Understanding a company’s business model is crucial to investing in individual securities if the purpose is to invest with the objective of outperforming a benchmark return or for a high absolute return. A key point is that the numbers are a result of the business operations; the business operations are not the result of the numbers. By this I mean that trying to make investment decisions on an individual security needs analysis that goes further than spitting back what a company’s net income might be and how that translates into a higher or lower multiple of earnings.
The security I am discussing today is Starbucks (SBUX) common equity (SBUX also has corporate bonds). Starbucks Corp. is a seller of coffee, tea, and related products and beverages. Starbucks is a retailer, a licensor, and a wholesaler, which are all completely different kinds of businesses in that they have economic characteristics that result in vastly different operating margins.
In analyzing the common stock of SBUX, the investor must understand what drives top line growth, operating income, and bottom line earning power of the company. During the second quarter of 2008, SBUX suffered their worst operating performance since the company went public in June of 1992. Top line revenue was up 12% to 2.526 billion, operating income fell 26.1% to 178.2 million and net income fell 21% to 108.7 million.
However, these numbers do not stand alone. One must analyze the financial information further to get a better understanding of the strengths and weaknesses of the entire SBUX business model. First, a key number is the percentage of revenue that is generated from company owned stores (I also call them company operated stores), which is considered the retail portion of the business. In the 2nd quarter of 2008, company owned stores generated 84.8% of total revenue ($2.143 billion/$2.526 billion) which was down from 85.2% in 2nd quarter 2007. Second, company operated stores represented 56.23% of all SBUX stores (9124/16226), with 7257 company operated stores in the United States and 1867 internationally. Third, company owned stores keep all revenue that is generated in the store. According to “Built for Growth,” written by Arthur Rubinfeld (currently Starbucks President of Global Development), a company owned store typically costs 40% of its first year’s total revenues, with the individual store keeping approximately 23% of all revenues as net income.
At the corporate level, include another 10% for overhead, so operating income for the corporation typically results in approximately 13-15% of total revenues at the individual store level. If an individual store produces $700,000 annually in revenue, operating income totals $90,000-$105,000 a year per company owned store. Current economic conditions have impacted the results at company owned stores, as evidenced by the contraction in operating margin at company owned stores to 7% (that works out to about $50,000 per store). The reason why these totals are significant is the scale of the SBUX operation. With 9,124 stores, every percentage point of margin translates into 21 million dollars of operating income. Historically, SBUX has used the company owned store as the key driver of top line and net income growth and this is where SBUX uses most of its capital by investing its operating income into building new stores.
The next area of the business to analyze is the licensing division. Licensing the SBUX brand name involves SBUX stores in places like airports, universities, hotels, and casinos (among others). The licensee uses its own staff and places a store in its location that sells SBUX products. SBUX earns an up front fee, 5-6% of all revenue at the store, along with supplies that are ordered from SBUX. If a licensee generates $1,000,000 in annual revenue, at 5% operating margins SBUX keeps $50,000 with no capital spent. Licensing represented 10.9% of 2nd Quarter 2008 revenue (274 million), which increased from 10.4% in 2nd quarter 2007. What is critical to understand is that licensed stores comprised 44% of all SBUX stores (7102/16226) and only make up approximately 11% of all revenue.
The reason why SBUX puts so much money into company owned stores is because as the scale gets larger, even in an environment with poor operating performance, company owned stores generate substantially more operating income than licensed stores. On a $700,000 annual revenue base, a licensed store would net the company $35,000-40,000 where a company operated store, even in the current conditions, would bring in around $50,000 and historically, around $100,000 in income. Simply put, the company operated store allows SBUX to grow bigger quicker, or more accurately, it has in the past. SBUX is expecting the current operating environment to persist for the next three years, and is spending more money on company owned stores internationally versus in the United States.
The final division in SBUX is the consumer packaged goods [CPG] division which provides bottled cold beverages and packaged coffee to big box stores like Costco, Vons, Albertsons (among others). The packaged division represented about 4.3% of total revenue in 2nd quarter 2008. The division had operating margins of approximately 44%, which was down 3.5% from 2nd quarter 2007. The CPG division is notable for its high operating margins. As SBUX continues to add countries where its partnership with Kraft can supply the packaged goods, profits from the division will grow and should make up an increasingly greater percentage of operating profits.
In looking at the overall strengths and weaknesses of the SBUX business model, the strength of the SBUX business is the reliance (or dependence, depending on how you view it) of the profitability of company owned stores in the United States to generate operating cash flow on an ever greater scale. During the current economic environment, margins have been squeezed significantly because of higher overhead and dairy costs. The weakness of the business model has been the huge amount of capital that is used to build the stores and grow the size of the company, which is one reason why many investors stay away from retail stocks. Starbucks has said publicly that it will reduce the amount of capital used to build stores in the United States over the next three years and should generate about 2.5 billion dollars of free cash flow over that time frame.
Just as importantly, the key question for SBUX shareholders and investors is how high the return is on the capital spent on international company owned stores? With the current economic environment providing headwinds, SBUX is adjusting its business model to spend less money and rely more on a licensing model which ties up far less capital. The free cash flow will be most likely be used for share repurchases. SBUX will spend approximately 1.1 billion dollars on building stores this year. The most important question from a model perspective is how can SBUX grow the company at a higher rate without spending so much capital building stores? As the company gets larger and larger, SBUX will have to either increase the number of stores it builds each year to maintain the current growth rate, or find less capital intensive ways to grow it business. A good candidate for increased importance in the business is the CPG division because of its high operating margins.
When Warren Buffett was asked why he spent 1 billion dollars to purchase Coke (KO) shares in the 1980s, he said that if he closed his eyes and thought about only one thing that he could be virtually certain of 10 years from that date, it would be that more people would be drinking Coca Cola. I believe the same can be said for Starbucks coffee products. Coffee is the second most consumed beverage in the world behind water, ahead of soft drinks. Starbucks has the leading brand in the coffee sector and its recognition as a brand is second to none. The difference between Coke and SBUX is the degree of capital that SBUX currently employs in its business model.
I can see no reason why SBUX cannot be in over 100 countries the way Coke is. There is the argument that because SBUX has a high priced product it does not have the sustainability of a brand like Coke because when economic distress hits (some might argue it is hitting now) consumers will stop buying it. I believe coffee buyers purchase the product based mostly on convenience and that puts a premium on store location. There is no company that does store location better than SBUX. I believe the reason why SBUX has had slower growth is because the real estate locations it has secured for its stores over the last few years have not been as consistently good as when the company embarked on its growth strategies many years ago. I believe SBUX will cherry pick the best locations for its stores in the United States and focus on building stores in the most important markets internationally (China, Russia, Brazil, possibly India) to build the business where it can get the highest returns on capital.
I have not included the stock valuation of SBUX as the topic requires an exhaustive review of many factors. The valuation of SBUX common depends on understanding the fundamentals of the business model and how that translates into consistent earnings growth. I hope the article gives investors a better understanding of how to look at a company’s business model in an effort to become more efficient in evaluating equity securities. Last but not least, make sure you try a vanilla bean frappucino this summer - you may be pleasantly surprised!
Disclosure: Author holds a long position in SBUX