1 Reason Starbucks' Growth is All but Assured to Continue

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Starbucks' (NASDAQ: SBUX  ) revenue is nearly triple what it was just ten years ago. It will be impossible to repeat the performance over the next ten years, but that does not mean double-digit annual revenue growth is out of the question. China, the world's most populous nation, represents an even bigger market opportunity than the United States -- a fact that Dunkin' Brands Group  (NASDAQ: DNKN  ) and Nestle SA (NASDAQOTH: NSRGY  ) have also discovered. The up-and-coming economic superpower has the potential to drive Starbucks' growth for years to come.

China loves Western brands
China is home to 1.35 billion people, or close to 20% of the world's population. China's middle class is expected to grow from 230 million in 2012 to 630 million in 2022 -- an enormous consumer base that is double the size of the current U.S. population. Moreover, China's coffee consumption is expected to grow at 9% per year for the next five years. This makes it Starbucks' most important source of growth going forward.

Starbucks already has a significant presence in the country. Its 1,000 locations have a 60% market share. 750 new Starbucks locations will be opened in Asia over the next year, most of which will be in China. The company's foothold in the country leads that of Dunkin' Donuts, which derives roughly one quarter of its global franchisee-reported revenue from Asia and the Middle East. Dunkin' Donuts may be able to expand even more rapidly than Starbucks given its reliance on franchising.

However, it is unlikely that Dunkin' Donuts will ever be as profitable as Starbucks in China. China's growing base of upwardly mobile citizens is willing to pay high prices for Starbucks; Western brands that are even remotely upscale are generally considered a status symbol in China. Starbucks earns a 21% store profit margin on its China and Asia-Pacific locations, similar to its U.S. store margin and triple that of its Europe, Middle East, and Africa locations. New Starbucks locations generate about $700,000 in sales in their first year, compared to $1.1 million in the United States, but the initial investment is less than half that of U.S. stores.

Although Dunkin' Donuts does not disclose its store margin, its lower-priced products likely yield a lower store margin. Dunkin' Donuts' international locations -- including mature ones -- generated $209,000 per store in 2012. Mature Starbucks locations in China generate $900,000 per year. At a 21% profit margin, Starbucks locations keep in profit about 90% of Dunkin' Donuts' sales. So at the very least, Starbucks' opportunity is larger on an absolute basis even if Dunkin' miraculously matches Starbucks in profit margin. This highlights Chinese consumers' infatuation with higher-priced Western brands -- the key to Starbucks' growth in the country.

Even more demand for instant coffee
Although demand for specialty coffee shops is expected to grow quickly, demand for packaged coffee is booming as well. Specialty Coffee Retailer cites a Euromonitor report that pegs the size of the instant coffee market at $1.3 billion in 2012.

Starbucks and Dunkin' Donuts are late to the game -- Nestle already claims a dominant 72% instant coffee market share in China, led by its Nescafe instant coffee lineup. Nescafe Dolce Gusto is an important growth driver for Nestle, especially in Asia. However, there is reason to believe Starbucks will be able to muscle its way into the Chinese instant coffee market as well. Nescafe dominates the developing world, but has struggled in developed countries where tastes are more refined. As more and more Chinese consumers join the middle class, there may be a shift in the instant coffee market to higher-end brands like Starbucks.

Foolish takeaway
Starbucks has an outstanding track record of revenue growth, but its best days may still lie ahead. The company has an opportunity to repeat in China its massive success in the United States. It took Starbucks decades to get to its present point in the U.S., but an enormous base of affluent Chinese customers that crave Western luxuries may shorten the time it takes to expand across the country.

In two decades, China could be Starbucks' biggest market. Even if it stops short of matching its success in the U.S., Starbucks' foray into China will drive growth for years to come.

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Ted Cooper

Ted Cooper is a value investor based in Texas. He does not ride a horse to work.

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9/2/2015 3:59 PM
DNKN $48.85 Down -0.59 -1.19%
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