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Will a $2.7 Billion Fine Significantly Dampen Starbucks' Performance?

November 20, 2013

Starbucks (NASDAQ: SBUX) was faced with paying a fine and fees of as much as $2.7 billion for ending its relationship with Kraft Foods in the packaged coffee supply business. After the arbitrator's ruling, Starbucks restated its 4th quarter profit to a $2.1 billion loss. However, the market did not seem pessimistic about this because Starbucks experienced a mere 0.11% decline in after-hours trading. It still trades at more than $81 per share, at a valuation of 25.5 times its forward earnings.

A business partnership turned sour
Since 1998, Kraft had marketed and distributed Starbucks' coffee bags in supermarkets. The business had experienced good growth, increasing sales from $50 million in 1998 to around $500 million in 2010. However, Starbucks' Chairman and CEO Howard Schultz felt dissatisfied with the partnership, and he demanded total control of the consumer-packaged business and capsule supply for Tassimo, Kraft's single-serve coffee machines.

The contract would not have expired until 2014, but Starbucks ended the deal three years early. Previously, Starbucks said that it offered Kraft $500 million as a settlement, but Kraft claimed that a fair payment would be around $1.5 billion.  Initially, the judge had allowed Starbucks to end the relationship without paying anything. However, the arbitration forced Starbucks to pay $2.7 billion, including a fine and fees. The proceeds will go to Kraft's spin-off, Mondelez International (NASDAQ: MDLZ). 

Not very good news for Starbucks' shareholders
For fiscal 2013, Starbucks has returned as much as $1.2 billion to shareholders via both share buybacks and dividends. It recently announced a 24% increase in its quarterly dividend to $0.26 per share. However, the fine will lower Starbucks' cash position materially, wiping out nearly $2.6 billion of its cash on hand.

Thus, in the short run, the fine will dampen Starbucks' share repurchases and dividend payments. It also limits the company in expanding its business. Nevertheless, this only affects Starbucks for the short run. Over the long run, I still believe that Starbucks will keep growing significantly. It is a cash cow, generating nearly $2 billion in free cash flow in the past year. 

Mondelez will have more power to enhance its global growth
Mondelez, with a similar market capitalization, has a lower valuation. The company trades for about 20 times its forward earnings at the current market price. The fine will increase the cash position of Mondelez from $3.7 billion to $6.4 billion, giving the company more power to expand its business in emerging markets and provide cash returns to its shareholders.

In the third quarter, Mondelez experienced 10.7% growth in emerging markets, driven by double-digit growth in the Brazil, Russia, India, and China, or BRIC, markets. The company also authorized a $6 billion share repurchase, which could provide shareholders with as much as a 9.7% yield. Currently, Mondelez's dividend yields around 1.70%. 

Dunkin' Brands uses too much leverage
Dunkin' Brands (NASDAQ: DNKN), a much smaller competitor of Starbucks, also enjoys a high valuation. At a $5.1 billion market capitalization, Dunkin' Brands