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MGMT 315 Valuation Memo of Starbucks Co

Executive Memo on Valuation of Starbucks Co.

Executive Summary

The forecast of Starbucks’ financial statements estimates that a 10% revenue growth provides total revenue for fiscal 2018 at $24.6 billion, while cost of sales including occupancy costs is expected to be 42% of sales, totaling $10.3 billion. Any further increases in revenue and cost of sales makes the external financing needed higher, so it is important for Starbucks to focus on same-store sales growth through beverage and food innovation and focus on its digital platform. This will particularly be crucial as the company is expanding China and Japan, which has rising costs. As Starbucks is also expanding stores globally, property, plant, equipment is expected to comprise 24% of sales at a total of $5.9 billion.

The valuation model shows that the value per share is $71, which is 9% higher than the current stock price at $65. With 1.24 billion shares outstanding, this provided a market capitalization at $88 billion, which is 7% higher than the actual market capitalization at $72 billion. The valuation model is based on assumptions of cost of capital at 13%, which is derived from estimated cost of equity at 14%, weight of debt at 10% and equity at 90% in its capital structure, a 21% corporate tax rate, and estimated cost of new long-term debt at 4.4%.

The range of valuation was investigated for the effects that weight of debt and equity had on value per share. It shows that the value per share increases as the weight of debt in the capital structure increases and the weight of equity decreases. Having debt comprise a bigger part of the capital structure is attractive for Starbucks as the data table on cost of new long-term debt shows that changes had little effect on the value per share. It is recommended that Starbucks should take on more debt in order to reduce the equity weight in the capital structure.

Cost of Capital

The weighted average cost of capital is the funding cost for Starbucks and is also used in the valuation model that provides an estimated value per share. To find the cost of capital, numbers are needed for the assumed future tax rate, and weight and cost of both long-term debt and equity in the capital structure.

Starbucks has 1.25 billion shares outstanding as of December 2018. With the current stock price at $65, the market capitalization totals $82 billion. As of end of fiscal 2018, the current portion of long-term debt is at $350 million and long-term debt at $9 billion, bringing total debt to $9.3 billion. With a market capitalization at $82 billion and total debt at $9.3 billion, Starbucks’ equity weight is at 90%, with the remaining 10% debt in its capital structure.

The assumed future tax rate is at 21%. This has been discussed in Starbucks’ annual report and is expected to be stable at 21% in the foreseeable future.

The new cost of long-term debt is derived from FINRA, Financial Industry Regulatory Authority. Starbucks has issued two 10-year bonds that are due in fiscal 2028, with yields at 4.1% and 4.2%, providing an average cost of debt at 4.15%. An adjustment of 30 basis points upward was made in order to adjust for interest rates having gone up during the last couple of months, providing new cost of long-term debt at 4.4%.

In order to find the estimate of cost of new equity, the capital asset pricing model, constant growth model, and industry estimate was used. For the industry estimate, the new cost of long-term debt at 4.4% is used. Adding an equity premium at 9%, the industry estimate totals 13.4%.

The capital asset pricing model indicates what should be the expected or required rate of return on Starbucks’ stock. It is calculated using the risk-free rate, a stock’s beta, and the expected return of the market. Starbucks’ beta is stable at 0.25 and indicates that Starbuck’s stock is less risky than the market. The risk-free rate is derived from the yield of the 10-year U.S. Treasury Bond, which is at 3.01% as of end-of November 2018. A rough estimate is of expected market return would be around 10%, and it may be worth mentioning that a recession is expected within the next few years. The beta is then multiplied by the market risk premium, which is the 10% expected return from the market above the 3.01% risk-free rate. The formula provides a 4.8% expected or required return on Starbucks’ common stock. This model was not factored into the estimate of cost of equity as it became too skewed by the low beta Starbucks had at 0.25.

The constant growth model provides an estimate of the intrinsic value of Starbucks’ stock based on future series of dividends that grow at a constant rat. The inputs for the constant growth model include the current dividend per share, growth rate of dividends, and current stock price. The most recent dividend payment for Starbucks was November 14, 2018 at $0.36 per share.

The quarterly dividends per share have grown by around 20% over the last fiscal years, which is part of Starbucks’ plan to return $20 billion to shareholders by 2022. The 20% dividend growth rate was not used as it skews the calculation since it is not expected to grow by 20% consecutively over the next five years. The growth rate was thus set at 12%, providing more balance. The current stock price as of end-of November 2018 was at $65.

The estimate of cost of new equity was calculated by taking the averages of the constant growth model at 14.5% and the industry estimate of cost of new long-term debt and an equity premium of 9%. This provided estimate of cost of equity at 14%.

Modeling

A valuation model was performed in which provided an estimate of stock price. The assumptions of the valuation included the cost of capital at 13%, the growth rate of the constant growth model at 6%, and a multiple of EBITDA at 20.

Numbers were drawn from the income statement, the statement of cash flows, and the balance sheet to create total operating cash flows in the valuation model.

Starbucks has seen strong growth over the last couple of fiscal years, but in fiscal 2017, total revenues grew by only 5% to a total of $22 billion, missing expectations. This is partly due to oversaturation where Starbucks had many locations in areas that were too heavily concentrated. Starbucks also decided to close all of its 379 Teavana stores in fiscal 2017, as these stores have seen revenues declining. Starbucks announced that it will be closing over 150 underperforming Starbucks locations and will instead focus its efforts on new U.S. locations in the South and the Midwest, regions which do not have as many locations as other areas in the U.S. Starbucks is also expecting revenues to improve amid its expansion in China and Japan among the countries with strongest growth in Asia. In May 2018, Starbucks formed a global coffee alliance with Nestle, the world’s largest food and beverage company, in a bid to expand its global reach and increase the growth of its products outside of Starbucks’ locations. With Nestle paying Starbucks $7.15 billion in closing consideration, it obtained the rights to market, sell, and distribute a range of Starbucks products, with Starbucks retaining a significant stake as licensor and supplier. This further expands the reach of Starbucks and will increase revenues through Starbucks’ supplier role. A 10% increase in revenue is expected for fiscal 2018 based.

Cost of sales including occupancy costs has remained at around 40% of net sales and is expected to increase slightly to 42%. The main driver is new store openings, and also rising inflation in China, which will drive up the costs of operating there.

Operating income, EBIT has been around $4 billion for the last fiscal years, and is expected to slowly increase, providing operating income for fiscal 2018 throughout 2022 at $3.9 billion, $4.1 billion, $4.4 billion, $4.6 billion, and $4.8 billion.

Before the tax reform, Starbucks’ tax rate was around 32%. Starbucks stated in its quarterly reports for quarter three in fiscal 2018 that it had paid a blended rate of 24.5% due to the new tax law but stated that the rate will be reduced to 21% in subsequent fiscal years. The total taxes expected to be paid from fiscal 2018 throughout fiscal 2022 is at $1.1 billion, $900 million, $980 million, $1 billion, and $1.2 billion.

Depreciation and amortization have remained steady at 21-22% of revenues and is expected to increase to 23% of revenues as Starbucks is expanding. This approximates property, plant, and equipment as a percentage of sales on the balance sheet. The increase for this item provides uses of cash for fiscal 2018 throughout 2022 at $990 million, $600 million, $650 million, $715 million, and $790 million in all five years that are forecasted. Total depreciation and amortization for fiscal years 2018 throughout 2022 are expected at $1.18 billion, $1.3 billion, $1.4 billion, $1.5 billion, and $1.7 billion.

Inventory has been steady over for the last fiscal years, with days inventory ranging from 61 days at the highest in fiscal 2015 to 59 in fiscal 2016 and then 55 days in fiscal 2017. Its inventory is comprised of unroasted and roasted coffee, other merchandise held for sale, and packaging and other suppliers. Inventory is forecasted to increase, with days inventory projected to be at 55 days. Starbucks has an extremely efficient logistics and supply chain system as it is important for the company to never run out of any items. Keeping days inventory at 55 days supports this. Since inventory will increase for all five forecasted years, there will be uses of cash around $200 million each fiscal year from 2018 throughout fiscal 2022.

A major expected source of cash in all five forecasted years is deferred revenue, called stores value card liability. Stored value cards, primarily Starbucks Cards, have grown in popularity since its inception in 2001, and is especially popular as gifts around the winter holiday season. Starbucks also includes deferred revenue from money loaded on its mobile app through the customer loyalty rewards program in addition to the cards. The card liability has grown evenly over the last couple of years and total deferred revenue has remained at 5% over the last fiscal years. This is expected to increase to 6% of sales as Starbucks’ expansion will continue to attract loyal customers. Starbucks has also announced that it is going to update the Rewards program in fiscal 2019 in a bid to improve it and attract even more customers. The increase in stores value card liability produces sources of cash in all years from fiscal 2018 throughout fiscal 2022 at $190 million, $150 million, $160 million, $180 million, and $200 million.

Starbucks’ accounts receivable has grown remained steadily with days sales outstanding at 13 and 14 days in fiscal 2016 and 2017. It is forecasted to be around 12 days as Starbucks might negotiate better terms for suppliers to pay Starbucks more quickly. This would provide a source of cash at $60 million in fiscal 2018 and uses of cash from fiscal 2019 throughout 2022 at $80 million, $90 million, $100 million, and $110 million.

Accounts payable have increased over the last fiscal years, with the days payable at 31 and 32 days. The average company in the "Consumer Discretionary" sector has days payable of 40 days, which puts Starbucks' days payable at 32 days 25% less than the sector median and is forecasted to remain at the same level. It is recommended that Starbucks should try to lower its days payable to 30 days by potentially requesting that a small percentage be deducted. This is possible as Starbucks is known to have strong, long-term relationships with its suppliers.

These represent the most major of the operating cash flows used in the valuation model. Other, minor cash flows include share-based compensation, deferred tax expense, goodwill, intangible assets, other assets, accrued liabilities, and other liabilities.

The total of operating cash flows in the valuation model from fiscal 2018 throughout fiscal 2022 totals $3.7 billion, $4.5 billion, $4.9 billion, $5.4 billion, and $5.9 billion. To find the terminal value using perpetuity, the operating cash flow at $5.9 billion in fiscal 2022 was divided by the cost of capital at 13%, providing a terminal value at $46 billion. The terminal value using a multiple of EBITDA at 20 provided a total value at $131 billion. The terminal value using the constant growth model provided a total value at $91 billion. The percentage of terminal value included in the operating cash flows was determined to be 100% as Starbucks is expected to continue operations beyond the 5-year forecast and valuation model. The enterprise value was found using the Net Present Value function with the input of cost of capital and the total operating cash flows. The latter cash flow for fiscal 2022 totaled an estimated $137 billion. The enterprise value totaled $88 billion. In order to find the value of total equity, cash and marketable securities at $3.2 billion was added, while total debt at $3.9 billion was subtracted. This provided a value of equity at $88 billion compared to the $82 billion market capitalization that Starbucks has today. Starbucks currently has 1.24 billion shares outstanding as of end of fiscal 2018. The $88 billion value of equity was divided by 1.24 billion, which provided a $71 value per share. This indicates a 9% premium over the current share price at $65.

Data Tables and Sensitivity Analysis

Throughout the forecasting and valuation, data tables were made to investigate the major assumptions and sensitive goals for the income statement, balance sheet, cost of capital, and valuation for the effect on the EFN, external financing needed, and the value per share.

On the income statement, the data table demonstrated that a further increase in revenue would drive the external funds needed up higher, while the same was true for cost of sales including occupancy costs as a percentage of revenues. A data table was also made on store operating expenses as percentage of revenues. It indicates that the external financing needed would go up if the store operating expenses increased. As Starbucks is expanding, it will be challenging to contain cost of sales and store operating expenses. A strategy would be to focus on innovation in food and beverages, which would help fuel same-store revenue growth without the company having to rely on solely new location openings in order to increase revenue.

Data tables on value per share were also made for items on the income statement. Data tables on growth of revenues shows that with the current 10% growth of revenues, the value per share is $71. If revenue increased by 12%, the value per share would be at $79, indicating that revenue growth has a strong effect on the share price.

Data tables on the cost of sales as a percentage of net revenues, and depreciation and amortization as a percentage of property, plant, and equipment, indicate that increase for both items would lead to a lower share price.

On the balance sheet, data tables on the value per share investigated the effect of days inventory, days sales outstanding, property, plant, and equipment as a percentage of revenue, and days payable.

The number of days inventory had little effect on the value per share. If the days inventory went down from the current 55 days with $71 per share to 40 days inventory, the share price would only go up to $71.5. This was similar for both days sales outstanding and days payable as well.

Changes in property, plant, and equipment as a percentage of revenues had a bigger effect on value per share. The data table indicated that if the current property, plant, and equipment at 24% of revenue went down to 20% of revenue, the value per share would be $74. While this is a good sign, it would be challenging for Starbucks to be able to reduce its property, plant, and equipment since it most often moves in conjunction with sales. Starbucks’ sales are increasing in part because it is expanding and opening new locations, which increases the property, plant, and equipment. In order to rely less on property, plant, and equipment, it would be necessary for Starbucks to drive innovation in food and beverages to increase same-store sales and sell more packaged products in supermarkets. The global coffee alliance deal signed with Nestle May 2018 will provide an increase in revenues without Starbucks having to expand locations to facilitate and increase its property, plant, and equipment.

For data tables on EFN, external funds needed, changes in stored value card liability as a percentage had a strong effect on the external funds needed. If the stored value card liability had moved from 6% of revenues to 9% of net revenues, the external funds needed would be at $1.2 billion in fiscal 2018 and would sharply decrease in subsequent fiscal years. Starbucks understands the strength and popularity of its rewards program and gift cards and has a goal of increasing the stored value card liability and revenue generated through its application. The company is committing to do this by updating its Rewards Program in fiscal 2019. While the company has been secretive as to specifically what changes will be made, it has announced that changes will improve the program and attract more customers for the long-term.

Data tables were conducted on assumptions for to calculate cost of equity to investigate the effects on value per share. The data table on effect of cost of new equity indicate as expected that a lower estimate of cost of new equity has a positive effect on the value per share. If the cost of new equity went down from the current 14% to 12%, the value per share would move from $71 to $76.

Likewise, the data table on estimated cost of capital indicate that a lower cost of capital increases the value per share. A cost of capital at 10% brings the value per share to $80.

The composition of the capital structure has a strong impact on the value per share. The data table on weight of debt shows that a higher weight of debt than the current 10% had a positive impact on value per share. If debt were to comprise 30% of the capital structure, the value per share would be $78. This positive pattern is further underscored by the results of the data table on new cost of long-term debt, which shows that any deviation in the cost of long-term debt has little effect on the value per share. This indicated that it is attractive for Starbucks to have debt make up a bigger percentage of its capital structure. The company has increased its debt over the last fiscal years and is moving towards a more leveraged structure. In fiscal 2018, the company issued debt at $5.5 billion, which brings Starbucks’ total debt to $9.3 billion.

As an increase in the weight of debt in the capital structure increases the value per share, a decrease in the weight of equity naturally increases the value per share. The value per share would increase from $71 to $75 if the weight of equity moved from 90% to 80% alone. Starbucks is already moving towards a more leveraged capital structure as it is on track to return $25 billion back to shareholders by fiscal 2020 through an accelerated share repurchase program and steady dividend increases. In fiscal 2017 and 2018, the company returned $3.5 billion and $8.8 billion to shareholders.

Conclusion

The calculation of Starbucks’ cost of capital included new cost of long-term debt at 4.4%, cost of equity at 14%, a 90% weight of equity, 10% weight of debt in its capital structure, and a 21% tax rate to provide an estimated cost of capital. The valuation model used the operating cash flows forecasted for the five years fiscal 2018 throughout fiscal 2022. Terminal values were calculated using perpetuity, a 20 multiple of EBITDA, and the constant growth model. The enterprise value was calculated using the cost of equity, where cash and marketable securities were added, and debt was subtracted. This provided a value of equity which was then divided by the 1.24 billion shares outstanding, which provided a value per share at $71 with a market capitalization at $88 billion compared to the actual share price at $65 and market capitalization at $82 billion.

The data tables indicate that Starbucks’ value per share would increase with the weight of debt comprising a bigger part of its capital structure than the current 10%. The company is moving in this direction as it is continuing to take on more debt and repurchasing shares and increasing dividend payments to shareholders. The current and long-term debt totals $9.3 billion.

Starbucks seen challenges to its same-store sales during the last fiscal years and is closing 150 domestic U.S. stores in fiscal 2019, three times the average annual store closures and is focusing on areas such as the South and the Midwest which is not a saturated market as the other areas are.

With revenue growth at 5% for fiscal 2017 and 10% for fiscal 2018, revenue totaled $22.3 billion and $24.6 billion in fiscal 2017 and 2018. Property, plant and equipment is also expected to increase, with this item forecasted to comprise 24% of sales, bringing total property, plant, and equipment to $5.9 billion. This is expected to continue rising as Starbucks is expanding.

Starbucks overarching strategies are to grow same-store sales through food and beverage innovation, changes to its Rewards Program, and gaining share of at-home coffee, which will be facilitated in part through its Global Coffee Alliance Deal with Nestle. Starbucks is also concentrating on growing in Asia and in particular in China and Japan, markets that adapt quickly to technology and will be attractive for the Rewards Program and mobile application.

Reflection & Learning

Doing the forecast and estimation of cost of capital and modeling has been challenging but also very rewarding. I really do enjoy researching companies and learning as much as I can about them, and I particularly enjoy learning about the different industries the companies operate in. I view that as extra learning from the finance classes and also regard it as not only beneficial career-wise to understand different industries, but also in that it has helped me understand what types of industries I might want to be involved in throughout my career. As I am interested in the world of investing, wealth management, and private equity, I would be very interested in focusing on the automotive industry and consumer discretionary, which Starbucks is a part of.

I was initially not quite sure what to think of Starbucks when I decided to focus on this company at the beginning of the semester, but I have grown to become very fond of Starbucks, not just because it is a very well-run company, but because it also has a serious commitment to sustainability and equal opportunities. It offers educational opportunities and provides health benefits for all employees and is constantly working to maintain a good relationship and business terms that benefits its suppliers among some, and I think investors are becoming increasingly aware of this. Beyond creating value for its shareholders, Starbucks is also creating value for the planet by adopting sustainable practices into its operations.

I think it was interesting to estimate cost of capital and valuation. I really enjoy the format of the instruction in which we work over a model with the Professor in class, post it and receive feedback to make sure we are doing it correctly, and then apply the method to our company.

The excel spreadsheet for estimating cost of capital was very clearly laid out, simple to use and visually very helpful for me to learn. I think I have a much better understanding of how to perform and estimate of cost of capital. When I think about cost of capital in general, I actually imagine the tab in the excel model for how to calculate it, so I definitely think the model helped me remember the assumptions well.

It was a bit tricky to accurately decide if the cost of capital and its assumptions were correct. While assumptions such as the tax rate and weight of both debt and equity in the capital structure among some are fact-driven, I did not immediately know not to include the capital asset pricing model in the estimate of cost of new equity. When included, it made the cost of capital 11% compared to the 14% derived from just the industry estimate and the constant growth model which I went with after receiving help from the Professor. I now understand that the low company forecasted beta at 0.25 skewed the result of the capital asset pricing model to be around 5%, which significantly reduces the cost of equity if included. I think the important thing to learn for not only cost of equity and valuation, but all financial excel models, is to be able to understand what is going on, and to understand which numbers drive which numbers up by how much. It is not enough to just research and plug in the assumptions and go with the outcome. You have to be able to assess and understand if some numbers should not be included in a certain calculation because it might skew the total too much in a direction. I think working with the valuation model and all of its consistently really helped open my eyes up for this, and I am excited to continue to build on that knowledge.

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