Starbucks Case Accounting

Starbucks Case Part I – Prior to reading Starbuck’s Form 10-K, please answer the following questions. Your answers should be based upon your general knowledge of Starbucks, gained from visiting their stores, purchasing their products and/or observing them in the marketplace. a. Up until the economic downturn (Fall of 2008) what do you believe was Starbucks’ growth strategy? Give three examples of specific actions (growth initiatives) you observed Starbucks execute upon as part of their growth strategy? 1. Saturate the U. S. arket: Based on our observations, it seemed that Starbuck’s primary strategy for growth was to saturate the U. S. market. At one point there seemed to be a Starbucks at every corner, sometimes so close that one had to wonder why in the heck they were opening stores within a couple dozen feet from each other. 2. Expand internationally: We presume that one of their growth goals was to expand abroad, specially if they began to realize they were cannibalizing their own established stores, so they likely had to go outside of the U. S. o keep up their growth targets. 3. Develop complementary products/alternative revenue sources: We also think that around 2006-2007 was when they started to promote downloadable music and also began to sell CDs & books in stores; which means they began to more aggressively add alternative revenue channels, beyond that of coffee/drinks, to their many locations. (Personally, I purchased a bottle of Starbucks coffee liqueur around that time, which I still have because it’s not as good as other coffee liqueurs such as Kahlua. b.

How do you believe Starbucks measured their success in executing their growth strategy? Give four specific measures you might use to evaluate the success of Starbucks’ growth strategy. Very likely that they were measuring it against number of new stores opened, and sales growth. We would probably use the following to evaluate the success of Starbuck’s growth strategy: 1. Sales growth. 2. Operating Revenues. 3. Net income. 4. Return on assets. The remaining sections of the case should be completed after you have read Starbucks Form 10-K and any other information deemed pertinent.

Part II – Results of the audit by Starbucks’ outside independent accountant, status of Starbucks’ financial reporting controls and industry specific accounting. a. Who is Starbucks’ outside independent auditor? Did Starbucks receive a qualified or unqualified (clean) audit report from their outside independent auditor for the 2010 fiscal year end? a. Deloitte & Touche, LLP. b. Unqualified. b. What was Starbucks management’s conclusion in their report on internal control for financial reporting? What was the outside independent auditor’s conclusion regarding management’s review and assessment of financial reporting controls? . That their internal control over financial reporting was effective as of October 3, 2010. d. That Starbucks maintained effective internal control over financial reporting as of October 3, 2010. c. How does Starbucks account for gift cards? What impact do unredeemed gift cards have on the reported operating income in each year? How does Starbucks’ accounting for unredeemed gift cards compare to other retailers? e. Revenues for cards are recognized when tendered for payment, or upon redemption. Outstanding balances are included in deferred revenue on the balance sheet.

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Balances on cards that are deemed unlikely to be redeemed, get recognized as net interest income. f. Operating income is increased by balances on cards thought unlikely to be redeemed; therefore, it can be argued that operating income is being overstated by the addition of “unlikely-to-be-redeemed” card balances to net interest income. g. Gift card balances by other retailers are probably carried as a liability (unearned revenue). When gift cards are not redeemed, some retailers return the balances to the state where the card was issued assuming the unclaimed balance to be “unclaimed property” in some states.

As seen above, Starbucks does carry outstanding balances as deferred revenue (a liability) as well, but once the cards are deemed unlikely to be redeemed, it treats the unclaimed balance as an asset. Part III – Trend Analysis of Sales and Earnings Growth During 2006 - 2010 Review Starbucks income statement and common size income statement for the years 2006 through 2010. Identify and comment on the major trends in the growth in Starbucks sales and earnings, including: a. Sales growth – was Starbucks’ sales growth consistent or inconsistent over the above five year period?

Do you see signs of acceleration or deceleration in Starbucks’ historic growth rates? How does Starbucks’ sales growth compare to its industry averages? Are same store sales or the opening of new stores the more important factor in driving Starbucks’ sales growth during this period? Do you believe Starbucks sale trends over the past few years will continue over the next two to three years? Please provide rationale for your belief. Starbucks’ sales growth was inconsistent over the above 5 year period. Data from the last 5 years suggests that Starbucks’ growth rate is actually decelerating.

Starbucks’ sales growth was below the industry sales growth. The industry has average 9. 25% over the last 5 years while Starbucks averaged 7. 5% only. The opening of new stores is vital to Starbucks’ sales strategy. During 2006, 2007, and 2008, Starbucks added 2199, 2571, and 1669 net stores. During the same years, sales grew by 22%, 21%, and 10% respectively. During 2009, Starbucks reduced 45 stores and their sales dropped by 7%. In 2010, Starbucks added 223 stores and not surprisingly their sales increased by 10%. In our opinion, Starbucks’ sales will continue to grow but at a decreasing rate over the next 2 to 3 years.

This projection is based on historical sales data from the last 5 years which suggest a deceleration of sales growth. Starbucks’ average sales growth for the last 5 years is 11%. In 2006, Starbucks’ sales grew by 22%. This suggests a deceleration of sales growth. b. Gross margins – did gross margins expand, contract or hold steady over the period? What major factors account for the trend you’ve identified? The gross margin has held steady over the last 5 years ranging anywhere from 55% to 59%. Gross margin is affected by sales and cost of sales. c.

Operating expense – make sure you look at operating expenses in both absolute dollar terms and as a percent of sales. Did operating expenses grow slower, faster or at the same rate as revenues? Would you expect to see more leverage on Starbucks’ cost base, given their growth history? (Note: operating leverage is demonstrated when a company’s operating expenses grow at slower rate than its sales, thereby resulting in operating earnings growing faster than sales. ) Do you believe Starbucks’ cost base is mostly fixed, mostly variable or an equal mix of each?

What implication does the structure of Starbucks cost base (i. e. % fixed / variable) have on the relationship between the growth rates of revenues and earnings? Make sure you present information to support your conclusion. Operating expenses have grown at a higher rate than revenues over the last 5 years. Revenues grew at an average of 7% while operating expenses have grown at an average of 11. 34%. Based on these numbers, we expect to see less leverage on Starbucks’ cost base as operating expenses are growing at a higher rate than revenues.

The fact that Starbucks’ operating expenses are growing at a higher rate than its revenues shows that Starbucks’ cost base is mostly variable. This is also proven by the income statement as most of Starbucks’ operating expenses are Cost of Sales and Store Operating expenses. Most of these are usually variable. Having more variable expenses usually means that earnings will not necessarily grow at the same rate as revenues. This is demonstrated by the income statement from the last 5 years. Starbucks’ revenues and earnings have grown at different rates over each year of the last 5 years.

The average earnings growth per year over the last 5 years is 12. 62% as compared to an average sales growth per year of 7. 5%. d. Operating income – have operating earnings grown at the same rate, faster or slower than sales? What factors (e. g. gross margins, operating expense/charges) account for the trend you’ve identified? Be specific and provide support for your answer. Operating income has grown at a faster rate than sales on a per year basis over the last 5 years. Sales growth has averaged 7. 5% per year as compared to an operating income growth of 11. 75% per year during the same period.

The reason that operating income has grown so fast is because Starbucks recently made changes to its cost structure that made it more efficient. As per the 10-k statement filed with the SEC, Starbucks decreased its Cost of Sales by 260 basis points by making their supply chain process more efficient. This resulted in lower food, beverage, and paper packaging costs. Because of its sales leverage, Starbucks was also able to decrease its occupancy costs. Because of the reduced costs, Starbucks was able to have a higher operating income in 2010. This caused the 5 year average to jump up to 11. 75%.

Also contributing to this growth was the fact that sales increased at a higher rate than operating expenses. Therefore, operating income also went up at a higher rate than sales. e. Net Income - has net income grown at the same rate, faster or slower than sales? What factors (e. g. gross margins, operating expense, non-operating items) account for the trend you’ve identified? Be specific and provide support for your answer. Net Income has increased at a higher rate than sales also on a per year basis for the last five years. In fact, Net Income has pretty much mirrored Operating Income in growth.

The factors tied to Net Income are Sales, Operating Expenses, Interest, and Taxes. Taxes remained relatively proportionate EBT each year. During each of the 5 years, Starbucks experienced a positive interest income for 3 years and a negative for 2 years. This helped Starbucks increase their Net Income. However, the factor that affected Net Income the most was Operating Expenses. Operating expenses grew at a slower rate than sales from 2006 to 2010. This resulted in Starbucks having a higher Operating Income which in turn resulted in a higher net income. Starbucks’ net income grew by 142. 2% in 2010 from the previous year. This big change resulted in the average net income growth rate to increase to 12. 62%. During the same period, Sales has grown by 7. 5% and operating expenses grew by 7%. All of this contributed to the Net Income growing at a higher rate than sales. f. Earnings per share – Does Starbucks’ earnings per share increase/decrease at a rate consistent with revenue and net income. Why is this? Do you expect this relationship to continue into the future? Starbucks’ EPS increases and decreases at a rate consistent with net income but not sales.

This is because earnings per share are calculated by taking the net income and dividing that into the number of shares outstanding. As a result, there is a direct correlation with net income and not sales. We expect this relationship to continue in the future as long as the number of shares outstanding doesn’t change drastically each year. Part IV – Analysis of Operating Efficiency, Liquidity and Solvency Using data included in the Form 10-K analyze Starbucks’ operating efficiency and liquidity. That is, answer the questions below.

The ratio definitions used to calculate the figures in the Ratio Analysis table are described in the text and lecture notes. a. Operating efficiency: Turnover ratios. In one paragraph, explain what the values of turnover ratios reveal about Starbucks. That is, for each ratio, discuss the trend, compare Starbucks’ ratio to the industry average (for receivables, inventory turnover and asset turnover only) and discuss whether the trend indicates improvements or deteriorations in operating efficiency. Can you think of any other measures that would be useful to assess Starbucks’ operational efficiency?

Turnover ratios reveal that in 2010, Starbucks’ sales increased. Receivables turnover jumped up slightly from previous years to 37. 31. The industry’s 2009 median receivables turnover is significantly higher than Starbucks’ at about 98. 64. This trend indicates that Starbucks made less sales on credit in 2010. It could also mean that Starbucks improved collecting on its accounts receivables; however, since Starbucks’ average collection period ratio has not changed in the last three years (holding steady at about 11 days), there is no indication that collection on receivables has improved. The inventory turnover ratio of 7. 8, which slightly increased from 2009, also suggests a decrease in inventories, which is supported by the drop of inventory assets shown on the balance sheet. This trend supports the observation that sales have increased significantly for Starbucks in 2010 which is always an improvement for any business. PP&E Turnover ratio of 4. 32, which increased from 2009, again, demonstrates higher sales since PP&E remained at similar levels as previous years per the balance sheet. Total asset turnover, 1. 79, remained very close to last year, and is slightly less than the industry average, 1. 3. This shows Starbucks continues to generate sales at a level of almost twice as much as they carry assets on their books. The fact that their asset turnover is slightly less than that of their competitors suggests that Starbucks may have more assets than their competitors. b. Liquidity: In one paragraph, explain what the liquidity ratios (current ratio, quick ratio and cash from operations ratio) reveal about Starbucks. Include an explanation of how the cash flow from operations ratio differs from the current and quick ratios. What is your conclusion egarding Starbucks’ liquidity position? With significant increases in 2010 in current ratio, 1. 55, and quick ratio, 0. 99, Starbucks is very liquid. Quick ratio shows they have 1. 5 times current assets on the books as they do current liabilities. Likewise, the quick ratio shows they would be able to cover current liabilities with their current assets. The cash from operations ratio is . 96, which states that Starbucks’ cash from operations would not be enough to cover its current liabilities. This ratio differs from the first two in that it compares a cash flow item to a balance sheet item.

It is an indication of a firm’s ability to pay off its current liabilities; however, it is the most conservative liquidity ratio since it excludes all current assets except for the most liquid: cash and equivalents. It tells that Starbucks would not quite be able to pay off all of its current liabilities with just its cash and equivalents, although it does come close. c. Solvency: Interpret the values of the relevant ratios and provide a conclusion regarding Starbucks’ ability to service its debt and risk of future insolvency. Does your conclusion change if you include “off balance sheet debt”.

How much off balance sheet debt does Starbucks have as of the end of the most recent fiscal year? Starbucks’ solvency ratios suggest that it is in a strong position and would likely be able to service its debt as it shows low risk of future solvency. It’s debt to equity ratio for 2010 of 0. 73 is at the lowest it has been in the past five years. From 2009 Starbucks had a big increase in retained earnings, this pushed all solvency ratios including interest coverage, return on assets, and return on equity up. ROA and ROE were doubled from 2009 to 0. 16 and 0. 28 respectively.

Likewise, interest coverage also had a big jump due to a significant increase in earnings before interest and taxes. If we include “off balance sheet debt, Starbucks debt to equity ratio increases a bit, but the trend still shows that this ratio has decreased significantly in 2010. The increase would not be enough to state that Starbucks runs a high risk of insolvency. Starbucks has $4,084. 2 in off balance sheet debt as of end of most recent fiscal year. (We assume that the numbers provided are in millions). Part V – Analysis of Cash Flow Refer to Starbucks’ cash flow statement: a.

During the past three years, what was Starbucks’ largest source of cash? What were Starbucks’ two largest uses of cash? a. For the past 3 years, the largest source of cash for Starbucks was Net earnings including non-controlling assets from its operating activities. Starbucks’ two largest uses of cash were additions to property, plant and equipment, as well as purchasing available for sale securities. It is stated in the 10-k that the major components of the PPE spending were remodeling and upgrading equipment in stores, as well as updating the IT infrastructure of the retail network. b.

For the past three fiscal years, has Starbucks’ CFO been adequate to fund its growth initiatives? If no, how has Starbucks funded the CFO shortfalls to fund growth? a. As stated in the 10-K Starbucks’ believes that cash flows generated from operations and existing cash and short term investments should be enough to support their core business activities. However, it is also stated that new business opportunities, joint ventures, and acquisitions would have to utilize outside funding sources. Starbucks has augmented to their cash flows by heavily investing in available for sale securities, and purchasing US Agency and investment grade bonds.

These investments, and outside financing, can be used to fund growth initiatives while CFO can be used to support Starbucks’ core retail business. The 10K also mentions that the issuance of commercial paper and its proceeds can be used for working capital needs, capital expenditures, and other corporate purposes, including acquisitions and share repurchases. c. Based on your review of Starbucks’ cash flow statement, has Starbucks’ growth been driven by organic growth or acquisitions? Provide support for your answer. a.

Starbucks growth has been driven organically, with strong, steady growth in net earnings including non-controlling interests, and investing a large amount of cash in property, plant, and equipment by opening new retail locations and upgrading existing stores and information systems. By utilizing CFO and short term investment earnings to support their core business, Starbucks’ has maintained a high growth, very successful retail operation. Acquisitions play a minor role compared to the growth and earnings from operating activities. d. If Starbucks continues to grow at its historic rates, does it appear that Starbucks’ CFO can fund this growth?

If CFO isn’t sufficient, how might Starbucks fund its future growth? a. Yes, it does appear that Starbucks’ CFO can fund its historic growth. This is stated in the 10k; CFO and short term investments, as well as any potential future borrowings and the commercial paper program can support the existing core business as well as related marketing support, product innovations, and new business opportunities related to the core business. If CFO is not sufficient to fund the historic growth, Starbucks can utilize channels within the investment and finance sections of the cash flow statement.

Particularly, Starbucks can invest more heavily in short term investments, and utilize the commercial paper program. Additionally, Starbucks purchases available for sale securities heavily – these could be sold in the future to fund any growth where CFO is not adequate to support the core business. e. During the past three fiscal years, what dollar amount of common stock did Starbucks repurchase and what dollar amount of dividends did they pay? Why would Starbucks repurchase their own stock and/or pay a dividend? How does this impact Starbucks ability to fund future growth?

How did Starbucks’ strategy with regard to share repurchases and dividends change during the past few years? Why did it change? a. In 2008, Starbucks repurchased $ 311. 4 million in common stock. In 2009, Starbucks did not repurchase any stock. In 2010, Starbucks repurchased $ 285. 6 million in common stock. Starbucks may want to repurchase their own stock so that they can increase their earnings per share ratio. This is especially true if Starbucks shares were perceived as undervalued, as Starbucks can repurchase the shares and hold them in the treasury for future reissuance at a higher price.

Starbucks may be able to obtain more financing and loans with better earnings per share ratio as well. Dividends can be paid to shareholders to increase the value of their shares, and encourage other interested parties to purchase Starbucks shares. Paying dividends is a way to help impact positive future growth by making the purchase of Starbucks stock more profitable – more people will want to buy it providing more cash for Starbucks to utilize. In the 10-k, it is stated that Starbucks had 1. 7 billion in CFO for 2010 compared to 1. 4 billion in fiscal 2009, and capital expenditures were approximately 440 million in both fiscal years.

This left roughly $460 million for stock repurchases and dividends. Starbucks had to repay short term borrowings in 2008 and 2009, but did not have to use cash for repayment in 2010. The cash that would have been used to payback short term borrowings could instead be used to repurchase stock and pay dividends. Thus, the strategy changed because Starbucks was able to operate without short term borrowings in 2010, and was able to pass on the excess case to shareholders. Part VI – Market Valuation a. What is Starbuck’s net book value as of the end of the most recent fiscal year?

What was Starbuck’s market capitalization as of that date? Why is there a difference in these two amounts? What specific items do you think comprise the difference? Starbucks’ net book value as of the end of 2010 fiscal year was $3,611,500,000 while its market cap was $19,270,826,000. The reason that the two numbers are different is because the net book value is calculated by taking the total assets of Starbucks and subtracting its intangible assets and total liabilities, while the market cap is calculated by multiplying the outstanding shares into the stock price.

Because each is calculated using 5 different numbers, there will almost always be a difference in the two numbers. b. Do you believe the difference between Starbuck’s net book value and market capitalization will increase or decrease in the future? What specific factors or trends identified in Starbucks’ financial information (or identified elsewhere) support your view? We believe that the difference between Starbucks’ net book value and market capitalization will decrease in the future.

One of the biggest reasons for this is the fact that Starbucks restructured its Supply Chain process to lower costs. As a result, net income grew by 142% in 2010. This was a huge turnaround by Starbucks in one year and it can be attributed to the fact that leadership identified and implemented this cost saving mechanism. Another trend that indicates that Starbucks is on its way back is the fact that they opened more stores than they closed in the last 2 years. This strategy is key to Starbucks succeeding. Third, Starbucks’ gross margin has remained constant in the last 5 years despite the down years.

This shows that management knows how to cut down on costs when times are rough, or that despite financial downturns, people are still willing to pay for expensive coffee. Conclusion Refer to your responses in Part 1: How do the results of your analysis in Parts II through VI support or contradict your original thoughts regarding Starbucks growth strategy and the success or failure of the three action areas (growth initiatives) you identified? Our assumption on their strategy to saturate the U. S. Market by building as any stores as possible is supported by our discussion on sales growth, which shows that there is a direct correlation between sales revenue growth and net new stores opened. Likewise, in analyzing the CFO, we concluded that Starbucks has grown organically through their investment in PP&E, which corroborates our original thoughts. Although they probably realized they were overdoing it with having a Starbucks on every corner, their growth strategy of increasing store numbers has been a success for the company as sales have also increased.

Going forward, the challenge will be to maintain high sales rates while being able to cover its large PP&E/overhead expenses. Although we didn’t really analyze the impact of international expansion in our analysis above, according to the company’s 10-K, operating income from international activities more than doubled from 2009 to 2010; however, this increase was mostly due to foreign currency translation among other things. Therefore, our original thoughts are not necessarily proven by the data that we analyzed. Finally, we stated that one of Starbucks’ growth strategies was to develop alternative revenue sources.

As we looked deeper at the reasons for sales growth, we noticed that licensing and food service both were strong contributors to the increases in net revenues. Our discussion on sales growth indirectly supports this hypothesis, since the increase in net revenues was affected by an increase in average value per transaction (as stated in the 10-K). This means that customers are not just buying coffee at the checkout stand because Starbucks is being successful at selling other complimentary goods along with their drinks. Therefore, this is definitely being a successful growth strategy for Starbucks.

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