Starbucks Corp (SBUX) is a coffeehouse chain and is categorized in the restaurant industry. They provide their customers with selected sorts of coffee from all over the world, as well as tea, cold beverages, patisserie, hot and cold food offers. Their competitors consist of local coffee shops as well as global players like McDonalds (MCD), Dunkin Donuts (DNKN), Yum Brands (YUM) and others. As of April 3, 2017, Kevin Johnson became CEO and president of the company and former CEO Howard Schulz, who bought the Starbucks chain in 1987, is now the executive chairman. Following brands are owned by the company: Teavana, Tazo (SBUX announced the sell Tazo to Unilever (UL)), Seattles Best Coffee, Evolution Fresh, La Boulange and Ethos. Nearly each one of the acquired brands has been successfully integrated into the Starbuck business.
The stores are in high-traffic, high-visibility locations, they have been on average opening 2 stores per day for the last 3 years. Starbucks operates currently in 75 countries, with a total of 25,085 stores which includes the company operated as well as licensed stores in which 254,000 employees are currently at work. Their global structure is segmented into Americas including USA, Canada and central America, China/Asia Pacific (CAP), Europe, Middle East and Africa (EMEA), Channel Development as well as the non-reporting segment, including Teavana, Seattles Best Coffee and Evolution Fresh and other parties that are included in All Other Segments. All other Segments include offers to foodservice companies that service business and industry, education, healthcare, office coffee distributors, hotels, restaurants, airlines and others. Most of the companys sales in this channel come through national broadline distributors like Sysco Corporation (SYY), US Foodservice (USFD), and others. The “Channel Development” segment includes products sold worldwide through channels such as grocery stores, warehouse clubs, convenience stores and US foodservice accounts. Included are whole bean and ground coffees, premium Tazo/Teavana, Starbucks – Teavana – Tazo branded single serve products, ready to drink beverages, and other products sold in markets.
Next to the beverages and food provided in their stores, the customer pays a premium for the Starbucks Experience on which the customer can rely all over the world as well as the brand itself. In each store the customer can expect free Wi-Fi, a cozy atmosphere and a place to back out, set up small meetings or study. A relaxing interior in brown/grey/green accents adapted to the country and city the store is operating with accessories that emphasize the experience result in this overall Starbucks Experience.
Store Portfolio/Products, Strategic Development and their effects:
Data in Table as of mid October 2017
Depending on the market and the awareness for the brand Starbucks, the company uses company-operated stores or grants licenses to partners who operate the stores in their own market. Sometimes the only possibility to get access to certain locations are licensed stores that are set up and managed by the licensing partner. The licensing model comes into hand when addressing new markets in which the expertise is missing to establish the brand. The licensees know-how, expertise and resources can be accessed to foster the Starbucks brand in the new market while hedging the downside risk for the company. The company actively manages their store portfolio and has shifted multiple times between company-operated and licensed stores when the market position demanded it. The “American”, especially the U.S. sector is the most mature market with high brand recognition and awareness among the whole customer base. Europe, Middle East and Africa show only a small fraction of company-operated stores, while making 17% of total licensed store portfolio. Europe and especially Starbucks main markets like Germany, France, and the Scandinavian countries all have a strong coffee culture on their own.
Source: Starbucks Annual Report 2016
For example in Germany the classical bakeries make up a big portion of the “coffee-to-go” market, which makes it hard to create profitable company-operated, large-scale store portfolio in this market. The licensing partners in these markets are therefore essential, giving the company access to high traffic and high-visibility locations in these markets as well as their knowledge, expertise and resources in these markets.
The USA is Starbucks strongest market and the ratio between licensed and company owned stores strengthens this argument. The company has its own expertise in the USA and doesnt necessarily need a licensing partner to establish new stores. Many of those US-licensed stores are in locations like grocery stores (Safeway (SWY) or Wal-Mart (WMT)) or markets owned by the licensees where Starbucks wouldnt have direct access to.
The biggest portion of revenues are from the Americas segment, especially USA, since this is the strongest and oldest market in their portfolio.
Source: Starbucks Annual Report 2013-2016
In 2016, 69% of the revenue came from the Americas segment. The All Other segment is the smallest market which consists of Teavana and Seattles Best Coffee. Revenue from Europe, Middle East and Africa (EMEA) has been decreasing as percentage of total revenue over the past years, with the shift from company-operated to licensed stores in EMEA, Starbucks hedged their downside risk in this market but also reduced the received revenue substantially. The CAP market shows the biggest growth over the past 10 years. The shift from licensed to company-operated stores in Japan emphasizes the influence of the new market which is also indicated by 14% of total revenue.
Every Starbucks store offers an always changing variety of coffee, hot and cold beverages, snacks and single serve products, high quality nutritious food offers (warm & cold), pastries, breakfast and lunch sandwiches and salads.
Past Performance & Fundamentals
In this paragraph I will talk about Starbucks past performance in regard of their income, operational effectiveness and their financial stability. Further I will include the company’s return ratios for the past 10 years.
Considering that Starbucks is in a fast changing industry with an high number of local and global competitors, they have been able to increase their revenue substantially.
Source: Starbucks Annual Report 2007-2016
Starbucks revenue growth undermines its successful efforts to expand its business. The decline in 2008 and 2009 were partly due to the recession and the following financial crisis and a misalignment in their store portfolio and leadership positions. The company’s executives reacted excellently in these years, increasing their operational effectiveness, initiating a business model shift, realigning their leadership positions by reducing 100 open/filled positions and restructuring accountability and reporting in the operating segments. Over these years, Starbucks closed 1000 stores, and initiated changes in different markets from company-operated to licensed stores and set new initiatives for the leadership positions all over the world. In the figure above we can see how the net income moved over the past 10 years. The litigation charge in 2013 reduced net income substantially but was just a temporary change. Number of shares over the past 10 years were constantly in a range from 1.45 billion to 1.55 billion, therefore the earnings per share follow the movements of net earnings.
Source: Starbucks Annual Report 2007-2016
Gross Margin-, Operating Margin- and Net margin-change undermine the restructuring efforts from 2007 to 2009. Starbucks has considerably increased their gross profit in these years and strengthened their operational effectiveness sustainably. They have strengthened relationships with suppliers all over the world. In many markets this was realized through increase of economies of scale and hence the increase of buyer power. Their future contract management for green coffee has improved over the years and they actively manage their coffee suppliers and have established support mechanisms for them. The economies of scale is visible in their gross margin which has increased to an all time-high of 60%
The dip in 2013 is from the litigation charge caused by the legal process between KRAFT and Starbucks:
In 2011 Starbucks discontinued the partnership with KRAFT due to material breaches. Through KRAFT Starbucks sold a selection of Starbucks and Seattles Best Coffee branded products in US, Canada, UK and Europe. Kraft managed distribution, marketing and advertisement of these products. Caused by the agreement breach, Starbucks has to compensate KRAFT with the fair value of the contract and an additional premium of 35% on top of the fair value.
Quote from Starbucks Annual Report 2013
Since Starbucks is operating in the consumer sector we can see that the brand awareness increased over the past 10 years. They can afford to demand a premium from their customers for the Starbucks experience. The customers appreciate the certainty of the experience all over the world which results in a 19.57% operating margin and a 13.22% net margin, which are higher than the industry average.
Inventory turnover with an average of 14.44 over the past 10 years and an average asset turnover of 1.6 for the past 10 years. Both metrics fluctuated over the past 10 years but were constantly in a 10% range around their averages.
Starbucks gearing ratio over the past 10 years is highly conservative, with an average of 25% gearing, they recently started to leverage their business with the use of debt. Before 2012 the company was free from short-term debt and had only the “2017-notes” with $750 million face value. Beginning in 2013 due to the litigation charge they had to finance part of the payment with newly issued debt. Interest rates were and still are very low and Starbucks started to finance more activities with the use of long term-debt, as we see in the increase of their gearing in the past 3-4 years.
Source: Starbucks Annual Report 2007-2016
To sufficiently discuss the financial stability of the company, we analyze the gearing-, current- and the quick-ratio of the company. The gearing is the ratio between long-term debt minus cash to equity, it shows how much leverage the company is using or in other words how much external money they are using to finance their operations. Over the years, the company used rarely debt to finance their operations but since Interest rates are low and borrowing money is cheap, the decision to finance their operations with external money goes in hand with the current trend in the market. The increase of leverage as well as their ability to repay the money by their current assets as well as their cash reserves in less than 2 years undermines the financial stability of the company.
Source: Starbucks Annual Report 2007-2016
Starbucks return on invested capital (ROIC) is highly impressive and well above industry average. With an average of 29.24% ROIC in the last 5 years excluding 2013, Starbucks is exceeding all its competitors in this measure. ROIC is used to assess a companys efficiency at allocating the capital under its control to profitable investments. I merged different weighted average cost of capital (WACC) assumptions from different sources together and got a value of 7% weighted average cost of capital, comparing the ROIC and WACC shows that the market can be pleased with the company’s return over the past years. Starbucks Return on Equity (ROE) is below industry average, just looking at this number and comparing it with their competitor would give us a wrong view of the company’s ability to use their equity efficiently. Return on Equity is calculated by using net income income in the nominator and average equity in the denominator. Equity is the difference between the company’s asset and liabilities. Starbucks competitors increased debt to finance their operations (see for example MCD financials). As seen in the gearing ratio, Starbucks debt to asset ratio is more conservative as those of their competitors therefore the ratio between debt and equity is much lower, resulting in a lower return on equity ratio in comparison. The company can return on average 26 cents on each $1 of asset (ROA).
In conclusion the above mentioned return ratios indicate that Starbucks was able to increase the value of their brand to a point where they can demand a premium on their products.
DCF Analysis & Future Prospects
To get an idea about the possible return Starbucks could provide over the next 5 years, I provide a discounted cash flow valuation.
In my DCF analysis I use two methods, the first one is the EBITDA-multiple method (Earnings before Interest Depreciation and Amortization) and the second one is the perpetuity growth method. Both methods are based on assumption that are obtained by analyzing the companys past performance, the person doing the analysis can therefore assume a variety of different scenarios. Starbucks is operating in the restaurant industry and has won a certain level of brand awareness, this industry is seldom affected by big innovations, therefore I use a very conservative view in this analysis.
Starbucks P/E ratio over the past 13 years has been mostly in the 20+ range, highest P/E ratio was 614.92 and the lowest was 18.23. The high was due to the litigation charge that they had to pay in 2012/2013, apart from this the median P/E ratio over the past 13 years was 29.7. Starbucks current P/E ratio is 28.1 while industry-average is 27.1. In conclusion Markets expectation is slightly higher compared to their industry competitors but still in an acceptable window, considering the strong economic phase that we are currently experiencing. In the DCF analysis provided in this analysis, I haven’t considered the possible outcomes of an upcoming recession and projected the current market mood on the next 5 years but it is an interesting question to ask what influence a recession might have on Starbucks. I will discuss this in the “Future Prospects”-paragraph.
For the EBITDA-multiple method I personally look at the P/E ratio as well as the ratio between EBITDA and Enterprise Value (EBITDA/EV). By comparing the history of both values, I can verify my assumption about the terminal value at the end of the projection period. The EBITDA/EV-ratio gives us an estimate on how much the cash flow is worth after the projection period, therefore we have a rare idea about the terminal value at the end of the projection period.
The perpetuity growth method assumes the growth of the company after the projection time, normally this rate is close to the inflation rate of the country the company resides in.
In addition to the assumption for the terminal value we must also assume realistic values for the free cash flow in the projection period. In this DCF analysis we use the unlevered FCF because I want to separate the cash flow produced by the company from the structure of the ownership and liabilities of the company. The table below shows the unlevered free cash flow of the past 5 years and the upcoming 5 years
For the first year, I chose a 10% revenue growth and each year the growth is reduced by 1% down to 6% in year five. I projected a 0.41% (of revenue) decrease for change in working capital for the projected time period. For capital expenditure I chose values between 5%-7% of revenue for the time period.
The first table shows the results for the Terminal EBITA Multiple method.
The current price is $54.72. The conservative chosen values in the EBITDA multiple method show an upside potential of $13 with low downside risk in Starbucks current state and the current market mood. For Starbucks current weighted average cost of capital, that is used on the left side of the table, I used an average from different sources.
The perpetuity growth method shows a different picture, the value for the growth vary between 3.1%-3.5% with the current inflation rate in the USA of 2.2% and Starbucks high growth potential for the upcoming 10 years I chose this range as the best compromise between conservative valuation and potential. The perpetuity growth method shows a downside potential of $15 and an upside potential of $25. I personally assume that an upside potential of $25 is too high for the next 5 years, but I’m open to be proven wrong.
Both valuations show a high growth potential with low to mid downside risk. The perpetuity growth method shows that Starbucks is well valued now but has a high growth potential, the multiple method points out that the company is slightly undervalued in the moment and has a mid to high potential growth chance. Resulting from the observations in the DCF analysis and the company’s market power as well as strategy I assume that the price of Starbucks will increase with a possible valuation of $70 in the next 5 years. At the moment of writing, Starbucks valuation is $55.68, which would induce a 25.71% upside potential.
The USA is currently breaking all historic valuation records, in regard of the Dow Jones, S&P500 and Nasdaq composite. Even though the current trend of the big 3 is positive, the market is obviously getting nervous about the future outcomes at current valuations.
Where would Starbucks stand in a possible future recession?
Starbucks valuation would decrease in a recession, which would be indicated by the decreasing P/E ratio but let us take a further look at the fundamentals and make our assumptions about the reduction afterwards. Starbucks has built long lasting fundamentals, with a well balanced store portfolio and a strong brand awareness all over the world. I want to further analyze the store portfolio. Currently Starbucks store portfolio consists of roughly 50% company owned and 50% licensed stores. Most company-operated stores are in the US, at locations where Starbucks has verified the stores profitability (If it wouldnt be the case, management would have either changed to a licensed store or closed it). In addition, the brand awareness is very strong in the US, also in 2007/2008 these strong fundamentals showed consistent revenue from the US market even though they were executing portfolio, management and strategy changes in these crisis years. Over the last 10 years not only their US market has improved but they also entered new markets like China and Japan and expanded their business. Revenue from these markets are smaller than from the US market but they set up a strong and long lasting fundament, furthermore diversify Starbucks store and revenue portfolio. Other markets like EMEA are mostly based on licensed stores and most of the risk in these markets are beared by the licensee. Revenue and net income would decrease in a recession but the company has hedged their downside losses. Would an Investor be willing to pay a premium for this fundamentally strong company in a recession? Would the decrease in the P/E-ratio be very high? These resulting questions have to be answered by the individual investor.
This is my first publicly available analysis, and I am thankful for feedback and constructive criticism.
Disclosure: I am/we are long SBUX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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