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Morningstar | Starbucks' Progress With U.S., China, and CPG Initiatives Supports Long-Term Cash Flow Story

Wide-moat Starbucks' second-quarter update reinforced many of the key investment criteria that made the company our top restaurant idea heading into 2019, with the U.S., China, and Global Coffee Alliance segments each making progress on their strategic initiatives and the company successfully reducing costs across the system. With shares now up 20% on the year (compared with 17% for the S&P 500), we see Starbucks as fairly valued, even after factoring in a modest increase to our $74 fair value estimate. While we'd prefer a wider margin of safety, we still view Starbucks as one of the more dynamic growth and income stories among large-cap consumer stocks and remain confident in our 10-year targets for average annual revenue growth of 8% (3%-4% comps, 6%-7% unit growth), consolidated operating margins exceeding 20%, and the ability to sustain a 50%-plus dividend payout ratio.

We believe that Starbucks has largely put in the past the inconsistent operations that weighed down 2017 and early 2018 results. In the U.S., streamlined store operations, new restaurant remodels/formats designed on satisfying experience and convenience need states, cold beverages, and digital platform improvements helped to drive 4% comps, which is where we expect trends to persist for the balance of the year when factoring in delivery adoption. The 3% increase in China comps (including improved transaction trends) suggests some normalization from the disruption we've seen from Luckin and other value-based platforms, and we expect modest sales acceleration over the near term as Starbucks recaptures transactions among higher-end millennial customers through upscale store openings and the delivery partnership with Alibaba's Ele.me. The GCA partnership with Nestle continued to unlock new channel and geographic diversification opportunities, with new Nespresso, Dolce Gusto, and whole bean products launched supporting our longer-term segment revenue growth assumptions in the midsingle digits.

Starbucks' fiscal 2019 targets still strike us as reasonable, including 2,100 net new stores (1,100 in China/Asia-Pacific, 600 in the Americas, and 400 in Europe, the Middle East and Africa), global comps of 3%-4%, revenue growth of 5%-7% (including a 2-point hit due to streamline-related activities), a slight decrease in adjusted operating income growth (excluding the impact of its consumer packaged goods partnership with Nestle) despite employee and technology investments, some general and administrative expense leverage, adjusted EPS of $2.75-$2.79 (versus previous guidance of $2.68-$2.73 due to year-to-date results and certain tax benefits), and $2 billion of capital expenditures.

While second-quarter adjusted operating margins fell 40 basis points year over year to 15.8% due to mechanics of the GCA partnership, we believe the 80-basis-point increase in Americas segment margins to 20.9% due to cost-cutting supports our longer-term margin expansion outlook, as does management's commitment to reduce core G&A expenses by 100 basis points over the next three years (implying G&A of $1.7 billion in fiscal 2021). After raising our fiscal 2019 margin outlook to account for new Americas segment margin guidance calling for slight improvement (versus earlier expectations of a slight decline) and channel development segments in the mid-30s (versus a prior outlook in the high 30s), we still expect around 100 basis points of margin compression this year. However, over a longer horizon, we still anticipate operating margins exceeding 20%, driven by sales leverage from streamlined store operations and technology initiatives, international scale improvements, and contribution from the GCA.