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Starbucks: Impressive Brand Strength and Dividend Growth

The first Starbucks (SBUX) cafe opened in 1971, and the company has since grown to become the world’s largest coffee purveyor with over 29,000 stores in 78 countries. Starbucks stores sell not just premium coffee but also tea, packaged coffee, juices, bottled water, pastries, and various lunch items.

In addition, the company licenses several of its products, which are available in supermarkets and stores, and sells through other up-and-coming brands such as Teavana, Tazo, Seattle’s Best Coffee, Evolution Fresh, and Ethos.

In its most recent fiscal year, the vast majority of Starbucks' sales (80%) came from the company’s namesake, company-owned stores. Licensed stores and consumer packaged goods generated 11% and 9% of revenue, respectively.

By geography, Starbucks generated 68% of its revenue last year in the Americas (U.S., Canada, Latin America); 18% in China / Asia Pacific; and 4% in Europe, Middle East, and Africa. The remaining 9% of revenue was related to channel sales of Starbucks’ products (packaged coffee, Frappuccinos, etc) and other business segments.

Business Analysis
Starbucks' key to its long history of impressive sales and earnings growth has come down to its ability to differentiate its brand and often become a destination in its own right.

Each location does its best to provide visitors with superior customer service, high-quality coffee, a seamless digital experience, and clean and well-maintained stores that reflect the personalities of the communities in which they operate.

The end result has been a high degree of customer loyalty in what is otherwise a crowded coffee market, helping the company command strong pricing power and generate excellent profitability.

To put it another way, Starbucks' competitive advantages, including its substantial economies of scale, mean that this coffee chain generates unusually high margins for a brick-and-mortar business. That's a testament to the great job management has done creating a unique coffee experience that its core customers will continuously pay up for.

Starbuck's high margins make opening new stores a lucrative venture. The higher a company's margins, the more profit each dollar of additional sales will produce.

As a result, Starbucks expects much of its long-term earnings growth to come from expanding its store count in both the U.S. and abroad, especially in China where per capita coffee consumption has room to rise significantly over time.

Today, Starbucks has a little under 4,000 stores in China and expects to grow that count to 6,000 by the end of 2022. That would be a 50% increase in just a few years, made possible by China's size (1.4 billion people) and fast-growing middle class.

In the long-term, it's not out of the question that Starbucks' store count in China approaches the size of its U.S. store base, which exceeds 14,500 locations today.

Besides growth through expansion, Starbucks has a number of opportunities to grow sales and increase traffic at its existing locations, primarily through digital initiatives, new product development, and improvements to the in-store experience.

On the digital side, Starbucks has a popular mobile app and loyalty program with over 15 million members (and counting) that the company is continuously experimenting with to incentivize customers to visit more often. The company also recently implemented online ordering and delivery, which is expected to boost sales further.

Product innovation can also drive incremental sales growth. For example, the company's Nitro Cold Brew, which is a cold coffee beverage infused with nitrogen to give it a foamy, carbonated-like texture, is gaining popularity as an afternoon drink of choice.

Finally, Starbucks recognizes that a key reason customers love the brand and make return visits is their positive experience with staff. That's why the company announced an initiative in 2018 to cut store administrative tasks by 50%, freeing up two to three hours per day for store managers to improve customer interactions.

The bottom line is that there's no shortage of ways for Starbucks to grow its business, and the company should remain a dividend-paying cash cow for years to come. However, a bright growth story alone doesn't make Starbucks an obviously good investment.

Key Risks
With a P/E ratio well above the S&P 500's, Starbucks' stock has historically traded at a large premium to most other stocks on the market, reflecting investors’ expectations for strong and sustained long-term growth.

In other words, investors in Starbucks need to be bought into the company's growth plans at home and abroad and believe that the business can maintain its high growth rate long into the future. Should growth decelerate for any number of reasons, Starbucks' valuation will likely contract, resulting in disappointing returns for shareholders, even if the dividend remains safe.

One of the biggest challenges Starbucks now faces is its size. The company is so large that it is increasingly running into major competitors at all price levels in the coffee market. That includes McDonald's McCafe and Dunkin' Donuts at the low end, as well as Peet's, Caribou Coffee, and Panera at the upper end of the price market.

In response, Starbucks is making a push "upmarket" with its new Starbucks Reserve and Roastery stores that sell higher market coffees and baked goods, but the ultimate success of these efforts is far from certain. After all, there is only so much consumers are likely to pay for even the highest quality coffee and baked goods.

Management has said that globally Starbucks continues to gain market share, but that might not always be the case. If the global economy weakens, consumers may become more price sensitive and satisfy their coffee addiction with less expensive alternatives (McDonald's, brew at home, etc).

Meanwhile, as popular as Starbucks already is in the U.S. and China (where the brand already dominates with a 60% market share), the company may find it more challenging to find profitable new growth avenues. Many of the easiest expansion opportunities have likely already been saturated with Starbucks cafes.

At the end of the day, Starbucks seems likely to continue finding new paths of growth. However, investors should have more modest earnings and dividend growth expectations (probably along the lines of 10%, as management has guided recently) than in the past as the company runs into more competition and confronts more difficult expansion opportunities.

Closing Thoughts on Starbucks
Starbucks has proven itself very good at building one of the world's most premium brands and quickly growing while adapting to various challenges over time. As a result, the innovative company appears to have a solid plan to continue rewarding income investors with double-digit dividend growth for the foreseeable future.

While there are real risks to Starbucks' growth profile, the management team is also very experienced and seems likely to continue finding success in expanding the company's global reach and store concepts.

Just remember that for a blue-chip global giant of Starbucks' size, investors need to have realistic growth expectations and value the stock accordingly.

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