A Decaf Future for Starbucks?

Check out the latest Starbucks earnings call transcript.

With Starbucks' (SBUX 0.47%) first-quarter report out, it's increasingly apparent that Kevin Johnson's leadership gives the company a different flavor than it had under Howard Schultz. In this week's episode of Industry Focus: Consumer Goods, host Shannon Jones and Motley Fool contributor Dan Kline take a deep dive into what the future holds for Starbucks. The coffee dynamo's move away from the Roasteries might improve efficiency, but it might kill some of the magic, too.

On the other hand, mobile ordering is taking off, and Starbucks is leveraging user data to fantastic effect with its loyalty program. Promotions like Unicorn Frappuccinos can be gimmicky (and/or questionably edible), but they serve a vital purpose for the company's operation. And, of course, there's the itty-bitty matter of figuring out the whole China thing. Tune in to find out more.

A full transcript follows the video.

This video was recorded on Jan. 29, 2019.

Shannon Jones: Welcome to Industry Focus, the show that dives into a different sector of the stock market every single day. Today is Tuesday, January the 29th, and we're talking consumer goods. I'm your host, Shannon Jones, and I'm joined via Skype by all-around awesome Fool and our Foolish contributor Dan Kline. Dan, how are you?

Dan Kline: Hey there, Shannon! I think this is our first show together.

Jones: This is our first show, and very much long overdue. I'm super excited about that, even more excited to talk about what I consider one of the four basic food groups, and that's coffee, today with you, Dan. Honestly, no greater person to talk about coffee with, because apparently, you're quite a coffee connoisseur, aren't you? 

Kline: Well, I more sort of play with it. I own every coffee gadget. I have an espresso, I have the Starbucks machine, I have multiple Keurigs. And I'm definitely the person that tries every single drink that comes out. When Starbucks releases something new, I'm generally one of the first people in line to try it and maybe not have it ever again.

Jones: Fair enough. You definitely drink the proverbial Kool-Aid that Starbucks offers, Dan.

Kline: Oh, don't give them any ideas. If there's a Starbucks Kool-Aid mash up, that's not a great idea!

Jones: I want to talk about something before we get into Starbucks, because that'll be the focus of today's show. You mentioned something in planning the show. You drink coffee every day, but when it comes to hot coffee, you've only actually purchased it a handful of times? Is that right?

Kline: I live in West Palm Beach, Florida. Have for the past two and a half years or so. It's never cold enough, in my opinion, to need hot coffee. The two or three times I bought it have been days where I'm walking to the office and there's a freak rain storm so I'm absolutely soaked to the bone. It's "cold" today. It's 65. 65 is iced coffee weather, it's not hot coffee weather. If I'm in the office at home and it's air conditioned, maybe I'll make a cup of coffee or something. But I really see no scenario where you're going to purchase hot coffee when you live in basically a tropical paradise.

Jones: OK, fair enough, Dan, because I was going to be with a stick over that. I think it's blasphemy, iced coffee. Whatever kind of concoction that is, I don't think it's right. It's not natural.

Kline: Here's the thing. I'm from New England. If you go to Dunkin' Donuts right now, where it's zero degrees in Salem, Mass where my mom lives, 80% of the coffees sold are going to be iced coffee. 

Jones: Fair point. Let's talk about some of the other folks that are being lured by iced coffee and hot coffee, and specifically to Starbucks. For our listeners joining the Consumer Goods show today, we're going to be talking about Starbucks. They just reported their Q1 earnings for fiscal year 2019. We're going to be talking about that, and also their strategy. Let's start with earnings. What did we see in this first quarter of the year? 

Kline: Well, the numbers are good. On a superficial basis, Starbucks tends to sink or fall based on same-store sales. They posted a 4% increase in same-store sales specifically also in the U.S., which is way better than they've been doing. It's a testament to how they've been focusing on operations. They did not increase foot traffic, but they did manage to get people to spend more. That's something they've been working hard on. 

Jones: Absolutely. You mentioned that 4% increase in same-store sales. Certainly good for our investors and listeners who've been following Starbucks for some time. 5% is what the Howard Schultz era has been looking forward to, so to see it 4% is certainly an encouragement, especially when they were below 4% in the past. So, we're starting to see somewhat of a turnaround. Although, I will say, new CEO Kevin Johnson is narrowing the focus in terms of guidance. He's aiming for about 3% to 4% same-store sales, which I think is certainly a much safer way to play it, especially as we get into strategy, what they're going to be doing. Certainly interesting to see that you've got this increase coming from how much consumers are spending. It's the average ticket sales that are driving that, not necessarily foot traffic. We do like to see both, we love that, but here, we'll take what we can get.

Kline: I think you also have a store that's, at least in the United States, near the saturation point. You're not necessarily going to bring in a lot of new customers. Everyone knows what Starbucks is. It's not like they open a Starbucks in your neighborhood, and you're just getting exposed to it. They're opening one in your neighborhood and there are 17 others. So, the fact that you can even stay even in that market, 4% is a pretty big number. And that's 4% based on efficiency. When they first launched mobile order and pay, there were backups in the store. That caused people to literally pop their head in the store, look in and go, "Oh, I'm getting my coffee someplace else." They've managed to handle that problem, and that's largely by efficiency. They've taken about 40% of the work out of the barista's day that doesn't have to do a serving customers. Things like ordering are now automated. Some of the cleaning functions have moved to the end of the day after the stores have closed. They're getting more people in and out, and that might make it easier for you to say, "You know what? I'm getting a latte. I can wait for a sandwich to get heated up. It's not going to be too long."

Jones: Speaking of operational efficiency, I think this is the earmark of new CEO Kevin Johnson. He's a much more disciplined leader. You had Howard Schultz, who was really the visionary, he was the one with these grandiose expansion plans and store concepts like The Reserve, this premium, high-priced coffee. Now, under CEO Kevin Johnson, it's a much more disciplined approach. He's going and targeting the data and analytics that the company has to offer, especially with their app, but also scaling back a lot of those grandiose plans that were there. We saw in this announcement that The Reserve cafes -- at one point, Starbucks was hoping to open up over a thousand of these stores. They've scaled that back, looking to actually pilot this in a few select markets moving forward just to see if it's indeed worth the returns before they start building more. So, under CEO Kevin Johnson, you have a much more disciplined, strategic focus. 

Kline: I have very mixed feelings about this. I like the work he's doing to make stores operate better, but I don't like him not having a vision. I think a thousand Reserve stand-alone stores was kind of silly, but he's also scaled back the plan to put Reserve bars into 20% of the existing stores. Now, what Reserve bars would have allowed is Starbucks to have a secondary experience where you spend more money. It's like putting a coffee-based wine bar inside 20% of Starbucks. I've been to the Roastery in Seattle. I've seen how much money people spend and how much they enjoy that tailored experience, where you talk about what you like, and they match your coffee to your pastry and all that. Frankly, I think that would work, and I don't want to see Starbucks just become this company that micromanages the margins and gets rid of innovation.

People sold out the $20 whiskey-barrel-aged coffee at the Roastery in a couple of hours. I hope this is just Johnson taking a measured, careful approach to Howard Schultz, who would just throw everything at the wall and see if it worked. If he's going to test this and then roll it out, I think that's great. If he's mothballing this, like it kind of feels like he's doing, then I'm a little bit concerned. 

Jones: Yeah, fair point there. Let's also talk about the number of new stores they opened in this Q1. What was interesting to me, Dan, is that a significant portion of those new stores was actually outside of the U.S. What can you tell us about that? 

Kline: It's about one a day in China. They opened, I don't remember the exact number, 550 or so new stores. Right there, you're getting a big chunk in China. In the U.S., they're only doing strategic openings. About half the stores they've opened are not company-run stores, they're stores done with partnerships. So it's a very aggressive expansion plan, but for the most part, it's operating in markets where they've already figured out what the business is. In China, they already have thousands of stores. It's not a risk to move into a new city or expand their base. This is really China catching up to the U.S., the U.S. filling in holes, and -- I hate to say lesser markets, let's call them smaller markets for the company -- smaller markets building out the scale.

Jones: Dan, I want to pick your brain here. Certainly, expansion in China makes sense. You've got a growing middle class there. Going after and capitalizing on the Starbucks brand there in China makes 110% sense. But I think, as an investor, do you also worry about the slowdown in China impacting these aggressive expansion plans for Starbucks?

Kline: I don't that much. Starbucks is what you call an affordable indulgence. When everything goes bad, you might scale back on vacations, you might not go to a sporting event, not buy a new purse, a new outfit, whatever it is; but you're probably still going to have your $4 latte. In fact, that you might have your $4 latte more often because you can't go on vacation, you can't do some of the grander things. So, unless the economy truly collapses in China, to the point where people literally don't have the money to go to Starbucks, I actually feel they might benefit from a little bit of a slowdown. 

Jones: It was interesting, looking at same-store sales. Of course, in the U.S., we saw 4%. It was only about 1% in China. It'll certainly be something to watch. I have to agree. I would say I'm mixed on China. You do have the economy there, I think slowing to the slowest pace in about three decades. There will be some slowdown. You've also got competition. I think there's a new start-up that just launched recently in China. So I'm a little tempered there in China, just given all of those factors. But, all in all, with that being said, it sounds like Starbucks overall had a good quarter. Looks like they grew their loyalty program to 16.3 million active members in the U.S. That's up 14% year over year. That led to some pretty impressive revenue numbers, Dan. 

Kline: We're going to talk a lot about the loyalty program later in the show when we talk about dayparts and how they're trying to move traffic around. But there's two major pieces to their technology initiative. They added a million people to the loyalty program. That's just flat-out customers they can message regularly, people who have the app installed, they have mobile order and pay. Those are hardcore Starbucks customers. They've also collected millions of addresses through a new program where, if you log into wi-fi at Starbucks, it collects your email one time on that device, and then they have the ability to message you. They're not going to message you very often. Once a week, maybe even only twice a month. But once they start doing that, they'll have tens of millions of more people that they can try to, one, move to action, but also, try to get them to cross the hump to join the loyalty program.

Jones: It certainly make sense. What we actually saw was revenues hit $6.6 billion in Q1. I do think a lot of that is about building out this ecosystem within the rewards. Looking at the active users vs. those that are simply registered, and being able to target them with the data, is a very smart move. 

Let's actually dig more into the strategy. It's not just about technology. It's not just about having a good cup of coffee. It's also about when and how you target people. Let's shift gears and talk a little bit about how they're trying to drive more traffic throughout the day.

Kline: The afternoon is the coffee shop holy grail. We talked about this back and forth when we were planning this show. We could probably spend an entire half hour just laughing about things that Starbucks and Dunkin' Donuts have tried to get you to go there in the afternoon. Beer and wine. Dunkin' Donuts had pizza. Starbucks had the physio sodas. What's your favorite failed Starbucks afternoon initiative?

Jones: I don't know if I would call this "failed," but it was certainly worth a lot more effort than it actually put out, the Unicorn Frapp.

Kline: [laughs] The Unicorn Frapp was more of a way to get kids in than so much a way to get you in in the afternoon. And it was terrible. I don't know if you were in the office when former Industry Focus host Michael Douglass and I walked around sharing one with everyone, but it was dreadfully sweet. 

Jones: Absolutely, and certainly, for my part, it was one of the worst things I tasted. I didn't even know how to describe it at that point. To your point, they've tried a lot of different unique offerings, unique takes throughout different times of the day. Even like what you saw with the 2017 holiday season, they had this huge menu of offerings, they even started to pare that back this year to become a much more focused company in terms of what they're offering to customers. 

Kline: I think they realized, when it comes to dayparts, nobody is going to say, "Hey, where I'll go for dinner? Starbucks." So, instead of focusing on, here's a new magic product that's going to get me to come in at three in the afternoon, they started analyzing their data. They've looked and said, "OK, Dan comes in in the morning and he buys an iced coffee every day. He comes in on the weekend and has his son with him, so he buys a refresher and some gummy bears or a bagel or something else." And they analyze that data and they say, "Here's a free offer specific for Dan," a buy-one-get-one or a discount or extra stars for the rewards program, whatever it is. And they say, "If you come in after two o'clock and do these things, we'll give you this." And that absolutely drives behavior. That makes me say, "Well, I wasn't thinking about walking to Starbucks with my son after school, but maybe we'll do that because they're giving me buy-one-get-one, so I won't be spending as much money." It's a much smarter strategy than throwing some ice cream and some coffee and trying to lure people in.

Jones: Not only that. To your point about the market being oversaturated with all these retail locations, if you can drive more customers to the store throughout the day, you're actually being able to leverage these existing locations and just crank out more revenue per location. It makes sense to focus on that. But, with all the failed opportunities that they've had, Dan, certainly easier said than done. It's also changing consumer behavior to get them to come to a coffee location for something like dinner.

Kline: Yeah. Look, I don't think Starbucks is going to become more than a secondary lunch option. They have the whole Mercato menu that they're testing some places. I'm sure, if you work near a Starbucks and can pick up a lunch and take it to go, you might do that. I don't think it's going to become a place a ton of people go in and sit down. But, they're open. If you're a Starbucks in a business district, maybe you're open until seven o'clock at night, and you're very busy until 10 o'clock in the morning. So, from 10 to seven, every new person you can bring into that store basically brings your costs down and your profit up. You already have the staff. You're already putting the lights on. Your incremental cost of serving a customer is almost zero. So, as I said earlier, they've gotten very smart. They're using their existing customers, their most loyal people, and they're trying to figure out -- I've probably gotten 20 different emails in the past two months with different ideas trying to lure me in in the afternoon. And I'm sure they're parsing all that data, figuring out what works, figuring out if there's different parts of the year where different offers work. Sometimes it's, "Come in at three o'clock and get a deal on mugs or other merchandise." That's bizarre, but maybe I was thinking about buying a mug, and that would put me over the top, and when I'm there, I'll buy a cup of coffee and a pastry. So, they're getting very smart about it. And I think, whatever they figure out, you'll see Dunkin' copy within the next six months. 

Jones: Yeah, totally agree. Just to continue on the technology front, just with the Starbucks app in and of itself, consider this. Starbucks, 90 million transactions a week in over 30,000 stores now worldwide. The Starbucks app is actually considered one of the most popular mobile payments app -- hello, Apple Pay -- in the world, which is amazing to me. They've got 30 million users, 16 million of which are actual active rewards members. You can see how a company like Starbucks, with all of this data on so many users in terms of what they're buying, what time of day they're buying it, you can see how they can begin to leverage that data to target some of those upsell opportunities, to target their marketing and even their distribution and delivery, which we'll get to in a minute. You can really see how this is taking shape. Even more importantly, Starbucks has an AI cloud based system to predict what a customer may actually like, even if they've never tried it before. So, Dan, maybe that mug that you saw in the store that you were enticed to buy, you would have not thought about that unless you actually had the app. 

Kline: It's also one of the easier-to-use apps. I point this out because my mom does not use Apple Pay, but she absolutely uses the Starbucks app. The reason for that is, you can walk into a Starbucks, do your whole order. It all takes place in the app. If you're using Apple Pay, you have to figure out exactly where to hold it to the reader, it doesn't always pop up correctly, in different stores it works different ways, sometimes you have to put a pin in and sometimes you don't. The Starbucks app, if you mobile order and pay, you put your order in, you can customize it exactly how you want -- that's obviously contributed to same-store sales. If I'm walking up to a barista, I'm probably not going to say, "I'd like my Frappuccino with heavy cream, extra whipped cream, and could you grind up a cinnamon roll on top of that?" Whereas in the app, you can do all of those things with no shame. That's something we've talked about on the Consumer Goods show regarding app-based and kiosk-based ordering a whole lot of times. It's definitely helping push up sales when I can add a pastry or a piece of cake or a cookie or whatever without having to directly tell another person that I'm doing that on top of my coffee. 

Jones: Absolutely. More importantly, if I have the app open, I'm much more likely to spend more time actually perusing the menu than I would if I just walk up. Naturally, I'm just going to order what I normally order anyway if I just walk up. But when I have a chance to actually sit and look at the menu, I'm more than likely going to have a higher order size. It's interesting because with Starbucks and this app, what they've found is that mobile app users are actually spending about three times more than the average Starbucks customer who's just walking in. It's really interesting there.

Kline: There's also a strategy there. I don't know how often you walk into a Starbucks, but most Starbucks, the physical menu is very limited. When you walk in, the menu is there for people who aren't familiar, who don't go to Starbucks that often. It has a selection of Frappuccinos, a selection of different coffee beverages, a few things, but it does not have all the seasonal drinks. Now, there might be some signage promoting those. But if you go into the app, not only are there maybe three times as many things you can order, but all of your ability to manipulate those drinks -- to change the milk to skim, to cut down on the sugar, to add a different syrup or topping -- that's all in the app. It makes it very enticing, as an app user, to use the app, just to see if maybe there's a new special drink. If I walk into a Starbucks that has the nitro cold brew, which my regular Starbucks doesn't, I'll see right away on the app that that's an option. It's a very sophisticated way for the company to make its most regular users part of a club in a way that's not off-putting to regular customers.

Jones: Another strategy that Starbucks is employing to drive more traffic, especially in those daypart hours that traditionally don't get a ton of traffic, is with the delivery model. I actually had a conversation with Chris Hill just this week about delivery. We both pretty much agreed. I think delivery is going to become the expectation rather than something that's an extra perk or added benefit. For any quick service restaurant, you need to have a delivery model. Let's talk about how Starbucks is planning to capitalize on that.

Kline: Starbucks tested delivery in partnership with Uber Eats in the United States in Miami last year. They're rolling that out to, I want to say six more cities, maybe it's seven, very slowly, with the idea that they're going to eventually deliver maybe not everywhere, but certainly in dense urban markets. 

I have been a delivery skeptic. Vince Shen and I often did shows talking about McDonald's. And I would say, "I don't understand who wants McDonald's delivered when the lifespan of a Big Mac or a Chicken McNugget is like three minutes before it becomes absolutely inedible and not enjoyable in any way." And in some ways, I feel like that about Starbucks. Why would I want a coffee that's 25 minutes old? I think they promised 30-minute delivery. On the other hand, I do think, in a business setting, Starbucks makes some sense. I'm sure you've been in an office where someone takes a Starbucks order, and it takes like 25 minutes to get everything specifically down. If you could actually just pass around a phone and have people input their own ridiculous drinks, that's going to speed up a system and make it easier for the intern you're making take your drink order go take your drink order. 

That said, I think there's going to be an explosion of it, an expectation of it, and then a fallout of, "Hey, wait a minute, there's a Starbucks two minutes from here. Maybe I don't need to place a delivery order."

Jones: You know what I think will be the key to that collapsing, Dan? When the millennials, who are definitely the ones who actually are trying out deliveries, when they see that $5 delivery fee or however much it will be. It'll be when they see that delivery fee tacked on to the already very expense cup of coffee.

Kline: It's $2.95 for Starbucks, and I don't believe there's a limit to order size. Again, very useful for quasi-catering, where we're all having a meeting and the coffee machine's too far away, we want to get some Starbucks. That's great! I think that's going to work. 

I think this will be incremental. Because it's Uber Eats, this isn't adding any work to Starbucks other than that they have to make the drinks. And that's all within the Starbucks system. The tags for these delivery orders are popping up the same way a tag pops up if I walk into the store and have put a mobile order in. They're handling this very smart. This is one of those areas where Johnson focusing on workflow is absolutely going to let stores increase their same-store sales without increasing personnel, without building a bigger store, having to add a second production line. They're going to be able to serve these online orders without slowing things down for customers in the store. 

Jones: Speaking of Johnson, this is also an area where, to your point, Dan, nobody wants a cold cup of coffee when it does arrive. This is where Johnson is really starting to push, in terms of innovation. How can we make delivery work for many of our menu items? On the packaging side, you're talking about splash-proof lids, tamper-proof packaging for something like their sandwich offerings, and even hot and cold delivery containers. They'll have to figure out a way to make this work, then figure out which menu items are best served via the delivery. I think that's a part of this pilot as they're rolling it out to these major cities.

Kline: Yeah. Right now, they're testing 95% of the menu. They might figure out, take something like a crumb cake, they might find out that the crumb cake falls apart when you deliver it, and maybe you should not offer that for delivery. I think they'll figure out the hot and cold issue, though they have to balance that with the fact that they've also made promises on the environmental front. It's not like they could just throw it in a heavy Styrofoam cup. They have to create reusable, recyclable packaging, as well. 

It's a challenge, but it's not anywhere near the challenge that the food companies face. If you get a breakfast sandwich from Starbucks and you have to throw it in the microwave for 20 seconds, breakfast sandwiches microwave much better than, say, French fries or chicken wings. It's not as big of a problem for Starbucks as maybe it is for some of the other food retailers. 

Jones: I think this will be an even bigger thing for Starbucks, especially as they expand in China. The start-up that they're competing against is called Luckin Coffee. Basically, they sell on-demand coffee via their app delivered to customers in 30 minutes or less or it's free. You can easily see with a start-up like this, which has been growing quite tremendously in China, why this delivery model is so important, especially there. I know they also announced a partnership with Alibaba's platform to get up and running on their delivery model. The Alibaba partnership also gives them access to their 600 million users within their ecosystem. I think delivery makes sense, not just from a brand awareness perspective, access to a much larger customer base, but also to keep up with the competition. 

Kline: I think there's more of an expectation of delivery in China based on where Starbucks already is in terms of being able to deliver. But I won't hazard a guess. Maybe it's harder to get places, maybe transportation is more of an issue. But, yeah, they're going to figure out how to use third parties to deliver in every market where delivery is an expectation. I mention third parties because that becomes scalable. If this is only a 2% add to stores, great! They didn't hire anybody. This isn't Pizza Hut hiring thousands of drivers to deliver their pizza. This is just another method where really, the Uber Eats driver is no different than me when it comes to picking up an order. They're grabbing the order at the counter, putting in their thing, and leaving. This is just Starbucks doing business as Starbucks, figuring out every possible way to get their products out there. 

Jones: Very good point, Dan! To close out our show today, I want to throw one question to you. This is something that's been debated among many the analysts even here at The Fool. Do you see Starbucks still as a growth story? Or, is Starbucks now settling into a more mature, slower-growing company overall?

Kline: The day Howard Schultz left is the day I started to worry about Starbucks as a growth company. They're too far into the Roastery building to scale that back, but that's only going to be a handful of Roasteries. What we talked about earlier with scaling back the Reserve stores, and more importantly, adding Reserve bars, I do think that tempers Starbucks as a growth company. If you don't find a way to add something truly new that changes the experience, you're going to max out in the U.S. There's only so much efficiency. There's only so many more people you can serve. So, unless they test the Reserve program, and then figure out, "OK, here's how we're going to get to that 20%. It's just going to be a smaller rollout," then, yeah, I do think once China tops out, Starbucks won't be a growth company anymore. 

Jones: Fair enough. Lots to watch, especially 2019 into 2020 and with China. Dan, thank you so much for joining me here! We'll have to do this again very, very soon!

Kline: Next time I'm in the office. Thank you for having me!

Jones: Thank you! For all of our listeners, thanks so much for tuning in! So glad to have you! That'll do it for this week's Industry Focus: Consumer Goods show.

As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Dan Kline, I'm Shannon Jones. Thanks for listening and Fool on!