OMBA606: Section 9023

Week 11- The Assessment of Business Risks in South Korea for Starbucks

Alicia Adams-Glover & Bill Kemp

Executive Summary

Starbucks Corporation, the doyenne of coffeehouses, is experiencing tremendous growth within the United States and abroad. Its popularity has people from all facets of life tasting and craving a Starbucks cup of coffee or white chocolate café mocha. Starbucks Korea operations have expanded to roughly 60 retail stores in the region with plans for future expansion outside the capital of Seoul (Starbucks, 2003). The purpose of this report is to summarize and evaluate the various business risks Starbucks faces. In this paper, the team Global Strategists has identified those risks that pose the greatest potential loss for Starbucks including influences of the South Korea government and the Korean economy on the operations of Starbucks Korea.

The paper provides both an analysis and recommendation of the best vehicles suited for expanding retail stores in South Korea, while mitigating risk. Our analysis has concluded that long-term staffing needs, political, and monetary risks pose the greatest threat to long-term profitability. Our recommendation is that Starbucks maintain a close watch of political and economic actions that will affect Korea’s economy while planning a cautious expansion forward. Starbucks must also work closely with Shinsegae to ensure that its expansion strategy takes into account political and economic risks during this time of change. The Joint venture business structure now in use by Starbucks at Korea is the preferred structure for this business and political environment.

Introduction

Starbucks Coffee Korea opened its first store in the Edae district of Seoul July 1999 (Starbucks Coffee Korea, 2003). Since its inception into the Korean market, Starbucks has expanded its operations to well over 60 stores to date, and an additional 20 stores are planned in 2003. There is no doubt that the company has successfully entered and extended its operations in South Korea. However, a balanced plan that takes into account potential barriers such as cultural differences, and effective management of political, economic, and business risks will give Starbucks a long-term comparative advantage over its competitors. These risks raise measurable possibilities of Starbucks not achieving a sufficient return on investments on its Korean operations. The key to achieving and maintaining profitable operations is to understand the political, economic, and business landscape in Korea, then form an appropriate strategy to mitigate those risks.

Throughout the course of OMBA 606, The Global Strategists have explored a range of issues that can significantly affect the profitability of Starbucks’ operations in South Korea. This report represents a culmination of that previous work, and discusses what the Global Strategists perceive to be the major risks associated with establishing and expanding Starbucks Coffee operations in South Korea. Challenges and opportunities for Starbucks in Korea will be presented, as well as, the various types of political and economic risks followed by a description of potential methods to begin operations in Korea (vehicles of entry). A greatest risks assessment of Starbucks’ operations in Korea has been conducted to form our recommendation.

Economic Risks

When conducting operations in foreign countries one of the most important classes of risks that must be managed effectively is economic risk. Economic risks take many forms, among them are monetary, exchange rate risks, and access to investment funds. This section will discuss each of those risks in the context of South Korea and Starbucks’ operations there. The author defines economic risks as risks to capital flowing into the company (inflows) or out of the company (outflows). If cash inflows are not properly managed then Starbucks will not be able to produce a profit from operations after expenditures are paid. Similarly, if operating costs (outflows) are not kept under control, even high revenue operations will prove to be unprofitable after operating expenses are paid. Starbucks has chosen a joint venture as the mode of entry into Korea. Its partnership with Shinsegae Co Ltd should provide Starbucks Coffee International and Starbucks Korea with additional knowledge about Korea’s political landscape, monetary and fiscal policies.

Korea is still on the path of recovery from a severe downturn in its economy that began in 1997(Hill, 2003). As a result of that crisis the country has undertaken wide sweeping changes in the areas of corporate structuring, bank reform, economic oversight, and privatization. In addition to these changes new levels of uncertainty have arisen over North Korea, its relationship with NATO and South Korea, and a renewed potential for unification with the South. This mixture of issues makes the topic of economic risks for Starbucks particularly relevant. The economic changes now underway in Korea were mandated by the IMF as a condition for receiving economic aid. The Korean government required the aid to repay defaulted foreign loans taken out by the chaebol and Korean banks for manufacturing expansion (Hill, 2003). One of the many important changes underway in Korea is the addition of financial oversight of the country’s banks. Adding oversight will effect two changes that are important to Starbucks. The first is mandating a requirement for defined levels of reserves coupled with a prudent portfolio of loans. This change is positive for Starbucks because it raises investor confidence and stabilizes the value of the Won (SaKong, 2000), thereby reducing Starbuck’s exchange rate risk. Second, oversight may open up more opportunities for Starbucks Korea’s investment capital needs by requiring a more even-handed loan policy.

Monetary Risks

Monetary risks are risks that affect the value of a country’s currency due to monetary policy (Hill, 2003). For the purposes of this paper, monetary policy refers to actions taken to increase or decrease the country’s money supply. This is normally done in two ways: first by changing the rate of interest charged to banks for borrowing funds, second by changing the percentage of deposits banks must keep in their possession as reserves. The higher the interest rate charged for loans between banks the higher the rate will be for individuals and companies borrowing from banks (Heyne, Boettke & Prychitko, 2002). A higher interest rate may make a marginally profitable investment no longer profitable, or move a profitable investment into the “questionably profitable” realm. South Korea’s monetary policy is important to Starbucks for two reasons: first, it affects the amount of investment capital available to Starbucks Korea from Korean bank loans. The higher the interest charged to Starbucks from Korean banks, the less money Starbucks will borrow, thereby providing less money for investment using that avenue. High Korean bank loan rates force Starbucks and Shinsegae to come up with investment capital from their own capital reserves or from loans provided by U.S. banks. Second, monetary policy has the added affect of raising or lowering the value of a country’s currency relative to another country.

Poor monetary policy was the cause of Korea’s economic crisis in 1997. The crisis arose when investors realized that the structure of loan portfolios in Korean banks exposed them to too much risk of default. The result of low investor confidence was a flight to safety that sent the value of the Korean won tumbling, and the foreign debts held by the banks and chaebol to skyrocket. The scenario experienced in 1997 was extreme, but it illustrates the power of monetary policy in the context of a global market. This crisis was mentioned to underscore the fact that monetary policy plays a critical role in the profitability of Starbucks Korea’s operations. Because of the sweeping changes imposed by the IMF and implemented by Korea, the chances of such a catastrophe occurring again are greatly reduced. Using a term coined in Friedman’s book (2000), Korea appears to be successfully upgrading their operational software to “DOScapital 6.0” (Friedman, 2000, p. 145). A government oversight department has been formed that governs banking policy and corporate restructuring (SaKong, 2000). This department is in charge of restructuring the chaebol conglomerates.

One other area of concern for Starbucks resulting from restructuring is the change in percentage of foreign ownership of Korean companies. As a condition to providing economic aid, the IMF required Korea to remove caps on the maximum percentage of a Korean business a foreign entity could own. Caps still exist in a few industries (such as manufacturing). But the removal of this restriction opens up the markets and allows for greater competition from other foreign coffee companies. They could purchase a Korean coffee company outright, and then implement changes that use a “Starbucks like” formula (high quality coffee in a casual lounge atmosphere). Opening up its markets could reduce the cost of entry into Korea's markets for other coffee competitors. As more "look-alike" competitors enter the Korean market, the switching costs for Korean consumers declines, and loyalties to Starbucks degrades. If too many competitors enter the Korean market, the end effect could be a reduction of market share for Starbucks and a commoditization of the gourmet coffee house experience now dominated by Starbucks. Commoditization will have the effect of reducing prices, and with it, overall profitability.

Exchange Rate Risks

Exchange rate risks are those risks caused by the relative change in value in one currency with respect to another (Hill, 2003; Heyne, Boettke, Prychitko, 2002). Exchange risk is an ever-present danger that is hard to predict and can quickly have severe consequences on profitability of a foreign operation. A sudden shift in investor sentiment can disturb the delicate balance of supply and demand for a currency and result in a relative change of a currency’s value. If investor confidence rises in Korea, it can cause a rise in the value of Korea’s currency due to a higher demand for Korea’s financial instruments. As mentioned in an earlier paper, currency risk is one of Starbuck's primary on-going operational concerns. This because the final assessment of how profitable Starbucks Korea’s operations are to the parent company is highly dependent on favorable a conversion rate of Korean Won profits back to U.S. dollars. This conversion must be done without a loss of value in order to retain profit margins. Starbucks must use appropriate hedging techniques to help establish a known, favorable, exchange rate at the time of exchange (Hill, 2003; Heyne, Boettke & Prychitko, 2003).

Similarly, if investor confidence were to lower, then demand for the Won would decrease, decreasing its value relative to the U.S. dollar. The result would be lower realized profits for Starbucks after converting Won profits back to U.S. dollars. Exchange risk and its effect on Starbucks were discussed in an earlier paper written by this team for this OMBA606 class. Changes in the value of the Won relative to the U.S. dollar can impact the amount of investment funds available for Starbucks. This very real risk manifested itself in a devastating manner in 1997. As mentioned in the monetary risks section, investor confidence plummeted causing a flood of Korean dollars back into the economy that created a de-valuing effect. The Won lost more than 50% of its value relative to the U.S. dollar in the 1997/1998 period (Hill, 2003). Fortunately, Starbucks had not yet begun operations there, but they had begun investigating the country as a prospect (Starbucks, 2003) and had perhaps already begun talks with potential joint venture candidates. Korea’s leadership is successfully implementing the IMF changes AFP (2003). This bodes well for the country as the right protections are being put in place to prevent such an event from reoccurring.

Political Risks

Political risk develops from the possibility of unfavorable government action and/or as in the case of South Korea unhelpful relations with neighboring countries (North Korea). These risks add to the pressures of managing and conducting business in South Korea. Although political risk cannot be predicted precisely, there are certain factors that Starbucks must be cognizant of when evaluating South Korea’s political risk environment. They are: stability of the social infrastructure, current administration problems, and anti-competitive practices. All of these areas represent short and long-term risks that impact business development.

Social Infrastructure

Social infrastructure risks are risks created from disruption to a social environment. A deplorable and deteriorating South Korean social infrastructure affects the structure of its workforce and customer base. As noted in an earlier report, South Korea’s social infrastructure does not pose an immediate risk to Starbucks’ operations. It appears to cause a more long-term alarm when considering employee retention and hiring. The wide availability of quality education and health care has proven beneficial to the productivity, agility and mobility of Korea’s labor force. However, one preliminary postulation from this analysis was the discovery that an aging population suggests a possible employee challenge. The improved quality of health and medical services has increased the life expectancy of Koreans, and in turn that created an aging problem for future generations. The problem includes concerns such as funding pensions, retirement plans, healthcare, and supplemental support, as well as future labor shortages.

Korea’s Current Administration

The current administration of South Korea, led by Roh Moo-hyun, is playing a delicate game of trying to maintain a prosperous economy in the midst of tension between the two countries (North and South Korea), and while implementing sweeping financial changes. The growing regional dispute between the North and South Korea has global anxieties on the rise. The North continues to threaten the South with a nuclear attack (Cite?). A major concern for Starbucks is whether the regional dispute will give rise to an economic crisis. The uncertainty of positive resolution and inter-Korean relations threatens the stability of Korea’s economy. At the same time, Moo-hyun must continue the economic reforms started before he took office. These reforms touch every aspect of South Korea’s financial markets. This too threatens the stability of Korea’s economy. Initial indications suggest that Roh Moo-hyun will continue the economy on its present course of improvement while actively working to resolve North Korean tensions.

Anti-competitive practices

Anti-competitive practices are any activities conducted in a country that prevent competition from entering a market. Anti-competitive activities in South Korea have not been observed in the coffee/retail industry, thus the risk to Starbucks is not evident. Anti-competitive practices in South Korea have been most prevalent the areas of industrial manufacturing, steel production, and semiconductors. These are industries dominated by the chaebol (Korean government controlled conglomerates).

Eight risk areas for Starbucks operations in South Korea are ranked in table 1 below. These attributes were covered in previous OMBA606 team reports.

Table 1

Business Risk Ranking in South Korea

Risk Area	Risk Ranking
	Very Favorable	Favorable	Cautious	Dangerous
Economic infrastructure			X
Financial markets			X
Business and work force culture		X
Product/Service standards		X
Social Infrastructure -stability			X
Social Infrastructure -Aging population			X
Current administration – government policies			X
Anti-competitive Practices/Foreign policies		X

Possible Vehicles for Starbucks Entry into Korea

There are various vehicles for starting businesses in a foreign market. Choosing a method that provides the right combination of risk aversion and profitable growth is important. In his text, Hill (2003) discusses six ways to enter a foreign market. They are exporting, turnkey projects, licensing, franchising, joint ventures, and wholly owned subsidiaries. Starbucks does not engage turnkey projects as this mode of entry is appropriate for construction companies. Starbucks uses one of three strategies when starting operations in a foreign country: licensing, joint ventures, or wholly owned subsidiaries. All in all, Starbucks chooses the approach that renders a partnership that helps alleviate some of risks associated with entering a foreign market Starbucks International’s primary entry vehicles are through joint ventures or licensing. Using this approach operations have been extended to 31 foreign markets. Table 2 below provides a ranking of each entry mode Starbucks could have used in Korea. The results show that a wholly owned subsidiary would pose significant economic and political disadvantages, as Starbucks would have to negotiate the complex web of Korean culture and business relationships in order to begin operations. Similarly, the Korean government has no incentive to aid a foreign owned subsidiary in any way. The table also shows that there are comparable advantages to a joint venture in Korea. Starbucks would have the benefit of a cultural and political liaison that would be motivated by potential profits. The Korean government and banking system would be much more receptive to this over a Wholly Owned subsidiary because local businessmen and the local economy would be benefiting from Starbucks’ success. A joint venture does not leave the impression of taking all of the profits out of a country for the benefit of others.

Exporting

To date, Starbucks has chosen not to vertically integrate into the coffee exporting market. Its buyers take great care in selecting the highest quality beans, but there has been no inclination to undertake the coffee bean growing and export business.

Franchising

Though franchising is a low cost mode of entry, Starbucks not used it as an entry mode domestically or internationally. The main reason is that Starbucks prefers to exercise more control over all aspects of foreign operations and expansion within a country than franchising provides. Starbucks leadership sees direct control over operations as the only way to ensure all customers in any country enjoy a consistent experience.

Wholly Owned Subsidiaries

Wholly owned subsidiaries are separate corporations whose shares are 100 owned by the parent company (Hill, 2003). The main disadvantage of a wholly owned subsidiary is the burden of high cost and risk. The main advantages are total control of operations and expansion, and the benefit of receiving all profits from operations. Starbucks Coffee International is a wholly owned subsidiary of Starbucks Corporation and was created to help further the expansion efforts outside of North America. The creation of Starbucks Coffee International has proven profitable for Starbucks Corporation, as it focuses the unique issues associated with international business in one group.

Licensing

As an alternative to franchising, Starbucks licenses its operations to companies that have access to attractive retail space that would otherwise be off limits. Venues such as airports, grocery stores, hospitals, and college and university campuses are common choices for this approach (Starbucks International Development, 2003). Some advantages to licensing in South Korea are the reduced operational risk level and reduced financial burden. The disadvantage of licensing Starbucks operations is the lack of control over the market (Hill, 2003). The number of stores Starbucks has licensed in the United States and internationally has increased from 1,412 in 1997 to 4,700 in 2001.

Joint Ventures

A joint venture is a business relationship in which a parent company forms a new business unit with another company. Both companies own a portion of the new business entity and exercise a level of control based on the percentage owned. Starbucks Coffee International formed a 50/50 joint venture partnership with the Shinsegae Department Store Co, Ltd., a successful retailer in Korea (Starbucks 2001 Annual Report). This cooperative type of business arrangement provides the most advantageous way of entry for Starbucks because it gives Starbucks access to knowledge about the Korean market while sharing costs and risks. This venture with the Shinsegae gives Starbucks a competitive edge that reduces the above reservations. As discussed in a previous report, Hill (2003) cautions that one major consequence of a joint venture includes the potential loss of important core technologies to its partner. If the Shinsegae and Starbucks joint venture agreement is not constructed to mitigate this risk, Shinsegae could leave with knowledge of what makes the Starbucks Experience such a success. Starbucks must ensure they understand the legal elements that must be in place to ensure Shinsegae does not acquire or adopt its trade secrets.

Table 2

Business Structure Ranking for Starbucks Korea

Business type	Risk Ranking
	Economic advantages	Economic disadvantages	Political advantages	Political disadvantages
Exporting	0	0	0	0
Licensing	+1	-1	+3	0
Franchising	0	0	0	0
Joint Venture	+5	-2	+5	0
Wholly-owned Subsidiary	+5	-4	-4	+1

Key: Risk Scores range from highest (-5) negative indicating the degree to comparative disadvantage, to lowest (+5) positively indicating the degree of comparative advantage, with zero (0) being a category that presents not applicable and/or no significant country difference with regards to Starbucks’ business expansion.

Business and workforce culture

Business and workforce culture of South Korea appears to have a favorable effect. As analyzed in week 10’s report the Confucian philosophy of perseverance governs the work ethic of Korean society. Starbucks would benefit from this value, as employees embrace productivity and hard work.

Product and service standards

Product and service standards pose minimal risk to Starbucks operations. Starbucks company standards provide a solid framework for its national and international operations. Its diligence in adhering to the highest standards help to mitigate any risk imposed by standards and/or regulations imposed by the Korean government

Conclusion

Over the course of OMBA606, the Global Strategists have assessed six broad business areas and their applicability to Starbucks’ operations in Korea. Those business risks are: product and service standards, anti-competitive practices, economic infrastructure, financial markets, Social infrastructure, and business and workforce culture. As mentioned in this report, and assessed in previous papers, anti-competitive practices are not a problem area for Starbucks in Korea, nor are product and service standards. Business and workforce culture risks were discussed in a previous paper and were assessed as largely mitigated because of the joint venture with Shinsegae. Economic infrastructure and financial markets are intertwined and manifest as one of the highest risk areas for Starbucks in Korea.

Currency conversion is one of the two top risks Starbucks faces in Korea long term. Though currency conversion risk exists in every foreign operation, the relative stability of a country’s currency exacerbates or mitigates that risk. In Korea’s case the risk is exacerbated. This is primarily due to the extensive economic reforms now underway in the country. The reforms touch every area of Korea’s economic landscape: Interest rates, monetary policy, banking policy, employment policy, business protections, oversight, etc. With so much change going on, the economy will likely behave in fits and starts as adjustments are implemented. These fluctuations in the economy will affect the value of the Won in a more unpredictable way, making it difficult for Starbucks to predict the future direction of the Won, and therefore make it difficult to form a conversion hedging strategy to reduce conversion rate risk.

Another import wildcard in Korea’s economic future is North Korea. North Korea has been raising the concerns of South Koreans and the world as a whole through its recent actions. They have been aggressively developing a nuclear program that would threaten the South and other countries. This activity is raising the ire of the United States and the United Nations. Also, North Korea has been suffering from economic problems that prevent them from purchasing all of the raw materials and food items its population needs. It is now the recipient of foreign food aid. North Korea’s ailing economy may make it much more possible that they may unite with South Korea. South Korean President Roh Moo-hyun is actively pursuing a platform of engagement with the north in order to smooth relations and find a peaceful path forward. The results of this engagement are undetermined at this point.

The other primary risk to Starbucks is monetary. Starbucks Korea must keep a close eye on the monetary policy changes underway in Korea to ensure that investment capital is still available, and that the new policies support a stable currency. Monetary risks and Exchange rate risks move hand in hand and directly affect each other. They fall under the umbrella of economic infrastructure and financial markets.

Starbucks must forge an expansion strategy that takes into account the looming issues of war or unification with North Korea, and the sweeping changes presently underway in its financial markets and infrastructure. The global strategists believe that Starbucks use of a joint venture for this country is wise. Shinsegae will be a valuable ally for Starbucks in the event of political or economic upheaval. A cautious expansion is advised until all of the IMF mandated changes have been successfully implemented in the economy. Korea has weathered the IMF changes well. Since 1998 GDP growth has been positive, consumer confidence is high, and unemployment is at manageable levels (Chan, 2002). In view of this, expansion is warranted, but the Global Strategists advise a slower rollout rather than aggressive expansion. Finally, Starbucks must continue to work closely with Shinsegae, carefully managing that relationship to ensure that Starbucks Korea expansion strategy adequately takes into account political and economic risks during this time of change and uncertainty.

References

Agence France-Presse (AFP) (2003). IMF says South Korean economy set to grow 5.5 percent this year. Agence France-Presse (AFP). Retrieved from http://quickstart.clari.net/qs_se/webnews/wed/av/Qimf-skorea-economy.RWNJ_DM6.html

Chan, A (2002). Consumer Reigns Supreme In Korean Economy. Alliance Bernstein, Asian Economic Perspectives. Retrieved from http://institutional.alliancecapital.com/document_client_upload/040502_111522_Final_AsianPerspectives_020329.pdf

Friedman, T.L. (2000). The lexus and the olive tree. New York: Random House.

Heyne, P., Boettke, P., & Prychitko, D. (2003). The economic way of thinking (10th ed.). Upper Saddle River, NJ: Prentice-Hall, Inc.

Hill, C.W.L. (2003). International business with Global Resource CD, PowerWeb and World Map (4th ed.). New York: McGraw Hill.

SaKong, I. (Winter 2000-2001). Korean Economic Restructuring: Current Status and Prospects. The Korea Society Quarterly. Retrieved from http://www.koreasociety.org/TKSQ/TKSQ%20PDF/TKSQ_1-4/05-Il-Sakong-Korean-Econ-Restructure.pdf on April 16th, 2003.

Starbucks (2001). Company Information: Company History. Starbucks Coffee Company South Korea. Retrieved from http://www.sinc.co.kr/star/en/company_history.htm

on 20 March 2003.

Starbucks Coffee Korea (2003). Retrieved from http://www.istarbucks.co.kr/

Starbucks Company. International Development. Retrieved from: http://www.starbucks.com/aboutus/internationaldev.asp