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Nestle-Starbucks Distribution Deal: Win-Win

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Nestlé is paying Starbucks (SBUX - Free Report) $7.15 billion plus royalties for the global distribution rights to several Starbucks brands including Starbucks Reserve and Seattle’s Best Coffee packaged coffees, and Teavana packaged teas, with combined annual sales of around $2 billion. The Starbucks brands join Nestlé’s portfolio that also includes the Nescafé and Nespresso brands.

Nestlé expects the deal to be accretive to its 2019 earnings. Starbucks will use the $7 billion cash infusion to increase its share buyback authorization. It will now return $20 billion to shareholders over the next three years through buybacks and dividends. The deal is expected to be accretive to its earnings by 2021.

Direct Benefits For Both

The deal also includes Starbucks-branded capsules for Nestlé’s Nespresso and Dolce Gusto single-serve brewers that have only been available for Keurig cups thus far. But Europe’s JAB Holdings, with a view to strengthen its global coffee business, recently picked up both Keurig Green Mountain and Peet’s Coffee & Tea, potentially increasing competition for both Nestlé and Starbucks. While the Keurig deal will likely continue, it makes sense for Starbucks to expand to a competitor’s offerings as well.

According to Euromonitor, the Nescafe and Nespresso brands commanded 15.0% and 4.5% market share globally in 2017 compared to Starbucks’ global market share of 2.4%. However, in the U.S., the two Nestle brands were limited to 2.2% and 2.5% shares with Starbucks accounting for 12.8%. So being able to sell Starbucks can help Nestle increase sales here while Nestle’s huge distribution network can help Starbucks grow sales internationally.

And that’s exactly how the arrangement is being worked out: Nestlé is not buying equipment from Starbucks, but is taking over 500 employees as part of the deal. It will be in charge of producing Starbucks packaged coffees from beans sourced by Starbucks outside the U.S. in accordance with the terms of the license, while Starbucks continues to produce packaged coffee and other goods in North America. All sales will be booked by Nestle.

The deal is even sweeter for Nestlé because its Nescafe brand of instant coffee has been losing market share over the past few years (Euromonitor).

Feeds Starbucks’ Broader Growth Strategy

Starbucks needs to strengthen its position in the domestic market and quickly expand in emerging international markets.

Domestic

So as far as the domestic market is concerned, the coffee drinking culture (starting from teens hanging out at a coffee shop because it’s cool to an old timer taking it at home) helps the company a lot. In fact, according to the National Coffee Association’s (NCA) National Coffee Drinking Trends (NCDT) report for 2017, coffee consumption, especially of gourmet varieties, is increasing across all age groups.

Gourmet is especially popular in the two youngest age groups of 13-18 year olds (29% consume daily) and 18-24 year-olds (39% consume daily). Even among older adults, gourmet consumption is growing much faster than overall consumption, making it a very important category.

Gourmet is a loosely-defined term based on consumer perceptions in which the NCA includes any sort of non-instant arabica or arabica blend coffee product, including certain K-cups, premium arabica roasts from local roasters, bagged grocery coffee, or filter coffee and espresso drinks served in independent and chain coffee shops.

So it basically requires specialty coffees served in unique and innovative ways. Since specialty coffee is dependent on soil and climate conditions, fermentation and roasting techniques, and other processes, now more than ever before, there is the need for a connection between the farmer and the end consumer.

The coffee chain can be that important link, as it also experiments with innovative ways of serving up coffee. In addition to cold brews, these innovations could include the kind of water/tonic being used for rendering different textures, the health aspect (using mushrooms) and appealing to the younger demographic with sweeter and creamier options.

As Starbucks turns its entire focus to its chains (that have taken a slight hit from lower mall footfall due to the shift online), it can do a better job of focusing on these customers.

International

Coffee-drinking is a cultural thing, so there are parts of the world, like the Nordic region, which consumes the most, to places like North America, most of Europe and parts of South America and Africa, which follows. But the coffee drinking culture is practically absent in Asia, where tea consumption is customary. So the ability to sell the social aspect to the upwardly mobile middle class in countries like China presents an attractive growth opportunity. China is all the more attractive because of its huge and growing middle class.

Starbucks CEO Kevin Johnson has said that the two biggest growth engines for the company are the U.S. (where it focuses on premium sales) and China, where it is introducing the coffee culture to tea drinkers. So it is opening 500 stores a year in China with the goal of getting to 5,000 stores by 2021. Because it is easier to cater to customers that are learning about coffee, this is the company’s fastest growing market.

In December last year, the company opened a 30,000-square-foot Reserve Roastery in Shanghai that is even bigger than its flagship roastery in Seattle. A third roastery is set to launch in New York this year. A Starbucks roastery showcases the processes through which various coffee beans pass to reach the customer. It’s a huge branding and marketing exercise designed to build a premium clientele over time.   

Starbucks also bought out the 50% interest of its China JV partners Uni-President Enterprises Corp and President Chain Store Corp. for $1.3 billion in cash, making all its Chinese stores company-owned. Concurrent with the store expansion, it is racing to build customer relationships to ensure that people keep coming in.

Summing Up

Licensing the retail operations out to Nestle will allow the company to focus better on its key growth engines while helping to build brand awareness in other tea drinking populations like India where the Nestle brand is strong.

While strained U.S.-China relations are an overhang on all companies dependent on China, Starbucks has spent 18 years building relationships with its Chinese partners and its stores create a good employment opportunity for Chinese people. So, because of the positive commercial effect of its operations and the non-threatening nature of its business, it’s likely that the Chinese government will take a more pragmatic view of its operations in the country.

 

Recommendations

Starbucks has a Zacks Rank #3 (Hold). Other restauranteurs that are worth investing in instead are buy-ranked Arcos Dorados Holdings (ARCO - Free Report) , Wingstop (WING - Free Report) , Brinker International (EAT - Free Report) and Del Taco Restaurants (TACO - Free Report) . Or, you can take a look at the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

 

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