Starbucks Corporations Commodity Market Risk

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Introduction

Starbucks is a high-end roaster, marketer, and retailer of speciality coffee globally (Starbucks Corporation, 2015). The company now operates in 65 countries since its inception in 1985 (Starbucks Corporation, 2015). Besides, it also trades at the NASDAQ Global Select Market. Starbucks purchases and roasts high-quality coffee from various parts of the world. In addition, it is also recognized for handcrafted coffee, tea alongside other beverages and a wide range of fresh food products generally in its operated retail outlets.

The company also sell different types of tea and coffee products and license its trademark to be used in other retail outlets, including grocery, licenced stores, and national foodservice arrangements (Starbucks Corporation, 2015, p. 2). Apart from its leading Starbucks Coffee brand, the company also sells goods and service under various brands, including Seattles Best Coffee, Tazo, Evolution Fresh, Teavana, Ethos, and La Boulange (Starbucks Corporation, 2015).

Currently, the company aims to maintain its position as one of the best and admired companies globally (Starbucks Corporation, 2015, p. 2).

This term project analyses a specific issue that Starbucks faces currently. It looks at strategic importance and urgency of the issue, and offers decisions, recommendations, justification, and implementation strategy.

Key Issue of Concern: Commodity Risk

Commodity market risk presents a significant challenge to Starbucks. Commodity risk represents the primary market risk brought about by buying of dairy products, green coffee, tea and other items the company uses to create its food and beverage items (PricewaterhouseCoopers, 2009, p. 40). These products are however faced with price volatility, in particular the green coffee. Further, the company also buys huge quantities of dairy products for its retail store line of business.

The company acknowledges that factors related to pricing and supply or availability of these vital commodities directly affects its fiscal results and operations (Starbucks Corporation, 2015, p. 40). In fact, specifically, coffee price is expected to affect future operations of Starbucks.

Findings

As previously mentioned, the rising costs of high-quality Arabica coffee beans and other commodities Starbucks uses in its retail stores generally affect the company operations. Besides, a decline in supplies of these commodities generally has a significant effect on financial results of the company.

It is generally acknowledged that the commodity market faces critical volatility issues. For instance, prices are notoriously subjected to sudden increment, and they may rise further because of some factors noted. First, Starbucks generally purchases the high-quality Arabica coffee. This type of coffee has always attracted premium prices. In addition, supplies and demands generally affect the price during the period of purchase, and there is a notable trend in amount of premium coffee supplied, which can differ considerably.

The pricing category of the high-quality Arabica coffee often increase. This situation leads to expensive coffee and difficulties in negotiating fixed prices under purchase agreements with various supplies. While Starbucks enters into negotiated contracts with its suppliers to determine the quality, delivery periods, quantity, and other relevant information, the supply contracts do not fix dates and prices. Instead, it is not known when the price of the commodity is fixed. Starbucks refers to these contracts as price-to-be fixed contracts (Starbucks Corporation, 2015).

Second, it has been noticed that a wide range of factors can influence prices of coffee and dairy products, which the company purchases. For instances, the major drought in Brazil in the year 2014 affected the quality and quantity of Arabica coffee. In addition, natural disasters, diseases, rising costs of farm inputs, levels of inventory, costs of production, and unstable political and economic environments, for instance, in Brazil will affect the price of these commodities significantly. Specifically, the El Niño weather system and persistent drought patterns in major coffee zones, such as Brazil, Columbia, and Indonesia, will result in rising coffee prices (Woody, 2015).

In addition, organizations, such as Fairtrade International, with stakes in coffee pricing have historically influenced green coffee pricing mainly through different agreements that aim to create export quotas or control supplies of coffee in the global markets (Fairtrade International, 2011).

Third, speculative tendencies in the global coffee market has hurt coffee pricing. Coffee beans are significant to the companys operations. It is however recognized that Starbucks might not fully mitigate future risk associated with the pricing through its purchasing habits and hedging approaches.

As such, future increment in prices of the high-quality Arabica coffee beans will adversely affect profitability of the company. In addition, if the company is not able to buy adequate quantities of green coffee because of some of the above-mentioned factors or a global or regional shortage, it will definitely not meet its demand targets and sales, which in turn would affect its revenues and profitability.

Fourth, the company also buys large quantities of dairy products, specifically milk for its retail operations. Since the year 2014, milk prices have remained low. Experts have however pointed out that such low prices are not expected to last much longer because of declining herd size and production of milk.

At this point, milk prices are expected to rise in the year 2016 (Constable, 2015). This implies that Starbucks will have to pay more for dairy products, which will ultimately affect its costs of goods and profitability. Specifically, it is observed that consumers are most likely to pay $1.25 per pound in the later period of 2016 (Ledman, 2015). In addition, the current favorable prices for skim and butter will not last. Current inventories and imports continue to hold down prices of cheese (Ledman, 2015).

Finally, while Starbucks consider other commodities, such as cocoa, meat, team, food inputs, energy, and baking ingredients among others as less important to its operations relative to coffee, these commodities have huge significant on its profitability once their supplies decline or prices increase, particularly in the global market.

As stated above, Starbucks buy various commodities, such as dairy products, meat, tea, and coffee for its retail operations. However, the company faces constant price fluctuations that affect its overall profitability. As such, Starbucks has adopted a combination of pricing methods established within its supply contracts and financial derivatives to control risk exposure from prices. For instance, it uses price-to-be-fixed contracts and fixed-price contracts mainly to purchase green high-quality Arabica coffee.

In the fiscal year 2014, for instance, Starbucks presented the possible effect of prices on net earnings and other comprehensive incomes if commodity prices had to change. The following table presents possible cases on commodity hedges.

Table 1: Commodity Hedges.

	Increase/(Decrease) to Net Earnings		Increase/(Decrease) to OCI
	10% Increase in Underlying Rate	10% Decrease in Underlying Rate	10% Increase in Underlying Rate	10% Decrease in Underlying Rate
Commodity hedges	$ 4 million	$ (4) million	$ 3 million	$ (3) million

Given these figures, many senior executives agree that commodity price risk is important, and it is a risk that requires immediate attention because of its impacts on financial performance. Perhaps, the company has not been able to manage commodity risk effectively.

Strategic Alternatives

It is imperative to recognize that most approaches used to manage commodity price risk generally focus on common elements of risk transfer to a third party using various strategies (PricewaterhouseCoopers, 2009, p. 28).

In this case, the customer is mostly affected when a company concentrates on margin management, procurement will impact the supplier while hedging will affect a financial institution involved in hedging (Erskine, Mauffette-Leenders, & Leenders, 2005). Apart from these strategies, other alternatives used to manage commodity risk price may not necessarily focus on risk transfer to third parties or risk mitigation. Instead, they focus on operational efficiency and innovation to create competitive edge.

Starbucks, however, requires approaches that are more radical to deal with commodity risk rather than the traditional approaches.

Therefore, the decisions presented focus on managing commodity risk price, but a radical approach that goes beyond margin management, procurement strategies, and hedging could be developed later.

Margin management

Starbucks is a consumer of Arabica coffee, tea, dairy products, energy, and other raw materials it uses to run its operations. The company, however, has been negatively impacted because of a rising commodity price. In this case, Starbucks cannot leverage firm sales price because of the nature of its supply contracts. In most instances, and for clear reasons, this might not be a good alternative since Starbucks will concentrate on managing margins.

The most preferred method of risk management in business is to avoid it completely by passing costs to consumers (PricewaterhouseCoopers, 2009). Any firm that can utilize this strategy effectively without any adverse impacts on its sales volumes may not experience any commodity risk challenges.

In practice though, factors related to pricing will influence market pricing. As noted above, the increasing demands for coffee, various coffee varieties available in the market, market concentrations, and availability of other alternative products such as tea, for instance, usually influence price elasticity. In the past few years after the recession, Starbucks major market, the North America, has experienced sustained growth and increased investments.

This implies marginal price increment has been effective, but not sustainable because of rising competition. Besides, Starbucks now faces declining global growth of its key target markets, such as China and Brazil. Hence, relying on margin management to manage commodity risk is becoming impossible and may not yield the desired results.

Procurement strategies

Apart from accepting commodity price risk or increasing prices of products to account for rising prices of commodities, Starbucks may also use its procurement strategies to control commodity price risk. In this case, Starbucks supply contracts concentrate on risks associated with Arabica coffee availability and reliability of supplies from its major suppliers, quality of these commodities, and the overall cost levels reserved for price-to-be-fixed contracts against some prevailing market benchmarks. Suppliers hardly present opportunities for Starbucks to manage its commodity risk. Starbucks has adopted fixed price contracts with its suppliers to achieve this objective.

It provides the simplest and direct method of fixing fluctuating prices of Arabica coffee and dairy products. It also assists the company to reduce risks associated with operational and financial risks while promoting supplies to some extent.

However, fixed contracts may only offer simplicity while the company may not enjoy falling prices. In most cases, organizations that supply coffee often advocate for higher prices and, at the same time, they expect Starbucks to commit itself to purchasing a given quantity of coffee based on the fixed price contract. Besides, given the expected rise in coffee prices in the near future, suppliers may not opt for prices that are below market averages.

Hedging

In most instances, the preferred, flexible, and worthwhile means of controlling commodity price risk is to rely on derivative financial tools to hedge any unknown price fluctuation factors in volatile markets (PricewaterhouseCoopers, 2009, p. 29). Financial derivative instruments are generally financial contracts, which a company can either trade or negotiate with service providers. Parties to the negotiation or trade may include coffee producers, processors or even consumers, and in the recent past, the company must now deal with speculators who wish to profit from fluctuations in commodity prices or investors focusing on diversified portfolios.

In the global coffee market, financial derivative instruments have allowed many companies to manage their financial risk exposure attributed to commodity price risk effectively and efficiently. These instruments are designed to meet specific risk exposure of the buyer. While they have worked in some instances, commodity markets however have some unique characteristics. By considering highly specific requirements of Starbucks risk profiles against product quality, timing of delivery and the location of delivery, commodity derivatives may not be effective in all cases (PricewaterhouseCoopers, 2009, p. 29).

For example, if Starbucks wishes to hedge a purchase of Arabica coffee from Brazil, there might be readily available alternative derivatives to use to attain this goal at fair prices. On the other hand, if Starbucks wants to hedge a purchase of Arabica coffee from Kenya, then it may have limited options because of supply and demand factors associated with coffee, as well as the distance. The basis, which is the difference between the hedging instrument and hedged commodity, often limits the application of derivatives in most cases. Besides, derivatives are complex, and they may bear unknown risks to consumers. In fact, flawed derivatives have often affected many players, including banks.

For instance, in 2012, JP Morgan lost more than $2 billion dollars on flawed derivatives linked to credit performance (Fitzpatrick, Zuckerman, & Rappaport, 2012). The bank senior executive referred to the trading strategy as flawed, complex, poorly conceived, poorly vetted, and poorly executed (Fitzpatrick et al., 2012, p. 1). Given such history of massive losses associated with derivative instruments, some traders may not opt for it to manage commodity price risk.

Just like any other commercial instrument, when used poorly, derivatives can cause massive unplanned financial losses to a company (PricewaterhouseCoopers, 2009). Hence, it is imperative to ensure that derivative hedging arrangements should be effectively controlled and managed.

Despite some critical inherent drawbacks associated with using commodity derivatives to manage losses, Starbucks has often used it successfully to manage potential risk exposure.

Decision Implementation

Hedging is therefore the most preferred approach to managing commodity price risk that Starbucks constantly faces in its operations. The company should consider hedging strategies that cover at least every trading quarters and extend to over a year.

Justification of One Strategic Alternative Using Qualitative Analysis

The company has noted that passing such costs to consumers affects its revenues, customer loyalty and profitability. As such, hedging will offer some advantages to Starbucks. While in the last few year coffee price has declined steadily, this situation is not sustainable for producers. In 2011 when the prices of high-quality coffee steadily increased to reach unsurpassed high of about $3/pound, the company suffered some financial setbacks.

For instance, it incurred additional cost of about $200 million in the financial year 2011 and even a higher figure in the fiscal year 2012 because of a lack of effective well-monitored hedging strategies. The rising commodity costs resulted in a significant increase in costs, which later resulted in declines of operating margins in the subsequent fiscal years.

At least one year of hedging strategy will cover the company from market uncertainties. After past losses, Starbucks had adopted some fixed-price contracts and variable-price on Arabica coffee. Hedging against increasing prices of commodities will generally assist the company to secure all Arabica coffee and dairy product supplies required for a given fiscal year at slightly better prices. Hedging commodity risk strategies will therefore ensure that Starbucks has sufficient supplies of inputs and improve its operations (Krikorian, 2014).

Starbucks must however ensure that hedging strategies are well managed and executed to avoid possible losses. Besides, the period of hedging should be comparatively shorter to ensure effective management of supplies and prices in a volatile market. Hedging will assist the company to stabilize its coffee and other food items prices, grow sales and realize increased profitability while protecting customer base simultaneously.

Starbucks should use its position as the global premium coffee company to leverage favored market conditions. Starbucks must realize that it has a limited market depth because of few producers of high-quality Arabica coffee. In this case, Starbucks commands a significant position in the small market of high-quality Arabica coffee. As such, it can realize significant benefits through enhanced active trading in Arabica coffee and, in some cases, take the role of a market leader and maker.

Besides, the company has intimate knowledge of coffee and dairy product commodity markets, which it should leverage for profitability. In this case, it will actively assess risks and mitigate it too. Hence, only hedging strategies supported with unique market knowledge and insights will allow Starbucks to make profits.

Conclusions

Starbucks, the premium coffee company, faces significant commodity price risk. In fact, commodity price risk management is vital for the overall profitability of the company. Starbucks, however, cannot continue to pass along high prices to its customers due to possible loss of market shares and revenues.

As such, effective approach to manage commodity price is necessary. While multiple strategies, such as procurement contracts and margin management, are available, it is noted that well managed and executed hedging strategies will assist Starbucks to manage commodity price risk. Further, the company should also move beyond the traditional approaches of cost management and focus on operational efficiency and flexibility, and innovation to develop its market share and profitability in the changing retail landscape (Bryan, 2016).

References

Bryan, B. (2016). STARBUCKS CEO: Were witnessing a seismic change in retail. Business Insider. Web.

Constable, S. (2015). Milk Prices Likely to Rise in 2016. Barrons. Web.

Erskine, J. A., Mauffette-Leenders, L. A., & Leenders, M. R. (2005). Learning with Cases. London, ON: Richard Ivey School of Business.

Fairtrade International. (2011). Fairtrade Coffee Standards and Pricing. Web.

Fitzpatrick, D., Zuckerman, G., & Rappaport, L. (2012). JP Morgans $2 Billion Blunder. The Wall Street Journal. Web.

Krikorian, M. (2014). Must-know risks: Why Starbucks should hedge its shrubs. Web.

Ledman, M. (2015). Expect Stronger Dairy Prices in 2016. Dairy Foods. Web.

PricewaterhouseCoopers. (2009). Navigation: Managing Commodity Risk through Market Uncertainty. Web.

Starbucks Corporation. (2015). Starbucks: Fiscal 2014 Annual Report. Seattle: Starbucks.

Woody, C. (2015). El Niño-related weather conditions could endanger coffee crops around the world and drive up prices. Business Insider. Web.

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