British star investor Terry Smith, of Fundsmith Equity has exited his investment in Starbucks NASDAQ:SBUX, the Seattle based global coffee chain as detailed in the latest May newsletter for the fund.
The UK’s largest actively managed equity fund purchased Starbucks in 2020 after disposing of the fund’s investments in Reckitt Benckiser and Clorox. The Fundsmith equity fund typically seeks investments with sustainable growth prospects and high returns on capital – something that clearly excited Fundsmith about Starbucks back in 2020. Fundsmith detailed the rationale for purchasing Starbucks in the 2020 Annual Letter to Shareholders below.
“Whilst it is easy to see the challenge to the lockdowns for Starbucks’s urban outlets which partly rely on seating and coffee collected on the way to the office, this is far from their only format. The sometimes spectacular queues and resulting in traffic jams at Starbucks drivethrough outlets both illustrate another format and testify to the continued loyalty to the brand as does the rise in loyalty club members in 2020. During this period Starbucks’s main competitor in its second largest market — Luckin Coffee in China — was exposed as a fraud.”
With a self-professed ideal investment holding period at Fundsmith of ‘forever’, the sale of Starbucks within a two year period marks a significant walk back in favourability for the company from Britain’s star manager, alongside the market, which has sold Starbucks heavily, resulting in a 36% fall since highs in 2021.
What has gone wrong at Starbucks?
Starting with the numbers, performance at Starbucks so far in 2022 has been a mixed bag. The company got off to a good start in Q1 2022, with comparable store sales hitting 13% globally, driven by strong performance in North America, where the chain has 16,800 stores. However, global comparable sales growth slumped to 7% in Q2, as poor performance in China due to Covid lockdowns reduced sales by 23% in the Chinese market.
In terms of profitability, Starbucks has also been struggling, with Q2 operating margin slipping from 14.8% to 12.4% as supply chain problems, broad based inflation and staffing pressures weighed on profits. Starbucks has been unable to fully offset these cost increases through higher prices, shown through the fact average ticket values are only up 3% and 4% in Q1 and Q2 respectively (much lower than inflation) versus the prior year, likely a sign that Starbucks wishes to avoid customers trading down to other chains.
However, away from the numbers, Starbucks has also had to deal with several operational challenges. Earlier this year in March, CEO Kevin Johnson announced he was leaving the company, resulting in founder and ex-CEO Howard Schultz returning to lead the company on a temporary basis.
Starbucks has also faced increasing threats of unionisation, with over 100 cafés signing up to the union programme so far, and a $1 million workers fund created to protect employees striking at Starbucks locations. Workers attempting to unionise are requesting better pay, training and working conditions. Starbucks’ management have made steps to improve conditions, with news of a $1 billion package to improve pay and store conditions announced in the Q2 earnings call; however, unionisation calls have continued.
Still much to like about Starbucks
Adding to employee frustrations, and arguably weighing on profit margins is the increasing complexity to the drinks Starbucks is serving at its global stores. The FT reported on this Tik-Tok infused Frappe Madness back in April, with the revelation from Starbucks that it is possible to create 170,000 unique combinations of its various drinks options. The large number of custom combinations for Starbucks clientele may be something that separates Starbucks from the other chains, however it slows down the serving process and costs employees more time and training.
Despite the current headwinds, there is still much to like about the company. Starbucks has been highly successful in the roll out of its membership programme, with 26 million active members as of Q2 2022, this figure was up 17% on the year prior. Starbucks also still remains an attractive opportunity for franchisees, and has opened over 700 net new stores since the start of the year, which helps aid revenue growth. It is worth noting only 49% of Starbucks’ stores are currently franchised, a significant opportunity to drive further profitable expansion. Finally in 2021, for investors focused on ‘quality’ metrics, Starbucks delivered a return on capital employed of 21%, which is impressive.
Whilst there may be positive aspects to the investment story, the outlook for Starbucks has weakened. With a fairly rich valuation of 28x forward earnings, the move from Fundsmith would suggest there is better value to be had elsewhere.