Morning Coffee: A Profile and Valuation of Starbucks

Company Profile

Starbucks is a roaster, marketer, and retailer of specialty coffees. They purchase and roast high-quality coffee that they sell among tea and other beverages as well as food items. They sell a variety of coffee and tea products and license their trademarks through other channels such as licensed stores as well as grocery and foodservice through their Global Coffee Alliance with Nestle. In addition to Starbucks Coffee, they also have the following brands: Teavana, Seattle’s Best Coffee, Evolution Fresh, Ethos, Starbucks Reserve, and Princi.

Starbucks operates as a global retailer of specialty coffees. Currently they source 73% of their revenues from the Americas (inclusive of United States, Canada, and Latin America), 19% of their revenues from international operations (inclusive of China, Japan, Thailand, U.K, etc.) The remaining 9% of revenues are from their Channel Development segment. Channel Development includes whole roasted whole bean and ground coffees, Seattle's Best Coffee®, Starbucks- and Teavana-branded single-serve products, a variety of ready-to-drink beverages, such as Frappuccino®, Starbucks Doubleshot®, Starbucks Refreshers® beverages and TeavanaTM/MC iced tea, and other branded products sold worldwide. Historically, consumer packaged goods had been sold direct to grocery, warehouse clubs and specialty retailers through institutional foodservice companies. A large portion of the Channel Development business transitioned into a licensed model in the 4^th quarter of 2018 with the introduction of the Global Coffee Alliance with Nestle. The terms of the deal are that Nestle obtains the rights to sell, and distribute Starbucks coffee and tea, Starbucks will receive royalty payments for the licensing deal.

Industry

Total 2020 revenue in the global coffee industry is estimated at $358,000 million. Revenues are expected to grow annually by a compounded annual growth rate of 10.6% through 2025 (data taken from stastita.com). The United States accounts for approximately 20% of the share of global coffee revenues. 62% of Americans drink coffee daily, 70% of Americans drink coffee at least once a week. US coffee consumers have developed an appreciation for specialty coffees. Higher-grade coffee beans, improved roasting methods, and better brewing equipment have improved product quality and increased customer expectations. Specialty coffee drinks (cappuccinos and frappuccinos in the case of Starbucks) have attracted younger customers who prefer sweeter beverages. The US market is very saturated with coffee shops on most city corners, there are currently more than 35,616 specialty coffeeshops in the United States. Of these stores, 80% are operated by three main industry leaders: Starbucks (40% of US market), Dunkin (26% of US market), and JAB holdings which owns brands like Panera, Peet’s and Caribou (13% of US market).

As the US market continues to become heavily saturated with both large retailers and local coffee shops as well as slower growing, large competitors have turned to international markets for new growth opportunities. China is an attractive market for continued growth with the recent explosion of growth in the young middle class. Market revenue in China was estimated at $8,214 million in 2019 and is expected to grow at an annual rate of 11.3% through the next five years. The main force driving the boom in coffee sales is the rising middle class in China which is on track to expand from 430 million people to 780 million people in 2025 as well as a higher standard of living. China consumers are heavy mobile phone application users and stores focusing on mobile technology/ordering are expected to see more growth in the market.

Key Risks

Continued saturation and an emphasis of community coffee shops that provide a unique local experience pose a threat to Starbucks which has the image of an international brand. Starbucks has been combating this threat by associating their brand image with ecological sustainability and support for coffee growing farmers so consumers can feel positively about their purchases. Starbucks operates farmer support centers in coffee growing nations around the world. Farmers get free access to the latest findings of top agronomists, including new varietals of disease-resistant trees and advanced soil management techniques.

The impacts of COVID-19 continue to have a profound impact on the global economy as well as the coffee industry. Starbucks saw a significant drop in comparable store sales in China in Q2 2020 from a low of a 90% reduction in mid-February to a 35% drop in the month of April. Currently almost 100% of stores have been re-opened in China, however, there remains significant risk to future store closings in response to a potential second wave in infections. The COVID-19 effects were not felt as much in the second quarter as the United States initiated broad quarantine measures towards the middle to end of March. 50% of company stores were closed during that period which will have a drastic impact on Q3 sales results as closures and quarantines moved into April. Potential long-term impacts could be a reduction in higher margin coffee sold in Starbucks’ specialty coffee lines. These tend to be higher priced items like cold-brew coffees, cappuchinos, and Frappuchinos. Consumers who have lost income could move to lower priced coffee or reduce coffee intake altogether. Reduced foot traffic will also present a significant long-term headwind to coffee shops as social distancing measures are continued to be followed. Starbucks noted in their earnings call that they are expecting to have 90% of all US company-operated stores re-opened by early June with enhanced safety procedures.

The price of coffee beans is subject to volatility and with increased demand for coffee by growing consuming nations excess supply has driven the price of coffee beans to an unsustainable level for local farmers. With rising prices and demand for specialty coffees in established markets like the United States the price of coffee beans has diverged and dropped by 25% between 2015 and 2019. The low cost of coffee beans has reduced input costs for large roaster/retailers but has also hurt farmers as their incomes have been drastically reduced. Potential long-term impacts are farmers moving their fields from producing coffee beans to other crops. A possible outcome of persistent low prices would be the creation of a cartel along the lines of OPEC to manage the supply of coffee and create quotas to put upward pressure on the price coffee beans. Actions like this would create disruptions along Starbucks’ supply chain as the bargaining power of their suppliers would change from various collectives of farmers to unified groups as well as increase input costs putting pressure on margins.

Growth Potential

Starbucks is pursuing growth via multiple channels; through technological development, expansion in global markets, and expansion of ground/whole bean and ready-to-drink product licensing sales through their partnership with Nestle as well as PepisCo, Anheuser-Busch InBev, Tingyi Holding Corp, and Arla Foods.

Technological development is viewed by the company as a critical component of future success. Starbucks is developing multiple initiatives to use cloud technology to increase the efficiency of their operations. First, they are developing their “bean-to-cup” traceability via blockchain technology. This would allow for real-time information and transparency over their supply chain system while at the same time being interactive for customers who will be able to see where their coffee is being sourced from. Starbucks is also partnering with Microsoft for initiatives like predictive drive-thru ordering and connecting of coffee-making machines.  Expanding on their mobile app which already gives recommendations for drinks based on order history, the predictive drive-thru ordering will rely on store transaction histories and more than 400 other store-level criteria such as inventory, time of day, and weather to make recommendations to customers and display them on digital boards.

A further area of Starbucks’ technological development is the future use of connected coffeemakers. By using several Azure cloud products Starbucks can connect and secure more than a dozen pieces of equipment in stores. The connected machines could then collect more than a dozen data points for every shot of coffee pulled such as the type of bean used, the temperature of the coffee, and the water quality. The idea of pulling data from the coffee machines and having it stored on the cloud is to make it easier to be more proactive about maintenance instead of reactive. Coffee machines at Starbucks operated stores can run for 16 hours a day non-stop and glitches or a breakdown of the machines can cause significant operational distributions. The connected coffee machines would help that process by allowing for more preventative maintenance to ensure fully functioning operations.

Growth in Asia, specifically China, presents a significant growth opportunity for the Company. The Chinese market for Coffee consumption is expected to grow at an annual rate of 11.3% through the next five years. Starbucks and their competitors are rapidly expanding in China. Starbucks, before the impacts of COVID-19 planned to open 500 new stores per year, driving sales in China. Competitors such as Coca-Cola’s Costa Coffee have noted China as a key market for continued growth. Chinese consumers have been noted as heavy app users, Starbucks’ easy to use and popular app-based ordering system should help fuel growth in the region. Additionally, large Chinese competitor Luckin Coffee, which looked to be expanding rapidly, was found to have faked nearly half of their roughly $732 million in sales. This provides a further tailwind to Starbucks as the legitimacy of their Chinese competitor is called into question.

In 2018 Starbucks announced with Nestle their “Global Coffee Alliance” to leverage their complementary strengths, scale, and respected consumer brands. Terms of the deal allowed Nestle to obtain the rights to market, sell, and distribute Starbucks packaged coffee and tea globally. Nestle paid Starbucks $7.15 billion in 2018 (this amount was initially recognized as deferred revenue and will be recognized as revenue on a straight-line basis over the deal term) in closing consideration and Starbucks will receive a monthly fee equal to the product of Nestle’s net sales of all products in the applicable territory during the relevant month times the applicable royalty rate which varies product by product. This relationship with Nestle provides Starbucks with a global distribution network for their brand as well as leverages Nestles single serve capsule systems (Nespresso and Nescafe Dolce Gusto). The deal creates a capital light revenue stream outside of its retail sales and institutional foodservice business, operating margins for this segment were approximately 35% compared to a total operating margin of 15% for the total company. The strategic value is evident in the current crisis with at home coffee consumption expected to increase as the pandemic is prolonged.

Valuation

Does Any of this Make Sense???

The Coronavirus has turned the world as we know it upside down. The virus has raged through the world putting confirmed global deaths at over 282,000. It has had an impact on everyone throughout the world. Through lockdowns focused on reducing the spread of the global pandemic the impact on the financial markets has been severe.

Let’s look at the S&P 500 index and what some implications of the changing fundamentals due to the current situation have on its fair value. This analysis is based on a Discounted Cash Flow model of the S&P 500 index. I am taking the current index operating levels as reported by Standard and Poor’s and applying forward looking estimates to get a sense of what the fair value of the index is. This valuation is based on forward looking estimates; therefore, the result is only as good as the estimated inputs. A further warning, this is not a recommendation to buy, sell, sell-short, enter into a straddle or strangle or any other creative strategy that you may be able to think up with your broker. Now that I have finished my disclaimer section, let us look at some of these numbers.
My analysis is based off the most recent numbers reported by the S&P, this analysis will be updated as future estimates/actual financials are reported. At the time of this writing the index currently sits around a level of $2,924.4. Future estimates are based on analyst opinions of a 24% drop in operating income in 2020 for the entire index. My analysis diverges from the estimates for 2021 however, I have placed a 10% growth rate on operating earnings in 2021 from the 2020 level. Over the last 4 years the historical average growth in operating earnings on the S&P 500 has been 10.5%. From the estimated 10% growth in 2021 I am estimating another year of historical growth in earnings and then reducing the growth rate linearly to the 10yr T-bond rate which currently is at 0.64%

Now moving on from operating earnings we get to cash returns on the index. Cash is returned to investors in two ways, the first being direct payments to investors via dividends. The second mechanism of returning cash to equity investors is buying back share. Looking at 2020 I dropped the total payout ratio (inclusive of both dividends and buybacks) by 38% from a payout ratio of 93.07% to 57.7% as companies move into survival mode and need to preserve cash. After 2020 I moved the payout ratio back to a level of 90% and increase it throughout the next 4 years to 97.8% in the terminal year. Based on these estimates, I am calculating a fair value of the index at $2,747.45, a 6% discount to the current level.

Playing around with the expected recovery in earnings in 2021 if we factor in a complete recovery in earnings in 2021 (a 25% increase over 2020 earnings) the model derives an intrinsic value of $2,924.66, or a 0.01% difference to the current level. It looks like the market is pricing a complete recovery in 2021.

Now to the interesting part, does the current market level make any sense? Honestly, I have no clue. This is an unprecedented situation where the future has never been so murky. There are a couple camps of thought however that can help lead your analysis of the situation. First, we need to think of the current economic contraction as either a supply issue, a demand issue, or a combination of the two.

A supply issue would imply that there is demand for goods and services, but the current lockdown environment is creating a barrier for that demand to translate into purchases of goods and services. With this argument a complete recovery of earnings makes sense as once the economy is fully open GDP should recover to previous levels.
A demand issue is a little more interesting. A demand issue would imply that consumers will not be purchasing at the same levels when the economy gradually reopens as fear sets in and they want to hold onto excess cash. This would point a much longer recovery in economic activity as it would take consumers much longer to be comfortable returning outside and living in the same pre-COVID manner.

A likely outcome is that we will be facing both supply and demand issues. As the outlook for re-opening the economy becomes clearer, capacity limits will play a major role. Just from common sense, capacity limits will imply lower revenues from businesses as their turnover will take hits while their fixed costs remain high. Companies with high overhead like retailers will be particularly hurt. In addition to capacity limits, a certain portion of the population will remain afraid of returning to normal activities. This would imply a contraction from both supply and demand ends.
History can be a good indicator of where we will end up in the future in this situation. Looking at the 2008 Financial Crisis for example there was a 2.5% drop in real GDP (inflation adjusted) between 2008 and 2009. Looking at the unemployment rate after the Financial Crisis it took 8 years after for the unemployment rate to recover to pre-2008 levels. Real GDP however recovered to pre-Financial Crisis levels by 2010.

Looking at the movement in the S&P 500 during the Financial Crisis, it dropped from a high of around 1,400 in May of 2008 to a low of around 670 in March of 2009, a drop of more than 50%. The index did not recover to near pre-Financial Crisis levels until after 2011.

GDP in 2020 is expected to contract by 5.6% (source: https://www.cbo.gov/publication/56335). The unemployment rate currently stands at 14.7% and by some calculations the figure rests at a near Great Depression level of 23.6% (the peak of the Great Depression was 25% unemployment rate). Hiring should pick up as businesses re-open, however looking at capacity limits and a reduced consumer demand it seems hard to believe that unemployment will reach the 3.7% at the beginning of 2019.

The reaction to the COVID-19 lockdowns by the stock market was swift and severe. The index dropped from a high of around 3,400 in February to a low of around 2240 in March a drop of 34% in the span of one month. The recovery has been just as swift as the index has jumped from the low of 2240 to the current levels of 2920, an increase of approximately 30%. This puts the current level around 14% below the highs set this year. If the economy is expected to fully recover in 2021 as I laid out in the above DCF analysis, the current recovery in the market makes sense at a fundamentals level. However, if the economy is not operating at full capacity for the remainder of this year and into 2021 the recent upswing could be out of line with reality.
Will the economy bounce back in 2021? The short answer is nobody knows. If significant progress is made towards a vaccine which can be distributed to the population there could be a recovery in 2021 which would imply that the index is close at a fair value. However, another important thing to consider is how the virus will impact operating costs which will impact overall earnings. Companies already are spending more to protect their employees from infection and while the pandemic rages on it could be expected that the trend will continue. I believe the more likely outcome than a complete recovery to 2019 levels of profitability in 2021 will be a slower longer increase in index operating earnings followed by a recovery in the index payout ratio. A key question to keep asking during times of extreme uncertainty is, does this make sense? The current recovery in the market to me does not make much sense considering the future struggles that we will face.