Starbucks' Under Appreciated Growth Opportunity

Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

As many have wondered, how can Starbucks (NASDAQ: SBUX) continue to grow if it's on every street corner in America? The answer lies in Asia. Try finding a Starbucks in Asia outside the major shopping malls and the major cities. It's very difficult, most likely impossible, let alone find one on every street corner like in the US.

Meanwhile, China has not been treating the likes of McDonald's (NYSE: MCD) and Yum! Brands (NYSE: YUM) very well. Chicken supply and food safety concerns have pressured both companies. China's state television CCTV reported that two poultry farms that supply chickens to Yum!'s KFC had fed chickens with unapproved levels of antibiotics. Although the issue really only impacted KFC, the pressure extended to McDonald's as consumer confidence in food quality at many restaurants was brought into question. 

Yum! remains unsure about how long it will take to recover sales at KFC in China. Management expects continued weakness in China sales during the first quarter, with an expected drop of 25% in same store sales for the period. Yum! has taken steps to monitor its poultry suppliers in China and cut ties to questionable companies (read more about how China hurt Yum!).

China still holds the key to both McDonald's and Yum!'s overseas expansion plans. For Yum!, its China segment accounts for more than double its U.S. revenues, and the company has double the stores in China versus the U.S. However, McDonald's still has room to grow, with only 1,500 China-base stores, versus its 18,000 U.S. locations. McDonald's has increased its store openings in China, and Yum! plans to continue opening stores, but with increased store openings comes margin compression. However, Starbucks is already enjoying 30% operating margins in China, versus the company-wide average of just over 11%.  

But don't most people in Asia prefer tea over coffee?

Typically the average drinker in Asia preferred tea over coffee. But as incomes have risen and palettes have changed, the transition is being made to coffee. Starbucks believes that China will be its second largest market by 2014. In China alone, an estimated 1/3 of the population is now drinking coffee. That's 443 million people! For those that prefer tea, Starbucks last quarter completed the acquisition of Teavana for $620 million. Starbucks is going after the tea drinkers as well and wants to capture that segment of the market that it has been missing. The company will add this line to its existing Tazo tea products. 

The Growth Is Evidenced By The Numbers 

Last quarter Starbucks reported global revenues of $3.8 billion, a rise of over 11%. Inside those numbers was revenue of $214.1 million from the Asia-Pacific region, a jump of 28% from the previous year. These revenue numbers come from having only 700 stores in China. Compare that to over 11,000 in the US and you get the picture of the growth potential for Starbucks in Asia.

In terms of employee headcount, Starbucks employs over 200,000 on a global basis. Of that, roughly 10% or 19,500, are based in Asia. The best part about Starbucks is that they don't discount. The prices in China are the same as they are in the US, but margins are better because employee costs are much lower in the Asia Pacific region than in the US.

Growth Beyond China

India Is Next

Well at least the Chinese have over 700 Starbucks for their 1.34 billion people. People in India have a total of 7 for their 1.24 billion people. Starbucks has been slow getting into India because it didn't have the right partners. Now Starbucks has a 50/50 joint venture with Tata Global Beverages to build stores in India. The first 1 opened in October 2012 and 6 more have followed.

Starbucks Opens Its First Store In Vietnam

Vietnam is the world's second largest coffee producer after Brazil. Vietnam grows the robusta variety of coffee, which is sweeter than the Arabica variety. Arabica is the type of coffee used by Starbucks in its coffee. If Vietnam coffee drinkers are used to a sweeter type of coffee, isn't that a bad sign for Starbucks? Wrong! Starbucks opened its first store in Ho Chi Minh City last month and people lined up for more than 2 hours to get their first Starbucks coffee. The aura of the Starbucks brand is seen in Asia as being sophisticated and appeals to the growing population with more disposable income.

Attractive Valuation

Compared to other major peers, Starbucks also has the best (lowest) PEG ratio:

  • Starbucks 1.6
  • McDonald's 2.0
  • Yum! 1.7

Compared to these other companies, Starbucks also has the best balance sheet, with a debt to capital ratio of 10%, compared to McDonald's 45% and Yum! 55%.

Starbucks currently has a forward P/E of 21. This is extremely attractive for a company still in the growth phase. The company's current operating margin of 13.6% looks set to improve further as the company benefits from the weakness in coffee prices. Coffee was the worst performing commodity last year. That greatly benefited Starbucks as the prices dropped. Starbucks is able to use last year's weakness to negotiate better fixed-prices with its leading suppliers.

Further helping Starbucks with its coffee purchases is the outlook for the 2013-2014 crop. Brazil is the world's largest coffee producer and they produce the Arabica variety that Starbucks uses. The outlook for the Brazil crop is looking extremely favorable as weather has helped the crop and coffee growers invested in new seedlings and fertilizer. Production in Colombia, Mexico and other Central American producers look strong as well.

Marshall Hargrave has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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