Starbucks Operates in the Quick

Starbucks operates in the quick service food industry, with a coffee specialty. It has a differentiated strategy whereby it sells premium coffee-based drinks, along with food and ancillary products. The company has an international scope, and this geographic diversification has helped it grow into a global power in the coffee industry. Starbucks also loosely competes against other providers of caffeine, a disparate group, but one that at times has benefited from consumer dissatisfaction with Starbucks' prices.

Starbucks has come under intense competition in recent years. Its competitors in the coffee business are almost all significantly smaller by revenue, but in food service it now competes against McDonald's, a much larger company. This has shifted the emphasis at Starbucks from generating revenue from coffee to generating revenue from multiple streams. The company just bought a juice company for a move into both consumer products and into juice shops not unlike the Starbucks coffee shop model.

The company was struggling in 2008, and at the time had been forced to close stores in the United States and all but pull out of Australia entirely. Former CEO Howard Schultz returned to that role. Since that time, Starbucks has demonstrated a strong rebound in its financials. The company's liquidity, profitability and asset management ratios have improved steadily since 2008. At that time, the company was seen as having prices too high, but a slight rebound in the economy has been met with a strong rebound in the Starbucks' revenues. International revenues are part of that growth, with China in particular being a strong growth market that the company intends to pursue strongly over the next decade.

The company's stock price has nearly quadrupled in value since 2008, and this is a reflection of its strong financial performance. In addition to improved returns and operating efficiency, Starbucks also benefits from a low level of debt. The result of this is that the company's profits accrue to shareholders. This has accounted for some of the improvement in the company's stock.

A buy recommendation is issued on Starbucks stock. The company's management has been very strong of late. While this is reflected in its current stock price, that price increase has been justified by strong operating results. Nearly every single important financial ratio has improved in recent years, and this upward trend is encouraging for investors, especially given the lack of debt that the company has.

The buy recommendation also reflects the qualitative value of the company's management team. Starbucks outperforms its competitors in terms of corporate social responsibility initiatives and operating results. The company also has a number of different growth channels that it is pursuing simultaneously -- the juice stores, increased presence in consumer products, in-store improvements and geographic diversification. Its first mover advantage in China will help it to gain share in that country in particular. In addition, the current share price is not even that high on a P/E basis, indicating that relative to its growth prospects Starbucks is probably still undervalued on the market.

Introduction

The purpose of this report is to undertake a financial analysis of Starbucks. The report will focus on the company's most recent financial statements, and make use of a number of different analytical techniques. At the conclusion of the report, there shall be an assessment of the firm's overall financial health, based on the different measures that were discussed.

Starbucks competes in the quick service restaurant industry, using the coffee shop format. Founded in Seattle, Starbucks has grown to be an internationally-prominent coffee shop firm. The company's primary business is its coffeeshops, which feature a variety of coffee drinks and quick snacks. Starbucks also earns revenue from the sale of ancillary products in its shops, and from the sale of coffee on the institutional market (i.e. To hotels, restaurants and grocery retailers). The U.S. market continues to be the strongest for the company, but this market is fast-maturing. The company struggled with growing pains during the middle of the 2000s, as new entrants such as Dunkin Donuts and McDonalds began competing directly with Starbucks, reframing the company's industry and cutting into its margins. Starbucks also failed with a number of diversification initiatives, mostly focused on selling non-coffee goods in their stores. Those efforts have since been scaled back. In addition, Starbucks closed hundreds of underperforming stores in an effort to restore its historical profitability, and that strategy has largely been a success.

Starbucks first expanded internationally in 1987 by moving north in Vancouver. Since then, the company has had a strong international orientation and today has 15,000 stores in 50 countries around the world (Starbucks.com, 2011). Starbucks uses partnerships to expand internationally, and currently views the Chinese market in particular as critical to future growth (Jelter, 2011). Starbucks is also focusing its efforts on other Asian markets in particular, from the Middle East to Japan and Malaysia in an effort to leverage the strong economic growth in the region to deliver superior results.

The analysis of Starbucks' worth as an equity investment can only be analyzed in the context of its current operating environment. The shifts in the environment, when combined with the company's strategy, will be the key drivers of future financial performance. Ultimately, it is the future financial performance that is most important -- past performance is essential for providing context but the value of the company's stock going forward will relate to its future financial performance, not its past performance.

The research questions are going to be answered using a number of techniques. Understanding the history of the company and the nature of its current operations provides a framework for understanding the financial analysis that is the core of the report. The financial analysis itself will have several components -- a ratio analysis, an analysis of the company's stock performance, and an analysis of Starbucks vis-a-vis its competitors.

A conclusion will be drawn as to whether or not Starbucks will be a good investment. A good investment is a firm that has strong potential to deliver returns to the shareholders. A good investment will therefore have a relatively low stock price to its value. The value will be determined by looking at the trends in its financial statements, its liquidity and profitability and the company's qualitative fundamentals including its positioning with the market and its ability to leverage its strengths to take advantage of the opportunities in the market. The analysis will also need to ensure that the company is well-positioned to manage the challenges presented by the current operating environment.

A company that represents a good investment will have a stock price that is in line or better than its industry peers, as the investment decision is assumed to be relative to other firms in the industry. The financial analysis should reveal a firm that performs better than or equal to its peers. The key is that in order for an investment recommendation to be made, the reader must have an understanding of how Starbucks has performed, how it is likely to perform and how it performs in relation to its key competitors.

Statement of Purpose

The desired outcome of this analysis will be an investment recommendation for Starbucks. The recommendation will either be "buy," "sell" or "hold," depending on the outlook for the company in the coming year.

This paper will evaluate the financial health of the company and undertake a qualitative analysis of the company relative to its competitors. This will allow for a determination to be made with respect to the Starbucks' value to the equity investor.

Overview of Starbucks Company

Starbucks began life as a coffee vendor at the Pike Place Market in Seattle in the early 1970s, but the modern Starbucks only came into being in 1987 when the company was purchased by a former employee, Howard Schultz, who was running a small chain of coffeeshops already. The company began its rapid expansion almost immediately. The initial focus of expansion was on building out a network of coffeeshops. Two ownership models were used -- franchises and company-owned stores. When the firm expanded to Asia, it utilized a slightly different ownership model featuring the licensing of the name and systems to local food-service companies. The company expanded into Japan in 1995 because of that country's high level of disposable income and affinity for Western brands (JETRO, 2006). The model for success in Japan -- not a traditional coffee-drinking country -- has become the company's model for a number of overseas ventures, especially throughout the Asia-Pacific region. Starbucks emphasizes being a "third place" away from work and home, and this attracts customers. The company has also demonstrated flexibility in its menus overseas as well, to reflect the tastes of local consumers.

Since Schultz took over the company, Starbucks has been on a long-term growth trajectory. There have been, however, some bumps along the way. The company has failed in at least two markets -- Israel and Australia -- because of its inability to adapt to the challenges of local market conditions (ASB, 2010). However, the company has in general enjoyed success overseas and as a result international sales now account for 27% of operating income (2010 Starbucks Annual Report). The international division remains a key source for growth at Starbucks, in particular the Chinese market, where Starbucks has enjoyed considerable success and now sits at over 500 stores.

The company struggled in the mid-2000s due to two main factors. The first was the entry of new competitors into its space. Both Dunkin Donuts and McDonalds upgraded their coffee offerings in an attempt to win business from Starbucks. These moves were in response to Starbucks use of snack foods to win breakfast business away from fast food chains. These events reframed Starbucks' competitive positioning. The view that Starbucks was strictly a coffee company competing against other caffeine marketers became obsolete -- Starbucks was now in the quick service food industry, using coffee as its point of differentiation (Marketplace.org, 2011). This understanding of the Starbucks industry is critical to understanding its business model and its prospects for the future.

The other challenge for Starbucks during that period was the decline in the state of the U.S. economy. The United States remains by far the company's largest market, and Starbucks has long competed on a differentiated platform, meaning that it charges premium prices for products that it markets as superior. The decline in the economy forced some consumers to "trade down" to other coffee outlets or to drinking coffee at home. This reduced income and in response Starbucks was forced to close some underperforming stores. Compounding the issue was that the company had been focused so intently on maintaining a rapid pace of growth that it had made poor real-estate decisions; strong real estate decision had been critical to the company's early success (Allison, 2008).

Today, Starbucks has maintained its focus on its core quick service business. The featured product remains coffee, in particular high margin espresso preparations and dessert-like beverages. The company markets ancillary goods, snacks, and has a license with Pepsi to sell Starbucks coffee drinks in grocery stores. The company also markets coffee beans and equipment. Food service continues to form the bulk of the company's revenues.

This points to Starbucks operating with essentially two sets of competitors. On one hand, the core product of Starbucks has traditionally been viewed as coffee, or more accurately caffeine. Caffeine is a popular, addictive and widely-available drug. There are innumerable mechanisms for caffeine deliver, any of which could theoretically be viewed as competition for Starbucks. Starbucks competes for the caffeine market with value-added coffee products. These products add flavors, sugars and other benefits, in addition to a premium taste. These attributes differentiate Starbucks from most competitors in caffeine delivery, and for that the company charges a premium price.

As a quick service restaurant, Starbucks uses the coffee as a means to bring customers into its restaurants, where it also sells food and snack items. This industry is a combination product/service industry that typically emphasizes speed of service and a high-volume/low-margin business model. When the competition is framed this way, Starbucks competes not only against other coffeeshop businesses, but against other quick-service restaurants that sell a combination of food and coffee. For years, many of these did not sell premium coffee, but recently some have begun to have a premium coffee offering, specifically to cut into Starbucks' business.

Within the first set of competitors would be any caffeine company with coffee companies as the closest competitors -- Sara Lee, Green Mountain, Peet's, Coffee Holding Co and others. Within any given region there are likely to be multiple regional or local competitors with a business model similar to Starbucks. The company still must compete with drinking coffee at home, or in younger demographics with highly-caffeinated "energy" drinks. Some competitors, such as Sara Lee, are only tangential competitors and compete in many segments unrelated to Starbucks. Of the competitor group analyzed, Starbucks is the largest firm and has the best gross margin. The company has the highest EBITDA and market cap as well. With a share price of $44.19, Starbucks has a P/E ratio that is in the middle of the competitor group.

The other set of competitors in food service typically features larger firms -- McDonalds is larger than Starbucks for example. Some other major firms in the industry do not have strong coffee programs and therefore are only tangentially related. This includes the company's quick service competitors in the Chinese market, Pizza Hut and KFC, which have very little overlap with Starbucks.

Corporate social responsibility sometimes has an impact on profitability, particularly when it impacts on the customers' purchase decisions. Starbucks is committed to having a high level of corporate social responsibility. According to the company's Global Responsibility Report 2010, it divides its CSR responsibilities into the following categories: coffee purchasing, farmer loans, farmer/climate support, community service, youth action, front-of-store recycling, reusable cups, recyclable cup solution, energy conservation, renewable energy, water conservation and LEED certified stores (Starbucks.com, 2011). The company quantifies both its objectives and its CSR outcomes, something that is a sign of a good CSR program. Examples of these measures include 84% of coffee purchased from "ethical" sources, $14.6 million in farmer loan commitments and the sale of more than 5000 carbon credits.

Using CSR measures, Starbucks is a more ethical company than most of its competitors. Most major coffee companies do not focus on ethical, organic or sustainable coffee production. These major competitors typically purchase the cheapest beans and market their products at a low cost. Starbucks' differentiated business model allows it to focus on fair trade coffee and remain profitable. Starbucks also scores as one of the most ethical fast food companies as well, again with few competitors even making an effort at any sort of CSR initiative.

For the most part, recent news items about Starbucks focus on the company's current business prospects. An interesting item is that the company has just acquired a juice company, Evolution Fresh, for $30 million. This otherwise minor transaction has become noticeable because many observers believe Starbucks will attempt to build a juice business in much the same way that it has built its coffee business (Jargon, 2011). This represents a form of unrelated diversification that may see the company apply its business model and core behind-the-scenes competencies to an entirely new line of business. Past purchases have often been coffee-related, such as buying the Clover Company that makes high-end coffee machines. There is also the possibility that the company will use Evolution to build its consumer product business, which presently consists largely of the grocery-store Starbucks drinks that are made and marketed by Pepsi.

When Howard Schultz returned to the company in 2008, this marked a new direction for the company. The company improved its CSR program, with concrete targets. The company made changes to its business, even at small levels such as milk foaming. It has also increased its expansion program in Asia in order to improve its geographic diversification. The company sees future growth in building its portfolio of brands as well, and focusing on out-of-store growth. Evolution fits with this strategy.

In general, Starbucks is less focused on basic mission and vision statements and more focused on specific growth strategies. These are outlined in the 2010 Annual Report in the shareholders' letter from the CEO. The company sees value in a number of its properties and assets and believes that it has the ability to pursue a growth strategy on a number of fronts. This will see the company selling more in grocery stores, expanding more in Asia, focusing on its Ready-to-Brew business, in addition to making adjustments to its core coffeeshop business as well.

This vision for Starbucks in the coming years contains the elements of a strong vision -- it has tangible, achievable targets; it sets out a path by which the company will achieve these targets; and it provide investors with a coherent strategy that they can use to evaluate the company's ability to meet that strategy. Investors have the same opportunity as the company to see the potential roadblocks to success and evaluate whether or not the company will be able to overcome these roadblocks.

Financial Analysis

The first component of the financial analysis will be the ratio analysis. Financial ratios based on the financial statements are a valuable analysis tool because they are consistent (as are the statements) allowing for comparison year-over-year and against competing firms as well. There are several types of ratios -- liquidity, profitability, debt management and asset management.

The company's profitability ratios are ROA, ROI, ROE, EBITDA margin, calculated tax rate and revenue per employee. The ROA is the return on assets, indicating the company's ability to convert assets to profit. ROI is return on investments, indicating the company's ability to turn its investment into profit. ROE is return on equity, indicating the company's ability to convert equity into profit. EBITDA margin is the ratio of EBITDA to revenue, indicating how much of the firm's revenue flows into EBITDA.

The tax rate is important because firms typically seek to minimize their taxes. The revenue per employee is useful as a determinant of efficiency. The earnings that flow through to the shareholders are diminished by taxes, so any move that reduces the company's total tax rate is going to benefit the shareholders. For instance, if Starbucks makes more money in a low-tax jurisdiction, that will improve the bottom line faster than earnings in a high-tax jurisdiction. If the tax rate is declining, that indicates that the company is making investments in areas where the tax rate is lower -- a more efficient allocation of assets.

Revenue per employee is another measure of efficiency, especially for firms in Starbucks' industry. The company has far more employees than its competitors in the general coffee business, a reflection of its food service nature. But employees, along with plant, property and equipment are among the two highest cost elements in a quick service food company. The more sales can be generated per employee, the more profitable the company is going to be. That this figure has improved so significantly in the past two years indicates superior asset utilization.

ROA= Net income/total assets

FY 2010

FY 2009

FY 2008

Calculation

948,300/6,385,900

390,800/5,576,000

315,500/5,672,000

ROA

15.55

6.97

5.74

ROE= Net income/total equity

FY 2010

FY 2009

FY 2008

Calculation

948,300/3,674,700

390,800/3,405,700

315,500/2,490,900

ROE

27.69

14.16

13.25

ROI= Net income/avg operating assets

FY 2010

FY 2009

FY 2008

Calculation

948,300/4,872,550

390,800/4,638,300

315,500/4,645,660

ROI

31.99

12.01

10.72

EBITDA Margin = EBITDA/Revenue

FY 2010

FY 2009

FY 2008

Calculation

1,980,100/10,707,400

1,133,00/9,774,600

1,062,200/10,383,000

EBITDA Margin

16.92

10.27

9.58

Calculated Tax Rate= Tax Expense/operating income

FY 2010

FY 2009

FY 2008

Calculation

488,700/1,419,100

168,400/562,000

144,000/503,900

Tax Rate

37.92%

38.51%

41.63%

Revenue/employee

FY 2010

FY 2009

FY 2008

Calculation

10,707,400/137,000

9,774,600/142,000

10,383,000/176,000

Revenue/employee

76,892

69,024

59,156

The profitability ratios indicate that the company has significantly improved its profitability over the course of the past few years. While measures like ROA and ROE are clearly influenced by improvement in the net income, the company has also registered steady improvements in the revenue/employee metric, and seen a steady reduction in its tax rate as well. As a result, it is reasonable to conclude that Starbucks is experiencing an improvement in its profitability at all levels, and this is reflected in its net income.

The next set of ratios are the liquidity ratios. There are three of these: quick ratio, current ratio and net current assets as percentage of total assets. The liquidity ratios indicate the company's ability to meet its short-term obligations. The basic form is the current ratio, measuring current assets vs. current liabilities. Since some current assets (inventories) are less liquid than others, the quick ratio is another measure used, to indicate how well the company can cover its obligations with assets that can be sold quickly at book value. The percentage of current assets is another measure of liquidity, and in this case it has been increasing significantly in recent years.

Quick Ratio = (Current Assets -- Inventories ) / Current liabilities

FY 2010

FY 2009

FY 2008

Calculation

2,213,100/1,779,100

1,370,900/1,581,000

1,055,200/2,189,000

Quick Ratio

0.98

0.59

0.3

Current ratio = current assets / current liabilities

FY 2010

FY 2009

FY 2008

Calculation

2,756,000/1,779,100

2,035,800/1,581,000

1,748,000/2,189,000

Current ratio

1.55

1.29

0.8

Current Assets % = Current Assets / Total Assets

FY 2010

FY 2009

FY 2008

Calculation

2,756,000/6,385,900

2,035,800/5,576,800

1,748,000/2,189,700

Current Asset %

15.3

8.16

-7.79

These ratios also support the idea that Starbucks has improved its finances of late. The liquidity ratios reflect the ability of the firm to meet its short-term financial obligations. In each instance, Starbucks has clearly improved its liquidity over the past three years.

The next set of ratios are the debt management ratios. These illustrate the firm's capital structure. The appropriate capital structure is dependent on the nature of the firm's business, so an understanding of that business is important here. Ultimately, these ratios should provide a sense of whether or not the firm has too much debt.

LT Debt/Equity

FY 2010

FY 2009

FY 2008

Calculation

549,400/3,674,700

549,300/3,045,700

549,600/2,490,900

LT Debt/Equity

0.15

0.18

0.22

Total Debt/Equity

FY 2010

FY 2009

FY 2008

Calculation

549,400/3,674,700

549,300/3,045,700

549,600/2,490,900

Total Debt/Equity

0.15

0.18

0.22

Interest Coverage = Operating Income/Interest Expense

FY 2010

FY 2009

FY 2008

Calculation

32,700/1,419,100

39,100/562,000

53,400/503,900

Interest Coverage

n/a

8.79

These figures indicate that Starbucks has a fairly low debt level -- there is only one issue of debt outstanding. The company is not going to have a problem meeting its interest obligations on this debt. It has kept its debt stable, and at a very low level. Indeed, it could almost be argued that Starbucks does not have enough debt, as levels this low make the company's cost of capital higher. However, if this is the level that Starbucks is comfortable with, that is okay for the equity investor, because the profits will flow back directly into the company.