China and India Attract Major Coffee Retailers

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The world’s biggest coffeehouse company, Starbucks (NASDAQ: SBUX), has been in the news on charges of alleged tax evasion in the U.K. The head of the country’s Public Accounts Committee insists that the company should be investigated by U.K’s tax authority as to how it managed to avoid any corporate tax in the past three years despite earning around $1.9 billion in revenues. According to Reuters, Starbucks used loans and intra-company transfers to generate a net loss for its British operations. The company insists it has not done anything illegal and has paid its taxes “to the letter of the law.” It should be noted that the tax under question, the corporate tax, is charged on profits, not on revenues.

According to Starbucks’ most recent quarterly filings, the company’s Q3 revenues for its fiscal year 2012 jumped 12.7% to $3.3 billion while profits increased by 19.3% to $333 million. Same store comps (open for more than 13 months) rose by 7% in the Americas region and 12% in the CAP (China / Asia Pacific) region.  But the EMEA (Europe, Middle East, Africa) region pulled the overall sales growth down to 6%.

Moreover, the company’s operating margin improved in every segment except the EMEA, where it dropped by 47% to just $2.6 million. So, for 2013, Starbucks is planning to open 1,200 new stores, with just 100 of those going to the EMEA region. Its growth in the current fiscal year has been largely organic.

The company is also looking to tap into the Indian market, a country where tea dominates coffee. It is therefore highly unlikely that Starbucks will be able to offset its fall in Europe with India. But coffee is gaining ground there, which is evident in the hundreds of café bars that have propped up throughout the country in the previous decade that largely cater to the growing middle class. The total coffee consumption in India has doubled in the last ten years and now stand at 108,000 MT. Starbucks’ competition in India will come from Amalgamated Bean Coffee Trading’s (ABCT) Café Coffee Day, which has 1,350 stores, and Lavazza SpA’s much smaller Barista Coffee, which has 318 stores. ABCT claims to be “Asia’s largest fully integrated coffee company,” and is planning to reach 2,000 Café Coffee day stores by 2014. By comparison, Starbucks is a much bigger global player, with more than 17,600 stores.

However, Starbucks’s main concern here will be pricing. The average monthly wage, in purchasing power parity (US$), according to International Labour Organization’s data is $295 in India compared to $656 in China, $1,545 in Hong Kong, and $3,253 in the United States. If Starbucks wants to compete in this market, then it will have to reduce its prices by about a third. The Indian market leader Café Coffee Day sells its regular cappuccino for $1.13, while Barista Coffee sells a similar drink for $1.28. On the other hand, Starbucks is selling its coffees in China and the U.S between $4.00 and $3.50 a cup.

The company’s other fast food rivals Dunkin Donuts (NASDAQ: DNKN), McDonald’s (NYSE: MCD) and the much smaller Krispy Kreme Doughnuts (NYSE: KKD), are already present in this region and looking to tap into the growing coffee demand.

In the past 52 weeks ending Oct. 19, SBUX, KKD, and DNKN have been up 8.2%, 8.5%, and 15.5%, respectively, while MCD has been down 1.4%. Only DNKN has been close to the SPDR S&P 500 ETF, which has been up 16.9% in the same period.

<table> <tbody> <tr> <td> </td> <td> <p><strong>SBUX</strong></p> </td> <td> <p><strong>KKD</strong></p> </td> <td> <p><strong>DNKN</strong></p> </td> <td> <p><strong>MCD</strong></p> </td> </tr> <tr> <td> <p><strong>P/E</strong></p> </td> <td> <p>25.38</p> </td> <td> <p>3.45</p> </td> <td> <p>81.03</p> </td> <td> <p>16.67</p> </td> </tr> <tr> <td> <p><strong>EPS</strong></p> </td> <td> <p>1.8</p> </td> <td> <p>2.25</p> </td> <td> <p>0.4</p> </td> <td> <p>5.32</p> </td> </tr> <tr> <td> <p><strong>Yield</strong></p> </td> <td> <p>1.40%</p> </td> <td> <p>N/A</p> </td> <td> <p>1.90%</p> </td> <td> <p>3.30%</p> </td> </tr> <tr> <td> <p><strong>ROE</strong></p> </td> <td> <p>28.45%</p> </td> <td> <p>95.91%</p> </td> <td> <p>11.60%</p> </td> <td> <p>37.93%</p> </td> </tr> <tr> <td> <p><strong>ROA</strong></p> </td> <td> <p>13.77%</p> </td> <td> <p>7.74%</p> </td> <td> <p>4.47%</p> </td> <td> <p>15.87%</p> </td> </tr> </tbody> </table>

DNKN, with its high P/E and relatively lower ROE, is an expensive buy. MCD has relatively lower P/E, has given a good ROE, and has the highest yield, which makes it the most attractive buy of the lot. Both SBUX and MCD have focused on growth in the emerging markets, particularly India and China, but SBUX has clearly been much more successful with its hundreds of stores located all around China; however, it will have trouble expanding much past the Tier 1 cities.  That being said, for the time being they have plenty of room to grow, and their higher multiple reflects this. 

On the other hand, MCD faces tough competition from Yum! Brands’ KFC, which is much more popular in China than MCD. SBUX earns the highest operating margin from this region and has relied primarily on organic growth, while MCD has struggled with both margins and growth in China. For the next fiscal year, Starbucks is looking at 11.5% revenue growth and about 17.5% EPS growth. 

PeterPham8 has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Krispy Kreme Doughnuts, 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.If you have questions about this post or the Fool’s blog network, click here for information.

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