Wednesday, August 21, 2019

Starbucks, monetary superpower



I recently spent some time on Twitter discussing the monetary wonders of Starbucks. In this post I'll bring a bunch of tweets together into a single blog post.

I don't go to Starbucks very often, so I only recently learnt that the company has succeeded in getting many of its customers to stop using cash and debit/credit cards to buy coffee. Instead, they are using  Starbucks's own payments option:
Starbucks has around $1.6 billion in stored value card liabilities outstanding. This represents the sum of all physical gift cards held in customer's wallets as well as the digital value of electronic balances held in the Starbucks Mobile App.* It amounts to ~6% of all of the company's liabilities.

This is a pretty incredible number. Stored value card liabilities are the money that you, oh loyal Starbucks customer, use to buy coffee. What you might not realize is that these balances  simultaneously function as a loan to Starbucks. Starbucks doesn't pay any interest on balances held in the Starbucks app or gift cards. You, the loyal customer, are providing the company with free debt.

Starbucks isn't the only firm to get free lending from its customers. So does PayPal. That's right, customers who hold PayPal balances are effectively acting as PayPal's creditors. Customer loans to PayPal currently amount to over $20 billion. Like Starbucks, PayPal doesn't pay its customers a shred of interest. But Starbucks's gig is way better than PayPal's. PayPal is required to store customer's funds in a segregated account at a bank, or invest them in government bonds (see tweet below). So unfortunately for PayPal, it earns a paltry amount of interest on the funds that customers have lent it.

Starbucks, on the other hand, doesn't have to keep customer funds in a low yielding segregated account or government bonds. Why is that? PayPal allows people to cash-out of PayPal dollars into regular dollars, so for regulatory purposes it must keep an adequate reserve on hand to facilitate redemptions. But the only way to cash out of Starbucks balances is to buy a coffee--a promise that Starbucks can always keep! And so Starbucks can immediately put its customer loans to work in higher-yielding opportunities like funding its operations and expansion.

In addition to borrowing from its customers, Starbucks also borrows from professional investors. Here's a list Starbucks's long-term debt:


Starbucks is paying an interest to bond and note-holders that ranges as low as 0.46% (on its yen notes maturing in 2024) to 4.5% (on its 2048 notes). You can see why borrowing from customers in the form of stored value card liabilities is the better option. By expanding its borrowing from its non-professional lenders and using the proceeds to cancel its debts to professional lenders, Starbucks can make an immediate profit.

But there's more. As I pointed out in the following tweet, don't forget breakage. Bond and note holders are pros. They don't forget about debts. But customers aren't so exact. They are sloppy, or busy, or forgetful, which means that many gift cards and balances will go unspent:

Each year Starbucks recognizes that a portion of its stored value liabilities will be permanently lost. This is known as breakage. Starbucks recognizes this amount as profit. In 2018 the company recognized $155 million in breakage, around 10% of all stored value balances. Wow! Starbucks already pays just 0% on its debts to customers, but add in breakage and that equates to a roughly -10% interest rate!

On Twitter, Wayne points out to me that I need to add back the impact of Starbucks rewards. App users receive stars on each purchase which can be saved up for free coffee. This functions as a form of implicit interest that Starbucks pays to its customers.

That's a good point. But if were going to bring rewards into our calculation, then there are other non-pecuniary flows that need to be added in too. Keep in mind that each payment made through the Starbucks app is a payment that isn't made by credit card. Since each credit card payment will cost Starbucks 1-2% in interchange fees paid to the card networks and banks, the company saves a lot of money by guiding customers to its payments app. As for Wayne, while he may earn an implicit interest return in the form of Starbucks points, by forgoing a card payment he's giving up on the associated cash-back or airline points.

Another flow that needs to be accounted for is data. By capturing the customer's wallet, Starbucks is getting loads of free but valuable personal information that would otherwise be lost, or for which it would have to pay. Any customer who pays with cash forgoes rewards, but at least they get to retain their information. 

Adding all of this up, (0% interest + breakage - rewards + interchange savings + customer information), Starbucks's stored value liabilities are a terrific liability to have.

More generally, I think this calculation demonstrates how providing financial services to a retail customer base is a great business. Retail customers don't seem to be too fussy about the return they get. And they are busy and distracted and sloppy and forgetful. Take central banking, for instance, which serves a retail clientele. People are pretty happy to hold banknotes that pay 0%. But you never see businesses or professional investors hoarding banknotes. They quickly return the cash they take in during the course of the day to their bank so that they can harvest interest. Commercial banking is also a good example. Like Starbucks, banks are able to borrow from their retail customers at a measly rate approaching 0%. But professionals who lend to banks by purchasing their bonds require a much higher rate. To top it off, retail customers unnecessarily sign up for high-fee products and avoid changing banks when there is a cheaper option.  

Why doesn't every retail chain try get into this game? By borrowing as much as they can from the non-professional public, they'd steal plenty of profitable business from central banks and retail banks. Well they do. Gift cards are a big business. And if you think about it, retailers are perfect candidates for providing monetary services to the masses. Like banks, they already have a network of physical stores. But none of them have been successful at it as Starbucks. Walmart is much bigger than Starbucks, for instance, but it has just as many gift card balances outstanding:

Perhaps Starbucks's success has to do with the regularity and homogeneity of Starbucks purchases? And so customers are willing to preload a dedicated account? I'm not sure.

In any case, there are probably a few Starbucks executives who'd love to grow the amount of negative yielding liabilities that the firm issues. Why stop at $1.6 billion in stored value liabilities? Why not grow the program to $5 billion, $10 billion, or $100 billion? It would be a terrific business line to get into.

The problem here is that Starbucks only sells coffee. Coffee is great, but the demand for dollars that are only useful for buying coffee will always be limited. To really grow the amount of stored value liabilities it issues, Starbucks would have to increase the usefulness of Starbucks dollars. One way to do this would be to open up the Starbucks app up to other stores. If consumers could also buy Big Macs with the balances on Starbucks App, this would increase the demand for Starbucks balances. To secure McDonald's cooperation, Starbucks would have to share the savings, breakage, and data. Maybe companies like Home Depot and Costco would join the Starbucks-McDonald's alliance. (And other chains, say Kroger and Burger King, might join the competing Walmart Pay alliance).

Sure, each of these companies could simply pursue their own independent stored-value liability programs. But wouldn't an alliance be better? From the customer's perspective, balances held in a single payments app that can be spent at Starbucks, McDonald's, Home Hardware, or Costco would be far more useful then dollars held in four separate and walled-off apps. And so collectively these stores should be able to get the public to hold more stored value card liabilities than they could individually. Which means more breakage, free loans, and data for everyone (and less for the banks, card networks, and central banks).

Who knows if it would be successful. And it might not even be possible from a regulatory perspective. But it would be tempting, no? In a world where most debtors have to pay interest, being  a debtor who earns interest is pretty hard to beat.



*I believe that current portion of deferred revenue is equal to around $174 million. This comes courtesy of the current portion of an up front royalty payment from NestlĂ©. So the stored value card liability is actually closer to $1.46 billion. Still pretty high. 

42 comments:

  1. > One way to do this would be to open up the Starbucks app up to other stores.

    This might also reduce the amount of breakage though... consumers might be less likely to forget about their card balances if they are useful for buying more than just coffee.

    Might be an interesting experiment for Starbucks to run on a limited scale.

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    1. "This might also reduce the amount of breakage though... "

      Good point, Alex. And Starbucks might also lose some control over the customer experience, which it might not want to risk.

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    2. Then it just becomes a wallet!

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  2. This is awesome. I never knew Starbucks benefited so much from having customers store gift card balances!

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  3. Great article. Don't think there is any chance for McD to go with SB rather than solo, but calling attention to this better-than-free source of financing is quite insightful.

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  4. It's worth pointing out that it's unlikely customers are missing out on miles and/or reward points. A customer who is likely to purchase a coffee with a credit card is probably almost as likely to reload their balance with a credit card (which also means that Starbucks wouldn't completely avoid transaction fees albeit would avoid some of fixed cost fee per transaction by mandating a minimum reload).
    They also frequently incentivize reloads e.g. buy $10 worth of credit, receive $15; a marketing expense but if you're looking at liabilities as a 1:1 without considering costs then also going to factor in,

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    1. PK, good points. Yep, I missed that. Wayne would still get credit card rewards when he loads balances. And yes, Starbucks still has to pay interchange on Wayne's reload, although they'd save money since its cheaper for them to process one large $10 reload than four separate purchases of $2.50 coffees.

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    2. However, almost all credit cards don't offer points on recurring purchases. I have tried a number of my cc's to refill my starbucks app and none of them give me my cash back.

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  5. Online orders for in store pickup debit from your Starbucks account. So you have to top up that account, Minimum top up is $10, and defaults to $25. Could be a reason there is a lot of $$$ saved up vs other restaurants/retailers

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    1. Interesting, I didn't realize there was a minimum top up of $10. That will definitely allow Starbucks to save on interchange (see my thread with PK above).

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  6. Back in 2012 I found an exploit [1] that let you fabricate card balances. They fixed it 2012, but in 2015 another person found the same issue [2].
    I have no idea why they would not be using transactions, and make the same mistake twice. It really does make me wonder how much FAKE money is inside of that BILLION DOLLAR pot.

    I also found similar issues in 2017 for their Thailand division. But this is at least understandable as Thailand operates its own Gift Card system.

    [1] https://chadscira.com/post/556999d91cb00914380006ee/Re-Starb... [2] https://sakurity.com/blog/2015/05/21/starbucks.html

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  7. So what you are explaining in the end is basically facebooks attempt with libra.

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  8. > Keep in mind that each payment made through the Starbucks app is a payment that isn't made by credit card. Since each credit card payment will cost Starbucks 1-2% in interchange fees paid to the card networks and banks, the company saves a lot of money by guiding customers to its payments app.

    But to load my Starbucks app with money, I use a credit card, so they end up just paying that up front, no?

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    1. Probably quite a bit less though due to fixed per transaction costs.

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    2. Further to Sunny's point, credit card fees as a % of the transaction value +a fixed amount (10 cents is common). So a low dollar transaction is much more expensive than a high dollar transaction. When you load $50 to your Starbucks card with a credit card, the cost to Starbucks is much less than if you bought 10 lattes separately.

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  9. Eyeroll....when my savings account pays 0.5%, I'm not going to resent a free drink every 150 points as a "reward" for maintaining a relatively small amount of cash on my SB mobile app. And, BTW, the same could be said for Chic-Fil-A. I wonder if the balances on the mobile Chic-Fil-A app show up on the corporate balance sheet. But, outside of the replay of the ever popular "hatin' on Starbucks" meme, you bring up a great point. The unused balances on millions of gift cards. What about the unused balances on millions of cards used for product rebates?

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  10. I have always said that "in a few years, everything in the world will be made by Halliburton, sold by Amazon and paid for using Starbucks gift cards."

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  11. 2 points on the additional benefits:
    1) Starbucks is still paying card merchant fees....just on the initial or reload larger transaction (ie when I put $25 into starbucks $, my credit card is charged $25 and presumably Starbucks pays the 2% exchange fee of $0.50)
    This is instead of 5 $5 charges for my weekly latte (which Starbucks would pay $0.10 interchange fee on each). This is really a PV loss, they are paying $0.50 now vs. an 5 period annuity of $0.10 per week.

    2) Also, I benefit from credit card rewards....in reality in advance of my consumption, so there is an (albeit) small PV value of getting 2% credit card rewards on the $25 reload today instead of 2% on $5 lattes over the next 5 weeks, etc.

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  12. Um, this does not work so well for SBUX if/when we get deflation and negative interest rates.

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  13. I think fintech startups and Companies have already thought and started implementing cross-payment technologies using their own mobile apps which can let a customer use his digital wallet in a every business anywhere in the world. Let's also wait to see how Libra will disrup global payments.

    Greetings from Athens
    Stathis Kassios
    www.skasios.com

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  14. The breakage % is stunning. I worked at a competitor of Walmart in the early 2000's and our breakage at the time was around 1.5% to 2.0%. Clearly we were being exceedingly conservative, but these were uncharted waters... Gift cards were a new phenomenon, no one knew how consumers would act in the longterm.
    One thing that never occurred to me at the time and I would like to know the answer if anyone has one is. Why aren't gift card issuers required to escheat the abandoned value on giftcards as is required on other financial assets? Anyone know the answer?

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    1. On escheatment, I believe there are different rules in each state.

      Someone asked me the same question on Twitter. Here is my response:

      https://twitter.com/jp_koning/status/1164534109978468355

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    2. Some states have excluded gift cards from escheat requirements if they don't expire or bear fees. Some retailers have formed giftco entities to be the issuer in states with favorable laws, so those laws apply. Otherwise, the retailer escheats according to where the card was purchased. Since many cards are issued anonymously or through third party distributors, the retailer doesn't know and avoids escheat.

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    3. Thanks Brenda, very helpful

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    4. Good catch, Brenda. Escheatment laws vary quite a bit from state to state - and not all states have them. Clearly, Starbucks is finding plenty of gravy even with this regulations in place.

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  15. The way they have accomplished this is because in order to earn rewards in the app, users must load funds to their starbucks account aka gift card. You can't just use it as a stand alone reward program as you pay with a card/cash at the counter. And thus as people want their rewards, they load money in larger increments than one drink at a time, which saves Starbucks at minimum the per transaction fee if not the % fee.

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  16. Question: how do you load a balance on the app though? Starbucks pay a credit fee when customers add a balance

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  17. There's a whole other way Starbucks is, effectively, stealing from US, its customers. With every OTHER Rewards card I know, when you "earn" a Reward, that reward is YOURS for at least a stated time. THIS IS NOT TRUE WITH STARBUCKS. Each purchase gives you stars which have an Earn Date and EXPIRE six months later. Enough stars gets your reward ... ONLY until the OLDEST star making up the Reward hits THAT STAR'S expiration date. NOT THE REWARD mind you, but the INDIVIDUAL STARS that make up that reward. So, you take 5 months, 28 days to earn enough stars to get your Reward of a free item, and they email or app you, that you Earned a free Reward, you can go to Starbucks THREE DAYS LATER, expecting to use your reward, but they don't tell you that if the FIRST STAR that made up that Reward just expired, too bad: NO FREE ITEM FOR YOU that day.

    If you BUY something that day you will now again have enough for your Free Item ... as long as you go to use that Reward before the NEXT OLDEST star expires. And on and on. So you can keep being told you have EARNED a Reward, but never actually GET that Reward. (Yes now you can use fewer stars for extra syrup or an espresso shot, but I suspect most of us want our freebie.) Again: every other reward program I know once you earn your reward YOU EARNED IT and it will expire but you KNOW what day it will expire and can count on it. Here, unless you track EVERY SINGLE STAR DATE you will find yourself with no free drink over and over again. I know because this happened to me.

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  18. I don't know if this is widely known but I use my Starbucks card internationally. Some countries are OK with this whilst iirc Korea and China have separate schemes. Interestingly, I can establish auto top-up on a card from my own country's stores but not from, for example, a US store. I guess this is anti-money laundering.

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    1. Wow, I've never tried it. What country's SB card do you use to pay internationally?

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    2. UK card works internationally. US card works internationally, just won't accept internet top-up, has to be in person.
      Costa used to have the same system of payment on their cards (in the UK). When they withdrew that and switched to just loyalty I switched to SB, just before they introduced their own version as discussed here; must be a few years ago now.

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  19. If PayPal is regulated like a bank, does that mean they only have to do hold the reserve ratio on account, 10% of US customers funds?

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  20. Few points to keep in mind:

    1) Their liability number is not a true reflection on breakage. That $1.6B liability number includes cards they sold the day and week before reporting that haven't had a chance to be redeemed. While the number sounds astronomical, so is the total amount of cards that Starbucks sells so it's not surprising that number is so big.

    2) According to last Starbucks earnings call, 42% of that quarter's U.S. revenues were conducted on the app. That's 100% card-related and if you do the math it equates to $1.797.096B--an amount that exceeds the liability.

    3) Starbucks doesn't host a card program for the breakage or interest income. They do it to sell coffee. If you get a card that you're not going to use, regift or sell it.

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  21. Thanks for the great article! Really appreciate your analysis and the conversation it sparked. We consult merchants on gift card programs & produce a podcast. We recently did an episode on Gift Card Escheatment Basics https://bit.ly/32bHtFy and we would love to have you as a guest on the podcast to continue the conversation.

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  22. Once again I'm struck by how understanding at the level of money completely obscures how and why a system works. The insights offered in the article were good ones. Fascinating. I'd not considered it that way before because I'm not a finance guy. What I AM is a reasonably intelligent consumer. And the Starbucks app is the most seamless purchasing tool I've ever used other than the Uber app. It makes the buying experience every time I go to Starbucks effortless across multiple iterations. I don't really care much about the star rewards although I do use them. What I love is opening the application, making one touch, and completing the entire purchase in a couple seconds. No cash to calculate or carry or no credit card for a tiny charge. It's the entire experience of the application in use that gives me pleasure - never a factor when the bean counters start breaking things apart.

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  23. Negative interest rates turn this entire argument on it's head. I WANT to hold cash in a negative rate environment. Governments (the primary purveyors and beneficiaries of negative rates) can steal our wealth 2 ways: either inflate it away over time, or steal it directly via negative interest rates. Holding cash allows one to avoid the second of these two.

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  24. What are the store value card liabilities for Amazon?

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    1. $3 billion in their last annual report. Apple was $7+ billion.

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  25. How do they earn breakage if there are no fees? What mechanism are they using to monetize the breakage outside of a fee on dormant balances?

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    1. The FASB has establishment standards for claiming breakage income in proportion to redemption pattern.

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  26. This wasn't mentioned in the post (which is awesome, by the way), but one of my colleagues pointed out that many Starbucks cards are set to auto-renew once you hit a certain point. So it is quite literally automated replenishment of free debt. Mind blown!

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