Starbucks

Introduction
Over the past 20 years, Starbucks has experienced both periods of strong growth, and periods of retraction, most notably during the Great Recession. The company’s investment strategies should have reflected its strategic priorities during this period, and an analysis of the company’s financials over this time should illustrate that. Starbucks’ growth since 1998 has mainly been in overseas markets, but the company has also branched out into other business lines, in an attempt to diversify its income streams. Today, Starbucks appears to have settled into more of a “cash cow” state, where the company is earning healthy returns from its businesses, and focused on growth mainly in some of the overseas markets where the coffee market is maybe a bit more nascent, in other words where there remains high growth potential going forward.
Starbucks Income Statement
Starbucks has been a strong growth story for most of this period. According to the 1999 Annual Report, the company earned $1.309 billion in 1998, and steadily grew this figure through the 2008 fiscal year, when it recorded revenue of $10.383 billion (Macrotrends, 2019). The 2009 fiscal year saw a decline in revenue, for the first time since the company went public. But since that point, the company restored its positive growth trajectory, and in 2018 it recorded revenue of $24.719 billion.
The company’s net earnings have grown in a similar long-run positive trajectory. In 1998, net income was $68 million. This figure grew to $672 million in the 2007 fiscal year. The recession hit, and net income dropped to $311.7 million, and only increased slightly in 2009. For the most part, since that point Starbucks has seen its net income grow steadily, to the point where it was $4.5 billion in 2018. There was an exception in one year, 2013, when the company had an arbitrator’s decision go against it for $2.8 billion to Kraft Foods for prematurely terminating a deal (Sharf, 2013). That blip aside, Starbucks has seen both its top and bottom lines grow steadily over the course of the past twenty years, save for the 2008-2009 recession period when the company was forced to retrench, even closing a large number of stores. This move came with the return of former CEO Howard Schultz, who had left the company but then returned in order to bring it back to growth (The Coffee Brewers, 2008).
Balance Sheet
Decisions regarding the financing of this steady growth should be reflected on the company’s balance sheet. At the end of the 1998 fiscal year, Starbucks had just under $1 billion in total assets, about one-third of which were current assets. The company had minimal leverage, with shareholders’ equity amounting to 80% of the capital structure. In 2009, the growth of the company flatlined, but continued its growth as it came out of the recession. Starbucks now sits with a book value of its assets at $24.156 billion.
One of the big questions is whether the company would make any changes to its capital structure, based not only on its strategy, but on the prevailing financing environment, which included a very long run of rock bottom interest rates. By 2005, liabilities were already up to 40% of total assets, and they were at 45% by the time the company’s growth slowed in the 2009 fiscal year. Those low interest rates allowed Starbucks to use debt as its primary mode of financing growth in the past ten years. By 2016, liabilities were 58% of the capital structure and the company had grown its long-term debt significantly. But in the 2018 fiscal year, Starbucks underwent a massive shift in its approach to financing growth. Liabilities are worth 95% of the company’s capital structure. The company has issued a massive amount of debt in this fiscal year – in several issues – and committed to share buybacks with a significant portion of that money. As a consequence, retained earnings fell from $5.563 billion in 2017 to $1.457 billion in 2018. The company also committed to paying out higher dividends in order to return up to $25 billion to shareholders.
This program is extraordinary, and it is the work of new CEO Kevin Johnson. It marks a stark departure from the approach that was followed by Howard Schultz (Cannivet, 2019). This approach is more consistent with a company that sees itself as exiting a growth stage, and entering into a cash cow stage. The accumulation of capital is an important part of any growth stage, and under Schultz, that capital accumulation was an important part of the business model. Borrowing had steadily increased, but with an eye towards fuelling growth. In particular, Starbucks saw massive opportunities throughout Asia, and put substantial amounts of money into building its business in China, India and other countries. The current approach leaves less money available for such growth, especially with further commitments through 2025 to return more cash to shareholders.
The approach the company is using also comes with significant risk because of the high degree of leverage. Starbucks is at 95% liabilities in its capital structure, which is only viable for a company that feels that it has very low risk in its ongoing operations. Having a reliable cash flow allows a company to take on substantial leverage, which not only provides opportunities for returning capital to shareholders, but also allows the company to lower its cost of capital. Strategically, this financial shift highlights how the company sees itself, and how that view has changed. The rather dramatic nature of the change is more related to the fact that they have a new CEO, than a sudden change in the nature of the company’s business; Starbucks has had a cash cow business in its established markets for years, and with growth limited to a handful of major markets in Asia.
Foreign Currency Risk
Starbucks definitely faces some foreign currency risk, especially translation risk, as it owns thousands of stores in other countries. These earnings ultimately end up on the income statement of the company back home. This risk has not, however, impacted Starbucks all that much. The company’s growth has been strong enough that fluctuations in foreign currency have not really impacted the income statement. Furthermore, Starbucks has a healthy diversification of foreign markets. It has major markets in Canada, the UK, China, Japan, and more, giving it an opportunity to earn in many foreign currencies. Its major commodity, coffee, is traded in USD, and that is the currency in which Starbucks earns the majority of its money, even to this day. All told, this is a company that faces foreign exchange rate risk, but has never really faced significant adverse consequences of that risk, mainly due to diversification of foreign earnings and strong growth rates that obscure the random fluctuations of its major international currencies.
Working Capital
One of the implications of the new approach to Starbucks’ finances is the impact that it will have on the company’s working capital. Typically, moves to increase dividends and execute share buybacks will put the company in a position where it is using up cash flow that might otherwise go to working capital requirements. In 2014, the company had a current ratio of 1.37. Last year, the first year of its major restructuring, it was 2.2. This was because of the debt that the company took on. That debt is what is being used to pay for the buybacks and dividends, not the working capital. Thus, Starbucks’ current financial strategy does not appear to have much influence on working capital. There is a risk, however, that it could have such an influence in the future, especially if the company has to raise more debt in order to pay for its plans. Those plans, however, are not etched in stone, but of course the stock price could be negatively affected should the company be forced to backtrack on Johnson’s ambitious promises.
Versus Competitor?
Is there really a competitor for Starbucks? The company absolutely dominates its industry, and is better analyzed against other quick service restaurant competitors, than other coffee shops, as the comparables are so absurd in terms of the size and scope of the company. The biggest of those is McDonalds, a company which competes against Starbucks in both breakfast and lunch. The mode of competition is a bit different, but this is a rivalry dating back nearly 15 years (Hawley, 2019). Since 2014, McDonalds has seen declining revenue, dropping from $27.44 billion to $21.03 billion today, which makes it smaller than Starbucks by revenue.
For several of the past years, McDonalds has seen stable net earnings, but increased those in the last fiscal year to $5.92 billion, a level above that of Starbucks after trending in roughly the same territory for a few years. The two companies at this point are nearly the same size, but clearly on opposite ends of their fortunes. This is really more because of factors unrelated to their financial states, but clearly McDonalds does not have the same growth markets that Starbucks has. McDonalds has a more stable balance sheet. It has a higher working capital level, and has not made the sharp shift in financial strategy that Starbucks has made, being that the company is in an entirely different state of maturity.
Starbucks has a fairly high level of leverage, and this situation has worsened considerably over the past several years, a result of its declining fortunes. At the end of the last fiscal year, McDonalds had long-term debt that was nearly equal to its entire asset value. It has had negative shareholders’ equity for the past three years, and this figure has been declining for much longer. Where Starbucks has found itself in a position where it can pursue growth while returning a significant amount of capital back to shareholders, McDonalds finds itself with rather limited growth prospects, negative equity, and in no position to return capital to shareholders. In the matter of breakfast, Starbucks has beaten McDonalds hands down. These are, at this point, two companies on entirely different trajectories.
Opportunities in the Future
For Starbucks, the company’s current path is clearly established. The main challenge that it is going to face in the coming years is ensuring that it has enough money to pay for its CEO’s ambitious plans for returning wealth to shareholders. Starbucks used new debt issues to pay for the first few rounds, but that makes sense if one considers that the company wanted to make a change to its capital structure. But going forward, its capital structure should probably not be subject to significant change, and that means that it will need to pay for its buybacks and dividends with ongoing cash flows. So while today the company’s working capital level is high because of the debt issues, it is not sustainably high, and a major challenge will be to pay out on the CEO’s promises without causing financial strife.
McDonalds has a very different situation, where the company is facing contraction but does not appear to have built that into its financial plan. The decline in equity to the deep negative levels of today is the result of a company that appears to have thought that it would turn it around, but that is appearing less likely these days. So where Starbucks is unlikely to make a substantial shift in its policy in the coming years, McDonalds almost certainly will need to. It will need to cut costs, and that probably means closing locations and divesting itself of other underperforming assets.
Conclusions
The stark differences in the fortunes of Starbucks and McDonalds highlight the differences in the quick service sector. Starbucks is viewed by consumers as a more modern company, one whose products, ethos and way of doing business are more in step with current values. This differs quite a bit from McDonalds, which is viewed far less favorably. However, industry trends will occur regardless, and companies need to undertake the appropriate financial steps in order to ensure that they can meet their ongoing operational needs, and their expansion needs at the same time.
The abrupt change in financial policy for Starbucks was probably long overdue, and appears to be in line with where the company is in its life cycle. McDonalds, by contrast, may not be fully ready to admit where it is in the life cycle, despite facts that speak the truth. Yet, unless one takes the view that Starbucks’ shift was long overdue, it is probably rather jarring, especially in the coming years when there might be questions about whether ongoing cash flow can support the ambitious targets for capital repatriation. The inaction on the part of McDonalds – the company just started cutting costs in FY2018, resulting in an increase in profit – is just as drastic. Both companies are undergoing a shift in how the market perceives them, and their financial strategies need to change as the result. For Starbucks, attention will now to paid to running efficient operations, and for McDonalds, the call for efficiency probably must be even stronger, as it will need to cut costs substantially.
References
Cannivet, M. (2019) Starbucks’ big stock buyback limits future upside. Forbes. Retrieved October 4, 2019 from https://www.forbes.com/sites/michaelcannivet/2019/08/29/starbucks-big-stock-buyback-limits-future-upside/#26c434067047
Hawley, J. (2019) Who are Starbucks’ main competitors? Investopedia. Retrieved October 4, 2019 from https://www.investopedia.com/articles/markets/101315/who-are-starbucks-main-competitors.asp
Macrotrends (2019) Starbucks. Macrotrends.com. Retrieved October 4, 2019 from https://www.macrotrends.net/stocks/charts/SBUX/starbucks/financial-statements
Marketwatch (2019) McDonalds Marketwatch. Retrieved October 4, 2019 from https://www.marketwatch.com/investing/stock/mcd/financials
Sharf, S. (2013) Starbucks ordered to pay Kraft $2.8 billion. Forbes. Retrieved October 4, 2019 from https://www.forbes.com/sites/samanthasharf/2013/11/12/starbucks-ordered-to-pay-kraft-2-8-billion/#5516b7fa167d
Starbucks 1999 Annual Report. Retrieved October 4, 2019 from https://s22.q4cdn.com/869488222/files/doc_financials/annual/1999/102640_financials2_99.pdf
The Coffee Brewers (2008) With Starbucks closing 600 shops, is the coffee business still lucrative? The Coffee Brewers. Retrieved October 4, 2019 from https://www.thecoffeebrewers.com/starbucks.html