Following Starbucks' (SBUX) recent record setting quarter, prospective investors may be looking to build a position in this stock. However, given a rally of roughly 50% over the past eight months, has the opportunity to invest been missed? Given the rapid pace of expansion and tremendous cash flow generating ability of this company one could certainly argue for a continuation of share price appreciation. Regardless of your bullish or bearish beliefs, I would caution any investor to keep a close eye on the outcome of a major lawsuit with Kraft (KRFT) ($2.9 billion at stake) which is expected to be completed during the second half of Starbucks' FY13.
Throughout this article I will focus what the outcome of this lawsuit could mean for current and prospective investors using a best-case and worst-case scenario. Additionally, I will provide my estimates for the company's income statement, updated price multiples, and potential valuation of shares.
Source: Yahoo! Finance
If you would like to review the full details about the ongoing dispute with Kraft I would urge you to read the company's most recent 10-Q filing. To summarize, during the first fiscal quarter of 2011 Starbucks notified Kraft Foods Group that it would discontinue their existing distribution agreement due to "material breaches by Kraft". The agreement called for Kraft to manage the distribution, marketing, advertising, and promotion of Starbuck's brand products through grocery and warehouse club stores. Kraft denied the breach and is currently seeking damages of $2.9 billion plus attorney fees from Starbucks as a result of "materially breaching distribution agreements". Starbucks believes this number is "highly inflated and based upon faulty analysis." However one should note that Starbucks has not explicitly said they will come out of this without paying any compensation to Kraft. The SEC filings state, "At this time, Starbucks believes an unfavorable outcome with respect to the arbitration is not probable, but as noted above is reasonably possible" (legal jargon for we are not sure what will happen).
A decision was expected to have been made by the arbitrator during the first half of FY13, however this has been pushed back to the second half of FY13. So what impact does this half on investors?
Worst-Case Scenario - Assuming Kraft wins the dispute, Starbucks will need to pay out a substantial amount of capital. While we can only speculate on what this settlement may be valued at, the highest amount anticipated is $2.9 billion plus attorney fees. Since no separate account for loss contingency has been created for this litigation, we will likely see Starbucks spend available cash, tap into its line of credit, and/or access the debt markets. The interest from additional borrowing, although at historically low rates, will have a negative impact on earnings per share. Although Starbucks has just under $1.7 billion in cash on the balance sheet, $742.7 million of this amount is held in foreign subsidiaries. Repatriating these funds would cause additional expenses to the company. One would assume a $2.9 billion payment (roughly two years worth of Starbucks' earnings) would have significant implications to the downside of the stock price.
Best-Case Scenario - Assuming Starbucks wins the dispute, Kraft would have to pay legal fees incurred by Starbucks of $62.9 million. Although not substantial to Starbucks bottom line, this would be a slight boost to a one-time item on the income statement. However the bigger victory to a favorable outcome is management finding the clarity they have been waiting on to begin utilizing the massive cash pile on its balance sheet. We have seen many hints from management on the past earnings call as to what the company intends to do with its growing cash balance. Since expansion activities are adequately funded by cash flow from operations, the next steps would be a bump in the dividend payment and further increasing the share repurchase program. Assuming the best case scenario plays out, I anticipate a substantial jump in one or both of these options. If management delivers on their estimate of 20% earnings per share growth in FY13 and boosts the dividend and/or buys back additional shares, we are likely to see this stocks gains extended.
When asked about the significant amount of cash and marketable securities on the balance sheet, CFO Troy Alstead responded with a few noteworthy remarks.
- "we are awaiting resolution of our dispute with Kraft and as we come through that… that will bring clarity to allow us to then formulate a little bit more specifically our go-forward plans."
- "I would expect to grow dividends just as earnings growth… and I would anticipate at elevating that payout ratio at the appropriate time, which I think the strength of our cash flow in the business."
- "Similarly with share repurchases… we're committed to the program and our Board has authorized continued opportunities for us to being more active in the open markets, so we will take advantage of that as we believe market conditions exist for that."
In short, if the Kraft dispute turns out favorably, the stock will likely get a boost as the company turns non-performing assets (cash) into ways to return capital to shareholders.
Since I have not had access to the original distribution agreement between these two companies, my opinion regarding the case is purely based upon the facts presented in the SEC filings. It appears to me that Starbucks has breached the contract due to the fact that a $750 million offer was made by Starbucks to Kraft in August 2010 to "avoid litigation and ensure a smooth transition of the business." I believe this is a major piece of evidence and has the potential to serve as a baseline for compensation paid by Starbucks. Kraft's $2.9B figure is likely inflated and it would surprise me to see the settlement reach that level.
My Thoughts on the Future
Management did not provide vastly new information for the remaining portion of the fiscal year than what was reported at the end of Q1 of FY13. A few changes were made to my estimates from the prior article. To highlight the most relevant and point out some changes:
- Management is still projecting revenue growth of 10-13%, my estimate has been increased to 12.25% revenue growth. This revenue estimate is a result of management projecting 1,600 new store openings (up from 1,300) and mid-single digit same store sales growth.
- Full year operating margin improvement of 100 basis points (guidance provided by management)
- Depreciation and amortization expense growing 9% as a result of increased CapEx spending and acquisitions
- The line item of "Interest income and other" are adjusted slightly higher as a result of the $35.2 million gain from the sale of an 18% interest in Café Sirena
- A slightly lower share count as a result of the share repurchase program. As of March 31, 2013, 26.4 million shares remained available under the share repurchase program. Estimates moving forward for diluted share count may be changed based upon management's decision to buy back shares.
- Although not listed in the table below, the company includes "restructuring charges" and "property sale gains" as operating income/expense. I disagree with this treatment of specific line items, and if any are to occur in 2013 or 2014, my models will be updated to include those below the line item "operating income."
Please note that the estimates below are not guaranteeing any of the results will be met. These estimates are strictly based upon management's guidance, the company's SEC filings, press releases, and historical data. (CS=Common size, % of revenue)
Full Year Estimate
Full Year Estimate
Cost of Revenue
Store Operating Expenses
Other Operating Expenses
Depreciation and Amor. Exp
General and Admin Exp
Income from equity investees
Interest income and Other, net
Provision for income taxes
Net earnings (loss) non controlling interests
Net Earnings Total
Basic Shares Outstanding
Diluted Shares Outstanding
Source: Starbucks' SEC Filings, Starbucks' Management Guidance, and my estimates based upon historical data and future expectations. Estimates given above are no guarantee of future results, please evaluate the company in greater detail before making investment decisions.
Valuation using Price Models
A company that exhibits the ability to grow operations by opening new locations and increasing the customer's average ticket price is undoubtedly going to get noticed by investors. Starbucks has proven its ability to capitalize on both of these metrics in addition to lowering expenses (part of this is due to declining coffee prices). As a result of the performance mentioned above, margin expansion has become a common theme from this company and investors appear to have priced shares accordingly.
Source: Starbucks SEC Filings
One area management loves to discuss is top line growth. Given the ongoing acquisitions and new store openings, one would expect this number to keep growing at high single to low double digit rates for the next few years. However when you look at what portion of sales you are receiving for each share you own, the stock appears quite pricey. Shares of SBUX have grown at a faster pace than revenue and now trade at 3.4x trailing twelve month price-to-sales.
Source: Starbucks SEC Filings
Earnings continue to grow at double digit rates and we have seen significant P/E expansion over the past few years. As a result, shares now trade at historically rich valuation levels. Although Starbucks is becoming a common stock in most investors portfolios, and may appear a relatively "safe investment", it still exhibits growth stock characteristics. Not meeting Wall Streets expectations while trading at lofty price multiples can increase the potential downside volatility.
For example, following the record earnings reported by the company a few weeks ago, we saw a modest increase in the stock price. Why didn't we see the stock move significantly higher following this record quarter? If you exclude the gain on the sale of Café Sirena along and the 10.8 million shares repurchased, diluted EPS would have only increased 15% over the same period a year prior compared to the 27.5% increase reported. Given the stocks run up over the past few months, investors will likely look for small signs of weakness similar to the prior quarter, to begin selling positions and realizing their gains. This is worrisome as a prospective shareholder because it may not allow for any "hiccups" moving forward.
Source: Starbucks SEC Filings
Shares of SBUX currently trade at just under 31.5x trailing twelve month earnings. Assuming the company can continue to grow same store sales in the high-mid single digit range, improve operating margins, and grow EPS in the 15-20% range which management projects, a high multiple is likely warranted. Note that my assumptions below do not factor in a result from the legal battle with Kraft, this is the catalyst which I believe can propel this stock either higher or lower. Assuming my projections above lean towards the conservative side, and the stock trades at 29x TTM earnings in FY13 and 28x TTM earnings in FY14:
- End of Fiscal year 2013 value = $2.15 diluted EPS X 29x P/E ratio = $62.35 per share, roughly in line with current levels
- End of Fiscal year 2014 value = $2.57 diluted EPS X 28x P/E ratio = $71.96 per share, roughly 15% from current levels
Long-term shareholders may not see risk in initiating or holding positions at current levels, and given the company's performance thus far, it may be a rational choice for your portfolio. However, investors who are on the sidelines may want to sit out a few more months before making a decision. Given that there is no clear outcome regarding the Kraft lawsuit, coupled with historically high valuations, the risks begin to outweigh the rewards in SBUX.
Consider your investment goals and objectives before initiating a position in Starbuck's and please remember that the value of investments in equity securities, like SBUX, will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. Since I attempt to tailor my estimates above conservatively, any upside surprises would be beneficial. In my opinion, patience may be the best course of action before initiating a position in Starbuck's.