‘The health of the Chinese business is undeniable,’ analyst says

Morningstar Analyst Sean Dunlop sits down with Yahoo Finance Live to break down Starbucks’ Q2 earnings report, sales growth, and the impact of unionization movements on the brand’s stock.

Video Transcript

SEANA SMITH: Starbucks moving to the upside. You can see it on your screen following their earnings results to stock up just over 1 and 1/2%, the company reporting revenue of 7.6 billion. Earnings per share adjusted basis of $0.59. US same store sales up 12%. That was better than what we were expecting. So let’s break this down with Sean Dunlop. He is Morningstar’s analyst. And we have Yahoo Finance’s reporter Brooke DiPalma joining us as well. Sean, give us your first initial reaction of this report. Taking a look at the street, they seem to be happy with it. What do you think?

SEAN DUNLOP: Yeah, sales are definitely better than we expected. As you look back to 2019, pre-pandemic, you’re looking at about 6% growth annualized, which is pretty much the pre-pandemic run rate. And that’s in a category that’s been hit really hard. Also encouraging was to see that transactions were a decent chunk of that. So this isn’t exclusively price driven. You’ve also got people continuing to frequent the brand despite three price increases in the last half of the year.

So sales were definitely a positive. Restaurant margins were certainly negative. They were down to 14.2% in the US. And that’s down 180 basis points in a linked quarter basis. Driving, that is going to be a elevated utilities cost. And then also, elevated food cost of goods sold. So commentary was certainly light on the union front, which is the elephant in the room. It’ll be interesting to see what the updated guidance looks like on the call.

BROOKE DIPALMA: And Sean, I want to get to another whopping number here. China comparable store sales decreased by 23%. Should this trend continue where COVID-19 certainly takes a toll on stores overseas? What sort of impact do you expect to see?

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SEAN DUNLOP: Yeah, I think the important point here is that the near term picture is not great. But longer term, those markets should fully recover. The health of the Chinese business is undeniable. It’s got some of the best cash on cash returns in the industry globally. So we’re less worried about that. It’s more of an issue of timing risk. And then obviously, when consumers are spending a larger chunk of their consumption income on food away from home, there can be a little bit more elasticity to some of those price increases. That’s worth monitoring.

The other way to look at it would be that it’s actually fairly encouraging on an underlying basis in the international segment excluding China, which is going to be predominantly west Europe and Asia-Pacific was about flat, or up about 4% annualized, since 2019.

SEANA SMITH: Hey, Sean, you have a fair value price target on the stock of $109. Today, we’re sitting just above $74 a share. What do you think it needs? Or what do we need to see in order to get to that 109 value?

SEAN DUNLOP: Yeah, I believe it may be 106. But–

SEANA SMITH: 106.

SEAN DUNLOP: Yes. But I think what we need really is a little bit of clarity moving forward. So we’ve got a lot of moving pieces here, the big thing. In the press at the moment is this unionization push. So having some form of an idea of what the end game there might look like. Is it a unilateral wage increase? Does this company own stores and an improvement to partner benefits, and the working proposition there? What does CapEx look like in terms of the incremental expenditures and remodeling some of these stores?

And then how long does it take to get back to those 18% to 19% restaurant level margins? And are those really plausible as you think about partner wages creeping up to $17 on average at the summer and maybe as high as $20 an hour beyond that, whatever it ends up being in those contracts? So I think the uncertainty is really the catalyst that’s pushed that 40% contraction over the last couple quarters.

BROOKE DIPALMA: And Sean, I want to discuss what you called the elephant in the room when it comes to unionization efforts. As of Monday, we saw more than 240 stores in 32 states that have filed for union elections, of the company’s nearly 9,000 company operated US stores that is. But what exactly type of rhetoric are you hoping to hear from interim CEO Howard Schultz this afternoon on the call?

SEAN DUNLOP: Yeah, it’ll be interesting to see what learnings have come out of their listening tour, if you will, to see what partners are demanding in terms of benefits, in terms of wage increases, and ultimately, in terms of improving that employment value proposition. So if that’s something that Starbucks can extend unilaterally without having to broker that with the Starbucks Workers Union, I expect that they’ll do that. Because then you’re able to preserve the operating flexibility to implement whatever changes you would like without having to negotiate with the Workers Union for those non-union stores.

SEANA SMITH: Sean, another big question here for investors is who the next CEO is going to be of Starbucks. We have interim CEO Howard Schultz, obviously the founder of the company serving in that role at the moment. Any thoughts just on who you think would be the best pick for that job?

SEAN DUNLOP: I certainly haven’t heard anything and I’m in no position to speculate. But hopefully, that’s something that we get a little bit of news on on the call. If I’m remembering correctly, that’s something we’re looking at for the end of the fiscal year, which is in September.

BROOKE DIPALMA: And Howard Schultz also said in the note that the company plans to accelerate store growth plans, primarily add high returning drive throughs. What sort of investment in the digital footprint are you hoping to see from the company that really will lead to a return for investors as this consumer landscape continues to change?

SEAN DUNLOP: Yeah, it’s a good question. So there’s sort of two different questions embedded in that. The first one is those drive throughs in the middle America corridor principally, those tend to do average unit volumes, or AUVs, of about 2.1 million. And that’s against like 1.3 million for the footprint more broadly. So these are stores with much higher throughput. These are stores with much better unit economics. And it certainly makes sense that the approval to these stores moving forward, particularly as customer occasions continue to skew off premise.

The other aspect to that will be, I assume, shrinking those dynan footprints a little bit. Because you’ve got pre-pandemic only about 20% of traffic was coming through those dining rooms. So maybe if you’re able to shrink the footprints, either add a walk up window to add throughput capacity, or to add another drive-through lane, you’re able to make better use of that space.

So in theory, that CapEx should pay for itself over time.

SEANA SMITH: All right. Sean Dunlop, always great to speak with you of Morningstar. Thanks so much for joining us again. Starbucks shares moving to the upside after hours, up just over 1%.