The Numbers Don't Lie: This Starbucks Move Was Sheer Genius

Last Tuesday an arbitrator ruled that Starbucks (NASDAQ: SBUX  ) will need to fork over almost $2.8 billion to Kraft Foods (NASDAQ: KRFT  ) for the coffee giant's decision to sever ties early with the company back in 2011. (In 2012, Kraft Foods spun off into Kraft and Mondelez International  (NASDAQ: MDLZ  ) , which will receive the proceeds of this ruling.) Since then, there has been plenty of debate as to whether or not Starbucks' decision was a smart one. 

Don't be a chump
On one hand, $2.8 billion isn't chump change. But on the other, investors would be wise (nay, Foolish) to consider the bigger picture here. It's all about the future for Starbucks, not the past. With that in mind, I took a closer look at the numbers and what this all means for Starbucks over the coming years.

It's important to note that this relationship with Kraft dates back to 1998, when Starbucks' channel development was a fledgling business just gaining traction. Today it's a $1.5 billion (and growing) business. This deal was set to expire in March 2014, at which time both parties would look at the situation and consider renegotiation.

Starbucks offered Kraft $750 million in 2010 to end the relationship. Kraft said no; Starbucks decided to leave anyway and terminated the agreement effective March 1, 2011. Since that time in 2011, Starbucks' channel development segment has made $1.1 billion in operating profit, and growth is still accelerating. In fact, channel development operating profit grew 61% in 2012 and 67% in 2013.

This contract was set to expire in 2014. From the time Starbucks left in 2011 to the time the contract would have expired in 2014, the channel development segment would have earned about $1.6 billion. This number is based on the actual numbers from 2011 to 2013 as well as on assumptions based on company and analyst expectations for the upcoming fiscal 2014 year.
So there's one threshold right there: $1.6 billion is less than $2.8 billion. Based on that perspective, one might say that Starbucks made a poor decision.

Here's the interesting thing, though: Using some base assumptions on what we know in regard to the higher margins, channel development will continue to bring in along with some very reasonable sales growth numbers (7% annually through 2020); over the course of the next seven years (2014 through 2020) channel development will bring in at least $5.8 billion in total operating profit. It's also worth noting you can ratchet those sales assumptions back if you like, but it doesn't change much.

It could further be argued that Starbucks' success from 2011 to date with channel development is a direct result of its taking back full control in 2011. Kraft was at a point in the relationship where it was dragging down the segment, not propping it up. I don't think Starbucks would have had near the freedom to pursue grocery, K-cups, Via, Verismo, and other relationships if it had still been anchored to Kraft.

Lawyers, Oreos, and coffee
So, yes, Mondelez, Kraft, and a bunch of lawyers that had nothing to do with anything are winners with this judgment, no question at all. But this move gave Starbucks its freedom much sooner than it would have gotten it otherwise, which gave management significant time to formulate and begin executing this channel-development strategy that is still in the early stages of playing out today.

Kraft/Mondelez needs Starbucks more than Starbucks needs Kraft/Mondelez. I'm sure many will continue to debate whether or not Starbucks made the right move bagging this deal. And I'm also certain that Starbucks management didn't see this judgment coming down quite so harshly. But this judgment wasn't made willy-nilly; the court knew what it was doing. And it sure looks like Starbucks did too.

The Foolish bottom line
Investors can make up their own minds regarding this move. But I have no doubt that Starbucks breaking up with Kraft in 2011 was absolutely, 100%, without a doubt the right move for the company to make, and the numbers bear that out. Starbucks management is focused more on the future and not what has already been done. And judging by the way the stock has reacted since this ruling came down, it seems the market agrees.

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Read/Post Comments (5) | Recommend This Article (6)

Comments from our Foolish Readers

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 November 18, 2013, at 8:03 PM, GaryDMN wrote:

    Kraft is a much better long term investment. Starbucks has peeked and in no longer a growth company.

  • Report this Comment On November 18, 2013, at 8:50 PM, 10kreader wrote:

    Please get your # correct.

    Per SBUX 10-k, in 2013 it has $14.9 B revenue and $12.7B operating expenses which makes its operating margin at 14%. Shall we say the margin at $4/cup retail is more than the CPG channel. Even at the same 14%, from 2011-2014, its CPG may have had sales of say, $4B. That's merely $600M in operating profit contribution, vs. a judgment of $2.8B. Bad for investors!!!!

    Indeed, for a business's operating margin to leap 66% YOY, as indicated in your article, it has to start from much lower basis, say 2-3%. This will further diminish the $600M cumulative profit estimates.

    It's a bad temper someone threw out there and it costs the investors dearly Billions!!!!!

  • Report this Comment On November 18, 2013, at 9:52 PM, TMFJMo wrote:

    @10kreader: You need to go back and check your numbers again. Channel development operating income for the year ended September 29, 2013 was $415.5 million alone and that's per the company filing for 4Q.

    You are right that the company's blended operating margin is around 14% but your assumption in regard to the channel development operating margin isn't only a bad guess, it's flat-out not even close as the actual number is around 30%. Check the calls, read the filings, it's all there.

    @GaryDMN: I guess we'll just agree to disagree.

  • Report this Comment On November 19, 2013, at 1:38 AM, 10kreader wrote:

    @TMFJMo, two things here

    1. If you study how SBUX allocates cost to difference businesses, it will show it heavily favors CPG. The actual incremental cost to run its own CPG is much bigger than what was printed in paper. So the operating income for CPG is overstated by overloading NA retail with cost.

    2. The $2.8B penalty should be compared to the 3-year cumulative Op income on incremental basis. It's not SBUX will not make money if it were to continue with Kraft. So the incremental benefits of having it in house is much less than the $1B or so reported income.

    Which ever way you cut it, it looks like someone broke a lease with 3 months to go and ended up paying a penalty that is more than 9-month rent.

  • Report this Comment On November 19, 2013, at 12:27 PM, nerrad714 wrote:

    Another reason it's a good move is that Kraft has a dysfunctional appetite for bureaucracy which has stunted growth and innovation for years.

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