On August 20, 2007, Starbucks Corporation entered into an underwriting agreement with Goldman, Sachs & Co., Banc of America Securities LLC and Citigroup Global Markets Inc., acting on behalf of themselves and the other underwriters named therein (the “Underwriters”), for the public offering of $550,000,000 aggregate principal amount of its 6.25% Senior Notes due August 15, 2017.
So, does this dent on its otherwise pristine balance sheet mark the beginning of the end for Starbucks? I don’t think so. First of all, raising financing at 6.25% in the middle of a credit crunch is, if anything, a confirmation of the company’s strong financial position. Secondly, the company generated more than twice that amount in cash flow from operating activities last year, suggesting the company will have no problem paying it off should they choose, let alone meeting their interest obligation.
It is that interest obligation, in fact, that I think is the best part of the deal. On an after tax basis, it comes out to just 4.6% or so. That is pretty cheap financing for whatever the company chooses to do with it. Up until now, they have been able to open thousands of stores annually using only internally generated cash flow. Adding debt could allow them to grow twice as fast, should they choose.
Alternatively, the company could use the debt to “restructure” their balance sheet by buying back stock. At the current stock price, the $550 million proceeds could take in approximately 2.7% of the total shares outstanding. On the basis of earnings per share, doing this wouldn’t make much difference by my calculations. Using the full year ended October 2006 it would have reduced earnings by a penny. The effect is probably less on the current earnings and share base.
But the larger impact comes from reducing the total cost of capital to the firm. As I noted when I compared the Starbucks valuation to that of McDonald’s (MCD - Annual Report):
SBUX is more efficient than MCD, which is reflected in a 20.8% ROE for SBUX compared to 17.7% for MCD. And MCD has debt funding which boosts its ROE. As growth slows at SBUX it too could add some debt to its mix to generate better returns for equity holders. But at any rate, the 3 per cent differential in ROE says that SBUX should be more valuable than MCD when it finally tops out.
Looking up the fundamental P/E calculation on p. 192 of Analysis of Equity Investments: Valuation, we can get a good starting point. If we adjust the payout ratio to give us the same implied growth rate and required return for Starbucks as we currently have for MCD, we find that SBUX would deserve a 23.2x P/E multiple rather than the 17.3x that MCD has today. And assuming further that SBUX achieves the same debt/equity mix it could justify a $66.5 billion enterprise value.
If we get there the average annual return would be more like 8.5 per cent, which is a good deal better but still may not justify the price now unless one is willing to bet that SBUX can, indeed, grow to a larger size than McDonalds (or if one assumes the average return on other investments will be less than that).
Since that analysis, McDonald’s enterprise value has risen and that of Starbucks has fallen, which makes the comparison more favorable. But even using that original $66.5 billion estimated future enterprise value is sufficient to merit a 12% annual return before any incremental debt contributions.
In other words, I think Starbucks is doing exactly what I thought they should be doing when I wrote the original post, and the valuation has come down to a point from which I think it can do better than most stocks.
Disclosure: Author is long Starbucks (SBUX) at time of publication.
SBUX 1-yr chart: