Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 1
Ascendere Associates LLC February 12, 2010Steve Castellano steve@ascenderellc.comStarbucks Corp. (NasdaqGS: SBUX)Sector: Consumer DiscretionaryIndustry: RestaurantsStarbucks Corp. is bucking the trend
We took a quick look at Starbucks in early 2009, and as generalists searching for the best relative opportunity among 3000+stocks that trade on major U.S. exchanges, were not impressed. Fundamental metrics were trending poorly, internationalmarkets were in full fledged recession, and a premium-branded coffee and related items seemed like easy things for theconsumer to give up in the quest for newfound frugality. New initiatives announced upon the return of Starbucks' founderHarold Schultz to the CEO role in January 2008 did not seem to be having a measurable effect. The stock peaked close to $40 inDecember 2006 and traded as low as$7 in 2008.But March 2009 results marked the turning point. The cumulative effect of new initiatives focused on controlling operatingcosts, improving operating efficiency, strengthening connections among customers and the closure of 900 stores and theannounced lay off of 7000 employees and attrition of thousands more have translated into significant operating momentumwhich seems likely to continue through 2010 and perhaps beyond.
Impressive operating momentum since early 2009
Since the end of 2008, Starbucks has seen a significant decline in capital spending, operating capital has been reduced, andvarious measures of profitability and cash flow have drastically improved. In more detail, since December 2008 Starbucks hasreduced estimated Operating Capital by $1.6b to $6.9b from $8.6b, while estimated adjusted operating profit has improved
SBUX
LTMFY+1FY+2LTM5yr AvgInsidersStock Price$22.60EPS:0.76$ EPS:$1.10EPS:$1.25ROE:19.1%ROE:30.2%Own2.7%EBITDA/EBITDA/Number of Market Cap$16.8bP/E:29.9P/E:20.5P/E:18.1Capital42.8%Capital38.3%Analysts19Debt toEnterprise Val$16.0bP/CF11.0P/CF9.4P/CF8.6Margin9.7%Margin9.3%Captial14.0%DividendBeta1.35P/S:1.7P/S:1.6P/S:1.6Margin5.7%Margin6.0%Yield0.0%
Description:
Starbucks Corporationengages in the purchase, roasting, and saleof whole bean coffees worldwide. It offersbrewed coffees, related beverages andcomplementary food items. It alsoproduces and sells various ready-to-drinkbeverages. Its brand portfolio includesSt
arbucks, Seattle’s Best Coffee
and others.
There are not many companies in which nearly every fundamental metric we look at is improving across the board. Butthey do exist, and one such impressive company is Starbucks Corp.At the current level, SBUX is a good option for growth investors that expect significant upside to current consensusforecasts -- because we do think there is some chance of this occurring. SBUX is also currently a good stock idea for highturnover portfolios driven by constantly updated relative value decisions, such as the Ascendere Long/Short ModelPortfolio. But given our preference for highlighting stock ideas that show good value against sustained operatingmomentum, we would prefer portfolio managers wait for a better price, closer to $17-19, or at most at 15.2x theconsensus FY2011 EPS estimate. Such a purchase price would allow participation in a possible resurgent growth storywithout being aggressive.Our target 1yr value is $23, which is below the consensus average target of $25 and derived from a scenario analysisindicating a realistic valuation range of $9-46. For the stock price to reach near the high end of our range, we think thecompany would have to generate EPS approaching $1.70 in fiscal 2011 and show accelerating growth beyond. Incontrast, the consensus EPS estimate for FY2011 is $1.25 and the consensus high is $1.41. While these optimisticscenarios are aggressive, they are also plausible under perfect conditions.
Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 2more than 3x to $762m from $211m over the same period. Anyway you look at it -- EBIT, adjusted EBITDA, free cash flow --profitability has surged since December 2008 while the amount of capital required to create this profitability has declined. Thishas helped the company generate a ROIC higher than its cost of capital for the first time in several quarters. In addition, this hasput $700m+ in cash on its balance sheet bringing the total to $1.4b cash and short-term investments. In the most recentconference call the company said it expects to conclude work on a distribution strategy for this excess cash in the comingmonths.
Starbucks learned valuable lessons in its domestic market
CEO Harold Schultz
summarized the recent improvements in the company’s January 20, 2010 conference call transcribed by
Seeking Alpha for the fiscal first quarter that ended on 12/27/2009:
“
This was a very satisfying quarter by any standard and follows three successive quarters of continued improvement in ourbusiness. Our U.S.-company operated stores reached a significant milestone in Q1 as all regions reported positive comp growthand our U.S.-licensed stores also delivered strong results. As in prior quarters, our business this quarter benefited mightily fromcontinued innovation from the success of our company wide efforts to improve customer experience from our continued laserfocus on controlling operating costs and improving operating efficiency and from the impact of decisive actions we took early in2008.
”
Given the significant operating improvements seen thus far, maybe it is not a surprise the stock has seen a 165% rally from aMarch 2009 low of $8.27 to a recent close of $21.91, outperforming the S&P 500 return of 56% and the S&P Discretionary SPDR(XLY) return of 78% over the same period. If estimates are revised further upward, there could be more room for SBUX to move.
Upside possible if company remains focused and if global economies improve
We find the current consensus estimates that imply continued improvements for ROIC and solid earnings growth believable andperhaps containing some potential to move even higher, which makes us comfortable with not overly-weighting a negativevaluation scenario. The company seems to have learned some valuable lessons in its U.S. market, and has recently startedincreasing marketing spending to drive revenue on some key growth platforms and initiatives. It is also increasing investment inits well-received VIA instant coffee product and on efforts to "refresh" the designs of existing Starbuck stores. In addition, thecompany intends to apply the lessons learned in the U.S. to international markets. For now, international efforts appear to beconcentrated in the U.K., France, Spain and China.Starbucks believes China will become its largest market outside of the U.S. If Starbucks can drive revenue in China and otherinternational locations to one-half to two-thirds of the level of growth experienced in its early growth phase in the United States,there could be significant upside to consensus revenue and earnings growth forecasts.
Relative valuation summary
Starbucks is currently trading at 20.2x NTM consensus EPS of $1.12 versus a 5yr average of 26.8x and a range of 10.1-53.4x.Fifteen sell side analysts provide targets ranging $13 to $30 and average $25. Nineteen sell side analysts provide FY2011 EPSestimates ranging from $1.15 to $1.41 and average $1.25.On a relative EV/EBITDA basis, SBUX trades at a slight discount to a peer average, and on a PE basis it is at a premium. Given itshigh growth prospects and ROIC profile, these multiples are justifiable and actually offer a slightly better adjusted value at thissnapshot in time -- but they do not point to an overwhelming bargain.
Scenario analysis
We have chosen 4 different scenarios in which to value Starbucks. Numerous underlying factors can be summarized in the long-term earnings growth rates on a 10% WACC and 2.5% terminal growth rate -- 21%, 18%, 8% and negative 3%. A more aggressive9% WACC and 3% terminal growth rate may be justifiable, and could positively impact our range of targets by about $1-10.
The most realistic but conservative assumption in our opinion is the 8% growth scenario, which suggests the stockdeserves to trade at only about 17x the consensus NTM EPS estimate of about $1.12 or at about $19 one year from now.
Steve Castellano Ascendere Associates LLCsteve@ascenderellc.com Page 3
But If SBUX can beat and raise estimates throughout the next two years and get on track to close to 18% earningsgrowth on average for the next 5 years and moving higher beyond that, perhaps the stock should be more appropriatelyvalued at $30, or about 18x an above-consensus-high FY2012 EPS estimate of $1.70. We are comfortable with theseassumptions for this particular scenario because we think they reflect the possibility of continued operating momentumand a growing penchant for China and other countries to embrace a number of American brands.
A $46 stock price target is justifiable under the right conditions, though a bit farfetched at the moment. Such a targetwould have to assume flawless execution, faster than anticipated international expansion and a rebound in the globaleconomies so that the company could resume a growth rate seen 5 to 10 years ago. True believers would have to justifya target earnings growth rate of 21% compounding to $2.80 by FY2015 and accelerating at a higher rate beyond.
If Starbucks runs into additional problems or the economies falter again so that earnings essentially decline 3% onaverage over the next few years, a fundamentally justifiable target could be $9 today.Simple Microsoft Excel models for SBUX revenue growth and operating margin assumptions that we used to help generaterealistic scenarios for optimistic earnings growth are available at our website www.ascenderellc.com.
The current stock price embeds assumptions for continued operating momentum that can drive consensus estimates higher.While that is possible, we recommend waiting for a pullback to the $17-19 level before purchasing this stock. Using a most likelypossible target range of $17 to $30 by next year does not provide an overwhelmingly compelling risk/reward with the stock at$22. However, for the portfolio manager that is required to purchase a Consumer Discretionary stock immediately, or ismanaging a portfolio with high turnover in which decisions can be quickly adjusted (such as the Ascendere Long/Short ModelPortfolio), SBUX in our opinion is the best idea at the moment.Our current estimated stock price target for SBUX is $23, which is outlined in the table below.We are aware of our seemingly contradictory recommendation -- that on a relative basis SBUX is slightly more attractive but ona standalone basis is less so. This raises two basic questions though with very large implications: Is the entire Discretionarysector is embedding overly optimistic assumptions on a global economic recovery? Or will SBUX in retrospect confirm our pastobservations that in general sell side analyst estimates lag the market rather than anticipate it? It is probably a little bit of both.
Risks
Ascendere Associates LLC can makes no guarantee on the accuracy of the data, estimates, assumptions or forecasts in thisreport. Investing in SBUX or any equity entails a high degree of risk, including the risk of total loss. This report is not asolicitation to buy or sale any securities.
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Starbucks Improving Across the Board: Is That Enough?
Starbucks Corp. is an impressive turnaround story. Currently priced close to $23, it needs to continue beating and raising EPS estimates much higher than consensus to justify a higher valuation. Originally published by Ascendere Associates LLC on February 16, 2010.
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