After a spectacular four year long rally, shares of Starbucks (NASDAQ:SBUX) stalled out in 2014. The company faces the same question that has dogged it for years -- just how much bigger can the world's largest coffeehouse chain get before it tops out?
As a long-term Starbucks investor, I believe that this stock still has room to run. But that doesn't necessarily mean that I think Starbucks is a "buy and hold forever" stock. Let's talk about one thing that would convince me to sell my Starbucks shares -- a major slowdown in China and the rest of Asia.
Higher sales growth and beefier margins
Starbucks' China/Asia Pacific region posted 7% comparable sales growth in fiscal 2014. By comparison, the Americas region posted 6% growth, while the EMEA (Europe, Middle East, and Africa) region only grew by 5%.
The China/Asia Pacific and EMEA regions respectively accounted for 7.4% and 7.7% of Starbucks' top line last quarter, while 72.7% came from the Americas. However, the Americas matter more to Starbucks' bottom line, accounting for 86.9% of the company's operating income. The China/Asia Pacific region accounted for 12.1%, while EMEA only accounted for 4.5%.
However, operating margin in the China/Asia Pacific region, at 33.5%, remains the strongest out of all the regions, compared to 24.4% in the Americas and 12.1% in the EMEA region. Moreover, Starbucks is opening stores very rapidly across Asia -- it opened 199 stores in the region during the fourth quarter (two more than the prior year quarter), compared to 279 in the Americas (61 fewer) and 38 in EMEA (10 more).120 of its Asian region stores were in China, which brings its Chinese store count to nearly 1,400. By comparison, there are over 14,000 stores in America and over 4,600 across Asia.
The long-term goal is clear -- to take advantage of stronger sales growth and higher margins in the China/Asia Pacific region, Starbucks will keep boosting its store count across the region. Looking ahead into 2015, Starbucks intends to open 850 new stores in Asia, with two-thirds licensed (franchised), which helps it expand quickly while minimizing overhead costs. In the Americas, it intends to open 650 new stores, half of which will be licensed, along with 150 "primarily licensed" locations in the EMEA region.
The rise of China's coffee drinking middle class
Starbucks is excited about China for two reasons -- the rise of coffee consumption in the country, and the growth of its affluent middle class.
According to Hong Kong-based SPR Coffee, China only consumes an average of five cups of coffee per capita per year, compared to 360 cups in Japan, 400 cups in the United States, and a whopping 1,459 cups in Finland. However, Chinese coffee consumption is rising 30% annually, compared to a worldwide average of 2% growth. CEO Howard Schultz also noted earlier this year that the expansion of Starbucks across China had effectively changed customers' "morning rituals" to include a cup of coffee.
Meanwhile, McKinsey & Company estimated that by 2022, over 75% of China's urban consumers will earn between 60,000 to 229,000 RMB ($9,000 to $34,000) annually, giving it in the same purchasing power parity as citizens of Brazil and Italy. 68% of urban Chinese households were already within that range in 2012, up from just 4% in 2000. Between 2012 and 2022, China's urban population is expected to increase from 256 million to 357 million -- more than the entire population of the United States. Earlier this year, The University of Leicester found that most Chinese consumers considered Starbucks coffee to be a status symbol of the middle and upper class. This shields Starbucks from cheaper competitors, like McDonald's (NYSE:MCD) McCafé.
Put these two factors together, and we can see why Starbucks could evolve into a very different company in a decade, turning China into the company's core growth driver.
The risks of doing business in China
While Starbucks' long-term plan in China seems solid, there are risks which could hamper its growth.
In 2007, Starbucks closed down its Forbidden City location in Beijing, which critics claimed was inappropriate and diminished the value of Chinese culture. In 2013, CCTV and The China Daily -- both state-controlled media outlets -- accused Starbucks of price gouging, noting that the price of a Starbucks latte in Beijing cost more than one in London, Chicago, and Mumbai. Starbucks responded by stating that its pricing varies across different cities based on various expenses.
Although Starbucks easily weathered those two controversies, investors should note that the Chinese government could abruptly throw a curveball at the coffee giant to protect its local businesses. It recently did so with anti-monopoly probes of foreign automakers, pharmaceutical companies, and tech companies. Starbucks, which has a history of crushing smaller coffeehouse chains, certainly wouldn't be immune to such probes.
The one thing that would make me sell Starbucks shares
Therefore, as long as Starbucks' comparable growth and operating margins remain the highest in the Asia/Pacific region, and the company fulfills its targets for opening new stores in China, I won't be worried about the stock. But if Starbucks starts to fall short of these targets, I'd seriously consider selling the stock, since that would mean its core growth engine has broken down.