Starbucks Corp. (SBUX, Financial), founded in 1985, is one of the world’s leading roasters and retailers of specialty coffees and coffee-based drinks. The company sells its coffees, teas and other beverages along with a variety of fresh food items through retail stores located in 68 countries throughout the world. The company ended fiscal 2015 with 23,043 stores in operation. This included 7,559 stores in the U.S., 1,009 in Canada, 2,452 in China/Asia Pacific and over 700 located in Europe.
Starbucks has four reportable segments: (1) Americas, (2) China/Asia Pacific, (3) Europe, Middle East and Africa, and (4) Channel Development. Each segment’s share of total company revenues for 2015 were: the Americas at 69%, China/Asia Pacific at 13%, Europe, Middle East and Africa at 6%, Channel Development at 9% and All Other Segments (including its Teavana, Seattle's Best Coffee, Evolution Fresh and Digital Ventures businesses) at 3%. These results reflect the slight pullback in store openings between 2010 and 2011. This pullback in growth was, of course, clearly only temporary. In 2015 alone the company had 1,522 net store openings (with the majority of openings in China/Asia Pacific). Management has reaffirmed its commitment to continue to expand aggressively in 2016, particularly in overseas markets. This could involve partnerships, joint ventures or direct corporate purchases. In fact, the company recently announced plans to open approximately 1,800 net new stores, including 700 in the Americas and 900 in China/Asia Pacific.
The company’s operating objective is to become the leading coffee brand and coffee retailer in the world. Management emphasizes that what is key to achieving this objective is to continually offer products and customer service of superior quality as well as unique “visit experiences.” This includes offering customers clean, trendy, stimulating, pleasant and well maintained facilities.
Analysis
We are always on the lookout for competitively dominant firms with extremely loyal customer bases. This is certainly the case with regards to Starbucks – a firm that has been able to sell slightly modified commodity-type products at lucrative margins for many years while consistently growing its customer base. Key success drivers in its markets include maintaining strong brand appeal, customer loyalty, achieving economies of scale in production and distribution and achieving distributional advantages by setting up stores everywhere people work, shop, travel and eat.
Starbucks is operationally poised for success as it is a leader in most of its respective markets, has won consumers’ minds as a “best choice,” has achieved scale and has a well-established distribution network. The company has basically become a “place away from home” for people to meet and socialize and, in exchange for a few bucks, enjoy a premium drink and a light snack. The company has built phenomenal brand power; regardless of how successful other companies have been at imitating Starbucks’ business concept and drink quality, customers still for the most part remain loyal to Starbucks (maybe not for all but at least for some of their drinking activities). The company’s future growth will depend to a large extent on successful expansion activities in European and Asian markets. New product launches, such as lighter “blond roast” varieties, are appealing to new and younger customer segments and should help to support margins moving forward. Slow wage growth, intensified price competition and near market saturation in the U.S. could work against the firm’s sales growth moving forward.
The average return on investment for Starbucks during the last 10 years was approximately 28%, with returns on reinvested capital averaging 32%. The company is required to make substantial capital expenditures on facilities and equipment to maintain and grow company operations (averaging 85% of net earnings). Starbucks has generated reasonable cash margins with free cash flows to sales averaging 7%. Starbucks is modestly leveraged with an adjusted debt load that would take about six years of annual earnings to pay off.
Company profitability should continue to improve as the company’s brand reputation in foreign markets grows. The company is very well managed, generates reasonably stable financials, has a healthy balance sheet and should have sufficient resources to support growth without significantly diluting the equity base. It should also be able to at least maintain the current dividend rate, hopefully supporting strong shareholder returns.
Valuation – Multipliers
Discounted cash-flow analysis
Free cash-flow-to-equity projections
Assessment
Starbucks' per share earnings in 2015 were $1.82. Historical earnings per share grew at an annual rate of approximately 19.6% per year since 2005. Starbucks' sales per share in 2015 were $12.66. Sales should grow at an aggressive rate of between 8% and 10% over the next few years, declining gradually to a steady rate of about 5% per year by 2021. We expect slight operating and net margin compression. Interest expenses will remain minor. Capital expenditures will remain high over the next few years to support aggressive expansion but then decline gradually to about 6% of sales. Our fair value estimate of Starbucks equals $54.26. At a current price of $60.03, this suggests that Starbucks is overpriced by about 9.6%. Also, based on a pure Monte Carlo Simulation, there is a 69% probability that the company's true underlying fair value is less than the current market price.
Pure Monte Carlo Simulation
Recent developments
- Starbucks had a phenomenal 2015. Global comparable store sales increased 8%, driven by a 4% increase in traffic. Americas' comp sales increased 8%, also supported by a 4% increase in traffic while China/Asia Pacific comp sales and traffic increased 6%.
- Starbucks successfully opened 524 net new stores globally in the fourth quarter, which included opening the first Starbucks stores in Panama and in Azerbaijan.
- In total, 2015 saw Starbucks serve more than 60 million "customer occasions" from its U.S. comp store base and over 72 million more customer occasions from its global comp store base versus fiscal year 2014.
- Year over year, total consolidated net revenues were up 18% in the fourth quarter to $4.9 billion. Full-year consolidated net revenues were up 17% over fiscal year 2014 results.
- Consolidated GAAP operating income reached $3.6 billion with operating margins reaching 18.8%.
- GAAP EPS of 43 cents up 10% over Q4 FY14 GAAP EPS.
Management guidance
Management expects:
- Full-year consolidated revenue growth of more than 10% with global comparable store sales growth somewhat above mid-single digits.
- FY16 operating margin is expected to increase slightly versus prior year.
- Expecting a consolidated tax rate between 34% and 35%.
- Full-year FY16 EPS in the range of $1.84 to $1.86.
- Q1 FY16 EPS in the range of 43 cents to 44 cents.
Potential catalysts
- New product launches, including fresh fruit products and baked goods.
- Increased brand recognition abroad –Â further strengthening margins.
- Growth from additional k-cup single-serve coffee sales.
- Capturing additional market share as a result of greater brand penetration.
- Increasing market share through Tazo Tea sales and its acquisition of Teavana Holdings.
Risks
- Prices might get to be too high relative to competitors to hold brand loyalty.
- Intensified price competition.
- North American saturation is a continued risk.
- Increased jockeying for market share by McDonald’s (MCD, Financial), Tim Hortons (THI, Financial) and Dunkin’ Brands (DNKN, Financial).
- Trades at a P/E of 32.5x.
- PEG ratio of 2.6.
Conclusion
Given its strong competitive position, Starbucks is operationally an outstanding company. It does, however, trade at a very high P/E multiple. While it has held this multiple for quite some time, any slowdown in growth could hammer the stock. Furthermore, our discounted cash-flow estimate, which might be a little conservative, also points to moderate overvaluation and certainly doesn’t highlight an acceptable +25% margin of safety (which is what we normally require). The stock has grown considerably over the last year (+43%) – growing even more aggressively over the last 10 years. Simply put, while there might be enough positive momentum behind the stock to keep pushing its price up, for the value investor it is worth waiting for a more attractive price.
