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Could Starbucks Corporation's Big Bet on China Backfire?

By Leo Sun - Jan 28, 2016 at 9:30AM

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Is the coffee giant relying too much on China’s economic growth?

Over the past year, global markets have been weighed down by concerns about China's economic growth, which sank to a 25-year low in 2015. That decline darkened the outlook of many U.S. companies which are dependent on the Chinese economy. Yet one such company -- Starbucks (SBUX 1.19%) -- doesn't seem worried at all.

Source: Pixabay.

During last quarter's conference call, Starbucks CEO Howard Schultz said that the coffee chain was "just getting started" in China, its largest market outside the United States. Starbucks now has nearly 2,000 stores in almost 100 cities in China, and plans to boost that figure to 3,400 by 2019. By comparison, Starbucks ended last quarter with 23,571 stores worldwide, and 5,743 were located across the Asia-Pacific region.

Schultz noted that "short-term market gyrations" in China "shouldn't be confused with actions that will lead to long-term sustainable economic gain." Schultz also believes that the Chinese government will achieve its goal of doubling 2010 per capita income by 2021 to produce a middle class of nearly 600 million. Schultz's ambitious plans for China will likely pay off if that forecast is accurate, but could it backfire if China's economy has a "hard landing" instead?

Why Starbucks loves China
The International Coffee Organization estimates that coffee consumption in China has risen 16% per year over the past decade. On a per capita basis, consumption is just 83 grams (5 to 6 cups per year), but that figure has soared in more affluent urban areas. In Hong Kong, per capita consumption has reached 2 kilograms (120+ cups per year), compared to 4.9 kilograms in Europe and 4.4 kilograms in the U.S.

Euromonitor notes that the Chinese coffee market still mainly consists of instant coffee, which accounts for 99% of retail sales. But as disposable incomes rise among the middle class, the firm believes that these consumers will "trade up" to freshly brewed coffee at coffee shops. Last October, Credit Suisse reported that China's middle class had swelled to 109 million, overtaking the 92 million middle class citizens in the U.S. to become the largest middle class market in the world. Those factors all indicate that Schultz's long-term strategy for China will pay off.

Hong Kong. Source: Pixabay.

Starbucks also has a first-mover's advantage against its biggest rival in the U.S., Dunkin' Brands (DNKN), which only recently started focusing on China. Last January, Dunkin' declared that it would expand its Chinese presence from just 16 Dunkin' Donuts stores to 1,400 locations within the next 20 years. But by then, Starbucks could be more ubiquitous in China than it is in the U.S. today. Starbucks also faces very little meaningful competition in the domestic Chinese market, where coffee shops are mainly stand-alone cafes or smaller regional chains.

But what if China's economy crashes?
However, Starbucks reported some signs of weakness in China last quarter. Comparable sales in its China/Asia-Pacific (CAP) region only rose 5% annually, down from 6% growth in the previous quarter and 8% growth a year earlier. Analysts had expected 6.1% growth.

Last October, Societe Generale warned that there was a 30% chance that China could experience a "hard landing" that would cause its annual GDP growth to slow to 3% in 2016 -- less than half of China's own forecast for 6.5% growth. Since China will likely devalue its currency again to prevent a hard landing, most forex forecasts expect the RMB to fall about 7% against the dollar by the end of the year.

If China's GDP growth slows to a crawl and the value of the RMB slides, Starbucks' Chinese comps will decline and its Chinese profits will be gobbled up by unfavorable exchange rates. Due to these potential headwinds in China and the rest of Asia, Starbucks expects margins in the region to be "flat to down slightly" in 2016.

Should Starbucks investors worry?
Despite that cautious forecast, investors shouldn't worry about Starbucks' big Chinese bet backfiring just yet. A Chinese slowdown might throttle the growth of its middle class and cause the RMB to tumble, but that weakness could be temporary as the country transitions from a production-driven to a consumer-driven economy. Nonetheless, investors should still keep an eye on Starbucks' CAP numbers this year to make sure that comps growth remains positive and margins don't decline too much.

Leo Sun has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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