The Reed Report

The Reed Report

Company Spotlight ? Starbucks 09/15/2016

Business Overview

Starbucks is the premier roaster, marketer and retailer of specialty coffee in the world, operating in 68 countries. Formed in 1985, Starbucks Corporation's common stock trades on the NASDAQ Global Select Market ("NASDAQ") under the symbol "SBUX." They purchase and roast high-quality coffees that they sell, along with handcrafted coffee, tea and other beverages and a variety of fresh food items, including snack offerings, through company-operated stores. They also sell a variety of coffee and tea products and license their trademarks through other channels such as licensed stores, grocery and food service accounts. In addition to their flagship Starbucks Coffee brand, they sell goods and services under the following brands: Teavana, Tazo, Seattle's Best Coffee, Evolution Fresh, La Boulange and Ethos.

Previous Quarter

On 7/27/2016, Starbucks reported Q2 2016 results. EPS (earnings per share) were in line with analysts' expectations but revenue was lower than expected. More importantly, Starbucks reported 4% same store sales growth (SSS) which snapped their streak of 25 straight quarters of 5%+. This figure is the key metric used to determine how well a business is performing in the service industry. SSS is used to determine what amount of sales growth is due to stores that have been opened for more than one year as opposed to new store openings. Does this 4% SSS signify a turning point in the Starbucks's long term growth story? Or was this quarter an anomaly that presented a buying opportunity for investors?

On the conference call, Starbucks CEO Howard Schultz gave his explanation of why Starbucks did not meet expectations. During the quarter, Starbucks changed their loyalty program (which includes 12.1 active members who roughly spend 3 times as much as non-members) from a frequency based model to a spend based model. This change coincided with their Frappuccino Happy Hour promotion which is their busiest time of year and as a result drives increased traffic and revenue. In 2015, The Frappuccino promotion resulted in a 30% increase in revenue from 2014.

The news headlines of Starbucks changing to a spend based model painted the company as another greedy corporation to consumers. And in this world of social media everyone reads the headline and no one cares about the rest of the story. Under the old program you could make 12 transactions for a $2 cup of coffee and get 12 stars which could be used for a free reward. So that reward would cost you $24. Under the new program every dollar you spend is worth 2 stars and you need 125 stars for a reward. So the same reward would now cost you $62.50.

The news stations and consumers on twitter highlighted the negative aspects of the change to the loyalty program. At the same time, Starbucks did a poor job communicating the positive aspects of the program. First, since the old program was transaction based, members did order splitting. Order splitting means a member would buy a bagel and a coffee and make separate transactions for each item to accumulate more stars for their visit. The order splitting was resulting in longer lines, decreased speed in service and loss of customers. The new spend model would eliminate order splitting. Starbucks is seeing evidence of this as they reported a 2% decrease in traffic and a 2% increase in tickets in the current quarter. Second, members now have more ways to earn stars such as buying Starbucks items at the grocery store, participating in special offers, and visiting a store on Double Star Days when gold members earn 4 stars on every dollar spent. Also, Starbucks is partnering with Chase to release a prepaid Visa gift card that allows customers to earn stars every time they use their card. Lastly, in fairness to all customers, if you spend more you should get more rewards!

Do I think Starbucks's motivation for the change was to increase revenue? 100% yes. But that's their responsibility to their shareholders. In this case, their customers are also benefitting from the change to the program. Unfortunately, Starbucks did not effectively communicate this based on the numerous news stories and tweets on how angry people were with the changes to the loyalty program. I believe the timing and public perception of the loyalty program changes along with the weakening in the quick service restaurant (QSR) and restaurant sector (more on this later) resulted in the SSS decrease during the quarter.

Growth Opportunities The growth plan for Starbucks is 10% annual revenue growth, 15-20% annual earnings growth, and same store sales of mid-single digits. How does Starbucks plan to achieve their growth numbers? Starbucks CFO Scott Maw explained how Starbucks will reach these goals on September 7 2016, at the Goldman Sachs Global Retail Conference. First, Starbucks is aggressively increasing their store count. In fiscal year 2016 (Starbucks fiscal year is from September 2015 to September 2016) they will open 1,900 stores around the world and 600 in the U.S. alone. In fiscal year 2017, Starbucks will be increasing both of those numbers. Not only are they building more stores, they are doing different formats. Refer to the picture below.

So in this pyramid, at the top is the Roastery. There is one open in Seattle. Two will open in New York and Shanghai over the coming years and several more will be announced over the next 12 months.

The menu in the Roastery is very different than any menu in any Starbucks across the globe both from a food standpoint, but more importantly from a beverage standpoint. There's many different ways to enjoy coffee such as Pour-over, Siphon, Clover, specifically roasted Reserve coffees on-site that you are able to buy from a scoop bar. One of the things that Starbucks is doing with Roasteries is, trying new beverages such as nitro cold brew and if they are successful rolling them out in stores nationwide.

The next level down are Reserve stores. There will be about 500 and they will be roughly twice the square footage, of an average Starbucks store. They will have many of the elements of the Roastery, such as a premium food choices and lots of different ways to enjoy premium coffee.

The next level down are stores with reserve bars. There will be about 1,500 and they will be slightly larger than an average Starbucks store. They will have more Reserve drinks and varieties, multiple ways to enjoy coffee, and more upscale food.

Lastly, we have the Starbucks stores that have Reserve coffees for more of the coffee enthusiast and the core Starbucks stores. Currently, most of the core stores Starbucks built today are drive thru stores on the outer edge of urban areas and suburban areas. Also, express stores which are smaller stores with no seating. You either walk or drive up to get your coffee and go. It has recently been reported that more Starbucks express stores are being open in Macy's and Publix, a grocery store chain in the southeast of the USA.

I like the idea of the Starbucks hierarchy of store formats. It gives customers the opportunity to enhance their coffee experience. It gives the company laboratories where they can try new offerings and push them down the pyramid. So when new items get to the core stores, the issues should be worked out and the launch should go smoothly. Currently, they have an affogato drink in the Roastery, (ice cream and espresso) that they are considering moving down the pyramid.

So it's great that Starbucks is opening a lot of new stores but are they making money? The U.S. China and Japan, are not only Starbucks's three largest markets, but they also are the locations of most of their new store growth. The slide below shows profitability across those both for the store portfolio, which is the first three lines and for new stores. And as you can see, they are up to $1.6 million in average sales per store (AUV) in the U.S., about $1.2 million in Japan and $840,000 in China.

Year one cash profit and overall return on investment (Cash profit divided by store investment or ROI) are both strong. With the same store sales decrease, Starbucks has doubled the number of stores they review. Across U.S., China and Japan, they have only a few stores that are on their watch list and that aren't performing in line with expectations. Overall, new stores in their three largest markets are performing very well and they believe they can continue to open new high performing stores.

Another growth opportunity for Starbucks is their mobile app and loyalty program. Starbucks Mobile Order & Pay was rolled out a year ago. Mobile payments are about 25% of transactions and Mobile Order & Pay is 5%. If Starbucks can to get more customers to use the mobile order and pay function especially at their busiest times it could have a positive impact on sales, efficiency, and labor costs.

Starbucks experienced growth in their loyalty program as membership is up 18% from last year. The loyalty program gives Starbucks an opportunity to understand the behavior of their customers, both individually and in groups. They can use this information to not only get customers in the store but to get them to spend more. Some tools they can use are one to one personalized marketing which they started in June, launch new products and promotional campaigns, get feedback to either improve them or discontinue them, and expand the benefits of the program. The more people Starbucks can get into the program, the more they learn about their customers, which should lead to increased revenues and profits.

As far as the anger towards the loyalty program, Scott Maw CFO spoke at a conference on September 7, 2016 and said "When we first launched the program, we actually saw award redemptions drop pretty significantly. And I think that was because people were trying to figure out how do I go from 12 Stars to 125 Stars and how does this all work. Since that, in the month subsequent, we have actually seen that behavior come all the way back to where it was before. So I think people are normalizing relatively quickly. And I do think the tools that we have with personalization and the big data partnership that we have with a company called Takt, which is a joint venture between us and BCG. I do think that big data has helped us steer toward those customers where we saw a little bit of change in that behavior and just remind them and maybe educate them a bit on how the program works. And so as time goes on and we move from the email one-to-one marketing capability into in-app capability which will come in the next couple of months, I think the acceleration of understanding of the program will happen and then I also think we can start to really drive the spend-based behavior through some of the offers in one-to-one." Starbucks understands the mistake it made during the launch of the program and isn't taking for granted that customers will come back to them. They will make every effort to help them understand the new program and win them back.

Starbucks has been gaining momentum in their consumer product goods (CPG) and tea segments. CPG revenue has been growing 8-10%, mid-teens profit growth, and expanding margins to now 40%. In the past, growth came from taking share in packaged goods and K-Cups as Starbucks is the number one in K-Cup market share with 15.8%. But, as the K-Cup industry has slowed, Starbucks has announced new ventures to maintain growth. Starting in Fall 2016, Starbucks will offer capsules for Nestle's Nespresso unit which has a $25 million installed base. They have partnered with Anheuser-Busch to launch the first Teavana Ready-To-Drink (RTD) tea in first half of 2017. The RTD market had $1.1 billion in sales in 2015 and Starbucks in store tea sales grew 30% in Q2 2016. I think these two ventures are great long term opportunities for Starbucks to maintain growth and bring the experience from the store to the home.

Lastly, Starbucks's food offerings has been a source of growth for the company. In Q2 2016, food sales grew 10% and contributed to 1% of same store sales growth. The same store sales growth for food has slowed but it is a record 20% of sales. Starbucks is looking to expand food offerings not only for mornings, but for all parts of the day including, brunch on the weekends, lunch, and early evenings. The company is currently testing brunch in 78 stores in Seattle and Portland. Over the last couple of years,

lunch has been their fastest growing day part on a percentage basis. For early evenings, Starbucks offers food, craft beers, and wine in a few hundred stores but admitted they have a long way to go in this category.

Sector Review

On the Q2 conference call, CEO Howard Schultz, said the following about the sector "We did not and could not have fully anticipated was the profound weakening in consumer confidence in Q3 that has caused sharp declines in quick service restaurants (QSR) and restaurant traffic overall." Many QSR's including Mcdonald's, Dunkin Donuts, Restaurant Brand Industries, owner of Burger King and Tim Horton, and Shake Shack all had disappointing results or guidance. The cause of the weakness in the sector is the widening gap between the cost of food at home and away from home. According to Mcdonald's CFO Kevin Ozan, for the year, food at home is expected to remain flat or increase 1% while food away from home is expected to increase between 2.5% and 3.5%. In addition, rising labor costs due to increases in minimum wage and market wide discounting (McPick2, Wendy's 4 for 4 and BK's 5 for $4) has hurt profits across the sector.

A couple of companies in the industry that did report good Q2 results were Domino's and Panera Bread. Both have similar qualities to Starbucks. First they all have loyalty programs that they use to gather data on their customers. Second, they all invest heavily in technology to improve their businesses. Domino's announced during Q2 Zero Click ordering. Loyalty members can create a favorite order and when they open the app it will automatically place their favorite order after 10 seconds. In addition, they have found that tickets are higher on digital orders than phone orders because people have the entire menu in front of them. Panera has launched an initiative called Panera 2.0. These new store formats use technology to enable improved eat-in, to-go, and delivery experience and improve operational systems. Orders that are digitally placed and paid were 18% of sales in Q2 2016. Lastly, Panera and Starbucks view themselves as premium brands and avoid the discounting in the sector. According to Panera's president Andrew Madsen, their target customers are affluent, food forward, wellness minded and engaged with Panera. These customers are resilient customers with the financial means to maintain their restaurant visits despite changing macroeconomic forces. On the Starbucks Q2 conference call, Howard Schultz said "There is a tremendous amount of discounting and promotion going on in the market where people are buying business. We do not want to be in the business of buying business. We do not want to discount or dilute the integrity of the brand. We know who we are. We know what our core purpose is. And we've got to play the long game and have faith and confidence in what we stand for in terms of the experience, the quality of the coffee." I believe if Starbucks did a better job introducing the changes to the loyalty program, they would be in this class of sector outliers.

Technical Analysis

Below is a chart of Starbucks stock over the last 3 years. The good news is the stock bounced off it's low of $53 in August 2015 and has not broken that level again. That's strong support for this stock. The bad news is the stock is in a downtrend as it has made a series of lower highs since October 2015. That trend line is now resistance for the stock. Barring a market wide sell off due to the Federal Reserve raising interest rates next week, I believe Starbucks will trade in the range until they report Q3 earnings or some other major news about the company surfaces.

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