Estimating the Value of Starbucks Corporation
Estimating the Value of Starbucks Corporation
Business Valuation – Spring 2017
Team Snapchat:
Lara Dixon, Alfonso Aguilera, Ben Nematzadeh, Donald Horton
Executive Summary
1. Economic Environment
2. Industry Analysis
3. Company Description
4 Valuation Technique: DCF Analysis
4.1 Cost of Capital (WACC)
4.1.1 Cost of Debt (rd)
4.1.2 Cost of Equity (re)
4.1.3 Capital Structure
4.2 Creation of Free Cash Flow Projections
4.2.1 Base Year Free Cash Flow
4.2.2 Future Free Cash Flow (FFCF) Projections
4.3 DCF Valuation
5 Valuation Technique: Relative Valuation
5.1 Choice of Comparables
5.2 Adjustments
6. Summary of Valuation
Appendix25
Exhibit A - Interest Coverage Table25
Exhibit B - Altmans-Z Table26
Exhibit C - Average Bond Spread26
Exhibit D - Starbucks Long-term Debt Schedule (Source: Starbucks 2016 10K)27
Exhibit E - Present Value of Starbucks Debt, Starbucks Debt Repayment Profile (incl. operating leases)27
Exhibit F - Daily Regression Output - Starbucks Returns and S&P 500 Index Returns28
Exhibit G - 5-year Monthly Daily Regression Output - Starbucks Returns and S&P 500 Index Returns28
Exhibit H - 2-year Monthly Daily Regression Output - Starbucks Returns and S&P 500 Index Returns28
Exhibit I - Unlevering and Re-levering Starbucks Beta29
Exhibit J - Key 2017 Revenue Growth Drivers per Region29
Exhibit K - DCF Model and Driving Assumptions30
Exhibit L - Perpetuity Growth Rate Calculation Using Forecast GDP30
Exhibit M - Calculating Equity Value per Share Using Each Estimate of EV30
Exhibit N - Industry Analyst Starbucks Target Share Price31
Exhibit O - Sensitivity Analysis: Change in EV & Equity Value per Share driven by changes in WACC and/or ‘g’ 31
Starbucks: Valuation
Executive Summary
The purpose of this report is to discuss in detail our approach to arriving at an estimate of the valuation of Starbucks Corporation, a company that operates in the Quick Service Restaurant (QSR) industry and has grown to become a global premium brand leader with more than 25,000 stores in 75 different countries. An in-depth review into the company’s operations, growth plans, competition and external environment has aided our assessment of the key information required to generate robust valuation estimates when used in conjunction with key business valuation techniques.
Established in 1971 selling made to order coffee, Starbucks has expanded to sell ready-to-drink (RTD) coffees, ready-to-eat (RTE) Foods, snacks, and teas. Starbucks has endured the most recent global recession and even achieved a 10% compound annual growth rate since 2012. Going forward, major growth plans have been announced in two key regions, the America’s and the Asia Pacific (ACAP) regions. Starbucks has been aggressively expanding into the ACAP market in particular, which currently contributes 15.58% of total revenues. Company management have even admitted the ACAP market, specifically driven by Chinese demand, may one day contribute the majority of Starbucks’ revenue. Recently, however, market and macroeconomic conditions in both the Americas and ACAP regions respectively suggest ongoing growth of 10% may not be achievable. Same store sales growth in established stores in the Americas, for example, are the lowest since 2009, and lower GDP forecasts in key APAC economies could prove another limiting factor.
Industry analysts also consider the QSR market to be highly fragmented, saturated and incorporating a high level of product substitutes. Some competitors in the overall industry include Wendy’s, Yum Brands International, Jack in the Box, and Domino’s Pizza, among others, each fighting for market share. Despite the competitive landscape, Starbucks is expected to continue on a growth trajectory. Starbucks aims to open a further 5,000 stores by 2019 and that its growing product line of consumer food and drink choices will help maintain its leadership position. This position will be reliant on the company’s continued investment in some unique assets: employee (partner) engagement, menu expansion, product innovation, loyalty programs and new technology. By providing healthcare and tuition reimbursement Starbucks aims to attract high quality and committed “partners” which consumers will identify as core to developing an unrivalled, experiential store atmosphere. Starbucks continues to invest in a strong digital ecosystem (mobile loyalty programs, digital payment applications, and mobile gift cards) and menu improvements to boost customer convenience, appreciation, in-store spending and retention.
We employed two approaches to determine the enterprise value of Starbucks; Discounted Cash Flow (DCF) and Relative Valuation. DCF is based on the premise that the value of a company is the present value of all future free cash flows of the company. The present value of future cash flows is obtained by discounting the future cash flows a firm’s weighted average cost of capital (WACC). The sum of the present value of future free cash flows is the DCF estimate of Starbucks value. The WACC is defined as the required rate of return for a firm and, therefore, the rate of return one should expect per annum upon investing in the company. The WACC is reliant on multiple factors each of which are specific to the company, such as a firm’s capital structure (proportions of debt and equity financing) and investors’ expected rates of return. As such, it is highly likely the WACC for Starbucks will not be identical to that of its competitors. Furthermore, it is difficult to estimate all factors influencing WACC precisely. Nevertheless, in this report we employ and discuss multiple data sources and methods to instill confidence in our calculations of all components required to estimate Starbucks' WACC.
Once we established our estimate of WACC as 7.11%, the focus of our discussion turns to the estimation of Starbucks’ future free cash flows (FFCF). FFCF is defined as a company’s net operating profit after tax (NOPAT) less capital expenditures and working capital investments. We are interested in FFCF because this measure represents cash (value) generated by Starbucks once Starbucks has spent the necessary money it needs in order to maintain or expand its asset base. Sales growth drives our estimates of operating income after tax, capital expenditures and the change in working capital. We estimate each of these factors using historic averages from 2011 to 2016 (latest year), and then adjust each factor in 2016, for example to account for any one-time deviations from historic trends. We project 2017 sales by projecting same store sales for a combination of existing stores and new stores opening in 2017. Our 2017 growth rate is estimated to be ~8.5%. As projected revenue drives our estimates for capex and net working capital adjustments it is, therefore, critical we are comfortable with our revenue projections.
When valuing a company, we make the key assumption that we are valuing FFCF out to eternity. Despite Starbucks’ recent growth being higher than global GDP growth, we cannot assume this level of growth shall continue forever. We have made detailed FFCF projections for the period 2017-2022, however beyond this period we assume Starbucks FFCF growth is aligned with global GDP growth estimates. Data from the International Monetary Fund, World Economic Outlook Database, April 2017 aided our calculation of an appropriate growth rate beyond 2022. Once all FFCF were estimated we discounted each annual FFCF back to a present value of the cash flow using our estimate of WACC. We apply a perpetuity growth method formula to calculate the value of FFCF beyond 2022, which is also known as the terminal value (TV). The sum of the discounted annual FFCFs, including that of the TV, was ~$105B and represents our DCF estimate of the enterprise value (EV) of Starbucks.
Our Relative Valuation methodology involves the use of comparable companies, whereby the value of Starbucks is compared to the value of the similar companies as assessed by the market. One major difficulty with using this approach for Starbucks is the lack of direct or close comparable companies to Starbucks. Nevertheless, we filtered companies operating in Starbucks’ industry by a set of three criteria (annual revenue, operating margin and five-year growth forecast) and obtained a set of five close comparable companies. For this comparable set we calculated three valuation metrics for each company and obtained the median valuation for the comparable set. The three valuation metrics include: EV/Revenue, EV/EBITDA, and EV/EBIT[1]. We use EV in the calculation of this multiples as EV is a more comprehensive measure of the market value of a company than equity value because it accounts for claims by all claimants on the company, i.e. debt holders and equity holders. As such, EV is a more accurate measure of the theoretical price to acquire a company debt free. We compared the median expected growth rate, EBIT margin and revenue for the comparable company set to Starbucks own projected growth rate, EBIT margin and LTM revenue and used any deviations between Starbucks and the comparable set to apply an adjustment to the median valuation multiples. The purpose of this adjustment was to ensure each multiple was a better match to Starbucks given Starbucks’ size and forecast growth. By multiplying the adjusted valuation multiples by the relevant Starbucks' financial statistic (Revenue, EBIT or EBITDA) we derived three additional estimations of Starbucks EV. The three values ranged from ~$98B to $117B.
The key output from this report is four estimates of Starbucks EV. By adding back Starbucks cash balances and subtracting the present value of company debt from each EV estimate we were able to determine implied equity values for the company. Dividing each equity value by the total number of Starbucks shares outstanding (1,457.4m) allowed us to demonstrate four estimates of Starbucks equity value per share. The average equity value per share using our estimation techniques was $68.23 and the median $68.24. Such estimations are approximately 12% higher than Starbucks’ market share price of $60.87 (May 11th, 2017). Our estimates are also higher than analyst consensus, albeit within the range of analyst target prices.
By its very nature, business valuation is difficult to estimate with accuracy. All valuation techniques employed involve a high degree of estimation in order to forecast future events which is inherently difficult. As such, our estimates of Starbucks’ value, despite being driven by our best efforts to forecast the unknown, will differ, perhaps considerably, from other estimates due to variations in key assumptions which drive future FCF. Whether our revenue growth is too conservative, or perpetuity growth rate too optimistic, only time will tell and for now we feel our estimates to be as good as any other.
1. Economic Environment
The global economic environment is filled with uncertainty. According to the World Economic Forum’s Insight Report there are five key trends determining global development: rising income and wealth disparity, climate change, increasing polarization of societies, rising cyber dependency, and an ageing population[2]. Tied to the aspect of rising income and wealth disparity is lower than expected global productivity. Especially concerning is that whilst most economies around the globe have concluded the recent recession period is complete, recent actual GDP growth rates are lower than expected. Most important to Starbucks, are the North American and Asia Pacific (APAC) markets, both of which account for and are expected to continue accounting for a significant portion of global revenues. Uncertainty in the US and APAC markets, specifically regarding forecast GDP growth concerns in China and lower than expected growth rates in the US, have been a source of contestation regarding the economic strength of these two regions. Nevertheless, US and Chinese GDP growth is trending positive which is beneficial to Starbucks and the industry they operate in.
2. Industry Analysis
The industry Starbucks operates in is recorded as Eating Places (SIC 5812) by the Standard Industry Classification (SIC) system, or as a limited service restaurant (NAICS 722513) by the North American Industry Classification (NAICS) System. Slowly improving macroeconomic conditions are expected to improve revenues for these industries overall as they are considered cyclical and will tend to follow the trends of the economy. Close competitors to Starbucks are not easy to find, however the closest may include Wendy’s (WEN), Jack in the Box (JACK) Domino’s Pizza (DPZ), Panera Bread (PNRA), and Yum Brands (YUM). These establishments primarily engage in the retail sales of prepared food and drinks for on premise or immediate take-out consumption. The threat of new entrants to the market is moderate-high as there are few, if any, barriers to new company entry.
Starbucks operates in a subset of the Eating Places industry known as Quick Service Restaurants (QSR). Analysts consider QSR to be a highly saturated and fragmented market with many competitors and a vast array of consumer choices. The threat of substitutes is, therefore, considered high. In this subset, the Starbucks brand positions itself as the coffee beverage leader in the premium product category[3]. In the US, the market for premium coffee is considered mature while, in emerging economies the industry remains in the growth stage. Starbucks faces intense competition, which is something that analysts and Starbucks both agree on. According to the 10K, Starbucks management perceive specialty coffee shops and quick service restaurants as direct competitors within the US. Internationally, mature QSR companies are considered their main competitors. Starbucks also acknowledges direct competition in their channel development business unit.
Demand determinants for premium coffee include disposable income, trends in per capita coffee consumption, and health perceptions regarding Starbucks products. Buyer power is moderate with no large players able to affect overall industry pricing. Profitability drivers in the industry primarily revolve around coffee bean pricing. Historically, bean prices have been volatile but typically increaseas demand rises. Although low given global demand, coffee prices are expected to increase in coming years with rapid forecast demand growth in Asia considered a major driver of demand and coffee price growth[4].
3. Company Description
Starbucks (SBUX) was established in Seattle, Washington in 1971. Starbucks’ principal line of business comprises the operation of over 25,000 specialty coffee stores across the globe. Company-operated stores accounted for 79% of Starbucks' $22.2B revenues in 2016, and licensed stores generated 10%. Starbucks' consumer packaged goods (CPG) segment achieved 8% of total revenues and comprises the sales of packaged beverages to grocery, warehouse clubs and specialty retail stores. Starbucks also supplies coffee and tea related products to institutional food service companies that service operators in education, healthcare, hotels etc., and this unit contributed the residual 3% of Starbucks' revenues. Starbucks' revenues have increased at a 10% compound annual growth rate (CAGR) since 2012. Over this period, company operated store revenues grew at 9.8% CAGR whereas licensed stores and CPG/Food service revenues grew at 12.1% and 8.6% CAGR respectively.
According to the company’s quarterly earnings call, Starbucks has dominance in its position with the closest competitors selling discount coffee products[5]. Leveraging product differentiation and their premium product mix, Starbucks is expected to maintain its dominance as the world’s leading coffee retailer with plans to reach 30,000 stores by 2019. With a high level of competitive rivalry, the company focuses on offering an experiential purchase and unique in-store ambience that competitors will find difficult to imitate. Part of this experience includes superior customer service in a well maintained, relaxed atmosphere with free wi-fi. These factors have combined to create a globally recognizable brand operating in over 60 countries and achievement of approximately 40% market share in the United States[6]. The company targets prime real-estate and high traffic locations for new store openings which ties into to its brand positioning.
A few aspects unique to the company, compared to the industry overall, is their human resource management, use of technology, and social activism. Employees of Starbucks are known to receive excellent training, stock options, retirement options, tuition reimbursement, and healthcare options while operating in a healthy culture. The use of technology allows Starbucks to target, analyze, and expand its customer base while increasing the frequency of customer visits. This has proven extremely successful in recent years as consumers adopt technology as a part of their daily lives, share gift cards with friends, and load up loyalty accounts before redeeming them for purchases. Finally, Starbucks is one of the few companies to participate in activist movements reflected by modern society. According its customer base, Starbucks does this successfully by picking movements largely considered to be in the best interests of society. The company frequently deals with misinterpreted marketing campaigns and messages, but the brand has always managed the publicity well and is one of Starbucks most recognizable attributes.
4 Valuation Technique: DCF Analysis
Outlined below is a detailed description of the two approaches utilized to determine the value of Starbucks, Discounted Cash Flow (DCF) and Relative Valuation.
DCF is based on the premise that the value of a company is the present value of all future free cash flows of the company. The present value of a cash flow refers to the current worth of a sum of money that is expected to be received in the future. To arrive at the present value, all future free cash flows must be discounted back to today’s value using an appropriate discount rate. This is shown mathematically in Equation 4.1 below.
Equation 4.1
whereby:
n = The time period between now and the future cash flow in number of years.
CFn = Cash flow for period n. In the context of the valuation of a company, the cash flow is free-cash-flow (FCF). FCF is the cash generated from the normal operations of a business, and that is available to its creditors and owners.