Starbucks financial performance and competitive strategy analysis

Financial Research Report

Company Overview

Starbucks operates a chain of coffee shops in the United States and in dozens of other countries around the world. The company offers gourmet coffee drinks along with a large list of ancillary products ranging from take-home beans to compact discs to assorted menu items. The company grew rapidly throughout the 1990s and 2000s until the late part of the last decade when it entered a period of slow growth and finally some contraction. Even though the core North American market is relatively saturated, strong growth opportunities remain overseas where the company franchises its name to local operators. The company views China as a major source of growth going forward (Sanchanta, 2010).

Starbucks built its brand on a differentiated strategy. The company focused on acquiring prime real estate in high traffic areas in order to draw customers. It provides an atmosphere that in the 1990s was relatively unknown to coffee drinkers, based on the concept of a "third place" besides the home and workplace, where one could comfortably spend time or meet people. This part of the company's business model has been widely emulated and in part this competition has hurt the company's earnings. Major competitors such as McDonald's and Dunkin Donuts have attacked Starbucks' market share at the low end, taking advantage of Starbucks' relatively high prices and the economic downturn (Tancer, 2008). Nevertheless, Starbucks has strong brand equity, a great real estate portfolio and retains a loyal customer base.

Ratio Analysis

As mentioned above, Starbucks' gross margin increased in 2009 to 20.7% but is still below its five-year average, which is 22.3%. The net margin of 4% is below the 5.6% five-year average, but represents an increase from the 3.03% of 2008. The company's operating margin was 5.7% in 2009, up from 4.8% in 2008 but below the 12.25% of 2005, when the company was in a better competitive situation. These figures indicate that while Starbucks still retains healthy margins, those margins have come under pressure as the result of increased competition in the industry, in particular at the low end. As strong players enter the low end, they drive down prices and this has squeezed Starbucks. It is also worth considering that Starbucks is subject to fluctuations in the price of coffee, one of its most significant inputs. The price of arabica -- the main coffee used by Starbucks -- has increased steadily in the past five years (MongaBay.com, 2010). This has placed upward pressure on the cost of goods sold at a time when Starbucks is facing downward pressure on its beverage prices. That the company was able to improve margins in 2009 despite this pressures hints that the strategic response to these price and cost threats has been at least somewhat successful in the short run.

Despite the recent struggles, Starbucks has remained profitable. Because of this, it remains a liquid company. The company's current ratio is 1.28, up dramatically from 0.79 in 2008 and the best such figure in years. The quick ratio is at 0.59, compared to 0.29 the year previous. The cash ratio improved in 2009 as well, to 0.42 from 0.14. Each of the liquidity ratios in 2009 represents the best values in the past five years. This can be attributed in part to a much higher level of cash that the company holds. In addition, Starbucks has reduced its level of current liabilities in 2009 as well, to $1.581 billion from over $2.1 billion each of the past two years. The current level is the lowest since 2005.

The company has not simply swapped out short-term liabilities for long-term debt either. The level of long-term debt has remained stable over the past three years at $550 million and the level of long-term liabilities is at its lowest level since 2006. The debt-to-equity ratio was 83.1% in 2009 compared to 127.8% in 2008. The debt-to-equity ratio today is the lowest since 2005. The debt ratio is at 45.3%, compared to 56% in 2008 and 57% in 2007. These ratios indicate that Starbucks has been able to weather the increase in competition and the impact of the economic downturn without taking on significant debt levels. No new debt issues have been incurred since the 2007 issue, at a point when the company's external environment was just beginning to shift. Equity has grown steadily throughout the entire period, adding almost $1 billion since 2005.

In terms of operating efficiency ratios, Starbucks had in 2009 a receivables turnover of 32.5. This compares with 33.6 in 2008 and 36.7 in 2009. This indicates that the company has had increased difficulty during the recession years in collecting on its receivables. Inventory turn was 14.4 times in 2009, compared with 15 times in 2008 and 14.1 times in 2007. This indicates that the company's inventory turnover has been relatively stable over the past few years. The asset turnover rate has declined steadily in the past three years, however. This was 1.73 in 2009, compared with 1.88 in 2008 and 1.92 in 2007. These ratios provide a somewhat mixed view of Starbuck's recent performance, but indicate that the company has become somewhat less efficient. This may be due to the slimmer margins on which the company has been operating.

The company's return on assets was 6.9% in 2009, compared with 5.7% in 2008 and 13.7% in 2007. The return on equity was 14.1% in 2009, 13.2% in 2008 and 29.8% in 2007. Both of these figures closely track the company's profit swings. The decline in profit in 2008 was reflected in the returns, as was the rebound in net profit in 2009. As a result, these figures do not reveal anything new about the company's performance.

Stock Price Analysis

Starbucks' stock price is $26.15 as of the market close on June 4th, 2010 (MSN Moneycentral, 2010). The stock price has been fairly volatile over the past five years. At the end of June, 2005 the stock was priced at $25.83, just slightly below the current value. The stock increased roughly through November 2006 when it began to fall. This occurred against the grain of the market, owing to the increased level of competition in the coffee shop business. From this high - $35.29 -- the stock fell down to $91.5 in February of 2009 and has recovered since then to its current level. Most of the fall and all of the recovery has closely tracked the performance of the S&P 500. The Index remains 10% below its level of five years ago, compared with Starbucks' position slightly above par. The company's beta of 1.27 supports the chart's view that Starbucks is somewhat more volatile than the broad market.

At this point, Starbucks only represents a "hold," rather than a "buy," as investment opportunities go. The company's ability to withstand pressure in the domestic market has been solid, as evidenced by the year-over-year improvements in the income statement and balance sheet from 2008 to 2009. However, the stock's price has reflected this improvement, as well as expectations of an improved economy. The price is at its level of five years ago, when the external environment was much more favorable for Starbucks. The price of arabica has increased significantly and while Starbucks is a major buyer, it is not the largest buyer and does not have significant pricing power. The competitive pressure that has been applied by McDonald's, Dunkin Donuts and a host of imitators has not eased. Given this, margins can be expected to remain at current levels. While the company can still achieve more improvements with respect to its internal metrics, those are unlikely to drive the stock much beyond its current level. The key driver for Starbucks' stock in the coming years is going to be more dependent on foreign market growth than any other single factor. Foreign market indicators are not a cause for intense optimism. Dubai's default calls into question the long-term growth potential of the Middle East. China's addiction to currency manipulation will eventually be broken, putting at risk the company's plans for rapid expansion in that market as costs of Starbucks' foreign-sourced inputs (such as coffee and paper) will skyrocket at a point simultaneous to declining real incomes among China's middle class. There are other potential growth markets, such as Southeast Asia or Japan, but Starbucks is a very high end product in many of these markets and that will limit growth opportunities to growth in the upper middle class of these countries. In short, the stock has performed well since it hit bottom in early 2009, but it has likely achieved the bulk of its growth. The company is well-positioned, hence the "hold" recommendation, but as a growth story Starbucks' operational improvements are not going to offset the risks in foreign markets that will likely stifle the firm's long-term growth ambitions.

References:

MSN Moneycentral: Starbucks. (2010). Retrieved June 6, 2010 from http://moneycentral.msn.com/investor/invsub/results/statemnt.aspx?Symbol=SBUX

Monga Bay.com: Coffee, Arabica price chart (2010). Retrieved June 6, 2010 from http://www.mongabay.com/images/commodities/charts/chart-coffee_arabica.html

Starbucks 2009 Annual Report. Retrieved June 6, 2010 from http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MjczNTB8Q2hpbGRJRD0tMXxUeXBlPTM=&t=1

Sanchanta, M. (2010). Starbucks plans major China expansion. Wall Street Journal. Retrieved June 6, 2010 from http://online.wsj.com/article/SB10001424052702304604204575181490891231672.html

Tancer, B. (2008). Brewing battle: Starbucks vs. McDonald's. Time Magazine. Retrieved June 6, 2010 from http://www.time.com/time/business/article/0,8599,1702277,00.html