Starbucks Valuation

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(1)STARBUCKS VALUATION An analyst’s perspective on the past, present and future of America’s coffee giant. Prepared by Gavin Virgo Prepared for Professor Michael Reynolds ADM 4350 – Equity Valuation 8 April 2009.

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(5) . $. . $. . % Boom and Bust .................................................................................................................................................... 6 Brief Company History....................................................................................................................................... 7 Praise and Criticism............................................................................................................................................. 8 . & Global .................................................................................................................................................................... 9 The United States ..............................................................................................................................................10 Industry ...............................................................................................................................................................11 . !" Direct Competition ........................................................................................................................................... 12 McDonalds Corp. .............................................................................................................................................12 Peet’s Coffee & Tea Inc. ................................................................................................................................... 13 Tim Hortons Inc. ..............................................................................................................................................13 Indirect Competition......................................................................................................................................... 13 Nestle S.A. ......................................................................................................................................................13 Yum! Brands Inc. .............................................................................................................................................13 Competitive Forces ........................................................................................................................................... 13 Bargaining Power of Suppliers ...........................................................................................................................14 Bargaining Power of Customers .........................................................................................................................14 Threat of New Entrants.................................................................................................................................... 15 Threat of Substitute Products.............................................................................................................................15 Competitive Rivalry Within an Industry............................................................................................................ 15 . !% Strategic Transformation Initiatives ...............................................................................................................16 Reduced Customer Traffic.................................................................................................................................. 16 Commodity Costs ..............................................................................................................................................16 Economic Crisis ................................................................................................................................................17 Competition.......................................................................................................................................................17.

(6) 3 Perceived Brand Value...................................................................................................................................... 17. #%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%(-

(7) $ ! %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% (. Free Cash Flow to the Firm (FCFF) Projections .........................................................................................18 Cost of Equity ....................................................................................................................................................18 Risk-free Rate of Return ................................................................................................................................... 18 Beta .................................................................................................................................................................. 19 Market Risk Premium ..................................................................................................................................... 19 Capital Asset Pricing Model (CAPM) .............................................................................................................19 Cost of Debt.......................................................................................................................................................19 Weighted Average Cost of Capital (WACC) ................................................................................................. 19 Growth Rate.......................................................................................................................................................19 Valuation Application and Sensitivity Analysis.............................................................................................20 Implications ........................................................................................................................................................20.

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(11) The Seattle-based Starbucks Corporation. (Nasdaq: “SBUX”) is the world’s leading roaster and retailer of speciality coffee. There are more than 16,680 Starbucks stores located around the world, of which approximately 8,536 are company owned and operated.. Target:. After enjoying years of phenomenal growth and high margins, the. Recommendation:. company appears to have hit a stumbling block. $14.24 BUY. in the mid 2000s with the simple realization that such high growth is not sustainable. The stock, which had reached a high of nearly $40 per share in May 2006, nosedived, touching a low of $7.83 per share in November 2008. The stock is currently hovering around $11.19 as of April 7, 2009. After a shake-up. in the executive ranks of the company, Starbucks announced several transformation and restructuring initiatives to slow the company’s growth and trim costs. This included the closing of 600 stores in the United States, another 61 in Australia, and the elimination of 600 administrative and support positions. In addition, the company is facing significant competitive threats from major U.S quick-service restaurants, the most apparent being McDonalds. It is expected that competition from McDonalds, which has recently announced plans to open cafes within their existing restaurants, will increase pressure on profit margins and reduced Starbucks’ market share in the future. In the following analyst report, a number of methodologies have been applied to assess the value of Starbucks’ current share price and make a sound recommendation to investors. Together, these methodologies support the conclusion that. Starbucks shares are. presently relatively undervalued. A weighted blend of absolute and relative valuation methods implies that the intrinsic value of the stock is approximately $14.24 per share. This represents are 27 per cent premium over the April 7, 2009 close price of $11.19. It is likely that the share price will converge to this intrinsic value in the long-term. Given that the target price represents a substantial premium over the current price of the stock, Starbucks has been assigned a buy. recommendation..

(12) 5. Please note that this document refers to information from many sources. Where direct or indirect references have been made, they are carefully documented in the footnotes found at the bottom of each page. In some instances I have referred to the source directly within the text. All financial information within this document and used in the analysis was obtained through Starbucks financial statements, Yahoo! Finance, Mergent Online or Research Insight. Yahoo! Finance is a public data repository, which can be accessed at http://finance.yahoo.com. Mergent Online is a subscription-based database, which is available to students at the University of Ottawa. Research Insight is a subscription-based software that uses Standard & Poor’s COMPUSTAT database, and is also available to students at the University of Ottawa..

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(14) This assignment conforms to the rules and regulations on academic integrity at the University of Ottawa..

(15) 6. The Seattle-based Starbucks Corporation (Nasdaq: “SBUX”), formed in 1985, is the “world’s leading roaster and retailer of specialty coffee.”1 There are more than 16,680 stores operating under the Starbucks banner in regions all over the world, including the Americas, Europe, Middle East, Africa and the Asia Pacific. Of these, approximately 8,536 stores are companyowned and are disproportionately located in the United States. The company’s self-stated business description, according to the 2009 annual report is as follows: “Starbucks … purchases and roasts high-quality whole bean coffees and sells them, along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended beverages, a variety of complementary food items, a selection of premium teas, and coffee-related accessories and equipment, primarily through Company-operated retail stores.”2. .

(16) Notwithstanding the financial environment that is wreaking havoc on U.S. markets and the global economy, Starbucks is in the midst of a crisis of its own. Having reached a high of nearly $40 per share in May 2006, the stock has since plummeted falling as low as $7.83 in November of 2008. While much of this can be attributed to the U.S. economic meltdown and deteriorating business conditions, Starbucks is also in the midst of a great transformational challenge. Once thought to be a “hot growth stock,” expectations have plunged as analysts, investors, and management have come to realize that some markets have become super-saturated with Starbucks stores.3 There has been a revelation in the investment community and awakening to the fact that there is a limit to the demand for coffee, espresso, lattes, and Frappucinos – which was once thought to be insatiable.4 In addition, Starbucks is now facing major competitive threats from much bigger rivals seeking to enter the lucrative gourmet coffee market. As a result, the beleaguered company has responded with a number of changes and transformational initiatives. In January 2008, Starbucks announced a surprise change in leadership as Chairman and company founder Howard Schultz fired Chief Executive Officer Jim Donald and took on that role himself. Schultz announced a back-to-the-basics “longStarbucks 2009 Annual Report Starbucks 2009 Annual Report 3 Karen Blumenthal, Grande Expectations: A Year in the Life of Starbucks’ Stock, Crown Business: New York, 2007, p. 12 4 Frapuccino is a Starbucks trademark, referring to a line-up of cold-blended coffee-based beverages. 1 2.

(17) 7 term” approach for the company that would deliberate slow the company’s growth and attempt to rekindle customers’ “emotional attachment” to Starbucks.5 While it is too early to see whether this gamble will pay off, it is clear that many investors have opted not to stick around and find out. Given the high degree of uncertainty surrounding the company and the stated long-term approach to building shareholder value, is it possible that Starbucks has become an investment opportunity for value investors? This is the very question that this report sets out to address. By attempting to identify the intrinsic value of the Starbucks Corporation and comparing this value to the current share price, it is possible to determine whether this security represents a valuable opportunity for investors..

(18) Starbucks has an epic and storied history, which has been documented extensively in company literature, on the Internet and in many books that have been written about the company. Reborn into its modern, more recognizable form in 1985, the first Starbucks was located in the heart of the Pike’s Place fish market in Seattle in 1971. Founded by three partners, the company sold dark-roasted, high-quality whole bean Arabica coffee. The store, which did not sell prepared coffee beverages, was moderately successful and popular among locals. In 1982, Starbucks’ current Chairman and Chief Executive Officer, Howard Schultz, joined the company. Working in the capacity of Director of Retail Operations and Marketing, Schultz travelled to Italy in 1983 where he witnessed “the romance of Italian espresso,” and became determined to bring this experience to Starbucks.6 However, the three original Starbucks partners stood in Schultz’ way and resisted to the changes that he proposed: namely, that Starbucks begin selling prepared coffee and espresso beverages in-store. Then, with the support of Starbucks, Schultz began his own company called Il Giornale to test his idea. Il Giornale offered customers prepared coffee beverages made from Starbucks’ own beans, and was an instant success. Looking to expand his new company, Schultz acquired Starbucks and its assets in 1987 and changed the company’s name to Starbucks Corporation. In 1991, Starbucks completed an initial public offering (“IPO”) and began trading on the Nasdaq under the symbol “SBUX.” Over the years, Starbucks continued to expand at a supersonic growth rate, both in the U.S. and abroad. The company and its stock, by extension, continuously outperformed the “In a jolt, Starbucks fires CEO, replaces him with Schultz,” Seattlepi.com. Retrieved from http://www.seattlepi.com/business/346397_sbuxdonald08.html on 7 April 2009. 6 Howard Schultz, Pour Your Heart Into It, Hyperion: New York, 1997, p. 56 5.

(19) 8 market and surpassed the expectations of analysts and investors. In 2005 the stock was so hot that it was widely regarded as a “must-have” for fund managers and often used to “window-dress” portfolios.7 Shortly after this, however, the Starbucks engine began to sputter. The first indication came in the form of “declining comps” – referring to comparable same-store sales – a key organizational health indicator for analysts. This was regarded as a sign that Starbucks was approaching (if it had not already reached) the peak of its growth, which was previously thought to be limitless. In January 2008, Howard Schultz, the company founder and chairman, returned to the role of CEO after an eight-year hiatus, announcing a renewed focus on building brand loyalty and rekindling the “emotional attachment” with customers.8 Nearly simultaneously, Schultz announced plans to close more than 600 underperforming U.S. company-operated retail stores and 61 more stores in Australia.9 Soon after, the company announced plans to eliminate more than 600 administrative and support “non-store” positions in an effort to trim costs.10 In fiscal 2008 and first quarter 2009, Starbucks reported $342.4 million in “restructuring costs” related to these measures resulting in a substantial decline in year-overyear earnings..

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(21) Over the many years of operations, Starbucks has received its share of praise and criticism. The company has strived to build a reputation for caring for employees and community involvement. Some initiatives to this effect include: • • • •. •. granting health benefits to full and part-time staff; offering employee stock option and purchase programs to full and part-time staff; promoting child and adult literacy through numerous book drives and the Starbucks Foundation, which supports local literacy programs; forming Urban Coffee Opportunities, a joint-venture with celebrity Earvin “Magic” Johnson to introduce the Starbucks brand to underdeveloped urban and suburban communities; introducing coffee sourcing guidelines and committing to make some purchases of fair trade coffee.. Window-dressing refers to a strategy used by portfolio managers to enhance the appearance of performance. Fund managers purchase the hottest and best performing stocks to literally “dress-up” their portfolios (especially toward the end of a reporting period), so that it appears that they were insightful enough to purchase these high-performing securities. 8 “In a jolt, Starbucks fires CEO, replaces him with Schultz,” Seattlepi.com. Retrieved from http://www.seattlepi.com/business/346397_sbuxdonald08.html on 7 April 2009. 9 Starbucks Coffee Company, Announcement to Customers. Retrieved from http://www.starbucks.com/australia/ on 7 April 2009 10 “Starbucks turns to customer ideas,” BBC News. Retrieved from http://news.bbc.co.uk/2/hi/business/7338448.stm on 7 April 2009 7.

(22) 9 However, on the other side of the coin, the company is a popular target for criticism and has been denounced for its labour practices and alleged unethical conduct with regard to its purchasing practices and supply chaining. Criticism related to labour practices is often made with respect to the fact that the company is decidedly anti-union, and has engaged in mischievous, and at times illegal, behaviour in order to discourage or stomp out employees’ efforts to form unions. Starbucks has been accused of the mistreatment and exploitation of coffee farmers, who are overwhelmingly representative of the poorest parts of the world. While the company has committed to purchasing some “fair-trade certified” coffee, this amount represents a tiny fraction of Starbucks’ total coffee purchases. In addition, the company and its representatives have, at times, publically lambasted the fair trade model of business, asserting that this business model distorts incentives for farmers and results in the purchase of poor quality coffee beans..

(23) As of the end of the first quarter of 2009, the outlook for the global economy is bleak. According to the IMF, world growth is expected to fall to just 0.5 per cent, the lowest rate seen since the Second World War.11 Increasingly, the effects of the U.S.-born subprime meltdown and credit crisis are being felt around the globe, hammering both advanced and emerging economies. In 2009, output in advanced economies is expected to contract by 2 per cent, while growth in emerging economies will “slow sharply from 6 per cent in 2008 to 3 per cent in 2009.”12 In addition, the IMF notes, the current economic environment has produced “dampened inflation pressures” and “some advanced economies are expected to experience a period of very low (or even negative) consumer prices increases.”13 Financial markets are in freefall around the world, and virtually all industrialized nations are pursuing fiscal and monetary stimulus packages in order to curb this sharp and painful recession. Furthermore, the financial crisis has created a “pernicious feedback loop” between the financial and real economy.14 Uncertainty and fear in the face of reduced wealth and asset. 11 January 28, 2009 World Economic Outlook Update, International Monetary Fund. Retrieved from http://www.imf.org/external/pubs/ft/weo/2009/update/01/ on 7 April 2009 12 Ibid. 13 Ibid. 14 Ibid..

(24) 10 values has “prompted households and businesses to postpone expenditures, reducing demand for consumer and capital goods.”15 The IMF notes that the most recent World Economic Outlook Update is characterized by an “unusually large” amount of uncertainty.16 It is clear that “Strong and complementary policy efforts are needed,” which should lead to a gradual recovery beginning in 2010.17.

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(27) The United States, which has lead the economic collapse among more advanced economies, continues to bear the brunt of the financial crisis. All indicators imply that the economy continues to be battered, despite the efforts of the administration of a new Democratic president: Barack Obama. According to a March 2009 Country Report, authored by the Economist Intelligence Unit, “GDP growth contracted by 6.2 per cent in the fourth quarter of 2008” and “Indicators have remained poor in recent months,” suggesting that the contraction will continue.18 It is expected that president Obama, who was warmly welcomed to the White House in January, “will generally seek to co-operate more with allies” opting for more multi-lateral solutions as opposed to the solo approach preferred by the previous administration.19 The new administration will primarily focus on “containing the financial and economic crisis,” beginning with a $787 billion stimulus package that was signed into law in February.20 A financial rescue package put forward by the Obama administration “received a cold response from financial markets” and it appears that some major financial institutions will have to be nationalized in the coming months.21 There are indeed some signs of increased stabilization in the financial system, although this is primarily a result of policy measures and “financial conditions remain very tight.”22 Current US stock market performance is characterized by extreme volatility. Every key index has lost value since the beginning of the year. As of March 31, the Dow Jones Industrial Average has retreated nearly 16 per cent in 2009. The S&P 500 index and Nasdaq Composite index have shaved 14 per cent and 6 per cent of their respective values. Market performance is illustrated in Figure 1, below.. Ibid. Ibid. 17 Ibid. 18 March 2009 Country Report: United State of America, The Economist Intelligence Unit. 19 Ibid. 20 Ibid. 21 Ibid. 22 Ibid. 15 16.

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(37) . %* $#* !'. "" '. Figure 1 - Performance of Broad U.S. Market Indices, First Quarter 2009. Optimism seems to be fading among investors who have so far remained largely unresponsive to the economic stimulus package and efforts of the Obama administration. This seeming lack of confidence is reflected in the fact that a disproportionate number of U.S. stocks are trading below their 200-day moving average, a key technical indicator for investors. It is now clear that U.S. markets have not yet reached the trough and the question investors are asking is just how far can they fall?. The food-service industry has been especially hard hit by the ongoing severe global recession. The performance of restaurants and specialty eateries, like Starbucks, are heavily dependent on consumer discretionary spending. Consumers, who are growing concerned about the safety of their jobs and retirement savings, are spending significantly less and it is showing up in the form of reduced revenues. In the coffee-retailing industry, Starbucks is facing increased competitive pressures. Major fast-food retailers and other quick-service restaurants have awakened to the high demand for, and lucrative margins from sales of gourmet coffee. Coffee costs have remained relatively stable in recent times (shown in Figure 2) and have not had a substantial price impact on coffee-retailers and quick-service restaurants in 2008..

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(39) . 12. . Figure 2 Average Monthly Coffee Prices based on the International Coffee Organization Composite, U.S. Cents per Pound.

(40) Starbucks faces stiff competition that has only been heating up even further in recent times. In the past, the company has made attempts to differentiate and stand out, which can make comparison difficult. Starbuck’s competition consists of both direct and indirect competition..

(41) Starbucks’ competed directly against competitors that offer similar product offerings – namely, prepared coffee beverages.

(42) McDonalds Corp. (NYSE: MCD) represents the number one threat to Starbucks’ at this point in time. The globally recognized fast-food heavyweight has recently announced its foray into the specialty coffee segment, and its intention to take Starbucks on headfirst. In what is being characterized as the American “latte wars,” McDonalds is rapidly adding coffee capabilities to select locations of its more than 30,000 restaurants around the world, and attempting to mimic the Starbucks model.23 McDonalds is a highly successful organization with resources that cannot be matched by Starbucks. There is no question that a successful entry into this market would significantly eat away at Starbuck’s profits and margins. 23. “The Latte Wars,” Newsweek. Retrieved from http://www.newsweek.com/id/91497 on 7 April 2009.

(43) 13 Peet’s Coffee and Tea (NASDAQ: PEET) is a coffee roaster and market of coffee with a moderate presence in the mid-West and West United States. The company sells coffee, tea, brewing equipment, mugs and accessories through many channels including company operated retail stores, grocery stores and foodservice accounts. As of the end of 2008, Peet’s had 188 retail stores and reported revenues of $284.8 M. Tim Hortons Inc. (NYSE: THI) is “engaged in the development and franchising of quickservice restaurants that serve food such as hot and cold coffee, baked goods, sandwiches and soups.” The company has a significant presence in Canada, with more than 2,800 stores, and approximately 400 more located in the U.S. While the company does not focus on gourmet coffees and espresso sought by coffee aficionados, it nonetheless remains and important competitor to Starbucks. Tim Hortons’ revenue in 2008 was in excess of $2.04 billion.. Nestle S.A. (SIX: NESN) is a Switzerland based holding company with 2007 revenues of more than $107.6 billion. Nestle is primarily engaged in food processing. The company produces Nescafe coffee, which is sold at grocery stores all over the world. This company competes indirectly with Starbucks since it offers coffee through a different distribution channel, but is an important competitor, nonetheless.

(44) Yum! Brands (NYSE: YUM) is a quick-service restaurant company that operates and franchises companies such as KFC, Pizza Hut, Taco Bell, Long John Silvers, and A&W AllAmerican Food Restaurants. Although the company does not compete in the gourmet coffee business, it competed with Starbucks’ and others for a portion of consumers’ discretionary spending. Yum Brands reported 2008 revenues of $11.3 billion.. While it useful to have an understanding of the competitive environment that Starbucks currency faces, it is important to recognize that the competitive landscape is dynamic, rather than static, and constantly changing. Thus, it would be prudent to identify trends and possible outcomes in this environment. Porter’s Five Forces Analysis model is applied below to provide insight to this environment:.

(45) 14 . Starbucks purchases high quality Arabica coffee from coffee growing regions throughout the world, with the majority of supply coming from Latin America, Africa and the Asia/Pacific regions. However unfortunate, the traditional and basic nature of the work often entails farmers working in poverty conditions or at subsistence wages. Thus, historically, coffee farmers have not been able to exercise a great deal of bargaining power in negotiations with Starbucks. Rising awareness of the plight of coffee farmers in the last decade has resulted in the increasing popularity of social movements encouraging ethical purchasing and consumption of coffee. At times, Starbucks has been targeted and criticized for its alleged exploitation of coffee farmers and unethical purchase practices. The company has taken some steps to address this including a attempting to develop and implement ethical coffee purchasing guidelines and sustainability plans. However, these efforts have been unexceptional and will do little to appease Starbucks’ harshest critics. Looking down the road, it is likely that supplier bargaining power will continue to increase marginally in the future as social movements continue to attract the attention of consumers, and coffee farmers become more advanced and able to collaborate. However, it is unlikely that this bargaining power will be significant enough to have a material impact on Starbucks’ cost of goods. .

(46) Historically, Starbucks’ marketing machine has been highly successful at attracting and retaining customers with the promise of a high-quality product and customer service experience. In addition, the company has resorted to efforts such as promotion of gift cards in order to win the loyalty of consumers. However, the company must continue to innovate in this area in order to retain the loyalty of increasingly fickle consumers. Today, consumers have an increasing number of options when it comes to their morning coffee – namely, the aforementioned competitors. Consumers are especially sensitive to price and will likely take their business where they can get the most value for money. The recessionary pressures of the current financial environment will only serve to exacerbate this. In the retail environment, buyer power is high and will only continue to increase as the competition heats up. Looking foreword, this represents a moderate threat and will likely put downward pressure on Starbucks’ margins as customers demand lower prices or threaten to switch to a competitor..

(47) 15 The barriers to entry in the coffee-retailing business are relatively low. As a commodity, coffee is typically purchased on a per pound basis meaning that Starbucks’ cannot benefit significantly from economies of scale. Furthermore, while the company does possess a number of patented products and trade secrets, it is not in possession of significant proprietary technologies that cannot be easily duplicated. Starbucks uses commercially available equipment such as coffee brewers, espresso machines, blenders, etc. which can be easily acquired by any competing operation. Indeed, many major competitors and smaller chains have thrived by adopting or mimicking Starbucks’ strategy. In the long-term, the threat of new entrants represents a possible and probable risk to Starbucks. Rivals, attracted by the high margins that Starbucks has historically obtained, are quickly moving into coffee retailing and putting downward pressure on Starbucks margins.

(48) As a retailer of a product derived from a commodity, there is little that Starbucks can do to differentiate its physical product. The physical properties of the product are largely derived from the quality of the ingredients used and how they are processed – only some of which are under Starbucks’ own control. The quality of coffee, for instance, may depend on the growing, harvesting, processing, roasting and brewing stages. Here, only roasting and brewing are directly under Starbucks’ control. Coffee growing, harvesting, and processing stages are carried out by the individual farmers. Consequently, Starbucks has attempted to differentiate its products on the basis of customer service and the in-store experience, which has often been characterized as the “Starbucks Experience.”24 The threat of substitute products from competitors and other retailers poses a serious threat to Starbucks future revenue and profitability. As a purveyor of a commodity-based product, Starbucks does not benefit from product differences that typically influence competitive rivalry. This is especially true given the increasingly popularity and availability of “premium” coffees, which has been Starbucks’ basis for differentiating itself in the past. While the company has previously benefitted from a very strong brand identity, there is some evidence suggesting that brand loyalty is eroding.. 24. The essence of the Starbucks Experience is outlined in a book of the same name..

(49) 16 Competitor rivalry represents a serious threat for Starbucks. As more competitors attempt to capitalize on the growing demand for gourmet coffee and lucrative profit margins, Starbucks’ own market share and margins are likely to be diminished.. Starbucks is subject to a number of operational risks that may have an adverse impact on the company’s performance if they were to materialize. A detailed list of conceivable risks facing the company is discussed at length in the Starbucks’ annual report. Some of the most important and most probable risks are outlined and discussed briefly below..

(50) When Howard Schultz returned as the Starbucks CEO in 2008, the company soon after announced a number of strategic transformational initiatives to bring the company back to the basics and build long-term shareholder value. This included, but was not limited to, a plan to close 600 underperforming stores in the U.S. market and a corporate-level restructuring that would eliminate about 700 non-store jobs. The company also spent considerable resources developing and implementing a new special coffee – Pike’s Place Roast – and revised brewing methods and standards for stores around the world. This was intended to represent the beginning of a renewed focus on coffee that management hopes will translate to higher sales and loyalty. These, and other, changes that the company is pursuing come with a myriad of risks. For instance, the company may not realize the expected cost savings from the restructuring efforts in the desired time frame, or perhaps at all. Management expects that investments in the business and development of new offerings like Pike’s Place Roast will yield a stream of future benefits for the company. It is possible that these benefits have been overstated or that these efforts will not be enough to reinvigorate the brand.

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(52) Starbucks may suffer from reduced customer traffic to the increased presence of competitors, the declining demand of gourmet coffee, or negative publicity regarding the company. Any of these factors, none of which can be predicted with certainty, would have an adverse affect on Starbuck’s business performance. Starbucks purchases large amounts of green coffee and dairy products, which are often subject to wide price fluctuations.25 Although risk exposure to volatile coffee prices can be 25. “Green coffee” refers to the coffee beans that Starbucks purchases from its suppliers in its raw green state, before it is roasted..

(53) 17 effectively hedged, it is much more difficult to hedge against commodities such as fluid milk. Thus, Starbucks is exposed to volatility in dairy prices.

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(56) A severe global recession is currently in progress. As a retailer that is “dependent on consumer discretionary spending,” Starbucks’ business is likely to suffer in the near future since consumers will have less discretionary income available. Management expects that this will “negatively impact the Company’s financial performance,” though it is difficult to estimate the extent.

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(58) As noted previously, Starbucks is presently facing a serious competitive threat from McDonalds – a fast-food giant with a strong global presence. McDonalds has comparatively more resources and quick-service experience than Starbucks. Even a semi-successful foray into gourmet coffee would have significant adverse effects for Starbucks.

(59) The Starbucks brand is highly valued and it is necessary for the company to maintain this perception of brand value going forward in order to take on emerging competitive threats. As a result, incidents or scandals that erode consumer trust or perceived brand-value of Starbucks would be disastrous for the company..

(60) Considering the current economic turmoil and unique transformational circumstances specific to Starbucks, placing a valuation on this company is a challenging and complex task. In the following section, multiple methods have been applied for the purpose of determining the intrinsic value of Starbucks including: • • •. an analysis of the discounted free cash flow to the firm; an examination of relevant valuation comparables; a review of performance metrics and organizational health indicators.. Given the enormity of the task at hand, in some instances, it is necessary to make certain assumptions. These assumptions are based on the views of company management, analysts, or are otherwise backed up by supporting material. In instances where assumptions have been made, they are carefully identified and justified..

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(62) As a non-dividend paying company, the only suitable absolute model to use in the valuation of Starbucks is a discounted free cash flow model. Since Starbucks’ has had relatively volatile earnings and cash flow in the recent past, a model analyzing the free cash flow to the firm (FCFF) is the best choice for valuation.. !"

(63) A summary of Starbuck’s FCFF calculations, five years forward, is presented in the table below: Table 1 - 5-Year FCFF Projections for Starbucks Corp. 2008 A. 2009 E. 2010 E. 2011 E. 2012 E. 2013 E. EBIT(1-T). 535,423. 214,708. 214,708. 225,443. 236,715. 248,551. +Dep. 549,300. 518,682. 504,401. 534,291. 576,418. 621,627. -FCInv. 626,029. -419,224. -145,871. 305,316. 430,305. 461,790. -WCInv. 31,517. 26,848. 36,731. 49,357. 65,407. 85,716. FCFF =. 427,177. 1,125,765. 828,249. 405,061. 317,422. 322,672. A close look at Table 1 reveals that EBIT is expected to continue to decline through 2010 as Starbucks faces increased competition and the effects of the global recession. Depreciation will continue to increase at a steady rate as the company continues to invest in fixed assets, which, in turn are a function of sales revenue. Note that capital expenditure, as a percentage of sales, will continue to decrease in the future as the company deliberately attempts to slow the growth of company-operated retail stores, in accordance with its transformational strategy (previously discussed.) Full details on the Starbucks FCFF calculation can be found in Appendix A.. As a U.S. based public corporation, the relevant risk-free rate of return is that of short-term (3-month) U.S. Treasury bills..

(64) 19 As of April 2009, that rate is 0.2%, annually.26 Starbucks beta is 0.93, indicating a relatively strong covariance with broad market indices. The market risk premium applied to the valuation is 6.5 per cent. This risk premium is based on an academic survey of more than 1000 professors in 2008.27 ! Based on the above-listed inputs, a simple application of CAPM reveals that Starbucks’ cost of equity is approximately 8.05 per cent..

(65) Starbucks’ Corp. has historically had a very clean balance sheet. In 2007 the company issued $550 million in senior notes at 6.25 per cent. The notes are due on August 15, 2017. Once the tax shield provided by the tax deductibility of interest is taken into account, the after tax cost of debt is approximately 4.26 per cent.. ! Starbuck’s long-term debt to total capital ratio is approximately 18.08 per cent. The company has not announced any plans to change the capital structure in the foreseeable future, so it is assumed that this will remain constant. Based on this assumption, Starbuck’s WACC is approximately 7.36 per cent.. The estimated FCFF growth rate is a key determinant of the intrinsic value in a discounted cash flow analysis due to the important of the terminal value. It is difficult to estimate this growth rate in such a turbulent environment, and therefore, it would be prudent to be mindful of the valuation’s sensitivity to this estimate. Consequently, a table has been prepared below using a range of growth rates with 4 per cent identified as the most likely outcome.. Note that this rate is relatively low by historical standards. The financial and economic crisis has resulted in a flight to safety in the form of U.S. government bonds. 27 Pablo Fernandez, “Market Risk Premium Used in 2008: A Survey of More than a 1,000 Professors.” Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1344209 on 7 April 2009. 26.

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(67) Table 2 - Discounted Free Cash Flow to the Firm Valuation and Sensitivity Analysis for Starbucks Corp. Growth Rate 3%. .4%. 5%. Firm Value. 7,904,048. 9,561,959. 12,624,868. Equity Value. 7,354,448. 9,012,359. 12,075,268. $10.05. $12.32. $16.51. $9.92. $12.15. $16.28. Implied Share Value Basic Diluted.

(68) The above table indicates a range of possible intrinsic values for Starbucks’ stock, given various growth assumptions. A close look at the table reveals that the implied share price is indeed quite sensitive to the growth rate. At a four per cent free cash flow growth rate, the estimated intrinsic value of the share price is $12.15. As of April 7, 2009, Starbucks ended the trading day at $11.19. Therefore, the stock is only slightly relatively undervalued in comparison to the estimate. This amount is so marginal that we would consider the stock to be priced near perfectly.. Methods of absolute valuation can and should be supplemented by relative valuation techniques. By analyzing comparables and multiples, it is possible to refine and develop support for the conclusions using absolute valuation methods..

(69) A table illustrating the trailing and forward P/E ratios for Starbucks and select competitors is shown below in Table 3..

(70) 21. Table 3 - Forward and Trailing P/E Ratios for Starbucks Corp. and Select Competitors Company McDonalds Nestle. Forward P/E29. Trailing P/E28 14.72 -. 13.29 -. Peet's Coffee and Tea. 26.94. 19.91. Starbucks. 48.23. 13.32. Tim Hortons. 20.91. 15.39. Yum! Brands. 14.66. 12.46. 25.092. 14.874. Competitor Average. An analysis of the above table reveals that Starbucks has a comparatively high P/E ratio than that of all competitors and the industry average. Starbucks, which has a trailing P/E ratio of 48.23, could be relatively overvalued as investors have paid more for each dollar of earnings. One possible reason for this has been the poor and volatile performance of the company, especially in the last twelve months. In 2008, profit dropped more than 53 per cent as the company incurred more than $266.9 million in restructuring costs. Note, however, that other competitors (also competing for consumer discretionary spending) faced the same deteriorating economic conditions meaning that these effects should be factored into their P/E ratios. For these reasons, it may be prudent to refer to the forward P/E multiple when conducting a relative valuation. Comparing Starbucks’ forward P/E multiple to those of its competitors reveals that Starbucks is relatively on part with its competitors with a forward P/E ratio of 13.32.

(71) Based on the industry average trailing P/E of 25.092, the implied share price of Starbucks is $23.34.30 However, adjusting for the fact that Starbucks’ own exceptionally high trailing P/E. Trailing, 12 months moving Forward, fiscal year-end 2010 30 Based on reported 2008 EPS of 0.93 (basic and diluted) 28 29.

(72) 22 ratio has undue influence on the industry average, the share price estimate declines to $17.96.31. A table illustrating the price-to-book ratios for Starbucks and select competitors is shown below in Table 4. Note that Yum! Brands has been excluded from this calculation since it has an exceptional P/B ratio of -127, reflecting the unique conditions of that company. Table 4 - Price-to-book Ratios for Starbucks Corp. and Select Competitors Company. Price-to-book. McDonalds Nestle. 4.62 -. Peet's Coffee and Tea. 1.97. Starbucks. 3.2. Tim Hortons Yum! Brands Competitor Average. 5.16 3.738. An analysis of the table above reveals that Starbucks may be relatively undervalued when compared to it two largest competitors and the competitor average.

(73) Using the competitor average P/B ratio, the estimated value of a Starbucks share is $10.99 (basic) and $10.88 (diluted.). A table illustrating the EV/EBITDA ratios for Starbucks and select competitors is shown below in Table 5.. 31. Industry average trailing P/E multiple is 19.31 when Starbucks is excluded.

(74) 23. Table 5 - EV/EBITDA Ratios for Starbucks Corp. and Select Competitors Company. EV/EBITDA. McDonalds Nestle. 9.00 -. Peet's Coffee and Tea. 8.76. Starbucks. 8.18. Tim Hortons. 9.21. Yum! Brands. 8.22. Competitor Average. 8.67. An analysis of the table above reveals that Starbucks is approximately in line with EV/EBITDA ratios of other firms in its industry. Starbucks EV/EBITDA is slightly lower than the competitor average indicating that the firm may be slightly undervalued based on its EBITDA..

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(76) The various conclusions reached using absolute and relative valuation methods can be blended to reach a single target price for the stock – and the basis for a recommendation. Below, in Table 6, conclusions from prior analysis are blended to reach a single share price. Table 6 - Blended Target Share Price for Starbucks Corp. Analysis Method. Estimated Intrinsic. Discounted Free Cash. P/E Implied Share. P/B Implied Share. Flow to the Firm. Price. Price. $12.32. $23.34. $10.88. 60%. 40%. 40%. Value Weight Given to Method Blended Target Price = $14.24.

(77) 24 Based on the blended analysis, using the estimated share prices and weights shown above, the target price for shares of Starbucks Corp. is $14.24. This represents a 27 per cent premium over the April 7, 2009 close price of $11.19.. STRONG BUY. $14.24. BUY HOLD SELL STRONG SELL. A through analysis of Starbucks Corp. indicates that the stock is currently undervalued at 11.19 (close price as of April 7, 2009.) It is probable that the stock price is currently being battered by economic uncertainty and investor risk-aversion to the potential for further losses in the stock market. Also, the current stock price may be an overreaction to disappointing results in the first quarter of 2009. However, these results have been taken into consideration in the discounted cash flow analysis – accompanied by very modest growth expectations for the future. It should also be noted that while recent financial results have been somewhat concerning, the company is taking strides to address this through a number of restructuring and transformation initiatives. As the company faces increasing competition in the future, Starbucks will likely experience reduced sales and earning growth, with margins lower than the company has typically achieved in the past. However, this is the new reality for this company. No longer a hot growth stock, Starbucks is making a rapid transition into its mature phase. Investors have penalized the company heavily during this transition, making it a valuable investment opportunity..

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(81) . Starbucks Corp. As Reported Annual Balance Sheet. 10/03/2004. 10/02/2005. 10/01/2006. 09/30/2007. 09/28/2008. Currency. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. Auditor Status Consolidated. No. No. No. No. No. Scale. Thousands. Thousands. Thousands. Thousands. Thousands. -. Operating funds & interest bearing deposits. 219,809. 62,221. 84,943. -. 79,319. 111,588. 227,663. -. Cash & cash equivalents Short-term investments - available-for-sale securities. 299,128. 173,809. 312,606. 281,261. 329,082. 95,379. 87,542. 83,845. 3,000. Short-term investments - trading securities. 24,799. 37,848. 53,496. 73,588. 49,500. 142,457. 193,841. 228,098. 291,125. 334,000. 2,231. 3,079. 3,827. 3,200. 4,500. Accounts receivable, net. 140,226. 190,762. 224,271. 287,925. 329,500. Unroasted coffee. 377,700. Money market funds. Accounts receivable, gross Less: allowance for doubtful accounts. 269,800. 233,903. 319,745. 328,051. 339,434. Roasted coffee. 46,070. 56,231. 80,199. 88,615. 89,600. Other merchandise held for sale. 81,565. 109,094. 146,345. 175,489. 120,600. Packaging & other supplies. 61,125. 61,229. 81,627. 88,120. 104,900. 422,663. 546,299. 636,222. 691,658. 692,800. Prepaid expenses & other current assets. 71,347. 94,429. 126,874. 148,757. 169,200. Deferred income taxes, net. 81,240. 70,808. 88,777. 129,453. 234,200. 1,368,485. 1,209,334. 1,529,788. 1,696,487. 1,748,000. Inventories. Total current assets Long-term investments - available-for-sale securities Equity method investments Cost method investments Other investments Equity & other investments Equity & cost investments. 135,179. 60,475. 5,811. 21,022. 71,400. 152,511. 189,735. 205,004. 234,468. 267,900. 16,430. 8,920. 11,283. 24,378. 34,700. 2,806. 2,806. 2,806. 171,747. 201,461. 219,093. -. -. -. -. 258,846. -. -. 302,600. Land. 13,118. 13,833. 32,350. 56,238. 59,100. Buildings. 66,468. 68,180. 109,129. 161,730. 217,700. 1,497,941. Leasehold improvements. 1,947,963. 2,436,503. 3,103,121. 3,363,100. Store equipment. -. 646,792. 784,444. 1,002,289. 1,045,300. Roasting equipment. -. 168,934. 197,004. 208,816. 220,700. Roasting & store equipment Furniture, fixtures & other property, plant & equipment Work in progress Property, plant & equipment, at cost Less: accumulated depreciation & amortization Property, plant & equipment before workin-progress. 683,747. -. 415,307 -. 476,372. -. 523,275. -. 559,077. 517,800. -. 293,600. 2,676,581. 3,322,074. 4,082,705. 5,091,271. 5,717,300. 1,298,270. 1,625,564. 1,969,804. 2,416,142. 2,760,900. 1,378,311. 1,696,510. 2,112,901. 2,675,129. -. 93,135. 145,509. 174,998. 215,304. -. 1,471,446. 1,842,019. 2,287,899. 2,890,433. 2,956,400. Other assets. 85,561. 72,893. 186,917. 219,422. 261,100. Other intangible assets. 26,800. 35,409. 37,955. 42,043. 66,600. Work in progress Property, plant & equipment, net.

(82) 26 Goodwill Total assets Commercial paper & short-term borrowings. 68,950. 92,474. 161,478. 215,625. 266,500. 3,328,168. 3,514,065. 4,428,941. 5,343,878. 5,672,600. 710,248. 713,000. Accounts payable. 199,346. 220,975. 340,937. 390,836. 324,900. Accrued compensation & related costs. 208,927. 232,354. 288,963. 332,331. 253,600. 65,873. 44,496. 54,868. 74,591. 136,100. Accrued occupancy costs Accrued taxes Insurance reserves. -. 63,038 -. -. 78,293 -. 94,010 -. 92,516. 76,100. -. 152,500. Other accrued expenses. 123,684. 198,082. 224,154. 257,369. 164,400. Deferred revenue. 121,377. 175,048. 231,926. 296,900. 368,400. 735. 748. 762. 775. 277,000. 700,000. Current portion of long-term debt Short-term borrowings. -. Total current liabilities. 782,980. Deferred income taxes, net. 46,683. 1,226,996 -. -. 1,935,620 -. 700 -. 2,155,566 -. 2,189,700 -. Senior notes. -. -. -. -. Other long-term debt. -. -. -. -. 400. Long-term debt. -. -. -. -. 549,600. Long-term debt. 3,618. 2,870. 549,200. 1,958. 550,121. 203,903. 271,736. -. Deferred rent. -. -. Unrecognized tax benefits. -. -. Asset retirement obligations. -. -. 34,271. 43,670. 44,600. Minority interest. -. -. 10,739. 17,252. 18,300. -. 303,900. -. 60,400. Other long-term liabilities. -. -. 13,944. 21,416. 15,200. Other long-term liabilities. -. -. 262,857. 354,074. 442,400. Other long-term liabilities Total liabilities. 8,132 -. Common stock Other additional paid-in capital Retained earnings (accumulated deficit) Net unrealized holding gains (losses) on available-for-sale securities Net unrealized holding gains (losses) on hedging instruments Translation adjustment Accumulated other comprehensive income (loss) Total shareholders' equity. 193,565 -. -. -. -. 2,200,435. 3,059,761. 3,181,700. 956,685. 90,968. 756. 738. 700. 39,393. 39,393. 39,393. 39,393. 39,400. 1,461,458. 1,939,359. 2,151,084. 2,189,366. 2,402,400. -254. 1. -4,100. -. -. -. -. -6,416. -27,051. -22,200. -. -. 43,943. 81,670. 74,700. 29,219. 20,914. 37,273. 54,620. 48,400. 2,486,755. 2,090,634. 2,228,506. 2,284,117. 2,490,900.

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(86) As Reported Annual Income Statement. 10/03/2004. 10/02/2005. 10/01/2006. 09/30/2007. 09/28/2008. Currency. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. Auditor Status Consolidated. No. No. No. No. No. Scale. Thousands. Thousands. Thousands. Thousands. Thousands. Company-operated retail revenue. 4,457,378. 5,391,927. 6,583,098. 7,998,265. 8,771,900. Specialty licensing revenue. 565,798. 673,015. 860,676. 1,026,338. 1,171,600. Specialty foodservice & other revenue. 271,071. 304,358. 343,168. 386,894. 439,500. Total specialty revenue. 836,869. 977,373. 1,203,844. 1,413,232. 1,611,100. Total net revenues. 5,294,247. 6,369,300. 7,786,942. 9,411,497. 10,383,000. Cost of sales including occupancy costs. 2,198,654. 2,605,212. 3,178,791. 3,999,124. 4,645,300. Store operating expenses. 1,790,168. 2,165,911. 2,687,815. 3,215,889. 3,745,100. Other operating expenses. 171,648. 197,024. 260,087. 294,136. 330,100. Depreciation & amortization expenses. 280,024. 340,169. 387,211. 467,160. 549,300. General & administrative expenses. 304,293. 357,114. 473,023. 489,249. Restructuring charges. -. Total operating expenses Income from equity investees Operating income (loss) Interest & other income, net Interest expense. -. -. 456,000. -. 266,900. 4,744,787. 5,665,430. 6,986,927. 8,465,558. 9,992,700. 60,657. 76,745. 93,937. 108,006. 113,600. 610,117. 780,615. 893,952. 1,053,945. 503,900. 14,140. 15,829. 12,291. 2,419. -. -. -. 9,000. -. 53,400. Earnings (loss) before income taxes Current federal income taxes provision (benefit) Current state income taxes provision (benefit) Current foreign income taxes provision (benefit) Deferred income taxes provision (benefit), net. 624,257. 796,444. 906,243. 1,056,364. 459,500. 188,647. 273,178. 332,202. 326,725. 180,400. 36,383. 51,949. 57,759. 65,308. 34,300. 10,218. 14,106. 12,398. 31,181. 40,400. -2,766. -37,256. -77,589. -39,488. -111,100. Income taxes Earnings before cumulative effect of change in accounting principle Cumulative effect of accounting change for FIN 47, net of taxes. 232,482. 301,977. 324,770. 383,726. 144,000. 581,473. 672,638. 315,500. -. Net earnings (loss) Weighted average shares outstanding basic Weighted average shares outstanding diluted Year end shares outstanding Earnings (loss) per share from continuing operations - basic Earnings (loss) per share - effect of accounting change - basic Net earnings (loss) per share - basic Earnings (loss) per share from continuing operations - diluted Earnings (loss) per share - effect of accounting change - diluted Net earnings (loss) per share - diluted. -. -17,214. -. -. 391,775. 494,467. 564,259. 672,638. 315,500. 794,346. 789,570. 766,114. 749,763. 731,500. 822,930. 815,417. 792,556. 770,091. 741,700. 794,811.69. 767,442.11. 756,602.07. 738,285.29. 735,500. 0.76. 0.9. 0.43. -. -. -. 0.495. -. -0.02 0.63. -. -. -. -. -. 0.74. 0.9. 0.43. 0.73. 0.87. 0.43. -0.02. -. -. 0.475. 0.61. 0.71. 0.87. 0.43. Total number of employees. 96,700. 115,000. 145,800. 172,000. 176,000. Number of common stockholders. 13,095. 13,900. 16,653. 18,500. 21,000.

(87) 28. Starbucks Corp. As Reported Annual Retained Earnings. 10/03/2004. 10/02/2005. 10/01/2006. 09/30/2007. 09/28/2008. Currency. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. Auditor Status Consolidated. No. No. No. No. No. Scale. Thousands. Thousands. Thousands. Thousands. Thousands. Previous retained earnings (accumulated deficit). 1,069,683. 1,444,892. Cumulative impact for adoption of FIN 48. -. -. Repurchase of common stock. -. -. Retained earnings (accumulated deficit). 1,461,458. 1,938,987. 2,151,084. 2,189,400. 352,162. 634,356. 100,800. 2,151,084. 2,189,366. 2,402,400. 1,939,359. -. -1,700.

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(89) As Reported Annual Cash Flow. 10/03/2004. 10/02/2005. 10/01/2006. 09/30/2007. 09/28/2008. Currency. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. USD Not Qualified. Auditor Status Consolidated. No. No. No. No. No. Scale. Thousands. Thousands. Thousands. Thousands. Thousands. Net earnings (loss) Cumulative effect of accounting change for FIN 47, net of income taxes. 391,775 -. Depreciation & amortization Provision for impairments & asset disposals Equity in loss (income) of investees Distributions of income from equity investees. 564,259. 367,207. 412,625. 304,820. Deferred income taxes, net. 494,467. 17,214. 672,638 -. 315,500 -. 491,238. 604,500. 13,568. 20,157. 19,622. 26,032. 325,000. -3,073. -31,253. -84,324. -37,326. -117,100. -33,387. -49,633. -60,570. -65,743. -61,300. 49,238. 65,927. 52,600. 105,664. 103,865. 75,000. -. 30,919. Stock-based compensation Tax benefit from exercise of nonqualified stock options. -. -. Tax benefit from exercise of stock options Excess tax benefit from exercise of stock options Net accretion of discount & amortization of premium on marketable securities. -. -. 1,318. 7,705. 3,800. -. -. -117,368. -93,055. -14,700. Net amortization of premium on securities. -. -. Other adjustments. -. -. Accounts receivable. -. 63,405. 109,978. 11,603. 10,097. -77,662. Prepaid expenses & other current assets. -16,621. -. -. -. -. -85,527. -. 653. -121,618. -. -. 2,013. -49,311. Inventories. -. -100 -48,576. -. 27,948. 9,717. 104,966. 36,068. Accrued compensation & related costs. 54,929. 22,711. 54,424. 38,628. Accrued taxes. 8,900 -. Deferred revenue. -. 47,590. Other accrued expenses. -. 16,465. 53,276 -. -600 -. Accounts payable Accrued occupancy costs. -. -. -63,900 -. 132,725. 86,371. 7,300. 56,547. 63,233. 72,400. -. -. -. Other operating assets & liabilities. -16,412. 56,894. -41,193. -16,437. 60,300. Net cash flows from operating activities. 793,848. 923,608. 1,131,633. 1,331,221. 1,258,700. Purchase of available-for-sale securities. -566,645. -643,488. -639,192. -237,422. -71,800. Maturity of available-for-sale securities. 163,814. 469,554. 269,134. 178,167. 20,000. Sale of available-for-sale securities. 190,748. 626,113. 431,181. 47,497. 75,900. -21,583. -91,734. -53,293. -74,200. -7,915. -39,199. -56,552. -52,000. Acquisitions, net of cash acquired Net purchases of equity, other investments & other assets Net additions to property, plant & equipment. -64,747 -386,176. Purchase of Seattle Coffee Company, net Distributions from equity investees Net cash flows from investing activities. -643,989. -7,515. -. 38,328. -. -632,193. -771,230 -. -221,308 -. -1,080,348 -. -841,040. -984,500 -. -1,201,951. -1,086,600. -. -16,600,841. -66,068,000. Repayments of commercial paper Proceeds from issuance of commercial paper. -. -. -. 17,311,089. 65,770,800. Repayments of short-term borrowings. -. -. -. -1,470,000. -228,800.

(90) 30 Proceeds from short-term borrowings Proceeds from issuance of common stock Excess tax benefit from exercise of stock options. -. -. Principal payments on long-term debt Proceeds from issuance of long-term debt. -735 -. -203,413 -. Other financing activities. -. Cash & cash equivalents, end of period Cash paid during the period for interest, net of capitalized interest Cash paid during the period for income taxes. -. -. Borrowings under revolving credit facility. 163,555. -722. Repurchase of common stock. Net cash flows from financing activities Effect of exchange rate changes on cash & cash equivalents Net increase (decrease) in cash & cash equivalents Cash & cash equivalents, beginning of period. 137,590. 770,000. 528,200. 159,249. 176,937. 112,300. 117,368. 93,055. 14,700. -898. -784. -1,113,647. -854,045. 277,000 -. 548,960 423,000. -. -600 -. -996,798 -. -311,400 -. -3,505. -1,700. -66,545. -673,827. -155,326. -171,887. -184,500. 3,111. 283. 3,530. 11,272. 900. 98,221. 28,756. 138,797. -31,345. -11,500. 200,907. 145,053. 173,809. 312,606. 281,300. 299,128. 173,809. 312,606. 281,261. 269,800. 370. 1,060. 10,576. 35,294. 52,700. 172,759. 227,812. 274,134. 342,223. 259,500.

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(96) 2004 A (Estimated) Company-operated retail revenue (Estimated) Company-operated retail revenue growth (Estimated) Speciality licensing revenue (Estimated) Specialty licensing revenue growth (Estimated) Speciality foodservice and other revenue (Estimated) Specialty foodservice and other revenue growth (Estimated) Total net revenues (Estimated) Total net revenues growth (Estimated) Cost of sales including occupancy costs (Estimated) Cost of sales including occupancy costs (Estimated) Total operating expenses (Estimated) Total operating expenses growth. 4,457,378 -. 565,798 -. 271,071 5,294,247 -. 2,198,654 -. 4,744,787 -. (Estimated) EBIT (Estimated) EBIT growth. 624,257 -. (Estimated) Net earnings (Estimated) Net earnings growth. 2005 A. 391,775 -. 2006 A. 2007 A. 2008 A. 5,391,927. 6,583,098. 7,998,265. 8,771,900. 0.209663394. 0.220917494. 0.21496976. 0.096725352. 673,015. 860,676. 1,026,338. 1,171,600. 0.189496958. 0.278836282. 0.192478935. 0.14153427. 304,358. 343,168. 386,894. 439,500. 0.122798086. 0.127514309. 0.12741864. 0.135970059. 6,369,300. 7,786,942. 9,411,497. 10,383,000. 0.203060605. 0.222574223. 0.208625543. 0.10322513. 2,605,212. 3,178,791. 3,999,124. 4,645,300. 0.184912224. 0.22016596. 0.258064465. 0.161579386. 5,665,430. 6,986,927. 8,465,558. 9,725,800. 0.194032525. 0.233256258. 0.211628231. 0.148866974. 796,444. 906,243. 1,056,364. 779,800. 0.275827103. 0.137861545. 0.165652038. -0.261807483. 494,467. 564,259. 672,638. 315,500. 0.262119839. 0.141145921. 0.192073144. -0.530951269. (Estimated) Gross margin. 0.584708836. 0.590973576. 0.591779289. 0.575080989. 0.55260522. (Estimated) EBIT Margin. 0.11791233. 0.125044196. 0.116379832. 0.112241868. 0.075103535. (Estimated) Profit margin. 0.074000136. 0.077632864. 0.072462207. 0.07146982. 0.030386208. 280,024. 340,169. 387,211. 467,160. 549,300. 0.214785161. 0.138290085. 0.20647399. 0.17582841. % of PP&E. 0.104620036. 0.102396575. 0.094841778. 0.091757048. 0.096076819. Effect Income Tax Rate. 0.372413926. 0.379156601. 0.358369665. 0.363251682. 0.313384113. 0.1. 0.1. 0.1. 0.3. 0.4. 0.037241393. 0.03791566. 0.035836966. 0.108975505. 0.125353645. (Estimated) Depreciation & amortization expenses (Estimated) Depreciation & amortization expenses growth. Weight Weighted Effective Tax Rate. -.

(97) 32. 2009 E. 2010 E. 2011 E. 2012 E. 2013 E. (Estimated) Company-operated retail revenue (Estimated) Company-operated retail revenue growth (Estimated) Speciality licensing revenue (Estimated) Specialty licensing revenue growth (Estimated) Speciality foodservice and other revenue (Estimated) Specialty foodservice and other revenue growth (Estimated) Total net revenues (Estimated) Total net revenues growth. 9,811,252. 9,541,120. 10,495,232. 11,544,755. 12,699,231. -0.055065761. -0.02753288. 0.1. 0.1. 0.1. (Estimated) Cost of sales including occupancy costs (Estimated) Cost of sales including occupancy costs (Estimated) Total operating expenses (Estimated) Total operating expenses growth (Estimated) EBIT (Estimated) EBIT growth. 327,948. 327,948. 344,346. 361,563. 379,641. -0.676265271. 0. 0.05. 0.05. 0.05. 518,682. 504,401. 534,291. 576,418. 621,627. 0.0979. 0.0979. 0.0979. 0.0979. 0.0979. (Estimated) Net earnings (Estimated) Net earnings growth (Estimated) Gross margin (Estimated) EBIT Margin (Estimated) Profit margin (Estimated) Depreciation & amortization expenses (Estimated) Depreciation & amortization expenses growth % of PP&E Effect Income Tax Rate Weight Weighted Effective Tax Rate.

(98) 33. Analysis of Fixed Capital Investment (Estimated) Property, plant & equipment, at cost (Estimated) Property, plant & equipment, at cost growth. 2004 A. 2005 A. 2,676,581 -. Change in PP&E % of Net Revenues. 0.505564058. 2006 A. 2007 A. 2008 A. 3,322,074. 4,082,705. 5,091,271. 5,717,300. 0.24116326. 0.22896269. 0.247033768. 0.122961241. 645,493. 760,631. 1,008,566. 626,029. 0.521575997. 0.524301452. 0.540962931. 0.55064047. Analysis of Net Working Capital 2004. 2005. 2006. 2007. 2008. Current Assets - Cash. 770,229. 861,716. 904,576. 1,415,226. 1,478,200. Current Liab - ST Debt. 782,245. 949,248. 1,234,858. 1,444,543. 1,476,000. NWC. -12,016. -87,532. -330,282. -29,317. 2,200. NWC_Change. -75,516. -242,750. 300,965. 31,517. CAGrowth. -. 0.118778961. 0.049737965. 0.564518625. 0.044497487. CLGrowth. 0.213491937. 0.300880276. 0.169804949. 0.021776437. 0.1. 0.1. 0.3. 0.5. Weighted_CAGrowthRate. 0.011877896. 0.004973796. 0.169355588. 0.022248743. Weighted_CLGrowthRate. 0.021349194. 0.030088028. 0.050941485. 0.010888219. FCFF from EBIDTA EBIT(1-T). 391,775. 494,467. 581,473. 672,638. 535,423. +Dep. 280,024. 340,169. 387,211. 467,160. 549,300. -FCInv. -. 645,493. 760,631. 1,008,566. 626,029. -WCInv. -. -75,516. -242,750. 300,965. 31,517. 264,659. 450,803. -169,733. 427,177. 923,608. 1,131,633. 1,331,221. 0.163456984. 0.225230834. 0.176371668. 1,258,700 0.054477055. FCFF = FCFF from CFO (Estimated) Cash flow from operations (Estimated) Cash flow from operations growth. 793,848. + Int(1-Tax Rate) -FCInv FCFF =. 34,961 -. 645,493. 760,631. 1,008,566. 626,029. 278,115. 371,002. 322,655. 667,632.

(99) 34. Analysis of Fixed Capital Investment (Estimated) Property, plant & equipment, at cost (Estimated) Property, plant & equipment, at cost growth Change in PP&E % of Net Revenues. 2009 E. 2010 E. 2011 E. 2012 E. 2013 E. 5,298,076. 5,152,205. 5,457,521. 5,887,825. 6,349,615. -419,224. -145,871. 305,316. 430,305. 461,790. 0.54. 0.54. 0.52. 0.51. 0.5. Analysis of Net Working Capital 2009. 2010. 2011. 2012. 2013. Current Assets - Cash. 1,765,562. 2,108,787. 2,518,736. 3,008,378. 3,593,206. Current Liab - ST Debt. 1,736,514. 2,043,009. 2,403,600. 2,827,835. 3,326,948. 29,048. 65,779. 115,136. 180,543. 266,258. NWC_Change. 26,848. 36,731. 49,357. 65,407. 85,716. CAGrowth. 0.1944. 0.1944. 0.1944. 0.1944. 0.1944. CLGrowth. 0.1765. 0.1765. 0.1765. 0.1765. 0.1765. EBIT(1-T). 214,708. 214,708. 225,443. 236,715. 248,551. +Dep. 518,682. 504,401. 534,291. 576,418. 621,627. -FCInv. -419,224. -145,871. 305,316. 430,305. 461,790. -WCInv. 26,848. 36,731. 49,357. 65,407. 85,716. FCFF =. 1,125,765. 828,249. 405,061. 317,422. 322,672. 1,080,846. 1,004,484. 1,024,574. 1,055,311. 1,097,523. -0.1413. -0.07065. 0.02. 0.03. 0.04. NWC. Weighted_CAGrowthRate Weighted_CLGrowthRate FCFF from EBIDTA. FCFF from CFO (Estimated) Cash flow from operations (Estimated) Cash flow from operations growth + Int(1-Tax Rate). 34,961. 34,961. 34,961. 34,961. 34,961. -FCInv. -419,224. -145,871. 305,316. 430,305. 461,790. FCFF =. 1,535,030. 1,185,316. 754,219. 659,967. 670,694.

(100) 35.

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(102) FCFF From EBIT FCFF From CFO. 2009. 2010. 2011. 2012. 2013. 1,125,765. 828,249. 405,061. 317,422. 322,672. 1,535,030. 1,185,316. 754,219. 659,967. 670,694. 327,335. 238,928. 226,229. 7,002,296. 609,494. 496,766. 470,231. 14,554,691. Target D/E Ratio:. Terminal. 0.180759743. Cost of Equity: Risk Free Rate:. 0.02. Beta:. 0.93. Market Risk Premium:. 0.065 0.08045. Cost of Debt:. 0.0425555. WACC:. 0.0736002. FCFF Growth Rate: PV of FCFF (EBIT). 0.04. 1,048,589. Value of the Firm:. 718,581 9,561,959. Less: Debt. 549,600. Value of Equity:. 9,012,359. Weighted average shares oustanding: Basic:. 731,500. Diluted:. 741,700. Intrinsic Value: Basic:. 12.32038187. Diluted:. 12.15094963. PV of FCFF (CFO). 1,429,797. Value of the Firm: Less: Debt Value of Equity:. 1,028,369 18,589,349 549,600 18,039,749. Weighted average shares oustanding: Basic:. 731,500. Diluted:. 741,700. Intrinsic Value: Basic:. 24.66131145. Diluted:. 24.32216439.

(103) 36. Growth Rate 3%. 4%. 5%. Firm Value. 7,904,048. 9,561,959. 12,624,868. Equity Value. 7,354,448. 9,012,359. 12,075,268. $10.05. $12.32. $16.51. $9.92. $12.15. $16.28. Implied Share Value Basic Diluted.

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