Starbucks Is a Great American Business. But 57% of Locations Are Outside of the U.S. and Are Bringing Down Profits. | The Motley Fool (2024)

At this point there's no sugarcoating it: If you bought shares of coffee giant Starbucks (SBUX 2.09%) anytime during the last decade, you're probably underperforming the S&P 500. And there's a good chance that you're not only underperforming, but you're also losing money.

As of this writing, Starbucks stock is down 42% from its highs in 2021. Back then, everything seemed to be clicking with the business. But its recent performance has been bad because its profits have taken a serious hit.

When I said Starbucks was a coffee giant, those weren't idle words: Starbucks has nearly 39,000 locations worldwide as of the end of its fiscal second quarter of 2024 (which ended March). Nearly 21,000 of these are international stores, making the company's international business quite consequential for shareholders.

In its fiscal second quarter, ended March 31, Starbucks' net revenue was only down 2% year over year, which wasn't too alarming. But revenue had help because the company is still opening new stores at a pretty fast pace. The company's operating income was more alarming.

Starbucks' Q2 operating income was down 17% year over year. To put a dollar amount to this, the company's operating income went down by nearly $230 million compared to the prior-year quarter -- that annualizes to nearly $1 billion. And of this $230 million drop, the largest drag came from its international segment.

In short, whatever is happening to the company's profits is a big deal. And it's something shareholders need to grapple with.

What's going on with Starbucks?

One of the biggest culprits to Starbucks' profits is promotional activity, according to management. This might come as quite a surprise, considering the company has raised its product prices in recent years. However, management finds itself needing to stimulate sales activity by offering promotions to its customers, which counteracts the price increases on the menu.

New CEO Laxman Narasimhan said on the recent earnings call, "In this environment, many customers are being more exacting about where and how they choose to spend their money." In other words, it seems that too many perceive Starbucks as too expensive right now and they're staying away.

This is affirmed by Starbucks' same-store sales results. In international markets, Q2 same-store sales fell by 6%, pushed lower by a 3% drop in transactions compared to the prior-year quarter. And this drop in transactions was with promotions. It suggests that the drop in transactions would have been greater if management hadn't offered promotional pricing.

There's a tricky problem to this strategy. Let's assume a company generates sales of $100 at a 10% margin. In this scenario, the profit is $10. If the company tries to offer better prices to boost sales, the profit margin decreases. If a company's margin falls to 9% because of promotional prices, it would need about $112 in sales for the move to be worth it -- I'll illustrate it in the table below.

To summarize, Starbucks has raised prices and customers appear to be pushing back. To counteract this pushback, management is lowering prices through promotions. This is hitting margins, which is expected. But it hasn't stimulated enough additional sales to make up for it. The result is lower overall profit. This situation is more pronounced in international markets but it's present in North America as well.

What now?

All companies go through challenging periods. But investors can count on management teams with good track records to find ways to persevere. This complicates things for Starbucks' investors. CEO Narasimhan is new and doesn't have the same track record that long-term CEO Howard Schultz had.

It would be easy to give Schultz the benefit of the doubt. But Narasimhan simply doesn't have the same track record as Schultz, which makes it harder to take a leap of faith.

One thing is for sure: Starbucks' valuation has dropped to its most attractive levels in over a decade. The price-to-sales ratio is just 2 whereas the price-to-earnings ratio is just 20.

SBUX PS Ratio data by YCharts

If Starbucks finds a way to win back some lost customers with fewer promotions, profits could bounce back in a big way. And if that happens, the stock will likely respond positively, making today's price quite the bargain.

However, Starbucks' management appears to be leaning into promotions even stronger in recent months, which likely means profits aren't on the cusp of surging.

As a shareholder, I'm still holding my position in Starbucks. But I'm not convinced that the company has a straightforward path to fixing its profit problem. Therefore, I'm not adding to my position until I'm convinced management is adopting the right bounce-back strategy.