite China), which would have been +23% excluding China. On a consolidated basis, transactions (-3%), comparable sales (-8%), and average ticket (-5%) all declined, alongside a lofty 520bps decline in international EBIT margins (10.6%), mostly attributable to the same variables that have plagued the domestic EBIT margin. Starbucks International generated just $181M in operating income this quarter for their 17,701 stores (+9%).
China is a Burst Couch
Shrowded by China’s zero-covid policy, 1/3 of stores were closed in Q2 and the rest remained partially open. Results are so poor and the near-term is so uncertain in this region, that company-wide guidance was suspended as the ambiguity looks set to continue. Reports suggest that China intend on continuing its zero-covid policy until October and possibly beyond.
“We expect an even greater impact on our Q3 results due to the timing of the Shanghai lockdown and a further resurgence of the virus in other cities”.
Since the beginning of 2019, Starbucks' Chinese footprint has grown from 3,685 to 5,654 stores (+35%). As ugly a picture the lockdowns paint on revenues and earnings, an optimist might argue that this has the appearance of a tightly wound spring, ready to unwind when things are "normal". In the second quarter of 2022, Chinese revenue fell 14% YoY to $734M, with average ticket down 4% and the volume of transactions down 20%, leading to a 23% decline in comparable-store sales.
As for the number of rewards members in China, cited to be ~18M in Q1’22, there was no update this quarter. These members drive ~75% of sales volume in China, compared to ~50% in North America. After an anaemic 100K net ads in Q1, my suspicion is that 90-day actives in China declined in Q2, understandably, and that management left out the number on purpose. Below is a visualization from 2018 (the furthest back China data goes). Here we can see the strong back-half resurgance that took place in 21’, only for revenues to be plagued by mobility once more in 2022.
The China business is set to look ugly for the remainder of the year, or at least until mobility resumes. For a business that should be generating more than $4B in annualised revenues at its current size, I stand by my assertion that China may one day be a $10B+ revenue business. That said, the fragility of Western brands’ relationship with the CCP is not lost on me. It only takes one policy alteration, one change of heart, or one tariff, for the China growth story to suffer the fate of a communist sledgehammer. As such, China represents one of the handful of facets that make up the Starbucks bull case but is a relatively larger component of the bear case.
When I first wrote about the union in February, 88 stores had filed to request a union vote. By March, 141 stores had filed and 6 stores had officially unionised. Today, the approximate number of unionised stores is 10x that, at 65 across the country with only ~12% of stores voting no.
Whilst still a fraction of the overall base, the momentum is continuing. In the earnings call, we finally had someone from Starbucks address the topic head-on. In his opening remarks, Schultz would remind listeners that “our values are not and never have been the result of demands or interference from any outside entity”. He would continue to outline new benefits that would be rolling out to non-union partners this fall. Benefits include; wage hikes, a new partner app, improved tipping functionality, reinvestment in stores, extending training hours from 23 to 40, and the reintroduction of Starbucks’ Black Apron, Coffee Master and Origin Trip programs. Naturally, the SWBU had their own narrative, claiming that Starbucks would be refusing access to said benefits for unionised stores.
This, being contrary to what Schultz actually said, simply remarking that these benefits would not be unilaterally granted to unionised stores because of the mandatory bargaining process that has to take place. They will be offered, at which point the SBWU are obliged to accept or counter.
If the SBWU “demand these modest improvements be given immediately to all workers”, then is that not the ideal outcome for both parties? I foolishly said as much under that tweet and was called every name under the sun by a gang of unionists. Lesson learned. These benefits are no doubt to control the narrative and persuade partners to buck the union. The SBWU would call it “union-busting”, but at the end of the day, are unions not there to ensure benefits like these come to pass?
Equally intriguing, Starbucks has decided to move up their December investor day to September, to show off both their “pipeline of disruptive innovation” and their “coming transformation and reimagination of the Starbucks customer and partner experiences”. I suspect this was also done to get ahead of the curve on the union drive and show off their spangly new benefit plan. All in all, this union isn’t showing signs of retreating anytime soon, but Schultz and the gang are doing everything in their power to halt it. I have spoken before about the ramifications on margins and the fact that a union for Starbucks makes little sense. So, will leave you with the points that Autumn Capital outlined last quarter on the problems with unionising low-skilled service workers
For the quarter, Starbucks pulled in $7.6B in revenues (+15%), growth which was carried mainly by North America and International Ex-China. EBIT of $949M was down 4% on the year, with margins down 240bps on account of variables already discussed. China is expected to contribute “half of what we typically expect” in EBIT by year’s end, so some notable headwinds there. Earnings, $675M, were up 2.3%. Much of what I wanted to highlight regarding the income statement has already been discussed, but one last anecdote about margins before we move on.
Last year, investors were told that EBIT margins could expand to 18.5% by 2023. Then the macro-environment got choppy, and Starbucks decided to reinvest ~$1B into staff wages and training. We were told this goal would be pushed out to 2024 as a result. This quarter, that LT target was brought up, only to be sidestepped by Ruggeri (CFO). With all of these reinvestment outlays coming, albeit necessary ones, across digital, automation, equipment, remodelling, staff training and wages, I suspect the majority of these expenses are capitalised, but with wages and benefits being included in store operating expenses, it might take some time before sales leverage can erode their margin impact.
Schultz attests that demand is healthy enough to allow that to happen, telling investors to “just wait until we upgrade the system”, remarking that following this reinvestment period, investors are “going to see us recording the kind of store-level economics we have in the past”. I don’t doubt Schultz has the vision and character to pull this off, but he is not going to be here to see that through.
With ~$2B in term debt ($1B of which is due in the calendar year) maturing in the next 12 months, Starbucks issued $1.5B in senior notes in February to refinance a portion of their $16B debt balance. $500M of which is due in 2024, with the remainder set to mature in 2032.
Whilst the decision to pause share repurchases was garnished with an ROI narrative, I suspect it had as much to do with Starbucks’ balance sheet weakness. Excluding the value of stored card balances, Starbucks has a cash ratio ($3.9B cash) of just 0.54. Interest is well covered by the company’s EBIT (~7.6x) and the business is a notorious cash flow producer, but with maturities looming, a $1.1B dividend to pay out each quarter, undergoing a reinvestment cycle during an inflationary environment, and the certainty of those cash flows diminishing in regions like China, halting Starbucks’ repurchases feels like the prudent move.
Prior to the announcement, Starbucks had been expected to utilise ~$8B to repurchase more shares through 2023. The move to abandon repurchases was met with a positive response from credit rating agencies. Moody’s (below) would note that they believe Starbucks has the “necessary levers to pull to navigate these operating challenges and the pandemic-induced restrictions in key markets such as China which should subside over time”.
Drawing conclusions on the quarter, and quarters past, it’s evident Starbucks is in a state of transition. So much so, that Schultz attests to be “playing the long game”. As noted, he is not reported to be at Starbucks long enough to see that through. Originally here until the fall, he now commits to staying on to assist the new CEO until early 2023, whilst remaining on the board thereafter. In his closing remarks, he would remark; “I understand what's needed, and I'm back to lead this transformation and committed to seeing it through”. So, either he thinks this can be completed within the year, or he is signalling that he will stay until the job is finished. I don’t quite know, but walking into this role mid-transition is not an easy feat for any new CEO, so I remain cautious of the eventual managerial transition.
Moving on, when is the best time to acquire a business? When the business itself is going through a hard time? Rather, I believe it is when the market recognises that a business is going through a hard time. There are a number of negative sentiments hanging over Starbucks, many of which I have spoken about today. In my opinion, most of them are temporal. China’s situation is uncertain but unlikely indefinite. Starbucks has survived recessions in the past seeing revenue grow in 2008, and fall 6% in 2009, before recovering the following year. Inflation, and macro generally, is something I have no control over, nor do I have any predictive powers. The data that came out today, on May 11th, shows that whilst inflation is still rampant, we might have seen the worst of it, with more than half of the components down MoM.
These things tend to be volatile but inflation could potentially be topping. Caveat: just because expectations are falling, I don’t assume humans are any greater at predicting disinflation than an aardvark is at playing Nocturne in E flat major.
Starbucks is not quite in capitulation mode, but it does trade a pretty discount to its pre-covid valuation in the low $70s. There are certainly cheaper names out there, but at 19x trailing earnings (24x forward earnings) I have been taking small bites of Starbucks once again after I sold the remainder of my stake from my taxable brokerage at $115 on September 21’ and at $93 on Feb 22’.
For context, the sale in September was unloading excess weight from a heavy March 20’ purchase after it had retraced. The remainder was sold on Feb 22’ so that I could place my Starbucks exposure into a second account, one with more of a focus on yield and coffee can style investing (no pun intended).
Thanks for reading.
Author of Investment Talk