STARBUCKS AND THE STAGES OF ECONOMIC MOATS
Economic moats are characteristics that help protect a company’s profitability just as Castle moats help protect people inside
There are 2 stages of economic moats: legacy (existing) and reinvestment (under construction)
Companies with reinvestment moats should invest more back in the business than legacy moat businesses
We believe the identification and evaluation of economic moats is an integral part of analyzing a company’s stock
Part 2 of a Series on Economic Moats
Building the Moat around Starbucks
Starbucks was founded in 1971 in Seattle’s Pike Place Market selling coffee beans and equipment. Longtime CEO Howard Shultz joined the company in 1982 and had a revelation on a trip to Italy. Shultz identified the romance of coffee bars along with the powerful connection their patrons had to what he would call a “Third Place” (in addition to home and work). When he decided to expand Starbucks into a chain, it already had a reasonably successful small business, but he made some conscious decisions that allowed for the creation of a moat. For one, he instilled a culture at Starbucks in which employees were called partners and given shares in the company along with health care benefits. This led to happier employees and better relationships with customers who became extremely loyal. Under Howard’s tutelage, Starbucks would institute guidelines to ensure that the Starbucks experience was consistent whether you visited a café in Seattle, Chicago, or Paris. As a barista in college, I mastered the recipes and lingo for the same menu that was being used globally. Starbucks would then go on to source coffee directly from farmers all around the world and perfect a signature roasting technique at their own roasting plants. Later, they became a pioneer in fintech with their mobile order and payment system. These actions were designed to build a consistent experience that customers craved, but it also built a moat that allowed the business to expand rapidly around the globe.
Reinvestment and Legacy Moats at Starbucks
Economic moats provide protection for a company’s profits enabling returns on investment that would not otherwise be possible. Economic moats are typically built over time and erode through competition if not properly maintained. Some companies have more and better opportunities to build onto their moats than others. I will use Starbucks as an example to illustrate the life cycle of economic moats and the connection to capital allocation along with the implications for investors:
Reinvestment Moats – A reinvestment moat represents the ability for a company to invest new capital at high rates of return. Starbucks had a playbook they could use to open new cafes with a high probability of success at rates of return far above their cost of capital, something that competitors could not match. The ability to replicate that concept for a coffee shop at scale by opening thousands of cafes was and is their reinvestment moat. Nothing is guaranteed, but one could reasonably assume that if one café were wildly profitable than the second would be and so would the 30,000th until they could saturate the global coffee market. This advantage allows the company to create considerable shareholder value through the reinvestment process.
Businesses with strong reinvestment moats are often categorized as growth companies by the investment community because the value of the business is mostly tied to cash flows that will be earned far into the future. Identifying companies with reinvestment moats before the rest of the market and thus not priced into the stock, is a successful strategy employed by many investors. A company with a reinvestment moat may not necessarily have impressive financial results today as the effects of the reinvestment moat will take some time to appear in financial statements. The company may be sacrificing current profitability for a brighter future! These companies should invest most or all their cash flow back into the business as a strategy to maximize the value of the company for the long term. If the reinvestment opportunities are large enough, they may even be wise to raise capital from debt or equity markets to take advantage. If Starbucks had not expanded so rapidly, it would have given competitors time to try and copy their business model and create formidable competitors. It is important however, for the company to disclose the economics of the typical location so an investor can ascertain the profitability of existing cafes independent of the costs to create new ones. A skilled investor will then use the information to create a financial model to project profits years into the future and back into a valuation of the shares of the company.
Legacy Moats – A legacy moat represents competitive advantages that protect a company’s current profits but offer little opportunity for expansion. It likely requires some spending to maintain, but there are not obvious opportunities to invest new capital at the high rates of return they achieved in the past. This is the natural evolution of a company and it does not happen overnight. Starbucks growth rate has naturally slowed because they are running out of room for new stores. It’s still a great business that generates enormous profits, but their historical growth rates are no longer possible. At the time Starbucks became a publicly traded company in 1992, it had 165 stores. A decade later they had 5,886. To achieve the same growth rate (from 30,000 today), Starbucks would need over 1,000,000 stores by 2030 or 1 for every 8,500 people projected to be on the planet at that time. So what is a company to do? Some companies like Apple can defy the odds and follow up the iPod with the iPhone but this is extremely rare. Starbucks tried this with a Tea chain called Teavana but ultimately could not replicate the magic in another beverage category. Today, Starbucks has a dwindling reinvestment moat in terms of capacity, but they still have a strong legacy moat that protect the profits of existing stores. Sure, there are many great local coffee shops but creating an empire to challenge Starbucks is another ordeal. They would need to spend billions of dollars on equipment, technology, R&D, and brand awareness that simply is not feasible.
Legacy moats are not necessarily a bad thing for investors. The key is that companies like Starbucks must recognize their opportunity set and resist the urge to reinvest all their cash flow. Many companies stumble in this transition. In fact, Starbucks went through a period around 2008 when they found they had grown too aggressively and closed some underperforming locations. Several that I used to work at no longer bear the siren logo. Following that realization, they implemented their first dividend in 2010. As a company’s cash flow starts to exceed their reinvestment moat, they are wise to spend that money in other ways. This means paying down debt, buying back their own stock and/or paying a dividend. At the time of this writing, Starbucks pays an annualized dividend of more than 2% of the stock price. I would expect the dividend yield to increase as the business continue to mature and it will likely eventually become known as a “value company”. This is the normal life cycle of a business and it can still be a great investment after reaching this stage. They must manage their capital differently and protect their moat. These types of stocks are also popular with investors because they often pay a high dividend in a world where income-producing investments are becoming scarce.
Our Take
At Aurora, we consider the presence of a moat to be a requirement to investing. We invest in companies with reinvestment moats as well as those with legacy moats where their capital allocation is aligned with their reinvestment opportunities. We believe this optimizes value creation for our clients. As always, it is vital to consider the price paid for an investment relative to their future cash flows. In future posts, we will continue expanding on this important investment topic of economic moats.
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states.
