Initial Report: Starbucks (NASDAQ:SBUX), 48% 5-yr Potential Upside (EIP, Clive TAN Yijun)

Clive presents a "BUY" recommendation based on well-managed ESG risks and confidence in its leadership.

LinkedIn: Clive Tan Yijun

Company Background

Starbucks Corporation (NASDAQ: SBUX), founded in 1971 and headquartered in Seattle, Washington, is a premier roaster, marketer, and retailer of speciality coffee worldwide. The company operates over 38,000 stores in 86 markets, making it one of the most recognised brands globally. Starbucks reports 3 operating segments where revenues as a % of total net revenues for FY2023 are as follows:

1. North America (74%): U.S. and Canada

2. International (21%): APAC, EMEA, Latin America and Caribbean

3. Channel Development (5%): single-serve, food service and ready-to-drink products outside of company-operated and licensed stores

With a dominant market position as of 2023, Starbucks holds 41% of the global Branded Coffee Chain market share with the next biggest competitors such as Dunkin Donuts (14.3%) and Luckin Coffee (11.8%) trailing behind.

1. Revenue Segments

Starbuck’s revenue segments are categorized into three revenue segments: Company-operated stores, Licensed stores and Channel Development.

• Company-operated stores

Revenue from company-operated stores accounted for 82% of total net revenues in FY2023. The objective of company-operated stores is to offer the highest caliber of coffee, tea, and associated items, along with complimentary food options, and by giving every customer a distinctive Starbucks Experience. The foundation of the Starbucks Experience is built upon superior customer service, convenience and a seamless digital experience as well as safe, clean and well-maintained stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty.

These Starbucks company-operated stores are typically situated in high-traffic, high-visibility locations. These stores also operate on an omni-channel approach, where a diverse customer base is served through growth in online, e-commerce, delivery, mobile ordering and in-store experience. Overall, the retail sales mix in company-operated stores consisted of 74% Beverages,21% Food and 5% Others (i.e. servewares and off-the-shelf products).

• Licensed stores

Revenues from licensed stores accounted for 13% of total net revenues in FY2023. These stores typically have a lower gross margin and higher operating margin than company-operated stores. Under the licensed model, Starbucks receives a margin on branded products and supplies sold to the licensed store operator along with a royalty on retail sales. Licensees are responsible for operating costs and capital investments. Most licensees are prominent retailers with in-depth market knowledge and access.

• Channel Development

This segment accounts for 5% of total net revenues in FY24. Coffee and tea products sold through this segment compete directly against specialty coffees and teas sold through grocery stores, warehouse clubs, specialty retailers, convenience stores and foodservice accounts worldwide.

2. Industry Overview

As a global market leader in the Restaurants industry, Starbucks faces strong competition from a few key competitors across its operating segments:

• North America & International: Dunkin’ Donuts is a household name in both donuts (evidently) and coffee. In December 2020, Inspire Brands completed an $11.3 billion acquisition of Dunkin' Brands. The coffee and donut chain now has more than 13,700 locations in 38 global markets.

  Secondly, McDonald’s (NYSE: MCD) has been long known as a fast food restaurant, but the global powerhouse has also joined in on the coffee craze through its McCafe menu offerings of about 20 different drinks. The brand operates more than 41,000 restaurants across 100 countries. MCD’s strategy has also shifted to long-term investment in its coffee offerings. In 2023, McDonald’s opened its first CosMc’s, a specialty coffee retailer, with 10 more stores slated to open in 2024. CosMc’s is expected to pose direct competition to Starbucks’ drink selection.

  Thirdly, Tim Hortons is also a strong competitor. A Canadian coffee and fast-food chain by origin is known for its coffee, donuts and baked goods. It is a subsidiary of Restaurant Brands International (NYSE: QSR), who also own other fast-food holdings such as Burger King and Popeyes. Tim Hortons has the strongest presence in Canada (4,000+ stores) and over 500 stores in the United States. The brand has also consistently focused its global expansion strategy into the APAC and EMEA region, with over 500 stores in China, and a growing presence in SEA.

  Lastly, Starbucks faces intense competition from smaller and niche coffee retailers. These retailers range from standalone cafe brands to chains such as Arabica Coffee, Peet’s Coffee, Cotti Coffee and The Coffee Bean & Tea Leaf. Globally, the coffee shop market is still warm and facing stiff competition, and projected to grow at a CAGR of 6.83% between 2023 and 2030.

• Channel Development: Brands like Nestle (SWX: NESN), Keurig Dr Pepper (NASDAQ: KDP), Kraft Heinz, J.M. Smucker Company as well as market-specific brands all pose significant competition to Starbucks. It is important to note that in 2018, Nestle acquired the rights to sell Starbucks’ packaged coffee and tea products. In addition, Starbucks sold its subsidiary Seattle’s Best Coffee to Nestle in 2022. This segment is also riddled with cross-brand partnerships to allow each brand to stand out against its competitors and gain market share.

3. Thesis: Strategic leadership revamp amidst uncertainty

Despite a challenging operating environment experienced by the entire consumer discretionary segment, Starbucks still managed to pull net revenues by 11.5% in FY23 from FY22. I do note that management guidance from its Q3 earnings report that global revenue growth is expected to be in the low-single digits, where global and US store sales are expected to see a low single-digit decline or stay flat. However, we must not be quick to assume that this performance is reflective of Starbucks’ operational efficiency. Challenging consumer environments driven by weak GDP growth in the US (where the bulk of revenue is generated) have rebounded and a faster pace of interest rate cuts by the Federal Reserve should provide a boost in consumer spending. A Deloitte report noted that consumer spending is expected to rise 2.4% in 2024, up from 2.2% last year. Employment rates are falling but the landing should be softened by the cutting of rates. Overall, while the 2024 environment presents challenging operating conditions for all companies in the Restaurant industry, we should look towards a long-term economic horizon with Starbucks’ ability to withstand short-term macro uncertainties through its strong fundamentals and strategy revamp.

On the company front, Starbucks is fundamentally a great company with strong fundamentals. Starbucks’ operating margin in the North American segment improved from 19.2% in FY22 to 20.7% in FY23. For its international segment, the operating margin increased 4.4% from 12.0% to 16.4% in FY23. The improvement in margins was driven by Starbucks' sales leverage, pricing power, in-store operational efficiencies, and lapping of amortization expense for its intangible assets, particularly for its International segment. Starbucks is now in the early stages of exploring joint ventures and strategic partnerships in technology, real estate and supply chain. In addition, the leadership revamp of Brian Niccol will stand to restore investor confidence in the battered brand. Brian Niccol comes from a long-standing restaurant industry track record with most recently, Chipotle. Niccol’s expertise also stems from implementing organizational changes and improving labor relations, something that Starbucks has consistently struggled with in recent times. While the expected reforms from Niccol’s expertise may take months or even years to actualise, Starbucks’ strong business case, strong cash flows and cash holdings should tide the company through short-term cyclical shocks.

4. Valuation

As such, EV will be used to value Starbucks. We will use a conservative 15.6x (industry average) as compared to EV ratio to the EBITDA FY2026 estimate of $8,897million, and FY2028 estimate of$11,591million.

• EV / EBITDA x EBITDA = Enterprise Value (EV)

15.6x $8,897mil = $138,793.2mil

• EV - Net Debt = Equity Value

$138,793mil - $20,646.8mil = $118,146mil

• Equity Value / TSO = Target Price

$118,146,400,000 / 1,145,400,000 = $103.15

This presents a 9% 3Y upside and 48% 5Y upside from the current share price of $94.77 based on my conservative EV multiple.

5. Risk and Mitigation

Starbucks' brand equity is one of its most valuable assets, contributing significantly to customer loyalty and premium pricing. However, this equity can be jeopardized by negative publicity, product quality issues, or failure to meet consumer expectations. For instance, controversies related to labor practices as alluded to earlier or sourcing could tarnish the brand's reputation. However, I am confident that Niccol’s leadership and prior expertise in the restaurant industry will resolve the current turmoil regarding labor union issues and brand image amidst the brand boycott.

Starbucks is heavily reliant on coffee beans and other raw materials that are subject to price volatility due to factors such as climate change, geopolitical tensions, and market fluctuations. Rising commodity prices can significantly impact profit margins and operational costs. Fortunately, Starbucks does engage in commodities hedging strategies which include forward contracts, futures, fixed-price and to-be-fixed pricing orders. In addition, Starbucks’ moat as a market giant allows it to have high bargaining power against its suppliers, thereby securing favourable pricing contract terms.

6. ESG Assessment

In conducting ESG analysis for Starbucks, these two were signaled as the most important material ESG factors:

a. Sustainable Sourcing

Sustainable sourcing is of paramount importance to Starbucks as a brand in the restaurant industry. The company has developed a comprehensive Coffee and Farmer Equity (C.A.F.E.) Practices program that ensures that its coffee is grown and processed in a way that is environmentally and socially responsible. As a result, Starbucks has achieved 98.2% ethically sourced coffee through its C.A.F.E. Practices. Starbucks also operates ten farmer support centres, including our China Farmer Support Center located in the Yunnan Province of this high-growth market. Farmer support centres are staffed with agronomists and sustainability experts who work with coffee farming communities to promote best practices in coffee production designed to improve both coffee quality and yields and agronomy support to address climate change and other impacts. Starbucks recently made several operational changes to strengthen the program’s verification approach, including increasing the frequency of audits and incorporating unannounced audits.

b. Supplier Diversity and Inclusion

As a company with a diverse sourcing and supplier network, ensuring equity across its supplier network is crucial to maintaining long-term, mutually beneficial relationships. Starbucks has initiated its Supplier Diversity and Inclusion program that aims to enhance the inclusion of qualified businesses across various sizes and categories. In January 2022, the company reinforced its commitment to this initiative. During FY2022, Starbucks allocated nearly $900 million to Tier 1 direct diverse suppliers, which in turn supported over 7,200 jobs in the United States and Canada.

Over the past two years, the program has evolved to incorporate participation from Tier 2 suppliers as well. Starbucks is dedicated to collaborating with all suppliers involved in the program to significantly boost economic impact and representation of diverse-owned businesses within its supply chain.

7. Conclusion

With well-managed ESG risks and confidence in its leadership, Starbucks is an attractive short-medium-term investment opportunity with a target price of $103.15 and a 48% upside from the current share price of $94.77.

*Do note that all of this is for information only and should not be taken as investment advice. If you should choose to invest in any of the stocks, you do so at your own risk.