By Refusing To Franchise, Starbucks Keeps Greater Control Of Business

By Refusing To Franchise, Starbucks Keeps Greater Control Of Business

Even though most US-based restaurant chains are re-franchising their operations, Starbucks is content with wholly-owning all its stores in the US. We analyze if the coffee chain is losing out due to that strategy

By Usman Farooq on May 20, 2014 at 8:17 am EST

Starbucks Corporation (SBUX), the Seattle-based coffeehouse company, has close to 19,000 stores worldwide, most of which are company-operated. The few exceptions include large retailers who stock Starbucks-branded coffee, tea and other products, with whom Starbucks has entered licensing agreements, and stores in the UK which the company franchised to lower its risks and bolster its operational efficiency in a challenging cultural and economic environment.

Total revenues from licensing fees and royalties accounted for only 9% of Starbucks’s revenues last year, and it seems as if the company is consciously refraining from adopting a wide scale network of franchised outlets in the domestic market. It may be doing so in order to maintain standards across its widespread stores, and to exercise complete control over customer service and product quality, which have been its hallmark features.

In contrast, other restaurant chains in the country, like The Wendy’s Co (WEN), McDonalds Corporation (MCD) and Burger King Worldwide Inc. (BKW), have been aggressively reducing their ownership in restaurant outlets in an attempt to move towards leaner cost structures and to boost their operating margins as health-conscious consumers and a global economic slowdown weigh on the industry’s earnings.

For example, Wendy’s has re-franchised 418 stores since July last year, and aims to reduce its ownership of restaurants from 22% to 15% by the end of this year. Its re-franchising efforts have yielded big gains: the company’s first quarter net income for the ongoing fiscal year came to $46.3 million, compared to only $2.1 million in the same quarter of last year.

Likewise, Burger King, the Florida-based fast food chain, started re-franchising in 2010 and as of the end of March this year, owns just 52 of the 13,677 restaurants that carry its name around the world. Its refranchising efforts helped the company post net income growth of 24.6% in its most recently reported quarter. Earnings, too, grew 18% YoY to 20 cents per share in the period, while its operating margin expanded from 53.2% in the fourth quarter last year to 54.5% in the first quarter of the ongoing year.

McDonald’s, which collected a third of its revenues from franchised restaurants last year, reported an annual operating margin of 82.4% for franchised restaurants, and an operating margin of 17.5% for company-owned stores. Operating margins at franchised restaurants have consistently remained near the 82% mark since 2008, when McDonald’s first began to aggressively franchise its outlets.

The Case for Starbucks

Starbucks’s operating margins have hovered around the 12.3% mark for the last five years, mainly due to the burden of controlling all its worldwide operations directly. For its most recent quarter, the company reported only 9.4% year-over-year (YoY) growth in net income, compared to the double-digit growth rates reported by Wendy’s and Burger King.

But Starbucks has a fair number of solid reasons for retaining store ownership, particularly in the domestic segment. The company’s revenues have grown at an average annual rate of 9.2% in North America over the last three years, and 22.4% in China and the Asia Pacific, where the company is looking to aggressively expand. Its operating margins, although not as high as they could have been had it franchised a sizable number of its stores, are still stable and healthy, especially considering that the aftershocks of the 2008 financial crisis have still not quite dissipated.

On the other hand, restaurants like Wendy’s, Burger King and McDonald’s are seeing their lavish, high-calorie offerings being rejected by health-conscious consumers, which seems to be a motivating reason behind their frantic attempts to bolster operating margins through franchising deals. They are doing this even at the potential risk of jeopardizing their operational control over the business.

Starbucks falls in a different league altogether: its main offering, coffee, is frequently touted for its health benefits, and a Starbucks coffee cup, which costs $3-4 on average, is not a bad bargain. The company’s decision to keep a tight leash on quality control and consistency, which can be ensured only through direct ownership, therefore seems like sound strategy. Furthermore, the availability of tangible growth prospects abroad leave it in no compulsion to experiment with a strategy that may weaken its core revenue streams and dilute its operational efficiency. With those reasons in mind, Starbucks seems to be doing just the right thing by not relinquishing control.

For more information on Starbucks, refer to our in-depth investment analysis of the company here.

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