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How Starbucks Quietly Benefits From Its Most Passionate Customers

By Neil Patel - Jun 17, 2020 at 10:26AM

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The coffee chain's popular rewards program not only boosts loyalty, but gives the company another key advantage.

When it comes to customer loyalty programs, Starbucks (SBUX 1.19%) has one of the best. Its Starbucks Rewards program lets members earn "Stars" (reward points) that they can use to obtain free food and drinks. Another important benefit is that it allows coffee addicts to order ahead and pay with their phones.

Let's find out how this mobile payment method, coupled with the company's branded gift cards, provides Starbucks with attractive financing on extremely favorable terms.

Take my money

If someone wants to use a smartphone to place a Starbucks order, he or she must first load money onto the company's app. This is basically a digital version of a Starbucks gift card. Similarly, the company offers physical gift cards, which also require a customer to initially load them with an account balance. As of March 29, these customer prepaid balances (which Starbucks calls "Store value card liability and current portion of deferred revenue") totaled just over $1.4 billion.

Think about that for a second. Consumers love Starbucks so much that they're willing to make a deposit to redeem coffee at an unknown future date and time. Starbucks is essentially gaining access to an interest-free line of credit, one that equates to roughly 4% of the company's total liabilities. Whereas a traditional bank is severely restricted on the actions it can take using customer deposits, Starbucks has more leeway; it can reinvest directly back into the business on expansion opportunities. The company's free cash flow is also enhanced, as this phenomenon decreases working capital needs.

A customer parked outside a Starbucks holds a smartphone with the mobile app

Image source: Starbucks.

But wait, there's more. As if interest-free loans aren't good enough, a significant portion of these "coffee deposits" end up going unused. The value stored on mobile apps and gift cards has no expiration date, so Starbucks uses historical data to determine how much is expected not to be redeemed. The term it uses for this is breakage, and in FY 2019, Starbucks generated $141 million in revenue from it. Based on the current liability balance of $1.4 billion at the end of Q2 2020, previously mentioned, Starbucks actually earns interest at a rate of approximately 10% (meaning it borrows at an effective rate of negative 10%). This is astonishing. We live in a world run on caffeine and negative interest rates, after all -- so why can't Starbucks get in on the action?

So what's next?

During Q2 2020, Starbucks' number of active rewards members in the U.S. rose 15% over the same period last year, to 19.4 million. This followed growth of 16% in Q1 2020. Before the coronavirus pandemic, about 80% of customer orders were "on the go." With plans to accelerate this takeout trend, which consumers seem to love, Starbucks is positioning itself for a different future.

Since 2014, the amount stored in prepaid accounts has moved in lockstep with the growth in revenue, rising at a 10% clip annually. I suspect customers will use this payment option even more as the shift to mobile ordering and contactless pickup intensifies, and as membership in Starbucks Rewards climbs. These digitally savvy customers interact more with the company, which creates greater lifetime value for Starbucks. Furthermore, mobile order transactions have already seen fantastic growth since they were introduced; I see this turning into an even bigger piece of Starbucks' business as convenience, safety, and speed become increasingly important.

Next time you head to your favorite Starbucks location for a cup of Joe, think about purchasing some stock too.

Neil Patel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Starbucks. The Motley Fool has a disclosure policy.

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