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In the book Rule Breakers, Rule Makers, Motley Fool co-founder and CEO Tom Gardner lays out certain criteria for judging a company worthy of "rule maker" status, i.e., a company that's the undisputed king of its market space, making for an investment that can be profitably held onto for years.  

This investing basics series takes well-known, consumer-facing companies and runs them step-by-step through Tom's merciless rule-maker gauntlet. Today we're looking at Starbucks (Nasdaq: SBUX  ) , ubiquitous purveyor of caffeinated beverages and enabler of coffee addictions. For our analysis, we'll be using the earnings numbers Starbucks released for the quarter ending July 3.

1. Automatic for the people
In terms of mass-market, repeat-purchase, (relatively) low-priced goods, Starbucks is it. People across the country, and increasingly around the globe, equate Starbucks with great coffee and come back day after day to get their fix.

2. Pricing power
Gross margin indicates brand strength and pricing power, and at 58%, Starbucks' is extraordinarily healthy, coming in just shy of our top-tier benchmark of 60%. For comparison, peers Dunkin Donuts (Nasdaq: DNKN  ) and McDonald's (NYSE: MCD  ) come in at a mouth-scorching 80% and a pleasant 40%, respectively.

3. The top line
Who doesn't like to see revenue increase? Starbucks picked up $320 million in new revenue for the quarter, giving growth of 12.3% and handily surpassing our top-tier benchmark of 10%.

4. The bottom line
Net margin tells us how much profit a company makes from every dollar of sales. Starbucks' is 9.5%, coming in just shy of our top-tier benchmark of 10%.

5. Cash rules, Fools
Rule makers should be cash heavy and debt light, ideally having at least 1.5 times more cash than debt. A look at the balance sheet tells us Starbucks has $549.4 million in debt and $1.72 billion in cash, for a cash-to-debt ratio of 3.13. Well done, Starbucks.

6. Lean and mean
The Foolish flow ratio measures how well a company manages its inventory and cash. To calculate it, take current assets minus cash and divide by current liabilities. Starbucks comes in at 1.0, telling us the company is keeping its inventory and accounts receivables low and paying suppliers on its own terms. The best companies have Foolish flow ratios of 1.0 or less.

7. What's in a name?
A lot. Your familiarity and interest in a company help you understand exactly what the business does and how it makes money, thereby lowering your overall risk. For me, Starbucks and its already iconic brand and simple business model get top marks.

Pretender to the throne, or king?
Mass-market appeal. Solid pricing power. Exceptional top and bottom lines. A great Foolish flow ratio and an easily understandable business model.

There's no doubt Starbucks is a coffee, and profit, making machine, but is it a rule maker? Stay tuned for Part 2 of this article, where we torture the numbers even more and find out what makes a rule maker a rule maker, and whether you should put your money where your latte is.

Fool contributor John Grgurich loves to ponder the mysteries of the universe over a venti drip and a raspberry scone, but owns no shares of any of the companies mentioned in this article. The Motley Fool owns shares of Starbucks. Motley Fool newsletter services have recommended buying shares of Starbucks and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 15, 2011, at 11:14 PM, germaineanne wrote:

    Enabler of coffee addictions, definitely. There was a certain lad in my life who introduced me to my first Starbux white chocolate mocha in DC, and I've been adding to their 'top line' ever since. Great article --- waiting with anticipation for your (Part 2) refill, JG.

  • Report this Comment On September 16, 2011, at 12:04 PM, surfbgull wrote:

    If cash is the fuel of rule-making power, SBUX, indeed, has it in spades. What is interesting is how well that cash flow has held up during significant downturns in the economy over the last three years. Should be interesting to see how their growth rate looks when their customers' cash flows more freely.

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