One of the worst sectors in 2022 has been consumer discretionary. High inflation has made input costs go up, and rising interest rates and falling real wages have made the economy less interested in the industry. This year, almost all consumer discretionary companies have seen their gross profit margins shrink, and some have seen their sales go down. Today, the economy may be at a point of change where inflation may finally start to slow down as demand falls faster. This is exactly what the Federal Reserve wants to happen with its “tightening policy.” For consumer discretionary firms, I think that change will slow down losses in profit margins but could speed up sales declines as people cut back on spending on things they don’t have to.
Starbucks Corporation is a good example of how this can happen (NASDAQ:SBUX). Before 2022, Starbucks was on a strong upswing as the company continued to grow internationally after building a strong brand in the U.S. This year’s events have changed the company’s chances, as it has to deal with rising wages and unhappy workers, which hurts its gross margins. Investors have to realize, whether they like it or not, that the lack of willing retail workers in the U.S. gives employees a lot more competitive leverage at the expense of corporate profits. Higher coffee commodity prices (though they have gone down recently) and higher energy costs (freight, etc.) also put some pressure on Starbucks, but the labor shortage is by far the most important pressure Starbucks is facing right now.
Falling real wages and a low level of consumer confidence are also bad news for the retail brand. Over the past year, the company has continued to bring in more money, but its growth rate has dropped by a lot. Starbucks has a very high “P/E” ratio of 29x because analysts think that the company will continue to grow its earnings per share (EPS) and sales quickly over the next ten years. If macroeconomic, geopolitical, competitive, or social factors slow its growth rate, even more, the stock is likely to go down a lot because it can no longer rely on expected cash flows in the future. This year, Starbucks stock is down about 15.6%, but it was down more than 37% in May before it started to go back up. Keeping this in mind, I think it’s likely that the stock will either turn down or keep going up, depending on what people think.
Starbucks’ Labor Issues Are Likely to Continue
Starbucks is the seventh-largest consumer retail company in the United States. It controls more than 40% of the coffee chain market share, most of which is still made up of independent local brands. The company is also the fourteenth largest employer in the U.S., which makes it very sensitive to wage pressures in the economy. Starbucks workers have tried to form a union, and many chains went on a one-day strike earlier this month. This is happening at a time when there aren’t enough people working in retail. The chain recently said it would spend hundreds of millions of dollars to raise wages and improve operations to keep workers from joining a union.
Since 2017, Starbucks’ gross profit margins have been going down pretty steadily. Around the same time, the average hourly wage for “special food services,” which includes coffee services, started to go up quickly. Around the same time, the total number of people working in this segment began to stay the same. Mass shutdowns in 2020 sped up this trend by a huge amount, causing the number of employees to drop, which led to worker shortages and higher wages. The number of people working in the industry is still lower than it was before the lockdown, so wages continue to go up.
Gross profit margins at Starbucks are going down. Early in 2020, lockdowns caused huge drops in business and layoffs of workers, which caused its margins to fall. Last year, its margins went back up, but not to the level they were at before the lockdowns. Also, as labor stress keeps going on, Starbucks’ gross margins are going down over time.
Notably, special food service is one of the only jobs where wages are going up at the same rate as inflation. This means that the gains from the first “wage stimulus spike” will still be there in 2020. Compared to the consumer price index, the average hourly wage for all workers is now lower than it was before the lockdown.
Wages may keep going up in the special food services sector, even if inflation slows down or wages for other workers go down. Most of this is because there are fewer people working in the sector than there were before the lockdowns, while the demand for special food services is generally higher. Starbucks’ same-store sales in the U.S. have gone up 11% over the past year. This is almost entirely due to more sales, not higher prices. But Starbucks’ North American operating income went down because its operating margins dropped by a sharp 3.2%.
Starbucks’ margins are going down in both the U.S. and other countries. Like the U.S., Europe has a big problem with a lack of workers, which is especially bad for “food accommodation services.” In most developed countries, there aren’t enough people to work in low-paying service jobs. People don’t seem to want these jobs as much as they used to, especially after the mass layoffs during the 2020 lockdowns.
There may also be demographic factors at play since the “millennial” group (ages 26 to 40) is bigger than the “generation z” group (12-26). This is because the larger “baby boomer” group gave birth to the even larger “millennial” group, giving the U.S. population pyramid two bumps for people aged 25 to 35 and 55 to 65. There is also a sharp drop in the group of people under 20. This is called an “inverted pyramid.” This pattern is common in western Europe and the UK, but it is a lot stronger in China (due to their older one-child policy).
When the “millennial bubble” was in place for people aged 15 to 25, Starbucks had a lot of new people coming into the workforce. Now that the “millennial bubble” is getting older, many people are moving into more stable jobs, but there aren’t enough people to replace them because there are fewer people between the ages of 15 and 25 than there were a decade ago. So, it shouldn’t be a surprise that there aren’t enough “entry-level” part-time jobs and that pay is going up faster than the average for those jobs. Population pyramid inversion will make things worse over the next ten years.
Are Starbucks’ Plans for China Doable?
The number of Starbucks stores in North America grew by only 3% this year, and the company probably didn’t have much room for growth in the U.S., where the market is already pretty full after decades of rapid growth. Outside of the few places that are still underserved, the continued growth of U.S. coffee chains is likely to make prices more competitive and make labor shortages worse, which will hurt profit margins, as we’ve seen this year.
Starbucks, on the other hand, grew its number of international stores at a faster rate of 8%, despite big problems in China. Starbucks now has almost as many stores outside of North America as it does in North America. However, its income and sales outside of North America are about 70–80% lower. Starbucks’ international market was hit hard by an 11% unfavorable currency impact and a 5% drop in same-store sales, both of which were caused by China’s extreme lockdown policy. Many people have thought that China’s “zero-COVID” policy would end, but in the last few weeks, things have only gotten worse.
The most recent round of lockdowns led to huge protests against them all over China. The heavy-handed Chinese government has never given in to what its people want, and information from the country is still hard to get, so it’s hard to say what will happen with these protests. Unrest in China is probably a net negative for Starbucks’ hopes in the country in the short term, as it will probably lead to lower same-store sales and store closures. Of course, the situation for Starbucks in the area would improve if the lockdowns were lifted.
Notably, Starbucks is valued based on the idea that going into China will help the company make a lot more money and bring in a lot more money. It is possible that the company will be able to do this, but investors might do well to be realistic about the chances. China is an authoritarian country with a terrible record when it comes to human rights. As Xi Jinping works to consolidate power more quickly, the country’s government has also done a lot of things that hurt business. This year’s events have shown how dangerous it is for Starbucks to try to expand into this area.
Luckin Coffee (OTCPK:LKNCY) is also a major competitor to Starbucks in China. Luckin now has more stores than Starbucks in mainland China, and despite the lockdown, its sales have grown much faster. Since Luckin was charged with accounting fraud two years ago and taken off the stock market, its metrics may not be reliable. Still, Starbucks’ potential could be hurt by the fact that there are a lot of competitors in China’s growing coffee market. All companies that do business in China, especially foreign companies, work at the CCP’s whim, and they could lose if domestic competitors get better treatment. Other western companies, like Disney, that want to expand into China are often forced to show support for the CCP and turn a blind eye to what it does. This puts all companies in China at risk in terms of geopolitics and brand trust.
In Conclusion
Starbucks is facing a lot of problems right now that I think will hurt its long-term growth and keep putting pressure on its income over the next year. Due to short-term and long-term labor pressures in the U.S., I think there is a good chance that Starbucks’ gross margins will continue to go down over the next few years (and most of the western world). Unionization could speed up this trend a lot, but it seems likely as long as there aren’t enough part-time workers who are just starting out (driven by demographic factors).
A big part of Starbucks’ value comes from the fact that it has room to grow. If we assumed that the company’s earnings per share (EPS) would stay the same over time, it would likely trade at a “P/E” more like that of the S&P 500, which is around 15-20X, or a share price of about $50-$70. Most analysts think that Starbucks’ sales will double in the next ten years, but I don’t think that will happen. Starbucks’ growth depends on its plan to expand in China. This plan seems very risky to me, given how bad things are getting in China and how strict its leaders are. Due to its one-child policy, China has a much steeper inverted demographic pyramid, and there aren’t enough young people to fill jobs once more people in the 25–35 age group find new jobs. From my point of view, this makes it likely that China will run out of entry-level workers in the next five years (and beyond).
The U.S. and world economies are finally slowing down. Consumer sentiment in the U.S. is very low because real wages are going down, and people aren’t saving much. Up until recently, rising consumer credit made up for the fact that people could spend less. But consumer credit is starting to slow down, which shows that discretionary spending is about to drop sharply.
Many people in the U.S. will want to cut back on spending in 2023. One of the easiest ways for many people to save $50 to $200 per month is to give up their “Starbucks habit” and make their own coffee. Since Starbucks’ prices have gone up to keep up with rising wages, the company’s “luxury” market position has grown, making it more vulnerable to a drop in economic consumption.
For now, a change in how people spend their money could be bad for Starbucks in 2023. I think this change will hurt earnings next year, and it could last if people change their habits permanently. Even if Starbucks’ same-store sales in the U.S. don’t go down, I still think the stock is way too expensive because I don’t think it will grow much in the long run. Still, a big drop in sales at the same stores next year would definitely be a bad sign for the stock.
I’m pessimistic about Starbucks stock as a whole, and I think the stock’s price will likely go down over the next year. I also think it’s a great short target because it has a very low short interest, no costs to borrow short, and historically low implied volatility. Options may be a good choice because their implied volatility is so low. I also think that its technical position is attractive since it has gone down a lot in the past six months. But if you bet against the stock, the biggest risk right now is that lockdowns in China will end. Even though I doubt it, this could happen in the next few weeks if protests in the country keep getting bigger.
Featured Image – Pexels © Dom J
