Beware Sectors With Low Barriers to Entry

Companies like Starbucks are not always guaranteed success

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Sep 20, 2022
Summary
  • Starbucks is a great business success story.
  • But its challenges in some markets show the risks of the sector.
  • No company can take its competitive position for granted.
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Starbucks Corp. (

SBUX, Financial) has been an excellent stock to own over the past 15 years, having produced a total return of 14.4% per annum over this period.

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The company has been a great investment because it is fundamentally an excellent business (though it has recently encountered some challenges).

The group's business model is relatively straightforward: Operate well-managed coffee shops around the world using a cut-and-paste business model, so consumers know what they are getting wherever they are in the world.

Thanks to its economies of scale, the company can also achieve excellent profit margins in what is already quite a high-margin business.

Coffee is one of the highest-margin products there is as it can cost just a few cents to make on a mass scale, but can retail for several dollars.

Starbucks has one big advantage, and that is the brand. Now that it has a globally established brand, it does not cost the business much to set itself up in a new market. All it needs to do is fund the initial cost of the café premises and its brand should hopefully pull in the customers.

With the hard work of establishing a brand behind it, the company does not have to spend heavily on marketing. The business can afford to reinvest the majority of its profit back into growth and return some cash to shareholders with buybacks and dividends. In the past five years, it has reported an average gross profit margin of 27% and an average operating profit margin of 14%.

But despite the company’s runaway success overall, it has achieved a much more mixed performance on a market level.

A competitive market

Starbucks has tried to prosper around the world, but it has not always been successful. It has retreated from the Australian market and there have been rumors that the business is thinking about pulling out of the U.K.

Why would the world's most recognizable and powerful coffee chain even think about pulling out of the U.K., one of the world's biggest coffee markets? It comes down to competition.

Starbucks dominates most of the markets it operates in, but the market is much more competitive in the U.K. The largest player in the market is the homegrown coffee chain, Costa Coffee, which is now owned by Coca-Cola (

KO, Financial). There are approximately 3,000 Costa outlets, compared to just over 1,000 Starbucks outlets. Both of these figures pale in comparison to independent coffee shops. There are 25,000 independent coffee shops in the U.K.

This is a great case study for investors.

In an incredibly competitive market, even the biggest players are not guaranteed to maintain their market share. They might be able to grab a corner of the market, but with competition growing, it may only be a matter of time before they have to close down.

Coffee shops have no barriers to entry. One only needs the initial start-up capital to fit out the store. If one is really lucky, one might be able to lease out a coffee shop that has already been established. In this scenario, initial start-up costs would be almost zero.

Too much competition is the reason why

Warren Buffett (Trades, Portfolio) has previously said he would never invest in the restaurant business. I believe he was talking about investing in McDonald’s Corp. (MCD, Financial) at the time.

He said that anyone can start a restaurant and a lot of people do if they have a bit of spare money.

That makes it incredibly difficult to forecast how the industry and certain players will perform over a long time period. It is exactly the same with coffee shops.

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Disclosures

I/we have no positions in any stocks mentioned, and have no plans to buy any new positions in the stocks mentioned within the next 72 hours. Click for the complete disclosure
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