Starbucks research report

Stock Mini Project Starbucks Corporation (SBUX) Updated March 13, 2013 Food and Beverage

Stock Mini Project Recommendation: Strong Buy

Key Stock Statistics: (Source Google Finance) 52 Weeks Range: 43.04 – 62.00 Market Cap: 43.98B EPS: 1.86 Open: 58.33 P/E: 31.53 Shares: 749.30M Vol/Average: 2.31 M/5.48M Div/Yield: 0.21/1.40 Beta: 1.18

Highlights: • Some risks that might impact

Starbucks include the increasing coffee prices and the changing political environment over US’s labor practices, which in return would significantly lower operating margin.

• We see strong fundamentals for the company. The pace of US economy has picked up recently and we see Starbucks benefit from the gradual expansion of the restaurant and special eatery industry.

• We see significant growth opportunities in the international market, especially China and India. We expect increase in operational margin for the next few years as Starbucks become increasingly focused operational efficiency and restructuring initiatives.

Investment Rational: • The target price of $61.29 on a combination of DCF

projection and comparable evaluation. With a project growth rate of 15% for the first 2 years base on possible expansions and sales forecast.

• Starbucks is good for value investing for its strong fundamentals and efficient management that aims to exploit all market benefits. The company exploits strong M&A opportunities and strategic opportunities such as the new Tarzo.

Qualitative Ratings: Corporate Strategy Management Dividend Policy

Target Price:

$61.29

SBUX Earnings Data EPS ($) Q1 Q2 Q3 Q4 2013 0.57 2012 0.50 0.40 0.43 0.46 2011 0.45 0.34 0.36 0.47

2010 0.32 0.28 0.27 0.37

2009 0.09 0.03 0.20 0.20

(source: Yahoo Finance)

(Source: National Restaurant Association Restaurant Industry Performance Index and its Components) The RPI is measured in relation to a steady-state level of 100. Index values above 100 indicate that key industry indicators are in a period of expansion, while index values below 100 represent a period of contraction for key industry indicators. The Index consists of two components

(Source: Yahoo Finance)


Industry Analysis and Economic Analysis Our outlook for the food and beverage sub-industry and the special eatery industry is moderately bullish. However, due to the political environment over US’s labor practices and increase in payroll taxes, Starbucks’ operational margin may be hampered. Food and Beverage Industry The Restaurant industry in US is expected to have a gradual expansion in 2013 with an estimated market size of $660.5 Billion and a growth rate 3.38% as per The USA Restaurant Forecast for 2013. The quick service restaurant sale is forecasted to be $188 Billion with a growth of 4.9%. The growth for 2013 is considerably low comparing to previous years. In addition, the Restaurant Performance Index also indicates a slower expansion in the restaurant industry. To add on top of the slowly expanding restaurant industry, the Special Eateries Index also showed a leveled-off growth. Since Starbucks has 32.6% of total market share and is a leading coffee chain in US, its sales volume is expected to experience a slower growth in comparison to previous years. As a highly fragmented industry, the food and beverage industry consists of both giant chain-stores and individual retailers, all of which are constantly changing to meet the demands of the customers. The general industry trend is shifting towards investing in new products and technology, and seeking for merger and acquisition activity to fuel sector growth. Companies are also concentrating on eliminating costs and improving operational efficiencies while placing an increased emphasis on talent management and regulatory compliance.

Technology will be taking a vital role in food and beverage business strategies in promoting brands and making better pricing decisions. The social media and other digital marketing channels also largely impact the food and beverage industry as they continue to gain ground; being used more for brand promotion and customer insight.

Economic Factors

There is an increase of US payroll taxes to 6.2% from 4.2% starting 2013 and it is reducing the outlook for consumer spending on durable goods in the coming year. However there are mix signals on its effect on non-durable goods. Our outlook is that this payroll tax will not affect Starbuck’s sales significantly since coffee consumption stays relatively stable according to historical statistics. However, this payroll tax may cause an increase in labor cost, which would lead to a reduced operating margin. There are mixed signals to how Starbucks will perform in the coming year based on the identified industry and economic factors. Our outlook for this company is fairly bullish incorporating all the relevant factors.

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RPI Indicator Jan 12 -‐ Jan 13


Other Relevant Factors influencing Operation: Coffee Commodity USA has always been the largest importer of coffee beans and having the largest consumption of coffees. According to the International Coffee Organization, although USA has the highest import of coffee, the importing volume only increased by 1% from 2011 to 2012. Due to the saturating coffee market in US, we do not expect Starbucks to have significant expansions in US. In addition, as per survey from the International Coffee Organization, Coffee imports for the European Union along with certain Middle Eastern countries are also experiencing a slower growth of less than 1%. Therefore we do not expect significant expansion by having more store openings in the EMEA regions as well. Although there may not be vast expansions for Starbucks in building significantly more stores, we expect its sales to be fairly stable considering the general demand for coffee is fairly stable. In addition, the coffee bean price is expected to decrease because crop yield for the coming 2013 year is expected to have an increase around 16% from production in Brazil in relation to the previous crop year. The decrease in coffee bean prices will significantly increase Starbucks’s profit margin for the coming 2013. The current economic and financial crisis, which began in 2008, does not seem to have a major impact on world coffee consumption. It continues to grow despite substantial increases in the retail price of importing countries. Date Key Strategy Highlights 2012 Nov 2012 Starbucks agreed to acquire Teavana Holdings, Inc. (Teavana), a specialty retailer offering

more than 100 varieties of premium loose-‐leaf teas, authentic artisanal teawares and other tea-‐related merchandise, for $620m in cash. This potential acquisition would complement its Tazo business – giving Starbucks a two-‐tiered market position for tea. With the combination of the Teavana and Tazo brands Starbucks plans to define a new-‐elevated platform of tea experience and education and expanding tea product portfolio.

July 2012 Starbucks acquired 100% interest in Bay Bread, LLC and its La Boulange bakery brand (collectively ‘La Boulange’), to elevate its core food offerings and build a premium, artisanal bakery brand.

March 2012, The company opened its first Evolution Fresh store in Bellevue, Washington, positioning it as a leader in the cold-‐crafted juice category. Evolution Fresh opened new retail locations in downtown Seattle and San Francisco; and announced a Such business acquisitions are expected to offer Starbucks opportunities to innovate new products, enter new categories, and expand its product portfolio and distribution channels.

February 2012 The company and its licensed partner SSP opened Norway’s first Starbucks coffeehouse at Oslo Airport. This relationship with SSP aligns with Starbucks to open stores where customers expect them to be and meets the growing demand for high quality coffee and service in the travel channel.

January 2012 Starbucks and Tata Global Beverages Limited have entered into an agreement to establish a 50/50 joint venture company, TATA Starbucks Limited, which will own and operate Starbucks cafes which will be branded as Starbucks Coffee ’A Tata Alliance.’ Initially, the retail stores will be developed in Delhi and Mumbai in calendar 2012. In October 2012, Tata Starbucks Limited opened the doors to the first Starbucks store in India.

November 2011 The company acquired Evolution Fresh, Inc. for $30m in cash. This has marked Starbucks entry into the $1.6 billion super-‐premium juice segment as well as represents its intentions to fully enter the $50 billion Health and Wellness sector.

CEO Howard Schultz defined a 5-point corporate strategy agenda: 1) Improve US business by focusing on customer experience and other factors affecting store operations 2) Slow the pace of US expansion and close underperforming US locations 3) Re-energize the Starbucks brand and create an emotional connection to the brand with customers and employees 4) Realign and streamline management and back-end functions to better support customer focused initiatives 5) Accelerate expansion outside the US and drive profit margins higher at international operations.

Starbucks Business Description Starbucks is the premier roaster, marketer and retailer of specialty coffee in the world, operating in 60 countries. The company purchases and roasts coffees that it sells, along with handcrafted coffee, tea, other beverages, and fresh food items through company operated stores. In addition, it also sells its products and licenses its trademarks through other channels. In particular, there are 76.9% licensed stores and national food service accounts. The company’s portfolio includes Tarzo Tea, Starbucks VIA Ready Brew, Starbucks Refreshers beverages, Versmo System and Seattle’s Best Coffee in addition to its flagship Starbucks brand. It has four segments: Americas, Europe/Middle East/Africa (EMEA), Chain/Asia Pacific (CAP) and Channel Development. As of September 30, 2012 FY, Starbucks owned and operated 6,866 stores in the US, and 2,539 stores in international markets. Special mentioning to net store openings of 130 new stores in China as of FY 2012 compared to 161 new stores in US. On the other hand, Starbucks store closure due to underperformance comparing to new store opening is 45% for Americas, 63% in EMEA and 4.3% in CAP. The company’s total licensed stores include 5,046 in Americas, 987 in EMEA and 2,628 in CAP countries. Corporate Overview Starbucks continue uses its Global Business Model along with the newly employed new regional operating model in the beginning of 2012. As a result, the company has four reporting operating segments: EMEA, CAP, America, and Channel Development, each with their own operating segment president. In the EMEA segment, the company put in place a new leadership team that is focused on increasing the Starbucks brand presence, health and relevancy across the region, improving profitability of the existing store base through on focus on revenue through and operating costs, and identifying opportunities for new store growth through licensing agreements. The purpose of this new leadership team is to improve operating performances and have operating margins in the mid-teens in the near future. In the American Segment, the strategy is to continually focus on operational efficiencies in order to drive increased sales leverage to offset the impact of higher commodity costs. Starbucks will continuously employ initiatives in new store development, and expanding pipeline of new product offerings to increase revenues. The CAP segment continues to grow rapidly and we expect continued growth to be from a mix of new store openings and comparable store sales growth. Starbucks aim to open a total of 1500 stores in 2015. In the Channel Development Segment are in a transition to a direct distribution model for packaged coffee starting in the second quarter of 2011. The company plans to have continued innovation and new product offerings to drive further growth and profitability. Starbuck’s corporate strategy is very adaptive to today’s changing market and it is constantly expanding. We see more company revenue growth from the Channel Development and the CAP segment in the future as Starbucks aims to become less dependent on the US market and to increase global footings. So far Starbucks has been on the right track in following the 5-point agenda set by CEO Howard Schultz in 2008. Therefore we suggest the Hold position.


Management and Governance The Management and Board of Directors of Starbucks is crucial to setting good corporate governance practices and also the proper management of Starbucks’ future expansion, development within existing market, and general operations. The current Board consists of 12 members, 10 of whom are independent. Management Performance

In 2012, the total net revenues increased 14% to $13.3 billion, which is mainly a result of the global comparable store sales growth of 7% and a 50% increase in Channel Development revenue. This growth drove increased sales leverage, which resulted in higher operating margin and net earnings. It also helped to mitigate the impact of higher commodity costs, mostly coffee, which negatively impacted operating income by approximately $214 million for the year, equivalent to approximately 160 basis points of impact on operating margin. Starbucks manages its exposure to various market-based risks according to its market price risk management policy, in which the market-based risks are quantified and evaluated for potential mitigation strategies, such as entering into hedging transactions. The market price risk management policy governs how hedging instruments may be used to mitigate risk. Risk limits are set annually and prohibit speculative trading activity. The management also monitors and limits the amount of associated counterparty credit risk. In general, hedging instruments do not have maturities in excess of five years. Starbucks’ management has proven itself in operating and strategizing according to the 5-point agenda. Although growth has slowed, management still maintains Starbucks’ high operating margin and constantly seeking future developments. Our outlook for Starbucks is that it will continue to expand and further develop internationally and in their Channel Development Segment.

Dividend Policy/Investor Relations

Starbucks actively manages cash and short-term investments to internally fund operating needs both domestically and internationally. It makes scheduled interest and principal payments on their borrowings, and return cash to shareholders through common stock cash dividend payments and share repurchases. Starbucks had started paying out cash dividends since 2010 and they have a good history of not missing any dividend payments. As of now the trailing Annual Dividend Yield is 1.3% and it is expected to have forward annual yield of 1.4%. The company uses a payout ratio of 39% for dividends. Although Starbucks does not have a long history of dividend payment, we project the company will continue to have stable dividend payment. In addition the company employs a Starbucks offers a Direct Stock Purchase and Sale Program (BuyDirect Plan), administered by transfer agent, Computershare. For the convenience of its investors, the program allows purchase initial shares and subsequent purchases directly from Computershare; reinvest dividends to purchase additional stock; direct deposit cash dividends; and sell stock and pay lower fees than those generally charged by stockbrokers for small transactions.

The stable and increasing dividend yield will contribute to Starbuck’s effort to building long-term relationship with investors, and indicate its future growth potential its development of its existing operations.

Management Rating Scale: Indication: BUY/HOLD

Corporate Strategy: Indication: BUY

Dividend Policy Indication: Hold


Peer Groups Overview Burger King (BKW) The Burger King Worldwide, Inc (NYSE: BKW) is a series of eateries that operates globally with a focus on fast food, specifically hamburgers. In addition to the burgers and fries, the Company also offers four new menu categories such as salads, wraps, smoothies and desserts, and expanded their chicken, coffee and ancillary menu items. As of December 31, 2012, the Company owns 418 restaurants worldwide and franchised 12,579 restaurants (about 97% of all Burger King restaurants). Although Burger King is in the Fast Food Industry and is not an immediate competitor to Starbucks, it is competing for valuable retail space in high traffic areas to Starbucks in addition to its planned expansion in their coffee and ancillary menu items.

ConAgra Foods (CAG) ConAgra Foods Inc. (NYSE: CAG) is a food with two different operations segment: Consumer Foods and Commercial Foods. The consumer food operations focus on branded, private label and customized food projects, mainly sold through retail and other foodservice channels. One of the biggest customers of ConAgra Foods Inc is the Wal-Mart Stores. The food it serves includes meals, entrees, condiments, sides, snacks and desserts. The commercial food operations focus on selling brand name food and ingredients sold mainly to foodservice, manufacturing and industrial owners. The main products offered by the commercial operations are specialty potato products, milled grain ingredients, vegetable products, and seasonings. ConAgra Foods is similar to Starbucks due to the perishability of their products, thus they have similar turnover ratios. Domino Pizza (DPZ) Domino's Pizza Inc. is an international food company with a focus on pizza delivery. The company operates in three business segments: domestic stores, domestic supply chain and international. The domestic stores is made up of 4,513 franchise stores and 394 company-owned stores. The international segment operates 4,835 franchise stores outside of the United States, as of January 1, 2012. The principal source of revenues for this segment is from royalties on sales generated by international franchise stores and sales of supplies to international franchisees. The international segment makes up 12% of the consolidated revenue. They are similar in terms of their EV/EBITA, which is due to their distribution channels. Yum Brands (YUM) YUM is the world's largest restaurant company in terms of the number of system units. It currently holds over 37,000 units in more than 120 countries operating under the KFC, Pizza Hut and Taco Bell brands. Its primary brands, KFC, Pizza Hut and Taco Bell, are the global leaders in the quick-service chicken, pizza and Mexican-style food categories. Of the over 37,000 restaurants, 74% are operated by franchisees and unconsolidated affiliates, 20% are operated by the Company and 6% are operated by licensees. YUM’s branded restaurants are direct competition for high traffic retail spaces to Starbucks. Panera Bread Co. (PNRA) Panera Bread Company and its subsidiaries operate and franchise retail bakery-cafes in the United States and Canada. The Bakery-Cafe Operations segment operates company-owned bakery-cafes under the Panera Bread, Saint Louis Bread Co., or Paradise Bakery & Café names, which offer fresh baked goods, made-to-order sandwiches on freshly baked breads, soups, salads, custom roasted coffees, and other complementary products through on-premise sales, as well as provide catering. The Franchise Operations segment licenses the Panera Bread or Paradise Bakery & Café names and monitors the operations of these bakery-cafes. As of December 25, 2012, Panera Bread Company owned and franchised 1,652 bakery-cafes. It is an immediate competitor considering its operation and product offerings are fairly close to Starbucks’.

Stock Mini Project Overview of Competitors – Peer Group Analysis Updated March 13, 2013 Food and Beverage

McDonald’s Corporation (MCD) McDonald’s Corporation franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. Its restaurants offer various food items from soft drinks, coffee, and other beverages to breakfast menus. As of December 31, 2012, the company operated 34,480 restaurants in 119 countries, of which 27,882 were franchised or licensed, including 19,869 franchised to conventional franchisees, 4,350 licensed to developmental licensees, and 3,663 licensed to foreign affiliates; and 6,598 were operated by the company. The new McCafe menu list brings direct competition to Starbucks on a global scale. Key Company Information

(source: yahoo finance)


Valuation Results from DCF and Trading Comparatives Valuation Model Weighted Share Price Proportion DCF Model 50% $60.16 $30.08 Trading Comparatives 50% $62.41 $31.21 Forecasted Share Price $61.29

Discounted Cash Flow Methodology Income Statement and Capital Expenditure The income statement was projected over ten years, refer to Appendix 4 for DCF model. The total revenue is expected to grow at 15% for the next 2 years before sales growth drops to 6% for the next 3 years. We expect the growth rate will hit the terminal rate of 3% after 5 years. The initial 15% growth is due to Starbucks' aggressive growth strategy in developing markets, which is reflected in its planned 1500 new stores opening in China by 2015 and capitalizing on Channel Developments. As a result, after large expansion into CAP, Starbucks can be less dependable on the US market. The sales will drop to 6% increase for the next 3 years due to the company entering the mature business cycle. Cost of goods sold, and Selling, General and Administrative expense are assumed to be the average percentage of sales from 2008 to 2012. Capital expenditures is expected to be high for the first 2 years due to the heavy investment in opening new stores. After the first two years, we assumed the capital expenditures to remain as the average percentage of sales from 2008 to 2012. WACC The Beta is a average of the peer companies. One thing to note is that Burger King Worldwide Inc. was not included in the Beta calculation peer group due to the fact that there was no recent estimate of BKW's beta. We expect these companies to be subject to the same macro-economic factors. As a result, we used unlevered the beta of the comparables before leveraging it based on Starbucks' D/E. The cost of debt is based on the coupon rate of the latest bond issued by Starbucks. The risk-free rate is based off of the 10 year-yield on 10 year US Treasury. Trading Comparatives Assumptions For the trading comparatives, we used PEG ratio and Price/LTM Earnings as our valuation multiples. The P/E ratio does not reflect the potential growth of Starbucks. As a result, we also used PEG ([P/E]/Annual EPS Growth) ratio, where we consider the expected the growth in EPS in addition to the price and earnings. We calculated the share price under PEG Ratio and P/LTM Earnings, then used the average between the two method to reflect the


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