When Starbucks Corporation (SBUX 0.53%) last reported earnings back in November, management backed down on its long-term expectations for traffic and same-restaurant sales growth. And with its first-quarter fiscal 2018 earnings just released after market close on Jan. 25, it's looking like it was the right move, with some already questioning whether guidance was lowered far enough.
The new target called for comps growth between 3% and 5% this year, more reflective of what the coffee giant had been delivering for the past year or so, but Starbucks' comps came in at 2% in the quarter, both on a consolidated basis and in the U.S., its biggest and most profitable market. The weak -- at least for Starbucks -- results led to sales growth of 6%, also below management's expectation of high single digits.
Fewer holiday shoppers meant fewer holiday Starbucks customers during off-peak hours. Image source: Starbucks.
The culprit? The e-commerce trend is affecting the king of caffeine, too, since fewer mall shoppers mean fewer casual Starbucks buyers, particularly during nonpeak hours. Let's take a close look at Starbucks' first-quarter earnings and the lessons learned.
Record sales, but operating results took a small step backwards
Here's how Starbucks delivered in some key metrics, as compared to 2017's first quarter.
| Metric | Q1 2018 | Q1 2017 | Year-Over-Year Change |
|---|---|---|---|
| Revenue | $6,073.7 | $5,732.9 | 5.9% |
| Net income | $2,250.2 | $751.8 | 199.3% |
| Earnings per share | $1.57 | $0.51 | 207.8% |
| Operating income | $1,116.1 | $1,132.6 | (1.5%) |
| Operating margin | 18.4% | 19.8% | (140) basis points |
Revenue, net income, and operating income in millions. Data source: Starbucks.
The first thing that may stand out is Starbucks' big profit surge, with earnings per share up an astounding 208% in the quarter. However, there's a big caveat: $0.79 per share of that result was a net gain related to the acquisition of the East China operations during the quarter, a nonrecurring benefit that should be adjusted out to get a more real-world comparison. On a non-GAAP basis, Starbucks reported earnings of $0.65 per share, a still-solid 25% increase year over year and far better than the company's own low double-digit growth guidance.
Starbucks is already seeing a benefit from the recently passed federal tax overhaul -- $0.07 per share of its adjusted earnings (about 11%) was directly attributed to the changes in U.S. tax law.
Food sales continue to be a bright spot. Image source: Starbucks.
But when we look beyond the benefit of tax changes and one-time financial gains, there was some deterioration of operating results. Operating margin fell from 19.8% last year to 18.4%, causing operating income to decline slightly, even though revenue was up to nearly $6.1 billion, a record amount.
On the call, management pointed to several challenges that it said affected its operating results, including slower sales and weaker demand for some of its seasonal beverages and merchandise during the holiday season. In part, it said this was weaker traffic than anticipated, particularly during typically busy shopping periods over the holiday season in locations that count on mall and other retail traffic to help drive sales, especially during afternoon and evening hours.
In other words, the so-called "retail apocalypse" is having an impact on Starbucks to some extent, with e-commerce keeping more shoppers out of malls this holiday season, which in turn affected Starbucks' sales and operating profits. Losses related to the closure of some of its Teavana retail stores also affected operating profits and margins in the quarter.
On the other hand, management said that it is still seeing strong demand during its peak hours, to the point that it's actually becoming a challenge in its busiest stores. To address this, extra staff is being added to greet mobile customers so that its "behind-the-counter" employees can focus on production.
Channel development, highlighted in the earnings preview as an important profit driver, was unimpressive. Sales were up 1%, while operating income was roughly flat on a small drop in operating margin. The company said that the sale of Tazo and some competitive pricing challenges pressured revenue while also weighing on operating margins. It bears watching whether this becomes a recurring concern or is just a blip on the radar over time.
China remains the big growth focus
Starbucks continues to invest heavily in its U.S. cafes, including expanded food offerings and noncoffee beverage choices to grow sales during the afternoon and evening, as well as the aforementioned efforts to increase order turnaround time, throughput, and customer service during peak hours in its busiest locations. These are important and necessary to help balance out the impact of less retail traffic to drive casual sales as well as to support growth.
Starbucks already has 600 locations in Shanghai, China, including its biggest: a 30,000-sq.-ft. Roastery. Image source: Starbucks.
But over the next decade, China will see more new locations opened than any other market, and could become the company's biggest source of sales and earnings in the long run. Last quarter, sales in China were up 30%, while comps increased 6%, all of which was attributed to increased transactions. The company's focus on China drives a significant portion of its China/Asia-Pacific segment, which reported 9% sales growth and 20% growth in operating income.
But heading into the second quarter, the acquisition and consolidation of all of its mainland China locations will start driving sales and earnings higher. In the earnings release, the company said that it expects this acquisition to drive approximately 2% in incremental net revenue growth for the full year. This is a key reason why management is holding steady with its full-year guidance for sales growth of 9%-11% in 2018.
Looking ahead, and the big takeaway
Based on its expectations of a boost from the integration of its Chinese locations, improved comps throughout the year, and the benefit of the recent U.S. tax rate cut, management expects sales to grow 9%-11% for the full year and earnings per share of $3.32-$3.36 on a GAAP basis and $2.48-$2.53 adjusted for nonrecurring items. On the low end, that's a 69% jump on a GAAP basis and a 20% increase when adjusted for nonrecurring items.
Starbucks, like essentially every other retail operator, is going to have to navigate the changing reality of fewer shoppers heading to local retail outlets. It's largely proven resistant to this in the past, but more recently -- as its comps results have shown -- it's far from immune. And even after the decision to lower its own expectations, the company's comps still fell short of the new guidance. So management has work to do to reach its stated goals.
On the other hand, traffic numbers are holding steady and visitors are spending more money on things like food, so that's a definite win. Furthermore, the bulk of its sales are not dependent on people out visiting other stores, and Starbucks steadily grew comps over the past several years while the casual-restaurant segment regularly reported traffic declines. So there's hope yet that more growth can be found at home.
Nonetheless, management's focus on China probably couldn't have come at a better time, especially if shifting retail trends in the U.S. prove a bigger challenge than it realizes or acknowledges. At some point, the impact of weakening retail traffic should level off, but Starbucks may struggle to return its comps growth to past levels. And even with plans to keep opening new stores in its biggest market for the foreseeable future, there's only so much room to expand in North America.
At this stage, China is a small fraction of the U.S. for Starbucks, but that's going to change. If the retail landscape at home continues to weigh on its comps, that will make it even more critical that the company continue to find success growing in the Middle Kingdom.
