Coffee behemoth Starbucks is reaching a tipping point in the US: same-store-sales growth is slowing as the chain nears full penetration and its digital efforts fail to keep up with competitors like Panera.
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Business Insider spoke with Palmer about all things Starbucks, from China and the company's upcoming debit-card partnership with Chase to its recent acquisitions of La Boulange and Teavana — and the struggling My Starbucks Rewards program.
Here’s what he had to say.
Graham Rapier: What's the most important thing for an investor to know about Starbucks?
David Palmer: Starbucks is primarily a US retail story, but it has some other things that contribute to its earnings growth over time. Over time that growth has been driven by an increasing consumption of coffee, and espresso-based beverages in particular, in the morning and afternoon-snack parts of the day. It’s had some additional help from digital interaction and what they call "food attachments."
The company also has significant business in supermarkets with consumer packaged goods (CPG), a significant Asia business. It has also been restructuring its way to more profitable sales in Europe, but two-thirds of this story is still US retail sales.
In addition to very significant unit growth — mid-single-digit — what's happened in the last few year and a half has been that the weak US retail environment has seemingly caught up to Starbucks, and some of its food layers and digital engagement have also slowed. For a while, Starbucks was onboarding rewards members and active digital users at an extremely rapid clip, but that has slowed. Additionally, after the La Boulange acquisition, the company has renovated and extended its breakfast-sandwich line. While the company has made efforts to bolster its afternoon food offerings, those layers have not done as much as hoped.
Rapier: How have acquisitions like La Boulange and Teavana helped Starbucks?
Palmer: La Boulange has been a hit. It actually helped transform Starbucks' supply chain to a more consistent, national supply chain. They went from a frozen, par-baked product to having more quality control with much lower food waste. It had been a very expensive supply chain with inconsistent offerings around the country, with a variety of suppliers and local bakeries. Now, with the benefit of technologies and know-how brought over with La Boulange, they've gotten much better at making a consistent product. That's been just as much a benefit to costs as it's been sales. The La Boulange acquisition wasn't about growing a sub-brand. It may not have been a home run on that front, but it did provide them with a more profitable breakfast-sandwich business that they expanded significantly.
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Teavana was about developing some tea know-how. There was a dream of potentially having a tea-bar-like experience that's reminiscent of a Starbucks reserve bar, where you can experiment and try different roasts or in this case teas of different regions and flavors, and that would be different than the mall-based Teavana stores are like today. That dream has not really been a payoff for Teavana. Instead, it has given Starbucks better tea credibility than their previous offering. They have done very well in the past with shaken teas, but the dream of the standalone theatre of tea has faded.
Rapier: Will we see more like this?
Palmer: They just did an acquisition of their Asia business, essentially consolidating one of their higher-return markets and adding to their incremental profit contribution that they'll be getting from their best growth market: China. That was an acquisition, but it was very close in. You would think if they get into acquisitions, they're going to have to think about what ways they can manage their box and digital know-how. It's possible, but they've likely learned some lessons about what works and doesn't work. What works best is when they can use that brand to leverage their existing Starbucks stores, rather than develop another parallel concept.
Rapier: How have digital offerings such as My Starbucks Rewards played out?
Palmer: The rewards customer base is very significant. Their brainstorming likely extends into how they can leverage that digital relationship beyond physical Starbucks stores. The digital relationship for the US business is critical.
For example, they have a closed system where you have to preload a card and link that card to your Starbucks app to start a digital relationship where you can then do mobile order and pay. Those two things are really only available to people who will preload a card and effectively enter into a debit-card relationship with Starbucks. You can't pay with your credit card directly. The benefit to Starbucks is they get to have your cash on deposit, and they get that float. It also lowers their interchange fees, but there's an issue with the so-called "closed cash deposit" system in that it lowers the number of people who would otherwise sign up for your digital relationship. For these guys to be at something like 13 million active users, whereas a much smaller brand like Panera has 30 million users, is evidence that having an easier matriculation process can allow more digital users.
The benefit of having someone in the digital ecosystem is greater today for Starbucks than it was one to two years ago, thanks largely to the technology that the company has to do personalized marketing, including suggestive selling when you're using the app. They have "gamification" of the rewards, where there are stars, for instance, and buy one, get one giveaways that can encourage the right behavior. All that marketing happens within the digital user base, and Starbucks has had a slower onboarding process in recent quarters that has resulted in slowed comps. Starbucks is going to try to find ways to open its system up, like Panera's, but unfortunately that's going to take them a few quarters to get it done, as late as next summer or so.
The other thing they're going to be doing in early 2018 is launching the Chase Visa debit card. It will be the first debit card with rewards attached to it. Because there are lower fees allowed by regulators for debit cards, there hasn't been the ability to have a rewards card for a debit card. This is going to be the first one, so there's a good chance that this will become a very big deal for Chase, and Starbucks might be able to have some joint marketing help.
One of the other barriers for millennials in particular with My Starbucks Rewards is their reticence to share personal information to a retailer. While that is a barrier, people do not have the same concern about sharing their info with a bank, so they should be able to get a lot from marketing to a huge Chase marketing base. The security of Chase will be associated with rewards, and you'll get the benefit of spending money outside of Starbucks too.
Rapier: Who are Starbucks' biggest competitors right now?
Palmer: Starbucks hasn't had that high a competitive overlap with McDonald's, Dunkin', or convenience stores. However, those three do have a significant overlap that revolves around drip coffee and breakfast sandwiches. Starbucks has tended to have a huge portion of its business in the fancy drinks, the espresso-based customized drinks, and oftentimes in teas. They operate in the espresso zone, which is somewhat labor-intensive and above the fray in terms of price competition, whereas in drip coffee you have far more competition from convenience stores and McDonald's. The competition seems to be more Dunkin's problem.
Starbucks' problem is that it tends to have a higher-income consumer base, skews female, 10% of its stores are in malls, and an even higher percentage are associated with retail in general. So there's a feeling that Starbucks is an indirect casualty of the increasing bias for the high-income consumer to eat, shop, work, and be entertained at home, rather than in retail shopping areas. As recently as two to three years ago, it seemed like Starbucks' starting point on same-store sales might be 3% or more comps and it could drive same-store sales above that from things like food and digital engagement. Lately, Starbucks' starting point feels flatter.
For a while, Keurig was gaining share at the expense of at-home, filter-brewed coffee. Keurig will likely try to broaden its user base by lowering the cost of a cup and lowering the cost of a machine, and by doing so will broaden its household penetration and gain share from other at-home coffee. Away from home coffee, customized espresso drinks seem to be slowing because of the overall retail environment, and not because of at-home-coffee growth. At-home coffee is not really growing — even Keurig's share gain has slowed.
Rapier: What will Starbucks' business look like 10 to 15 years from now?
Palmer: Starbucks is already a highly penetrated US retail chain. It's likely that its unit growth in the US will slow, and growth from its store base will shift to Asia. That process has already started, and the scale of Asia will only increase.
Penetration in the US will start to become a problem for US unit growth. Beyond that, the company has to figure out what its next growth drivers will be, how it can better penetrate the at-home market if that's where a lot of the growth is going to be, and how it can add to the experience in its stores through bolstering lunch business. They're toying with Mercato, which is a fresh-lunch offering. They've even tested doing dinners and delivery.
The unlock for digital is delivery, and the unlock for delivery is a $30 or higher order size. For Starbucks to leverage its digital infrastructure, it has to think about ways it can get bigger in catering and family orders, things that maybe aren't as natural for its current portfolio or menu.
Rapier: What's the biggest question on your mind for management?
Palmer: They just bought their China licensees, and have also bolstered earnings headed into FY19, which should have an accelerating benefit as they integrate that business. There's all these reasons why FY18 would end well, but what are some reasons for me to buy Starbucks today and not wait? Particularly as we're facing a tough retail environment. The Christmas shopping season is always a nail-biter.
Rapier: What's your go-to Starbucks order?
Palmer: Today I just had a venti black tea lemonade. It's not as sweet as your typical Arnold Palmer, and quite refreshing.
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