From the September 2011 issue of Treasury & Risk magazine

Intense Times at Starbucks

On the steep road to growth, Treasurer Richard Lautch and his team conquer the challenges of commodities hedging, debt and free cash flow.

When Richard Lautch joined Starbucks as its treasurer in 1999, the Seattle-based company had fewer than 2,500 stores in four countries—the United States, Canada, Japan and the United Kingdom. Today, its global empire comprises more than 17,000 stores in 55 countries. You can order a double mocha latte venti in such faraway places as Oman and Qatar. All this is the stuff of legend, but the company’s extraordinary growth still startles Lautch, a youthful 46-year-old Brit whose whippet build is thanks to years as a competitive ultra-marathon cyclist. “It has been an amazing ride,” he says, sitting in a conference room at Starbucks’ headquarters building, a former Sears catalog warehouse built in 1912, in Seattle’s trendy Sodo area.

On this day, Lautch’s left forearm and hand are bandaged, the consequence of a recent spill off his bike in a race, his second bad fall this year. Despite the accident, he somehow managed to finish the event, called RAMROD, for Ride Around Mount Rainier in One Day. The 152-mile race is not for the faint-hearted—contestants cycle 10,000 feet up Mount Rainier, one of the deadliest volcanoes in the U.S.

“The person in front of me slowed down, and I was hit from behind and fell,” Lautch says, wincing at the memory. “No stitches fortunately, but lots of road rash and hurt pride. Tarmac is always hard.”

Even harder might be the challenges Lautch has faced in recent years, including altering the company’s historic approach to debt, hedging and free cash flow. The fact that these projects fell to treasury—a centralized operation globally, except for regionally managed operations in China—underscores the vital role the group plays as Starbucks continues its mind-bending growth and transformation.

Let’s start with the Starbucks approach to commodity risks and their volatile impact on profit and loss. While the reader is probably thinking “coffee,” it is actually the latte part of the cup that Lautch tinkered with first. “We have a big exposure to dairy—to milk,” he says. “We didn’t have any means of fixing price with our suppliers. Companies like Safeway that supply us were prohibited from doing fluid milk—Class I—hedges with farmers. Because of this they had no interest in hedging with us.”

For suppliers to hedge with Starbucks would require them to have a fixed contract on one side with the company and a variable contract with the farmers on the other side. “They wouldn’t want to have this mismatch, so we had to go directly to the farmers,” Lautch says.

“We worked out a swap structure, really a swap auction, with a few farm cooperatives in 2005—the first-ever Class I milk swaps approved by the USDA and Commodity Futures Trading Commission,” he says. “It was a kick.”

Things didn’t pan out as hoped, however. “We never got the volume we wanted and it was a big ‘hit or miss’ whether farmers would want to hedge,” Lautch explains. “Then there was a reinterpretation of FAS 133 that resulted in us losing our hedge accounting. We still wanted to do something, so we started to think more broadly.”

The mulling led to another innovation—hedging using Class III milk futures based on cheese, the product that most closely matches fluid milk, as a proxy hedge. “I’d love to find the perfect hedge and we’re still looking, but for now we have something that works,” Lautch says. “We then branched into other commodities.”

For natural gas, which is what Starbucks’ roasting plants use for fuel, treasury was able to ink fixed-price contracts with producers. Diesel, burned by its trucks, was more complicated. “We’re hedging using the Weekly Retail On-Highway Diesel Prices, which is published by the Energy Information Administration within the Department of Energy, and then executing swaps with the banks,” he says.

When it comes to coffee, Starbucks’ coffee trading group, which buys coffee worldwide, executes the risk management. “We measure their risks, but they have the tools, using futures and some fixed-price purchases, to manage risk over the next 12 to 18 months,” Lautch explains. “That said, we are looking to help them by designing structures to hedge much longer term—out two to four years.”

Taken as a whole, the various commodities strategies have reduced P&L volatility “and helped create planning certainty for our supply chain operations and business units, allowing them to concentrate on operating efficiencies,” he says.

As Starbucks grew from a single store in 1971 to a company with $10.7 billion in revenue in 2010, building more and more stores was the mantra. “Historically, the organization was focused primarily on revenue and earnings metrics, not unusual for a high-growth company such as Starbucks,” explains CFO Troy Alstead.

While growing the top line and earnings per share remain key areas of focus, Starbucks is now placing additional emphasis on free cash flow. “We didn’t want to get in a situation where we were buying growth—striving to grow revenue and EPS, but making lower-quality investments, building stores that might be profitable but wouldn’t provide a good return on capital,” Lautch explains. “We also knew investors would increasingly want us to return cash to them.”

Treasury evaluated the company’s capital structure and contemplated how much debt would be appropriate. It also educated colleagues that store leases are akin to debt and should have a capital charge in investment decisions, which hadn’t previously been the case. “Banks see it that way, and some investors, too, but internally that isn’t necessarily the way people here were thinking—they saw us as a debt-free company, which we weren’t,” Lautch says. “When the company launched, we had very little debt, one tiny bank line and no money. We now had a capital structure that could bear some balance-sheet debt.”

This analysis took place in the mid-2000s, well before the financial crisis struck in 2008. “We looked at the current market credit spreads, which were razor thin and implied that we should lever up and become a BB company. This just didn’t seem right, so we took a different approach,” Lautch notes. “This involved looking at the average of credit spreads over the market cycle. We ended up targeting a BBB-plus [credit], which set up the framework for us to think about adding balance-sheet debt, distributions and dividends.”

Treasury set up a commercial paper program that can issue up to an aggregate amount of $1 billion outstanding at any time. Lautch says this alternative source of funding served the company well in the downturn, since the rates the company paid fell as business softened. A few months later, in August 2007, Starbucks did its first long-term debt issue, selling $550 million of 10-year notes.

These events were important steps in the company’s evolving capital structure. The latest installment occurred at the 2010 annual meeting, when CEO Howard Schultz announced that the company would start paying a dividend, equal to 35% to 40% of net income. “We made the argument that we can be a growth company and pay a dividend,” Lautch says. “If you’re throwing off strong free cash flow, as we were, you should return a portion to shareholders as dividends.”

Lautch was next tasked with increasing Starbucks’ return on invested capital. The target is 20%—a bit of a stretch given the company’s previous peak was 14.6% prior to the financial crisis, at the end of fiscal 2005. In fiscal 2006 and 2007, ROIC fell—the company was growing its lease portfolio faster than revenue and profits. “Some of those stores weren’t good stores,” he acknowledges. “Cost was creeping up, and performance wasn’t as good as could be hoped.”

The low point, not surprisingly, was fiscal 2008, when ROIC crawled into the mid-single-digits. Since then, it has been up, up and away. “We rationalized the store portfolio,” Lautch says. Starbucks axed about 900 underperforming shops in the last 18 months. The company “took out some capital with that, and since these stores were negative cash flow and negative P&L, it boosted our return,” he says. “We have transformed the company, are focused more on cost than ever before, and are taking it out while still improving customer experience.”

Consequently, cash flow is improving. Starbucks is driving more same-store sales, christening more stores—300 in the U.S. and 500 overseas so far this year—and getting the returns it wants. It hit the lofty 20% ROIC target and now is seriously considering hiking the target to 25% next year. “That would be a high mark for a company like ours,” Lautch says.

Alstead agrees: “We have a clear path toward the mid-twenties (ROIC) in the few years ahead of us, all while Starbucks continues deploying increasing levels of capital into high-growth, high-return opportunities.”

The treasurer’s keen focus on free cash flow and ROIC wins praise from his boss. “Largely as a result of Richard’s work and leadership, we are adding ROIC and its drivers as primary metrics to our reporting, our planning targets, and our compensation systems,” Alstead says.

Key banking partner Bank of America Merrill Lynch also offers kudos. “Richard was instrumental in assisting the company to build out its infrastructure for the long term and is very proactive at making sure the banks understand the company’s strategy,” says Cristin O’Hara, managing director of the consumer and retail corporate and investment banking group in B of A’s Boston office. “He was the driving force behind several key first-time financial initiatives for them, including putting in place their first revolver, increasing that to $1 billion in 2006 when Starbucks was looking to do share repurchases, issuing bonds and utilizing commercial paper. With Richard’s leadership, Starbucks has cultivated a supportive and diversified bank group and, like many high-grade companies, they have leveraged their good relationships when reducing the size of their credit facility to $500 million in their most recent deal with us. Again, he was vital to the process and is well-versed in the capital markets.”

As Lautch sees it, “It’s obvious that hedging is about risk management, but setting capital structure also requires a careful consideration of risk. If you have your market risk under control through a hedging program, it can allow you to use more of your debt capacity to take advantage of opportunities for investment.”

The treasurer is now riding herd on Starbucks’ plans to utilize couriers to carry cash to and from its retail stores in the U.S. “From the customer to the point of sale to getting the money into a wholesale banking structure is one of the biggest challenges a company has,” he says. “In our case, this has been handled by our store employees, who must stop what they’re doing, go to the nearest bank, wait on the teller line and come back to the store.”

Obviously, this is not the most efficient way to conduct business. “Have you seen the lines at our stores? We want the point of sale to be a sure, quick and easy transaction,” Lautch says. “Our loyalty card assists this aim by limiting the use of cash, but we’re always looking to do better.”

The primary aim of the courier strategy is not necessarily enhancing employee productivity—it’s about protecting them. Treasury is leading the strategy, which is not as easy as it might seem. “We have to know when stores will likely need cash or change and then manage that visit during store hours,” Lautch adds. “We also have to get our banking partners involved and manage the handoff between the courier and them. Behind all this is the record keeping. Multiply this by the number of stores and you can imagine.”

Tough work for sure. But with Lautch in tip-top shape, it’s just another jaunt up a mountain.

 

Earlier this year, Treasury & Risk wrote about Pitney Bowes Treasurer Helen Shan’s role in the company’s financial re-engineering, in Putting Her Stamp on the Revamp. And last year, it profiled Citi Treasurer Eric Aboaf’s efforts to remake the giant financial firm’s balance sheet, liquidity and funding profile, in Citi’s Balance Sheet Makeover.

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