Can More Food Drive Profit Growth at Starbucks?

One of the biggest drags on Starbucks (SBUX 0.73%) over the last six months has been its sluggish same-store sales growth. The company missed analysts' expectations in each of the last two quarters for the metric, ultimately producing lower-than-anticipated overall revenue. Management expects same-store sales to turn around in the second half of the year, and one of the big drivers could be food sales.

Starbucks has been concentrating on selling more food in its stores since it acquired La Boulange in 2012. Food sales in its stores have increased 50% since 2013, and the company plans to double sales by 2021. But food has accounted for a fairly stable 19% of total sales in stores even as non-beverage options available to customers have been expanded. While the company regularly cites 11 a.m. to 1 p.m. as its fastest-growing part of the day for food sales, it's still not considered a lunch destination. Lunch, though, remains its biggest opportunity with food.

But how will food sales impact Starbucks' bottom line?

The Thai Chicken Wrap Bistro Box sold at Starbucks. Image source: Starbucks

Lower gross margins

There's a lot of gross margin built into a $5 cup of coffee. Even a $2 cup of black coffee doesn't cost much to produce. CFO Scott Maw says the company averages more than 80% gross margin on its beverages.

The margin on food items, however, is just over 50%. So, if food becomes a larger percentage of sales, investors should see a decline in gross margin. But despite the increased emphasis on food over the last few years, cost of sales as a percentage of revenue has actually fallen from 43.7% in 2012 to 39.9% last year. Even though food sales as a percentage of revenue have been fairly flat, that's still surprising.

The key is Starbucks includes "occupancy costs" in its cost of sales. That means considerably fixed expenses like real estate leases or purchases are lumped in with cost of goods sold. And as more customers attach food items to their beverage orders, Starbucks increases total sales per store. Thus, the fixed costs account for a smaller percentage of sales, driving down cost of sales as a percentage of revenue.

Data source: Company annual reports.

While Starbucks is masking the impact on gross margin, what ultimately matters is the impact on the company's bottom line. So, as the company leverages more fixed costs and attaches more food items to beverage sales, overall profit margin should continue to improve. Indeed, operating margin has improved 460 basis points since 2013.

So, what is Starbucks doing to sell more food?

Lunchtime at the coffee shop

As mentioned, lunch is still probably Starbucks' biggest opportunity in food. To that end, the company is conducting a couple of experiments in select markets.

In Chicago it's testing Mercato, a fresh-food lunch menu of salads and sandwiches. Maw said early results are "very strong," so the company will roll out the menu to more stores next year.

In Houston, the company partnered with Snap Kitchen, a Texas-based start-up focused on healthy grab-and-go meals. Snap Kitchen meals are only available in five stores right now, but CEO Kevin Johnson said it plans to expand the test soon.

Starbucks has also been making efforts to gamify its rewards program. It introduced Star Dashes last year after changing how customers earn rewards, and it can now incentivize the purchase specific products. It can even incentivize purchases at specific times of day. It can also use old-fashioned discounts to incentivize food purchases, too.

As Starbucks offers more food options and gives customers more incentives to purchase food through rewards or discounts, investors should see a return to normal same-store sales growth. And despite the lower gross margin on food items, the leverage in Starbucks stores means the company ought to see improved profits as well.