Over the last three years, Starbucks (SBUX) was locked in a dispute with Kraft Foods (KRFT), which was promoting and distributing Starbucks consumer package products to retail shops and supermarkets since 1998.
With the commencement of this distributing agreement in 1998, Starbucks' retail business grew from $50 million to $500 million in 2010. However, Starbucks stated that sales growth at grocery stores fell, decreasing its market share to almost 25% in the beginning of 2010 from 33% in 2005.
With the reduction in market share in 2010, Starbucks decided to unilaterally terminate the contract and take full control of its Consumer Package Goods, or CPG, segment. In return, the company offered $750 million to Kraft Foods as compensation, on which it declined and demanded the fair market value of the lost business, thus creating the dispute between the parties.
Recently, this three-year dispute reached a settlement through an independent arbitrator, requiring Starbucks to pay $2.79 billion in compensation to unilaterally terminate the contract. Starbucks said it has enough liquidity and borrowing capacity to fund this expense, which will be charged to its fiscal year 2013. With this, the company has restated its fourth quarter results and announced an operating loss of $1.2 million, or $1.64 per share.
In the trailing twelve months, Starbucks has shown a tremendous free cash flow growth rate of 98.30%, which I believe will support the fine payment. Moreover, the company plans to issue additional debt of $750 million in the next three months to fund the payment. In its fourth quarter, Starbucks already issued approximately $750 million of long-term debt, bringing its total long-term debt to approximately $1.3 billion. Grounded on Starbucks' strong cash flow growth and EBITDA of $580 million in the trailing twelve months despite the heavy fine payment, I feel Starbucks has enough capacity even after the upcoming issuance of debt.
As far as growth of its CPG segment is concerned, I believe this is the right move for Starbucks to take full control of its CPG segment. With the full control over the operations, its revenue has reached $1 billion, which is double the revenue of $500 million in 2010 (when Starbucks decided to terminate the contract).
In addition to revenue growth, in fiscal year 2013, the company also witnessed market share upsurge in CPG. This was supported by the company's packaged goods price reduction strategy. Furthermore, Starbucks has recently launched a marketing campaign that focuses on the awareness of the quality of its coffee beans and where they come from. This is expected to enhance the demand of Starbucks coffee and will benefit its CPG segment, thus enhancing the segment's revenue going forward.
During this dispute, Kraft Foods joined hands with Starbucks' competitor McDonald's (MCD) for distribution of McDonald's consumer package goods in retail outlets. In the third quarter, Kraft Foods' revenue from its beverage segment declined 7.95% year over year to $625 million, and this segment accounts for approximately 15% of the company's total revenue. The alliance will help the company enhance the revenue from its beverage segment, as it will be introducing McCafe in a new format. The company will start testing McCafe roasted and ground bag coffee at grocery stores and other retail outlets in the beginning of 2014. McDonald's package goods are expected to witness an expanded market presence. This partnership isn't expected to affect Starbucks since it is efficiently managing its CPG segment, as I discussed above.
Starbucks' fine payment of $2.79 billion will support the financials of Mondelez International (MDLZ), as in 2012 Kraft Foods split into two units with Mondelez handling the snack's business. So, Kraft Foods won't experience any financial effect from the deal. The amount will be used by Mondelez to repurchase its shares, enhancing its shareholders' value. In the month of August, Mondelez expanded its share repurchase activity by $4.8 billion, bringing a total amount of $6 billion by the end of 2016. With this, the company is aiming to repurchase $1 billion to $2 billion shares every year. On a year to date basis, the company has repurchase $800 million of shares, and I expect that the company will repurchase a minimum amount of $200 million in its fourth quarter this year.
Starbucks Stock Valuation
On average, the company's bottom line in respect to earnings per share, or EPS, has grown approximately 20.03% in the last five years. Its EPS in 2013 declined because of its huge expense payment to Mondelez in regards to the settlement of distribution dispute. As far as its next year's earnings are concerned, Starbucks declared that its EPS target for fiscal year 2014 will remain unaffected. The company has an EPS target of $2.6 for fiscal year 2014, and its five year historical P/E average is 33.35. Taking into consideration these parameters, I anticipate its target price to reach $88.37 by the end of 2014. Currently the stock is trading in the low eighties, giving its investors an upside potential of approximately 10% in terms of returns within one year.
As discussed above, Starbucks' future growth potential won't be affected by the termination of the distribution contract for its consumer package business. Full control and flexibility is expected to enhance the revenue generation from this segment. As far as its future earnings are concerned, the company has stated that its earnings target for next year remains unaffected. As of now, an investor should remain long on Starbucks stock, as there is still upside potential with its strong fundamentals.