Starbucks II the First Component

Starbucks II

The first component of the financial analysis will be a ratio analysis. There are several categories of ratios that can be used to help analyze the company's financial condition -- these including profitability, liquidity, long-term debt ratios and asset management ratios. These ratios allow the analyst to determine the company's ability to earn profit on its revenues, how solvent the company in both the short- and long-term and the strength of its operational efficiency.

For the equity investor, the return on equity (ROE) is an important ratio. The ROE reflects the firm's ability to convert its equity financing into profit. The numerator is the net income, which is the after-tax income that accrues to shareholders. The denominator is the book value of the firm's equity. This is affected by two things -- the book value of the equity in terms of the shares that have been issued and the retained earnings that represent the accumulated profits that have been converted to equity. If the company reduces the book value of its equity, for example in a share buyback, it will improve its ROE. The ROE for Starbucks for the past three years is as follows:

ROE= Net income/total equity

FY 2010

FY 2009

FY 2008

Calculation

948,300/3,674,700

390,800/3,405,700

315,500/2,490,900

ROE

27.69

14.16

13.25

These figures indicate that Starbucks has made significant improvements in its ROE in fiscal 2010. The book value of the equity has improved each year, the result of increases in retained earnings, but the net income has increased more rapidly. The net income in FY 2010 was 2.4 times the FY 2009 level, and this accounted for most of the improvement in the ROE. For the equity investor, improving ROE -- especially in the form of higher net income -- is attractive.

The liquidity ratios reflect the ability of the firm to meet its short-term obligations. Those obligations are measured by the current liabilities. The firm's current assets are often used to measure liquidity. Whether or not to include the inventories (current ratio vs. quick ratio) depends on the type of inventories the firm has, and the likelihood of having to sell them at a discount. For Starbucks, most inventories are food and coffee and these would not be sold at a discount, and are likely to be sold given the firm's increasing revenues. Therefore the best liquidity measure is the current ratio, because it incorporates all of the current liabilities and the company is likely to use all of them if it experienced a cash crunch. In addition, the current ratio is a better measure for firms not currently in distress, because it smoothes out fluctuations that might occur in individual current asset category levels year-over-year.

Current ratio = current assets / current liabilities

FY 2010

FY 2009

FY 2008

Calculation

2,756,000/1,779,100

2,035,800/1,581,000

1,748,000/2,189,000

Current ratio

1.55

1.29

0.8

The current ratio at Starbucks has been improving over the past few years. In FY2008, the current ratio was below 1.0, which is a common cutoff point below which an investor should be concerned. The company has improved its current assets significantly in the past two years, while showing a net reduction in current liabilities from FY2008. It is important to understand which current assets have increased, and in this case it is cash that is the bulk of the current asset increase, improving from $600 million in FY2009 to $1.164 billion in FY2010. This means that Starbucks is improving its liquidity rapidly with its current trajectory.

The long-term debt ratios indicate the long-run financial health of the company. All companies have ideal capital structures that help them to balance the low cost of debt capital with the limits that debt places on financial flexibility. In general, firms with a strong growth orientation prefer to finance with equity, so that more of their free cash flow can be dedicated to growth rather than debt service. The most important of these ratios is the ratio of long-term debt to equity.

LT Debt/Equity

FY 2010

FY 2009

FY 2008

Calculation

549,400/3,674,700

549,300/3,045,700

549,600/2,490,900

LT Debt/Equity

0.15

0.18

0.22

The long-term debt to equity ratio is promising for Starbucks. It is low, and it is declining. Despite the struggles that the company has had, the level of long-term debt has not changed since FY2008. The only change to this ratio is the increase in the book value of the equity that goes along with the company's increase in net income. This is encouraging for investors.

The asset management ratios reflect the ability of the company to manage its resources. These ratios typically measure sales, profits or COGS against one of the company's assets. For Starbucks, it is arguable that the fixed asset turnover (plant, property and equipment) is the most important. This is because of the company's significant investment in stores and leasehold improvements, and its effectiveness should be measured in its ability to convert these properties into profits. For companies with high levels of plant, property and equipment this ratio is more reflective of operational efficiency than any of the current asset management ratios, and is akin to the common retail metric of "same store sales."

PPE Turnover = Net sales / ppe

FY 2010

FY 2009

FY 2008

Calculation

10,707,400/2,416,500

9,774,600/2,536,400

10,383,600/2,956,400

PPE Turnover

4.25

3.57

3.56

The improvement in this ratio is positive for the equity investor. The improvement reflects two things. The first is that the company's asset base declined in FY2010. This decline was the result of depreciation, however, as the company's gross fixed assets increased. Starbucks also saw significantly higher sales in FY2010, and this contributed to the improved ratio. Combined with the other ratios, Starbucks has clearly improved its financial condition in the past three years. The trend is improving at this point. That FY2010 was strong for the company is something that, if only one ratio or two had improved, the results would not mean much. But Starbucks has improved all of its financial results, showing progress in all categories. As a result, it is reasonable to conclude that Starbucks has made operational improvements that are being reflected in the company's financial condition. If these improvements continue, and the operating conditions (external environment) remain the same, an investor in Starbucks can expect to see continued growth in the value of the company.

Stock Performance

Starbucks' stock has experienced significant improvement over the past three years. The value of the company's stock three years ago was $8.93, and now its value is $43.64 (MSN Moneycentral, 2011). This is a return of 394% in that time. For the equity investor, clearly purchasing into Starbucks three years ago would have been astute. The stock's performance is a function of a couple of factors. The first is that the broad market has increased in that time as well. The fall of 2008 was a down time for the market, but the broad market began to rise in early 2009 and has continued to perform well despite the overall economic malaise. Some of the growth in Starbucks' stock can be attributed to the improvement in the general market conditions. But the S&P 500 has not quadrupled in the past three years, and on a risk-adjusted basis Starbucks should not have either. Thus, most of the improvement in the company's stock price over the past three years can be attributed to firm-specific performance. The improvements that Starbucks has made to its operations have been reflected in the firm's financial statements.

The market clearly believes two things about Starbucks. The first is that the improvements in the company's financial performance are going to continue. The P/E ratio at present is 30.9, which is a moderate multiple but reflective of the fact that only some of Starbucks' business is a growth business (Asia) while most of it is mature and subject only to incremental improvements. The second thing that the performance of Starbucks stock implies is that the market believes the improvement is going to continue in the long-term and that Starbucks is going to outperform the market in general. Starbucks struggled like most other firms during the downturn, but the company made some strategic moves to turn itself around. That it was able to do so quickly is a sign of management strength. The quantitative analysis bears this out -- Starbucks has excelled at improving a number of metrics simultaneously. The market, therefore, rightly sees Starbucks as a well-managed company that has multiple growth opportunities, any one of which could drive the stock price even higher. After quadrupling share value in three years, that there is still room for significant growth for this company is impressive, and the market recognizes that and has rewarded Starbucks not only for its profit improvements, but for the promise of even more such improvements in the future.