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  • KPB & Co Research

Recently, Starbucks released its Q1 of FY-19 results, and though it wasn't terrible, it further highlights the challenges the company will face in growing in the upcoming quarters. Global comparable store sales increased 4%, on the back of a 3% increase in average product prices. Overall company sales grew 9% to US$6.6Bn relative to the same period a year earlier. On the surface, the numbers appear ok, but as you begin to peel back the layers you uncover a few things. For one the North American market appears to be slowing, the Chinese market has slowed and will likely be challenging in the near term, Europe Middle East and Africa markets are slowing, and management is really narrowing in on China as the credible way to lift a heavy baseline sale number (which was at US$24.7Bn in FY-18).

Let us parse the DiSCLOSURES

The printed top line growth of 9% in Q1 of FY-19 overstates what growth is likely to be in the year ahead. The Americas market - USA, Canada, and South America - which accounts for 70% of total sales, grew 8% on the back of a 3% increase in average prices, and 5% growth in the number stores. Over the last 6-years, growth in the North American market has steadily declined from 12.2% in 2013 to 5.3% at the end of FY-18. Also, management in-spite of the growth in sales for Q1 is still predicting 5% for the full year. In the USA, which accounts for the majority of Starbuck's sales, the company has 3 stores for every 100,000 people, while a restaurant like McDonald's has approximately 4 stores per 100,000 people. Keep in mind that McDonald's is selling a sub-premium product, unlike Starbucks which is serving up expensive coffee "Give me a Tall Iced Peppermint White Chocolate Mocha.... and what name shall I write on your cup today ? ".

Recent M&A deals done by management exposes how they are thinking about the future, and it appears they are narrowing their focus on China. Back in August 2018, the company entered into a deal with Nestle, where Nestle paid US$7Bn upfront for the perpetual right to sell, market and distribute Starbuck's consumer packaged goods and food service products globally (for both coffee and tea brands). In the same year the company sold (and converted to a licence arrangement) its operated retail business in Brazil to SouthRock, sold its 50% interest in President Starbucks Coffee Taiwan Limited, but purchased the remaining 50% interest in their East China joint venture from President Chain Store Holding Ltd. and Kai Yu, for approximately US$1.4Bn. The deal gave the company over US$270Mn in additional sales, and over 1,400 stores in the Shanghai, Jiangsu and Zhejiang Provinces.

But China is Also Showing Cracks

In China, comparable store sales growth came out at approximately 1% with transactions down 2%, and with average product price increases of 3% across the board. Overall sales growth came out a whopping 45%. According to the company, most of the growth in the China business is due to additional sales from the East China joint venture deal, a 13% growth in a number of stores up and running in the country, and an increase in product prices. The China deal is not likely to recur and you can only do a limited number of price increases before it becomes problematic. On the face of it, the 13% growth in the number of stores look impressive, but the concern, however, is that with declining transaction volumes the profitability of each additional store will become lower, and it becomes much harder to justify building more stores at lower operating profits. Already the operating profit margins for the China/Asia business is 4 percentage points lower than that of the Americas business. Furthermore, the Chinese Q4 GDP growth is slower and if this trend continue you could see a further slow down in transactions volume as discretionary spending slows.

Starbuck's Growth is Slowing In Its Largest Markets

The picture in the Europe Middle East and Africa (EMEA) business is clear as day, it is declining. Comparable store sales came out 1%, total sales declined 1%, and transactions volume same. The 1% decline in store sales growth came within the context of a 10% increase in the number of stores over the period. This indicates in our minds that the new stores are doing terribly in these areas, perhaps because they were built in areas where the brand equity is low.

By anyone measure, Starbucks is a great company. Even activist investor Bill Ackman took a stake in the business after the stock declined significantly in the middle of 2018. So far he and others who followed him into the stock would be making a few bucks. However, there are early signs that the company may get dragged through the mud for a while as growth slows in the USA, and international expansion proves much more difficult than expected. In the long run, there is good value here as the company is essentially a US domestic company today with the potential growth in international markets.

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