Executive SummaryFrom the following research, I’ve concluded that SBUX should be granted a Buy recommendation. It is clear to us that Starbucks dominates their niche in the restaurant industry. The company demonstrates quality earnings with a promising international presence. Moving forward we believe that their strong growth will continue with the massive expansion both domestically and internationally.

Opportunities for growth:

Their recognizable brand creates huge opportunities for continued expansion which has proven to drive more than half of their revenues. Furthermore, the trend towards healthier alternatives has created major opportunities in the restaurant industry that Starbucks can capitalize on. Not only is coffee a healthy drink, but as the company implements a larger menu they can appeal to this trend to increase traffic into their locations by providing better alternatives to typical fast food chains. Attracting Customers to their current international locations should be their main objective. Starbucks has the same number of stores domestically as internationally, yet they generate half as much revenue. This represents a huge earning potential.

Risks

The biggest risk that could derail my growth expectations is the lack of earnings realization in the international markets. Half of my expected ST growth potential comes from outside the US where the company has yet to match their domestic efficiency. Domestically, the company faces the growing concern of local coffee shops that

manage to serve better quality coffee at competing prices.

BUYStarbucks Corporation (SBUX)

Current Price: $57.70

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SBUX performance relative to the market

SBUX S&P

Best Base WorstH-Model 85.88$ 81.00$ 75.93$ DCF 118.04$ 83.18$ 52.21$ Cap Earnings 33.64$ 27.30$ 25.52$ Mod Cap E 66.37$ 53.90$ 47.33$

SBUX Valuations

The valuations that take into consideration the short-term growth that the company will potentially experience in the next 5-10 years clearly show that Starbucks is currently undervalued.

Relative valuations show that the market may in fact recognize the company’s potential, however, they might be overstating the risks. Starbucks is a solid investment for any investor that is looking for strong growth. I believe the company will continue to experience strong

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growth and SBUX stock should be part of any portfolio.

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Table of ContentsIndustry Analysis................................................3

Overview.......................................................3

The Players....................................................4

Trends............................................................4

Regulations....................................................5

Porter Industry Analysis.................................5

Porter’s Competitive Strategy.......................8

Implications for Growth.................................9

Macro Analysis..................................................9

Consumer Spending.......................................9

Consumer Confidence Index..........................9

Per Capita Coffee Consumption...................10

Macro Conclusion........................................10

Company Overview.........................................11

Starbucks.....................................................11

Key Executives.............................................12

Culture.........................................................12

Competitive Position...................................12

Acquisitions.................................................13

SWOT Analysis.............................................13

Insights........................................................14

Fundamental Analysis......................................16

Short-term Liquidity....................................16

Short-Term Solvency...................................19

Short-Term Viability/Credit Rating..............20

(Long-Term) Turnover.................................21

Margins........................................................22

Returns (Conclusion)...................................24

Overall Financial Performance.....................25

Forecast...........................................................26

Revenue and Profits....................................26

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Balance Sheet and Financial Ratios..............29

Cost of Capital.................................................31

Cost of Equity..............................................31

Cost of Debt.................................................35

WACC...........................................................35

Terminal Growth and Valuation......................36

Short-Term Growth.....................................36

Long-Term Growth......................................36

Discounted Cash Flow Model......................37

H-Model Multi-Stage...................................38

Capitalized Earnings Model.........................38

Relative Valuation............................................40

Industry.......................................................40

EV/Sales.......................................................40

EV/EBITDA...................................................41

P/E...............................................................41

Ranking Model.............................................41

Target P/E....................................................42

Valuation Summary.....................................42

Technical Analysis............................................43

Simple Daily Moving Average......................43

Bollinger Bands............................................44

Price by Volume...........................................44

Technical Conclusion...................................45

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Industry AnalysisOverviewThe restaurant industry is very highly competitive given that it has reached a mature stage. Moderate growth of the industry has driven companies to compete against one another to gain market share in order to avoid revenue growth from stagnating. Margins are experiencing squeeze from both, the fierce competition and employees demanding better salaries, which has created a trend towards better technology and menu expansions in order to maintain profitability.

Breaking the industry down into further components allows for a better understanding of the forces acting upon it and offers a better visualization of the major players involved. Bloomberg groups the industry as follows:

DRI8%

DIN10%

EAT5%

BLMN4%

YUM4%

Other*70%

Full Service Market Share %

*Firms with less mkt share than Yum!

MCD21%

Subway8%

YUM8%

QSR8%

THI8%

Other*48%

Limited Service Market Share %

*Firms with less than 7.5% mkt share

Although the limited service segment has some clear dominant players, it has a low market concentration which emphasizes competition. Full service has an even lower concentration; the top 6 companies amount to a mere 33% of the market share.

In addition to the low margins and highly competitive environment, there are very attainable substitutes for the industry as a whole. The whole sector is very dependent on consumer sentiment, consumer spending, and health trends as we will discuss in depth throughout the analysis.

These are the two main segments of the restaurant industry, however, for our purposes we will be going further into detail to obtain a better understanding of the main players and economic influences of what is labeled as Coffee and Snack Shops by IBIS World, which would fall under the limited service category.

It is important to recognize the trend that limited service restaurants have acquired in order to apply a fair comparison. As margin tighten, limited service restaurants are expanding their menu’s in order to include items with a better margin spread. However, as coffee shops such as Starbucks and Dunkin Donuts attempt to enhance customer experience by offering more food and better service, it brings them into direct competition

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Full Service

This sub group of restaurants focuses on the full dining experience as the name implies. Costumers usually pay after the meal, and are attended by a wait staff. They also offer a menu with a wider variety of items.

Limited Service

These establishments have a much smaller menu, the items are usually made to-go and the customer pays immediately after placing an order .Sub-Categories include: Fast Food & Fast Casual

Source: Bloomberg

Source: Bloomberg

with other parts of the industry. I’m surprised Bloomberg decided to separate Starbucks and place them in their own category where they take up over 70% of the market share and not directly into the limited service industry along with Dunkin Donuts.

The Players

In terms of numbers, McDonalds seems like the most powerful competitor in the restaurant industry as a whole, but they also appeal to a larger customer base. In the coffee and snacks category however, Starbucks dominates the market.

StarbucksWith over 20,000 stores worldwide and growing, Starbucks is the industry leader in the Coffee and Snack Shops segment of the restaurant industry. Controlling 39.8% of the market, according to IBIS World, they were able to generate over $14 billion in sales in 2015 and is expected to keep growing at a generous pace. Starbucks brand was built around coffee, but their introduction of hot breakfast along with assorted menu expansions and the offering of a convenient drive thru in many locations, Starbucks has been steadily growing as a threat to rivals.

Dunkin’ Brands Inc.Dunkin' Donuts and Baskin-Robbins operate under the umbrella of Dunkin’ Brands Inc. with over 18,000 and 6000 locations respectively. Dunkin’ Brands Inc. controls 21.9% of the Coffee

and Snacks industry with presence in more than 60 countries around the world. They specialize on serving coffee, donuts and ice-cream between the two companies. Dunkin’ Donuts has a unique structure in that less than 1% of the retail locations are company operated, relying heavily on franchising.

McDonald’s CorpMcDonalds is a heavily franchised fast food operator with less than 20% of their 36,000 locations being company-operated. Their brand covers about 120 countries and they are the largest competitor in the restaurant industry, especially when it entails fast food. They are trying to penetrate the coffee industry with their McCafe brand by using their influence in the breakfast segment which they dominate.

TrendsSpecialty CoffeeCoffee has grown to be much more respected as a growing part of the consumer base seeks out a much higher quality cup of coffee, shot of espresso or a cappuccino. Although specialty coffee shops are more local and make up a small share of the coffee and snack shop industry, it is one of the fastest growing segments within the sector. Starbucks has caught on to this trend and is beginning to introduce its very own specialty coffee shops under the name Reserve.

Healthier OptionsDue to many factors, consumers have become more conscious of their health, which has forced the industry to either change or expand their menus to avoid losing customers and keep growing. Subway was one of the first to capitalize on this trend and everyone followed as they offered healthy meals in their menu and low calorie drinks. Recently, the industry as a whole has focused on marketing their healthy

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Source: IBIS World

products such as gluten free choices and much more.

TechnologyIn efforts to become more efficient in their operations and appeal to the younger, more techie consumer base, many players in the industry have tried to find a way to reach and maintain their customer through technological innovation. Capturing big data and trying to decipher the messages hidden within it to improve performance has been another difficult task for the industry, but many are tackling the issue. Most of the technological advancements are aimed towards improving quality of service and achieving faster service.

RegulationsAffordable Care Act2010. Firms with over 50 employees that work at least 30 hours must now provide healthcare to their employees. The CEO of one of the dominating firms in the industry, Starbucks, stated that he will not cut worker hours. This could have a small impact on the company along with many others that comply with this regulation or pay the fine.

Minimum WageDue to the nature of the industry, minimum wage changes could have a huge impact on profits. A large portion of the industry’s expense could be attributed to labor. Consequently, a slight increase in minimum wages would be a tremendous squeeze to an industry with already low profit margins.

FDAThe FDA sets the standards in the entire food industry, and has some serious power over the restaurant industry as a whole. Their most recent regulations include the calorie labeling in menus and the banning of trans fat. Some regulations might be minor, but the FDA is

important to observe as they can potentially put a company out of business by banning specific ingredients.

Porter Industry Analysis Summary

Buyer Power

Supplier power

New EntrantsThreat of Substitures

Degree of Rivalry

012345

Overall

As an industry that sells directly to the consumer, buyer power is minimized by the large number of customers it serves, which individually hold little financial power. However, buyers are sensitive to price changes.

As there is no substitute input, supplier power is strong and further accentuated by the size of suppliers. The only flipside to this is player independence given that all suppliers offer the same product, aside from quality.

New entrants are a threat, as suppliers are easily accessible. Low switching cost for consumers and low capital requirements lower the barriers of entry. Established players hold the upper hand through economies of scale, but no real competitive advantage.

Threat of substitutes is strong as restaurants are considered a leisure activity that can be waived. The alternative is cheaper and healthier.

The lack of differentiation and switching costs along with low industry concentration make for a very high degree of rivalry.

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Overall the industry is moderately attractive. Established players with considerable market share and brand loyalty hold most of the power and can remain profitable for the foreseeable future and even continue to grow. Easy entry will keep attracting new entrants who might struggle from low margins, but will benefit from a healthy industry growth.

Overall Rating: Moderately Attractive

Buyer PowerThe main source of buyer power comes from the low cost switching between shops and the high level of buyer independence. These factors make buyers very sensitive to price changes among competitors.

The flipside however, is that the industry mainly serves the individual consumer which significantly lowers buyer concentration and company’s dependence on single buyers as their revenue mainly comes from high volume sales given the low margins, although some local shops that specialize in higher margin premium items are more susceptible to the financial power of individual consumers.

Lastly, as the products sold in the industry are far from dispensable; consumers can choose to forgo spending towards the industry entirely. This makes consumer spending a key economic measure to look out for.

Buyer Independence

Low Cost Switching

Price Sensitivity

Product Dispensability

Buyer Size

Financial Muscle

012345

Buyer Power

In the end, the best measure of defense against buyer power in the industry is building a strong brand that promotes consumer loyalty.

Buyer Power Rating: Moderate

Supplier PowerIn the restaurant industry as a whole, profit margins are very narrow. Because of this, the importance for players to keep their costs as low as possible is greatly amplified. Therefore, the dispensability of a reliable supplier with quality products is highly noted.

Suppliers of the industry are usually large firms that supply a large number of players making them highly concentrated. This strengthens supplier’s negotiating power as revenues from individual players amount to an unremarkable percentage of the total. In the Coffee and Snack Industry this is more pronounced because 4 companies control a staggering 40% or more of the global coffee bean trade.

Furthermore, there is no real substitute, especially in the Coffee and Snack Shop industry where supplier power is very strong. Even suppliers have limited power over the price of coffee, as it is not only dictated by demand, but also by the volatile supply that is heavily influenced by weather conditions and plagues in the coffee growing countries.

In contrast, most of these forces are countered by a number of factors. First, there is minimal input differentiation. Although quality may differ from one supplier to the next, suppliers are incentivized to have a measure of quality control in order to attract more business.

Players in the industry also have a high degree of independence, as they are able to shop around for the supplier that best fits their needs and their financial constraints.

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No Subbstitute Inputs

Importance of Quality/Cost

Switching Cost

Forward IntergrationSupplier Size

Player Independence

Differentiated Input

012345

Supplier Power

Lastly, forward integration is not a big issue, as suppliers would have a hard time to move the amount of produce they currently do due to the lack of strong branding in the current market.

Supplier Power Rating: Strong

New EntrantsAlthough there are plenty of ways for players to differentiate themselves from one another, it is tough to maintain a real competitive advantage facilitating the entrance of new competition.

The modest growth of the industry allows for new entrants to make way into the industry, if the industry and demand are growing faster than the current players, newcomers are able to fill in the gaps. Combined with low capital requirements to enter the industry, new entrants are well incentivized.

Additionally, consumers face virtually no switching costs which enables new entrants to quickly gain a customer base in their corresponding markets, this coupled with the ample range of suppliers make it a very attractive industry.

In divergence from the favorable environment for new entrants however, is the high concentration of the Coffee and Snack segment of the industry. The few players that control the market have very well-known brands such as Starbucks. The sheer size of these competitors

also gives rise to another entry barrier, which is economies of scale.

Given the low margin nature of the industry, the ability to keep low costs is crucial to create and maintain a profitable business. Bigger, well established players are able to compete at a lower price range given the economies of scale, making it difficult for new entrants to generate positive cash flows from the start.

Low-Cost Switching

Supplier Accessible

Weak Brands

Scale Unimportant

Market Growth

Low Fixed Cost

012345

New Entrants

Furthermore, The FDA and the USDA are in charge of impose yet another barrier, as the food industry has strict regulations due to the health risks associated with hygiene malpractices. However, adhering to these regulations comes at a low cost. Moreover, the minimum wage laws should also be taken into account, as this is a low margin industry and any raise in minimum wage can have a significant impact. Minimum wage is expected to rise.

New Entrants Rating: Moderate/High

Threats of SubstitutesAs consumers trend towards a more health conscious mentality, threat of substitutes becomes a more real issue. In the restaurant industry as a whole, the main substitute arises from the fact that the industry is not essential to the consumers.

The primary substitute is home cooked meals. There are no switching costs associated with

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this substitute from the restaurant industry and is generally regarded as being more beneficial to consumer’s health. Additionally, the alternative to the industry is much cheaper and less time consuming, which has become increasingly more important as consumer’s seek convenience.

Low Cost Switching

Cheap AlternativeBeneficial Alternative

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Threat of Substitutes

Furthermore, in the more specific Coffee and Snack Shop industry, consumers are presented with a wider variety of substitutes. “Sport drinks, energy drinks, and energy shots… This is clearly appealing to the younger consumers,” -Allen Whitehouse, of Kraft Foods Group Inc. according to International Business Times. Although these substitutes do not compete with the industry as a whole, they do compete with their coffee related sales, which account for over 50% of industry revenue (IBIS World).

Threat of Substitutes Rating: Strong

Degree of RivalryThe restaurant industry as a whole has very little concentration, with a vast number of players of which the majority are small or medium local businesses. This and the fact that the industry has very little differentiation creates a very competitive field.

No switching cost for customers is one of the main amplifiers of rivalry. Players are forced to compete for the best locations and offer consumers the best possible experience in

order to build loyalty. Brand strength and recognition become very important to remain competitive.

Low-Cost Switching

Similarity of Players

Undiferentiated ProductIndustry Concentration

Number of Players

012345

Degree of Rivarly

Degree of Rivalry Rating: Strong

Porter’s Competitive StrategyThe main strategic trend I observed while analyzing individual players in the Coffee and Snack Industry was their focus on differentiation.

Starbucks DifferentiationThe first line of differentiation seen with Starbucks is how heavily their brand is marketed. They hope to achieve greater brand loyalty and recognition by a “disciplined global expansion” as stated in their annual report. Additionally, Starbucks strives to offer new coffee products that cycle seasonally to achieve greater product differentiation.

Dunkin’ Brands Inc. StrategyHaving a 100% franchised business model allows Dunkin greater flexibility. They believe that this strategy enables them to focus their efforts in menu innovation and marketing given that they operate an immaterial number of restaurants. Another plus of this strategy is that it allows them to grow their brand with minimal capital investments.

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Furthermore, their strategy towards being the technological leader in the industry. Their digital presence boosts their accessibility and customer loyalty.

Implications for GrowthAlthough the Restaurant industry has reached a mature stage as a whole, the Coffee and Snack Shop industry within restaurants continuous to experience a healthy growth. Low barriers of entry will keep on attracting new players to the

industry to fill in the gaps and push development forward. The high degree of rivalry will incite innovation in the way companies interact and serve their customer to obtain a competitive edge. Geographic expansion will also be a main source of growth for the dominant firms. Lastly, the high competition and low margins will give rise to specialty boutiques that offer higher value and quality items that focus on the high margin niche.

Macro AnalysisConsumer Spending

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015150

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4.0%

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10.0%

12.0%

187

206217

224230 230 233

239248

254262

27310.4%

4.9%

3.5%2.7%

-0.1%

1.2%

2.6%

3.8%

2.5%3.0%

4.2%

Consumer Spending in the Quick Service Restaurant (QSR) Sector ($ US Billion) w/ YoY Growth Rate

Source: Statista

Because the restaurant industry is not indispensable, the revenues are closely tied to consumer spending. This graph shows the consumer spending specifically tied to the QSR sector of the industry, which is a superordinate to the Coffee and Snack Shop industry. Factors that cause this metric to go move in either direction can be expected to influence the Coffee and Snack segment as well, making it a good indicator.

It is evident that the industry is resilient as it very well endured the “Great Recession” of 2008 with a minor loss to Consumer Spending. Moreover, the growth rate has been rather consistent for the past decade with the exception of 2005 which was a major outlier. According to IBIS World, consumer spending is expected to grow in 2016 “providing a potential opportunity for the industry”.

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Consumer Confidence IndexConsumer spending and the Consumer Confidence index go hand in hand. This index is a combined measure of consumer’s perception of their current and future financial situation. If this index drops, consumers are less likely to spend more money on leisure activities such as high end restaurants and premium coffee shops.

Feb-1967

Jul-1968

Dec-1969

May-1971

Oct-1972

Mar-1974

Aug-1975

Jan-1977Jun-197

8Nov-1

979Apr-1981

Sep-1982

Feb-1984

Jul-1985

Dec-1986

May-1988

Oct-1989

Mar-1991

Aug-1992

Jan-1994Jun-1

995Nov-1

996Apr-199

8Sep-19

99Feb-

2001Jul-2002

Dec-2003

May-2005

Oct-2006

Mar-2008Aug-20

09Jan-2

011Jun-2

012Nov-2

013Apr-201

5

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

160.0

Consumer Confidence Index

Consumer Confidence Index® (CCI) (1985=100) Median 95.1

Source: The Conference Board

Although Consumer Spending did not significantly decline in the QSR industry according to the previous graph during the 2008 recession when the CCI plummeted, spending within the industry did change as consumers adhered to lower end value items that different competitors offered while the premium brands suffered.

The current value for the CCI is sitting at 98 while the median is 95.1. This is a good indicator since the median serves as a benchmark, which indicates that consumers are currently feeling optimistic about the future. IBIS World expects CCI to continue to increase in the near future which could translate to an increased growth rate for the restaurant industry as a whole.

Per Capita Coffee ConsumptionAs mentioned before, coffee sales make up about 50% of revenue in the Coffee and Snack Shops industry, making coffee consumption a key metric to consider.

My observation with this metric is that it has remained fairly stable with a recent uptrend. This leads me to believe that one of the key drivers of industry growth could be tied to either population growth or geographic expansion, as individuals have consumed approximately the same amount of coffee for the past decade.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

10.3

9.59.2

9.5 9.6 9.5 9.5 9.6 9.59.1 9.2

9.6 9.79.9 10

U.S. Per Capita Consumption of Coffee (Pounds) Source: Statista

Furthermore, given that per capita consumption has not changed significantly, another factor that could be leading to increased industry revenues is menu expansions and higher margin items.

In conclusion, this metric is useful to figure out where the industry growth is coming form and it seems that it will remain idle in the future with the possibility of an unremarkable downtick.

Macro ConclusionMacro factors seem to indicate that the restaurant industry, along with the coffee and snack shop sector will continue to experience attractive growth in the foreseeable future and

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may even grow at an accelerated pace in the near future.

Consumer spending growth rate seems to be on the uptrend as consumer confidence grows significantly since the 2008 financial crash. Additionally, this macro analysis seems to indicate that the industry is recession resistant and large players that enjoy economies of scale could survive by pushing lower end items. Companies should also continue to seek geographical expansion to gain market share and capitalize on increased consumer spending in multiple locations.

Company OverviewStarbucksThe first Starbucks coffee shop opened in Seattle’s Pike Place Market in 1971 with a very different vision, if any. It wasn’t until, now CEO, Howard Schultz, along with the help of other investors, acquired it in 1987 that the Starbucks we know today began to truly evolve. Now the company is one of the most recognizable brands in the world. The Starbucks brand is worth a little over $43 billion making it the 2nd most valuable brand in the restaurant industry and 21st most valuable overall according to Millward Brown.

When Schultz acquired the company, they expanded to Chicago, Vancouver and Canada and by the end of the year they were operating 17 stores. Now Starbucks serves in roughly 70 countries with more than 25,000 stores, and as stated in the industry analysis, controls 39.8% of the coffee shop industry specifically.

Starbucks continues to expand worldwide in order to maintain their brand image and infiltrate new markets while actively trying to increase profitability on their current stores. The company’s most profitable region by far is the Americas, accounting for a little over 78% of worldwide revenues. Additionally, the China/Asia Pacific region more than doubled their revenue, from $1.13 billion to $2.4 billion. Next couple reports should clear up whether this is true growth or an unusual event.

Finally, it is essential to note that Starbucks revenue is mostly generated by their main product line, which is beverages; they generate well over 50% of revenue, while their food items, single serve coffees, teas, and ready-to-drink beverages amount to the remaining share among a few other items. However, the revenue share of beverages has been shrinking

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Source: Millward Brown

as they try to expand their menu to attract a broader customer base.

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20150

5,000

10,000

15,000

20,000

25,000

-10%

-5%

0%

5%

10%

15%

20%

25%

7,302 8,896 10,684 11,567 11,128 11,131 10,787 11,045 11,457 11,962 12,521

2,939

3,544

4,3275,113 5,507 5,727 6,216

7,0218,310

9,40410,522

Starbucks focuses on expanding outside the U.S seeking unsaturated markets and growth opportunities

U.S. International U.S. Growth International Growth

Sto

res

Key ExecutivesHoward Schultz, CEO, ChairmanSchultz pure fiery passion and motivation to recreate the culture and environment he encountered in Milan, Italy could be seen as the single most important factor of Starbuck’s success since 1985. His whole life after college has been dedicated to the world of coffee. It was his vision of creating a coffee shop that served specialty espresso drinks in addition to the traditional filtered coffee and providing a gathering place with the vibes of Italy that defined what Starbucks is today.

Kevin R. Johnson, Director, President and Chief Operating OfficerJohnson leads the global operation across the Americas, EMEA, and CAP, the Starbucks Supply Chain and the Information Technology. Given all these responsibilities it is crucial that he is tech savvy and assumed by his credentials and 30 plus years of experience I presume that this is one of the better filled managerial seats as he served in a variety of senior executive positions during his 16 years at Microsoft.

Michael A. Conway, President, Global Channel DevelopmentAlthough he has not been with the company very long, he is positioned in a part of the company that has a lot of growth potential. His experience with Johnson & Johnson marketing innovative nutritional products sets him up nicely for his current position. He will be the key component into driving Starbucks into the Consumer Packaged Goods segment. Additionally, his experience while Vice President of Marketing at Campbell Soup Company will come in handy while trying to gain market share in this new segment.

CultureThe culture and atmosphere Starbucks has created is a big attribute to their vast success. Starbucks changed everything about what a coffee house should be. As they like to put it, Starbucks is “a third place between work and home”, it’s comfortable atmosphere is inviting and creates a sense of community where people can go to not only have coffee, but stay and either do their work or socialize with their friends. Plus, the addition of Wi-Fi further encouraged customers to stay.

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This new take on coffee houses allowed customers to spend more time in the shop and possibly spend more money. The social aspect of this new coffee house environment allowed people to create a routine around it and boost the success of the company. In the end, what makes Starbucks such a valuable brand is not only the coffee they brew, but the experience they provide; a cup of Starbucks makes you feel good before you even take a sip.

Competitive PositionStarbucks position in the market has certainly shifted over the years along with its massive growth. When Starbucks began, it offered something new at a pristine quality. Now, quality has not necessarily dropped, but smaller, local gourmet coffee shops are more focused on the quality of every individual cup they brew; while Starbucks focuses on the quality of the brand as a whole which has made them so successful. Although local shops make a better cup of coffee, it was Starbucks that started the movement towards specialty coffee, and the atmosphere that many shops now mimic, giving them the advantage and the recognition that allows them to dominate the market today.

The biggest competitor Starbucks faces directly is Dunkin Donuts controlling 21.9% of the coffee shop industry, although they have very different environments and price ranges. Another player in this market, although not as direct, is McDonalds. As Starbucks expands their menu to accommodate and lure in more customers with their breakfast offerings and other food items, they are starting to step on the toes of McDonalds, however their target markets are vastly different.

Starbucks targets the individual who seeks social status and is environmentally conscious,

while their competitors focus on the more price aware consumer.

AcquisitionsStarbucks has made various acquisitions in order to expand their target market and keep up with consumer’s changing preferences.

In 1999 Starbucks acquired Tazo Tea. This move not only allowed the company to slightly diversify their product line, but was also a huge step towards international expansion. Tea is huge in some countries, more so than coffee, this gives Starbucks a way to penetrate new markets abroad and strengthen their brand. Although it doesn’t represent a large portion of the company’s revenues, it is a good forward looking acquisition.

Furthermore, when they acquired Teavana in 2012, Starbucks noticed a very positive response from the public. Now Tazo Tea being pushed out by Teavana to make room for the better product.

2012 was also the year that Starbucks decided to acquire La Boulange Bakery. This was a very strong move on Starbucks behalf given that it allowed them to expand their food offerings very fittingly to the company’s atmosphere.

SWOT AnalysisStarbucks is a premier specialty coffee roaster, marketer and retailer in a highly competitive market. Through differentiation by providing the Starbucks coffee experience and a high emphasis on brand awareness, the company has managed to control the coffee shop market.

StrengthsOne of the company’s most significant strengths is definitely their worldwide brand recognition which allows them to grow at an accelerated rate in comparison to their competitors. Strong Brand recognition enables them to open stores

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in a variety of locations that instantly lure in customers. Furthermore, this ties into another one of their strengths which is customer loyalty; this loyalty is further enhance by their ability to add value to their customers by offering much more than just a cup of coffee. In addition to providing customers with free Wi-Fi in all company operated stores, walk-in customers have the ability to use the Starbucks Digital Network. This feature offers free access to premium news sources such as The New York Times. In effect, customer’s spend more time than they otherwise would at a coffee shop, and even encourages doubtful customer’s to come in and spend more money. Coupled with their loyalty programs and mobile apps that allow to order and pay in advance for minimize hassle while at the store, customers are left with no excuses not to come into a Starbucks.

Moreover, Starbucks has many convenient factors that make it easy for the customer to go spend money there in addition to the previously stated strengths. Some of them include their locations. The company looks for locations with high visibility and traffic to open stores, also they usually look for locations that can be complimented with a drive-thru. This is all able to be accomplished due to their strong financial standing which also helps them open many stores in close proximity to minimize the distance customers have to travel; again to emphasize convenience.

WeaknessesOne of their weaknesses actually emerges from their convenience. Through their aggressive expansion they tend to oversaturate markets, although Schultz mentioned this was a risk he was willing to take. Overcrowding areas where they operate means that some of their own stores are detracting revenue from each other, which translates into a lower location turnover.

This method of increasing revenue is very expensive.

Another weakness emerges from their target market. Because the company is a specialty coffee brewer, prices tend to be premium in comparison to the competition. In the case of a recession people will keep buying coffee, however, they will likely be shifting to the price friendly competition.

OpportunitiesThe most obvious opportunity that Starbucks has continuously tried to capitalize on as we can see at the beginning of this company overview, is the growth in international presence. Starbucks experienced a revenue growth of 112% between 2014 and 2015 in their China/Asia Pacific operations. Although, this revenue only represents less than 15% of total revenues, this further strengthens the outlook for opportunities in this quickly expanding region. According to Marketline, Starbucks plans to triple the number of stores currently in china by 2019.

Other clear opportunities emerge from the current consumer healthy trend. As demands for healthier products increase, Starbucks could use their brand recognition to quickly grab a considerable share of the fast growing market of healthy foods and beverages. They are currently trying to do this with their fruit and vegetable juices.

Lastly, the company also has yet to fully explore other distribution channels. With the help of their mobile app, they are currently attempting a delivery system. Given that most customers live in the close vicinity of a Starbucks, this could be a viable way to increase revenue cheaply.

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ThreatsThe main threat to the company comes directly from the industry they are in. As stated in the industry analysis, this is a mature market. Moderate growth means that competition within the U.S. markets, which is their main revenue generator, is very fierce. If the industry were to stagnate, the only way to continue growth is to take away market share from competitors. This along with the rise of local specialty coffee shops creates great pressure on the saturated industry that Starbucks sits on.

Furthermore, to add to the threat of competition is the uncertainty of costs. Due to the nature of the business, the cost of the raw product is very volatile; in this case that would be coffee. Supply and demand determine the price, but the supply part is tricky as it can fluctuate given the weather, and is susceptible natural disasters and crop diseases.

Finally, one more threat could be attributed to the uncertain economic conditions of the various markets Starbucks operates in.

InsightsThe fact that Starbucks dominates such a competitive market speaks volumes to the quality of business it is and the management that runs it. Starbucks has stayed true to the vision Schultz had when he acquired it with the help of investors and continues to do so. The Starbucks culture that Schultz created differentiates significantly from the competitors and the strong brand and customer loyalty help Starbucks remain dominant.

Given the maturity of the industry in the U.S. it will be interesting to see how not only Starbucks adapts in the next few years, but also the other players in the coffee shop sector. Given this company’s strong financial standing however, it has a definite upper hand when it comes to international expansion. The deciding

factor on who controls the variety of territories outside the U.S. will come down to strategy, and Starbucks has the financial leverage to find the effective routes of growth.

Exploring new distribution channels at home might be essential to combat self-cannibalizing forms of expansion. Finding new and cheaper ways to reach the consumers is essential in this technological era where convenience is a huge factor. Quality coupled with efficiency seems like the way to go and Starbucks has them both.

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Fundamental AnalysisStarbucks’ size and fast growth should not be mistaken for the ability to keep up with short and long term financial obligations that could

cause the company to go bankrupt if not properly managed.

In the following sections, we will discuss metrics that will allow for a crisper evaluation of the company down to the fundamental level.

Short-term LiquidityCash from OperationsFiscal Year Ended 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015OPERATING ACTIVITIES:NI 388.88 494.37 564.26 672.60 315.50 390.80 948.30 1,248.00 1,384.70 8.80 2,067.70 2,759.30Adjustments to reconcile net earnings to net cash provided by operating activities:Depreciation and amortization 314 367 413 491 605 563 541 550 581 656 748 934Litigation charge 2,784Deferred income taxes, net (4) (31) (84) (37) (117) (70) (42) 106 61 (1,046) 10 21Income earned from equity method investees (32) (50) (61) (66) (61) (78) (17) (33) (49) (172) (183) (190)Distributions received from equity method investees 38 31 49 66 53 53 116 139 148Provision for impairments and asset disposals 18 19 20 26 325 224Gain resulting from acquisition/sale of equity in JV (23) (85) (80) (70) (394)Loss on extinguishment of debt 61Stock-based compensation 106 104 75 83 114 145 154 142 183 210Tax benefit from exercise of stock options 63 110 1 8 4 2Excess tax benefit on share-based awards (117) (93) (15) (16) (258) (114) (132)Other 12 10 19 116 71 67 76 33 24 23 36 54CFO Minus Adjustments 799 951 910 1,287 1,255 1,220 1,596 1,964 2,154 2,174 2,818 3,470Cash provided/(used) by changes in operating assets and liabilities:Accounts receivable (33) (89) (90) (68) (80) (83)Inventories (78) (122) (86) (49) (1) 29 123 (422) (273) 153 14 (208)Accounts payable 28 10 105 36 (64) (53) (4) 228 (105) 89 60 138Accrued litigation charge (2,764)Accrued compensation and related costs 55 23 54Income taxes payable, net 8 14 133 86 7 57 298 310 88Accrued liabilities and insurance reserves (19) (82) 24 47 104 124Stored value card liability 48 53 57 63 72 16 24 36 61 140 141 170Prepaid expenses 4 (7) (41) (93) (11) 121 17 (23) (20) 76 5 50CFO minus Δ Op Assets & Liabilities 64 (28) 222 44 4 170 109 (352) (404) 735 (2,210) 279CFO 863 923 1,132 1,331 1,259 1,389 1,705 1,612 1,750 2,908 608 3,749EBIT 635 798 900 1,098 520 601 1,472 1,847 2,094 (192) 3,230 3,975CFO-EBIT 228 125 232 233 739 788 233 (234) (344) 3,100 (2,623) (226)

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

CFO and EBIT for SBUX growing at a similar rate

CFO EBIT

Cash from operations has been growing at a 15% CAGR from 2005 to 2015. This growth is on par with EBIT’s 17.4% CAGR for the same period which mostly validates the quality of earnings that SBUX reports in their Income statement. I expect CFO’s CAGR to increase above EBIT’s

soon; possibly evident in the upcoming annual report.

The latest down spikes in the growing trend were caused by a lawsuit settlement of $2.8 Billion paid to Kraft Foods after Starbucks ended their partnership that gave Kraft the distribution of Starbucks Coffee bags in grocery stores. Although the impact from this lawsuit was quite large, it is a non-recurring charge, which could be considered an investment. The reacquiring of this business unit will generate over $500 Million in revenue per year which Starbucks will now attribute to their Channel Development Segment likely increasing their revenue growth rate.

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Furthermore, the significant drop in EBIT between 2008 and 2009 was caused by a combination of factors; most predominantly of which were restructuring cost incurred by the company in response to the economic slowdown, some of which are added back to CFO which causes discrepancies between the two.

The previous table highlights the accounts with the biggest impact towards the calculations of CFO. Following their trouble with Kraft Foods that started in 2011, SBUX working capital assets and working capital liabilities have fluctuated more than usual having a mixed impact. With a history of stable growth in CFO until the Kraft incident, it will be interesting to see how Starbucks will cope moving forward once fluctuations have stabilized.

I suspect volatility will diminish dramatically in normal economic conditions. The radical changes in the past have very simple explanations and earnings volatility does not seem to be core to the industry.

From this analysis, it is evident that Starbucks earnings are strong and not being propped up by accounting schemes. Even with the heavy spikes, the company shows a promising upward trend in earnings and CFO which is a good indicator for liquidity.

Net Working Capital RequirementAs mentioned above, working capital liabilities and assets have a direct input into our CFO and therefore overall liquidity of the company. Taking a closer look, we see that the net working capital requirement of Starbucks is rather a source of cash and has been for the past decade.

After adjusting for the litigation charge in 2013(Yellow), it is evident that, not only have WCL have consistently been greater than WCA,

but they are also growing at a faster pace of 14.4% CAGR vs 11.8% CAGR respectively increasing liquidity.

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 900

1,400

1,900

2,400

2,900

3,400

3,900

WCL outpace the growth of WCA providing a source of cash

Working Capital Assets Working Capital Liabilities

Most accounts in WCL have been growing at about the same rate for the past 5 years, with Accrued Dividends Payable leading the growth at 25% CAGR.

Moreover, Store Value Card Liability holds more weight than the rest, accounting for an average of 24% of WCL since 2010. This is good move on SBUX as it is a source of liquidity that can potentially prevent liquidity shocks during rough economic climates.

2005 2007 2009 2011 2013 2015

(1,000)

(800)

(600)

(400)

(200)

-

200

400

600

NWCR have been trending down as SVCL leads the way (+ Liquid)

NWCR NWCR- SVCL

Without SVCL, NWCR is flat over the 10-year period, which is not a cause for concern given the healthy growth of the company. Moreover, WCL’s growth is not very volatile which indicates that most fluctuations in NWCR (in

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both scenarios) come from the volatility in WCA. Upon further analysis, a regression between the change in WCA and the change in Inventory reveals that 80% of WCA’s volatility can be described by the change in inventory.

I expect NWCR to remain a source of cash rather than a use. The instability in inventories resulted from Starbucks taking back their business from Kraft Foods and should stabilize moving forward, although it should be monitored in the upcoming statements to assess efficiency.

Free Cash FlowNow that we’ve discussed CFO and analyzed the trends in NWCR that affect CFO we can take it one step further and calculate how much cash flow SBUX has left to employ as management sees fit. Free Cash Flow can be utilized in one or more of the following:

1. Pay Dividends2. Buy Back Stock3. Pay Down Debt4. Expand5. Hold Cash

Now, FCF was calculated in two different methods by attempting to separate CapEx into two categories, Expansionary CapEx and Maintenance CapEx.

The first method is a straight forward CFO – CapEx which allows us to see how much FCF the company can generate while maintaining a similar expansion rate moving forward. The second method uses a regression analysis to calculate maintenance capex as a percent of CFO. With this method, we can keep expansionary capex as part of FCF to determine how effective the company is at generating FCF as it stands.

Additionally, by modifying the equation for return on invested capital replacing NI with FCF

as part of the numerator we can evaluate how profitable the company’s expansionary investments are. However, this is more effective if we can differentiate between the two categories of capex.

After running a couple of regressions, trying to separate maintenance capex from capex as a whole, I managed to describe 80% (R2 of .795) of the volatility of CapEx as a percent of CFO by using the number of new Company Owned Locations opened as the independent variable.

Regression Statistics

Multiple R 0.891181R Square 0.795204

CoefficientsIntercept 0.288469

The intercept of 29% indicates the CapEx as a Percent of CFO when there are no new locations, therefore, no Expansionary CapEx.

2007 2009 2011 2013 2015 -

500

1,000

1,500

2,000

2,500

3,000

FCF sufficient to cover stock buy backs and dividends

FCF Dividends + Stock BB FCF - CapEx

By comparing these two methods of calculating CFO we can see that between 2008 and 2011, the simple method can be deceiving. It could be interpreted that the company was becoming more liquid and generating a healthier FCF. However, Starbucks seized expansion and even downsized during this period causing their FCF to be artificially inflated due to the lack of expansionary CapEx.

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Additionally, from this graph we can gather that SBUX generates sufficient FCF to cover

cashflows to shareholders.

Cash Flow to Share Holders Fiscal Year Ended 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015FINANCING ACTIVITIES:(Payments)/proceeds from short-term borrowings 10 2 (713) 31 (31)Proceeds from issuance of long-term debt 277 423 549 750 749 849Repayments of long-term debt (1) (1) (1) (1) (1) (1) (35) (610)Cash used for purchase of non-controlling interest (46) (28) (361)Proceeds from issuance of common stock 138 164 159 177 112 57 133 250 237 247 140 192Excess tax benefit on share-based awards 117 93 15 16 37 104 170 258 114 132Cash dividends paid (171) (390) (513) (629) (783) (929)Repurchase of common stock (203) (1,114) (854) (997) (311) (286) (556) (549) (588) (759) (1,436)Minimum tax withholdings on share-based awards (5) (15) (59) (121) (77) (76)Other (4) (2) (2) (8) (5) (1) 10 (7) (18)

Net cash used by financing activities (67) (674) (155) (172) (185) (642) (346) (608) (746) (108) (623) (2,257)

The table above lays out in detail the financing activities of SBUX, again, highlighting the activities in certain years with the most significant cash flows. Dividends and Stock Repurchases have been growing at a 24% and 27% CAGR respectively since 2010. These growths are significantly greater than EBIT (22% CAGR) and CFO (17% CAGR) for the same period. This is a very good sign from management as it signifies confidence in their short their viability.

Furthermore, over the past 3 years the company has been taking on a significant amount of debt which further strengthens my previous argument. The heavy debt, however, could be mostly attributed to their recent lawsuit settlement, which may also impact the aforementioned growth rates and should be monitored in the following statements.

Short-Term SolvencyTimes Interest Earned

SBUX 2012 2013 2014 2015EBIT / Interest Exp. 61x -12x 48x 51x

EBITDA / Interest Exp. 72x 9x 54x 61x(EBITDA-CAPEX) / Interest Exp. 48x -21x 38x 44x

Industry Average 12x 9x 9x 8x

Times Interst Earned

SBUX has clearly demonstrated their ability to pay their debt as their times interest earned ratio is very high relative to the industry, and

rebounded quickly to normal levels after their lawsuit against Kraft Foods. Even during their lawsuit, they were able to maintain the industry average times interest earned when Depreciation and Amortization were not considered.

In contrast, one of the company’s biggest competitor, Dunkin Donuts, has been operating in the lower end of 3x times interest earned in recent years.

Financial Leverage

2005 2007 2009 2011 2013 20150

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

2 SBUX well below industry average on Debt/Equity

SBUX Industry

SBUX has maintained a very low financial leverage historically. Even during the restructuring during 2008 when they significantly levered up, they managed to stay well below industry averages and promptly came back down. Since the lawsuit, they have levered up again, although still very low compared to the industry. It begs the question that Starbucks may be underleveraged.

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SBUX seems to be in a very favorable financial situation and will be interesting to see whether their Leverage returns to extremely low levels, although this may be hurting the company’s potential profits.

Total Debt to EBITDA

2006 2008 2010 2012 2014 20160.00x

0.20x

0.40x

0.60x

0.80x

1.00x

1.20xDebt to EBITDA has remained below 1 for the past decade. No solvency concern

We see here that the company’s earnings can easily cover their debt. The 2008 peak was caused by a drop in earnings and restructuring that we’ve discussed. (2013 figures were adjusted to exclude the lawsuit)

2012 2013 2014 2015Total Debt/EBITDA 1.3x 1.6x 1.8x 2.0x

Industry Tot Debt / EBITDA

The recent up trend seems to be an industry wide thing as the ratio has consistently creeped up since 2008. However, SBUX remains well below industry averages and there is no evident cause for concern as their solvency seems solid accompanied with healthy growth.

Short-Term Viability/Credit RatingAlthough SBUX is in a mature industry, it has a lot of potential to keep up their current growth rates. With good management, the company can keep up their quality earnings and healthy cash flows which allow them to cover their short-term obligations.

One cause for concern is their cyclical nature, which seems to affect earnings during tough economic times, although their recent fluctuations in earnings and cash flow are not alarming as they were caused by a onetime litigation charge.

Their leverage is extremely low compared to their industry, but their debt levels should be monitored going forward as they have recently been trending up. Yet, their current debt levels are no concern for long term solvency given their stable and growing earnings.

Moody’s Credit Rating: A2

S&P’s Credit Rating: A-

Both Moody’s and S&P’s ratings have improved since the company’s worst financial position in the last decade which occurred during the financial crisis. During this time, the company’s ratings were as low as Baa3 and BBB.

Moody’s latest rating upgrade for SBUX was 9/15 while S&P’s was 2/12. Both rating agencies give their current rating towards Starbucks a Stable Outlook.

One of their few competitors currently rated as investment grade is MCD with a rating of BBB+ and Baa1, both with Stable Outlooks. Starbucks leads the pack among rated companies in the restaurant industry.

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Moody's S&P'sStarbucks Corp A2 A-

Wendy's Co/The B2 BRuby Tuesday Inc B3 B-

Yum! Brands Inc Ba3 BBBrinker International Inc Ba1 BB+

Darden Restaurants Inc Baa3 BBBMcDonald's Corp Baa1 BBB+

Credit Ratings

Through my analysis, I have not found a reason to dispute SBUX’s credit ratings. It is a stable company with healthy growth and in their current state there is no cause for liquidity or solvency concerns.

(Long-Term) TurnoverRevenue Growth

2006 2008 2010 2012 2014 $1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

SBUX revenue growth outpaces the closest competitor and the industry as a whole

SBUX DNKN Industry

It’s not a surprise that Starbuck’s revenue growth at 10.5% CAGR since 2006 is way above that of the industry mere 1.3% CAGR for the same period given the maturity of the industry. Yet, when compared to Dunkin Donuts with a 5.8% CAGR (since 2008 due to lack of data), one of SBUX’s leading rivals, the company’s growth really shines.

The company’s growth shows no sign of slowing down, on the contrary it seems to be picking up

speed periodically since 2009. Next, I will observe whether this growth is coming from an increase in turnover within the company or instead coming from added capacity and expansion of the business.

Increased performance through turnover is highly desired as it is an inexpensive mean of adding revenue. Still, improved revenues through expansion is beneficial providing that the returns offset the costs.

Capacity vs TurnoverAs discussed before in the company overview, Starbucks has been expanding quite aggressively, especially internationally, which seems to be one of the main drivers augmenting their revenues year over year.

A regression showed that about 55% of the variance of the percent change in revenue could be described by the percent change in location. With more than half of their increased revenues coming from expansion I’m curious to see how well that translates into earnings and whether the return on investment justify the expansion.

U.S. Revenue 8.9%U.S. Locations 3.9%U.S. Rev/Location 4.8%International Revenue 18.2%International Locations 12.9%International Rev/Location 4.7%

CAGR

The table above shows just how heavily the added locations increase the growth rate of revenue. The company’s aggressive international expansion seems to be paying off given the strong 18% CAGR in revenue; although these revenues account for a fraction of the total, their share total revenue is rapidly increasing as seen in the following chart.

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2006

U.S. Revenu

e83%

2006

In-ter-na-tion

al Revenu

e17%

2015U.S. Revenue

69%

2015International Revenue

31%

International revenue doubled its share of total revenue in 9yrs

In terms of turnover, U.S. stores are dramatically more efficient with twice the Revenue per Location, $1,062 in 2016, compared to the $558 generated by international stores (Figures in thousands). Given their consistent improvement over the last decade with a 4.7% CAGR, international store turnover is not a concern. The high turnover at home could be attributed to brand recognition, one of the company’s strongest assets. This could potentially bring turnovers abroad up to par in the near future as the brand establishes itself. International store turnover should be monitored.

Note that although 46% of Starbucks locations are international, they only generate 31% of revenue due to the low turnover. This creates a huge potential opportunity for cheap growth.

In brief, total revenue growth could approximately be attributed to capacity and turnover equally. Even with the rapid international expansion, those still account for less than 1/3 of the total. The low turnover in international stores could initially indicate the expansions to be a subpar investment, however if these revenues per location growth rates can be maintained the case would soon be otherwise.

And lastly, in the US, turnover growth seems to outpace the increase in locations. This increase

in efficiency as opposed to capacity is ideal in a market as mature and saturated as our home base.

Asset Turnover

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 -

0.50

1.00

1.50

2.00

2.50 SBUX ATO trying to get back in the 90th percentile of the competition

Median 10th Percentile 90th Percentile Starbucks

Starbucks had been on track with the 90th

percentile of the competition for a couple years until falling below somewhat recently. The faster CAGR in assets of 12% as compared to the 10.5% in revenues since 2006 is beginning to affect their positioning against the competition.

This downtrend, however, appears to be part of a something greater than Starbucks as the 90 th

percentile mark is also dropping. Most recently it looks as if the company is regaining its dominance and as mentioned earlier, if store turnovers keep increasing at the same rate, Starbucks may even surpass that 90th percentile mark.

To finish, as previously discussed, Starbucks is rapidly expanding and adding new stores which increases the growth rate of assets beyond revenues. Current assets are maybe not being fully utilized causing the ATO to decay. These assets due have healthy growth rates in regards to turnover. This slip should not be seen as a deterioration in performance, but rather an investment. If managed effectively, Starbucks could retain its dominant position while still experiencing healthy growth.

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MarginsAs previously seen, Starbucks has very intriguing growth when it comes to pure revenues, but how well does the growth in revenue transfer to the gross earnings and then over to net earnings? Next I will analyze bottom-line growth as compared to top-line growth.

Gross MarginFor gross margin, we are only subtracting cost of sales from revenue. This was done manually given the inconsistency in Bloomberg’s calculation of COGS after 2008.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 -

2,000 4,000 6,000 8,000

10,000 12,000 14,000 16,000 18,000 20,000

53%

54%

55%

56%

57%

58%

59%

60%

After the heavy drop in margins, SBUX has eperienced a healthy uptrend

COGS Gross Profit Gross Margin

In this chart, we see Gross Margin represented by the line while revenue is represented by the stacked columns which is broken into COGS and Gross Profit.

The company’s gross margin experienced a substantial drop from 2006 to 2008. Gross margin went from 59.2% to 55.3% during this period.

The cause of this decline was a very rapid increase in cost of sales relative to revenue. From 2004 to 2008 cost of sales increased at a 21% CAGR while revenue grew at a relatively mere 15% CAGR.

Following this decline, however, Starbucks has remained much more constant with the exception quick bump in COGS in 2012 whose source is difficult to pinpoint. During this 2009-2015 period, Starbucks experienced CAGR’s of 12% and 10% with their Revenues and COGS respectively which allowed for this expansion in their Margins from a decade low 55.3% to a decade high 59.4% which seems to be where the gross margin had remained stable in the past.

Going into the future I don’t expect gross margin to increase substantially, although gaining a couple more percentage points could be quite a significant improvement to the company’s performance.

Net MarginsFor the exception of the crisis of 2008, which affected the company thoroughly down to the net margins with a decline to 3% from 7%, the company has otherwise been steadily improving.

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20152%

4%

6%

8%

10%

12%

14%

16%

Net margins are consistently improving

2008 Crisis

(the chart is edited to exclude the lawsuit in 2013 in yellow)

Over the past decade, net margin has almost doubled from 7.8% to 14.4%. This, however, might not be a sustainable margin and may revert to around 12% in the coming years. This is not to say that net margin may never reach 14%, but it seems that the reason that it is so

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high this time around is due to unusually low tax as a percent of EBT.

For perspective, tax as a percent of EBT has averaged 36% over the past 15 years with the low being 31%. This year’s number was 29%.

Compared to gross margin, net margins bounced back stronger after 2009 and stay up as they managed to control operating expenses. While gross margin dropped heavily in 2012, it barely had an impact on net margins as they remained somewhat flat.

From Revenue to EarningsAlthough it took about 7 years for gross margins to recover after the crisis, net margins were back above and beyond pre-crisis levels within 2 years.

The quick recovery of net margins coupled with their continued Improvement has allowed revenue growth to not only be transferred to the bottom-line of the income statement, but also to become amplified.

As pointed out earlier, revenue has grown at a 10.5% CAGR since 2006. The company’s net margin improvement combined with this growth generated great results in the earnings. When compared with the same period, earnings experienced an astonishing 19.2% CAGR, almost double the growth rate of revenue.

Returns (Conclusion)To conclude this fundamental analysis, I will first evaluate the “true growth ratio” of this company which will be a combined summary and evaluation of the (Long-Term) Turnover and Margins sections. This will give us a sense of the strength of the returns the company is generating.

Furthermore, I will assess the impact these factors have on ROE along with the rest of the components that comprise this measure.

Return on EquityI will begin by inspecting ROA as it is one of the most popular metrics and its components were closely examined in the previous sections. Return on assets is seen as the “true growth ratio” given that it combines two measures of performance that when looked at individually can be rather deceiving, but combined tell a different “true” story.

Starting with ATO which as we’ve seen earlier, it has been consistently declining over the past decade which is due in part to their rapid expansion. However, per the revenue growth section, Starbucks revenue per store is increasing at a healthy rate which is slowing down the decline in ATO even with the heavy expansions. In the end, ATO has only deteriorated by 15% in the past decade.

This lower performance could’ve let to a declined in ROA, however, it wasn’t significant enough to overpower the immense improvement in Margins.

Compared to the negative CAGR (-1.62%) since 2005 in asset turnover, Margins have grown at a CAGR of 5.18% offsetting the worsening turnover. Conclusively, this has led to a ROA of 32%, which is 41% higher than it was 10 years back.

Moreover, the tax impact has remained tight between 66% and 70% and the fluctuations don’t seem to have very clear trend. According to a regression between ROE and its components, a 1% change in this factor attributes to about ½% change in ROE. Although I cannot find a trend in tax impact, I know it has been confined to the aforementioned parameters. This means that a full swing of 4% in tax impact (all else equal) would affect ROE by 2%. Without a trend, it is nice to know the potential effect.

Jose Perales 26

Now, combined financial leverage is a mix between interest impact and financial leverage. Due to the immaterial amount of interest expense, interest impact has been almost insignificant. The company has retained, on average, 98.7% of their EBT after interest when looking at the past decade. Aside from fluctuations that were caused by the crisis and the lawsuit, this impact remains rather stable.

Moreover, as mentioned in the solvency section, I believe that Starbucks might have been underleveraged. Since the trouble with Kraft, however, financial leverage has increased from 1.61 to 2.14.

2006 2008 2010 2012 20140%

10%

20%

30%

40%

50%

60% Underleverage causes SBUX to underperform relative to the industry (ROE)

SBUX ROE Industry ROE

The increased leverage coupled with the strong growth in ROA has led the company’s ROE to finally outperform the industry average. Yet, even with the increase in leverage, the industry’s average has remained, on average since 2009) 42% above that of Starbucks.

In conclusion, from my observations, Starbucks should fund their rapid expansion with debt to increase leverage in an attempt to offset more of the decline in turnover. Even though ROA has experienced growth in the past decade due to expanding margins, this trend may not be sustainable. As margin stabilize, if ATO continues to deteriorate, ROE will be negatively affected.

Overall Financial PerformanceConsidering the short-term outlook, Starbucks is in a very solid standing. The company is generating strong cash flows and shows no lack of liquidity, but rather solid earnings. Furthermore, in comparison to the industry, leverage is extremely low even after a heavy increase following the lawsuit. The strong earnings and low leverage are a reassuring sign to signify no solvency issues.

Wide margins, in comparison to competitors, and improving sales per store give confidence to believe that Starbucks will continue to experience growth rates above the competition in the long term. A growing strong international presence allows for much room to grow as the market saturates in the US. Utilization of assets, however, should be monitored, as the company might be expanding faster than it can sustain and overcrowding areas which can lead to self-cannibalization of revenues and a decay in ROE. In brief, Starbucks has much potential to increase their returns through leverage and improved asset turnovers.

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ForecastRevenue and ProfitsGoing forward I will be doing a top-down forecast for Starbucks. First, analyzing the revenue and then moving through the margins of the company to have a comprehensive understanding of the income statement items going into the next 5 years.

RevenueIn the past, as shown in the turnover section, Starbucks grew their income at 10.5% CAGR since 2006 and it seems that they have the potential to continue to do so as they expand their international reach.

Per USA Today, Management seems to be doing just that as they announced that they plan to open about 12,000 stores in the next 5 years starting with 2100 in 2017. This would be a 47% increase in their current number of locations, which executives say will increase revenues at 10% YoY; this growth would be in line with the growth they’ve experienced in the past.

For my forecast, I separated the revenues and number of locations into two sections, U.S. and International, for more depth. The way I estimated revenue was by first forecasting the growth in locations followed by an estimated increase in revenue per store YoY. Since US stores generate a lot more revenue per location this allows for a greater insight.

According to SBUX executives, they plan to open half of the 12k locations in China and the U.S. markets; more specifically, they plan more than double China’s current location count from about 2400 to 5000. This leaves about 3600 locations that will be added to the US market. The rest 6k stores will all fall into the international category.

2006 2009 2012 2015 2018 20210

5,000

10,000

15,000

20,000

25,000

International stores will surpass U.S. Stores by 2018

US locations International Locations

The added U.S. stores will allow the company to continue to grow their presence at 4.2% CAGR (.3% higher than it had in the past decade) while International location growth will drop from 12.9% to 11.9% CAGR, still a very rapid expansion. In the end, U.S. and International store count will go from 13,171 to 16,139 and 11,914 to 20,946 respectively (2016 – 2021).

Revenue per location in the U.S. market seems to be very stable after bouncing back from the crisis and has hovered just over 6% for the past 5 years. I expect this trend to slowly decay as Starbucks stores saturate the US markets which might cause revenue self-cannibalizing. Also, as competition intensifies with local coffee shops, growth in revenue per store will slow down. I think revenue per store growth will drop to the risk-free rate (2.36%) which is in par with GDP growth.

U.S. 7% 7% 4% 6% 6%International 13% -3% 2% 17% -2%

Revenue/Location Growth (2012-16)

As seen above, in the past 5 years International revenue per location is a lot more volatile than at home, because of this I used a 5-year average of 5.6% to get rid of the noise as it has mostly trended upward.

Jose Perales 28

2006 2009 2012 2015 2018 2021 -

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Revenue growth will speed up slightly into the next 5 years

Revenue (Billions)

I believe revenue will grow at 8% CAGR domestically while the international revenue will continue to grow more radically at a CAGR of 18% as it has in the past 10 years. Overall revenue should grow at 11.8% YoY until 2021.

Per my assumptions, the revenue split between the international and domestic markets should go from the current 69/31 to 60/40, and the international portion of the revenue will continue to become more significant. Even with international locations surpassing domestic, U.S. locations still generate much more revenue per store.

In summary, I grew locations according targets set by management. Revenue per location growth was set domestically at the 5-year average growth until it reached risk-free growth of 2.36% by year 2021. For International the growth was set at the 5-year average as it has much more headroom for improvement.

Revenue = Locations * Rev/Location

Using these two factors I estimated the overall revenue of the company into 2021. Most of the risk would more likely be in the margins as revenue could only be negatively impacted by a crisis at this point. Growth rates might be off, but the revenue will definitely trend upward with future expansions.

Gross MarginFor gross margin, I’m only taking away the cost of sales from revenue. This had to be fixed as Bloomberg seems to have inconsistencies.

Considering the cost of coffee as the most substantial cost, Starbucks does not have much room for improvement there as Coffee is currently trading at near all-time lows. Coffee futures are currently trading at 142.90 and they haven’t found a groove post crisis as they have trended down for the past 6 years. Pre-crisis coffee prices hovered at 250 for almost a decade.

From 2010 to 2011 coffee prices surged and Starbucks did experience a 2% drop in their gross margins, but aside from that they have remained tight between 55% and 59.5% for the past 15 years.

I don’t believe the recent uptrend will continue for too long and any upside left could possibly come from the introduction of higher margin items to the menu or as current new items in the menu gain popularity. Going forward I assume gross margin to remain within the 59%-60% mark.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 202155.0%

55.5%

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Gross margin will continue to increase at a slow and decreasing pace

Jose Perales 29

EBIT MarginWhile there is not much room for growth in gross margin because COGS are growing at the same rate as revenue, the case is much different when observing EBIT margin.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 20210%

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Expenses as % of revenue decrease due to slow growth in Store Op Exp.

COGS Store Op Exp Other Op Exp D&A Gen Admin Exp

The chart above shows all the expenses leading up to EBIT as a % of sales. COGS are the most significant expense Starbucks deals with followed by Store Operating Expenses, which has the greatest impact on EBIT margin. The rest of the expenses seem to be very consistent with their ratio in relation to Sales.

10yr 5yr 3yr 2yr %SalesSales 12% 12% 13% 13% 100%COGS 12% 12% 10% 10% 40%Store Op Exp 10% 9% 11% 12% 28%Other Op Exp 10% 13% 7% 10% 3%D&A 10% 12% 18% 20% 5%Gen Admin Exp 13% 11% 14% 13% 6%

CAGR

It is noticeable in the chart that the portion of Store Operating Expenses has been consistently shrinking which has led to a steady uptrend in EBIT Margin. This shrinkage is backed by the slow growth rate in Store Op Exp relative to Sales shown in the CAGR table.

This benefit comes from the economies of scale associated with expansion. Specially in this

heavy expansion era for Starbucks, which could keep contributing to their margins. Not only are current stores becoming more efficient, but with each store added there seems to be a greater benefit to Sales versus the cost associated with running yet another location.

In 2010 Store Op Exp detracted 32.4% of sales, while in 2015 this number shrunk to 28.2%. With increasing economies of scale as Starbucks adds nearly 50% more stores in the next 5 years, this number will continue to shrink to the benefit of EBIT margins.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 20215.0%

7.0%

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EBIT Margin will continue to improve as starbucks expands

Jose Perales 30

(margin excludes litigation charge and restructuring costs)

EPSStarbucks is not particularly heavy on debt by any means. Due to this, interest expense has never really had a significant impact on EBIT, which on average is about 2.4%. Although recently Starbucks levered up to pay off the lawsuit, it seems that the interest expense has remained unchanged. Without a clear trend, I used the 5-year average for my forecast.

With regards to taxes, they seem to fluctuate a little, but stay consistently above 30% and rarely go over 33%. Going forward I assumed an effective tax rate of 32%

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 20210.00

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rapid expansion and better margins will fuel EPS growth

Going forward SBUX should experience rapid growth in EPS as the company expands and the margins improve slightly, specially EBIT margin. Compared to the expected revenue growth of 11.8% YoY, I expect EPS to grow at a 15% CAGR into 2021.

Balance Sheet and Financial RatiosATO * MarginAssets have been smoothly increasing at a 14% CAGR over the past 6 years and with their current expansion strategy I believe this trend will continue. The main driver of this increase

will be PP&E as it has accounted for an average of 33% of total assets.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 202110%

15%

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25%

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35%

ROA will begin to deteriorate as Margin Growth slows

With our current predictions on revenue growth and margins I assume ROA does not have much room to go up and will begin to deteriorate. ATO has been trending down since 2008 and margins will not be able to maintain the growth on ROA.

Financial LeverageDue to the lawsuit, Starbucks had acquired a large amount of long term debt, which is very uncharacteristic of the company. After sitting at around $500Million for some time, long term debt quadrupled in the span of 2 years and is now at $2.3Billion.

Given the circumstances for which this debt was acquired, I assumed this number would remain the same for the duration of the forecast. I excluded this sudden gain in LT-Debt when I calculated the growth in Liabilities YoY and this yielded a compounded growth rate of 12%. I used this growth to forecast liabilities out 5 years as opposed to using the 20% CAGR that was calculated when taking this massive debt gain into consideration.

Jose Perales 31

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 1.00

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Financial Leverage will decline without further long term debt gains

Considering a growth of 14% YoY for Assets and 12% YoY for Liabilities, I assume equities will grow at a 16% CAGR to keep the Balance Sheet constant. I believe this lack of additional debt will cause a decrease in the company’s financial leverage position from the current 2.14 to 1.92 in 2021.

ROE

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 202110%

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ROE will take a hit due to lack of leverage and decreasing ATO

(The gap is due to the exclusion of negative ROE caused by the lawsuit against Kraft)

Given my assumptions on how the Balance Sheet will play out, and how this will affect the current financial ratios, I believe that ROE will eventually start to suffer.

Margins will benefit ROE for the next couple of years, but this trend will only hold so long as ROA keeps on having a negative impact on it. As the growth in margin begins to slow down, the

negative impact of decaying ROA will begin to show.

The big jump after the gap on the chart was a direct result of the quadrupling of LT-Debt to cover the expenses of the lawsuit against Kraft. Going forward, I assume Starbucks will refrain from taking any additional debt. Historically, the company has maintained a very low leverage compared to the industry and I believe this trend will continue.

Jose Perales 32

Cost of CapitalI will be calculating the cost of equity and debt to obtain a WACC to use as one of my discount rates in the valuation section of this analysis. This figure was also used earlier to determine the ROIC for SBUX to evaluate their effectiveness using their free cash flows.

I should point out that these calculations will be done in nominal terms using US Dollars to determine the nominal discount rate.

Cost of EquityK(e) = Rf + β * MRP

To determine our cost of equity I will be utilizing the very well-known method of CAPM. Using assumptions and forecasts derived from research to achieve a discount rate that best reflects SBUX for a more accurate valuation. I believe that individually calculating the resulting components of CAPM is a good way to add value as an analyst.

Within this section I will justify my discount rate by rationalizing the methods used for each input in the following order:

1. Risk-Free Rate

2. Equity Risk Premium

3. Beta

Last, we will solve for our discount rate using 3 scenarios with different betas and varying probabilities for each.

Risk-Free RateThe base of the CAPM model is the risk-free rate. To determine this rate, we must first establish what it means. Per Damodaran, the characteristics of the risk-free rate are a as follows: the actual return must be equal to the expected return, meaning there is no variance. Moreover, the asset providing the return can’t

possess any default risk or reinvestment risk. That last one is a bit tricky, as we must first recognize the time horizon for our investment. For our purposes, we will be using 10 years as our time horizon.

The time horizon to value a stock should be as long as possible given that the methods used assume infinite cashflows into the future, however, due to inadequate data, 10 years will suffice.

I will be doing a dynamic valuation (as explained by Damodaran) because I believe normalizing risk-free rates is a very subjective practice. Furthermore, by normalizing risk-free rates, we might be overstating the power that central banks have on current interest rates and ignoring the fact that the risk-free rate is influenced by many more factors outside the control of the central bank such as economic conditions and other fundamentals.

Also, normalizing the risk-free rate by assuming reversion to the mean or any given moving average (as it is very subjective) could be a mistake if there was a structural shift that lead us to the economic environment in which we are today. Unless we can explain how our current rates will return to “normal” by being from the future (which would eliminate the need to value anything) I believe that the current risk-free rate is the best one to use.

Last, the risk-free rate is also an opportunity cost. If we normalize the risk-free rate and reject an investment because of our subjective numbers, we will not be able to invest in our imaginary risk-free asset.

Jose Perales 33

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18.00% Our measure of the risk-free rate closely tracks nominal GDP growth rate

Ten-year T.Bond rate Nominal GDP growth rate

It’s difficult to see exactly what this chart could potentially be telling us. It is clear, however, that our risk-free rate is closely tied to nominal economic growth and that risk-free rate higher than the growth of the economy is not sustainable.

Our low risk-free rate is largely due to our current stagnant economy, and with no roadmap back to a booming economy, I cannot justify normalizing the risk-free rate.

In conclusion, I will be using the current 10-year treasury as my risk-free rate and try to avoid making assumptions that rely on all other factors remaining the same as one changes.

Rf = 2.36%

Equity Risk PremiumAs with the risk-free rate, assuming reversion to the mean while calculating the ERP would contradict my previous argument and I would be ignoring the possibility of a structural shift, thus eliminating the viability of using the historical approach to calculate our ERP.

Instead, I will calculate a ERP using the implied approach to achieve a forward-looking number. I will use the S&P 500 as my market, and treat it as a bond that pays dividends. Using this approach will allow me to calculate a yield to maturity for the market which would equal to the expected return on stocks; this minus my risk-free rate will give me the implied ERP.

First, I had to gather the following data to build a table that allowed me to calculate the expected return of the market:

1. Expected ST earnings growth rate2. The last 4 quarters of earnings for the

S&P 5003. The last 4 quarters of Dividends +

Buybacks for the S&P 5004. Current S&P 500 Price

For item number one, using Factset’s estimates for earnings growth in 2017 of 11% and assuming a LT growth equal to my risk-free rate of 2.36% to be reached in 5 years as the growth slowly decayed, I calculated a geometric average of 6.64%.

Next item on the list is the earnings for the S&P 500. I used Capital IQ’s quarterly earnings reports, provided by Professor Damodaran, for the last 4 quarters and adjusted the sum to the index. This yielded an earnings figure of 98.98 given the past 4 quarters. This earnings figure will be the one growing for my calculations while the dividends and buybacks will remain at a constant percentage of this figure.

For the dividends and buybacks, I used the same reports and followed the same process used to calculate the earnings. This gave me a combined dividends and buybacks figure of 112.42

Jose Perales 34

To finish, the easiest piece of this puzzle to acquire is the current S&P 500 price, which is now at 2,205.72.

Now I’m able to move on to calculating the yield to maturity, which is dynamic and forward looking.

Last 4 Quarters 1 2 3 4 5 Terminal YearEx Earnings 98.98$ 105.55$ 112.56$ 120.03$ 127.99$ 136.49$ 139.71$ Ex Dividends as % of earnings 113.57% 108.66% 103.75% 98.84% 93.93% 89.02% 89.02%Ex Dividends 112.42$ 114.69$ 116.78$ 118.64$ 120.22$ 121.50$ 124.37$ Ex Terminal Value 2,467.26$ Present Value 106.79$ 101.24$ 95.76$ 90.36$ 1,811.57$ Intrinsic Value of Index 2,205.72$ ERP 5.04%

ERP Calculation Table

Highlighted in green are the numbers that we acquired earlier. I grew expected earnings at our calculated ST Growth of 6.64% until year 5 and assumed the Rf rate for perpetual growth after that.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 20150

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160%Payout rate is growing to unsustainable levels

Earnings Payout P % of E

Due to the unsustainable payout rate, I could not maintain dividends as a percent of earnings constant. Instead evenly decayed this ratio to the 10-year average of 89.02%, which then I used in perpetuity. Note that forecasted dividends were all calculated as a percent of Earnings.

I calculated the PV for the expected dividends along with the terminal value and added them up to estimate the intrinsic value of the index. The rate used to discount back the cash flows was the sum of the Rf rate and a rough estimate of ERP to be later refined.

Finally, using Goal Seek, I set the intrinsic value of the index to the current price seen on the table, by changing the estimate of ERP. This whole process yielded an Equity Risk Premium of 5.04%

ERP = 5.04%

BetaFinally, we arrive at beta which is a way for us to measure how risky SBUX is in relation to the market. I will estimate this figure by analyzing how sensitive the company’s revenues are over time. To do this I will examine the company’s operating leverage in relation to some key competitors, as well as looking at the volatility of SBUX’s margins in relation the entire market along with levels of debt.

Also, I will be examining the company’s historical 3 year rolling beta before coming to my conclusion. This will allow us to see how the beta of Starbucks behaved during different economic climates.

As we had discussed in earlier sections of the analysis, Starbucks falls under the category of consumer discretionary, which gives me the first reason to give it a beta greater than 1. Not only does the company fall into that category, but also the items it sells could be considered high end. The products in the Starbucks menu

Jose Perales 35

come at a premium, specially the coffee, their principal revenue driver.

In a bad economy, many customers would more than likely switch to an alternative, cheaper option. This was noticeable during the recession as EBIT margins were cut in half. However, the company remained Profitable and quickly recovered which makes me more comfortable giving it a beta that isn’t significantly greater than 1 for this observation.

S&P 500 SBUX RankMedian 5.9 4.0 37%90 Precentile 79.410th Percentile 1.5

Net Margin Standard Deviation (%)

Compared to the market, however, Starbucks does rather well at keeping their margins tight. Falling just below the median volatility, the company manages to be ranked in the top 37%.

Given that beta is a relative risk to the market this makes me think that the company’s beta has the potential to be lower than one.

Moving on, another way to look at the company’s earnings sensitivity is to analyze their operational leverage. To do this I ran a regression between revenue and ebit, where ebit was my dependent variable.

With an R-Squared of .86 to back up my findings, the regression generated a slope of .20. The low slope is an indication of a low operating leverage which also points to a sub-1 beta, especially after comparing it to key competitors.

SBUX MCD DNKN PNRA0

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SBUX operating leverage is among the lowest against key competitors

One last item I’ll look at before historical beta is their debt levels, which play a big role when deciding how risky a company could be. Fortunately for Starbucks, as we saw during the financial analysis, is among the least leveraged in terms of debt and has maintained this low debt for a long time.

S&P 500 SBUX RankMedian 57.9 40.3 40%90 Precentile 267.910th Percentile 0.0

Debt to Equity

Even with the recent quadrupling of their LT-Debt, Starbucks still manages to remain below the median when compared to the market. If the lawsuit wouldn’t have happened it is likely that their debt would have remained the same which would yield a much lower debt to equity of .09 (or 9 if we use the same format as the table above). This would have resulted in Starbucks being ranked in the top quartile.

So far, every analysis seems to contradict the fact that Starbucks is a cyclical stock, making a case for a beta below 1.

Jose Perales 36

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SBUX Jumped after the bump in dept but has settled at around .90

Surprisingly, Starbucks rolling 3 year reveals how unusual of a consumer discretionary company they are. The median beta sits at .98 and if we exclude the 2008 crisis there seems to be a downtrend that could be caused by the how big the company has gotten over time. Their increasing worldwide presence could attribute to a lower perceived risk.

Best Base WorstBeta 0.90 1.00 1.15

Likely Beta Scenarios

Cost of Equity Calculation

Best Base WorstRisk-Free Rate 2.36% 2.36% 2.36%ERP 5.04% 5.04% 5.04%Beta 0.90 1.00 1.15Cost of Equity 6.90% 7.40% 8.16%Probability 25% 60% 15%

Cost of Equity

Using CAPM to calculate the cost of equity with my assumptions I got the percentages on the table above. Weighting probability I got a final k(e) = 7.39%

Cost of DebtDue to the almost insignificant weight of Debt (Total Debt / (Market Cap + Total Debt) = 4.36%) I used a simplified approach to determine the cost of debt. Dividing the

Interest Expense for 2015 by the total debt for the same year yielded a k(d) = 3.16%.

Starbucks is currently rated at A- by S&P. Although their outlook is stated as “Stable”, I’m will assume a worst-case scenario of a downgrade in the event that they decide to lever up. On average, BBB+ corporates have a spread 50bps wider than A- making my worst-case scenario cost of debt equal to 3.66%.

Furthermore, I believe it is highly unlikely for SBUX to be upgraded to a single A rating. Due to this, I will use the same cost of debt in my best case scenario.

WACCFollowing I will evaluate WACC using the market weight of each factor. Starbucks has a corporate tax rate of 35% which will be used to calculate the effective cost of debt. Using the same probability scenarios implemented while calculating cost of equity the results are as follows:

Best Base WorstCost of Equity 6.90% 7.40% 8.16%Weight of Equity 95.6% 95.6% 95.6%Cost of Debt 3.16% 3.16% 3.66%Weight of Debt 4.36% 4.36% 4.36%Tax Rate 35% 35% 35%WACC 6.68% 7.17% 7.90%Probability 25% 60% 15%

WACC

Although SBUX’s debt carries little weight in their WACC, it still managed to reduce the base cost by a little over 20 basis points.

With the results weighted in, I’ve reached a final WACC = 7.16%.

Jose Perales 37

Terminal Growth and ValuationIn the following sections I will determine the short-term growth for Starbucks, and how long it will continue to grow at this rate before reaching its terminal long-term growth.

Furthermore, I will use these rates to value the company through a series of different models that will hopefully reflect an accurate value that allows me to make recommendations on the status of the stock. The models I will be using are the following:

Discounted Cash Flows

H-Model (Multi-Stage)

Sweet’s “Capitalized Earnings” model

The models were chosen because of the diverse approaches. Starbucks generates strong free cash flows and I believe the DCF model will reflect that. The multistage model will allow me to input the strong short term growth the company is experiencing and the capitalized earnings model lets me grow EPS as opposed to DPS which is a much more stable figure given that payout is under management’s control

Short-Term GrowthAs explained in the forecast section, Starbucks is undergoing heavy expansion which will continue for at least 5 more years. Individual stores keep on generating more revenue YoY and new stores are being built non-stop. Although management has only expressed a 5-year plan of global expansion, I believe this trend will continue for almost 10 years if the current expansion performs as expected. Worst case scenario, the company stops or drastically slows down their development.

I expect short-term growth will be somewhere between my forecasted revenue growth, 11.8%, and EPS growth, 15%. This growth will decay over the next 10 years as it reaches terminal growth

ST Growth = 12.7%

Long-Term GrowthFor Starbucks’ long-long term growth I will assume that they will continue to expand, although at a very reduced pace as compared to current trends. Additionally, revenue per store will continue to improve at the risk-free rate, which is comparable to GDP growth.

By the end of the company’s 5-year expansion plan, Starbuck’s will have as many stores as McDonalds does today. I believe McDonalds is a mature company in the same industry that has reached its terminal growth, and like Starbucks, they both have a worldwide presence. This makes it an ideal comparison and a good proxy to estimate terminal growth.

At its mature stage, McDonalds location count has grown at a 2.21% CAGR over the past 5 years. Using this figure as an expansion rate for SBUX while growing the revenue per store at the risk-free rate gave me a terminal revenue growth of 4.62%.

I really like this approach because I believe once terminal growth has been reached, the only way to grow faster than GDP is through expansion and this method takes that into consideration by independently growing location count and revenue per location.

Best Case LT Growth = 4.62%

Additionally, I calculated MCD’s location CAGR for a 10-year period as well, which yielded a rate of 1.73%. This feels like a more realistic scenario and when used to calculate SBUX’s

Jose Perales 38

terminal growth it produced what I will be using as my base LT rate:

Base case LT Growth = 4.13%

Discounted Cash Flow ModelNow that I evaluated all the necessary assumptions to move forward, I can begin the DCF analysis to value the stock of Starbucks.

As mentioned above, I believe Starbucks will maintain the ST growth rate of 12.7% for the next 10 years as it slowly decays into the terminal LT growth rate of 4.13% by year 2025.

To calculate the FCFF I first grew CFO at the expected rates and subtracted all of CapEx. The reason I decided to subtract all of CapEx as opposed to only subtracting the maintenance portion is due to the company’s current expansion strategy. As the company continues to expand, expansionary CapEx will be a recurring payment, which lead me to exclude it from FCFF.

Next I added back the after-tax interest which I’m assuming will remain very low due to the company’s history of low debt and finally calculated the FCFF.

Using my base assumptions, I got a value of $83.36 per share. If this is accurate the upside on my base assumptions is a very attractive 44%. Observing the data table there seems to be a lot of upside with a best case scenario of 104% increase in price, however that seems highly unlikely.

The high discrepancies in my valuation and the current market price could be mostly attributed to the uncharacteristically low beta that I used relative to the industry. Nevertheless, I don’t feel the beta I utilized is pushing any boundaries. As Starbucks grows and diversifies geographically the relative risk to the market should remain close to 1.

From this model’s perspective, SBUX looks like an opportunity to invest.

WACC = 7.16% 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Growth Rate 12.7% 11.7% 10.8% 9.8% 8.9% 7.9% 7.0% 6.0% 5.1% 4.1%

CFO 3,749$ 4,225$ 4,722$ 5,231$ 5,746$ 6,257$ 6,754$ 7,226$ 7,662$ 8,051$ 8,384$

After-Tax Interest 46$ 47$ 48$ 49$ 50$ 51$ 53$ 54$ 55$ 57$ 58$

Maintenance CapEx 1,304$ 1,469$ 1,642$ 1,819$ 1,998$ 2,176$ 2,349$ 2,513$ 2,664$ 2,800$ 2,915$

FCFF 2,491$ 2,803$ 3,128$ 3,461$ 3,798$ 4,133$ 4,458$ 4,767$ 5,053$ 5,308$ 5,526$

PV FCFF 2,491$ 2,616$ 2,724$ 2,813$ 2,881$ 2,925$ 2,945$ 2,938$ 2,906$ 2,849$ 2,768$

DCF Model (ST Growth)

Jose Perales 39

Terminal Growth 4.13%

Terminal Value 190,107$

PV Terminal Value 95,234$

Sum PV FCFF 28,366$

EV 123,600$

Debt 3,602$

Cash 2,263$

Equity Value 122,261$

Shares Out 1,467

Share Value 83.36$

Terminal Value (LT Growth)

83.36$ 2.03% 2.56% 3.08% 3.61% 4.13% 4.66% 5.19%

6.00% 67.93$ 77.31$ 90.06$ 108.41$ 137.08$ 188.25$ 305.52$

6.39% 61.55$ 69.12$ 79.08$ 92.80$ 112.91$ 145.24$ 205.82$

6.78% 56.22$ 62.44$ 70.41$ 81.03$ 95.85$ 118.04$ 154.86$

7.17% 51.71$ 56.89$ 63.40$ 71.83$ 83.18$ 99.28$ 123.92$

7.56% 47.83$ 52.21$ 57.61$ 64.46$ 73.39$ 85.57$ 103.14$

7.95% 44.46$ 48.21$ 52.76$ 58.40$ 65.61$ 75.11$ 88.22$

8.33% 41.52$ 44.75$ 48.62$ 53.35$ 59.27$ 66.86$ 77.00$

8.72% 38.91$ 41.73$ 45.06$ 49.07$ 54.00$ 60.20$ 68.24$

Disc

ount

Rat

e

57.70$

SBUX Current Terminal Growth Rate

H-Model Multi-StageFor this model, I’m going to take a bit of a different approach at the way I will grow Dividends per share. Starbucks just recently began to pay out dividends, so the dividend growth for the past 6 years has been about 30% YoY. If I grew Dividends at this rate they would quickly blow out of proportion in relation to EPS giving me an unsustainable growth.

Instead, I will grow EPS at a rate a bit higher than the one used on the previous model. This is because since EPS are at the bottom of the income statement they can take better advantage of whatever leverage the company has. When normalizing EPS to exclude any non-recurring charges for a better growth evaluation it shows that they have consistently being

growing on average at just over 19% so I will be using this as my ST growth to calculate DPS growth.

Additionally, the payout ratio has steadily improved at 2.6% YoY and I assume this trend will continue.

Assuming EPS initially grow at 19% and slowly decrease over a 10-year span to reach my assumed terminal growth of 4.13%, while payout ratio improves at a consistent 2.6%, I get a resulting growth in DPS that is on average 3% greater than EPS growth.

Consequently, I will be using a ST growth of 22% while my other assumptions such as time to terminal growth will remain the same (10 years) and the DPS at time 0 is $1.58.

85.88$ 2.03% 2.56% 3.08% 3.61% 4.13% 4.66% 5.19%

6.00% 80.35$ 91.65$ 107.03$ 129.18$ 163.81$ 225.63$ 367.35$

6.39% 73.18$ 82.35$ 94.44$ 111.11$ 135.55$ 174.87$ 248.57$

6.78% 67.18$ 74.76$ 84.50$ 97.48$ 115.61$ 142.75$ 187.83$

7.17% 62.09$ 68.46$ 76.46$ 86.82$ 100.78$ 120.60$ 150.95$

7.56% 57.72$ 63.13$ 69.81$ 78.27$ 89.33$ 104.40$ 126.17$

7.95% 53.93$ 58.57$ 64.22$ 71.25$ 80.21$ 92.04$ 108.38$

8.33% 50.60$ 54.63$ 59.47$ 65.38$ 72.78$ 82.29$ 94.99$

8.72% 47.66$ 51.18$ 55.37$ 60.41$ 66.61$ 74.42$ 84.54$

SBUX Current

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Jose Perales 40

Again, the market does not seem to have a very positive outlook for Starbucks, and I’m almost certain it must do with the relatively low beta that I assigned the company. However, I feel confident about my decision and the upside potential might still be there

In brief, the highlighted values are within the boundaries for best and worst case scenario, with the worst-case scenario in terms of LT growth bottoming out near the risk-free rate. Our base case scenario is at around $86 which is a total upside of 49%.

Capitalized Earnings ModelThis proprietary model, created by professor Ronald Sweet, assumes that a company with 100% payout ratio does experience growth, which in this case is driven purely by inflation.

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10-year Breakeven inflation has began to recover towards the 2% target rate

Breakeven inflation has been trending up for the better part of 2016. Its rapid incline has lead it back to the highest it has been in the past 18 months. After two years, it seems that inflation may finally reach the targeted 2% as it currently sits at 1.9%.

From these observations, I believe 2% inflation going forward may be the base case scenario.

Best Base WorstInflation 2.10% 2.00% 1.85%Ke 6.90% 7.90% 8.16%EPS1 1.61 1.61 1.61Value 33.64 27.30 25.52 Probability 10% 60% 30%

Cost of Equity

It doesn’t come as a surprise that this method has yielded a very low valuation for Starbucks even relative to the current market price of $57.70. This is due to the fact that this approach is better suited for mature companies that are not experiencing significant ST growth like SBUX.

Taking probabilities into account we get a weighted value of $27.40.

Now, I could modify this to allow me to take into consideration the ST growth to yield better results for a company like SBUX.

To consider ST growth, I used the same 19% I used in the H-model to grow EPS with a terminal growth of 2%.

Next, using goal seek I set the growth of the dividend payout ratio so that in 10 years the payout ratio would reached 100%.

With these two factors done, the resulting DPS was then given a terminal value after year 10. Then I summed up all the present values for the dividends and the terminal value. This yielded an intrinsic value for Starbucks of $51.56.

In essence, I used the concept of the discounted cash flows model and combined it with the Capitalized earnings model to obtain the present value of all future dividend growing at the inflation rate after finishing their ST growth stage.

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Relative ValuationFollowing I will be analyzing how SBUX has traded historically relative to their industry as well as the market and compare it to key competitors. If the entire industry has been trading at a premium it may distort my findings if only a relative to the market valuation is conducted.

Comparing it to both, the market and their industry will allow for a more complete understating of their true valuation.

To conclude, I will create a ranking model which evaluates the restaurant industry using profitability and risk metrics to estimate a value for each company that is compared to their market value. This method will help us visualize how rich or cheap stocks are trading relative to each other.

Industry

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The industry has consistently traded at a permium relative to the Market since the crisis

PE EV/Sales EV/EBITDA S&P

First, I analyzed the industry and it turns out that it consistently trades at a premium relative to the market on every valuation.

Further research to understand why this is the case led me to the conclusion that this industry has relatively less volatile profit margins which lowers its risk resulting in higher trading multiples across the board.

Gross Margin Net MarginMedian Rank 75% 24%

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Although the median rank pretending to gross margin volatility is in the worst quartile, the net margin is the complete opposite, being in the top 25%. This means that the companies in the industry pass on most of the volatility in costs to the customers resulting in more consistent profit margins, thus lowering risk

Due to the premium across the industry, it is important to adjust for SBUX’s premium going forward for an accurate representation.

EV/Sales

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For the exception of the crisis, Starbucks has steadily traded at a premium relative to the market. Recently however, Starbucks’s premium has increased significantly above its median.

The company’s EV to Sales seems to suggest that investors predict a considerable growth of sales in the future and are paying the price for it now. This is in line with my forecasted growth for the company as I predict sales will skyrocket in the next 5 to 10 years.

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EV/EBITDA

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Recent growth in EV/EBITDA is industry wide

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(Gap in graph is due to the exclusion of the lawsuit)

Relative to the market, SBUX’s premium seems to have significantly rallied although it is in fact quite overstated. The increase in premium seems to have been industry wide as the company’s premium has remained much closer to the average in relation to the industry.

Nonetheless, investors are confident regarding their positive expectations for Starbucks and it shows in the consistency of the premium the company trades at.

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P/E relative to the industry shows SBUX as an opportunity

SBUX’s PE ratio has been trending up over the past year relative to the industry and has just reached its 6-year average. From our forecasts and earlier valuations, I believe there is plenty of upside left in this trend. Given that it is

currently trading at just the average there might be an opportunity to invest and ride the wave up.

Ranking ModelAs a last method of relative valuation, I built a ranking model to compare SBUX to 45 other companies within the same industry.

The method used ranks the company’s metrics of profitability, risk, as well as its valuation between -1 and 1. This way of ranking is more accurate as it better captures the difference between very similar companies and avoids vast outliers from having a significant impact.

We then assign weights to each metric that is optimized using solver to yield the highest possible r-squared between the model’s output and the markets valuation.

The output of the model is the weighted rank of each of the metrics. This is compared to the ranking in the market, which in this case was derived from EV to Sales.

The metrics favored by solver to obtain an optimized r-squared were gross margin (28%) and operating margin (26%) for profitability, and Bloomberg’s 2-year default probability (24%) and Debt to Assets (22%) for risk.

After multiple attempts, these metrics produced the best r-squared of 22%. This means 22% of the markets EV to Sales is explained by our model. Although it isn’t a very favorable outcome, I believe the metrics used to calculate our ranking will still produce a meaningful chart to help us visualize which companies have the most potential upside, and how SBUX is valued against the industry.

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Finally, the chart seems to agree with previous valuations we ran on SBUX. The company has some upside to it. Relative to the rest of the model outputs, Starbucks is my 3rd best ranking company while the market has it ranked as 11th.

Nevertheless, SBUX is quite close to the line which depicts an accurately valued company. Preferably I would want to invest in a company that sits as close to the bottom right of the graph which equates to the highest possible expected upside.

Target P/EAs a last valuation before summarizing my findings I will use the Target P/E method. Using the same assumptions I used for my H-Model valuation, I grew EPS at an initial 19% with a terminal growth of 4.13% after 10 years. Furthermore, I grew the payout ratio at the same consistency it had grown before, with a CAGR of 2.56%.

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025EPS growth 19% 17.35% 15.70% 14.04% 12.39% 10.74% 9.09% 7.43% 5.78% 4.13%EPS 1.91$ 2.24$ 2.59$ 2.96$ 3.32$ 3.68$ 4.02$ 4.31$ 4.56$ 4.75$ DPS 0.85$ 1.02$ 1.21$ 1.42$ 1.64$ 1.86$ 2.08$ 2.29$ 2.49$ 2.65$ Payout Ratio 0.45 0.46 0.47 0.48 0.49 0.50 0.52 0.53 0.54 0.56 PV DPS 0.79$ 0.88$ 0.97$ 1.06$ 1.13$ 1.19$ 1.24$ 1.27$ 1.28$ 1.27$

ke 7.69%Terminal g 4.13%Target PE 15.69PE* EPS (10th Year) 74.57$ ^ PV ^ 35.55$ Sum of PV DPS 11.07$ Intrinsic Value 46.62$

Target PE Terminal Value Analysis

The Intrinsic value resulting of the Target PE method was $46.62 which is a 19% discount to the current market price of $57.70.

Valuation SummaryGiven the high expected short term growth rate for Starbucks, I believe that methods that can encompass this growth into their calculations will yield the most accurate valuation possible.

The DCF approach yielded an upside of 44% and it’s my favorite method. I believe it is the one that most accurately captures the short-term outlook of the company followed by the multi stage H-Model, however, the base case scenario for this approach results in an upside of 75%.

I assume that the reason for these seemingly large valuations is due to the low cost of capital used in my models, which is a direct result of the low betas I estimated. These assumptions, however, are not without reason. I believe that although the upside may not be 75%, the company does have tremendous potential and the market may be overstating the risks.

The relative values do show that Starbucks is trading at a premium. Nevertheless, relative to the industry the premium for Starbucks is not as significant.

Jose Perales 44

Further analysis showed how the premium of the industry could be attributed to the much more stable profit margins relative to the market which should attract a greater number of investors boosting the premium.

Conclusively, I don’t think Starbucks’ premium is encompassing the entire potential for the

future growth of the company. Although it is trading rich relative to the industry, my ranking model showed the probable upside to the company and the models that consider short term growth for Starbucks value it higher than the market even below base case scenarios.

Technical AnalysisSimple Daily Moving Average

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There could be a trend reversal soon as suggested by the moving averages

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Rule of thumb suggests that when analyzing this set of moving averages, whenever the following is true, it is an indication to BUY.

Price > 50day > 100day > 200day

However, looking at this YTD graph, these set of rules were almost met in April. Unfortunately, the stock sold off just before it happened and the stock along with the averages have been trending down ever since, although it seems like the trend has reversed just recently.

November marked the ending of the downtrend for the 200-day moving average after the stock began rallying past all three averages from the beginning of the month. Yet, most recently the

price may have experienced a resistance at the $59 mark.

I would not suggest this is a Buy signal just yet. Investors should be wary as the 50-day moving average encounters the 100-day moving average. In the past year, this has occurred twice. Following these average crossings, the stock promptly sold off.

Although through my analysis I’m leaning towards a buy position, I would suggest to wait and see how this plays out for the next week or two to verify this trend reversal.

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Bollinger Bands

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Bands may suggest the end of the price rally

The price for Starbucks seems to trend tightly between the 20-day moving average and the Bollinger bands at 2 standard deviations.

From my observation, there seems to be a trend reversal whenever there is a pronounced cross of the 20-day moving average. These trend reversals, however, usually begin with a big price jump in either direction which makes it difficult to capitalize and take advantage and capture the full percentage change.

More recently it is evident that the price has again re-encountered the 20-day moving average. This does not yet signify that the trend will be reversed, however, as mentioned in the previous technical analysis involving the moving averages, it would not be the best time to buy the stock either.

Moving forward the stock will probably react to the moving average as a resistance and trade tightly within the current price range.

This slow-down could also be a reaction to the unexpected upward momentum that caused RSI to shoot up past 70, which signals the stock was

overbought. Regardless, this indicator has just normalized and the uptrend might continue. Yet, from what the Bollinger Bands are telling us, it is a better idea to wait and see.

The stock seems to have encountered a new support, as it bounced off the $57 mark. If this breaks, the stock could reengage on its downtrend.

In brief, both the moving averages, and the Bollinger Bands tell me that investors should be cautious going into this stock. None seem like strong buy indicators at the moment even if my fundamental analysis and valuation seem to give a different signal.

Price by VolumeThe following indicator shows the amount of traded volume at a given price range over the past six months. On the left side of the chart we have the sum of volume for a particular price range while the line graph plots the price for the stock during the last 6 months.

Jose Perales 46

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SBUX price has broke through a main resistance at $57.5

Interpreting this chart is rather simple. The volume bars on the left help identify support and resistance levels, which are indicated by the long bars.

There have been two occasions in the past 6 months that the $57.5 resistance level has been challenged, however this was followed by a sell off period, the latest of which occurred in August. This time however, the price had a significantly stronger breakthrough.

In the past month, SBUX price has risen past two major resistance level. This could be interpreted as a strong buy signal, especially when we put the previous two technical analysis’ together.

Now that the price has rallied past the mentioned resistance it could represent a support going forward. The breakthrough signifies there is strong demand beyond the bar pulling the price upward. The lack of volume below the bar will help maintain the price above the newly established support level.

Technical ConclusionThe simple moving average showed trend reversal happening recently according to the

200 moving average, and although it is not significant enough to indicate a buy signal, coupled with the final technical analysis price by volume, it tells a different story. Not only has the trend reversed, but additionally the upward movement in price has broken through a major resistance level, which could become a new support moving forward.

The Bollinger Bands do show a slowdown in momentum, but the price remains even above the 20sma so there seems to be nothing to worry about.

In conclusion, this is a good time to buy the stock and after the lengthy analysis, not only is it a good time to buy, but a good buy overall for the value investor.

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