Starbucks Corporation (SBUX) - Texas Tech University

[Pages:51]November 1, 2006

Starbucks Corporation (SBUX)

Analysis By: Sarah Lamb sarah.a.lamb@ttu.edu Jeff Leaverton j.leaverton@ttu.edu Rachel Morris r.morris@ttu.edu Lauren Wein lauren.r.wein@ttu.edu Scott Weiser scott.t.weiser@ttu.edu

Starbucks Valuation

TABLE OF CONTENTS

Executive Summary.................................................3 Company Overview..................................................6 Industry Structure and Profitability..........................6 Value Chain Analysis.............................................11 Firm Competitive Advantage Analysis.....................11 Accounting Analysis..............................................12

Key Accounting Policies...............................12 Degree of Accounting Flexibility...................14 Accounting Strategy...................................15 Quality of Disclosure..................................16 Potential "Red Flags"..................................19 Undo Accounting Distortions......................19 Financial Ratio Analysis......................................20

Capitalized Lease Ratios............................22 Operating Lease Ratios..............................23 Trend Analysis..................................................23 Liquidity Ratios........................................24 Efficiency Ratios.......................................24 Profitability Ratios....................................25 Capital Structure Ratios...........................25 Ratio Changes After Capitalization............25 Financial Statement Forecasts............................27

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Firm Valuation..................................................29 Cost Of Debt..........................................29 Cost Of Equity.......................................29 WACC...................................................30 Credit Risks..........................................30 Intrinsic Valuations...............................31 Residual Income Valuation....................31 AEG Valuation......................................33 Long Run ROE Valuation......................34 Free Cash Flow Valuation......................34

References.....................................................36 Appendices.................................................37

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Executive Summary

Starbucks Corporation

Investment Recommendation: Over-Valued, Sell

11/01/06

SBUX ? NasdaqGS

52 week range Revenue (2005) Market Capitalization

38.26 28.7240.01 7.44B 26.61B

EPS Forecast

FYE 11/01 EPS

2006(A) 2007E 2008E 2009E 0.91 1.09 1.26 1.44

Shares Outstanding

756.07M

Valuation Estimates

Dividend Yield 3-month Avg Daily Trading Volume

Percent Institutional Ownership

N/A

8,036,250 65.50%

Book Value Per Share (mrq) ROE ROA Long-term growth rate (5 yr)

Cost of Capital Est. R2 Beta

Ke Estimated 10-year 1.6685 5-year 1.6645 2-year 1.6604 6-mon 1.6587

Published

.20472 .20443 .20342 .20242

1.17

10.83 23.88% 16.46% 22.00%

Ke 16.30%

16.30%

16.30%

16.40%

16.40%

Actual Current Price

Ratio Based Valuations P/E Trailing P/E Forward PEG Forward Dividend Yield M/B

Intrinsic Valuations

Discounted Dividends Free Cash Flows Residual Income Abnormal Earnings Growth Long-Run Residual Income Perpetuity

35.29

49.79 33.10 1.69 N/A 10.80

N/A 33 5.13 2.69 0.00

Kd After Tax Kd WACC

5.59% 3.47% 8.04%

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Starbucks Corp. has established itself as one of the top producers of specialty food items in the world. With an unwavering commitment to quality they have been able to produce a product that has found its way into the hearts and minds of their customers moving Starbucks into the forefront of the industry.

Starbucks has become such a success that many of its competitors have been forced to leave the market or been acquired by Starbucks itself. Through their commitment to a superior product quality and variety Starbucks has been able to keep consumers coming back day after day. They have also taken great steps in investing in their brand image to the point that consumers will accept no substitutes and will go out of their way and pay a premium for Starbucks coffee.

When looking at Starbucks from the surface it appears that everything is fine. After analyzing their financial reports Starbucks appears to be very cavalier with their accounting policies by not capitalizing their operating leases and not fully disclosing all of their financial information. They did not disclose any of their interest rates for their liabilities. Their lack of disclosure accompanied with the fact that Starbucks does not capitalize any of their operating leases was a cause of concern and raised the chance of manipulations taking place within the

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financial statements. Some of the financial ratio tests that were run over the previous five years resulted in some very inconsistent results. These results accompanied with the apparent lack of disclosure for certain items raised a few "red flags" when valuing the Starbucks Corporation.

The first step in forecasting the future value of our firm was to calculate the value of the firm for the fourth quarter of 2006. Once we were able to determine the value of the firm for 2006 we then estimated the future value for the next ten years. We then found average growth rates from the previous years and estimated them out for the next ten years. We took into account that we did not think that Starbucks would not be able to sustain its abnormally high growth rate. We looked how Wal-Mart grew as its growth as a company was similar to that of Starbucks.

The last thing that we did was valued our company using several valuation models. Some models such as the dividend growth model and the long run return on equity did not apply to Starbucks because they do not pay dividends and their Return on Equity is equal to the Growth in book value. In order to value Starbucks we first computed the necessary components such was cost of debt, cost, of equity, and the weighted average cost of capital. With these components in place we were able to run valuation models on Starbucks in order to find whether it was over or under valued. In all of our valuation models we found that Starbucks is significantly overvalued and we strongly recommend selling.

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Company Overview

The Starbucks Coffee Company was founded in 1971, opening its' first store in Seattle, Washington. Starbucks' products consist of a variety of hot and cold coffees, teas, juices, and pastries. Starbucks stores also sell non-food items such as espresso machines, coffee brewers; drink related items consisting of mugs, thermoses, plastic drink containers, and coasters.

In 1992, Starbucks became a publicly traded company on the NASDAQ National Market under the symbol "SBUX". As of July 2006, there are 11,784 Starbucks locations worldwide and the company headquarters is located in Seattle, Washington. The increasing popularity and customer loyalty has led to Starbucks being the only major player in the specialty coffee industry and has enabled the company to expand into new markets with relative ease and efficiency. Last year Starbucks has a market capitalization of $25.59 billion dollars in 2005 while also seeing its sales increase by over one billion dollars.

Industry Structure and Profitability

Rivalry Among Existing Firms

The coffee industry is a highly competitive industry in that coffee is served at almost every restaurant, diner, and convenient store in the nation. Most homes brew their own coffee as a more convenient and less expensive way of getting their daily coffee fix. Thirty years ago people who wanted a premium cup of coffee would head to their local coffee houses or their corner cafes in order to obtain the highest quality of coffee. Today with the onslaught of corporate chains these local establishments have become an archaic symbol of the past.

Starbucks has differentiated itself from its competitors by offering higher quality of coffee which it charges a premium price for. While its prices are much

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higher then that of its competitors Starbucks has such a strong brand loyalty that

it has been able to consistently outperform other coffee houses. Starbucks, as

with all local caf?s, also has to compete against home coffee producers such as

Procter & Gamble's (NYSE: PG) Folgers brand of coffee and Kraft Food's (NYSE:

KFT) Maxwell House brand. With a high concentration of competitors Starbucks

has been able to thrive by offering a high quality product that commands a high

brand loyalty.

Starbucks has a differentiated itself from its competitors by offering a vast

array of coffee flavors from all ends of the spectrum. This allows them to create

unique flavors that can only be found at Starbucks. Starbucks also offers baked

goods, sandwiches, and recently added movies and music to its ever expanding

line of goods. With such a wide variety of specialty goods available for sale

Starbucks is able to differentiate itself from its competitors.

Sales Volume Total Assets Stock Price Performance (per share)

2001 $2,648,980,000 $1,851,039,000

$7.14?$12.23

2002 $3,288,908,000 $2,214,392,000

$9.40?$12.59

2003 $4,075,522,000 $2,729,746,000

$10.05?$16.58

2004 $5,294,247,000 $3,386,541,000

$16.45?$31.18

2005 $6,369,300,000 $3,514,065,000

$22.78?$31.93

With an expanding market the likeliness of excess capacity is minimal. However if Starbucks were forced to close a store at a particular location the exit barriers would be small for such a large corporation. Any equipment in the closed store could be moved to a new store and there are now regulations for exiting the industry.

Threat of New Entrants

One area of concern for Starbucks is that startup costs for local coffee shops are relatively low and many people open caf?s everyday in the hopes of offering a local alternative to the corporate chains. Fortunately for Starbucks, these caf?s do not have any brand recognition or loyalty and more often then

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