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AMM Dividend Letter #38: Loss Aversion, Fear, and Starbucks
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You can find Pershing Square’s Starbucks presentation below.
Episode Transcript
We have three main categories of dividend paying stocks that we invest in the AMM Dividend Growth Portfolio.
We have the dividend stalwarts.
We have new dividend payers and we have special situations.
We classify Starbucks as a new a dividend payer. These are companies that have initiated or started a dividend within the last ten years or so. New Dividend Payers usually start off with a low payout ratio which gives them the ability to grow their dividend at an above-average for the foreseeable future.
Starbucks started paying a dividend in 2010. Their first dividend was five cents per share. Last quarter, Starbucks paid a quarterly dividend of 36 cents per share. That’s a compound annual growth rate of twenty four percent. Starbucks is targeting a payout ratio of fifty percent to produce a dividend yield around two percent. Starbucks’ current payout ratio is thirty eight percent. This allows management the room to grow their dividend at above-average rate and above its earnings growth rate for the next few years or more.
The catalysts that we have for future dividend growth and price appreciation are all based on Starbucks unit economics.
On average, each Starbucks store that it builds costs around six hundred and eighty thousand dollars. Each store generates about 1.5 million dollars in sales and four hundred fifty thousand dollars in profit. This is a thirty two percent profit margin and a sixty six percent return on investment. For comparison, the average return on investment for a fast-casual store is about 40 percent.
We put together a chart of competitors to compare their returns. Now you can’t see chart in this podcast but if you download the full letter from the show notes you can see what I’m talking about.
McDonald’s stores generate about a thirty percent return based on its latest franchisee disclosure documents.
Taco Bell generates around 38% returns. this is from Pershing Squares presentation Doppio.
Dunkin Donuts generates around 37% per store based on numbers from their most recent investor day presentation.
To really take advantage of these strong store economics, Starbucks needs to increase foot traffic and increase the sales per square foot. This is achieved by expanding the brand with new stores and increasing the average ticket size per customer.
China is Starbucks’ biggest growth potential because it is here that they can hit on both pillars. They can increase foot traffic and they can increase the average ticket size per customer.
Right now Starbucks is on pace to open a new store almost every day in China. Starbucks’ China buildout strategy has three levels.
First they will build out stores in major Chinese cities that are more cosmopolitan and globalized. The people living here have probably had previous exposure to Starbucks.
Then, Starbucks will build out its stores in the second tier cities. These cities re still cosmopolitan and somewhat globalized but they still have strong local preferences.
The final step is to build out their stores in third tier cities.
This sort of trickle down growth strategy is designed to expand the awareness of Starbucks. As each new store is built and that awareness expands the more foot traffic Starbucks will generate, the more loyal Chinese customers it will create, increasing the sales per square foot and the size of the average ticket.
The first counter that probably comes to mind is China is a predominantly tea drinking population. The benefit for Starbucks is caffeine is an addictive stimulant. Like all drugs we go for the medium that gives us the quickest and strongest high. On average, a cup of tea has half the caffeine as a cup of coffee. A cup of coffee has anywhere between 95 to 165 milligrams of caffeine versus tea which has about twenty-five to forty eight milligrams of caffeine.
So if you need a bigger pick me up which one would you choose? coffee or tea?
We do have precedent. England a predominantly tea drinking country now drinks more coffee now than they do tea. The latest number I saw is they drink about twice as much coffee as they do tea.
In China we still have the novelty of espresso based drinks, a low consumption rate of coffee, and very large population to expose espresso based drinks to. All this offers Starbucks a very long runway for growth in China.
And this is what Starbucks management had to say during its latest Chin Investor Day Presentation.
“Belinda just announced we will bring the same experience and approach to another hundred new cities by 2022 and let me remind you with another important fact, the majority of these new cities are home of an average four million people approximately equivalent to the size of Los Angeles. Everyone what this means is that we are going to be introducing the Starbucks experience to a population nearly 100 times that of Los Angeles in the next five years! Now how can I not be excited about this amazing runway of growth ahead of us.”
In the mature markets that Starbucks is in is like the US or the UK the Starbucks brand is well known and its stores are already heavily trafficked. So Starbucks needs to really focus on increasing the average ticket size per customer. An they can achieve this several ways.
One way is they have to improve their operational efficiency. You’re on your way to work, you stopped off at your local Starbucks, you want some coffee, you poke your head in you see this very long line and it’s not moving very quickly, do you stay and get coffee? Or do you leave and go to the next coffee shop? Or just grab some coffee at work? You probably leave and Starbucks loses some revenue.
If Starbucks can get that line moving faster you’re more likely to stay. And if it’s moving fast enough, You might add on a pastry or one of the breakfast sandwiches to your order driving the average ticket size up.
Mobile ordering is going to be another pillar of growth that we’ll talk about here in a second but Starbucks’ big push into mobile ordering caused a lot of inefficiencies at the stores especially during peak hours.
Kevin Johnson is the new CEO of Starbucks and he’s an Operations guy. His main focus is improving the efficiency of each store and he’s focusing on the workflow in the store. They’re already shifting maintenance and other tasks that take the baristas away from serving the customers at peak hours to other parts of the day. They’re also trying to automate repetitive tasks like inventory management so it doesn’t take the baristas away from serving the customers.
They’re also remodeling the store and trying to right-size the staff to take care of the mobile orders during those peak hours so that every drink every food item is going out the door as quickly as possible, keeping those lines moving, and generating more sales per square foot during those peak hours.
Let’s talk about how mobile ordering can help drive growth.
When we place an order face to face with someone at a counter we do a little psychological trick on ourselves where we think we’re being judged. When we order through a digital kiosk, through an app, or online that perception of being judged disappears and we tend to order more driving our average ticket size up.
With the Starbucks app another ordering fear is removed. When you’re in long line and it is now your turn to order you don’t want to further hold up that line. So you may not order the most complicated drink or the new seasonal latte which are more expensive. But now when you’re placing your order through the mobile app you can order as many substitutions or additions as you want without that fear of being judged and without the fear of holding up the line.
The Starbucks mobile app is already one of the largest payment apps out there. Everything about your order, my order, everyone’s order is a data goldmine for Starbucks. They’re using their AI and machine learning programs to generate customized promotions to get you into the store at different parts of the day increasing your average spend at Starbucks. This is part of the reason why Starbucks changed its free Wi-Fi policy. Tt’s still free but you have to enter your name and your email to get it. This is the top of Starbucks digital sales funnel. The idea is as you go down the funnel you’ll become a more loyal customer, you’ll probably start using their app, they’ll get more data on you, and then they can run those more efficient promotions to get you to spend more increasing your average ticket size.
Another catalyst for growth in mature markets and in China too is delivery.
Starbucks has been partnering with Uber Eats and testing delivery. They tested delivery in one U.S. city and they now are rolling it out to six more.
The delivery order is placed through the Starbucks app so that’s more data for Starbucks, it removes the fear of being judged so the average ticket size goes up and then the other quirk with delivery is people tend to add to their order to justify the fact that they’re having their food and their drinks delivered to them.
Delivery can increase the average ticket size in a couple of other ways too. Let’s take the standard morning office coffee run. The most junior person takes everyone’s orde,r runs down to the store, places the order, hopefully they can carry it all and then get it back to everyone within time. One or two people have to leave and it disrupts work. It’s not the most efficient way to get that big Starbucks order.
Now with delivery you have one phone, one app that is passed around, everyone places an order through the app and then the order is going to be delivered to the office. No one has to leave, work isn’t disrupted, and the ticket size has probably gone up because people will add their substitutions and add more items to justify it being delivered to them.
The afternoon is Starbucks weakest part of the day in terms of sales.
Delivery can help here.
Biologically the two best times that have coffee if you wake up around 6:30 a.m. are between 9:00 and 11:00 a.m. and then again in the afternoon between 1:30 and 5:00 p.m. the problem for Starbucks is that customers may want that triple-shot-double-pumped-vanilla-soy-latte but that means they would have to leave work so with delivery they get their drink of choice when they want it in the afternoon without having to leave work without disrupting work and this helps Starbucks increase sales during the afternoon.
Delivery is just another means for Starbucks to reduce the barriers for people to get their coffee when they want it how they want it.
Onto the risks we see.
The biggest risk is also the biggest potential for reward it’s China.
As Starbucks builds out its stores in the second tier and third tier cities, they need to overcome all the localized tastes, and get them to embrace espresso based drinks and then you have to have them favor a Western brand over a Chinese brand. This now becomes harder because China now has their own Coffee darling, Luckin Coffee
Luckin Coffee wants to open 2,500 stores this year and they want to overtake Starbucks as the leading coffee house in China.
Luckin Coffee is barely a year old and they have pursued a highly aggressive expansion.
What Starbucks has going for it is they are extremely profitable. Luckin Coffee is not.
Luckin Coffee has been spending themselves deeper into a hole to grow as fast as possible. Usually spending this aggressively to pursue an even more aggressive growth strategy is
a recipe for disaster you just run out of capital. But Luckin Coffee is backed by some deep pocketed investors. The Singapore wealth fund, The China International Capital Corp and there’s rumors that Luckin wants to pursue an U.S. IPO to raise more capital to fuel more growth.
China is facing a little bit of an economic slowdown right now and the trade war with the U.S. is not helping. If the slowdown gets bigger, if there’s a recession in China, that means Starbucks can’t grow as quickly, and they can’t grow their brand awareness as quickly, and that means our valuation of Starbucks is too high.
If this Trade War continues and there’s propaganda against U.S. based businesses then the Chinese consumer might revolt against US and Western brands hurting sales and Starbucks growth potential.
The Starbucks US business is really mature and the opportunity to build new stores and get that high return on investment that we mentioned earlier is hard to come by. If Starbucks expands too much in the U.S. it will be investing in lesser stores with smaller returns and Starbucks’ return on incremental invested capital will decline. But in China Starbucks has a real opportunity to build new stores that generate the high returns on investment. The problem is if they can’t crack localized tastes, and they can’t compete against Chinese brands, or the Chinese government increases the pressure on U.S.-based businesses, Starbucks loses that opportunity to build out new stores then our fair value for Starbucks is much lower than we think it is today.
We’ve followed Starbucks for many years now and it’s always traded above our estimate of fair value. Then last year there were some missteps in Starbucks same-store sales growth and there was a sentiment shift about their potential to grow in China. The stock sold off and it went below our estimate of fair value and we started buying Starbucks. As we were buying, unbeknownst to us, a larger investor, Pershing Square run by Bill Ackman, was building their position. Then they released a report called Doppio as to why Starbucks is a great investment. Sentiment shifted again and Starbucks has gone back up in price.
Right now our estimate of fair value is $67 per share. Starbucks again is trading above our estimate of far value. So if there’s any future price weakness we’ll add to our position and also as quarterly data comes out or new annual data comes out and our estimate of fair value increases we’ll look to add more as well.
