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Morningstar | Starbucks' U.S. and China Comp Reversal Indicates Menu, Digital, and Layout Initiatives on Track

Starbucks capped off its fiscal 2018 with signs of encouragement, as comparable-store sales in its two largest markets (U.S. and China) reversed negative trends, alleviating some of the overhang with the stock. While Starbucks still needs to take additional steps to adjust to consumers' evolving views about experience and convenience, we believe the key takeaway for investors is that initiatives like beverage innovation and digital engagement drove results in lieu of discounting, thereby lending support to the brand intangible asset behind our wide moat rating. We're planning to raise our fair value estimate by a little less than 10% to account for greater near-term top-line visibility and a pull-forward of contribution from the Nestle partnership. While we see the shares as only modestly undervalued at current levels, Starbucks remains one of the more intriguing combinations of long-term growth and capital allocation in the restaurant category.

In the U.S., the 4% comp was driven by a 5% increase in average ticket (2 points of pricing and the rest attributed to mix benefits from its cold beverage platform, which also helped to reverse recent weakness in the afternoon daypart) offset by a 1% decrease in transactions, which was an improvement of 2 points versus the 3% decline in the third quarter. China was a menu innovation story as the 1% increase in comps was aided by coffee plus ice cream products, cold foam, and holiday food items. We see a number of levers in both regions that should keep the company aligned with its fiscal 2019 comp guidance for the low end of its longer-term 3%-5% range, including digital engagement (Starbucks Rewards members jumped 15% to 15.3 million in the U.S. during a typically slower recruitment quarter), delivery (including new test markets in the U.S. and the partnership with Alibaba in China), and new store layouts (including drive-thru formats in the U.S. and Star Kitchen locations in Alibaba's Hema stores).

Management's other targets for fiscal 2019 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), revenue growth of 5%-7% (including a 2-point hit due to streamlining-related activities), a slight increase in adjusted operating income growth (excluding the impact of its consumer packaged goods partnership with Nestle), some general and administrative leverage, adjusted EPS of $2.61-$2.66 (which also assumes 1-2 points of dilution to the Nestle partnership), and $2 billion of capital expenditures. Somewhat lost among the comp improvement in the U.S. and China was the strong returns Starbucks is seeing among its new store openings, giving us greater confidence that the company is adjusting to the convenience and experience needs at the individual store level, something that we discussed in greater detail in our Oct. 2 piece, "The Restaurant Industry Is Evolving--Your Key Performance Benchmarks Need to, Too." Additionally, we're encouraged that the Nestle partnership appears to be ahead of schedule--management now expects it to be margin-accretive in fiscal 2020, a year ahead of previous expectations--which should be a high-margin vehicle to brand awareness and distribution across the globe, especially as rivals like JAB and Coke/Costa refine their CPG strategies.

Taken together, there aren't significant changes to our 10-year forecasts. We continue to anticipate average annual revenue growth of 8%-9%, factoring in roughly 2-3 points of revenue growth impact from the Nestle partnership beginning in 2020, 6% average annual unit growth, and 3%-4% global comps driven by Mobile Order & Pay and other digital initiatives, new beverage/food innovations, daypart expansion, and streamlined restaurant operations. We project operating income growth around 10% over the same time frame, implying low 20s operating margins longer term.