Starbuck's Valuation: A Few Thoughts

Starbuck’s Coffee (nasd: SBUX)- Discounted Cash Flow Valuation: $23

Starbuck’s stock has been getting a beat-down for more than a year already, down more than 50% from the $ 40 high reached Nov ’06. In the past few months, SBUX fell from the $ 26-28 range where it was treading water all summer into the fall. Now, trading around $18, SBUX is still not cheap. Applying a discounted cash flow model gives a fair value estimate of $23. 

Even though fair value exceeds current price by a decent amount, the margin of safety is too small given Starbuck’s negative momentum and expected near-term weakness. However, for a long-term investment horizon (10yr+), I believe SBUX can be bought here. However, Starbuck’s may have rough time in the near-term.

Last August, I placed a value on SBUX of $35 /share. SBUX announced it is scaling back store additions for the coming year, thus I slashed my sales growth forecast resulting in the steep drop in valuation. Projected 5 year growth rate assumption decreased from 18% (aug) to 14%. The other input assumptions really didn’t change, just the revenue growth projection. Read SBUX: Long-term Hold

The last 5 years, SBUX sales growth averaged 23.5% fueled primarily by new store additions. Starbucks cut its previous forecast for 2008 new stores from 1,600 to 1,175 (US), plus mentioned closing 100 or so underperforming locations. The company is forecasting ’09 US store additions of less than 1000. Slower/less growth in Starbuck’s store count translates into less revenue in future periods.

Fear of slowing growth is the main culprit to Starbuck’s stock price slide. Concerns that a slowing economy will materially affect SBUX might be discounted in the share price, but SBUX is well insulated and recessions are short-lived events. Stocks are valued over a long-time horizon, at least 50 years. Worries about McDonalds giving SBUX a run for its money are laughable. Yes, MCD may negatively impact Starbuck’s growth, but only slightly, if at all. I believe that new store expansion has been too aggressive, causing cannibalization of store traffic. Aware and addressing this issue, Starbuck’s is scaling back store openings. Read SBUX Face-off

Foot traffic at comparable stores declined (or was flat) for the past several quarters, leading me to suspect sales cannibalization. Some geographies likely became over-saturated, thus a new store takes traffic from an existing, causing weak SSS comparisons. Surely, some customers who constituted the sales at new locations had visited a SBUX in the previous year. Take a person who had 20 store visits last year. This year that customer returned 10 times to that location, but also went to newly opened store on other ten occasions. That’s where the foot traffic is going, to the 1,800 stores opened this year. Read SBUX Cannibalization

Last fall, management maintained saturation played no part in declining foot traffic as concerns rose. The Reduction to planned store openings is an admission that cannibalization is becoming an issue. On the last call, the CEO said they were slowing down store additions to avert sales cannibalization of existing locations. So, it is problem, the primary problem, not the MCD noise or economy fears.

I think SBUX still has significant growth potential, albeit at a slower pace. SBUX still has some room to grow domestically and plenty of room internationally. Management needs to be more deliberate about expansion, instead of shooting from the hip putting stores any & every where.

Starbuck’s generates high returns on capital and equity. Usually competition and market forces drive returns down to a more normal rate, yet Starbuck’s possesses a very strong competitive position that will keep returns above normal for a considerable time. These factors underlie premium multiple that investor’s have placed on SBUX.

Examining Starbuck’s market valuation from price/earnings vantage point also suggests that shares are fairly-valued. Maybe slightly undervalued, maybe. Certainly not undervalued or cheap by any means.

SBUX is trading at 19x Sep FY earnings and 16x next year’s estimate. Using ValueLine and Nasdaq.com for estimates years farther out, I calculated my 5-year growth rate projection of 15%, not 19% analyst consensus estimate. 13-15% growth may not warrant a 19 multiple, but given ROI and the persistence of growth and competitive advantages, SBUX trades at a reasonable multiple. Interest are very low too, making a case for higher P/Es.

One area of concern is the downward trend in revisions to EPS estimates, which may portend even more downward revisions.

Earnings Estimates and Revisions:


Starbuck's Historical Data:


SBUX Valuation: Discounted Cash Flow Model

Starbuck's Traffic Decline Due to Cannibalization

Starbuck’s Coffee (nasd: SBUX) is experiencing a slowdown in same-store sales – specifically declines in transaction volume or “foot traffic.” This has been cause for alarm as some theorize that the business model is in jeopardy. Yet, I believe that SBUX is intact, and it’s the aggressive store expansion that has caused cannibalization. However, not positive, cannibalization can be addressed and solved, but it will entail slower growth than what has been expected.

Starbuck’s Historical Performance:
Starbucks turned out 17% sales growth for the Q1 2008, yet same-store sales increased only 1%: 2% rise in value per ticket coupled with 1% decline in transaction volume. In the US: SSS dropped 1%: 2% increase in average ticket value and 3% decline in number of transactions.

Cleary, foot traffic is declining for stores older than one year, and some are speculating that customers are defecting to McDonalds. Simply, this is not the case. Foot traffic declines are primarily a result of cannibalization from new store openings. Sales growth continues to be robust due to new store additions, yet some of that traffic is stolen from stores open longer than 13 months.

Looking back several months, Starbucks management stated on the 07Q4 conference call (11/15/07) that the 1% decline in US store traffic (# transactions) in Q4 was not due to saturation. For FY07, store traffic was basically flat. I don’t know how they could be denying the fact that their aggressive store expansions haven’t cannibalized sales from existing stores. That implies that virtually all sales generated from the 1,788 new stores opened FY07 are from customers, who hadn’t been to Starbucks in the past 13 months (FY06).

I’m really surprised that there hasn’t been a greater decline in transactions just from the simple fact that a new store addition may be more conveniently located for a regular customer than an existing store. It’s safe to assume that a portion of the new store traffic includes customers, who had been going and would still be going, to an existing location.

SBUX management is accepting the fact that cannibalization is occurring as evidenced by the announcement to dial down the number of planned new store openings.

Same Store Sales Metric Explained:
The highly popular same store sales (SSS) metric can be quite nebulous at times. Its purpose is to capture organic sales growth from existing (comparable stores) and exclude growth attributed to additions of new stores. Overall revenue growth due to new store openings can conceal falling sales at existing stores unless sales from the both segments are isolated. SSS compares sales of stores open at least a year (13m) thus excluding growth associated from an increased store count in the current period. Comps can indicate if competition is affecting sales, or if customers are spending less due to economic hardships. SSS can also uncover if the firm’s product offerings have become less relevant to consumers.

SSS can be clouded since often SSS growth is driven by new store growth, which counters the purpose and value of the SSS comparison. New store additions can affect SSS growth when the new stores require time to reach maturity (or peak revenues), which may be several months to several years. Considering a new market lacks an existing customer base, a new store will have to build a customer base by increasing awareness with promotion, advertising, and word-of-mouth. In addition, the new store will need to become familiar with local tastes and preferences in order to optimize its inventory by stocking a product assortment that best matches the surrounding community. These are just a couple factors that describe the revenue growth curve for a new store.

Individual store revenue curves widely vary due to numerous factors. The type of industry that the firm operates makes a difference. The most significant determinant is the existing customer base, specifically brand awareness and familiarity. New markets where brand penetration is absent will not have much, if any customer base. Highly visible brands in distant markets can create awareness in un-penetrated markets resulting in a more rapid build in the customer base once a new store arrives. Store additions in markets that are in close proximity to existing stores will have an existing customer base to draw from. This scenario will likely result in the quickest maturity since a portion of the customer base will be cannibalized from the other existing stores.

Retailers that are aggressively adding stores in new markets tend to have overestimated SSS figures. This is how it works: A retailer with 1000 stores opens 300 new stores, which won’t reach maturity for at least two years. The following year, the retailer now has 1300 existing stores with 300 generating 60% of maturity sales. For the year, the company adds 400 new stores bringing the total to 1700, but the SSS comparison only involves the 1300 existing at the start of the year. At year end, those 300 stores operating at 60% the year before, are now at 90% of peak store revenues. The increase in sales per store associated with those stores open longer than a year but less than time to maturity are included in SSS calculation. Thus, adding new stores will boost SSS sales if there is a considerable period between the open date and the date the customer base matures.

In general, there is a direct relationship between SSS and store count increases, especially when new stores are added in markets characterized by a small customer base that gradually increases. If possible, calculating sales per store at existing stores versus new stores can aid in uncovering situations where SSS is blurred from aggressive store expansion. If there is a wide discrepancy between the two, it’s likely that SSS is overstated. For instance, if existing stores have historically averaged 500k per store, and new stores (less 1 yr) average 250k, then SSS will grow as new stores approach peak sales of 500k. The 250k per store generated by new additions are responsible for growth associated with new stores only. Yet, for the subsequent year, the SSS metric will use 250k in comparison.

Starbuck’s Same Store Sales:
In the case of Starbuck’s, I believe that the slowdown in SSS is due to new stores having a larger initial customer base (higher sales/store) thus the comparisons are tougher. Stores coming online generating sales/store closer to peak sales and maturing more quickly will result in higher new store sales growth and lower SSS growth in the subsequent period.

A logical assumption is that during SBUX expansion into new geographic markets, new stores gradually grew traffic as brand exposure increased with time. In contrast, stores opened in already well penetrated markets require less effort drawing traffic since many consumers have already experienced Starbucks’s offerings. SBUX current store footprint virtually blankets the US, therefore a significant portion of store additions will be in locations in the vicinity of existing SBUX stores. SBUX is highly visible, well-established brand that reduces the local effort needed to inform and attract a customer base because of the large percentage of local consumers is already familiar.

Many new Starbuck’ stores provide a more convenient location for some of its current customers who are regular visitors at more distantly located stores. Thus, SBUX customers switch to the new location. It’s also likely that some customers opt for a new location to avoid the high traffic stores. Yet, it’s hard to argue that sales generated at new locations do not come at the expense of existing stores. How much? It’s hard to say without conducting extensive market research and customer surveys.

I have little doubt that cannibalization is responsible for the decline in SSS transaction growth. Traffic migrating from an existing store to a new store, causes SSS revenue to fall, but total revenue is unaffected because of the offsetting increase in new store sales growth. The overall effect is negative because the same level of revenue is spilt between two stores instead of one, thus lowering margins and return on invested capital. Yet, if new stores increase an existing customers’ visits/yr and allow existing stores to capture new customers as well, then growth could outweigh cannibalization.

According to my calculations, for the past couple years, it appears that revenues at new stores are closer to revenue/store at existing locations than in previous years. This suggests more recent store openings have a larger initial customer base.

Turning Cannibalization into Positive Growth:
It’s possible that this type of cannibalization can actually end up being positive for SBUX if several factors occur.

1) Transactions/Customer are higher at new locations than what was lost from existing stores.
2) Costs for new store openings are lower.
3) Relieve capacity pressures at high volume locations

It’s positive if a customer who averaged one visit/month at an SBUX is now averaging five visits/month at the new location. SSS will fall because store visits have fallen from 12/yr to zero. But, new store sales will increase by an amount larger (60/yr) than that lost in SSS (12/yr).

If SBUX can migrate regular, high frequency visitors from a high volume store to a new store, then that will free up capacity to attract new and low frequency customers at the high visibility locations. Premium locations serve as a marketing tool as well. The SBUX brand is exposed to the large sums of people passing by daily. Since Starbucks historically has not aggressive engaged in advertising, the stores serve as its primary marketing effort.

High traffic at a SBUX can be both beneficial and disadvantageous for attracting consumers with minimal brand experience. High volume indicates that the offerings are very liked and demanded, and provides a vote of confidence for those unsure due to lack of brand experience. Yet, some consumers may reluctant because they are unwilling to deal with long lines.

Consumers willing to engage crowded locations are more likely to be regular visitors who perceive SBUX product value to exceed the cost of waiting. The cost of a premium location is worthwhile when the additional expense for visibility attracts new customers or increases visits of low frequency customers. The additional expense provides less benefit if the highly visible locations are packed with regular customer who “crowd out” curious, potential customers.

The ideal scenario: high frequency visitors go to convenient, but less visible (lower store cost) locations thereby freeing up service capacity at the premium locations. This will allow the highly visible, premium locations to attract more new / seldom customers.

Anecdotal Evidence:
To give an example, I will describe my recent Starbuck’s visiting pattern. Of course, this is just my experience and may not accurately represent the norm. Yet, I can envision that a portion of SBUX customers share a similar pattern. I think it’s at least worth mentioning and contemplating.

The SBUX store closest to my house was a premium location in mid-town. During morning rush hour, the drive-thru line spills all the way out into the street. Occasionally, I couldn’t get in line because I would be blocking traffic at the intersection so I would have to keep moving. At this time, I probably visit SBUX once every two months (6 visits/yr). This distance from my house and the large crowds at SBUX dampened my visit frequency. Several months ago, a small SBUX opened close to my house downtown. With much smaller lines and the convenient location, I now go to Starbucks at least twice a month (24 visits/yr) and usually spend more too.

Now- my visits have increased, my average ticket has increased, and the new location is likely less expensive to open and operate. In addition, since I no longer visit the high traffic SBUX, there will be smaller lines to capture customers who may pass-up due to the high volume.

I have asked several acquaintances what would influence them to visit SBUX more frequently, and the top responses I received were convenient location and shorter lines. A few essentially mentioned they don’t think about SBUX until they see a store, but usually the road traffic and store parking lot appear to be a hassle.

My experience is just an anecdotal scenario that has little value unless we could ascertain the exact percentage of consumers who share my experience. Yet, I am certain that some do, and at minimum, it’s a worthy scenario to a least consider.

Conclusion:
Starbucks needs to manage its store expansion strategy more effectively to reduce the negative effects of cannibalization. Situations where cannibalization is unavoidable, SBUX needs to find methods to limit the negative impact to achieve scenarios I mentioned above. Essentially, this involves selecting locations that can be supported by an existing customer base coupled with potential to attract new customers. It appears that SBUX is beginning to understand the issue from the recent announcement to slow store expansion as well as closing underperforming locations. Management plans to be meticulous with respect to store additions. A scaled back expansion plan will translate into slower sales and earnings growth, hence price multiple. It appears that this information is reflected in the stock price as the multiple has already been compressing for some time.

I believe that sales and earnings growth, albeit a slower rate, will still be above average and persist for a considerable length of time. Shares are fairly valued currently, yet as a long-term hold, SBUX is relatively attractive.

Disclosure: No position in SBUX

Starbucks Coffee (SBUX): SmartMoney Face-Off Review

Starbucks (SBUX) is the subject of debate for the Face-Off column in this month’s (Nov ’07) issue of SmartMoney Magazine “Can Starbucks Serve Up Venti Profits?” If you are not familiar with this column, SmartMoney asks two experts to take opposing views on a company, and give five reasons on whether to buy/sell the respective stock.

Sharon Zackfia, analyst at William Blair gives the bull case and Mark Coffeit, portfolio manager of the Empiric Core Equity Fund responds with the bear case for Starbucks Coffee.

I have summarized the main points for both arguments below. I didn’t include all arguments from the article, just the most relevant.

BULL CASE: Sharon Zackfia

1. Sales growth will continue to be solid due to new breakfast & lunch offerings and international expansion (profitability in China is better than U.S.). Store count is expected to double in 5 years.
2. SBUX faces increased competition from MCD but they are not fighting for the same consumer. Until 2003, coffee consumption had been declining, but 2006 was the highest level since the mid-80’s. In growing markets, all competitors can win.
3. P/E of 26x 2008 estimates is lower than the mid-30’s multiple SBUX has historically commanded. SBUX has maintained guidance for this year’s earnings since giving it August 2006. Growth is still impressive; It’s only large-cap retailer growing sales at more than 20% annually.

BEAR CASE: Mark Coffeit

1. Discretionary spending is slowing, and “I can’t think of anything more discretionary than a morning cup of coffee.”
2. Sales up 4% this year. “That’s not good for a retail company.” 26 P/E vs. 16 P/E for the Market. “Starbucks is priced for perfection” and the odds of it delivering perfection are the same for “tossing heads 10 times in a row.” “Could be dead money for five years.”
3. Breakfast will attract more customers, but the flip side is that new additions make the business more complicated thus prone for making mistakes and turning customers off.
4. McDonald’s has upgraded its coffee and will be offering lattes/cappuccinos that will cut into SBUX sales.
   

I the paragraphs below, I evaluate both stances and provide my opinion on the strengths/weaknesses of the contributors’ points.

Consumer Spending:
The first bear case argument: can’t think of anything more discretionary than morning coffee? That’s a totally absurd statement. I can think of many things a pinched consumer would cut back on before coffee: entertainment, travel, fashion apparel, leisure spending, and electronics to name a few. I think most all consumers would cut out an upscale dinner or new X-Box before giving up their morning coffee.

Ms. Zackfia believes that SBUX may not be immune to consumer spending downturns, but it is well insulated. I agree.

a) Caffeine is a highly addictive substance.
b) Drinking coffee is a morning ritual for many.
c) The unit price of coffee is low, thus not a blatant target for budget cuts.

I hear people all the time talk about “their morning coffee” and how they have to have it. It’s a daily pattern for some, which implies that the purchase decision process has become automatic. Coffee is closer to a staple than a discretionary good.

Competition:
Both agree that Starbucks and McDonalds product offerings are different, but Coffeit states that MCD provides a decent alternative. In my mind, there's much more to Starbucks than just its coffee. If that weren’t true, then SBUX couldn’t charge a premium. Additionally, if it were easy to duplicate SBUX model and offerings, many would have followed Starbucks years ago. SBUX has held of competitors since its incipience, so what makes them so vulnerable today? McDonalds and Dunkin Donuts have forever served coffee, likewise most every other restaurant.

Zackfia’s provides a stronger argument as to why MCD will not be a significant factor to SBUX sales growth since she cites evidence of growing coffee consumption.

I believe that MCD will only mildly impact growth in the sense of potential future new customers, not stealing current SBUX customers. I believe MCD is selling a good amount of coffee to customers who previously didn’t buy coffee from them nor SBUX. MCD is just taking advantage of their high foot traffic already in place.

Sales Growth:
Coffeit’s statement about 4% sales growth is misleading, growth was 20% year/year and 4.6% qtr/qtr. Sequential growth of 4.6% is not bad since multiplying by four quarters is close to 20%, putting it loosely.

The bull argument cites new stores and international markets paving the way for sustained growth. The bear does not address growth prospects of SBUX store expansion plans.

Both participants say new food additions at Starbucks will increase traffic, yet Coffeit claims that is a reason for not buying the stock. He implies more harm can be done, than good, since SBUX store processes will become more complicated.

In my mind, Coffeit contradicts himself since he says MCD new offerings present a threat. If McDonald’s is rolling out new coffee beverages, such as lattes, then their business becomes more complicated too. They face the similar risk of driving away customers from poor customer service. I believe SBUX is capable of better managing a new product addition due their better management and employees than MCD. It maybe a valid point, but all companies face that challenge when they introduce a new product line. It’s a part of business, and the odds are low that it will detrimentally affect either firm, but even less likely in the case of SBUX.

Valuation:
A multiple of 26x can be cheap or expensive depending on how one looks at it. The bear case is that SBUX is expensive because growth is slowing, and the bull case is that future growth can still be as high expected when SBUX traded at 35ish multiple. The bear states that SBUX is overvalued relative to a 16 market multiple.

SBUX should trade at a premium to the market because it has higher sales growth and higher returns on invested capital. SBUX has a valuable brand leading to a strong competitive position. Morningstar agrees, their economic moat rating for Starbucks is “wide.” A 26x multiple may be justified, but I would feel much more comfortable if it were in the low 20’s. It’s certainly not grossly overvalued at these levels as the bear implied.

Conclusion:
I was not impressed with Coffeit’s arguments because of his dearth of evidence, and the little he did provide was misleading (stating 4% growth incorrectly). Second, He appeared to inject too much unsubstantiated opinion such as his comments about “coffee is discretionary spending” and the odds of SBUX performing up to priced-in expectations are “tossing heads ten times in a row.” If one chooses to use hyperbolic exaggerations, then he needs to provide sufficient evidence to support his inferences. Otherwise, I get an impression that his commentary contains a unwarranted bias. Third, Coffeit’s logic regarding the possibility of complications from offering sandwiches is a stretch.

The bull, Ms. Zackfia, lays out a reasonable argument. None of her main points make SBUX a compelling buy, but she does give reasons against taking a bearish stance. On balance, SBUX faces more opportunities than threats. The major risk I see is that competition may limit SBUX ability to raise prices if costs (such as dairy) climb significantly higher, and disproportionately affect Starbucks more than its competitors. I believe that scenario coming to fruition is less likely.

I opined on Starbucks back in August with this article: Long-Term Hold (SBUX near same price then- $26), and my thesis was SBUX was attractive given a long-term investment horizon, but I wouldn’t be inclined to buy unless the SBUX dropped close to $20. I based this on the fact that SBUX price multiples had fallen to a more palatable level, and that the company’s future growth prospects and return on capital appear to be intact. I concluded that Starbucks shares were not bargain, but reasonable enough for consideration.

I reiterate my earlier (August 2007) position; Starbucks has moved from being very overvalued to reasonably valued, and SBUX would be very attractive/undervalued at a low-20’s share price.

Disclosure: I do not have a position in SBUX.

Considerations for Starbucks as a Long-Term Hold

Starbuck’s shares have been under immense pressure the past few months as the stock has fallen to $26 from the $37 level seen back in January making the stock more attractive on a long-term hold basis. I would be compelled if SBUX share price fell to the low 20’s, but at around $26 shares still offer some value. My Discounted cash flow valuation Models suggest a $35 fair value assuming: 18% sales growth for the next five years and 13% average growth for the next ten years as revenue growth decelerates to a normal long-term rate of 3%. Margins should remain stable with a slght decline in later years. We can make forecasts with some relative degree of confidence given Starbucks’ consistent growth record, strong competitive position, and market potential.

I do not expect any significant catalysts to move the stock in the near-term, but operating with the assumption that markets are efficient in the long-run, SBUX should eventually rise to its intrinsic value. The recent disappointing news really only impacts the short-term picture. Starbucks’ dominance and brand strength should limit competitive pressures as it grows revenue through increased market penetration. Starbucks should be able to generate strong levels of cash flow for a long time period, and cash flows will increase from growth and the eventual decline in required capital investment. I believe Buffett would say that Starbucks has a wide competitive “moat.” As shares represent a reasonable value at $26, any further decline will boost the margin of safety and make SBUX worth considering even more.

Competitive Position:
Coffee, it’s a bean that comes from the ground. Pretty simple. Most every restaurant sells it. Yet, Starbucks is able to sell coffee to more customers at even a higher price. The price premium that the brand commands is direct evidence of the firm’s competitive advantage. Consumers perceive real value in Starbucks’ offerings which is very difficult for competitors to duplicate. People are never going to quit drinking coffee; it’s a daily routine for most people. Additionally, caffeine is addictive according to health experts. When you take a product that a significant portion of the population consume on a frequent basis that they may even be addicted to, you have a very sustainable business. Starbucks’ has superior customer service and product consistency which gives customers confidence that their expectations will be met. In other words, consumers know what they are getting as opposed to other outlets with less product familiarity and consistency. Starbucks has already captured many premium locations as well as surrounding locations that provide convenience leaving little potential for entry by competitors. Current competitors pose a mild threat to eroding Starbucks’ strong consumer base due to already engrained habits. McDonald’s offers premium coffee which has received higher ratings in surveys, yet that doesn’t change the fact that it’s still McDonald’s. MCD has a reputation for mediocre service and product inconsistency and lacks the product breadth of Starbucks. The Starbucks’ brand appears to be much more than just coffee, and this brand strength will assuage risks as the firm continues to grow.

Growth Potential:
Revenue and earnings have grown at roughly 25% annually for the past five years, and should continue at an above-average rate given Starbucks’ competitive position and already proven record. Management is expecting 18% top-line annual growth and 20-22% in the bottom-line for the next several years. Domestic same-store sales have been stabilizing at around 4%, with transactions accounting for 1%. Internationally, same-store sales increased 7% for Q3 driven by 5% transaction growth. International comparable sales growth has been north of 5% every quarter.

Starbucks had 14,396 stores at the end of Q3 and management believes they can ultimately hit 40,000 total stores. International expansion is the key factor in the firm’s long-term growth ability. At the end of Q3, SBUX had 4,000 stores outside the U.S., and the company believes it can achieve 20,000 locations abroad meaning that projected expansion is only 20%. Domestically, SBUX feels it can double in size of its current business.

Valuation:
At $26, SBUX trades at 30x current year estimated EPS of $.87 (Dec 2007) and 25x next year’s $1.06 estimate. That is not exactly cheap, yet analysts are forecasting 5 year annual growth of 22% justifying the high P/E multiple. Aside from just prospective growth, SBUX deserves a higher multiple due to its high return on invested capital. Two primary drivers of ROIC are profit margin and asset utilization: Remaining profit from a $ of sales and the amount of assets needed to generate that $ of sales. Starbucks’ margins have been healthy and trending upward the past 10 years. Brand strength should continue to support pricing power and cost efficiencies will continue to increase from scale benefits spreading fixed costs over a larger revenue base. Requirements for capital asset investment should decline from decelerating growth and because capital investments are made “up front.” Starbucks’ asset utilization (sales/total assets) has trended upward the past ten years along with ROA doubling from 7% to 14% and ROE increasing from 11% to 26%. Each dollar of fixed assets generate $3.50 in sales- very impressive given McDonald’s FA turnover is 1.0x and Panera Bread’s is 2.4x.

Summary:
Starbucks possesses one of the most valuable brands in existence and operates in a space where consumers are habitual users less subject to swings in macro-economic conditions. Starbucks generates healthy operating cash flow but free cash flow is paltry due to the capital expenditures required to support robust growth. When growth normalizes 12-15 years down the road, OCF will be substantial and without capital expenditure needs OCF will roughly equal FCF. SBUX’s price decline is warranted in part, yet it’s likely that the decline has been too drastic. Considering the overall long-term picture, SBUX is not a bad choice at current levels, but any continued pessimism pushing SBUX would make for a great buying opportunity.