☕️ Starbucks: The Star economy
Why the cost of free coffee has doubled this week
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Starbucks (SBUX) recently reported its earnings and reached a significant milestone with its Rewards program. So I wanted to zoom in on the Star economy.
I chuckled when I saw someone calling Starbucks “the bank that sells coffee” on my Twitter feed. Another way to depict it might be “the rewards program disguised as a coffee chain.”
Let’s review why that might be the case.
Today, we’ll cover the following:
Starbucks Q1 FY23 .
Recent business highlights.
Key quotes from the earnings call.
What to watch looking forward.
Starbucks might be a coffee chain, but it has embraced the app economy early on.
The company’s loyalty program has long been hailed as the restaurant industry's gold standard. Since 2016, Starbucks has made a big change to its program by giving rewards based on dollars spent rather than the number of store visits. It proved to be the right move ever since.
US Active Rewards crossed 30 million memberships (+15% Y/Y, +6% Q/Q).
The chart below shows the steady rise of the program. The shelter-in-place orders worldwide explain the decline in the second half of 2020.
Let’s review how Starbucks makes money.
Here are a few key metrics you should know:
Comparable store sales (or same-store sales): The revenue an existing retail location generates over time. Using comparable store sales allows for excluding the impact of new stores.
Average ticket: The amount paid by customers on average when they visit.
Transactions: The total number of transactions that occurred during the period. It shows the overall traffic in Starbucks stores.
Active Rewards Memberships: The number of loyalty members in the US.
Card Loads: The amount added to Starbucks Reward Cards for future spending.
Let’s turn to the financials:
Revenue is broken down by segment:
☕️ Beverages (~60% of overall revenue) within company-operated stores.
🥐 Food (~18% of overall revenue) within company-operated stores.
💵 Other (~22% of overall revenue), including packaged and single-serve coffees and teas, royalty and licensing revenues, serveware, beverage-related ingredients, and ready-to-drink beverages.
Revenue is also presented by store type:
Company-operated store (~81% of overall revenue).
Licensed stores (~13% of overall revenue). Licensed stores generally have a lower gross margin and a higher operating margin than company-operated stores. Starbucks receives a margin on supplies sold to the licensed store operator and a royalty on retail sales. Licensees are responsible for operating costs and capital investments, which more than offset the lower revenues received under the licensed store model.
Other (~6% of overall revenue). Goods and services under the following brands: Teavana, Seattle’s Best Coffee, Ethos, Starbucks Reserve, and Princi.
Costs and expenses include:
Store opex: Costs to operate and maintain retail stores (rent, utilities, supplies, store employees, and day-to-day operations).
Product & distribution:
Costs of producing and distributing Starbucks' products (coffee beans, tea, and other ingredients).
Costs of manufacturing and shipping the company's branded merchandise.
Costs of purchasing and maintaining equipment.
General & administrative: Costs associated with running corporate operations (legal, accounting, marketing, etc).
Depreciation & amortization: Depreciation of property and equipment, as well as the amortization of its intangible assets, such as trademarks and goodwill.
Margins: If we exclude the pandemic:
The gross margin has been consistent in the mid-to-high 20s.
The operating margin has been consistent in the mid-to-high 10s.
Let’s look at the most recent quarter.
1. Starbucks Q1 FY23
Global store count reached 36,170 (+5%).
51% company-owned and 49% licensed.
61% of stores were in the United States (44%) and China (17%).
North America grew +3% Y/Y to 17,381 stores.
International grew +8% Y/Y to 18,789 stores.
Global comparable store sales grew +5% Y/Y, driven by a +7% Y/Y increase in average ticket, partially offset by comparable transactions declining -2% Y/Y.
North America +10%: Average ticket +9%. Transactions +1%.
International -13%: Average ticket -12%. Transactions -1%.
China alone -29%: Average ticket -1%. Transactions -28%.
Here is the bird’s-eye view of the income statement.
The company doesn’t break down its gross profit, but several financial outlets categorize only store opex and product & distribution as direct costs, so I followed the same categorization.
Revenue grew +8% Y/Y to $8.7 billion ($70M miss).
Gross margin was 26% (-1pp Y/Y).
Operating margin was 14% (-0.2% Y/Y).
Non-GAAP EPS (earnings per share) was $0.75 ($0.02 miss).
Operating cash flow: $1.6 billion (18% margin, -5pp Y/Y).
Cash and short-term investments: $3.3 billion.
Long-term debt: $13.2 billion (and $7.6B in operating lease liabilities).
So what to make of all this?
Revenue grew +12% fx neutral. It’s crucial to look at the revenue growth on an fx-neutral basis to evaluate the long-term growth profile of the business.
Inflation partially explains the solid comparable store sales, with the average ticket up +9% Y/Y in the US. Prices at the chain were up +5% Y/Y, and it didn’t adversely impact traffic.
International (ex-China) was hurt by fx headwinds, as illustrated by the average ticket decline. However, comps were up +11% Y/Y fx neutral.
China was hurt by COVID-related headwinds, leading to lower traffic in stores.
FY23 guidance: China is expected to rebound in the back half of the year. Management reaffirmed 7%-9% same-store sales growth in the US, with more of a balance between the ticket size and transaction.
The company declared a $0.53/share quarterly dividend, implying a forward yield of ~2%. The dividend program started 51 quarters ago with annual growth of over 20%.
Is the business sustainable?
Starbucks has a significant net debt position on its balance sheet, with more than $13 billion in long-term debt, not to mention close to $8 billion in operating lease liability.
The company generated over $4 billion in cash from operations and $2 billion in free cash flow in the past 12 months. If we exclude the pandemic, these numbers have been relatively consistent throughout the years.
Starbucks has taken on more debt since 2013 for a few reasons, including:
Expansion: Starbucks has been rapidly expanding in the US and internationally. This expansion requires a lot of capital investment, such as opening new stores, upgrading existing ones, and investing in new technologies. Debt financing allowed the company to fund this growth.
Share buybacks: Starbucks has also been buying back its own shares. Share buybacks can boost a company's stock price by reducing the number of outstanding shares, making each share more valuable. However, buybacks also require a lot of cash, which can be financed through debt. The company bought back $3.9 billion in FY22 alone.
Low interest rates: Interest rates have been historically low in the past decade, making it relatively cheap for companies to borrow money. This has made debt financing an attractive option for Starbucks.
Moving forward, the balance sheet should improve since taking on more debt now would not be as attractive for the company in a higher rates environment.
2. Recent business highlights.
Howard Shultz has been CEO of Starbucks for almost three decades over three terms. He will officially pass the baton to Laxman Narasimhan on April 1st, 2023.
Laxman was previously Chief Commercial Officer of PepsiCo and CEO of Reckitt. He spent 19 years of his career at McKinsey. He grew up in Pune, India, and struggled with grief, losing two siblings and his father at a young age.
When the transition was announced last year, he said to a crowd of thousands:
“I should not be here but I am. The world has handed me some really tough things, but resilience defines me. We win from within.”
Even free coffee is more expensive now
Stars are the points earned from spending in Starbucks stores.
Starbucks updated its loyalty program, changing how many stars are needed to redeem specific items. Since the rewards program drives most of the company’s revenue, adjusting its rewards economy is no joke.
The Star economy is seeing a steep inflation impact. For example, a free coffee used to cost 50 stars. It now costs 100 stars.
Who knew free coffee would become so expensive in 2023? 😅
Brady Brewer explained:
“From an economic perspective, the redemption tiers and the changes we're making there better align the cost of product redemptions to our current pricing. And by making that change, it will create discount efficiency, which helps us to continue to grow the program while effectively managing margins.”
3. Key quotes from the earnings call
Howard Schultz on China:
“In China, COVID-related mobility restrictions and a spike in COVID infections following the end of zero COVID resulted in comp sales of minus 29% for the quarter, 4x worse than what we expected. […] The end of Zero COVID will enable renewed consumer activity in China and recovery of our business in the back half of fiscal 2023. Our view is informed by patterns of post-COVID behaviors we have seen in countries around the world as consumer activity accelerates as years of pent-up demand is released. Today, our stores in China are again open without restriction and our partners are back at work.”
On the mid-term store goal:
“Starbucks is more relevant globally today than ever before in our history, ideally positioning us to successfully execute our ambitious growth agenda and have roughly 45,000 stores delivering best-in-class returns around the world by the end of fiscal 2025.”
On Starbucks Rewards and mobile:
“Loyal Starbucks Reward members drove a record 56% of tender, up 3% from last year, reflecting increased customer engagement throughout our system. Our convenience channels, Mobile Order & Pay, drive-through and delivery continue to fuel our business, delivering 72% of U.S. revenue in Q1.”
Many of the chain’s licensed US stores are not connected to the digital tools that benefit corporate stores. To remedy this challenge, the company rolled out Starbucks Connect last year, enabling mobile orders and Rewards benefits across more stores.
On future product innovation:
“We will continue to delight our customers with exciting new beverage innovation in the months ahead, including with the launch of Starbucks ready-to-drink Pink Drink inspired by the overwhelming success of Pink Drinks served in our retail stores and certain to become a customer favorite, especially with our young customers and our Gen Z audience.”
CMO Brady Brewer on segment performance:
“Customized beverages continue to be a differentiator with customers all year long. Modifier sales were up 28% year-over-year in our U.S. company-operated stores, showing that customers are visiting Starbucks for beverages customized to their preferences that they cannot find anywhere else.”
Complex viral Starbucks orders are a Gen Z favorite on TikTok.
On Mobile usage and card loads:
“We drove record-breaking mobile order usage at 27% of transactions in the U.S. company-operated stores, and we reached an all-time high in the population of our weekly total active customer base. We also saw more than $3.3 billion loaded on Starbucks cards in the U.S. […] setting a new record.”
On Gift Cards:
“Our gifting business was so strong that the unit sales of Starbucks Cards were greater than the next four brands of gift cards combined.”
4. What to watch looking forward
Based on the recovery trend in other markets, management believes China’s growth trajectory will return to form by the end of 2023 and beyond. It will remain a focal point in the coming earnings calls.
Continued store expansion
To achieve its ambitious goal of 45,000 stores by the end of 2025, the company must add 753 stores per quarter on average. To do so, it will need to maintain an aggressive international expansion.
Digital and rewards
Starbucks has been at the forefront of the digital retail transition with its successful mobile ordering and payment app. So it will be critical to watch for continued progress in memberships and digital share of the overall revenue.
The coffee chain launched Starbucks Odyssey, a web3-powered extension of the Rewards program. It will include ‘Journey Stamps’ (NFTs) and Odyssey Points to unlock new benefits and experiences.
Big product announcement
Howard Shultz teased a product announcement coming soon:
“While I was in Italy last summer, I discovered an enduring, transformative new category and platform for the company, unlike anything I had ever experienced. The word I would use to describe it without giving too much away is alchemy. We won't unveil details today, but it will be a game changer, so standby.”
That’s a lot of superlatives from someone who’s been with the company for 27 years.
As a coffee drinker, I look forward to the product announcement in the coming weeks.
That’s it for today!
Stay healthy and invest on!
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Hey great writeup, I have followed your work on Twitter for a while, just found you over here on Substack. I once was a Starbucks customer, many years ago, back when the rewards program was just getting off the ground. I thought coffee prices were too high back then, silly how low they were compared to now. I would be curious to see how Starbucks measures up when compared to Dutch Bros & Peet's Coffee.
Wow, very interesting article! You have described everything in such detail. Starbucks is really impressive, I'll be waiting for the new product, as I am also a coffee drinker. Thank you for such a detailed analysis!