Valuecruncher Valuation Report – Starbucks

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.

DCF Assumptions

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

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

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.

Conclusion

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. 

Valuecruncher places a mid-point valuation of $119.74 per share on IBM with a sensitivity range of $113.71 to $125.92. This valuation range is noticeably higher than the current market price of $105.16 per share. 

IBM Overview 

Over recent years IBM has undertaken a series of acquisitions and divestitures that have resulted in a significantly change in the company’s business focus. This restructuring was a conscious move away from a number of IBM’s traditional product lines that it saw being commoditized (e.g. sale of Personal Computers business to Levono in 2005). In 2006 IBM completed 13 acquisitions valued at $4.8 billion, these acquisitions focused on growing IBM’s software and services businesses. These acquisitions are part of a wider strategy: 

“The company is continuing to refocus its business on the higher value segments of enterprise computing—providing technology and transformation services to clients’ businesses. Consistent with that focus, the company continues to significantly invest in growth opportunities as a way to drive revenue growth and market share gains. Areas of investment include strategic acquisitions, primarily in software and services, focused client− and industry−specific solutions, maintaining technology leadership and emerging growth countries such as China, Russia, India and Brazil.” IBM 10-k 2006

IBM’s current operations can be divided into three principal business segments; services, software and systems & financing. 

DCF Valuation Assumptions 

The Valuecruncher mid-point valuation assumes IBM’s revenue grows to $103 million in 3 years; this represents a compounding annual growth rate of 3.9%. As IBM increases its software sales EBIT margins are projected to improve to 15.9% (from 14.0% in 2006). Valuecruncher uses a cost of capital of 9% and a terminal growth rate of 3%. 

Comparable Company Analysis 

The Valuecruncher mid-point reflects an EV/EBIT multiple of 14.9 compared to the current market EV/EBIT multiple of 13.2. It is difficult to identify a comparable company with a similar mix of business units to IBM. Valuecruncher has identified a number of companies that compete with IBM to varying levels.   

Accenture – EV/EBIT 16.8,  Accenture is global firm operating in 49 countries that specializes in management consulting, systems integration and technology and outsourcing services. Accenture has an enterprise value of $30.85 billion and EBIT of $1.84 billion in FY2006. 

Electronic Data Systems (EDS) – EV/EBIT 18.0,  EDS provides information technology and business process outsourcing services in 64 countries around the world. EDS had $816 million EBIT in FY2006 and has an enterprise value of $14.68 billion.   

SAP – EV/EBIT 16.4, SAP specializes in providing enterprise software solutions to corporations, government agencies and educational facilities around the world. In 2006 SAP had EBIT of $2.56 billion and currently has an enterprise value of $41.88 billion. 

These comparable companies provide a reference point for IBM’s EV/EBIT multiple but do not sufficiently reflect IBM’s overall business mix to validate a comparable company valuation.      

Conclusion 

IBM’s ability to achieve the short-term financial projections applied by Valuecruncher will depend largely on their ability to grow the software segment of the business and penetrate emerging markets. The higher margins provided by the software segment are a key driver of the projected EBIT growth. IBM faces competition in each of its business segments but the growth assumptions used are not overly aggressive and IBM is well positioned to focus on these opportunities following the recent restructuring. Overall Valuecruncher believes that the current market price of $105.16 undervalues IBM.   

Valuecruncher Valuation Report – IBM                                   

New Zealand gourmet burger chain Burger Fuel has announced it’s intention to list on the NZAX. The IPO is to raise $15 million at $1.00 per share and values the company at $60 million. According to the Burger Fuel Prospectus proceeds of the IPO will be used to fund expansion into the Australian market. The expansion will involve Burger Fuel setting up and operating restaurants before on selling them to franchisees. Burger Fuel currently has 19 stores in New Zealand and 1 in Australia.

Burger Fuel is a growth company that has potential to expand both within New Zealand and overseas but a valuation today of $60 million is crazy. The absence of any projections (operating or financial) and detailed financials in the prospectus makes it difficult to value the company. Valuecruncher has conducted some high-level analysis of the $60 million valuation implied by the IPO issue price. The analysis draws on information contained in the Burger Fuel prospectus and operating and valuation data associated with Burger King.

Assumptions

Valuation Today: $60 million (Based on IPO issue price)

Cost of Capital: 20% (Based on risks associated with investment)

EV/EBITDA Valuation Multiple: 13 (Based on established burger chain Burger King)

EBITDA Margin: 15% (Based on established burger chain Burger King)

Burger Fuel Royalty: 10% of total system sales (6% revenue royalty + 4% marketing levy)

Average Sales per Store: $1 million per annum (Based on information contained in the prospectus)

Horizon: 5 years

Dilution: Any future capital raising would not dilute the value of shares issued in IPO.

Based on these assumptions Burger Fuel’s $60 million valuation today implies expected revenues of $76.6 million in 5 years, based on 100% of the stores being franchisee owned and revenue + marketing royalties of 10% this equates to approximately 700 stores and approximately $700 million of total system sales. Burger Fuel currently has 20 stores and had $16.5 million of total system sales in the 2007 financial year. These assumptions are very subjective but highlight the magnitude of growth implied by the $60 million IPO valuation.

Valuecruncher believes that based on the high-level analysis, current status of Burger Fuel’s operations and the extremely competitive nature of the market the IPO valuation cannot be justified and question why Burger Fuel is undertaking an IPO at this stage. These issues are compounded by no substantial explanation of how the funds from the IPO will be used and the absence of any financial projections in the prospectus.   

Since the end of January the Amazon.com Inc (Amazon) share price has nearly doubled, closing at 72.29 on 6 June 2007. This dramatic increase followed the release of Amazon’s first quarter result in late April in which Amazon announced $3.02 billion of revenue for the quarter, a 32% increase on the first quarter of 2006. Amazon also announced an increase in their second quarter guidance and full year expectations forecasting net sales of $13.4 to $14 billion for 2007 and operating income growing by up to 52% to $593 million.

Valuecruncher DCF Valuation 

Valuecruncher places a mid-point DCF valuation of $58.88 per share with a sensitivity range of $53.56 to $64.49 per share on Amazon based on consensus estimates and Valuecruncher’s own analysis. The DCF mid-point assumes revenues growing to $20.9 billion and EBIT reaching $1 billion in 2009, these are aggressive forecasts. These growth forecasts incorporate Amazon’s potential to diversify into other online retail product lines and the DRM-free music sales opportunity. Although Amazon has been able to consistently produce strong revenue growth it has struggled to improve its profitability margins (EBIT margin of 3.5% in 2006), these forecasts represent an increase in Amazon’s EBIT margin to approximately 5% by 2009. Valuecruncher assumes a long-term growth rate of 5% and uses a cost of capital of 8%. This relatively low cost of capital reflects the dominant position Amazon currently holds in its core markets and product lines and success it has had expanding outside of North America. Despite these aggressive growth, profitability and cost of capital assumptions the Valuecruncher valuation is still significantly lower than the current market price.

Amazon’s Growth Options

Amazon has a number of operations outside of it’s core online retail business including www.a9.com an e-commerce focused search technology, www.alexa.com the traffic ranking site and www.imdb.com the internet movie database. It is impossible to value these and the other growth options Amazon has explicitly due to the lack of information available but it is difficult to imagine these options account for the approximately $5.5 billion difference between the Valuecruncher mid-point valuation and the current market valuation.

Comparable Company Analysis

It is difficult to identify a pure comparable company to Amazon so Valuecruncher has compared the forecast EV/EBIT multiple of Amazon of 50.3 with a number of high profile listed companies. eBay, Google and Microsoft have forecast EV/EBIT multiples of 16.5, 25.9 and 13.4 respectively. Admittedly these companies have a range of growth opportunities and have varying levels of risk but it puts into perspective the amount of growth the market appears to be pricing into the current Amazon share price. To take the comparison to the next level eBay whose core business is online auctions had EBIT of $1.4 billion in 2006 (over 3.5x Amazon) and has a number of growth opportunities is being valued at only 1.4x Amazon based on the latest share prices.

Amazon has exhibited strong growth over the last two quarters and the market has responded positively to the latest quarterly result and revised guidance but based on Valuecruncher’s analysis the stock appears over-priced. Even considering growth options potentially not captured in the DCF valuation it is still difficult to reconcile the current market price with our analysis. The current forecast EV/EBIT multiple of 50.3 suggest the market is over-valuing the growth potential of Amazon.

Valuecruncher Valuation Report – Amazon

Valuecruncher Early Stage Valuation Report (Example) – Click Here

Over the last couple of months Valuecruncher has received a number of queries asking how to value early stage companies. The majority of these early stage valuations have been for the purpose of capital raising. Valuecruncher’s March Newsletter provides an outline of how venture capital (VC) investors approach valuation.

Typical valuation methodologies have limited or no use when attempting to value early stage companies.

• Discounted Cash Flow (DCF)

The uncertainty surrounding the financial projections of early stage companies limits the effectiveness of DCF valuations. Using a scenario analysis can provide an idea of value across a series of potential outcomes but the subjective nature of the scenario construction and relative probability of each scenario make it difficult to make an investment based on these outputs.

• Comparable Company Analysis

The absence of publicly available information and the loss making nature of early stage companies voids the use of comparable company analysis.

• Asset Based Valuations

Asset based valuation methodologies such as net tangible assets typically do not capture the value of the growth potential of early stage companies.

Valuecruncher has constructed a new valuation report that uses DCF scenario analysis to provide three alternative scenario based valuations reflecting a range of potential outcomes for the company. These scenarios are designed to highlight the value impact of not achieving projected targets. The new report template complements the DCF valuation with a VC valuation. The VC approach assumes that the investor requires a 10 x return on investment over 3-5 years. Valuecruncher estimates the value of the company at the 3-5 year horizon using the financial projections of the client and market data of comparable established companies. Working backwards from this estimated exit value Valuecruncher estimates a valuation today based on the VC investors required return.

The VC approach is designed to give a robust indication of the post-money valuation VC investors will place on early stage companies. It is important to note that the VC valuation represents a post-money valuation (value after any required capital has been raised), this valuation will generally be lower than the DCF base case but should fall within the range defined by the scenario analysis.

This new Valuecruncher valuation report uses the standard Valuecruncher Input Sheet.

Valuecruncher Early Stage Valuation Report (Example) – Click Here

Valuecruncher has run the numbers on The Coca Cola Company (Coca-Cola) and arrived at a mid-point valuation of $46.16 per share with a sensitivity range of $41.86 to $50.65. At the time of the valuation Coca-Cola was trading at $52.67 per share, slightly higher than the upper end of the Valuecruncher valuation range. A comparable company valuation approach values Coca-Cola at $50.70 per share based on a comparable company Enterprise / EBIT multiple of 18.7.

Key Assumptions

• Short-term revenue and EBIT growth of approximately 10%
• Long-term growth of 3.3%
• Cost of capital 8.3%

Are we not accounting for all of Coca-Cola’s growth opportunities?

Is the cost of capital of 8.3% too high for Coca-Cola?

Valuecruncher Valuation Report – The Coca-Cola Company