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Accumulate Starbucks on a Correction

- By Subia Khan

Starbucks Corp. (SBUX) recently announced impressive first-quarter 2017 results. Revenue increased 7% over the last year to $5.7 billion. Operating income grew 7% to $1.1 billion and the operating margin expanded another 10 basis points to 19.8%. Both numbers reflect well-managed and efficient operations. Same-store sales grew 3%, missing analyst estimates of 3.8%, which was one of the reasons why the stock fell after the earnings announcement.


According to management, congestion at the hand-off counter led to a rise in mobile traffic. As a result, customers either did not enter the store or left without completing a transaction. Another reason is the steep rise in the number of new restaurants. The company opened 649 new locations during the quarter, bringing the total count to 25,734 stores in 75 countries. This massive increase in restaurant count has led to customers spreading out to different locations, leading to a slight decrease in same-store sales. I am not concerned about this as I believe the company has a quality offering and customers are likely to remain loyal and attracted to innovations.

Innovation is the key to success

Some of the recent innovations in Starbucks' products was the Tuxedo Beverage Collection to celebrate the new year. The collection comprised a trio of handcrafted beverages featuring silky swirls of dark and white chocolate toppings. Customers had the option of choosing from the Tuxedo Mocha, Tuxedo Hot Chocolate or Tuxedo Frappuccino.

For Valentine's Day, the company has come up with Teavana tea gifts, which offer a variety of dessert-inspired, decorative tins and mugs that make perfect gifts for loved ones. In addition to these gift sets, the company also has Valentine's Day drinks and food items that launched on Feb. 7. All the drinks have chocolate.

Although theses offers were only available for a short time, the idea and experience would certainly remain with customers. Starbucks' ability to constantly provide innovative and limited time products make it a brand of preference among consumers.

China has huge growth potential

China is the key growth driver for Starbucks. The company opened its first Chinese store in 1999. As of Jan. 1, 2017, there are 2,000 stores in China with a plan to operate 3,400 stores by 2019. In order for the coffee company to succeed in a country that traditionally favors drinking tea, it must implement a marketing strategy that will appeal to Chinese consumers.

Moreover, China's middle class is growing and getting richer at a faster pace compared to other parts of the world. This would have a considerable impact on the consumption pattern across the country. Companies like Starbucks that offer different products will likely benefit from the changing demographics.

The key to the company's success is to cater to its Chinese audience through local Chinese culture and not push Western values on them. In addition, the company is building a relationship with the Chinese government and plans to open a 30,000 square-foot Starbucks Shanghai Roastery and Tasting Room inside a commercial mall in 2017.

Since China is a huge growth opportunity for Starbucks, management plans to take bolder steps in making the Shanghai location its most stunning store, while making it completely unique and relevant to Chinese customers. The store is fully supported by local government officials, including Shanghai's Jing'an District Mayor Lu Xiaodong.

On Feb. 10, Starbucks announced the launch of a new social gifting feature on Weixin, which aims to deepen the shared moments of connections by allowing the customers to express their love, gratitude and concern. The company is leveraging the power and reach of Weixin to connect with people to encourage simple acts of kindness.

Weixin allows consumers to send free drinks or digital gift cards through the "Say it with Starbucks" feature, indicating the importance of the strategic partnership for both companies. I believe this will help Chinese consumers enhance their social gifting experience to celebrate important festivals and holidays as well as special occasions. The partnership with Weixin will further give the company access to users of WeChat, which would help build brand values while simultaneously having a greater reach.

Considering the huge growth potential in China and Starbucks' efforts to continuously provide customers with innovative products, I believe the company has significant upside potential.

CEO's departure is not a concern

On Dec. 1, 2016, Starbucks announced CEO Howard Schultz would be stepping down. Investors did not take the news well, causing the stock to decline. I am not concerned about the news because he will continue to work with Starbucks as executive chairman and will focus more on the company's retail outlets.

Kevin Johnson, the current chief operating officer, will be stepping up to serve as CEO. Johnson has 16 years of experience at Microsoft (MSFT) and five years at Juniper Networks (JNPR). His experience will help Starbucks expand its business, which is evolving from a pure brick-and-mortar outlet to more of a technology play. I believe growth in retail outlets has become stagnant, so there is a need for someone like Johnson to help Starbucks expand its business through technology.

Valuation

As discussed, Starbucks has strong fundamentals and impressive growth drivers. Despite this, the company had a stagnant performance last year. This has brought its valuation to a more reasonable level however.

For 2017 and 2018, Starbucks is trading at estimated EV/Revenue ratios of 3.6 and 3.3. This compares to Dunkin Bands' (DNKN) EV/Revenue ratios of 8.6 and 8.4 and YUM Brands' (YUM) EV/Revenue ratios of 6.0 and 7.5. Considering Starbucks' current undervaluation, I believe the company has high intrinsic value and would generate good returns.

Conclusion

Starbucks is a well positioned business with a good management team and huge growth opportunities not only in China, but Asia as a whole. Considering its attractive valuation and favorable market conditions, I believe the stock is a good long-term investment.

Disclosure: No position in the stocks discussed.

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This article first appeared on GuruFocus.