We maintain our SHORT position on Starbucks heading into the Q2 2024 earnings report, as we believe the current setup of accelerating EPS growth quarter-over-quarter for the fiscal year is unlikely to materialize. Our short thesis is on a tight leash because we believe that an EPS miss and downward guidance for 2024/25 will allow a significant activist shareholder to accumulate the stock if they haven't already. While all significant quick-service restaurant (QSR) names have underperformed the S&P 500 over the past two years (except for Domino's Pizza), Starbucks is notably down 19.9%, underperforming the S&P 500 by 18%. The underperformance of this magnitude for a company with the size, scale, and brand loyalty of Starbucks happens for a reason and nearly always attracts activist investors.
STARBUCKS IS BROKEN
In April 2022, Howard Schultz returned as Starbucks' interim CEO, stating that the company was broken again, similar to 2008. He compared the challenges of 2022 to those faced in 2008, highlighting Starbucks' capacity to innovate and adapt during tough times. However, despite promises to simplify store operations and address employee concerns, the company has yet to deliver on these plans years later.
During the 2022 analyst meeting, Starbucks made crucial promises and set expectations for 2024 and 2025, emphasizing the company's reinvention and modernization. At this meeting, they introduced the untested Siren System, a proprietary innovation designed to simplify tasks, improve quality consistency, meet growing customization demands, and solve the company's labor problems. In FY23, they praised the reinvention program and said it was why the company saw margin expansion and a 10% increase in average checks. I suspect the margin gains realized in FY2023 were due to aggressive pricing rather than the reinvention plans set at the 2022 analyst meeting.
At the November 2023 Reinvention update analyst meeting, Starbucks highlighted its success in using customization to enhance customer experience, increase sales through premium offerings, and strategically drive higher ticket sizes. How could that be if the siren system rollout was pushed to 2025 and, as of FY24, only 6 Siren Retail in North America and internationally had 5? Aggressive pricing can cover many problems, and the company no longer has that lever.
CORE GROWTH MARKETS ARE STRUGGELING
Starbucks is struggling in the two most crucial segments: North America and China. North America and China account for nearly 64.7% of Starbucks' worldwide store count, highlighting the strategic importance of these two markets to the company's global business. The North American segment, which includes the U.S. and Canada, has 40% licensed stores (7,182 licensed out of 17,810 total stores), and 100% of China is company-owned. This brings us to the first place an activist will look to improve the company's performance: to increase its licensee stores as a % of the total and move to a more asset-light model.
Here are the biggest challenges that Starbucks North America faces:
Traffic Softening: In the U.S., traffic has softened, especially among occasional afternoon customers, partly due to misperceptions linked to events in the Middle East affecting the brand's image.
Engagement Challenges: Although Starbucks retains strong loyalty among frequent customers, it faces challenges in engaging occasional customers, which affects traffic and sales momentum.
Operational Adjustments: To address these issues, Starbucks is implementing targeted offers to integrate occasional customers into their loyalty program, hoping to improve traffic and customer engagement.
Starbucks in China: The Need for a Paradigm Shift - PARALLELS TO YUM BRANDS
In 1987, Yum's China business was born with the opening of the first KFC restaurant, marking the arrival of the first Western quick-service restaurant in the country. Over the decades, the business flourished alongside the Chinese economy, with KFC becoming the dominant restaurant chain and Pizza Hut becoming the top casual dining concept. However, the company faced significant challenges in 2012 when a controversy arose over the use of antibiotics in its food, followed by a food safety scare two years later. These incidents dealt a severe blow to KFC's same-store sales. Subsequently, economic concerns also impacted Pizza Hut's sales. Between 2012 and 2015, Yum China's revenues remained stagnant, as sometimes steep declines in same-store sales have offset the rapid expansion of new units. This led to an activist to pressuring Yum! Brands to spin off the China business. In November 2016, YUM Brands spun off its China division; at that time, the company had 7,300 restaurants across China, generating more than $6.9 billion in annual revenue.
Starbucks is currently facing a situation reminiscent of YUM's challenges in 2015. Despite a 65% increase in its store base in China since 2019, Starbucks has only seen a 6% growth in revenue, while average unit volume has declined by a staggering 18%. This discrepancy highlights Starbucks China's difficulties over the past four years, bringing the company to a critical juncture as it celebrates its 25th anniversary in the Chinese market.
Since it entered China in 1999, Starbucks has become a dominant player in the country's coffee industry, a testament to its pioneering spirit and successful expansion. The company now boasts over 7,000 stores across the nation. However, missteps during the Kevin Johnson era have left Starbucks vulnerable to competition from more agile rivals, while a slowing Chinese economy further compounds its challenges.
As Starbucks navigates this crucial period, the company must reassess its approach to operating in China. Adapting to the evolving market landscape and addressing the root causes of its recent struggles will be essential for Starbucks to maintain its position as a leader in China's coffee industry and ensure sustainable growth in the future.
Given where YUMC trades, a spin of SBUX China does not pencil out, but the beginning of the licensing part of the market could help the company better manage growth and the volatility in the business. While acknowledging the challenges in the Chinese market, we believe that a more agile Starbucks China could deliver better returns. This strategic realignment, although complex, has the potential to unlock greater value and flexibility for Starbucks in the dynamic global market. As Starbucks navigates this transformative phase, it can draw insights from YUM Brands' successful spin-off of its China division and improved operational performance. YUM now trades one of the higher valuations of the peer group. By leveraging its strong brand presence, adapting to local market dynamics, and embracing a more agile structure, Starbucks can unlock significant value and position itself for sustained growth in China.
Importantly, Starbucks's issues in China are not going away soon. There is a case to be made that the incursion of strong competitors in China is a structural shift in market dynamics, and the slowing economy suggests that the business might be better off with a strong licensed partner. Reducing the earnings volatility of the Chinese market was a strong strategic move by YUM, reducing earnings volatility and enhancing shareholder value and valuation.
HERE ARE THE CHALLENGES THAT STARBUCKS IS FEELING IN CHINA:
Consumer Caution: Despite a strong showing during the Double 11 holiday, overall recovery in China is slower than expected due to cautious consumer behavior. This hesitancy affects the growth rate and indicates a potential ongoing struggle to reach pre-pandemic sales levels, thus the need to increase licensed stores.
Increased Competition: Starbucks faces stiff competition from mass market competitors in China who employ aggressive pricing strategies. This increased competition has led to a more challenging operating environment and necessitated increased promotional activities.
Promotional Activities: While striving to maintain its premium market position, Starbucks has ramped up discounting to combat competitive pressures and attract customers. This strategy focuses on quality over "price wars" but could impact profit margins.
THE STARBUCKS LICENSING MODEL
Under the licensing model, Starbucks sells coffee, food, tea, and other products to licensees, who then resell them to customers. Starbucks receives royalties and license fees in return. Licensees also purchase coffee equipment like brewers and espresso machines from Starbucks to facilitate operations. Unlike franchising, licensees do not own the Starbucks stores. They are essentially renting the Starbucks brand for a licensing fee. Starbucks helps licensed stores with many aspects of the business, including store design, menu, equipment, training, support, food, and promotions. However, licensees take care of capital investments and operating costs. The licensing model allows Starbucks to expand more quickly by leveraging licensees' capital and real estate. It also reduces Starbucks' operating costs, as licensees are responsible for rent and wages. Starbucks exchanges its expertise for knowledge of local markets from licensees. While Starbucks does not franchise in the U.S., its licensing model allows it to expand through partnerships with local operators who invest in and run the stores, while Starbucks provides the brand, expertise, and support. Accelerating this part of the business model will enable Starbucks' rapid global growth while reducing labor costs and capital expenditures.
Can the terms of the licensing fees be improved, and this ability be added to have more traditional franchisee agreements? McDonald's, beginning in January 2023, raised royalty fees for new U.S. franchised restaurants, which will increase from 4% to 5% of revenue (this is the first royalty fee hike in nearly three decades).
ACTIVISTS WILL WANT INCREASED LICENCING WITH HIGHER MARGINS
In FY23, Starbucks operated in 86 markets globally, while revenue from company-operated stores accounted for 82% of total net revenues during fiscal 2023 (74% beverage and 22% food). Between 2013 and 2021, there have been 16 transactions where Starbucks has bought/sold stores and markets to franchises, totaling $10.7 billion in value, including the Nestlé and Starbucks Corporation deal granting Nestlé the perpetual rights to market Starbucks Consumer Packaged Goods. To frame the argument that Starbucks is underperforming and at risk of activist shareholder intervention to push for a more asset-light, licensing-focused strategy in North America and China, one could build a case around the following points from the fiscal 2023 data.
Despite Starbucks' strong brand and global presence, its overall operating margin of 17.6% in fiscal 2023 could be considered below its potential. An activist could point to the higher operating margins of licensed stores and the Channel Development segment (51.1% in fiscal 2023) as evidence that Starbucks' heavy reliance on company-operated stores in some critical markets is dragging down profitability. While improved from the prior year, the International segment's operating margin of 16.4% in fiscal 2023 still lags behind the more mature North American segment's 20.7%.
The difference in profitability is due to Starbucks' insistence on operating its stores in key growth markets like China rather than leveraging local partners' expertise and capital through licensing. Company-operated stores require significant upfront capital investment and ongoing capital expenditures. The aggressive growth rate of new stores also depresses profitability in that market. An activist could argue that this capital intensity is depressing Starbucks' return on invested capital and that a shift towards more asset-light licensing could boost returns and shareholder value.
The market is not rewarding the company for its aggressive unit growth; operating a vast network of rapidly growing company-owned stores globally exposes Starbucks to execution risk and may distract management from brand, product, and technology innovation. An activist could argue that by licensing more stores, Starbucks could focus its resources and talent on its core competencies. An activist could point to the example of other global restaurant brands like McDonald's and Yum! Brands that have successfully employed a predominantly franchised model argue that Starbucks is an outlier and could unlock value by following a similar path.
LICENCING EASES PRESSURE ON STARBUCKS' BIGGEST PROBLEM - LABOR
As we said in the beginning, Starbucks's labor challenges are the biggest factor impacting Starbucks's profitability and brand image. One of the most significant advantages of transitioning to a more heavily licensed business model for Starbucks would be the potential to control labor costs better. Store operating expenses, primarily labor costs, are one of Starbucks' largest expense categories. In fiscal 2023, store operating expenses were $14,720.3 million, representing 40.9% of total net revenues and 50.0% of company-operated store revenues. Increased labor costs, including wages, benefits, and healthcare and workers' compensation insurance, could adversely impact Starbucks' business. These risks are particularly relevant for company-operated stores, where Starbucks directly bears these labor expenses.
By transitioning to a more licensed store model, "Licensees are responsible for operating costs and capital investments, which more than offset the lower revenues we receive under the licensed store model." This means licensee partners manage and bear most of the store-level operating expenses in licensed stores, including labor costs. Starbucks receives a percentage of sales as royalty income and revenue from product sales to licensees but does not directly incur store operating expenses.
Therefore, transitioning to a more licensed store model could help Starbucks better control its labor costs by shifting the responsibility for managing and funding store-level labor expenses to its licensee partners. This could be particularly beneficial in markets with high labor costs, unionization pressures, or other labor-related challenges.
