Starbucks Long-Term Prospects Bright Despite Lackluster Q2

We issued an updated research report on Starbucks Corporation (NASDAQ:SBUX) on Apr 21.

On Jan 21, Starbucks reported second-quarter fiscal 2016 results. Adjusted second-quarter earnings of 39 cents per share came in line with the Zacks Consensus Estimate. However, sales fell short of expectations. On a year-over-year basis, earnings surged 18%, while sales rose 9%.

Higher sales in China and the U.S. offset a relatively softer performance in Europe. Comps grew 6%, less than 8% the previous quarter, due to declining global traffic trends. Global traffic rose 2% in the quarter, less than 4% increase in the previous quarter.

Though the second-quarter results were lackluster, Starbucks’s operating fundamentals remain strong and the company is poised for solid growth, going forward.

We believe that digital efforts like Mobile Order and Pay, delivery services and third-party loyalty partnerships, food and beverage innovation, lunch and evening programs, Starbucks Reserve premium coffees and Teavana teas should fuel stronger comps growth in the Americas in fiscal 2016.

The coffee giant’s latest digital initiative, Mobile Order and Pay, is witnessing increased usage and could prove to be a key growth driver in 2016 as adoption increases. This initiative allows customers to order before arriving at a Starbucks café and pick up the items at their preferred Starbucks outlet, thus saving time. The company currently processes over 8 million transactions every month. Mobile Order and Pay transactions represented approximately 4% of total transactions in the quarter, up 40% sequentially.

Starbucks started food and beverage delivery through its employees at New York’s Empire State building last October. The company also began testing food and beverage delivery in collaboration with on-demand delivery service, Postmates, in a few areas of Seattle last December. These initiatives are expected to quicken service, increase convenience and enhance customer loyalty, thereby driving mobile payment transactions and in turn, traffic.

Further, CPG growth across the world as well as international expansion will enhance value creation. Starbucks has entered into a new partnership agreement with Keurig. The agreement will make way for improved economics along with providing more flexibility to sell directly to several key alternative channels such as offices and hospitals.

Starbucks also plans to sell Starbucks-branded Nespresso compatible pods in Europe later this year. This should help the company in expanding its single-serve offering globally. The joint ventures in China with partner Tingyi and in Latin America with PepsiCo, Inc. (NYSE:PEP) remain on track to launch ready-to-drink beverages later this year.

In terms of international expansion, Starbucks plans to enter new markets like Luxembourg and Italy in the EMEA (Europe, Middle East and Africa) region in 2016. In the CAP (China, Asia-Pacific) region, Starbucks plans a twofold increase in the CAP store count to roughly 10,000 and threefold increase in the CAP revenues to over $3 billion by 2019.

However, accelerated global employee and digital investments can keep fiscal 2016 profits under pressure. Over the past couple of quarters, higher employee expenses, mainly in the U.S., as well as digital investments put pressure on profits.

Starbucks’ employee investments in fiscal 2015 included higher pay rates for barista and shift supervisors, additional performance-based recognition programs, new food benefit policies and online college education program in collaboration with Arizona State University. In fiscal 2016, employee investments will include wage and benefit increases and even housing benefits in some countries. Moreover, the company will increase digital investments, both in the U.S. and its largest international markets.

In fiscal 2016, management expects employee and digital investments between $275 million and $300 million as against roughly $145 million a year ago. These investments are likely to erode fiscal 2016 earnings growth.

Zacks Rank and Stocks to Consider

Starbucks has a Zacks Rank #3 (Hold). Some better-ranked stocks in the restaurant sector include Dave & Buster's Entertainment, Inc. (NASDAQ:PLAY) and Carrols Restaurant Group, Inc. (NASDAQ:TAST) with a Zacks Rank #1 (Strong Buy).