Starbucks is an American coffee company founded in Seattle in 1971. The company operates 27,339 locations across the world. Starbucks serves an assortment of hot and cold beverages, pre-packaged food, and snacks. Following a sustained period of above average growth, Starbucks is experiencing a slow down in comparable store sales growth in the US, exacerbated by the rise of e-commerce and its impact on retail malls. While the market focuses on the troubles in the US business, a material investment opportunity is being overlooked in China.
After recently returning from the opening of the Starbucks Shanghai Roastery (6 December 2017), we have increased our conviction on China and the opportunity to substantially expand the business in this market. China is in the nascent stage of a burgeoning coffee culture. Coffee consumption in China grew 16% p.a. from 2004 to 2014 as consumers shifted away from tea to hot and cold coffee-based beverages. Euromonitor estimates the speciality coffee market in China will grow at a 15% CAGR from FY16 to FY21 (Source: Euromonitor FY16 Report). This growth will be led by the Chinese middle class, which is expected to double from 300m to 600m over the next 5 years. Interestingly, consumption per capita in China is following a similar path to Japan’s curve between 1963 and 1973 (Source: Bloomberg 2017) indicating a structural trend.
Whilst observing Starbucks in China, three things become apparent. Firstly, the stores serve as a comfortable destination to meet and connect with friends. In such a populous country, the stores offer a welcome environment to relax with friends. Secondly, the beverages are localised for the taste and enjoyment of Chinese consumers. Localisation of product has contributed to Starbucks position as the leading coffee house in China. Thirdly, the stores are busier in the afternoon and evening day part, in contrast to the US stores which are busier in the morning. This provides an opportunity to grow the food attach rate and increase average transaction value.
Starbucks boasts 6.2m My Starbucks Rewards members, which are growing 17% year on year. The Chinese customer is highly engaged and pays an annual fee to join the My Starbucks Rewards program. The 6.2m active Chinese members, almost half of the US active members, are delivered with one-fifth the US store count. This membership base bodes well for Starbucks as they migrate the customer to higher value items. Alipay and WeChat Pay account for over 60% of total tender. If we include other cashless tender, the number increases to >80%. This opens opportunities to develop these digital relationships aiding the digital flywheel effect.
The opportunity for Starbucks in China is vast, with a middle class approaching 600m by 2022. We note the middle class is defined as households that earn between US$9,000 to US$34,000 per annum (Source: McKinsey & Company). With a middle class almost 2x the size of the US population, China could support a business at least as large as the US (currently more than 13,000 stores).
Presently, Starbucks operates around 3,000 stores in China, one-fifth the size of the US business. Management are targeting at least 500 stores annually over the next 4 years. We believe Starbucks will upgrade their store rollout guidance in May this year at the Investor Day. We assume Starbucks will reach 8,136 stores by 2025, a very achievable target. Howard Schultz has indicated an aspiration for China to one day surpass the US.
In December, Starbucks opened the Shanghai Roastery on Nanjing Road, a high-end shopping district in Shanghai. Dubbed a “Coffee Wonderland” by Executive Chairman, Howard Schultz, the 30,000 square foot Roastery provides a clear signal about Starbuck’s commitment to China. Howard recently shared some insight on the most recent earnings call, indicating that the Shanghai Roastery is presently turning over US$64,000 per day, nearly 2x the weekly turnover of a US store.
To calculate the value of Starbucks core business, we need to ascribe a value to Starbuck’s business in China. To do this, we need to make some assumptions about store growth and revenue per store. Management have not disclosed the revenue per store in China, accordingly we have used various data points to quantify the revenue per store.
- In 2016, Euromonitor estimated the Chinese Specialty Coffee market to be valued at US$3.8B, with Starbucks China holding a 55% share;
- In 2016, Starbucks forecast annual revenue and EBITDA from China to triple by 2021, our forecast assumes revenue nearly triples by 2021.
- In 2017, Starbucks forecast annual revenue from the China Asia Pacific (CAP) region to equal US$5.5B by 2019. At this time, China is expected to be >50% of the CAP region.
- In 2017, Starbucks disclosed that China is expected to contribute one-quarter of Starbucks total revenue growth in each of 2018 & 2019.
- In 2017, Starbucks disclosed that they are serving 6m customers per week, this implies an Average Transaction Value of around $5.80.
- In 2017, Starbucks disclosed comparable store sales growth in the most recent quarter of 6% in China driven entirely by transaction growth (no pricing).
- In 2017, Starbucks disclosed that East China (Jiangsu & Zhejiang) was growing slower than Mainland China owing to the rapid acceleration of the store footprint.
- Starbucks recently upgraded their store guidance in China to open nearly 600 stores in China for FY18. We highlight that they rolled out 188 new stores in Q118, implying an annual run rate of 752 stores. We assume that Starbucks will rollout 650 stores per annum out to 2025.
Based on these data points, we believe that annual Chinese revenue will be approximately US$7.5B by 2025. To give this number some context, the US business produced $15.6B in FY17. With the coffee market estimated to grow at a 15% CAGR, we have assumed Starbucks comparable store sales growth averages ~4.5% CAGR out to 2025. This growth rate reflects the dramatic acceleration in new stores over the coming years.
Starbucks have recently acquired the remaining 50% share in the East China JV they didn’t own, while divesting their 50% interest in Taiwan. With a purchase price of US$1.3B, Starbucks will assume 100% ownership of 1,300 stores in East China, its fastest growing market. The East China business will be consolidated in the financial accounts beginning Q218. Previously, Starbucks reported 50% of the JV profit, whilst only a small proportion of the revenue, i.e. royalties and product sales. The consolidation will lift net revenue by 4%. Whilst this is only an accounting change, the acquisition will allow Starbucks the opportunity to leverage its business infrastructure and digital innovation.
Starbucks recently provided guidance around EBITDA (Earnings Before Interest Tax Depreciation Amortisation) margin in China. Management believe the China EBITDA margin can eclipse the US EBITDA margin over time. We believe China can deliver a 28% EBITDA margin by 2025. Taking the Revenue and EBITDA margin into account, we estimate the Chinese business to produce ~$2.1B EBITDA in 2025. After evaluating the growth prospects and the Return on Invested Capital (ROIC), we ascribe a $33.7B Enterprise Value by 2025 and an EV/EBITDA multiple of 16x. After discounting the future value at the cost of capital, we ascribe a $19.7B Enterprise Value today. From this analysis, we have backed out the value of the Starbucks core business and estimate the value to be circa US$58.5B.
If we aggregate the estimate FY18 EBITDA from each region, Americas + CAP (excluding China) + EMEA + Channel, we approximate the Rest of World EBITDA to equal US$5.152B in FY18. This places the Starbucks Core Business on an 11.35x EV/EBITDA multiple. We believe this multiple significantly understates the value of the Starbucks core business which has traded at an EV/EBITDA multiple of 15.6x over the last 6 years. This represents 37% upside to the current share price.
The catalyst to re-rate this stock is the Starbucks Investor Day in China in May. We believe that the market has overly focused on the woes of the US business and has not accounted for the opportunity that lies ahead in China. The brand equity that Starbucks owns in China is highly valuable. The Shanghai Roastery is a testament to this and serves to position Starbucks as the premium coffee destination in China, whilst acting as an innovation centre to test new beverages that can be rolled out to the network of 3,000 stores.
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Model Assumptions (where not specified above):
- Assume SBUX China adds 650 stores per year from 2018 to reach 8,136 stores in 2025. Yum China (KFC, Pizza Hut, Taco Bell) opened nearly 750 new restaurants in 2015, including more than 3,000 in the four years prior (Source: Yum China Prospectus Summary page 2). We are comfortable with our above consensus forecast.
- Growing revenue per store from $12.5k currently (est.) to $17.7k, assumes 4.5% CAGR.
- 4.5% CAGR is a blend of East China and Mainland China. We note East China region represents 11% of China’s population and 22% of China’s GDP.
- Store EBITDA margin 28% in 2025, a few pts higher than North America’s EBITDA margin (internal est.)
- Assume a 16x EV/EBITDA exit multiple by 2025. The historic normalised six-year average is 15.6x. SBUX China’s store rollout potential is ~13.5k+ stores. Our model assumes SBUX reaches 8.1k stores in China by 2025. It also generates nearly triple the ROIC of the core business ~73% (Source: SBUX China: Deep Dive Into The Business, Belinda Wong, CEO China, 7 December 2016).
- WACC 8% (internal est.)
- SBUX China PV $19.7B (FV= $33.7 I/Y = 8.0% N=7)
- SBUX Rest Of World EBITDA (excluding China) $5.152B (internal est.)
- Implied EV/EBITDA margin for Starbucks Stub 11.35x
Lachlan is the founder and CIO of Swell Asset Management, a boutique investment manager specialising in global equities.
Lachlan, your Starbucks analysis is most interesting. A company is valued on the expected cash-flows which can be returned to shareholders over time. Almost the entire Starbuck's growth story is based on China. How confident are you that any excess returns generated in China can be repatriated to shareholders? What evidence do you have to support this conclusion? Best regards, Rob