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By howardroark
December 31, 2004

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I admit out front I'm trying to change the subject. I don't really have a great opus of built of exposition about why I'm putting 20% into Starbucks thanks to the FIFO under valuation of their Cranium inventory. But when I see a thread that invokes the deadly confluence of lawyers, fertility issues and massive six figure salaries, I fear for New Year's Eve full of nightmarish flashbacks. So Starbucks.

Starbucks is pretty amazing, huh? It IPO'd, I believe, at around 67X earnings back in 92, which a lot of people thought was pretty heady at the time (though it doubled over the next year). And here it is, 12 1/2 years and 36% compound annual returns later, still at 67X earnings. Now there's a stock that has made a lot of smart cynics look stupid. I wonder how many times I've heard the Starbucks short pitch in the last decade. But what's even more amazing (to me at least), is that Starbucks' return on equity over the last 12 months of 17% was the only year since IPO that its ROE exceeded 15%. A very ho-hum 10-14% has been the norm for most of its public life. Its growth has been insane, of course (to understate matters), with 39% compounded revenue growth of and 45% annual net income growth. That's Dell and EMC and almost nobody else.

There's no disputing it's been a good business -- the returns on capital have been reasonable (and recently, quite good), and the ability to reinvest capital to generate more of those returns (grow) have been Olympian. And the earnings have been remarkably consistent. Oh, and most of the infertile, six-figure lawyers in this country are now addicted to its product, despite it having existed for centuries. But we're talking about a company that IPO'd at around 65-70X earnings, compounded at enormous rates, and ended the period as a $25b monster still trading at 67X trailing earnings (54X NTM earnings). So whether it's good isn't interesting.

Does it boggle the mind that a company with these unfathomable market performance and valuation characteristics has only produced average to good returns on capital employed over time? It does mine, and I am not a bitter former SBUX short, though I am a bitter overpaying addict sometimes desperate for fake communal proximity among strangers-seated-apart-staring-at-laptops. Of the best performing and highest valued stocks of the last 12 years, have others produced mere reasonable returns on capital? None that I can think of. Dell? Anywhere from 40-80% unlevered, with a larger cash drag. Bed, Bath and Beyond? 23-33%. Best Buy? Had some middling years, but has averaged over 20% returns on equity. SBUX's invested capital returns are slightly worse than its return on equity as appears as it has always leased essentially all of its stores, a form of leverage.

Until the last couple of years, Starbucks was using all its operating cash flow to grow. That's of course not economically negative if the returns on that reinvestment are satisfactory, but as mentioned, the returns have been pretty good but hardly extraordinary to date. But SBUX has not had to go heavily into debt or dilution to finance this enormous 40% annual growth if it didn't have the returns to match it? Actual OCF from 92-04 was $3.26b versus $3.02b in capex, for $239m in total FCF since public birth. Starbucks also raised $727m over the years via debt and (primarily) equity (net of share repurchases). Equity issuances have essentially doubled shares out over the period from a split adjusted 209 million to 400 million, while the company is debt free with $1b cash and long term investments (see the FCF plus the net capital raised above).

But all this creates a burning question in the mind of the one fertility hating sap still reading along. How has Starbucks managed to grow revenues at and earnings at 38% to 45% without (1) producing returns on capital anywhere near that or (2) putting more capital into the business than they've been generating (remember OCF has slightly exceeded capex during the period). By definition, you can't grow at 40% with returns on equity of 13% unless you reinvest 300% of your earnings. Yes, Starbucks issued 191m net split adjusted shares over the years; but remember, the gross proceeds from that total issuance can largely be seen as responsible for the cash and investments built up on the balance sheet today -- sales and earnings per share regardless have risen over 31% and 38% regardless -- it doesn't answer the question.

The answer seems to be that Starbucks has either been substantially over-depreciating its stores or that its going to require a lot of maintenance capital that has thus far been hidden by its growth (or choice number three, they will all suddenly collapse, instantly destroying the market for thematic impulse CDs). Why? Well, the issue I brought up is that Starbucks has produced enough operating cash flow since IPO to fund an expansion that has produced 38% and 45% sales and earnings growth despite averaging sub-15% returns on equity. But while it has generated a lot of OCF, it has not produced anywhere near enough earnings during that period to create that growth. The difference between net income and operating cash flow, in fact, has been huge. Net income over the 12 years was in fact only $1.46 billion versus the aforementioned $3.26b in operating cash flow. And the difference is largely attributable to depreciation, as growth has required inventory investment (though much less than you'd think thanks to improved turns and expansion in lighter working capital businesses), with $1.44b in total depreciation over the period (they've also had stock options deductions among other cash flow benefits).

Over time, depreciation and actual maintenance capital costs are by definition equal. But as long as a company is growing, actual economic depreciation versus accounting depreciation is hard to figure from raw numbers. Usually you have to figure out how much they're actually spending on old stores/infrastructure versus old stores to see how much is required to maintain their PP&E, but even then it's a guess because actual depreciation can be lumpy. It looks like SBUX depreciates its buildings over 30-40 years, but equipment over 2-7 years and leasehold improvements over 10 years. Not at all abnormal in retail. Buildings are an insignificant part of its capital base at $66m, the depreciation we're talking about comes from store improvements ($1.5b gross), Roasting equipment ($683m), and FF&E ($415m). It supposedly costs $350K to open a Starbucks, and they opened 634 (owned) last year, which should have cost around $220m. Gross capex was $434m, which implies maybe $210m of maintenance capex versus $305m in depreciation. That implies a pickup of maybe $90, which is pretty substantial from an ROE respective, though it doesn't necessarily solve the puzzle over time.

That little snapshot isn't near enough to answer the question, but overall it brings up  semi-interesting issues (speaking relatively, tonight). Likely, it will never be answered because business is dynamic and changes such as Starbucks' large move to licensed sources of revenue make it very hard to judge company stores in a vacuum. But it makes you think about whether a retail/restaurant accounting presentation could be so misleading as to fundamentally misstate the real economics of a simple business over decade plus periods, or whether the market could be so misguided to slap a 67X trailing multiple on a large cap business which has never returned more than 17% on equity in its history.

Years ago, there was a thread on the Berkshire Board started by Roughly Right, where he challenged people to name one S&P 100 sized company trading at 50X non-trough earnings which did not under perform over the subsequent ten years. Starbucks has basically just breached that size level at $25b+ in market capitalization, so it'll be interesting to see how the next ten years play out. It's not something I'd be willing to make a bet on either, though I personally wouldn't go near the stock here.

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