Unlike some of its competitors, Starbucks Corporation (NASDAQ: SBUX ) remembered to bring an umbrella to work during the first three months of the year. Despite the extreme winter weather that plagued most of the U.S., the company reported a 9% revenue increase over the prior year's comparable quarter, posting record fiscal second quarter 2014 sales of $3.9 billion. While competitors McDonald's and Dunkin' Brands both blamed the weather in part for their quarterly results, Starbucks was able to deliver despite a quarter in which it saw "unprecedented store closures" due to the virulent winter. Below are four key points from Starbucks' earnings that investors may want to take note of for the rest of the year.
Teavana is not a stand-alone division
In the past, I've called Starbucks the "dark horse of the tea wars" for its potential to shake things up in the market for the world's most consumed beverage after water. On last week's earnings call, CEO Howard Schultz signaled Starbucks' seriousness in pursuing this market.
Since the coffee giant acquired the Teavana premium tea chain in late 2012, it's devoted resources to integrating the property into the larger Starbucks brand, rather than attempt to grow Teavana solely as a mall-based specialty tea shop. Starbucks has opened several high-end Teavana "tea bars" in New York and Seattle, and Schultz announced on the call that the company will be launching new tea bars in Chicago and Los Angeles in the coming months.
More significantly, management announced that by this summer, the company will offer Teavana loose leaf samples and tea merchandise within Starbucks stores. This is noteworthy as Starbucks can use its own powerful retail distribution network, its coffee stores, to scale Teavana well beyond its potential as a stand-alone division, with its existing base of mall-based units. Chalk this action up to Schultz's oft-stated prediction that, long-term, the company will do for tea what it did for coffee.
Flipping real estate acquisition on its head
A traditional model for acquiring retail real estate is to seek locations of a certain build and aesthetic standard that fit square-footage requirements and that lend themselves to templated store layouts. On the earnings call, CEO Schultz relayed an interesting twist to this standard strategy. Essentially, Starbucks is now not only ascertaining where the optimal locations for its units are, it's evaluating locations in some instances at face value, to understand how to be successful given a specific location's constraints. As Schultz explained on the call: "Also I think we've done a very good job over the last 12 to 18 months in creating store designs that are linked to real estate segmentation, which gives us the ability to almost create any configuration now in terms of size and the kind of real estate it is."
Schultz went on to explain that the company is creating new opportunities with drive-throughs attached to freestanding locations, walk-up windows, and drive-through-only units. Experimentation with size and format could help Starbucks achieve a greater density of stores in metropolitan areas. This is important for investors, who should rightly question whether, as the company matures, it can still expect 10% to 11% revenue growth each year, given that it would seem to be well-established in its primary geographic market, North America. Management certainly thinks the expectation is valid, as it put forward that it believes it is "under-stored" in the Americas.
Both margin and revenue expand across the board
During the quarter, each reportable segment increased its operating margin, contributing 130 basis points to the company's record 16.6% operating margin. Management attributed this to lower commodity prices and "sales leverage," implying lower fixed costs and higher incremental sales. Each operating segment saw its revenue increase as well.
The company's 16.6% operating margin is a good demonstration of the principle that when a corporation can control its fixed costs, additional sales beyond the break-even point tend to lift operating margin. That's because each additional dollar of sales is reduced only by the cost of the actual product sold.
In other words, at a certain point each month when a typical Starbucks store sells enough to pay its fixed costs such as labor, premises rent, insurance, etc., its primary costs going forward are associated with products: highly profitable brewed cups of coffee and baked goods, bottles of Evolution Fresh juice, Starbucks-branded Keurig cups sold in grocery store aisles, etc. The more product sold, the higher the operating margin. Look for Starbucks to maintain a high operating margin through the rest of this year.
Coffee price strategy: Hedge and tweak
If you're a serious coffee drinker, you're probably aware that the drought in Brazil has caused coffee futures to rise more than 80% since the beginning of the year. The price of the global coffee standard Arabica bean, of which Brazil is the largest supplier, has doubled since last year. If coffee prices continue to run, it will eventually cause headaches even for companies such as Starbucks and Dunkin' Brands' Dunkin Donuts, which keep several months of inventory on hand as a hedge against rapid price increases. On the earnings call, CFO Scott Maw related that Starbucks' coffee bean supply needs were more or less met for 2014, and roughly 40% "locked" for 2015 at favorable prices versus the current year.
Maw stated that if coffee prices moved more significantly, the company would be able to manage increases selectively through offsets on the profit and loss statement, as coffee accounts for "only" 15% to 20% of cost of goods sold. While this may seem implausible, Starbucks probably does enjoy such flexibility.
As a recent Bloomberg article indicates, brewed coffee enjoys a very low elasticity of demand: customers are willing to pony up when prices rise. Thus, even if Starbucks were to begin to face higher raw coffee costs, through a combination of incremental price raises and "offsets" (cost cutting, productivity improvements) elsewhere on the profit and loss statement it could conceivably maintain its margin and revenue growth without driving away its customers.
A final takeaway
In the same way that Starbucks can tweak its model to absorb cost impact, investors may want to follow some of the themes above through the next few quarters, to see if portfolio positions in Starbucks need tweaking. At present, the most visible risk appears to be a question of how long the company can continue to maintain its stellar growth. The first two quarters in the current fiscal year indicate that a slowdown, while maybe inevitable, isn't imminent in the near future: for those currently invested, Starbucks is a comfortable hold.
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