Steve Case, Itay Cohen,

Starbucks Corp. (NASDAQ: SBUX) A lukewarm latte Steve Fisher, Doug Moon
December 5, 1999

Price: $27.81 Consensus Estimates 1999A 2000E 2001E

Price/52 Wk High: 68% EPS $.54 $.67 $.82
Price/52 Wk Low: 140% P/E 51.5 41.5 33.9
Price Chg. 26 Weeks: -22.7%
FY2 Earnings Yield: 2.4%
Shares Out / Float: 182mm / 169mm EBO Valuation: $14.24
Mkt. Cap: $5B Comparables: $8.50 - $13.00
Shares Short: 7.4mm (2.7 days)
Average Vol.: 2.8mm
T/O (tot shs out.): 1.5% (66th percentile) Long Term Growth Rate: 25%
Book Value/Share: $5.04 Target ROE (Ind. Ave.): 17%
Div. Yield: 0.0%
Inst. Ownership: 46.3% Analyst Cov.: Strong Buy Buy Hold
LTD: $0 9 4 8
Beta: 1.95 Beneish Score (8 var.): -2.22

Key Points Summary

+ Starbucks continues to grow total revenues, from a mix of same store sales
increases and new store openings. Additionally, the company plans to roll out
new products for retail and wholesale distribution.
+ Fourth quarter earnings were on target, enabling the company to hit its yearly
targets. Analysts subsequently upgraded recommendations.
However, these figures were revised downward earlier in the year.
- As the company’s retail business matures, EPS growth is leveling off.
- Wages for retail store employees are on the rise contributing to higher operating
costs – this is causing per store revenues to flatten out. Thus same-store sales
(comps) are facing increasing downward pressure.
- The current high valuation is called into question by the above observations.
- As the existing store base continues to expand, maintaining the same % growth
rates becomes increasingly difficult to achieve.
Starbucks continues to grow earnings per share in the short term, and still
has long term growth opportunities. However, the company is likely to
face increasing store operating costs as a result of increasing labor costs.
Additionally, domestic store openings and same store sales are likely to level
off. As the domestic retail business is starting to mature, the company is
focusing more on international expansion and domestic specialty sales.
The stock is a “high volume (66th percentile) loser” trading at approximately
50% of its 52 week high. However, we feel that a short recommendation is
not appropriate at this time as the stock has rebounded in the last 8-10
weeks, largely as a result of meeting year-end earnings estimates. Further,
income and market based valuation analyses indicate that the current price
is significantly overvalued.
Recommendation

Starbucks trades in relatively high volume (66th percentile) and has exhibited Accordingly, we recommend the stock as a HOLD.
negative 26-week price momentum (down 23%). This identifies the stock as a
“high-volume loser”. In recent days, the price slide has stopped, and is now
inching back up again.
Starbucks
Table of contents

1 Business and Industry Analysis ________________________________________ 2

1.1 Company Background _____________________________________________ 2
1.2 Strategy ________________________________________________________ 2
Performance of Business Units ____________________________________________ 5
1.4 Insider Trading __________________________________________________ 7
1.5 Market and Market Share Analysis ___________________________________ 7
1.6 Management_____________________________________________________ 9
1.7 Industry Outlook ________________________________________________ 10
2 Accounting Analysis ________________________________________________ 13
2.1 Review of Accounting Policies ______________________________________ 13
2.2 Test of Earning Manipulation_______________________________________ 14
3 Financial Analysis _________________________________________________ 16
3.1 Ratio Analysis __________________________________________________ 16
3.2 Overall Profitability ______________________________________________ 16
3.3 Operating Profitability Analysis _____________________________________ 16
3.4 Liquidity and Solvency analysis _____________________________________ 21
4 Valuation _________________________________________________________ 21
4.1 Overview ______________________________________________________ 21
4.2 Cost of Capital __________________________________________________ 21
4.3 Foster Model ___________________________________________________ 22
4.4 DCF Model_____________________________________________________ 22
4.5 EBO __________________________________________________________ 31
4.6 Multiples ______________________________________________________ 31
4.7 Other Information _______________________________________________ 34
5 Recommendation___________________________________________________ 35
 2

1 Business and Industry Analysis

1.1 Company Background

OVERVIEW
Starbucks Coffee Company is a the nation’s largest retailer, roaster and supermarket store-
brand of coffee. It has 2,498 retail locations in North America, the United Kingdom, the
Pacific Rim and the Middle East. Starbucks sells whole bean coffees through its specialty
sales group, direct response business, supermarkets and online. Additionally, Starbucks has
entered into joint ventures with Pepsi and Dreyer’s to sell bottled Frappuccino® coffee
beverages ice cream through supermarket channels. The company makes and sells teas
produced by its wholly-owned subsidiary, Tazo Tea Company.

In the retail stores the company sells an array of coffee drinks and beans, fresh pastries, and
other foods and beverages, as well as mugs, coffeemakers, coffee grinders, and storage
containers.

HISTORY
Starbucks was founded in 1971 in Seattle. The company’s aim was to sell the finest-quality
whole bean and ground coffees. By 1982 Starbucks consisted of five retail stores and was
selling coffee to restaurants and espresso stands in Seattle. In 1987 Howard Schultz acquired
Starbucks' retail operations for $4 million. Starbucks lost money in the late 1980s as it
focused on expansion (it tripled its number of stores to 55 between 1987 and 1989). Schultz
brought in managers from Blockbuster, Taco Bell, and other companies to run Starbucks'
stores.

On June 26, 1992 Starbucks went public at a price of $17 per share ($2.125 per share
adjusted for three subsequent stock splits), underwritten by BT Alex Brown. Since the IPO,
Starbucks has had three, 2-for-1 stock splits on September 29, 1993, December 1, 1995, and
March 19, 1999.

Starbucks has never paid a cash dividend and presently intends to retain earnings to help
finance the Company’s continued growth.

1.2 Strategy

Starbucks' strategy is simple -- to sell premium products for premium prices and to lever
Starbucks brand awareness by introducing new products and through the development of
new distribution channels. Starbucks also wants to apply its name to more than just coffee.
The Company sells cold beverages (Frappuccino) with PepsiCo and a line of coffee ice
cream with Dreyer's. Starbucks is also developing its own line of chocolates and is selling its
brewing equipment in traditional retail locations. It also has begun test marketing a new
menu of breakfast, lunch, and dinner items in its retail stores.
 3

The Company’s core retail business (84% of sales) has traditionally been strong. The
“We view the Internet
investments as
symptomatic of
management’s concern
about continued retail
growth.”
company has recently rolled out a number of initiatives to
increase its specialty sales business, currently 16% of
sales. Of these, we are skeptical of the company’s recent
forays into the internet. While new sales will undoubtedly
appear from the sale of coffee and accessories on the net,
we do not believe that the Starbucks brand name is
sufficiently powerful to draw sales of music, housewares,
appliances, and alcoholic beverages. These extensions are
now offered through Starbucks ventures into Hear Music
($10mm purchase), Cooking.com ($10mm equity
investment) and Geerlings & Wade Winery (marketing
alliance).

The company has stressed recently that its internet strategy will not “dilute attention from
core business”, but we see these investments as symptomatic of management’s concern
about continued retail growth. Although revenue at store locations has continued to grow,
the company must find new engines for future earnings, because retail saturation of their
U.S. niche may be on the near horizon.

INTERNAL GROWTH AND JOINT VENTURES

To expand its U.S. retail presence, the company has joined with Kraft Foods to sell its coffee
in some 25,000 grocery stores across the US. It has also signed an agreement with
Albertson's to open more than 100 coffee bars in some of its supermarkets. Starbucks is also
expanding their international retail presence, primarily through company-operated retail
stores. The company recently moved into China as part of its plan to operate 500 stores in
both Asia and Europe by the end of 2003.

Starbucks, determined to boost sales after morning

rush hours, also said it will expand its lunchtime
offerings in six unspecified “major” markets in
coming months. The lunch program, which “we plan to watch the
features sandwiches and other self-serve items, has success of the lunch roll-
already been introduced in 120 Starbucks outlets in out cautiously, because
Seattle, Chicago, Washington, D.C., and Toronto, the Company’s food
and are resulting in what CEO Howard Schultz offerings have
called “significant incremental sales”. Starbucks is
targeting incremental sales of between $50,000 to
traditionally been inferior
$100,000 per store. In the test markets, stores to the quality of its
offering lunch service have already exceeded the coffee.”
lower target number. Still, we plan to watch the
success of the lunch roll-out cautiously, because the
Company’s food offerings have traditionally been
inferior to the quality of its coffee.
 4

GROWTH BY ACQUISITIONS
Starbucks acquired London-based Seattle Coffee Company in May 1998. The acquisition
gave the company an immediate presence in the U.K. with 61 retail stores and a platform for
future expansion in the European market. In the U.S., last year, Starbucks acquired Pasqua
Inc, a chain of lunch cafes. In relation to the above expansion of food sales within Starbucks
locations, the Pasqua merger brought with it three central commissaries in addition to the
Pasqua outlets. However, Starbucks has not yet decided on whether to use the commissary
model or an in-store preparation model for its lunchtime offerings. The trade-offs have
revolved around issues of freshness and quality, preparation time, and space constraints
within the retail shops.

For the most part, SBUX acquisitions have been consistent with Company growth strategy.
The Seattle Coffee Company deal was consummated as a pooling of interest, thereby
avoiding any goodwill amortization. For the Pasqua acquisition, Starbucks used the
purchase method. Of the $17.1 million price tag, fully 80% will be amortized as goodwill.
This statistic makes us wonder if SBUX overpaid for the entry into lunch sales.

SPECIALTY SALES
Starbucks is growing its specialty sales business by pushing the Starbucks brand outside the
company-operated retail environment. Starbucks strategy for expanding its specialty sales
operations is to reach customers as they shop, travel, work and dine, by establishing
relationships with prominent third parties. These
relationships take various forms, including
domestic wholesale accounts, domestic retail store
“In rushing to grow its and grocery channel licensing agreements,
international licensing arrangements and direct
business, Starbucks may response business. In some situations, the licensee
be losing valuable is a joint venture in which Starbucks has an equity
ownership and giving up ownership interest. For example, they are doing
brand equity in return for joint ventures with PepsiCo (Frappuccino) in the
improved revenue.” chilled beverage market and with Dreyer’s
(Starbucks ice cream) in supermarkets. These joint
ventures allow Starbucks to hand over marketing &
distribution to experienced third parties with
extensive presence in the new channels and the
marketing resources to drive sales volume. In both of these joint ventures Starbucks has only
50% equity. We believe that in rushing to grow its business the firm is losing valuable
ownership and giving up brand equity in return for improved revenue. Moreover, the firm is
not building expertise in these areas, and they may need it down the road as the new
channels contribute a greater % of revenue and profits.

The company is also pushing a mini-retail expansion of “coffee bars” into grocery stores
through an alliance with Albertson's Inc. (ABS) announced earlier this month. According to
founder and chairman, Howard Schultz, this is likely to lead to similar pacts with other
chains. Such partnerships could include self-serve kiosks, Schultz said.
 5

Starbucks plans to complete its national rollout of whole-bean coffee into supermarkets by
the end of its fiscal second quarter, which ends in March. Already the beans are being sold in
about 8,500 stores via a distribution pact with Kraft Inc. In several key markets, stores have
posted double-digit sales increases year over year.

DIRECT SALES
Through their mail-order catalog and website, Starbucks sells coffee and other products like
music CDs, wine, and cooking equipment. It is this line of business that has most often
troubled investors. The investments in internet businesses and in other “ancillary”
businesses have prompted many to question the relationship between the new business
investments and Starbucks core business
(coffee!). Recent activity includes the acquisition
of San Francisco's Hear Music, a closely held
music retail chain with “We are a coffee outlets on the West
Coast and in Canada. company, and that’s what The goal of the
acquisition is to help we’re going to stay, determine what music
customers will hear in though there are different Starbucks' coffee
shops. While Starbucks ways of being in coffee.” didn't divulge a price, it
is believed to have spent less than $10 million.
Starbucks has also taken a $10 million stake in
Internet cooking site - Howard Schultz, CEO Cooking.com, which
sells cookware and dispenses recipes and
expert advice to cooking aficionados. Starbucks
recently formed a non-financial relationship with Geerlings & Wade Inc. (GEER), a wine
purveyor whose products will be offered on Starbucks' Web site.

All three ventures are aimed at increasing Web-based revenues for Starbucks, which
currently produce $150,000 in revenue per month. In other words, the company is still
investing in the future of Internet businesses that MAY share some connection with
Starbucks’ other lines of business and MAY add value by helping to enhance the retail
environment, add insight into customer buying habits, and add incremental sales. Our
interpretation is again, that the company is looking for new ways to maintain strong growth
rates as retail expansion becomes increasingly difficult to sustain.

1.3 Performance of Business Units

“Net of the extra week
PER-STORE OPERATING MEASURES
Starbucks’ retail effectiveness is summarized in the
and price hike, per-store
exhibit on the following page. SBUX operates its retail revenue growth in
locations directly, which is in contrast to many other FY1999 was probably
chain food retailers that franchise their operations. The flat to only slightly
benefit of this policy is that SBUX can enjoy undiluted higher.”
profit from its locations. The danger is in maintaining
centralized control of an expanding set of all-cash sites,
now numbering nearly 2,500.
 6

Starbucks Corporation (SBUX)

Non-Financial Ratio Analysis

9/99 9/98 9/97 9/96 10/95 10/94

Operating Statistics
2
Retail Employees 27,353 24,000 22,000 15,000 N/A N/A
2
Other & Admin. Employees 2,279 2,000 3,000 1,600 N/A N/A
2
Total Employees 29,632 26,000 25,000 16,600 N/A N/A

N.A. Corp. Store Locations 2,038 1,622 1,270 929 627 399
Global Corp. Store Locations 97 66 31 9 1 0
Licensed Store Locations 363 198 111 77 49 26
Total Store Locations 2,498 1,886 1,412 1,015 677 425
Growth in Total Store Locations 32% 34% 39% 50% 59% N/A

Per Store Performance Metrics

Growth in N.A. Corporate Stores 25.6% 27.7% 36.7% 48.2% 57.1% N/A
% Change in Same Store Sales1 5 - 6% 5% 5% 7% 9% 9%
Retail Revenue/ Corp. Location (mil) $666.7 $653.2 $642.8 $641.2 $641.0 $622.8
Growth in Revenue/ Corp. Location 2.1% 1.6% 0.2% 0.0% 2.9% N/A
Net Income/Location (mil) $40.7 $36.3 $39.1 $41.1 $38.6 $24.0
Growth in Net Income per Location 12.3% -7.3% -4.8% 6.6% 60.6% N/A
Operating Cost/ Location $217.6 $221.9 $222.4 $208.4 $219.7 N/A
Growth in Operating Cost per Location -1.9% -0.2% 6.7% -5.1% N/A N/A

Per Employee Performance Metrics

Retail Revenue / Retail Employee (mil) $52.0 $45.9 $38.0 $40.1 N/A N/A
Change in Retail Revenue per Employee 13.3% 20.9% -5.2% N/A N/A
Net Income / Retail Employee (mil) $3.7 $2.8 $2.5 $2.8 N/A N/A
2
Employee / Location 14.2 14.2 16.9 16.0 N/A N/A
N/A
Operating Cost / Employee $18,344 $16,095 $12,563 $12,745 N/A N/A

1
Includes only Company-operated stores open 13 months or longer
2
Estimate
 7

Since 1995, top-line growth per store has fluctuated between 0 percent and 3 percent, with
fiscal 1999’s performance near the top end of the range (2.1 percent). This rise is
attributable to an increase in the number of customers, an increase in prices ($0.10 per cup),
and the fact that FY1999 included 53 weeks rather than 52. Of these elements, only the
increased traffic represents ‘organic’ growth’ in our view, since the latter are not dependable,
persistent revenue sources. Net of the extra week and price hike, per-store revenue growth
in FY1999 was probably flat to slightly higher.

On the expense side, SBUX needs improvement. Operating costs per store grew by 2.7
percent in both FY1998 and FY1999 after fluctuating widely in the two previous years. We
believe that costs per-store have grown faster than revenue per store since FY1996, putting
downward pressure on the company’s per-store operating margin.

1.4 Insider Trading

Currently there is no clear trend of insiders selling or buying, but in March 1999, when the
stock price reached to the level of $60 per share (before the 2:1 split on March 22, 1999) we
could easily identify a trend of insiders selling or exercising options and then selling.

1.5 Market and Market Share Analysis

GROUNDED/WHOLE BEAN COFFEE

There are approximately 190 million people in the U.S. that buy coffee. 107 million of them
buy ground or whole bean coffee, and 3.6 million of them buy Starbucks coffee (Source:
Choices II / Simmons Market Research / 1997). This creates good opportunities for
Starbucks to expand it’s wholesale sales through supermarkets and grocery stores in the U.S.

However,, the consumer segment that buys Starbucks’ coffee is in the higher income
segment -- from $60,000 annual income and above, with higher likelihood for individuals
with income of $150,000 to $250,000 a year. See exhibit below.

How Likely a Customer will Buy Coffee at Starbucks

0-100 Less Likely
100-199 More Likely
200-299 Two times more Likely

700
600
500
400
How Likely
300
200
100
0
$250K +
$75K - $100K
$20K - $25K

$25K - $20K

$30K - $35K

$40K - $45K

$45K - $50K

$50K - $60K

$100K - $150K

$150K - $250K
$12K - $15K

$15K - $20K

$35K - $40K

$60K - $75K

Source: Choices II / Simmons Market Research / 1997 Income

 8

Starbucks customers are also more likely to be either young or old: 18 to 34 year-olds and 45
to 54 year olds buy the most Starbucks products. Combining this information with the above
information makes it difficult to believe that the potential for increasing the sales of
Starbucks’ whole or ground coffee is as big as it may appear at first sight. The younger
people do not have the money to buy this premium brand, so the strategy appears to be
targeting older and more established consumers. The exhibit below illustrates that SBUX
market growth strategy may be at odds with the country’s age and income demographics.

How Likely a Customer will Buy Coffee at Starbucks

0-100 Less Likely
100-199 More Likely
200-299 Two times more Likely

160
140
120
100
How Likely 80
60
40
20
0
18-34 35-39 40-44 45-49 50-54 55-59 60-64 65-69 70-74
Age
Source: Choices II / Simmons Market Research / 1997

RETAIL
While there are no national coffee-bar competitors on the scale of Starbucks, but there are
many regional competitors.
Among the regional players
that compete with Starbucks
are Peet’s, New World
Coffee, Brothers Gourmet
Coffees (recently acquired by
Proctor and Gamble),
Caribou Coffee, Second Cup,
Barnie’s Coffee & Teas Inc.,
Diedrich Coffee, Seattle
Coffee Co., and Green
Mountain Coffee. Most of
these competitors have
somewhere between 30 and
New York
 9

300 retail locations. Many are also growing at rates similar to what Starbucks experienced in
it’s early period of expansion (late 80s, and early 90s). However, in spite of seeing themselves
as coffee chains, these competitors often restrict growth to certain regions (i.e. Diedrich in
the Western U.S.) or certain markets (Gloria Jeans – a Diedrich brand that is operated
mainly in suburban malls).

We feel that Starbucks is up against two forces that will limit the strong growth in sales that
they’ve enjoyed in the past. First, the increasing amount of local competition makes it
difficult to continue to operate as an unchallenged leader. Second, as Starbucks begins to
saturate certain markets, they will be forced to do two things: 1) open in less attractive
markets; and/or 2) cannibalize sales from existing retail locations thereby reducing same-
store sales growth (currently 5-6%). The map above shows locations of Starbucks retail
shops in New York neighborhoods. It is not hard to imagine a time of a “Starbucks on every
corner.”

Overall, Starbucks continues to put stock in the potential of both the domestic market and
in opportunities overseas. In the U.S. alone, the coffee processors predict that by 2000,
Americans will spend up to $3 billion a year on gourmet coffee beans or drinks, accounting
for one-third of all coffee consumed. A large portion of this growth is projected to come at
the expense of the large consumer goods companies (General Foods, Proctor & Gamble).
The days of Maxwell House and Folgers are over. Previously, almost all coffee consumption
came from grocery store sales. The underlying demographics have also changed. As the
name implies, gourmet coffee targets an upscale market, with higher amounts of income,
disposable income, and a predisposition to “luxury” items. The buying trends support these
findings. The larger food companies (Hershey, Nestle, General Foods) are now beginning to
fight back through development of flavored coffees, coffee drinks, cappuccino drinks, and
milk-based coffee beverages. As Starbucks has pushed to extend its brand, it increasingly
goes head-to-head with these larger competitors.

1.6 Management

Howard Schultz continues to be a driving force at Starbucks. The charismatic leader has
refocused his interests on the core lines of business and is no longer trumpeting a big push
into the Internet. However, the recent investments made in
Cooking.com ($10 million) and in Living.com ($20 million
loan), alliance formed with Oxygen Media, and the
acquisition of Hear Music indicate that the company is still
pursuing what many analysts consider to be distractions from
the primary coffee or coffee-related business. From a
management perspective, there is enormous time
commitments made to making these relationship work; and
when the link between the core products and the new
mediums are only tangential, an argument can be made that
this time could be better spent developing the core business.
 10

For example, product and store licensing is a high-margin business that leverages the
Starbucks brand, requires minimal oversight, and extends the core lines of the business
(coffee, coffee drinks, coffee ice-cream, etc,…).

In the past couple of years, the company has hired management with foodservice and
consumer product experience and expertise. Collectively, the senior management team
comprises individuals with experience at Nestle, Proctor & Gamble, Burger King, and Taco
Bell. The experience brought into the company covers financial, operational, sales, and
marketing functions. In addition, the COO, Orin Smith, and president, Howard Behar, have
both been with the company for the past 10 years.

The company has recently hired new management to run the consumer products division,
which accounts for the bulk of specialty sales. The consumer products group is a new
division that was started last April, and is run by Paul Davis, the former president of Hostess
Frito-Lay, Canada. Davis is expected to pull together all of the non-retail-based sales
(grocery store sales, foodservice (hotels, restaurants, office, etc.) and licensing and joint
ventures. The new division allows for greater consolidation and control over lines of
business that were formerly scattered throughout the company. The new management
brought in to run this division has broad consumer product experience and is expected to
grow the specialty sales significantly. Most of these businesses generate higher returns on
invested capital than returns generated by retail sales.

Starbucks work force enjoys lower turnover than the rest of the industry. From the start,
Starbucks has treated its employees very well, with the belief that happy workers make happy
customers. Even part-timers are offered health benefits, 401(k) plans, and stock options.

1.7 Industry Outlook

COFFEE INDUSTRY: “Gimme a cuppa joe”

Today, you are much more likely to hear customers request “an iced short schizo skinny
hazelnut cappuccino with wings.” (Translation: a small iced hazelnut coffee with one shot of
regular and one of decaf, plus skim milk with foam, to go). Today, the specialty or gourmet
coffee business has overtaken the “cuppa joe” that consumers (especially in the U.S.) used to
drink as part of their daily regimen. This niche of specialty coffee is in fact the only growth
segment of the coffee market. The Specialty Coffee Association of America is projecting that
there will be 10,000 coffee bars in the U.S. by the year 2000. Estimated consumption of
coffee in the U.S is 7.45 billion gallons, with an average of 3 cups consumed per day. In the
U.S., roughly 50% of the total population (approx. 250 million) are coffee drinkers. The
specialty coffee sales segment of the market is a $5.2 billion market and sales breaks out as
follows:

• Coffee bean retailers: $2.5 billion

• Coffee cafes: $1.95 billion
• Coffee kiosks: $0.86 billion
• Coffee carts: $0.36 billion
• Total: $5.22 billion
 11

THE EVIL EMPIRE

Starbucks has landed directly on the top of this trend, but is facing
increasing pressure from many regional competitors that are eating
into the “Starbucks Sprawl”. Even comedians poke fun at the ever-
present Starbucks brand – in the recent Austin Powers movie, “The
Spy Who Shagged Me,” Mike Myers’ character, Dr. Evil turns to
Starbucks to fuel the growth of his evil empire. Jeanne Garofalo also
jokes about having Starbucks open an outlet in her living room.
While the jokes are funny, the implications are not. Starbucks is
increasingly demonized as the McDonalds of Coffee – and
competitors, especially local retail chains, are quick to capitalize on
this characterization and offer up new choices for dissatisfied
customers.

RETAIL ENVIRONMENT
Starbucks retail business is part of the restaurant industry, which can be divided into Quick-
Service Restaurants and Casual Dining. Overall, the restaurant industry is enjoying an
improving business climate, where the lead players exhibit healthy increases in same-store
sales (comps) and expanding returns. The perky climate can be explained by trends within
the restaurant industry and favorable macro-economic forces (i.e. the booming economy).
Within the industry, unit expansion has slowed over the past few years, which helps boost
guest counts within existing stores (same-store sales gains). Accompanying this trend is
renewed attention to operational execution to increase efficiencies and improve the cost-
structure at the existing base of restaurants. For Starbucks, percent growth of new units is in
the mid twenties while same-store sales growth is about 5 percent. The healthy economy has
helped the industry as well with higher consumer spending (employment is up, wages have
increased, and disposable income is up). For many in the industry, low commodity prices
have also helped increase returns, although for Starbucks this is offset somewhat by their
more expensive labor pool and training costs and the fluctuations of the coffee markets.

DINING OUT IS “IN”

As lifestyles have changed, eating out has become more and more popular.
Research cites increases in dual-income families, decreases in free time, and
increases in the number of women in the workforce as reasons for more
“dining out.” The same factors are also used to explain the rise of “meals on
the go” (the Quick-Service component of the industry). Starbucks is clearly
situated in the middle of this environment and through their European-
inspired cafes have helped create some of the trends. Currently, they are
experimenting with offering more food at some of their locations, along with
opening up larger cafes that offer full-service meals in more of a traditional
restaurant atmosphere.

Many analysts are worried that the increases in dining out may be wiped out during a
downturn in the economy. In the past, Starbucks has had difficulties rolling out full-service
food capability at either existing locations or in new retail concepts and this may be further
tested in the event of a downturn.
 12

LATTE, LATTE, EVERYWHERE…

At the outset, Starbucks was helping to usher in a new trend, bringing high-quality coffee
and a stylish European café store design into the U.S. They helped start the coffeehouse
phenomenon. As countryside was quickly populated by the “Green Menace”, competitors
popped up everywhere. At some point, the trend may peak. In the meantime, competition
continues to heat up, with pressure from both local shops, regional chains, and larger
international giants who are moving into the market:

- McDonalds recently acquired Aroma, a chain of 23 coffee shops in London

- Nestle just struck a deal with Granada Road Services to run their national chain of coffee
houses (Café Nescafe) at service stations around the country.

In the U.S. coffeehouses and cafes number over 8,000, and by 2000, this is expected to
double. And most of the new competition is following Starbucks’ example of making the
experience as important as the coffee itself. These are the new places to hang out The
concern is how long will this trend continue before the next “hot” thing come along.

SPECIALTY SALES
As the Starbucks name has blossomed into a world-class brand on par with McDonalds and
Coke, the company has gradually increased its presence in new channels. These include sale
of their whole-bean and ground coffee in grocery stores along with distribution of their
coffee through the foodservice channel (hotels, airlines, offices, etc,.). In addition, the
company licenses stores and pursues joint ventures (Frappuccino with PepsiCo and ice
cream with Dreyer's). As previously stated, these lines of business are contributing a larger
percentage of Sales (15%) and more importantly an even higher percentage of operating
income (25%).

GROCERY CHANNEL IS POTENTIALLY DANGEROUS GROUND…

As competition has risen in the retail arm of the specialty coffee industry, Starbucks has
managed to stay in the lead and push into new markets and channels. However, the grocery
store environment is home to consumer products giants who are beginning to respond to
Starbucks moves. (P&G recently agreed to buy the assets of Brothers Gourmet Coffees Inc,
a wholesaler of roasted gourmet coffees).

SHARING CUSTOMERS INCREASES RISK OF NEW COMPETITIORS

In addition, by pursuing these channels through joint ventures and alliances, Starbucks is
forced to share knowledge and give up some ownership of the customer relationship. When
the brand power is strong and favorable, this is not a problem. In fact, it helps increase
margins for Starbucks, due to lowered overhead and capital investment (no retail locations to
build out, staff to hire/train, etc,..). Over time, however, these alliance partners often exhibit
fickle behavior and move to the latest fad that can offer a quick boost to sales. In addition,
the knowledge gained over time leads partners to believe that they can “go it alone.”
Starbucks has continued to expand their Specialty Sales lines of business in order to improve
their margins and extend the brand reach. As they move with greater force into these
channels, they will face increasing competition from the traditional consumer products
giants. This channel has traditionally required substantial advertising support to influence
consumer buying. Up until now, Starbucks has not had to advertise – their stores and
 13

consumers do all the work. To compete in the grocery stores, they may eventually have to
bump up advertising, especially if they begin eroding market share from the dominating
firms.

COFFEE COMMODITIES
Obviously, Starbucks has a great deal of exposure to coffee prices. They manage this
exposure through systematized inventory stocking that includes sophisticated commodity
derivatives used to control the cost of their primary input – coffee beans. Starbucks deals
mainly in green coffee, which can be stored for long periods of time, and does all of its own
roasting. In the past, as more expensive layers of their coffee inventories have been exposed
(due to faster than expected sales growth), Starbucks has been forced to raise retail prices to
protect their margins from the increased cost. Many believe that Starbucks retail prices are
about as high as the market will bear, and grass-roots resistance to high prices is starting to
appear.

Coffee commodity prices have traditionally been very volatile, but Starbucks recently
indicated that the recent volatility would not significantly boost their costs in the near-term
future. CFO Michael Casey recently announced that, “although we are continuously
monitoring movements in the price of commodity coffee, we are currently very comfortable
with our outlook for the cost of premium coffee in fiscal 2000.” He reassured analysts that
“at current levels there will not be a significant impact on our overall weighted cost of coffee
for the year.”

In summary, Starbucks and other coffee retailers will always be subject to the volatility of the
coffee commodity markets, but through their sophisticated hedging policies, they are able to
contain costs and smooth out the price fluctuations so as to better manage their cost
structure. Only in the event of large price changes over an extended period of time would
Starbucks feel the impact on their margins. Even in this case, their competitors would be
similarly hurt.

2 Accounting Analysis

2.1 Review of Accounting Policies

Starbucks core business is to purchase, roast and sell premium coffees in its company-run
retail outlets. As such, the accounting process for this business segment is fairly
uncomplicated.

The company leases its retail locations, distribution facilities and office space. Minimum
future payments under these contracts are not materially different than the company has
paid in the past.

The company is currently debt free, having called a series of convertible bonds in FY1998.
 14

Inventory levels have traditionally been well managed by the company since its coffee bean
products are perishable. As of the FY1999 third quarter, SBUX had 6 days inventory of
roasted coffee, 24.5 days inventory of unroasted coffee, and 55 days inventory of non-
perishable other merchandise.

As of June, 1999, SBUX had not made any material

changes in financial accounting methods, estimates
SBUX recorded a reduction in or timing. The company’s FY1999 10K is still
bonus compensation accruals unavailable, so a detailed review of their latest
that helped the company hit financial accounting policies is impossible. However,
Wall Street’s $.17 per share Morgan Stanley reports that in the fourth quarter of
EPS target -- one that had been FY1999, SBUX recorded a reduction in bonus
previously lowered. compensation accruals, lowering the General and
Administrative ratio by 90 basis points. While this
change economically reflected lowered expected
bonuses, it also helped SBUX report $0.17 per share earnings, a figure which was exactly in-
line with Wall Street expectations and one that had been lowered significantly already.

2.2 Test of Earning Manipulation

The exhibit on the following page summarizes the Beneish 8-variable model to detect
earnings manipulation. With a M-score of –2.22, the company is on the threshold of looking
like an earnings manipulator. Indices that are high include receivables growth and sales
growth. SBUX receivables increased from 11 days to 14 days, likely reflecting the increasing
amount of specialty sales in the product mix. Retail customers pay in cash, so there is no
need for concern regarding receivables growth. Sales growth was also high on a relative
basis, but this is a result of the company’s strategy and position. In the aggregate, we do not
believe that the Beneish indicator should represent an indictment the company.
 15

M-score for Starbucks Corporation

The Full Beneish model for ANNUAL earnings manipulation
(Based on Eight Variables)
INPUT VARIABLES 9/98 9/97
Net Sales 1308.7 975.389
CGS 1069.50 803.81
Net Receivables 50.97 31.23
Current Assets (CA) 337.28 317.555
PPE (Net) 600.794 488.791
Depreciation 80.90 58.86
Total Assets 992.755 857.152
SGA Expense 77.575 57.144
Net Income (before Xitems) 68.372 55.211
CFO (Cash flow from operations) 142.879 100.294
Current Liabilities 179.475 145.476
Long-term Debt 0 165.02

DERIVED VARIABLES
Other L/T Assets [TA-(CA+PPE)] 54.7 50.8

DSRI 1.216
GMI 0.962
AQI 0.929
SGI 1.342
DEPI 0.906
SGAI 0.988
Total Accruals/TA -0.075
LVGI 0.499

M = -6.065+ .823 DSRI + .906 GMI + .593 AQI + .717 SGI + .107 DEPI
M-score (5-variable model) -2.58

M = -4.84 + .920 DSRI + .528 GMI + .404 AQI + .892 SGI + .115 DEPI
-.172 SGAI + 4.679 Accrual to TA - .327 Leverage
M-score (8-variable model) -2.22
Note: if M > -2.22, firm is likely to be a manipulator
 16

3 Financial Analysis

3.1 Ratio Analysis

A Dupont Decomposition of Starbucks

performance reveals that its return on equity
“Starbucks historical ROE is between
has moved between 10 –11 percent in recent
10 – 11 percent. Their cost of equity is
years. Because SBUX beta, and
also roughly 10 percent, which means
consequently its cost of equity, is so high
the company has created zero
(somewhere between 10 – 11 percent), it’s
clear from a simple ROE analysis that the economic value for its shareholders to
company is barely creating economic value, date.”
if at all. The exhibit page 17 illustrates this.

3.2 Overall Profitability

For the 8 weeks ended November 28, 1999, consolidated net revenues were $302 million, an
increase of 33 percent from consolidated net revenues of $226 million for the same period in
fiscal 1999. Comparable store sales increased 8 percent for the 8-week period ended
November 28, 1999, as compared to the same 8-week period in fiscal 1999.

While revenue and earnings per share growth has been a leading selling point of this
company, the rate of growth across both metrics is slowing.

3.3 Operating Profitability Analysis

See pages 17 - 20 for quarterly performance and common-sized income statements &
balance sheets.
 Starbucks Corporation (SBUX)
17
Dupont Analysis
Fiscal Year
LTM
9/94 9/95 9/96 9/97 9/98 6/99
Profitability
Asset Turnover 1.32 1.33 1.17 1.23 1.41 1.48
x Pretax Profit Margin 6.23 9.27 9.76 9.36 8.89 9.66
= Pretax Return on Assets 8.20 12.33 11.40 11.53 12.58 14.25
x Tax Rate Compliment 57.49 60.50 61.26 60.47 58.76 62.86
= Net Return on Assets 4.71 7.46 6.98 6.97 7.39 8.96
x Equity Leverage (Assets/Equity) 2.13 1.66 1.56 1.61 1.39 1.26
= Net Return on Equity 10.03 12.37 10.92 11.21 10.30 11.24
x Earns Retention (1-Payout) 97.35 100.00 100.00 100.00 100.00 100.00
= Reinvestment Rate 9.76 12.37 10.92 11.21 10.30 11.24

EBIT Return on Assets 8.20 12.33 11.40 11.53 12.58 14.25

Interest as % Assets

Selected Financial History

Total Assets 231.42 468.18 726.61 857.15 992.76 1168.54
Net Sales 284.92 465.21 697.87 975.39 1308.70 1562.96
Net Income 10.21 26.10 41.71 55.21 68.37 94.88
Sales/Share 2.39 3.26 4.67 6.12 7.43 8.55
Earnings/Share (Operating) 0.08 0.18 0.28 0.35 0.39 0.52
Cash Flow/Share 0.21 0.36 0.57 0.75 0.86 1.11
Dividends/Share 0.00 0.00 0.00 0.00 0.00 0.00
Book Value/Share 0.95 2.20 2.91 3.31 4.43 5.04

Debt Adjusted Market Value

+ Market Value of Equity 668.09 1343.75 2560.27 3368.37 3243.61 5315.58
+ Preferred Stock
+ ST Debt + LT Debt 80.50 80.40 165.02 165.02 0.00 0.00
+ Other Liabilities 0.00 0.00 0.00 0.00 0.00 0.00
- Cash and Equivalents 15.92 62.45 229.44 153.63 123.54 149.41
= Debt Adjusted Market Value 732.66 1115.13 1847.50 2433.88 1973.06 5166.17

Earns Before Interest, Tax, & Depr. 32.02 67.97 107.52 150.17 197.25 251.86
Debt Adjusted Market Value / EBITD 22.88 26.19 32.30 31.77 20.00 20.51

Liquidity
Current Ratio 2.09 2.89 3.36 2.18 1.88 1.72
Quick Ratio 0.71 1.15 2.53 1.36 1.08 0.98
Cash & Equiv % of Current Assets 18.82 30.41 67.57 48.38 36.63 38.66
Receivable Turnover - Days 5.44 5.98 7.18 9.14 11.46 8.81
Inventory Turnover - Days 64.29 85.74 64.67 46.12 44.86 45.34
Inventory to Cash - Days 69.72 91.73 71.85 55.26 56.32 54.16
Oper Funds / Current Liabilities (%) -3.70 -109.21 31.89 114.57 87.56 94.03
Oper Funds / LT Debt (%) -1.86 -96.51 19.53 101.00
Oper Funds / Total Debt (%) -1.86 -95.31 19.33 101.00

Leverage
Assets / Equity 2.11 1.50 1.61 1.61 1.25 1.27
LT Debt / Capitalization (%) 42.28 20.48 26.76 23.62
Total Debt / Total Assets (%) 34.79 17.17 22.71 19.25
Total Debt / Cap. + ST Debt (%) 42.28 20.48 26.76 23.62
Total Debt / Equity Market Value (%) 12.05 5.98 6.45 4.90

Fixed Charge Coverage

EBIT / Interest Expense
Oper Funds / Interest Expense
Fixed Charge Coverage incl. Rents
S&P Bond Rating

Source: Market Guide © FactSet Research Systems, Inc.

 Starbucks Corporation (SBUX) 18

Quarterly Summary
($mm)

Net Pretax Pretax Tax Net LTM

Period Sales Income Margin Rate Income E.P.S E.P.S

12/96 239.1 23.4 9.8 38.5 14.4 0.09 0.29

3/97 217.3 14.8 6.8 40.9 8.7 0.06 0.27
6/97 244.2 23.4 9.6 39.2 14.2 0.09 0.30
9/97 274.7 29.8 10.8 40.0 17.9 0.10 0.33
Year 975.4 91.3 9.4 39.5 55.2 0.33

12/97 321.3 34.8 10.8 39.8 21.0 0.12 0.36

3/98 295.2 23.4 7.9 40.4 14.0 0.08 0.38
6/98 334.4 19.0 5.7 58.4 7.9 0.04 0.33
9/98 357.7 39.1 10.9 34.7 25.6 0.13 0.37
Year 1308.7 116.3 8.9 41.2 68.4 0.37

12/98 405.6 43.1 10.6 38.0 26.7 0.14 0.40

03/99 375.8 29.0 7.7 38.0 18.0 0.10 0.41
06/99 423.8 39.7 9.4 38.0 24.6 0.13 0.50
09/99 475.0 32.4 0.17
Year 1680.3 101.7 0.56

Percent Change Analysis

Net Pretax Pretax Tax Net LTM

Sales Income Margin Rate Income E.P.S E.P.S

12/96 41.1 48.0 4.9 -2.5 50.4 35.4 54.1

3/97 41.5 -12.6 -38.2 6.0 -15.9 -20.0 23.7
6/97 38.0 50.8 9.2 0.5 50.3 45.8 29.0
9/97 39.9 46.8 4.9 7.1 40.5 44.1 25.2
Year 40.0 33.3 -4.8 2.7 31.1 25.2

12/97 34.4 48.7 10.7 3.3 45.6 33.0 25.3

3/98 35.9 58.6 16.7 -1.1 59.8 35.7 39.1
6/98 36.9 -18.6 -40.5 49.1 -44.4 -50.0 12.1
9/98 30.2 31.3 0.8 -13.3 42.9 34.7 12.2
Year 34.2 27.4 -5.0 4.3 23.8 12.2

12/98 26.2 23.9 -1.8 -4.5 27.6 23.1 10.6

03/99 27.3 23.6 -2.9 -6.0 28.6 25.0 9.8
06/99 26.7 109.0 65.0 -35.0 211.9 200.0 49.7

Year
 Starbucks Corporation (SBUX) 19

Common-Sized Income Statement

% of Sales 9/98 9/97 9/96 10/95 10/94 10/93 9/92

NET SALES 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Cost of Goods Sold 49.7 50.1 53.4 48.9 49.1 48.8 48.5
GROSS PROFIT 50.3 49.9 46.6 51.1 50.9 51.2 51.5
Selling, General and Admin Expenses 37.9 37.9 35.6 39.5 39.7 40.2 42.2
Research and Development Expense *
Other Operating Expenses 3.3 2.9 2.8 3.0 3.1 3.1 2.4
OPERATING INCOME before D&A 15.2 15.1 13.8 14.0 13.1 12.1 11.3
Depreciation and Amortization Expense ** 6.2 6.0 5.7 5.3 4.9 4.2 4.4
OPERATING INCOME after D&A 9.0 9.1 8.2 8.6 8.2 7.9 6.8
Interest Expense 0.1 0.8 1.3 0.8 1.3 0.5 0.5
Non-Operating Income (Expense) 0.7 1.3 2.9 1.5 0.7 1.0 0.7
Reserves - Increase (Decrease) 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Extraordinary Pretax Credit (Charge) -0.7 0.0 0.0 -1.4 0.0 0.0
PRETAX INCOME 8.9 9.7 9.8 9.3 6.2 8.5 7.1
Total Income Taxes 3.7 3.7 3.8 3.7 2.6 3.3 2.7
Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0
NET INCOME before Extraordinary Items 5.2 5.9 6.0 5.6 3.6 5.2 4.4

NET INCOME after Extraordinary Items 5.2 5.9 6.0 5.6 3.6 5.2 4.4

* R&D Expense is included in SG&A Expenses

** Depreciation and Amortization Expense is included in Cost of Goods Sold

Source: Market Guide © FactSet Research Systems, Inc.

 20

Starbucks Corporation (SBUX)

Common-Sized Balance Sheet

% of Total Assets 9/98 9/97 9/96 10/95 10/94 10/93 9/92

ASSETS
Cash 12.4 18.1 31.6 13.3 6.8 17.5 41.2
Net Receivables 5.1 3.6 2.4 2.2 2.3 1.5 1.7
Inventories 14.4 14.1 11.5 26.4 23.8 12.3 12.8
Other Current Assets 2.0 1.5 1.3 2.0 3.1 2.4 2.3
CURRENT ASSETS 34.0 37.2 46.7 43.9 36.0 33.7 58.1
Net Plant 60.5 56.8 50.8 52.3 59.9 33.4 36.7
Other Assets 5.5 6.0 2.4 3.8 4.2 32.9 5.2
TOTAL ASSETS 100.0 100.0 100.0 100.0 100.0 100.0 100.0

LIABILITIES AND EQUITY

Short-Term Debt 3.4 3.2 2.4 2.8 5.1 3.2 5.0
Accounts Payable 5.5 5.4 5.2 6.1 3.9 2.9 4.4
Income Taxes Payable 0.9 0.5 0.4
Other Current Liabilities 8.3 7.1 5.9 6.2 8.2 6.4 4.4
CURRENT LIABILITIES 18.1 16.3 13.9 15.2 17.2 12.4 13.7
Long-Term Debt 0.0 19.6 22.9 17.4 34.2 40.9 0.0
Provisions for Risks and Charges
Deferred Taxes 1.9 1.5 1.0 0.7 0.3 0.0 0.0
Other Liabilities 0.0 0.0 0.0 0.0 0.0 0.0 0.0
TOTAL LIABILITIES 20.0 37.5 37.8 33.3 51.7 53.3 13.7
Non-Equity Reserves 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Minority Interest 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Preferred Stock (Carrying Value) 0.0 0.0 0.0 0.0 0.0 0.0 0.0

Common Equity 80.0 62.5 62.2 66.7 48.3 46.7 86.3

TOTAL STOCKHOLDERS' EQUITY80.0 62.5 62.2 66.7 48.3 46.7 86.3
TOTAL LIABILITIES AND EQUITY
100.0 100.0 100.0 100.0 100.0 100.0 100.0

Total Invested Capital 80.0 82.2 85.1 84.1 82.6 87.6 86.3

Source:
Source:
Market
Market
Guide
Guide © FactSet Research Systems, Inc.
 21

3.4 Liquidity and Solvency analysis

Starbucks currently reports a modest $9 million in debt and ample cash ($124mm). The
company is tremendously healthy in terms of near term liquidity and solvency. We do not
anticipate major changes to the capital structure since operating cash flow has historically
been sufficient to fund most of Starbucks' expansion plans.

4 Valuation

4.1 Overview
Our valuation analysis suggests a price range for Starbucks of approximately $9 - $13 per
share, as compared to its current price of $27.81 per share. We performed the valuation
analysis using both an income approach and a market approach. The income approach
included a discounted cash flow model (DCF), an Edwards-Bell-Ohlson (EBO) residual
income model and a Foster model to predict earnings. The market approach included an
analysis of trading multiples of companies that are comparable to Starbucks.

4.2 Cost of Capital

The firm’s cost of capital was a key assumption in the DCF and EBO models. The firm
presently has no debt or preferred stock; accordingly, our cost of capital represents
Starbucks’ cost of equity.

CAPM
Using the CAPM approach, the firm’s cost of equity WACC (CAPM)

is approximately 10.6%. Key assumptions in this Risk Free Rate 6.19%

calculation included a risk free rate of 6.2% (30 T- Market Risk Premium
Beta
3.00%
1.46
Bond), market risk premium of 3%, and adjusted
beta of 1.46. Cost of Equity 10.57%

INDUSTRY WACC
We calculated an estimate of the industry cost of WACC (FF 3-Factor / Industry)

capital using the Fama and French three factor SIC Code 5812
model. This model is driven off an industry-based Risk Free Rate 6.19%
market risk premium for companies in the 5812 Industry Risk Premium using 3 Factor 6.81%
Beta 1.46
(meals) industry. With a market risk premium of
6.81%, the suggested cost of capital is 16.13%. We Cost of Equity 16.13%

believe that this is relatively high, given the current

overall lower market risk premia for all industries.
WACC (Implied Cost of Capital)
IMPLIED COST OF CAPITAL Original EBO Implied Price 14.24
Based on an EBO implied price of $14.24 using the
Current Price 27.81
CAPM discount rate, the implied cost of capital that
Implied Discount Rate (Cost of Equity) 7.2%
 22

equates the current price of $27.81 to the EBO implied price is 7.2%. This is an extremely
low cost of equity capital, and in the current interest rate environment, it is not substantially
greater than the risk free rate. As such, a higher discount rate is more appropriate, suggesting
a price for the stock that is lower than the current price. While the implied cost of capital
approach is somewhat tautological for valuation analysis, it provides an additional view of
the cost of capital.

4.3 Foster Model

We prepared the Foster earnings model, which suggests . . .

E[Qt] = E[Qt-4]+.02 + .35(E[Qt-1]-E[Qt-5]

= .14 + .02 + .35*(.17 - .13)
= .174

. . .versus analyst’s consensus of $.16/share.

4.4 DCF Model

In our base case scenario, the discounted cash flow model suggests a price of $11 per share.
This result is driven by key assumptions in sales growth, store operating costs, and cost of
capital.

DCF – SALES GROWTH

Sales growth, while still strong, has been declining over the past four years. Sales are broken
down into retail (products sales at company owned retail stores) and specialty (wholesale
product sales and store/grocery licenses). Retail sales account for 85% or sales and specialty
approximately 15%.

Growth in total revenues has been primarily a result of new store additions (399 stores in
1994 to 1,688 in 1998). Growth in same store sales has been relatively steady at
approximately 5-6% in the last three years. Additionally, as the company has begun to reach
penetration in large domestic markets, we have projected growth in the retail segment to
continue to decrease. Retail growth, while decreasing, will still stay around 20% due to a roll
out of expanded food sales in the retail stores.

The company has also begun to increase focus on specialty sales. New products are expected
to be rolled out for distribution in grocery stores, and the company plans to sell additional
licenses pursue other joint ventures.
 23

Historical and Projected Sales Growth

60%

Retail
50%
Specialty

40%
Net Sales

30%

20%

10%

0%
1996A 1997A 1998A 1999A 2000E 2001E 2002E 2003E 2004E

OPERATING MARGINS
The DCF valuation is very sensitive to changes in the operating margin assumptions. We
expect the company to experience higher store operating costs in the future primarily due to
increasing labor costs. Given the current labor market conditions, only future increases in
store labor costs are predicted. See assumptions and the complete DCF model on pages 24 -
30.
 24

Starbucks Corporation
Projected Free Cash Flows
2000-2004
Projected
Free Cash Flows and Valuation 2000 2001 2002 2003 2004

EBIT 194,975 226,120 291,521 322,366 400,330

Less Taxes on EBIT 77,990 90,448 116,608 128,946 160,132

EBI (NOPAT) 116,985 135,672 174,913 193,419 240,198

Depreciationand Amortization 111,578 119,477 132,063 149,885 165,052

CAPEX (222,565) (263,657) (312,313) (375,959) (486,784)
Change in Working Capital 299,495 114,352 131,540 148,011 170,084

Free Cash Flow 305,493 105,844 126,203 115,356 88,550

Terminal Value 2,272,452

Year 1 2 3 4 5
Discount Factor 0.90 0.82 0.74 0.67 0.61

Total Free Cash Flow 276,290 86,575 93,359 77,177 53,580

Present Value of Terminal Value 1,375,017

Valuation
Total PV of Cash Flows 1,961,998
Less Debt -
PV of Shareholder's Equity 1,961,998
Shares O/S 182,190
Price Per Share $ 10.77
 25

Starbucks Corporation
DCF Model Assumptions

INCOME STATEMENT ASSUMPTIONS

2000 2001 2002 2003 2004 Comments

Sales Growth
Retail 27% 25% 23% 21% 20% Annual Growth
Specialty 23% 21% 20% 19% 18%
Net Sales 26% 24% 23% 21% 20%

Gross Margins 55% % Sales, 4 year average

Store Operating Expenses 32% 33% 33% 33% 33% % Sales, 4 year average
Other Operating Expenses 3% 3% 3% 4% 4% % Sales, 4 year average
Depreciation and Amortization 5%
Sales, General & Admin 6% % Sales, 4 year average
Merger Expenses

Interest and Other Income 12% % of M/S

Interest and Other Expense % Avg.Debt
Gain on Sale of investment

Income Taxes 40% Statutory Rate

Dividend Payout percentage 0%

BALANCE SHEET ASSUMPTIONS

Cash 11% % Sales

Marketable Securities 8% % Sales
Accounts Receivable 3% % Sales
Inventory 12% % Sales
Prepaid Expenses and oth curr assets 1% % Sales
Deferred Taxes % Sales
Joint Ventures 2% % Sales
Deposits and Other Assets 2% % Sales
Notes Payable #VALUE! % Total Assets
Accounts Payable 5% % Sales
Accrued Liabilities 7% % Sales
Other Current Liabilities 2% % Sales
Deferred Taxes 1% % Sales
PP&E 50% % Sales
Common Stock as % of Equity 78%

WACC (CAPM) WACC (Implied Cost of Capital)

Cost of Debt 0 Original EBO Implied Price 14.24

Risk Free Rate 6.19% Current Price 27.81

Market Risk Premium 3.00%
Beta 1.46 Implied Discount Rate (Cost of Equity) 7.2%

Cost of Equity 10.57%

Debt to Capital 0%
Equity to Capital 100%

WACC 10.57%

WACC (FF 3-Factor / Industry)

SIC Code 5812

Risk Free Rate 6.19%

Industry Risk Premium using 3 Factor 6.81%
Beta 1.46

Cost of Equity 16.13%

 26

Starbucks Corporation
Scheduled CAPEX
2000-2004

Actual Projected
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Land 3,602 3,602 3,602 3,602 3,602 3,602 3,602 3,602 3,602 3,602
Building 8,338 8,338 8,338 8,338 8,338 8,338 8,338 8,338 8,338 8,338
LHI 162,948 255,567 352,460 460,020 588,826 736,032 905,319 1,086,383 1,303,660 1,538,319
Roasting and Store Equipment 82,490 120,575 168,929 218,744 273,430 336,319 410,309 496,474 590,804 691,241
Furniture, Fixtures, and other 24,602 38,794 49,790 79,953 119,026 172,588 241,624 350,354 525,531 762,020

Gross PP&E 281,980 426,876 583,119 770,657 993,222 1,256,879 1,569,192 1,945,151 2,431,935 3,003,520

Year Over Year Growth

Land 0% 0% 0%
Building 0% 0% 0%
LHI 57% 38% 31%
Roasting and Store Equipment 46% 40% 29%
Furniture, Fixtures, and other 58% 28% 61%

Growth Rates

LHI 28% 28% 25% 23% 20% 20% 18%

Roasting and Store Equipment 25% 25% 23% 22% 21% 19% 17%
FF&O 49% 49% 45% 40% 45% 50% 45%

Gross PP&E 770,657 770,657 770,657 770,657 770,657 770,657 770,657

CAPEX 1999 222,565 222,565 222,565 222,565 222,565 222,565
CAPEX 2000 263,657 263,657 263,657 263,657 263,657
CAPEX 2001 312,313 312,313 312,313 312,313
CAPEX 2002 375,959 375,959 375,959
CAPEX 2003 486,784 486,784
571,585

Gross PP&E 770,657 993,222 1,256,879 1,569,192 1,945,151 2,431,935 3,003,520

CAPEX 222,565 263,657 312,313 375,959 486,784 571,585

Depreciation 72,542 97,797 111,578 119,477 132,063 149,885 165,052

Years
Building 40 208 - - - - - -
LHI 20 18,400.80 6,440 7,360 8,464 9,053 10,864 11,733
Roasting Equipment 3 40,508.15 12,302 20,963 24,663 28,722 31,443 33,479
FF&O 5 13,425.07 6,512 10,712 13,807 21,746 35,035 47,298
 27

Starbucks Corporation
Common Size Financial Statements
1995-1999 Year Over Year Common Size

Balance Sheet 1995 1996 1997 1998 1999 1996 1997 1998 1999 Average 1995 1996 1997 1998 1999 Average
1996-1998 1996-1998
Cash 20,944 126,215 70,126 101,663 NA 503% -44% 45% NA 168% 5% 18% 7% 8% NA 11%
Marketable Securities 41,507 103,221 83,504 21,874 NA 149% -19% -74% NA 19% 9% 15% 9% 2% NA 8%
Accounts Receivable 9,852 17,621 31,231 50,972 NA 79% 77% 63% NA 73% 2% 3% 3% 4% NA 3%
Inventory 123,657 83,370 119,767 143,118 NA -33% 44% 19% NA 10% 27% 12% 12% 11% NA 12%
Prepaid Expenses and other current assets 9,390 9,114 12,927 19,653 NA -3% 42% 52% NA 30% 2% 1% 1% 2% NA 1%
Deferred Taxes

TOTAL CURRENT ASSETS 205,350 339,541 317,555 337,280 NA 65% -6% 6% NA 22% 44% 49% 33% 26% NA 36%

Joint Ventures 11628 4401 34,464 38,917 NA -62% 683% 13% NA 211% 2% 1% 4% 3% NA 2%
PP&E 244728 369477 488,791 600,794 NA 51% 32% 23% NA 35% 53% 53% 50% 46% NA 50%
Deposits and Other Assets 6472 13194 16,342 15,764 NA 104% 24% -4% NA 41% 1% 2% 2% 1% NA 2%

TOTAL ASSETS 468,178 726,613 857,152 992,755 NA 55% 18% 16% NA 30% 101% 104% 88% 76% NA 89%

Liabilities and Shareholders' Equity

Notes Payable 13,138 16,241 NA NA NA 24% 0% 0% NA 8% 3% 2% NA NA NA 3%

Accounts Payable 28,668 38,034 47,987 54,446 NA 33% 26% 13% NA 24% 6% 5% 5% 4% NA 5%
Accrued Liabilities 29,240 46,816 68,907 91,395 NA 60% 47% 33% NA 47% 6% 7% 7% 7% NA 7%
Other Current Liabilities 0 0 28,582 33,634 NA 18% NA 18% 0% 0% 3% 3% NA 2%
TOTAL CURRENT LIABILITIES 71,046 101,091 145,476 179,475 NA 42% 44% 23% NA 37% 15% 14% 15% 14% NA 14%

Covertible Debt 0 165,020 165,020 0 NA 0% -100% NA -50% 0% 24% 17% 0% NA 14%

Deferred Taxes 3,490 7,114 12,946 18,983 NA 104% 82% 47% NA 77% 1% 1% 1% 1% NA 1%
Non current Cap Lease 0 1,728 0 0 NA -100% NA -100% 0% 0% 0% 0% NA 0%
TOTAL LIABILITIES 74,536 274,953 323,442 198,458 NA 269% 18% -39% NA 83% 16% 39% 33% 15% NA 29%

Shareholders' Equity

Common Stock 265,679 361,309 391,284 589,214 NA 36% 8% 51% NA 32% 57% 52% 40% 45% NA 46%
Retained Earnings 46,552 90,351 142,426 205,083 NA 94% 58% 44% NA 65% 10% 13% 15% 16% NA 14%
Total Shareholders' Equity 312,231 451,660 533,710 794,297 NA 45% 18% 49% NA 37% 67% 65% 55% 61% NA 60%

Total Liabilities and Shareholders' Equity 386,767 726,613 857,152 992,755 NA 88% 18% 16% NA 41% 83% 104% 88% 76% NA 89%
85% 80% 73% 74%
78% Year Over Year Growth Common Size

1995 1996 1997 1998 1999 1996 1997 1998 1999 Average 1995 1996 1997 1998 1999 Average
Income Statement 1996-1999 1996-1999
79% 82% 91% 84%
Retail Sales 402,655 601,458 836,291 1,102,574 1,423,389 49% 39% 32% 29% 37% 87% 86% 86% 84% 85% 85%
Specialty Sales 62,558 96,414 139,098 206,128 256,756 54% 44% 48% 25% 43% 13% 14% 14% 16% 15% 15%
Net Sales 465,213 697,872 975,389 1,308,702 1,680,145 50% 40% 34% 28% 38% 100% 100% 100% 100% 100% 100%

Cost of Goods Sold 360,064 336,658 436,942 576,715 741,010 -7% 30% 32% 28% 21% 77% 48% 45% 44% 44% 45%

Gross Margin 105,149 361,214 538,447 731,987 939,135 244% 49% 36% 28% 89% 23% 52% 55% 56% 56% 55%

Store Operating Expenses 148,757 211,575 314,064 413,611 543,572 42% 48% 32% 31% 38% 32% 30% 32% 32% 32% 32%
Other Operating Expenses 13,932 19,787 28,239 43,479 51,374 42% 43% 54% 18% 39% 3% 3% 3% 3% 3% 3%
Depreciation and Amortization 22,486 36,019 52,801 72,543 97,797 60% 47% 37% 35% 45% 5% 5% 5% 6% 6% 5%
Sales, General & Admin 28,643 37,258 57,144 77,575 89,681 30% 53% 36% 16% 34% 6% 5% 6% 6% 5% 6%
Merger Expenses

Operating Income -108,669 56,575 86,199 124,779 156,711 -152% 52% 45% 26% -7% -23% 8% 9% 10% 9% 9%

Interest and Other Income 6,792 11,029 12,393 8,515 8,678 62% 12% -31% 2% 11% 1% 2% 1% 1% 1% 1%
Interest and Other Expense 3,765 8,739 7,282 1,381 1,363 132% -17% -81% -1% 8% 1% 1% 1% 0% 0% 1%
Gain on Sale of investment

EBT -105,642 58,865 91,310 131,913 164,026 -156% 55% 44% 24% -8% -23% 8% 9% 10% 10% 9%

Income Taxes 17,041 26,373 36,099 47,978 62,333 55% 37% 33% 30% 39% 4% 4% 4% 4% 4% 4%

Net Income -122,683 32,492 55,211 83,935 101,693 -126% 70% 52% 21% 4% -26% 5% 6% 6% 6% 6%

#DIV/0!
Interest Income as% of Marketable Securities 16% 11% 15% 39% #VALUE! 14%
Interest Expense as % of Average Debt 29% 5% 4% 13%
#DIV/0!
Effective Tax Rate -16% 45% 40% 36% 38%

Notes Payable as a % of Total Assets #VALUE!

 28

Starbucks
Starbucks PARAMETERS FY1 FY2 Ltg
December 5, 1999 EPS Forecasts 0.67 0.83 25.00% (using the mean analyst forecast)
FY Ends October Book value/share (last fye) 4.82
Discount Rate 7.2% Formula = Rf + Adj. Beta * (risk Premium) Actual Beta
OUTPUT Dividend Payout Ratio 0.00% = 0.06 + 1.48 * 0.03 1.72
Current Price Next Fsc Year end 2000 = 10.4%
$27.81 Current Fsc Mth (1 to 12) 2
Implied Price Target ROE (industry avg.) 15.00%
$27.81
Discount/(Premium) Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
0.0% Long-term EPS Growth Rate (Ltg) 0.2500 0.2500 0.2500 0.2500 0.2500
Implied LT Gr. E.P.S. Forecasted EPS 0.67 0.83 1.04 1.30 1.62 2.03 2.53
8.1% Beg. of year BV/Shr 4.820 5.490 6.320 7.358 8.654 10.275 12.302
Implied ROE 0.151 0.164 0.176 0.187 0.197 0.206

ROE (Beg. ROE, from the DCF model) 0.139 0.151 0.164 0.176 0.187 0.197 0.206 0.195 0.184 0.172 0.161 0.150
Abnormal ROE (ROE-r) 0.067 0.079 0.092 0.104 0.115 0.125 0.134 0.122 0.111 0.100 0.089 0.078
growth rate for B (1-k)*(ROEt-1) 0.000 0.139 0.151 0.164 0.176 0.187 0.197 0.206 0.195 0.184 0.172 0.161
Compounded growth 1.000 1.139 1.311 1.526 1.796 2.132 2.552 3.078 3.677 4.352 5.102 5.924
growth*AROE 0.067 0.090 0.120 0.159 0.206 0.266 0.341 0.377 0.409 0.435 0.453 0.460
required rate (r) 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072 0.072
discount rate 1.072 1.150 1.233 1.322 1.418 1.520 1.630 1.748 1.875 2.010 2.156 2.311
div. payout rate (k) 0.000
Add to P/B PV(growth*AROE) 0.06 0.08 0.10 0.12 0.15 0.18 0.21 0.22 0.22 0.22 0.21 0.20
Cum P/B 1.06 1.14 1.24 1.36 1.50 1.68 1.89 2.10 2.32 2.54 2.75 2.95
Add: Perpetuity
beyond current yr (Assume this yr's AROE forever) 0.86 1.08 1.35 1.66 2.01 2.42 2.89 2.98 3.02 3.00 2.91 2.75
Total P/B (P/B if we stop est. this period) 1.92 2.22 2.59 3.02 3.52 4.10 4.78 5.08 5.34 5.53 5.66 5.70
Implied price 9.38 10.83 12.63 14.72 17.16 20.00 23.32 24.80 26.04 26.99 27.60 27.81

Check:
Beg. BV/Shr 4.82 5.49 6.32 7.36 8.65 10.28 12.30 14.83 17.72 20.98 24.59 28.56
Implied EPS 0.67 0.83 1.04 1.30 1.62 2.03 2.53 2.89 3.25 3.62 3.96 4.28
Implied EPS growth 0.239 0.250 0.250 0.250 0.250 0.250 0.140 0.126 0.111 0.096 0.081

Sensitivity Analysis
Long Term Growth Rate
Change Parameters Here 27.810 21.0% 22.0% 23.0% 24.0% 25.0% 26.0% 27.0% 28.0% 29.0%
Long Term Growth Rate 10.0% $7.86 $8.06 $8.27 $8.48 $8.71 $8.94 $9.18 $9.43 $9.69
1.0% 11.0% $8.80 $9.02 $9.26 $9.50 $9.75 $10.01 $10.27 $10.55 $10.84
Target ROE 12.0% $9.77 $10.02 $10.27 $10.54 $10.82 $11.11 $11.40 $11.71 $12.03
Target ROE

1.0% 13.0% $10.77 $11.04 $11.33 $11.62 $11.92 $12.24 $12.57 $12.91 $13.26
14.0% $11.80 $12.10 $12.41 $12.73 $13.06 $13.41 $13.77 $14.14 $14.52
15.0% $12.86 $13.19 $13.53 $13.88 $14.24 $14.62 $15.01 $15.41 $15.83
16.0% $13.96 $14.31 $14.68 $15.06 $15.45 $15.86 $16.28 $16.72 $17.17
17.0% $15.09 $15.47 $15.86 $16.27 $16.70 $17.14 $17.59 $18.06 $18.55
18.0% $16.25 $16.66 $17.08 $17.52 $17.98 $18.45 $18.94 $19.45 $19.98
 29

Starbucks Corporation
Projected Income Statements
2000-2004 Actual Projected
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Income Statement

Retail Sales 402,655 601,458 836,291 1,102,574 1,423,389 1,807,704 2,259,630 2,779,345 3,363,007 4,035,609
Specialty Sales 62,558 96,414 139,098 206,128 256,756 315,810 382,130 458,556 545,682 643,904
Net Sales 465,213 697,872 975,389 1,308,702 1,680,145 2,123,514 2,641,760 3,237,901 3,908,689 4,679,513

Cost of Goods Sold 360,064 336,658 436,942 576,715 741,010 961,999 1,196,777 1,466,842 1,770,724 2,119,925

Gross Margin 105,149 361,214 538,447 731,987 939,135 1,161,514 1,444,983 1,771,059 2,137,965 2,559,589

Store Operating Expenses 148,757 211,575 314,064 413,611 543,572 671,420 871,781 1,068,507 1,289,867 1,544,239
Other Operating Expenses 13,932 19,787 28,239 43,479 51,374 64,292 79,253 97,137 156,348 187,181
Depreciation and Amortization 22,486 36,019 52,801 72,543 97,797 111,578 119,477 132,063 149,885 165,052
Sales, General & Admin 28,643 37,258 57,144 77,575 89,681 119,250 148,353 181,830 219,499 262,786
Merger Expenses

Operating Income (108,669) 56,575 86,199 124,779 156,711 194,975 226,120 291,521 322,366 400,330

Interest and Other Income 6,792 11,029 12,393 8,515 8,678 21,255 26,442 32,409 39,123 46,839
Interest and Other Expense 3,765 8,739 7,282 1,381 1,363 0 0 0 0 0
Gain on Sale of investment

EBT (105,642) 58,865 91,310 131,913 164,026 216,230 252,562 323,930 361,489 447,169

Income Taxes 17,041 26,373 36,099 47,978 62,333 86,492 101,025 129,572 144,596 178,868

Net Income (122,683) 32,492 55,211 83,935 101,693 129,738 151,537 194,358 216,893 268,301

Shares 182,190 182,190 182,190 182,190 182,190 182,190

EPS $ 0.56 $ 0.71 $ 0.83 $ 1.07 $ 1.19 $ 1.47

EPS Growth 28% 17% 28% 12% 24%

Average Growth 22%
 30

Starbucks Corporation
Projected Balance Sheets
2000-2004
Actual Projected
Balance Sheet 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Cash 20,944 126,215 70,126 101,663 101,663 233,894 290,976 356,638 430,522 515,424
Marketable Securities 41,507 103,221 83,504 21,874 21,874 177,125 220,352 270,077 326,028 390,324
Accounts Receivable 9,852 17,621 31,231 50,972 53,886 68,106 84,728 103,847 125,361 150,083
Inventory 123,657 83,370 119,767 143,118 196,919 248,884 309,624 379,494 458,113 548,456
Prepaid Expenses and other current assets 9,390 9,114 12,927 19,653 23,147 29,255 36,395 44,608 53,849 64,468
Deferred Taxes

TOTAL CURRENT ASSETS 205,350 339,541 317,555 337,280 397,489 757,264 942,075 1,154,664 1,393,873 1,668,755

Joint Ventures 11,628 4,401 34,464 38,917 39,975 50,523 62,854 77,037 92,997 111,337
PP&E 244,728 369,477 488,791 600,794 846,663 1,070,086 1,331,242 1,631,651 1,969,676 2,358,112
Deposits and Other Assets 6,472 13,194 16,342 15,764 26,718 38,934 48,435 59,365 71,664 85,796

TOTAL ASSETS 468,178 726,613 857,152 992,755 1,310,844 1,916,807 2,384,606 2,922,717 3,528,210 4,224,000

Liabilities and Shareholders' Equity

Notes Payable 13,138 16,241 NA NA NA NA NA NA NA NA

Accounts Payable 28,668 38,034 47,987 54,446 81,375 102,849 127,950 156,823 189,312 226,646
Accrued Liabilities 29,240 46,816 68,907 91,395 116,247 146,923 182,780 224,026 270,437 323,769
Other Current Liabilities 0 0 28,582 33,634 30,805 38,934 48,435 59,365 71,664 85,796
TOTAL CURRENT LIABILITIES 71,046 101,091 145,476 179,475 228,427 288,706 359,165 440,214 531,413 636,211

Covertible Debt 0 165,020 165,020 0 0 0 0 0 0 0

Deferred Taxes 3,490 7,114 12,946 18,983 21,266 26,878 33,437 40,983 49,473 59,230
Non current Cap Lease 0 1,728 0 0 0 0 0 0 0 0
TOTAL LIABILITIES 74,536 274,953 323,442 198,458 249,693 315,584 392,602 481,197 580,886 695,441

Debt / Dividends 100,151 575,495 814,738 1,069,897 1,358,807 1,671,741

Shareholders' Equity

Common Stock 265,679 361,309 391,284 589,214 589,214 589,214 589,214 589,214 589,214 589,214
Retained Earnings 46,552 90,351 142,426 205,083 306,776 436,514 588,051 782,409 999,303 1,267,604
Total Shareholders' Equity 312,231 451,660 533,710 794,297 961,000 1,025,728 1,177,265 1,371,623 1,588,517 1,856,818

Total Liabilities and Shareholders' Equity 386,767 726,613 857,152 992,755 1,310,844 1,916,807 2,384,606 2,922,717 3,528,210 4,224,000
 31

4.5 EBO
In addition to a discounted cash flow analysis, we have computed the value of Starbucks
using the Edwards Bell Olsen Model, a residual income valuation tool. With a discount rate
of 10.4 percent, a long-term earnings growth rate of 25 percent, and an industry target return
on equity of 15 percent, we value the company today at $14.02 or roughly 50 percent its
current market value of $27.81. This valuation implies a terminal growth rate in EPS of 7.3
percent.

Based on a sensitivity analysis performed, in order to justify the current stock price of $27.81
per share, the long term growth rate would have to be well in excess of 38% with a target
ROE in excess of 19%. See the exhibit on page 32 for EBO model and assumptions.

4.6 Multiples

Using the market approach we performed an analysis of trading multiples for comparable
companies. Based on this approach, the suggested price range is $8.50 - $13.90.

Starbucks is a retailer and wholesaler of premium quality coffee, with company-owned retail
locations and wholesale distribution worldwide. Comparable companies are best identified in
both the wholesale and retail lines of business, as there is not an exact pure play company for
Starbucks.

In the retail side, the next largest national coffee retailer is significantly smaller (Deidrich
(DDRX) $24 million in sales) and has incurred losses for the last several years. Accordingly,
informal dining restaurant companies are the best comparable companies. Such companies
include McDonalds, Darden Restaurants, and Papa John’s.

On the wholesale side of the business, we compared Starbucks to consumer products

companies that sell products similar to the company’s whole bean coffee Such companies
include Unilever, Best Foods and Nabisco.

See page 33 for our multiples comparison and valuation.

 Starbucks 32

EBO Model

Starbucks PARAMETERS FY1 FY2 Ltg

December 5, 1999 EPS Forecasts 0.67 0.83 25.00% (using the mean analyst forecast)
FY Ends October Book value/share (last fye) 4.43
Discount Rate 10.4% Formula = Rf + Adj. Beta * (risk Premium) Actual Beta
OUTPUT Dividend Payout Ratio 0.00% = 0.06 + 1.48 * 0.03 1.72
Current Price Next Fsc Year end 2000 = 10.4%
$27.81 Current Fsc Mth (1 to 12) 2
Implied Price Target ROE (industry avg.) 15.00%
$14.02
Discount/(Premium) Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
-49.6% Long-term EPS Growth Rate (Ltg) 0.2500 0.2500 0.2500 0.2500 0.2500
Implied LT Gr. E.P.S. Forecasted EPS 0.67 0.83 1.04 1.30 1.62 2.03 2.53
7.3% Beg. of year BV/Shr 4.430 5.100 5.930 6.968 8.264 9.885 11.912
Implied ROE 0.163 0.175 0.186 0.196 0.205 0.213

ROE (Beg. ROE, from the DCF model) 0.151 0.163 0.175 0.186 0.196 0.205 0.213 0.200 0.188 0.175 0.163 0.150
Abnormal ROE (ROE-r) 0.048 0.059 0.071 0.083 0.093 0.101 0.109 0.097 0.084 0.072 0.059 0.046
growth rate for B (1-k)*(ROEt-1) 0.000 0.151 0.163 0.175 0.186 0.196 0.205 0.213 0.200 0.188 0.175 0.163
Compounded growth 1.000 1.151 1.339 1.573 1.866 2.231 2.689 3.261 3.913 4.647 5.461 6.348
growth*AROE 0.048 0.068 0.096 0.130 0.173 0.226 0.293 0.315 0.329 0.332 0.322 0.295
required rate (r) 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104 0.104
discount rate 1.104 1.218 1.344 1.483 1.637 1.806 1.993 2.199 2.427 2.678 2.956 3.262
div. payout rate (k) 0.000
Add to P/B PV(growth*AROE) 0.04 0.06 0.07 0.09 0.11 0.13 0.15 0.14 0.14 0.12 0.11 0.09
Cum P/B 1.04 1.10 1.17 1.26 1.36 1.49 1.64 1.78 1.91 2.04 2.15 2.24
Add: Perpetuity
beyond current yr (Assume this yr's AROE forever) 0.42 0.54 0.69 0.85 1.02 1.21 1.42 1.38 1.31 1.20 1.05 0.87
Total P/B (P/B if we stop est. this period) 1.46 1.64 1.86 2.10 2.38 2.70 3.06 3.16 3.22 3.24 3.20 3.11
Implied price 6.58 7.39 8.37 9.48 10.74 12.17 13.78 14.25 14.53 14.59 14.42 14.02

Check:
Beg. BV/Shr 4.43 5.10 5.93 6.97 8.26 9.89 11.91 14.44 17.34 20.59 24.19 28.12
Implied EPS 0.67 0.83 1.04 1.30 1.62 2.03 2.53 2.89 3.25 3.60 3.93 4.22
Implied EPS growth 0.239 0.250 0.250 0.250 0.250 0.250 0.141 0.125 0.108 0.091 0.073

Sensitivity Analysis
Long Term Growth Rate
Change Parameters Here 14.024 21.0% 22.0% 23.0% 24.0% 25.0% 26.0% 27.0% 28.0% 29.0%
Long Term Growth Rate 10.0% $7.72 $7.93 $8.13 $8.35 $8.58 $8.81 $9.05 $9.30 $9.56
1.0% 11.0% $8.65 $8.87 $9.11 $9.35 $9.60 $9.86 $10.13 $10.41 $10.70
Target ROE 12.0% $9.60 $9.85 $10.11 $10.38 $10.66 $10.95 $11.25 $11.56 $11.88
Target ROE

1.0% 13.0% $10.58 $10.86 $11.14 $11.44 $11.74 $12.06 $12.39 $12.74 $13.09
14.0% $11.59 $11.89 $12.21 $12.53 $12.87 $13.22 $13.58 $13.95 $14.34
15.0% $12.64 $12.97 $13.31 $13.66 $14.02 $14.40 $14.80 $15.20 $15.62
16.0% $13.71 $14.07 $14.44 $14.82 $15.21 $15.63 $16.05 $16.49 $16.95
17.0% $14.82 $15.20 $15.60 $16.01 $16.44 $16.88 $17.34 $17.82 $18.31
18.0% $15.96 $16.37 $16.80 $17.24 $17.70 $18.18 $18.67 $19.19 $19.72
 33

Starbucks Coffee
Comparable Company Analysis
Dollars in millions

Book value Price to . . .

Price Shares o/s 1998 - 1999 per share Book
Market Cap. 11/26/99 (millions) Sales (ttm) EBITDA Net income (ttm) EBI (mrq) Sales EBITDA Earnings Value EBI

Starbucks Int'l 5.01B $27.81 182.2 1,619.8 199.0 98.4 118.0 $5.04 3.13 25.46 51.50 5.52 42.94

Fast Food/Coffee
Applebees Intl (APPB) National 0.86B $31.31 27.2 624.0 125.0 45.7 90.0 $9.54 1.36 6.81 18.64 3.28 9.46
Tricon Global (YUM) Int'l 6.19B $40.19 154.2 7,702.3 1,445.0 607.5 1,028.0 ($4.00) 0.80 4.29 10.20 (10.05) 6.03
New World Coffee (NWCI) National 25.00M $2.50 10.2 36.9 4.5 (8.2) 5.5 $0.99 0.69 5.67 (3.13) 2.53 4.64
McDonalds Corp. (MCD) Int'l 61.40B $44.56 1,350.0 12,595.5 3,620.0 1,741.5 2,739.0 $7.01 4.78 16.62 34.54 6.36 21.96
Darden Restaurants (DRI) National 2.26B $17.13 131.4 3,310.0 362.0 144.5 237.0 $7.58 0.68 6.22 15.57 2.26 9.49
Cheese Cake Factory (CAKE) National 0.57B $29.63 20.1 312.6 30.0 19.3 21.0 $8.85 1.91 19.85 30.86 3.35 28.36
Papa Jone's (PZZA) Int'l 1.08B $35.00 30.4 614.7 80.0 48.3 60.0 $10.23 1.73 13.30 22.01 3.42 17.73
CKE Restaurants (CKR) National 0.34B $6.38 52.1 1,692.2 245.0 57.8 168.0 $11.84 0.20 1.36 5.74 0.54 1.98
Median 1.08 6.51 17.10 2.90 9.48
Average 1.52 9.26 16.81 1.46 12.46

Specialty Stores/Whole./Cons. Goods

William Sonoma (WSM) National 3.07B $55.00 56.0 1,238.7 128.0 61.0 $95 $5.51 2.49 24.06 50.46 9.98 32.42
Uniliver (UN) Int'l 32.80B $57.44 572.6 45,644.0 5,677.5 1,557.5 $5,847 $8.52 0.72 5.79 21.12 6.74 5.62
Nabisco (NGH) Int'l 3.91B $14.00 326.1 10,451.5 1,401.0 2,543.6 $266 $9.39 0.44 3.26 1.79 1.49 17.16
Bestfoods (BFO) Int'l 15.40B $54.31 278.9 8,222.0 1,466.0 644.3 $1,211 $2.44 1.84 10.33 23.51 22.26 12.51
Median 1.28 8.06 22.31 8.36 14.84
Average 1.37 10.86 24.22 10.12 16.93

Fast Food/Coffee 0.85 1.29 7.87 14.28 1.24 10.59

Specialty Stores/Whole./Cons. Goods 0.15 0.21 1.63 3.63 1.52 2.54
Total 1 1.50 9.50 17.92 2.76 13.13
Implied Price ($) 13.30 10.38 9.68 13.91 8.50
 34

4.7 Other Information

SHORT SALES
As of November 8, 1999 there were 7.41 million shares short, which represents and the
short ratio is 2.69 days’ trading volume. The following exhibit displays the changing short
ratio through time. Although we are not bullish on the stock and cannot recommend it for
purchase, we do not believe the short interest should be a material factor in consideration of
purchase or sale of Starbucks.

INSTITUTIONAL HOLDINGS
Historically, about half of SBUX float has been held by institutional shareholders. As seen
in the exhibit below, these large investors have been net sellers of Starbucks stock recently.
The amount of the shares owned by institutions has declined from 49.2 percent to 37.1
percent in a span of 26 weeks.
 35

5 Recommendation

Summary

Starbucks continues to grow earnings per share in the short term, and still has long-term
growth opportunities. However, the company is likely to face increasing store operating
costs as a result of increasing labor costs. Additionally, domestic store openings and same
store sales are likely to level off. As the domestic retail business is starting to mature, the
company is focusing more on international expansion and domestic specialty sales.

The stock is a “high volume (66th percentile) loser” trading at approximately 50% of its 52
week high. However, we feel that a short recommendation is not appropriate at this time as
the stock has rebounded in the last 8-10 weeks, largely as a result of meeting year-end
earnings estimates. Further, income and market based valuation analyses indicate that the
current price is significantly overvalued.

Recommendation

Accordingly, we recommend the stock as a HOLD.