Starbucks: Reaching for the Stars in Asia

By Peter Pham - April 30, 2012 | Tickers: AAPL, DEO, MCD, SBUX | 0 Comments

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In what is becoming a broken record this earnings season for major U.S. stocks, Starbucks (NASDAQ: SBUX) reported earnings growth that was driven by emerging markets and not business in North America.  While business in North America was good, 9% income growth is nothing to sneeze at, the 28% recorded in China and the 20% for the Asia/Pacific region as a whole is just plain better. 

Operating margins in China are better than in the U.S., 34.6% versus 21.8%. They have 470 stores in China currently, operating in 48 cities.  China now accounts for 9% of Starbucks’ net income, up from 5% in 2010, and is on a trajectory to become the second largest coffee market in the world by 2014, surpassing Canada in importance to the company’s bottom line.   

The Numbers Don’t Lie

The key to understanding just how big an effect China will have on the scale of Starbucks’ business going forward one has to compare the costs of opening a new store in a nearly untapped market in China versus the nearly saturated one in the U.S. 

Opening a store in China costs half as much which produces 27% more sales per dollar invested to generate 33% higher cash margins in the first year of operation returning nearly twice the amount of cash that a North American store does. 

Now you may understand why the company plans to open 1000 more stores in China in the next three years.  To service that many new stores they have recently signed a joint venture agreement with the Yunnan province based coffee grower Ai Ni Group to build an coffee purchasing and export business with a processing plant that will have a production capacity of 100,000 metric tons within five years of going online.  Needless to say, Starbucks is serious about China and Southeast Asia.

Roll all of this up with the fact that at every level of their business Starbucks has pricing power, leveraging their brand as a premium one rather than a value one. 

The Pitfalls

While reports of customers (and non-customers) lingering exist, it doesn’t seem to be impacting the business.  Starbucks has created a premium brand in China.  A Starbucks cup has become a status symbol in many ways.  Business meetings, thanks to free Wi-Fi, are conducted in them.  The coffee shop has always been a place for people to gather and hang out and Starbucks caters to that. 

Starbucks has met the competition from McDonald’s (NYSE: MCD) and their McCafes’ lower price by matching McDonalds in offering free Wi-Fi and improving the customer throughput model.  The introduction of the Starbucks card (3.7 million registered) gives them a means by which to reward regulars and pump prime new product offerings through incentives. 

Their Wi-Fi service and the Starbucks Digital Network is another source of revenue for those that come but do not necessarily spend more, monetizing any purchases made while at a Starbucks with any of their business partners. 

Starbucks is planning an expansion into Vietnam in 2013 and will face stiff competition from the local Highlands brand which just formed a partnership with Netopia the largest internet café chain in Vietnam where buying coffee will come with free internet time as they move towards building ‘lifestyle hubs.’  Unlike China coffee is so much more a part of Vietnamese culture.  We are the world’s 2^nd largest exporter of coffee, mostly in the form of lower cost Robusta.   Starbucks will have to focus on their status and brand here to take over the local market. 

The early indications are good as I have seen their bottled cappuccinos on the streets here even though they have not officially opened up business yet.  Western ex-pats are always an important early adopter segment to jumpstart any brand’s introduction in this part of the world.

But, Vietnam has a young and status-conscience emerging middle class where an iPhone 3 is seen as passé so it will be interesting to see if they flock to Starbucks’ brand the same way they have to Apple (NASDAQ: AAPL) gadgets and American fast food.  If so, their transition in country will be smooth.  I would not, however, be surprised to see Starbucks introduce products specially designed for Vietnam similar to how Diageo (NYSE: DEO) designed the Johnnie Walker Gold Reserve Scotch for this market, which worked so well they now sell it all over Southeast Asia.

Growing the Brand

But it is the overall growth story of the Pacific Rim that is the driver of Starbucks’ story now, not just in China and Vietnam but all over the region.  China’s GDP growth rate will likely average 5-7% as they target higher domestic consumption over the next decade.  The 10 countries that make up ASEAN are looking at similar growth rates in the aggregate.  As this region moves towards economic integration, softening the political borders between them this will result in an explosion of the middle class here. 

Starbucks, I think, is well-positioned to capture a significant part of that as their product line targets those moving up the economic chain.  The higher margins they are generating in this region will help offset the rising costs of coffee due to higher demand.  Being higher up the value chain gives them that cushion to build their business without sacrificing their brand as they tap into the biggest pool of potential customers in the world. 

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