Some like to joke about how a Starbucks (SBUX -0.63%) location exists on every corner. Although one could probably label that assertion as hyperbole, it speaks to the level of saturation the company has reached in the United States. This also means that it must turn to international expansion to fuel growth. In recent years, much of that focus has fallen on China.
However, China has faced accusations that they covered up the severity of the virus. Now, some Republicans in Congress have called for punitive measures against the country. Additionally, Democrats, who have mostly taken a less hawkish stance against China, have increasingly criticized the Chinese government.
Investors should know that neither the American nor the Chinese governments have acted to curtail Starbucks' expansion in China. However, such tensions will naturally cause concern for an American corporation with such a large Chinese presence. Given the company's dependence on China for much of its growth, investors need to account for these potential obstacles when considering Starbucks stock.
The fallout of COVID-19
The company opened more than 600 stores in China in fiscal 2019. Today, it operates over 4,200 stores in the People's Republic, making China the company's largest market next to the U.S.
Now, it remains unclear where Starbucks goes from here in China. The country has come under increasing fire for its handling of the COVID-19 crisis. Starbucks is not at fault for the Chinese government's response to coronavirus. However, the pandemic has slowed store expansion for the Seattle-based coffee giant as the company halts expansions and reopens under safety protocols in that country.
This also may leave Starbucks unable to capitalize on a critical opportunity. In a friendlier environment, the implosion of Luckin Coffee (LKNC.Y -5.12%), might have benefited this consumer discretionary stock. Luckin admitted to improper reporting of its sales numbers. The Nasdaq Stock Market halted trading on Luckin on April 7 as a result. Now, with widespread lockdowns and political tension, if or how Starbucks will benefit remains unclear.
Starbucks could face deeper pain
Any political obstacle could devastate Starbucks stock. This comes at a time when the forward P/E ratio has risen to about 39.2. Falling earnings helped to take the multiple higher last year.
The company cited technology investments and taxation to explain the lower profits last year. Unfortunately, Starbucks will probably not have such an easy explanation for its current financial struggles. The company has already warned of a likely 50% near-term decline in same-store sales in China. This does not account for the store closures that have also come to its other markets.
For now, analysts predict an earnings rebound in fiscal 2021. They also believe profit increases will average 9.1% per year over the next five years. However, that could change if the company's presence in China becomes a source of geopolitical tension.
Admittedly, a drastic move such as a forced pullout of China appears unlikely. However, seeing the Chinese government interfere with Starbucks' expansion at any level would probably make investors uneasy. That gives investors more reason to question the company's elevated multiple.
Starbucks lacks a comparable alternative market
If Starbucks China becomes a victim of deteriorating U.S.-China relations, it remains unclear where Starbucks could go to replace that lost revenue. In fiscal 2019, China accounted for more than 40% of all store openings outside of North America. The company also benefited from significant store growth in countries such as Japan, Korea, and the U.K. However, the number of new stores in these three markets combined fell short of the number of store openings in China in 2019.
In terms of population, the only country of comparable size to China is India. In India, Starbucks operates in partnership with Tata Consumer Products in a venture called TATA Starbucks Private Limited. There, the company can rely on its Tazo line of products.
However, since India is primarily a tea-drinking nation, Starbucks could face challenges in marketing coffee. Not only must it compete with the existing tea culture, but it must also try to market coffee in that country. In fairness, it has enjoyed some success in the U.K., despite Britain's status as a tea-oriented culture. Still, the move into India has not matched the success in China. As of 2019, the joint venture only operated 167 stores in India, a small fraction of the company's Chinese footprint. Even if Starbucks ultimately succeeds in repeating its China successes in India, that process will take several years.
In the U.S., the perception that Starbucks operates on every corner will likely not change. Even in times of a lockdown, people will probably continue to line up to buy its beverages. Still, to expand, it needs to see overall success in its markets outside of North America, and China offers the largest potential overseas opportunity.
Thankfully for Starbucks, it has not become a victim of increasing tensions between U.S. and China so far. Whether it will remains an open question. Still, it appears that U.S.-China relations will get worse before they improve. Investors should ponder this risk factor before buying Starbucks.