Starbucks

Moat: 3/5

Understandability: 2/5

Balance Sheet Health: 4/5

A global coffeehouse chain that, despite recent challenges, still benefits from a powerful brand and a vast network of locations, but faces pressure from changing consumer tastes and competition.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Starbucks, founded in 1971, is the world’s largest coffeehouse company. Their core business is selling coffee, espresso, tea, other beverages, as well as food products, including pastries, sandwiches, and snacks, both in-store and through packaged retail channels. In 2022, they transitioned to a 13-period fiscal year (ending on October 1), resulting in a quarter more data to go over.

Business Overview

  • Revenue Distribution:
    • Starbucks derives its revenues from two main sources:
      • Company-operated stores: Which constitute the majority of the revenue generation, selling directly to consumers.
      • Licensed stores: Which generates revenue through licensing and royalties, from the sale of Starbucks products by partners in many locations around the world.
    • Geographically:
      • North America is by far the biggest revenue generator.
      • International revenue comes mostly from China, Asia Pacific, EMEA, and Latin America.
    • By product:
      • Beverages make up the bulk of the revenue. Food items, packaged goods, and other related products follow.
  • Trends in the Industry:
    • The coffee industry is becoming increasingly fragmented, with specialty coffee shops and premium coffee blends gaining popularity. There is also a trend toward convenience, with ready-to-drink coffee products gaining traction. Competition is increasing with many regional and international companies trying to carve a piece of the market.
  • Competitive Landscape:
    • The competition is intense, ranging from well-established coffeehouse chains like Dunkin’ and Costa Coffee, to smaller independent cafes, and even other quick service restaurants. These competitors often try to imitate successful companies, but also have their own strategies.
    • Starbucks competes on location, product quality, customer experience, convenience, technology, and brand loyalty.
    • Many people believe that a brand with wide reach will always beat a smaller brand. While this might be true, it might not apply to companies that have wide moats.
  • What Makes Starbucks Different?
    • Starbucks has been trying to position itself to be more than a coffee shop, but a place where customers can connect and relax. Their brand is the embodiment of this idea.
    • The Company is trying to achieve growth through expanding digital ordering capabilities, and is also focusing on driving premium experiences.
    • Starbucks is also very focused on international expansion, especially in China.

Moat Analysis: 3 / 5

A wide moat is when a company can withstand its competitors for over 20 years, and have high profitability and returns on capital.

  • Brand Strength (Narrow Moat): The Starbucks brand is incredibly strong and enjoys very high loyalty. Customers will usually gravitate to Starbucks first before a random store if other stores are readily available. However, this brand isn’t as strong as something like Coca-Cola, and is not indestructible. As such, we’d say this is a moat, but not too wide.
  • Network Effects (Narrow Moat): As the most popular coffee chain in the world, their brand name and ubiquity can be considered a type of network effect. If you are traveling to a new city, you are far more likely to spot a Starbucks, and feel more comfortable with a Starbucks, rather than some random coffee shop that you have never heard of, making Starbucks an easier choice for most travelers.
  • Scale (Narrow Moat): With 37,000 stores worldwide, Starbucks has enormous scale, giving it access to great supply chain benefits.
  • Switching Costs (Limited): While the brand loyalty is strong, the switching costs for a consumer to go to a competitor is very low. Therefore, this is an area where Starbucks is very weak.

Given the relative strength of the brand, network effects, and strong scale, but offset by its low switching costs and the fact that their stores aren’t completely differentiated, Starbucks is awarded a rating of 3 / 5 for its moat.

Risks to the Moat and Business Resilience

While Starbucks has a decent moat overall, certain factors can still cause problems.

  • Changing Consumer Tastes: Shifting consumer preferences, such as a move toward specialty coffee or alternative beverages, could reduce Starbucks’ ability to generate growth. Starbucks needs to carefully monitor trends in the market and take actions accordingly.
  • Competition: Increased competition from both large coffeehouse chains and smaller local chains that can provide comparable or even better experiences and/or prices can impact Starbucks’ returns. Starbucks needs to try to maintain a lead, especially through product innovation.
  • Economic Downturns: A recession would almost certainly limit customers’ purchasing power and cause more customers to go for cheaper alternatives.
  • Brand Damage: Negative news about quality issues, labor practices, or tax issues could damage Starbucks’ carefully crafted brand image, and therefore its pricing power and sales.
  • Pricing Power: If the perception on price or value gets too negative, then Starbucks would have a hard time maintaining good profit margins.

However, the company has also shown resilience to most of those threats so far, which means a fair degree of business resilience is built in. For example, during the COVID shutdowns, the company’s sales declined, but their business model quickly recovered afterwards. And while they were criticized for their labor relations practices, it was not a factor that led to a major decrease in their earnings or share price.

Financial Analysis

Starbucks’ financial health is generally sound, despite having relatively high leverage. However, the financial statements do require some adjustment to arrive at a proper estimate of free cash flow.

  • Profitability:
    • The net profit margin has been fluctuating but remains quite stable, meaning they have been able to retain and pass on higher costs.
    • Return on equity (ROE) and return on invested capital (ROIC) are quite high, reflecting the ability of the company to efficiently use its financial resources.
  • Growth:
    • The company has had decent revenue growth in the past, and revenue growth in fiscal year 2022 was particularly strong.
    • However, there is increased uncertainty in growth due to several factors like foreign currency issues and slowdown in China, but there is still room for growth opportunities.
  • Cash Flow:
    • Starbucks generates a decent level of cash flow from operations.
    • The management has been allocating a larger than normal portion of this cash flow to share repurchases.
  • Leverage and Solvency:
    • Starbucks carries a significant amount of debt but seems to be managing it well.
    • The company has adequate liquidity to meet its near-term obligations, and generally the company’s finances are good enough for now.
  • Debt-to-Equity:
    • The debt to equity ratio is on the higher end at 2.75x but the company has had historical ratios on the same level.
    • The debt to equity ratio indicates that the company is making more use of debt than equity for financing.

Given the generally strong profitability, growth in their international markets, and cash flow generation-while maintaining adequate liquidity and managing leverage-we give the company’s balance sheet a rating of 4 / 5.

Recent Concerns and Management’s Stance

Starbucks has been navigating through several challenges in recent quarters. They have experienced a significant drop in profits due to a slowdown in China, inflationary pressures on costs, and supply chain issues in the global markets. The company is also facing an increasing unionization rate and labor pressure which could impact future profits. The management of Starbucks has acknowledged these problems during earnings calls and have been taking steps to resolve it, including optimizing operations, improving their supply chains, cutting down on unnecessary expenses, and focusing on new innovations. They have also stated that prices were increased in order to offset higher costs, and believe that with their brand power they can pass on those prices without any significant changes in customer demand. Further, they’ve identified the North American and International markets as key drivers of their business.

The management is also taking steps to accelerate expansion efforts, especially by trying to make themselves available in more locations. They are also attempting to improve operational efficiencies, streamline costs, make the company more customer-oriented by integrating their mobile application and loyalty rewards program more effectively, and are accelerating innovation on existing products, while also releasing newer and better products.

The management has a long-term strategy to create value which is based on improving the employee experience, expanding their global reach, improving customer experiences and the use of data analytics, and are planning to achieve a revenue growth rate in the long term (beyond fiscal year 2024) at a rate of between 10% to 12%. They have also indicated that they will focus on bettering their margins and productivity by streamlining operations and reducing wasteful expenses. While their path forward is not easy, they believe that they can achieve their goals by sticking to the new strategy they have outlined.

Understandability: 2 / 5

Starbucks is moderately difficult to understand due to some complexity in its financial analysis, but simple enough that a layman would be able to understand the basic business.

  • The business model itself is quite straightforward and easily understandable: they sell beverages and food to customers through a network of stores, and they also make a good amount of revenue by licensing their brand.
  • However, figuring out how to adjust operating expenses, how to account for non-operating activities, and determining the optimal growth strategy is difficult even for experienced financial analysts. The financial statements themselves are fairly complex.
  • The sheer size and operations of Starbucks also adds a layer of complexity for determining how everything might affect their business as a whole.

Because of the relative ease of understanding the basic business, and the complexity associated with accounting and financial statements we give the company an understandability rating of 2 / 5.

Based on this analysis, we have tried to understand Starbucks’ business model and competitive position. While its brand remains strong, there are potential risks to the economic moat. Still, its financial health is reasonably good, and the management is aware of its problems, and actively trying to better the company’s future financial situation.