Note from Daily Trade Alert: The following article first appeared in The Growth Stock Advisor, a premium newsletter offered by Investors Alley.

The conventional Wall Street wisdom was that homebound consumers would discover how much money they can save by skipping their morning coffee from Starbucks (SBUX).

And indeed, the coronavirus pandemic did hit Starbucks hard. Sales plunged by 40% year over year in the second quarter of 2020; however, Starbucks expects its business in China—its second-biggest market and growing—to recover fully in the current quarter.

And with the rest of the world also improving, the company’s earnings for the year through next September will approach or beat 2019’s figure according to CEO Kevin Johnson.

All of this explains is why Johnson is overhauling cafés, deploying artificial intelligence (AI), and raising wages.

The CEO wants to sharpen the competitive advantage of the world’s largest coffee chain, telliing the Financial Times, “We have line of sight to grow faster than the addressable market, which means we’re going to be taking market share.”

I think Johnson is right. Here’s why…

Starbucks’ Strategy

The pandemic pointed out a major flaw in the company’s previous strategy: Starbucks relied far too heavily foot traffic in downtown business districts and transportation hubs. Obviously, the number of people traveling and working in office dropped significantly due to the ongoing pandemic.

This reality prompted Johnson to rethink both the locations and formats of his stores.

Here in the U.S., in particular, Starbucks is now gearing its outlets more towards the two areas of growth for fast food restaurants as well as coffee shops: drive-throughs in the suburbs and small towns and pick-up sites in the major cities.

Starbucks still plans to open about 2,150 outlets this fiscal year, which would be about 150 more than last year. But it is also closing 1,050 branches, up from 600 in 2019. The effect will be fewer net new stores this year in the U.S. than in previous years.

Starbucks is using an AI tool called Deep Brew to help it plan its strategy. Deep Brew turns data around COVID-19 case counts into recommendations about how individual Starbucks locations need to adapt, as well as how to create more personalized offers to users of the Starbucks mobile app and loyalty program.

The strategy of fewer net new store openings is in stark contrast to the company’s strategy in China, a market it entered two decades ago.

The Battle for China

In China, Starbucks continues to expand aggressively. Its outlet count there rose 14% in the year through September, to more than 4,700. The U.S. total is 15,300 locations.

In such a large and still fast-growing market like China, Starbucks faces many challengers—including a familiar one: McDonald’s (MCD).

McDonald’s will spend $381 million over the next three years on a major expansion of its store-in-store McCafes in China. This is direct challenge to Starbucks in a race to cater to the growing Chinese middle class and its taste for premium drinks.

Under the plan, McDonald’s aims to have 4,000 McCafe’s in mainland China by the end of 2023.

McDonald’s opened its first China McCafe in 2009. But the McCafe format had been confined to larger, more affluent cities until recently. The company passed a milestone with the opening of its 1,000th Chinese McCafe in May of this year. It expects to have 1,500 stores nationwide by the end of the year as it rolls out the concept in smaller markets.

Still, Starbucks remains the clear market leader. It is able to charge a premium, with coffee typically averaging close to 30 yuan ($4.59) per cup. McDonald’s sells its coffee for about 20 yuan (3.06) a cup.

Starbucks’ digital push will ensure it stays ahead. The company’s emphasis on tech has been particularly aggressive in China. And it is working: the proportion of orders coming in on mobile phones more than doubled in the year through September. These orders now account for more than a quarter of total orders.

Johnson is right when he says: “China is kind of a leading indicator of where the digital consumer is going.”

What’s Next for Starbucks

At its 2020 investor day, the company outlined its expected trajectory through the pandemic recovery and beyond. Starbucks anticipates sales growth of 8%–10% and adjusted operating margins of 18%–19% through fiscal 2024, driven by growth of 4%– 5% globally as well as increased store productivity.

Not surprisingly, management was most optimistic about China. Starbucks has already seen demand there returning to close to pre-pandemic levels, and has committed to opening an additional 600 stores there this year, with a goal of 6,000 stores by 2023.

Even beyond China, the company sees increased potential for international growth. This growth projection is based on customer engagement measures like its Rewards programs as well as Mobile Order & Pay, which only exists in a handful of countries currently.

Note that the Rewards program has been a bright spot for Starbucks throughout the pandemic, with 90-day active membership up 10%.

From a wider perspective, specialty coffee retailers are being hit particularly hard by the coronavirus crisis. That will translate to some smaller coffee retailers closing, reducing competition for Starbucks. With its very strong brand and robust mobile ordering and payment platform, expect Starbucks to get through this crisis better than most other restaurant chains.

Wall Street now has woken up to the Starbucks story and expects it to emerge from the pandemic in an even more dominant position. Its market value has more than doubled from March’s low and is up 18.3% since the start of the year, to a record market capitalization of $122.3 billion.

Starbucks increased its quarterly dividend by a tenth in September, but it has put stock buybacks on hold. After issuing about $4.75 billion worth of debt to get the company through the pandemic, Johnson says he needs to reduce its leverage before resuming buybacks.

The Starbucks story looks solid and the company seems poised for even more growth in the years ahead—particularly in China. However, with the stock up so much in the past few months, it only gets a 4-star rating. You can still buy the stock, though, at any price up to $113 a share.

Tony Daltorio
December 21, 2020

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Source: The Growth Stock Advisor