Since mid-November Starbucks stock price has dropped from $40 to a 12 month low of $25.22 this week. Contributing factors appear to include the continuing decline in comparable store sales growth from 10% p.a to 8% p.a. over the last 3 years and the lower operating margin in 2006 financial year (11.5% down from 12.3%). The drop in same store sales may be a function of strong competition from existing players including Dunkin Donuts and moves by McDonalds to grow their McCafe brand. Starbucks faces ongoing competition from local niche/gourmet coffee retailers as customers migrate to higher quality products. The declining operating margins reflect the increase in occupancy costs, transportation costs and commodity prices.
Despite these declining metrics revenues have continued to grow (22% in 2006) as Starbucks pursues an aggressive growth strategy. The Seattle based coffee retailer has over 12,000 stores worldwide with plans to grow to 40,000. In the 2006 financial year Starbucks opened 2,199 stores and plans to open another 2,400 in 2007. Starbucks is focusing on developing the Starbucks Experience; this includes a film partnership, a music label and a book strategy. This strategy may allow Starbucks to extract extra value from it’s customer base and provide a point of difference in an increasingly competitive market. It remains to be seen if the Starbucks Experience will impact on the customer looking for the best value coffee or premium coffee product.
Starbucks’ DCF Valuation
Valuecruncher places a mid-point valuation of $25.04 per share on Starbucks with a sensitivity range of $22.92 to $27.23. The Valuecruncher mid-point is slightly below the current valuation of $25.77.
Revenues are forecast to grow to 13,780 million by 2009 representing a compound annual growth rate of 21% driven by aggressive growth strategy. EBIT margins are forecast to increase slightly to 11.8% (from 11.5%). It is hard to quantify the impact of the Starbucks Experience strategy on profit margins but with approximately 85% of revenue derived from company operated retail store sales Starbucks’ profitability will continue to be driven by occupancy, transportation and commodity costs. Short-term capital expenditure of $1 billion+ p.a is forecast to facilitate the planned expansion. Long-term growth is forecast at 6%, this relatively high assumption reflects the target of 40,000 stores worldwide. Valuecruncher has used a 10% cost of capital for Starbucks.
Comparable Company Analysis
Starbucks is currently trading at a forecast EV/EBIT multiple of 18.1 compared to the Valuecruncher valuation of 17.6, the forecast multiple is used to incorporate some of the short-term growth factored into Starbucks’ valuation. It is difficult to identify a comparable company that operates in the retail coffee market on a similar scale to Starbucks. In North America Dunkin Donuts is a major competitor but it is privately held. Valuecruncher has compiled valuation multiples for Tim Hortons and McDonalds to provide a point of reference but they are not suitable to provide a comparable company valuation.
Tim Hortons has over 3,000 in North America and was a wholly owned subsidiary of Wendy’s International until an IPO in March 2006 followed by a complete separation from Wendy’s International in September 2006. Tim Hortons have a forecast EV/EBIT multiple of 15.1 but although they compete directly with Starbucks they are not suitable for a direct comparable company valuation. Tim Hortons does not have the international presence of Starbucks and is not undertaking the rapid expansion strategy of Starbucks (in 2006 Tim Hortons opened approximately 160 stores). The Tim Hortons business model also differs from Starbucks, Tim Hortons franchise out over 95% of their stores compared to Starbucks who generate 85% of their revenue from company owned stores.
McDonalds has developed a McCafe brand that competes with Starbucks in the retail coffee market. Currently the McCafe brand represents a relatively small portion of McDonalds operations limiting the validity of McDonalds as a comparable company. McDonalds has approximately 30,000 stores worldwide and operates in the same geographical markets that Starbucks currently operates in and those it plans to expand into. McDonalds have a forecast EV/EBIT of 13.6.
Based on the DCF valuation the Starbucks’ stock price appears to be an accurate reflection the company’s current value. Starbucks has significant growth opportunities with only 17% of its current revenues being generated outside the United States. Starbucks strategy to grow its international presence is driving the 20% p.a growth forecasts. A market such as China presents enormous potential for Starbucks but developing it has risks and uncertainties. Starbucks must also address the issue of slowing growth, declining margins and increased competition in their existing markets. It will be interesting to observe the company’s performance as it tackles these challenges.