Starbucks Risk Analysis and Mitigation

Risk analysis is a process by which the different risks that an organization faces are identified and evaluated. There are many different types of risk, and they can be systematic or unsystematic in nature. There is credit risk, foreign currency exchange risk, interest rate risk, economic risk, country risk, political risk, technological risk, market risk and legal risk (Investopedia, 2016). Within each of these categories, there are specific itemized risks that will need to be evaluated. As example, health care providers face "legal risk," but there are many categories of this including malpractice risk, human resources legal risk and risk associated with legal rights.

This paper will examine the different risks that are faced by Starbucks. There are a number of risks that are apparent immediately from the aforementioned categories. Foreign exchange risk is obviously one of them. There are market risks, such as consumer tastes, or new competitors. There are risks associated with the company's supply chain, up to and including the risk posed by climate change on coffee crops. There are risks associated with the partnerships that the company has with franchisees, especially in foreign countries where Starbucks may not be able to exert the same level of oversight. This paper will elaborate on some of the risks that Starbucks faces, and how serious those risks are, in an attempt to determine the overall risk that the company faces to its revenues, cash flows and profits.

Overview of the Business

Starbucks is a purveyor of coffee and related products, including food and other beverages, as well as beans and coffee equipment. The company is headquartered in Seattle but it operates globally. The company has a mix of corporate-owned stores and ones that are run by franchisees. Starbucks did $19.1 billion in revenue last year, with net income of $2.7 billion (MSN Moneycentral, 2016). There are specific risks that are associated with running a food business, and there are risks inherent in both franchising and in operating internationally. There are several other categories of risk that apply to Starbucks as well, as a consequent of the nature of its business.

Market Risk

There are several categories of market risk that apply to Starbucks, ranging from commodity prices of coffee to the intense competition that the company faces. Starbucks faces significant risk with respect to price fluctuations of coffee, its main product. The price of coffee is determined in part by the cost of production -- around $1.00-$1.10 per pound -- but the price is determined by the global market. This in turn is affected by environmental risk, and the competitive nature of the market. Starbucks is a major buyer, but not the only one, and there are others that can help to drive the market. Starbucks cannot pass the price changes onto consumers immediately, not in a competitive marketplace, so the company faces some risk over fluctuating coffee prices. This risk is likely to occur -- coffee prices fluctuate regularly -- but the risk of damage to the company is relatively small.

The other aspect of market risk is the risk of competition. Starbucks has an industry-leading position and is therefore immune from some competition -- it is more likely to be the winner in a competitive battle. But the company faced an attempt in the mid-2000s by McDonalds to enter the coffee business in a serious way. McDonalds and Dunkin Donuts both made inroads into the Starbucks business in the U.S., especially when this was combined with the economic downturn that made premium coffee a luxury item. Starbucks' business suffered and the company was forced to close hundreds of stores. Having successfully combatted McDonalds, Starbucks now faces lower competitive risk than ever before, but the potential damage from a strong new competitor is still fairly significant. It is also worth noting that there are places where market conditions are entirely unfavorable for Starbucks -- it exited Israel, never even attempted to enter Italy and has struggled bad in Australia.

Political Risk

One would think that political activities surrounding coffee shops are fairly routine, mostly regulatory matters concerned food handling and service. As such, the political risk that Starbucks faces is fairly low. But the company did face difficulty in China when government officials launched a campaign against the company, decrying its prices, as part of a campaign against prominent foreign businesses that usually targeted Japanese companies. Starbucks has also faced protests, essentially as a symbol of cultural imperialism, in a variety of countries, and even had to close a store near Beijing's Forbidden City as a result of this (quickly replaced by a Chinese-owned coffee shop, of course). Political risk appears to be fairly high in terms of something happening, but the cost will likely be low -- a few protests, the occasional store closing. There are some minor legal risks as well, pertaining to daily operations, nuisance lawsuits and the like. These risks manifest all the time, and usually do not cost the company much. Political risk also encompasses risks such as nationalisation and war. For example, a couple of years ago Argentina nationalized a Spanish oil company, so that can occur albeit rather rarely. The Forbidden City Starbucks was basically nationalized as pressure caused Starbucks to close and a Chinese company moved into that same location. War seems a distant risk, but Starbucks used to have operations in Syria, so it is not an impossible risk.

Economic Risk

Starbucks positions itself at the high end of the coffee market. While it is very much an "affordable luxury," as evidenced by the stores' turnover, it is nevertheless dealing in a product where there are many substitutes available. During the economic slowdown in 2008 and 2009, Starbucks saw its business decline, as consumers traded down to more affordable coffee. This was either cheaper shops, or drinking coffee at home or the office more, but in any case Starbucks found that a certain segment of its customer base faced price sensitivity during the down economy. Since that time, the economy has largely recovered, bolstering the company's fortunes, but Starbucks still faces this risk in the event of another slowdown. The risk should be considered high, and the outcomes severe. . There will be another economic slowdown eventually, and when it comes the company will likely again struggle to be profitable. The only good thing here is that this is probably a long-run risk, rather than an imminent one.

Tied to economic risk is interest rate risk, where the company faces negative impact from rising interest rates. This risk is not great at the moment, but can have significant impacts on things like borrowing costs, should rates rise, and especially if they rise at a point in time when Starbucks needs additional external financing.

Foreign Currency Risk

There are two types of F/X risk. The first is transactional risk, which arises when currency is used in transactions, in particular forward or future transactions. Coffee contracts are in dollars, so this risk is minimal on the supply chain side. However, the company may wish to repatriate money from overseas operations, and that would create risk associated with that transaction. Furthermore, some countries, such as China and India, have capital controls that may make it difficult to repatriate money. At this point, Starbucks is still growing in those countries, so its earnings will simply be plowed back into growth, minimizing this particular type of risk, but the point may come in the future when it wants to move profits out of those countries and runs into difficulties. This risk is moderate, though being reduced regularly through trade liberalization. The risk carries with it moderate potential costs.

The other currency risk is translational risk, where the profits in foreign operations are translated back to U.S. dollars for reporting purposes. This can negatively affect earnings. For example, the 2015 Annual Report indicates that EMEA segment revenue (Europe, Middle East, Africa) declined by 6%, and that this was almost entirely attributable to foreign exchange rate risk in a year when the U.S. dollar was strong. The total loss due to translation risk systemwide in the year was $252 million (p.23). This risk is high, since currencies fluctuate all the time, and the impact can be quite severe. Compounding the problem is that there are few hedges against translation risk.

Environmental Risk

There are a number of environmental risks that the company faces. Starbucks relies on coffee supplies, and coffee plantations are threatened by climate change. Coffee grows in a narrow band at altitude in tropical latitudes. As temperatures rise, optimal coffee-growing areas rise as well, meaning less land is available for cultivation. Moreover, farmers need to move uphill with their plantations, which takes time. Climate change poses fairly significant risk to Starbucks' business, particularly in the long run, and this risk may be severe. In the short, environment risks are more specific to individual harvests, and while this is a fairly high risk, the impact is low because Starbucks has a diversified supply chain -- if Central America has a down year, the company buys from Asia and Africa instead.

Technological Risk

There does not appear to be much technological risk associated with Starbucks' business. It is a fairly low technology company all told, not at the cutting edge, and not really relying on technology for its business. It engages customers via social media, uses technology to manage its supply chain, but ultimately Starbucks does not appear to rely all that heavily on technology for competitive advantage. The risk, then, is fairly low that disruptive new technology will dramatically affect the company's business. Technology risk is therefore low, and low impact.

Inherent Risk

A final category of risk is inherent risk, which reflects the risk of material misstatement or omission in the company's financial statements (Investopedia, 2016). The negative consequences of inherent risk can be severe, but it can also be managed with proper internal controls. Residual risk is whatever risk still remains after all controls have been implemented. For example, if the company hedges all transaction F/X risk, it still faces translation risk.

Risk Management

Understanding the risks a company faces is just the first step in risk management. Steps must be undertaken to prioritize and manage these risks. We have seen, for example, that some of the more severe risks in terms of outcomes are foreign exchange rate translation risk, economic risk and environmental risk. Translation risk has a high likelihood of occurring every year. Economic risk has a high risk of occurring in any given ten-year period, but not every year. Environmental risk could occur any year in terms of harvests, but in terms of climate change is a certainty, in the long run. So these are the three most important categories of risk.

Risks that are lower at this point are transaction F/X risk, especially repatriation risk. This is a risk years into the future, but can be significant. Political and environmental risk are moderate risk types -- likely to occur but unlikely to be devastating to the business.

Lower level risks include inherent risk, which could be catastrophic and technology risk, which poses minimal threat of damage. Interest rate risk is not great, either, in the short run. Ultimately, the company must choose which risks it is willing to accept. Risk appetite should be low for risk that would have catastrophic impact, but can be higher for risks that are not expected to have severe impact. Risks with unknown impact, such as legal risk, probably have moderate appetite. The reason for different appetite levels is that the cost of managing each different risk category varies, so the company has to balance the cost of the risk occurring versus the cost of managing it.

Risk Mitigation Techniques

With respect to foreign currency translation risk, which has been demonstrated to be worth potentially hundreds of millions of dollars in a given year, there is actually little that can be done. F/X transaction risk can be managed with currency hedging, but translation risk is more difficult because there are no transactions involved. The money never changes hands; and Starbucks does not have any ability to control currency markets. The best way to manage translation risk is through diversification. By operating in a large number of countries, Starbucks can at least have the potential for different currencies to move in different directions, providing some offset to each other. With the USD being the company's base currency, this is less likely, however. A strong dollar is a strong dollar, and most currencies will lose value under such conditions, hence why translation risk cost the company $256 million in 2015. Moreover, Starbucks is not fully diversified globally. Its key foreign markets are Canada, the UK, the Eurozone, Japan and China. The yuan is on a soft peg to the dollar, and all the Western currencies tend to move in the same direction, providing little offset. Starbucks would need to grow strength in non-Western markets to provide better diversification, but most markets in the world are at least somewhat influenced by the dollar.

Economic risk is also best managed through diversification. While global markets are at least somewhat connected, evidence from the last economic slowdown suggests that emerging Asian markets are not as connected -- China slowed down a little, but not nearly as much as Western markets. Starbucks is still dependent on the U.S. market for over half its business, but as it expands internationally, it will improve diversification, and growth in markets that are not closely linked to the American one will be helpful in this regard. India, China and the Middle East are good growth targets, and Starbucks is making strong inroads in all three, evidence that it is managing its economic risk better.

The third major risk category is environmental risk. In the short run, diversification of supply chain is important to manage risks associated with harvests. As a major buyer, Starbucks is able to do this quite well. Starbucks also has a strategic reserve of unroasted beans in order to ensure supply in the event of severe negative harvest. This reserve has been estimated at around two years' worth of beans. The risk posed by climate change is much more serious. Over the coming decades, relationships with suppliers will be important to avoid supply disruptions. Having premium pricing helps the company here as well, as it is better able to pass higher costs onto its customers than low-end coffee producers. Becoming more engaged in initiatives to study coffee tree genetics in Ethiopia, in order to find other plants that might be suitable for cultivation, especially in future climate conditions, is recommended (Davis, 2014).