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Starbucks Improving Across the Board: Is That Enough?

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Starbucks Corp. is an impressive turnaround story. Currently priced close to $23, it needs to continue beating and raising EPS estimates much higher than consensus to justify a higher valuation. Originally published by Ascendere Associates LLC on February 16, 2010.www.ascenderellc.com

Ascendere Associates LLC Steve Castellano Starbucks Corp. (NasdaqGS: SBUX) Sector: Consumer Discretionary Industry: Restaurants

February 12, 2010 [email protected]

There are not many companies in which nearly every fundamental metric we look at is improving across the board. But they do exist, and one such impressive company is Starbucks Corp. At the current level, SBUX is a good option for growth investors that expect significant upside to current consensus forecasts -- because we do think there is some chance of this occurring. SBUX is also currently a good stock idea for high turnover portfolios driven by constantly updated relative value decisions, such as the Ascendere Long/Short Model Portfolio. But given our preference for highlighting stock ideas that show good value against sustained operating momentum, we would prefer portfolio managers wait for a better price, closer to $17-19, or at most at 15.2x the consensus FY2011 EPS estimate. Such a purchase price would allow participation in a possible resurgent growth story without being aggressive. Our target 1yr value is $23, which is below the consensus average target of $25 and derived from a scenario analysis indicating a realistic valuation range of $9-46. For the stock price to reach near the high end of our range, we think the company would have to generate EPS approaching $1.70 in fiscal 2011 and show accelerating growth beyond. In contrast, the consensus EPS estimate for FY2011 is $1.25 and the consensus high is $1.41. While these optimistic scenarios are aggressive, they are also plausible under perfect conditions.SBUXStock Price Market Cap $22.60 $16.8b LTM EPS: $ 0.76 P/E: P/CF P/S: 29.9 11.0 1.7 FY+1 EPS: P/E: P/CF P/S: $1.10 20.5 9.4 1.6 FY+2 EPS: P/E: P/CF P/S: $1.25 18.1 LTM ROE: 19.1% 5yr Avg ROE: 30.2% Insiders Own 2.7%

EBITDA/ EBITDA/ Capital 42.8% Capital 38.3% 9.7% Margin 5.7% Margin 9.3% 6.0%

Number of Analysts 19 Debt to Captial 14.0% Dividend Yield 0.0%

Enterprise Val $16.0b Beta 1.35

8.6 Margin 1.6 Margin

Description: Starbucks Corporation engages in the purchase, roasting, and sale of whole bean coffees worldwide. It offers brewed coffees, related beverages and complementary food items. It also produces and sells various ready-to-drink beverages. Its brand portfolio includes Starbucks, Seattles Best Coffee and others.

Starbucks Corp. is bucking the trend We took a quick look at Starbucks in early 2009, and as generalists searching for the best relative opportunity among 3000+ stocks that trade on major U.S. exchanges, were not impressed. Fundamental metrics were trending poorly, international markets were in full fledged recession, and a premium-branded coffee and related items seemed like easy things for the consumer to give up in the quest for newfound frugality. New initiatives announced upon the return of Starbucks' founder Harold Schultz to the CEO role in January 2008 did not seem to be having a measurable effect. The stock peaked close to $40 in December 2006 and traded as low as$7 in 2008. But March 2009 results marked the turning point. The cumulative effect of new initiatives focused on controlling operating costs, improving operating efficiency, strengthening connections among customers and the closure of 900 stores and the announced lay off of 7000 employees and attrition of thousands more have translated into significant operating momentum which seems likely to continue through 2010 and perhaps beyond. Impressive operating momentum since early 2009 Since the end of 2008, Starbucks has seen a significant decline in capital spending, operating capital has been reduced, and various measures of profitability and cash flow have drastically improved. In more detail, since December 2008 Starbucks has reduced estimated Operating Capital by $1.6b to $6.9b from $8.6b, while estimated adjusted operating profit has improved Steve Castellano [email protected] Ascendere Associates LLC Page 1

more than 3x to $762m from $211m over the same period. Anyway you look at it -- EBIT, adjusted EBITDA, free cash flow -profitability has surged since December 2008 while the amount of capital required to create this profitability has declined. This has helped the company generate a ROIC higher than its cost of capital for the first time in several quarters. In addition, this has put $700m+ in cash on its balance sheet bringing the total to $1.4b cash and short-term investments. In the most recent conference call the company said it expects to conclude work on a distribution strategy for this excess cash in the coming months. Starbucks learned valuable lessons in its domestic market CEO Harold Schultz summarized the recent improvements in the companys January 20, 2010 conference call transcribed by Seeking Alpha for the fiscal first quarter that ended on 12/27/2009: This was a very satisfying quarter by any standard and follows three successive quarters of continued improvement in our business. Our U.S.-company operated stores reached a significant milestone in Q1 as all regions reported positive comp growth and our U.S.-licensed stores also delivered strong results. As in prior quarters, our business this quarter benefited mightily from continued innovation from the success of our company wide efforts to improve customer experience from our continued laser focus on controlling operating costs and improving operating efficiency and from the impact of decisive actions we took early in 2008. Given the significant operating improvements seen thus far, maybe it is not a surprise the stock has seen a 165% rally from a March 2009 low of $8.27 to a recent close of $21.91, outperforming the S&P 500 return of 56% and the S&P Discretionary SPDR (XLY) return of 78% over the same period. If estimates are revised further upward, there could be more room for SBUX to move. Upside possible if company remains focused and if global economies improve We find the current consensus estimates that imply continued improvements for ROIC and solid earnings growth believable and perhaps containing some potential to move even higher, which makes us comfortable with not overly-weighting a negative valuation scenario. The company seems to have learned some valuable lessons in its U.S. market, and has recently started increasing marketing spending to drive revenue on some key growth platforms and initiatives. It is also increasing investment in its well-received VIA instant coffee product and on efforts to "refresh" the designs of existing Starbuck stores. In addition, the company intends to apply the lessons learned in the U.S. to international markets. For now, international efforts appear to be concentrated in the U.K., France, Spain and China. Starbucks believes China will become its largest market outside of the U.S. If Starbucks can drive revenue in China and other international locations to one-half to two-thirds of the level of growth experienced in its early growth phase in the United States, there could be significant upside to consensus revenue and earnings growth forecasts. Relative valuation summary Starbucks is currently trading at 20.2x NTM consensus EPS of $1.12 versus a 5yr average of 26.8x and a range of 10.1-53.4x. Fifteen sell side analysts provide targets ranging $13 to $30 and average $25. Nineteen sell side analysts provide FY2011 EPS estimates ranging from $1.15 to $1.41 and average $1.25. On a relative EV/EBITDA basis, SBUX trades at a slight discount to a peer average, and on a PE basis it is at a premium. Given its high growth prospects and ROIC profile, these multiples are justifiable and actually offer a slightly better adjusted value at this snapshot in time -- but they do not point to an overwhelming bargain. Scenario analysis We have chosen 4 different scenarios in which to value Starbucks. Numerous underlying factors can be summarized in the longterm earnings growth rates on a 10% WACC and 2.5% terminal growth rate -- 21%, 18%, 8% and negative 3%. A more aggressive 9% WACC and 3% terminal growth rate may be justifiable, and could positively impact our range of targets by about $1-10. The most realistic but conservative assumption in our opinion is the 8% growth scenario, which suggests the stock deserves to trade at only about 17x the consensus NTM EPS estimate of about $1.12 or at about $19 one year from now. Ascendere Associates LLC Page 2

Steve Castellano [email protected]

But If SBUX can beat and raise estimates throughout the next two years and get on track to close to 18% earnings growth on average for the next 5 years and moving higher beyond that, perhaps the stock should be more appropriately valued at $30, or about 18x an above-consensus-high FY2012 EPS estimate of $1.70. We are comfortable with these assumptions for this particular scenario because we think they reflect the possibility of continued operating momentum and a growing penchant for China and other countries to embrace a number of American brands. A $46 stock price target is justifiable under the right conditions, though a bit farfetched at the moment. Such a target would have to assume flawless execution, faster than anticipated international expansion and a rebound in the global economies so that the company could resume a growth rate seen 5 to 10 years ago. True believers would have to justify a target earnings growth rate of 21% compounding to $2.80 by FY2015 and accelerating at a higher rate beyond. If Starbucks runs into additional problems or the economies falter again so that earnings essentially decline 3% on average over the next few years, a fundamentally justifiable target could be $9 today.

Simple Microsoft Excel models for SBUX revenue growth and operating margin assumptions that we used to help generate realistic scenarios for optimistic earnings growth are available at our website www.ascenderellc.com. The current stock price embeds a

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