Starbucks: Why Howard Schultz's departure could 'open the door' for expansion in China

As Starbucks reshuffles its board, a new China strategy may be brewing at the coffee giant.

Last week, Starbucks' founder and three-time CEO Howard Schultz announced plans to step down from the board of directors after CEO Laxman Narasimhan took the helm earlier this year. Starting on Oct. 1, former Alibaba executive Wei Zhang will take Schultz's spot on Starbucks' board, an appointment seen as reemphasizing the company's commitment to China.

That could mean changes to Starbucks' strategy in China, the company's second-biggest market.

"Howard Schultz was the mind behind China's special positioning in Starbucks' ecosystem … and the key figure behind substantial Chinese government support on Starbucks expansion plans in China," Bernstein analyst Danilo Gargiulo wrote in a note following the announcement.

The coffee chain's international business has picked up momentum over the years. Starbucks recently announced its 20,000th location outside of North America and plans to expand to 9,000 stores in China in the next two years.

Starbucks has gone a different route than its restaurant peers, such as KFC and McDonald's, which run franchise models. But now that Schultz — who was largely against franchising — is out, one analyst thinks that could potentially change.

With Zhang now on the board, Gargiulo wrote, "we wonder whether Schultz's departure would open the door for Starbucks' franchising strategy in China, amid lower store profitability and increased competition."

Starbucks' history in China

Starbucks opened its first store in Beijing in 1999 and its first Shanghai store in 2000.

From the early 2000s to 2017, the coffee giant expanded with licensing agreements with joint venture partners as it looked to grow its presence in China, which at the time was a largely untapped market.

In 2017, Starbucks decided to bring its operations completely in-house when it bought the remaining 50% share of its East China business from joint venture partners for $1.3 billion. Since then, Starbucks has been ramping up its presence with stores directly owned and operated by the company.

"They saw the strong profitability of many of their existing units, and it got to the point where Starbucks probably learned enough about the Chinese market ... [that] they felt they didn't need need to have a partnership any longer," Georgetown professor Arthur Dong told Yahoo Finance.

Starbucks has continued to invest in China and research the demand for coffee in a nation of daily tea drinkers.

The company has also built up its manufacturing footprint there. On Tuesday, the company announced the opening of its China Coffee Innovation Park manufacturing facility. The initiative, introduced back in 2020, is the company's largest investment in any manufacturing and distribution center, totaling approximately $220 million.

"China's coffee market is still in its early stages, with huge potential to expand the addressable market," Starbucks China CEO Belinda Wong said during Starbucks 2022 Investor Day. "Per capita demand for coffee in China will grow further from 12 cups per year to 14 cups by 2025."

Today, China is known as the "second home market," per Gargiulo.

In the third quarter, the company opened 588 new stores worldwide, bringing its total store count to 37,222 stores. The US and China make up 61% of the company's portfolio, with 16,144 and 6,480 stores, respectively.

Meanwhile, Starbucks' international operating margin jumped 19%, up from 8.5% during the same time period last year.

Dong credited Starbucks' success to its access to prime locations and "friends in high places" compared to competitors. Other big coffee players in China now include Beijing-based Luckin Coffee (LKNCY).

"I have to give them credit, they are very politically savvy when it comes to entering the Chinese marketplace," Dong said. "Most of their real estate partners are either high-ranking party officials or real estate entities that are in some way tied to the Chinese Communist Party, and some of the leaders."

However, the environment in China looks very different today than it did just five years ago, China Beige Book co-founder and CEO Leland Miller told Yahoo Finance.

"It's much more restrictive towards foreign firms ... so the calculus has completely changed in terms of what the long-term trajectory can be," Miller said, pointing to geopolitical risk factors, such as worsening US-China tensions.

"The opportunities are there, but the challenges have never been appreciated," Miller added.

Wall Street would likely 'welcome' a Starbucks franchise model

Investors have keyed in on Starbucks' China business, though some are cautious about China's economic recovery.

"We worry China narrative is likely to present an albatross on shares," Cowen analyst Andrew Charles wrote in a note Tuesday. "We see risk that China headwinds are likely to get stronger rather than weaker."

As Starbucks moves towards that 9,000 store goal using its own capital, Georgetown's Dong said a franchise model would offer "a lot of positive benefits."

"Wall Street would probably greet that with welcome arms because they see the risk ... that the Chinese economy is in and the longer-term challenges that China is facing," Dong said. "Why commit your own money in such a risky environment, when you can just have local Chinese investors commit their money, and then gain the backing and support of Starbucks?"

This concept isn't too far-fetched, Dong explained, given the company's current model of half-licensed, half-owned stores. Globally, Starbucks locations are 51% company-operated and 49% licensed.

How would a potential Starbucks franchise work? Dong said it would be similar to peers.

Other US-based brands have had a footprint in the Chinese market for years. Yum Brands (YUM) opened its first KFC location there in 1987 and spun off its China business in 2015. McDonald’s (MCD) was one of the first to enter the market in April 1992 and grew its franchises there before selling its China business to a state-owned conglomerate, Citic and Carlyle Group, in 2017. Additionally, Shake Shack (SHAK) has licensed stores to global partners in Asia.

Starbucks would pick and choose which stores it owns, Dong suggested, keeping "the most prime" stores in first-tier cities that "contain large numbers of middle class with an income to buy a $5 latte" while expanding franchise or licensed stores in "second- and third-tier cities, where they wish to expand."

Still, Starbucks has a different model than others because it doesn't derive a significant portion of revenue from commercial real estate, Dong explained. That's unlike McDonald's, which had to pivot in China since it couldn't acquire land there permanently.

"Starbucks has never been a real estate-centered business model," Dong said. "They engage in leases with a variety of landlords, but they make most of their money to the sale of coffee and ... through the sale of food and beverage."

However, the uncertain environment could be a red flag for investors.

"Things are perhaps gonna get worse before they get better," Dong said, adding that there will be continued challenges in the next 12 to 24 months, "until some massive measure is taken by Beijing and Xi Jinping, to sort of kickstart their economy" and "the Chinese consumer feels comfortable enough to come out again and spend."

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Brooke DiPalma is a reporter for Yahoo Finance. Follow her on Twitter at @BrookeDiPalma or email her at bdipalma@yahoofinance.com.

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