The Best Coffee Stock $SBUX $DNKN $MCD

We place a strong buy on Starbucks Corporation (SBUX) stock on the back of its state-of-the-art product portfolio, diversity and superiority of its coffee products combined with resilient consumer demand and its future expansion plans in other markets. The company is one of the leading roaster, marketer and retailer of specialty coffee in the world through company operated stores, licensed stores, and through other retail channels. Owing to continuous investment on improved operational foundation, invigorated innovative muscle, the revenue base of the company depicted an increase of 11%, amounting to USD 11.7b in FY11. The revenues generated from Consumer Product Group (CPG) food service and licensed-stores showed immense growth of 22% and 15% respectively, while company-operated stores registered nominal growth of 7%.

Starbucks Corporation (NASDAQ:SBUX)

Key Thesis Points

1. SBUX holds a significant position in the global food sector and is the world’s largest coffeehouse company in the world, with more than 20,000 stores worldwide. The company holds a dominant position in the Coffee & Snack shops” in its US with a market share of 32.6%, followed by its main competitor Dunkin Brand (DNKN) with a share of 16.1%. Going forward, we expect strong competition in restaurant segment from McDonald’s (MCD) as they are shifting their focus from hamburgers to Freshly-brewed coffee, but keeping in mind Starbucks’s traditional Coffee experience and continued diversity in its products, they are well positioned to cope with the stringent competition. The competition in restaurant segment is more stringent, where MCD holds dominant position, while SBUX is striving hard to grasp market share from MCD.

2. During FY12, Starbucks witnessed a substantial growth in its bottom line which was mainly driven by its expansion strategy that includes; company’s loyalty program, innovative products and new food & beverage options. During FY11, the business generated from US market continued to expand with a modest growth of 6% in the revenue base and contributed 69% to total revenues. Moreover, the revenue generated from the international operations grew substantially by 15%, which mainly pertains to company operated stores during FY11. Going forward, we anticipate expansion in new markets will provide company with new revenue avenues. In FY11, sale of beverages account for a whopping 75% while company intends to shift its focus on food, whole bean and soluble coffees because it can provide them foundations to compete with giants like MCD and Dunkin Brand. In 1Q12, the company directly marketed and supplied SBUX products to retail/convenience stores, which has lead to a substantial sales growth of 57%.

3. Despite robust growth in sales and rising cost of sales, the gross margins of the company remained at prior year level of 58% against the industry average of 24%. While during FY11, the operating expenses increased by 5%, the rising operating expenses were in line with inflationary pressures. On the back of substantial expansion in revenue base, the company was able to increase its operating margin from 13% in FY10 to 14.5% in FY11. Accordingly, net income of the company increased by 32% and amounted to USD 1.25b against USD 945m in FY10.  Resultantly net margin of the company improved to 10.6% against the industry norm of 10.3%. Moreover, the ROA & ROE improved to 16.9% and 28.4% against 14.8% and 25.7% in FY10.

The equity of the company stood slightly higher at USD 4.4b, the increase was mainly attributable to the increased reinvested earnings. While, the total borrowing of the company remained at prior year level of USD 549m. Accordingly on the back of substantial improvement in company’s bottom line, the leverage of the company improved to 0.13x against 0.15x in FY10. The operating cash flows stood at USD 1.6b in FY11 representing ample cushion to support the continuous expansion in other parts of the world.

4. As a retailer that is dependent upon consumer discretionary spending, SBUX’s results of operations are sensitive to changes in macro-economic conditions. Its major source of revenue is the US market which, if at any time, faces financial/economic pressures could pressurize earnings. Moreover the company is exposed to several risks including; foreign currency fluctuations, macro-economic conditions of foreign markets, and penetrating competitive environment.

Brief Valuation

Starbucks Corporation is a growth stock with a price to book ratio of 6.33x against the industry norm of 0.7x. During FY11, the P/E ratio of the stock has experienced an increase and stood at 21.5x against 21.4x in FY10. While analyzing the historical share price trend, we believe that stock is slightly undervalued and will demonstrate a recovery in price going forward. The estimated beta of the stock is 1.23, which signifies higher sensitivity to the movement of stock market. Going forward, based on strong fundamentals originating from diversified [product portfolio, its presence around the globe, stringent market position, substantial cash flows, and expected PE multiplier we value SBUX at USD 65.00.