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By c0ffeen0te
December 18, 2006

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With the release of the 10-K, it is a good time to step back and assess SBUX. P&L results have been out for some time but now we have the balance sheet and cash flow as well to better complete the financial picture. Here is my initial take (setting aside the color commentary for the most part and focusing on the numerical play-by-play):

Revenue: Up 22% for the year and 21% for the last quarter
Operating Income: Up 15% for the year but only 1 % (?) for the quarter...this is before the impact of the accounting change which impacts net income, not operating income.

Gross Profit Margin: 59.2% for the year, vs 59.0% last year, but last quarter was 58.3%

Operating Income Margin: 11.5% for the year, driven largely by an exceptional first quarter at 14.5%; the other quarters were all below 11% and the last quarter was 9.9%. Margin had grown steadily from 10.4% in 2003 to 12.4% in 2005. Now what is the outlook? This is a critical question because as investors, we need clarity on whether margins would grow as revenue grows (as one might assume) as this would mean that the company's bottom line will grow even faster than the top line.

Balance Sheet: nothing exceptional to report, total asset turnover and inventory turnover was steady in 2006, the company managed to a negative working capital position at year end from modestly positive during the year, but it doesn't look like they did anything foolish to try to trick us.

Will need to take a closer look at that fourth quarter P&L versus the previous year, but that isn't necessarily what has me concerned. It's the cash flow and its relation to the value of the company:

Free cash flow (operating cash flow less capital expenditures) in 2006 was $361 million, up a solid 29% versus 2005. However, except for a huge first quarter, this number was actually negative for the last 3 quarters as the capital required primarily to open new stores exceeded the cash generated by the operation. Ignoring for a moment the short term swings, annual free cash flow has grown from $209 million in 2003 at an average annual clip of about 20% to 2006 levels. (There was a big jump in 2004 and a fall off in 2005.)

I consider free cash flow the critical financial metric for Starbucks because that is where the balance lies between investing in the business and generating cash returns for the owners. Since the company's growth plans assume significant new store growth as far as the eye can see and its attendant investment cost, the investor needs to know that the net growth in free cash can justify the value of the company.

To summarize: we have revenue growth this year of 22% and over the past three years was close to 25% p.a. Operating cash flow growth was 29% this year and over the past three years 20%. What might we be willing to pay for an "annuity" based on 2006 free cash flow of $361 million growing at 20 to 30% per year?

Based upon a 7% rate of return and assuming 10 or 15 years out, we get a pretty wide range of present values for this "annuity":

10 year horizon
20% growth $7.2 B
30% growth $12.3 B

15 year horizon
20% growth $15.3 B
30% growth $35.8 B

The market cap of SBUX today is about $27.7B, which we might adjust to an economic value of $27.3B considering cash on hand and the small amount of long term debt on the books.

I'm not much of a financial theorist but I believe this means that if you were interested in achieving a 7% return and you bought all of SBUX, you would need to grow operating cash flow by 30% per year every year and still have to wait close to 15 years to achieve your return objective.

The ratio of economic value to 2006 free cash flow is something like 76 times; normally this ratio should be about double the projected growth rate.

I am not saying SBUX is a bad company by any means, but I am beginning to add my voice to those who are saying it is overpriced.

What do you guys think? Is my logic flawed?

CN
Still long SBUX but not as much...

 


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