Background

I have a confession to make. I have lived in the San Francisco Bay Area for the last 6 years and living here has made me a big snob- a coffee snob to be exact. I never was much of a coffee drinker before I moved out to the Bay Area but once I did and I had my first taste of a Blue Bottle cappuccino, I was hooked. After that, I took on places like Ritual, Four Barrel, Verve, Stumptown, Sightglass and I was in love. No one had ever told me that coffee could be so good if the beans were roasted at just the right level and everything was made with careful precision. These so called Third Wave coffee shops had all kinds of fancy equipment and baristas that looked more like craftsmen than baristas. This led me to take home brewing classes so I could make beautiful concoctions at home. To my wife's dismay, I plunked down all kinds of money to buy a chemex, moka, French press and various other equipment that may be unfamiliar to the uninitiated. Making the perfect cappuccino is still out of reach for me until I buy my $15,000 La Marzocco espresso machine. I digress.

So what's a supposed coffee snob like me doing talking about Starbucks (SBUX)? Starbucks was the second wave. Before Starbucks, mostly everyone in America drank coffee one way - black drip coffee. Howard Schultz came upon the idea that Americans might actually like coffee based drinks like the Italians and imported some of the recipes over to the US. He singlehandedly changed Americans’ relationship with coffee.

But even though I’m not a daily Starbucks customer and even though I wasn’t pining for the Starbucks gift card at my workplace secret santa, I have been there many a time partly because it’s a ubiquitous behemoth that sells a lot more than just coffee. It offers a convenient meeting place (a “third place” as Howard Schultz coined it), a light lunch, a sweet treat, a cold drink and you likely already have a gift card in your wallet to pay for it.

Company Overview

Starbucks (SBUX) has 27,000+ shops that sell a product (coffee) with incredibly high repeat behavior to a very loyal group of consumers around the world. I would categorize SBUX in the bucket of reinvestment moat companies that can comfortably invest in their business to build out more stores in more locations to further “premiumize” the coffee experience. By doing so, they can continue to deliver strong returns of ~25% Return on Invested Capital (ROIC) that they have delivered in recent years. While concerns of slowing growth have weighed on the stock for some time, I continue to believe in SBUX’s ability to meaningfully increase free cash flow while making disciplined investments in Roasteries and Reserve stores to further elevate the coffee experience. There’s a lot to like about Starbucks:

Investment Merits

Customers with high frequency, repeat behavior and strong loyalty

I have a certain predisposition for businesses with recurring revenue streams. SBUX is not recurring the way a SAAS software company is, but coffee is a daily ritual for many- driving a reliable, repeating revenue stream. SBUX has been successful engendering loyalty from its customers as well- Starbucks Rewards has 13.3mm members in the US and an incredible 36% of all dollars tendered in the stores is transacted through the loyalty program (US Company operated stores). You would be hard pressed to find any other company loyalty program with this much engagement.

Stellar Unit Economics

SBUX benefits from strong unit economics that are best in class among quick service restaurants and other peers. In the US- the average new SBUX location generates revenue of $1.5mm (average unit volume or AUV) and generates a year 1 store profit margin of 34% or $510k. Based on an average store investment of $700k in the US, this results in an ROI of ~75%. Compare this to a McDonalds with an ROI of ~30%, an average fast casual operator at ~40% or even Chipotle (at its peak before the food illness issues) at ~70%. This means that the average SBUX store earns back its investment a third of the way into its second year – very compelling unit economics. The math likely changes with higher investments in Reserve stores and premium Roasteries in the coming years but if these seek to elevate the overall SBUX experience and thus drive pricing power through the entire system, it’s the right move for the long term.