The year 2018 proved to be an eventful one for Starbucks, with the founder of the modern version of Starbucks stepping down after 31 years. New management always leads to some degree of change, and 2018 certainly did show changes. A new and greater focus on the cost base, divestment of non-core activities, and significant capital distributions. The shareholder register now also includes an activist with the view that the coffee chain is significantly undervalued. We share this view at a time when Starbucks opens a new location in China every 15 hours.

2018 became the year that the visionary de facto founder of Starbucks, Howard Schultz, left the company and his role as chairman of the board.

In June, Howard Schultz announced that he would retire from his position as Chairman of the Board, thereby officially leaving the company of which he has been the driving force since he acquired Starbucks in 1987. This ends an era with the man who wanted to introduce Americans to the coffee experience that he had met on a trip to Italy some years prior. We have a deep respect for the commitment he has shown during this time. On the other hand, his wife is probably looking forward to him not receiving several daily sales updates from now on. The development has been impressive since Howard Schultz took over the company. Today, Starbucks is by far the largest global coffee brand, counting more than 29,000 stores, 350,000 employees, with revenues just shy of 25 billion US dollars at the end of the most recent financial year – something of an achievement by the founder who has been given the honorary title “Chairman Emeritus”.

Starbucks’ share price dropped significantly in the beginning of the year, reacting to weaker than expected – including our expectations – same-store-sales (SSS) figures in the USA and China. This led to a downwards adjustment of sales expectations for the important SSS figure as well as earnings. At the same time, some investors experienced a certain degree of distrust in the company regarding the communication from the company in relation to Schultz’s departure. SSS have turned around, and the aforementioned developments have not changed our view that Starbucks is a long-term attractive company that is expected to grow its earnings with double-digit rates of which most will be converted to free cash flows. Supporting this expectation is the growth within coffee, with it being one of the fastest growing consumer categories.

The culture of the company and the experience in Starbucks restaurants, for which Howard Schultz can take a good part of the credit for, are strongly anchored within the company’s management and partners, as the company refers to its employees. However, this does not mean that the new management lacks the will to do things differently. CEO Kevin Johnson refers to the transformation resulting from Howard Schultz’s departure as the company transitioning from being a founder-led company to being a founder-inspired company.

CEO with technological background

The strong culture, brand, and Starbucks experience must be retained, but there is a greater focus on running the company more efficiently with a stronger focus on capital distribution to shareholders. Administration costs are slated to be reduced from 4.5 percent of system sales to 3.5 percent, meaning that the company will trim around 5 percent of their administrative staff. The company has also started closing downing under-performing restaurants in the USA and is concentrating on the more attractive stores. At the same time, investments in value-creating innovation will be increased. This is primarily in the form of product innovation, where Starbucks, among other things, has had success with introducing cold drinks, which were initially intended for the less busy afternoon period.

Investments are not just for product innovation, but just as much for technology. One of the latest introductions is an inventory management system for stores, intended to automate administrative functions, for example the ordering of goods. The purpose is to save the time spent by employees on administrative, non-value creating tasks and releasing more time for customers, the most value-creating employee task, when serving more than 100 million customers visiting one of the stores on a weekly basis.

Starbucks is recognised as being leading within technology, and CEO Kevin Johnson has a technology-oriented background with more than 16 years at Microsoft. Starbucks’ digital customer loyalty programme in the USA now has 15 million members, and the number grows by about 15 percent per year. In China, seven million people have signed up. Members generally buy more than non-members, and members in the US represent just under 40 percent of American sales.

The programme gives Starbucks an additional advantage in the form of interest-free financing from the prepayments made by customers on to their Starbucks Rewards cards. Prepayments total just under two billion dollars. This interest advantage is passed on to customers as rewards in the shape of drinks or food items. The Starbucks customer loyalty programme also enables the company to tailor individual offers to customers, and at the same time customer traffic between stores can be used to optimise customer flow. Furthermore, the Starbucks app enables customers to order and pay via Mobile Order & Pay, making it easier and faster to service customers and thereby improve the customer experience. The share of transactions in company-owned restaurants via Order & Pay has reached 14 percent in just a few years, and the share is even higher during the busy morning hours where it exceeds 20 percent. This increases the efficiency and guarantees shorter queues for customers.

Prospective 6,000 restaurants in China in three years

Being able to meet the customers where they want has recently been a challenge for Starbucks, and this has, among other things, affected SSS negatively. Half of the American Starbucks stores are owned by the company while the rest are owned by franchisees who pay a four to five percent share of their sales to Starbucks. Most of the company-owned stores are in the USA and China which are the biggest Starbucks markets and a focus area for the company. Customers increasingly demand convenience, and this has led to changes in sales channels. This has resulted in a delivery collaboration with Uber Eats in the USA and in China, which is part of the Alibaba group, and most new locations in the USA feature drive-throughs.

These are measures intended to support growth in the US and China via increased sales in existing stores. On top of this comes the opening of new locations. In the USA, sales growth is to come equally from increased SSS and the opening of new stores. Since the SSS in the US were lowered, Starbucks has reduced the pace of new store openings, and has started closing less attractive stores. In other words, the focus is more on value than the top line. In China, the share of new stores is rapidly growing, and a new Starbucks is opened every fifteen hours on average. At this rate, the company will have doubled the number of stores in China during the period 2017-2022.

However, the accelerated new store openings in China do not mean that this isn’t value-creating for Starbucks, for whom 80 percent of the growth is intended to come from new stores. Chinese stores generate lots of cash and have pay-back periods of only 16 months. The return on investment exceeds 85 percent in the first year, meaning that these stores create lots of value. Returns on stores outside the larger cities, Tier 3-5 cities, are higher, and this is where many of the new stores will be established. Starbucks plans to be present in 230 Chinese cities by 2022, from the current level of 150, and the company will increase the number of locations from 3,500 to 6,000 by the end of 2022.

Starbucks’ presence in China is miles apart from the company’s position in the USA. Seven million customers are serviced in China a week, and the opportunities are tremendous. Most of Starbucks sales in China come from tea, with coffee still being a new experience for a lot of Chinese consumers. In China, the average daily consumption is 300 times less the coffee consumption in the USA. Coffee has therefore had to be introduced to China, and chief executive officer of Starbucks China, Belinda Wong, has been instrumental in the success of Starbucks in China. Belinda Wong has been with Starbucks for 19 years. Since 2011, she has been in charge of Starbucks in China and has, among other things, been part of creating and developing Starbucks’s more upmarket Reserve bars, the purpose of which was to introduce coffee and the Starbucks experience in just the right way.

The number of transactions in China are showing double-digit growth, and at the same time customers are buying more per visit. The target is to triple sales in China within the next five years, and this is supported by an expected doubling of the Chinese middle class from 300 to 600 million people and a 45 percent increase in expected coffee consumption. This all points towards high sales growth. And with an impressive return on invested capital of around 30 percent at group level, everything points towards strong future value-creation.

Strategic divestment to attractive partner

In 2018, Starbucks’ focus on core markets and products resulted in the divestment of Starbucks’ consumer packaged goods business, involving coffee pods and packaged coffee beans, to Nestlé. The sale to Nestlé netted Starbucks more than seven billion dollars, corresponding to ten percent of the market value of Starbucks. Our assessment is that this was a high sales price to a strong strategic partner. The agreement provides Nestlé with the exclusive rights to market, sell and distribute Starbucks’ consumer products away from Starbucks stores. Starbucks will continue to generate revenue from the sale of coffee to Nestlé as well as receive on-going royalty payments for the sales rights. Starbucks already has a coffee pod collaboration with the American company Keurig, and it is expected that double in connection with the Nestlé agreement.

The sale of rights to Nestlé is intended to increase market opportunities, now that the products can be sold to more platforms, Nespresso and Dolce Gusto, and in more countries, 189 against just under 30 prior to the sale. Starbucks applied the proceeds to increasing their share buyback by 5 billion dollars. An increase to an already large return of capital to shareholders. During the financial years 2018-2020, Starbucks intends to return 25 billion dollars to shareholders via dividends and share repurchases, corresponding to a third of Starbucks’ market value. With the 5 billion dollars from the sale of rights to Nestlé, Starbucks took advantage of the company’s share being undervalued and accelerated their buy back. As a result, the equivalent of one percent of the market value was returned per month, on average, during the last fiscal year. In connection with this distribution of capital, management has increased the company’s debt as part of a new debt structure.

The company now expects a debt level of just over 2.5 times operating income before depreciation and amortisations. We do not, however, see this as a problem for a company which generates cash to the extent that Starbucks does, with annual free cash flows equalling just under four percent of market value.
The well-known activist investor Bill Ackman has accumulated a position in Starbucks, as he believes the company to be strongly undervalued. Although we do not share Ackman’s investment philosophy and have complete confidence in Starbucks’ management being aware of the company’s opportunities, we do share his view that Starbucks is a deeply undervalued company.