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Starbucks ($SBUX) is in an interesting position. You would expect premium coffee purchases to be down in the current economic climate. The company has also just raised prices on some beverages. Yet $SBUX is currently trading toward the top of their 52-week range at US$19.35. Time to have a bit of a look.

Valuecruncher Interactive Analysts Report For Starbucks ($SBUX)

The key comparators are Tim Hortons ($THI), a direct competitor, and McDonalds ($MCD), a low-cost substitute.  You can change the generated peer companies on the site.

So what do we think?

Discounted Cash Flow Valuation

We have completed a discounted cash flow valuation using our interactive tools (there is a “discounted cash flow analysis” link just under the company name on the company page). We have populated our model with a mixture of consensus analyst estimates and Valuecruncher estimates. Our analysis produces a valuation of US$11.95 for $SBUX – 38.7% below the current share price. We see $SBUX well overvalued using a discounted cash flow model. But how about compared to a peer group?

Comparison Analysis

I am going to look at two of the metrics we use at Valuecruncher – Enterprise Value (EV)/Revenue and EV/EBITDA. Enterprise Value (EV) is simply market capitalization plus net debt [long-term borrowings less cash]. We use EV to capture the impact of debt and cash on a company’s balance sheet – market capitalization doesn’t capture different capital structures when comparing companies.

EV/Revenue shows how a dollar of revenues is being valued by the market against the comparator set. On an EV/Revenue basis $SBUX is trading at 1.5x ($SBUX is being valued at 1.5x last year’s revenues). This compares to $THI at 3.0x and $MCD also at 3.0x. $SBUX’s profit margins (at the EBITDA line) were 11.6% of revenues last year – against 25.4% at $THI and 31.5% at $MCD.  A dollar of $SBUX revenues is being valued at half that of a dollar of $THI and $MCD revenues – this is broadly in-line with the difference in profit margins in the businesses last year.  This is what we would expect.

EV/EBITDA shows how a dollar of profit (measured in as Earnings Before Interest Taxes Depreciation and Amortization) is being valued by the market against the comparator set. On an EV/EBITDA basis $SBUX is trading at 12.7x ($SBUX is being valued at 12.7x last year’s profit at the EBITDA line). $THI is trading at 11.8x and $MCD is trading at 9.3x. This difference will represent the different expected profit margins and growth prospects between the businesses – as being valued by the market. We are surprised that $SBUX profits are being more highly valued than their competitors. This suggests that the market currently believes that $SBUX’s fortunes are about to improve significantly and some of the gains are already being priced into the stock.

Summary

Based on our DCF valuation – $SBUX looks significantly overvalued. Looking at some comparators we are surprised that $SBUX is being so highly valued (especially on an EV/EBITDA basis) agaist key comparators $THI and $MCD. $SBUX looks a sell at these prices.

Disclosure: no positions.

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McDonalds recently released their second quarter result announcing $6.1 billion revenue for the quarter and a 6.1% increase in comparable sales. At $59.77 McDonalds is trading at the upper end of their 12 month range ($46.64 – $63.69) and are currently rated a buy or strong buy by 11 of 17 analysts aggregated by Yahoo Finance.

MCD Valuation

We have assumed McDonalds revenues will grow to $25 billion in 2010 representing an annualised growth rate of 3.14% over the next three years. This growth will be driven by a combination of organic growth of existing stores and the ongoing opening of new stores.

EBITDA margins are projected to grow from 31.5% in 2008 to 33.5% in 2010 reflecting Mcdonalds’ strategy of focusing on franchised and affiliate stores. “Margins” derived from franchise operated stores for the first half of 2008 averaged 81.9% versus 17.1% for company operated stores. McDonalds re-franchised 300 stores in the first half of 2008 and plans re-franchise 1,000 to 1,500 by 2010.

We have assumed a constant capital expenditure of $2 billion per annum over the next three years consistent with McDonalds’ 2008 guidance. In 2008 this capital expenditure will be split 50/50 between the opening of 1,000 stores (net 600 stores) and reinvesting in existing stores.

A WACC (discount rate) of 8% has been used and terminal growth rate of 3% has been applied to McDonalds ongoing cash flows beyond 2010.

Valuecruncher valuation model of MCD with interactive assumptions

Our analysis incorporates the cash and debt on the MCD balance sheet – Valuecruncher calculates a net debt number.

Our analysis gives a valuation of $62.50 per share which is 4.6% above the current share price of $59.77.

The current share price is consistent with our analysis but McDonalds faces a number of challenges that limit the share price’s upside potential. These challenges include:

• Pressure on margins from increased food and labour costs (e.g. chicken and beef costs are expected to increase by between 5% and 9% in 2008) are ongoing issues facing the industry.
• Sustaining U.S. sales growth is a challenge in an extremely competitive industry exposed to changing customer tastes. Growth drivers in the key U.S. market have been chicken, breakfast, beverages and convenience. The breakfast and beverage markets are extremely competitive as major industry participants see this as a key growth area in a saturated restaurant market.
• International expansion in markets such as China and Russia has been a key driver in McDonalds growth with over 50% of the company’s operating income being derived outside the U.S. in the first half of 2008. The reported growth of McDonalds international business has been amplified by currency movements. Adjusting for currency movements McDonalds revenues decreased slightly in the first half of 2008. The company’s share price is exposed to currency movements (approximately 50% of the company’s debt is denominated in foriegn currencies) and dependent on maintaining their strong growth in international markets.
• McDonalds sees itself primarily as a franchisor and a key driver in our projected margin expansion is the focus on re-franchising restaurants. This re-franchising and the continuing opening of new stores rely on the economic viability of the individual restaurants. A potential economic slow-down and cost inflation will impact on the viability of the individual stores flowing through to both the revenue and margin growth assumptions.

With over 31,000 stores worldwide and approximately $63.5 billion in total system sales in 2007 McDonalds is the global leader in convenience restaurants that won’t be disappearing anytime soon. This scale combined with McDonalds plans to return $5.6 billion to $7.6 billion to shareholders over the next 18 months may make the company a safe haven despite the “limited” upside share price potential.

Valuecruncher has a database of over 1,000 companies on major international exchanges. You can explore, create and share valuations for any of these companies.