The following is an equity research report on Starbucks. The company competes primarily in the quick service food industry, where it holds the #5 market share in the United States, and #1 in its segment of coffee (QSR Magazine, 2011). The company had revenues last fiscal year (ended 10/2/11) of $11.7 billion and net income of $1.245 billion. The current stock price is $43.91, which gives the company a market capitalization of $32.73 billion and a price/earnings ratio of 27.10.
This report will begin with a qualitative analysis of the firm, its industry and its markets. The next step will be an analysis of its financial statements, followed by an analysis of the stock price. A determination will be made as to whether the stock should be rated a "buy," "hold," or "sell."
The evaluation will be based on careful consideration of the company's recent financial performance and its current stock valuation. In particular, we are looking for signs that the company's true value is different from its market value. The intrinsic value of Starbucks is lower than the current market cap, but we have also found that that growth potential of the company has not been fully priced into the market.
Starbucks is a differentiated provider in the quick service restaurant business, focusing on coffee, coffee-based beverages and snacks. The company has one of the largest networks of restaurants, today numbering of 17,000 worldwide and over 50,000 points of distribution (2010 Starbucks Annual Report). The company is also involved in consumer products, including premixed coffee drinks, and has just entered into the juice business with the acquisition of Evolution Fresh, theoretically wanting to apply its coffeeshop business model to that segment (Cannold, 2011).
The quick service restaurant industry is in general mature, but there are still strong growth opportunities overseas. There is intense competition within this industry. Starbucks does not face strong competition from other coffee players, aside from the largest of those companies like Dunkin Donuts and Tim Horton's, and for the most part its direct competitors are not in the same premium segment of the industry. Starbucks also loosely competes against any other caffeine delivery mechanism -- for example against energy drinks for the youth market and home coffee or tea for older adults. The core target market for Starbucks is with middle and upper-income adults aged 25-45 and it is believed that this demographic accounts for most of the company's sales.
The company's core business is relatively mature in its main North American market, but is subject to rapid expansion in other parts of the world. The main target of growth for the company at present is China, where the company sees buildout from its current 500 stores to 1500 by 2015 (Starbucks Press Release, 2011, 1). Such a move would take the People's Republic from being the #5 market for the company (behind Japan, Canada and the UK) to the #2 market behind only the U.S. To facilitate this expansion, China has been given its own division within the organization, with higher status that any other national sub-market.
The role of the juice business is another issue. Evolution Fresh was purchased for $30 million. The company sees the brand as being a springboard into becoming a major player in the health and wellness sector, which is worth $50 billion (Cannold, 2011). Currently, the strategy is to expand the brand into the Starbucks distribution chain as well as using the brand to build out juice stores in the same manner in which the company built out its coffee business.
Another important growth business for the company is in consumer products. The company is working to expand on this division, adding to its single-serve coffee offerings in hotel rooms, as the company believes there is a market for the CV1 product in hotel rooms as an alternative to traditional in-room coffee systems (Starbucks Press Release, 2011, 2).
The company's core business is also improving. The majority of Starbucks' revenue derives from its coffee shops and most of that comes from the largest market, the United States. As of 2007-2008, the company was struggling strategically. It faced intense competition from McDonalds and Dunkin Donuts, who were moving aggressively to compete with Starbucks, as the latter had added food and therefore became a direct threat to the breakfast business of other fast food companies. McDonalds in particular rolled out the McCafe concept that it had originated in Australia, coming to the U.S. via Canada, and then on to Europe as well. This concept proved to be one of the greatest competitive threats that Starbucks had seen (Liu, 2009).
Starbucks also came under threat of the economic downturn. Uncertainty over the future of the U.S. economy caused a decline in consumer spending, and this hurt Starbucks particularly. The company is positioned at the top end of the coffee market, and charges premium prices to match the premium coffee drinks. While coffee-drinkers typically see coffee as a staple item, Starbucks coffee proved to be discretionary. In a recessionary environment, consumers began to trade down either to other fast food companies that had lower price points, or to the grocery store business (Adamy & Wingfield, 2009). The company had been forced to close underperforming stores and make $500 million in cuts to its operations in order to remain competitive in this environment.
The company re-hired former CEO Howard Schultz in 2008 and the turnaround began almost immediately. The in-store experience was improved. The food offerings were also improved, as there were issues that were causing the company trouble, like the smell of burning cheese permeating the store instead of the smell of brewing coffee. Starbucks introduced a new cafe concept and the Via instant coffee system. Internally, operations were tightened and there were some changes to the company's pricing structure as well. All of the different changes from that era have been expanded upon in the past couple of years, and the company's financial performance has improved as a result.
The financial trends at Starbucks are strongly positive. The company remained profitable even through the depths of the recession, but as consumer spending has improved slightly, the company's financial performance has improved significantly, leading to the conclusion that the company's performance is based at least somewhat on firm-specific factors rather than broad market factors. The company's earnings have improved 19.7% since the recession lows in 2009, and net income has improved 218% in that time. Cost containment has been a key part of the company's strategy. SGA expense was 4.6% of revenue in 2009 and today it is 5.4%, but margins are better. The gross margin is 26.3% today, compared with 20.7% two years ago.
The company's balance sheet has also improved as the result of its turnaround. There has not been any significant change in the level of long-term debt in the past five years. As a result, the company's improvements in retained earnings have left it with a capital structure that has 59.4% equity and 40.1% debt; two years ago it was 54.6% equity and 45.4% debt. There is no indication that Starbucks is planning to take out any more long-term debt, and instead the company is expected to finance its expansion and growth strategy with retained earnings.
The company's internal metrics remain strong, although there has been a slight decline in both the inventory turnover (8.9 times in FY2011 compared with 11.6 times in 2009) and the receivables turnover (30.3 times in FY2011 compared with 36.1 times in FY2011). Starbucks still has a strong liquidity position with a current ratio of 1.8, compared with 1.3 in FY 2009. Its fixed asset turnover is 4.9 times, compared with 3.8 times in FY2009. This latter measure is key because of the emphasis of fixed assets (stores) in the Starbucks business model. Same store sales growth was 7% in FY 2010, reversing two years of declines (2010 Annual Report).
The company's returns have also been strong in the past two years. EPS per diluted share was $1.62 in 2011, compared with $0.80 in 2009. The return on assets (ROA) is 18.2%, higher than the company's five-year average of 12.4%. The return on equity is 30.9%, compared with a five-year average of 24.1%. Return on capital investment (ROI) was 25.3%, compared with a five-year average of 18.7%. These returns indicate that the company's performance in the last fiscal year was strong compared with its performance in other recent years, in particular the relatively poor performing fiscal years of 2008 and 2009. This improved performance in most metrics is reflected in a dramatically improved stock price.
Stock Price Analysis
Three year ago, the price of a share of Starbucks stock was in the $8-9 range and today the company's stock trades at $43.91, an improvement of nearly 400%. The company's stock has risen steadily over the past three years and at a much faster rate than the general market: