Starbucks Corporation (NASDAQ:SBUX) has been getting a lot of love from analysts and the press lately. According to Yahoo Finance, the ratio of bullish analysts to bearish analysts is - well, apparently there are no bearish analysts. Hedge funds and insiders are piling into the stock, and the consensus forward earnings per share for year end 2013 is around $2.62, which is over 40% higher than the year end 2012 earnings per share. Starbucks, however, is not a good investment right now.
Before going any further you can find the data for this article here. I will try to accurately evaluate Starbucks' worth using a sum of discounted future earnings. There are a number of assumptions that go into this valuation and I will present the most likely ones in this article. However, the Excel spreadsheet in the link above will allow you to easily alter the parameters as you see fit and arrive at your own valuation.
Let's begin with gross revenue. Like any successful firm, Starbucks has seen its revenue growth decline significantly over time. This decline has followed a rather predictable, exponential decline (click to enlarge image):
Starbucks' days of double digit revenue growth are numbered. If the above pattern holds up, and it usually does for most large companies, Starbucks will probably be experiencing revenue growth below 8% in 5 years. Most likely, Starbucks revenue growth will continue to decline until reaching a steady growth rate of around 4% in the early 2020s. The 4% value is derived by looking at Starbucks' more mature competitor, McDonald's Corp. (NYSE:MCD). Over the last five years, McDonald's Corp. has averaged revenue growth of around 4%. Because Starbucks operates in a monopolistically competitive industry, its revenue growth rates should converge in the long run with its competitors.
Since 2010, Starbucks has done a fantastic job of keeping costs under control. In the last three years, earnings as a percentage of revenue has averaged 10%; in the years before 2010, it averaged 6%. This increase in margin is due to the closing of less profitable stores, reduction in personnel, and an increase in sales leverage for remaining stores. With most of its revenue growth coming from overseas stores, which are generally less profitable than U.S. stores, and from sales of its global consumer products, which are heavily tied to the price of commodity inputs, it seems unlikely that Starbucks will be able to sustain a 10% or higher margin of earnings to revenue. Going forward, I project an earnings to revenue ratio of 9%.
There is an adjustment that needs to be made to earnings. For a number of years, Starbucks has spent a large percentage of earnings on share repurchases. The table below shows Starbucks' earnings and money spent on share repurchases for the last 10 years (amounts are in millions):
SHARE REPURCHASE COSTS
To be fair to management, I added back the proceeds from re-issuing shares into the share repurchase costs, hence the occasional positive year for that column. You probably noticed this already, but Starbucks spends a large percentage of shareholder profits on buying back shares. This would be fine, except the share count has not decreased very much over time. For example, in the last five years Starbucks has spent roughly 20% of earnings on share buybacks and the result was an increase in shares outstanding. For a number of years, management has been issuing stock options to employees and has been using earnings to partially offset these dilutions. Given the blind enthusiasm share buybacks are greeted with nowadays, I assume most investors do not realize just how much of their profits are being siphoned off. Yet, any valuation of Starbucks has to take these repurchases into account. In modeling the fair value of Starbucks, the earnings spent to simply offset stock dilution have to be treated as an expense and not as profits to shareholders. Going forward, I assume that roughly 10% of earnings will be lost trying to offset shareholder dilution. Additionally, we can now calculate future earnings per share assuming that, with these repurchases, there will be little change in the amount of shares outstanding.
Finally, an acceptable discount rate needs to be determined. Currently, interest rates are at historic lows, but since we are modeling Starbucks' profits years into the future, we need a better estimate of the future discount rate. Since the end of World War II, the average 10 year US Treasuries rate has been about 5.8%. No doubt that an investment in Starbucks is a bit more risky, but as far as stocks go, Starbucks is a safe and secure investment. To account for the higher risk of owning Starbucks stock, I settled on using a discount rate of 6.5%
As can be seen in the spreadsheet for this article, from the assumptions mentioned in the above paragraphs a fair market price for a share of Starbucks is $57.89. In order to provide a margin of safety, it would be prudent to purchase Starbucks only when the price has dropped to the low 50's or high 40's.
A final note, Starbucks is a great company; in the last 10 years it has never had a return on equity below 10% even with a leverage ratio of less than 2. Starbucks is too consistently profitable to write off forever, but for now, I'm looking elsewhere to invest.