Financial Statement Analysis
1999/Abarbanell
Name ______
Section ______
Exam Instructions: Read all of the instructions before proceeding!
1. Write your name and section number in the space provided above before beginning the examination.
2. Write your name on the top of each page containing an exam question in the space provided before beginning the examination.
3. All answers and supporting calculations should be on the pages containing the exam questions or on the back of those pages. When calculations are required, you must show your work to get full credit.
4. The examination is open book/open notes. No communication among students is allowed (e.g., you may not share or exchange notes or reference materials).
5. You may take up to 180 minutes to complete the exam. Suggested times on the questions sum to 180 minutes so monitor your progress carefully. I urge you to take a quick glance at the questions before you get started to gauge the task ahead of you. A summary of the point and suggested time allocations for each question is given below.
Question number and topic / Suggested time / Points / Your scoreRead case / 10 minutes
1. Company Strategy / 15 minutes / 12
2. Profitability Analysis / 30 minutes / 18
3. Fundamental Analysis / 20 minutes / 12
4. Forecasting / 30 minutes / 20
5. Cash flow analysis / 25 minutes / 15
6. Valuation / 50 minutes / 23
Name ______
Question 1 (12 points): Company Strategy, Risks and Opportunities.
a. From what revenue source do you expect strong growth in Starbucks’ sales in the near-term? State two facts from the case or pre-reading materials that support your conclusion. 3 points
New reatil stores: Management states its intention to reach 2500 stores by the end of year 2000, implying approximately 600/1900= 32% growth in retail stores in two years.
Other acceptable answers when supported by facts from the case or pre-reading matereial include:
- Whole bean sales in grocery stores
- Bottled Frappucino
- Joint ventures in ice cream with Dreyers
- International expansion (e.g., Seattle Coffee in the UK or new stores in Japan)
Penalty for not providing support from 10-K, 10-Q or other sources.
b. Identify two important assumption Starbucks’ management has made about consumer preferences for the company’s products or product delivery methods. What risks are entailed in maintaining these assumptions? 3 points
Products: Consumers are not price sensitive
risk: higher prices drive away demand
Consumers continue to pay for conveinience
risk: retial expansion too great for demand
There is loyalty to the Starbucks brand
risk: consumers won’t discriminate as competition increases.
Foregin consumers will take to Starbucks coffee like in US
Risk: massive international investment in unprofitable retail stores.
Product delivery
methods:Consumers will buy Starbucks coffee in supermarkets
risk: canibalization of retail sales or dilution of brand
Kraft: agreement helps avoid big expenditures on distribution network
risk: Profits accrue to Kraft
Penalized 1 point for a) not citing two assumptions and b) not supplying a risk.
Name ______
Question 1 : Company Strategy, Risks and Opportunities (continued)
c. Identify two major strategic initiatives the company is currently undertaking. Supply one risk and one opportunity associated with each initiative. 3 points
Supermarket sales: risk: (see part b)
opportunity: 3 billion dollar market potential.
International expansion: risk: Foreign consumers behave differently from US consumers
opportunity: Source of new growth.
Joint ventures and newrisk: investments earn low returns and/or management loses focus
Products:opportunity: further penetration of brand, incresed sales.
Full credit was given for other answers if accompanied by coherent explanations of risks and opportunities. One point penalty for failure to mention risk.
d. Identify two possible changes in Starbuck’s business environment that have the potential to significantly alter the companies current strategies. 3 points
- Increased coffee prices
- Increased competition in grocery stores and other new markets
- Entrance of a big player into the retail coffee shop business
Increased cost of space for new stores sites
- Economic crises: e.g., Asia 1998
Strategic failures or mention of internal issues received no credit.
Name ______
Question 2 (18 points): Financial and Accounting Analysis
(Please keep your answers brief)
- How stable has Starbucks profitability been in recent years? Support your argument with data from the case or pre-reading materials. 3 points
Pretty stable based on avearge ROE; between 10-12% in the last 3 years.
Note profit margins, turnovers and leverage vary more over the last 3 years than ROE but profitablity in general stays fairly stable. Failure to recognize the overall impact on profitabilty as reflected in ROE or ROA was penalized.
Listing ROEs or ROA without assessing stability was also penalized
b. How profitable has Starbucks been relative to other firms in its industry? What is the source(s) of its profitability superiority/inferiority relative to competitors? Support your argument with data from the case or pre-reading materials. 3 points
Based on a comparison to direct competitors, New world and Dedrich, Starbucks is significantly more profitable. The sources of the advantage appear to be profit margins (SG&A) and turnovers. Note that leverage adversely affects the competitors. Starbucks has higher margins and turnovers than other restaurants but a lower ROE because of the absence of financial leverage. McDonalds profit margins and leverage are the source of its signifcant advantage over Starbucks with respect to ROE.
Comparison to the Restaurant retail composite or direct competitors only was penalized.
No support for conclusions or conclusions that are contradicted by the facts were
penalized.
c. Indentify any elements of 1998 earnings (included or excluded) or accounting practices that would lead you to question (though not necessary draw conlusions about) the quality of earnings. Identify facts in the case or pre-reading materials that lead you to your conclusion. 3 points
e.g.,
a)dilution effects of stock options
b)merger expenses in the third quarter of 1998.
c)recievables up 67% vs. Sales 34%.
No explanation for why these elements would raise questions was penalized.
d. Do you consider Starbucks’s accounting disclosures to be of high, medium or low informativeness for the purpose of forecasting and valuation? Briefly describe the reasons for your opinion. 3 points
In general disclosure was mediocre: Little forecasting of future margins and overall demand for products.
Full credit was also given for indicating good disclosue along with citing disclosures about forecasts of somenumbers like future CAPX and store openings or citing quality of segment reporting.
e. Using Starbucks’ 10-Q and any other information available to you, compare Starbucks operating income for the first quarter of fiscal 1998 to the comparable quarter from the previous year. Provide an explanation for any notable differences you observe. 3 points
e.g.,
Opearating income increased by 23% relative to a 26% increase in sales
MD&A suggests that the dropoff was the result of the purchase of Seattle Coffee. Higher cost of operations of these stores and transition costs were offset by a lower effective tax rate.
f. What do you anticipate for the behavior of Starbucks’ operating income in the near-term (i.e., over the next few quarters)? Provide support for your answer from the case or pre-reading materials.
Operating income and sales should grow. Also management states effective tax rate should stay low over the next year. There is an expectation that Starbucks will purchase Pasqua in the coming year, perhaps leading to a similar drag on profits even with a sales increase.
Failure to mention the effects of growth in sales in either part e or f was penalized 2 points (but only once).
Name ______
Question 3 (12 points) : Fundamental Analysis
- What was Starbucks’s cash flow from operations in 1998? 3 points
142,879
Directly from the statement of cash flows in the 10-K
No partial credit
b. Did the company generate enough cash flow from operations to finance its capital expenditures in 1998? If so, what did it do with its excess cash? If not, how did it finance its capital expenditures. 3 points
No: Internally generated cash was 142,879 and CAPX was 201,855
The shortfall was covered by maturities of investments and exercise of options.
Failure to indicate all means of covering the shortfall was penalized one point.
c. Consiser the information in Starbucks’ 10-K concerning the most recent year-to-year changes in sales relative to changes in gross margins, inventories, store operating expenses and general and administrative expenses. Do these signals indicate good news or bad news for future earnings? Briefly explain your answer.
2 points
Sales = (1308-975)/975 34%
GM = (578.5- 436.9)/436.9 26%, GM - Sales 2%
Inventory = (143.1-119.8)/119.8 19.4%, Sales- Inventory 14.6%
G&A = (77.6 -57.1)/57.1 36%, Sales- G&A - 2%
Store op exp = (418.5-314.1)/314.1 33%Sales - Store op exp 0
This solution uses last year’s balances as the expectations for this year. If you used the average of the balances from the last two years for expectation, you received full credit.
Only G&A rose faster than sales, implying bad news. The remaining signals appear to convey good or neutral news.
d. Which signal do you give the most weight to and what economic facts about Starbucks’ strategy or business environment do you think explain the behavior of this signal? 2 points
Either the inventory signal or gross margin signal. The inventory signal suggests that for the present time management’s fixed contract approach is working well. It also appears to reflect benefits of the new agreement with Kraft to distribute coffee in grocery stores. The gross margin signal may be showing early signs of the expected improvement implicit in analysts’ foreasts of earnings.
For a growth company like Starbucks the disproportionate increase in G&A is not unusal especially with the purchase and conversion of 61 Seattle Coffee stores in the UK. Given management indicated store operating expenses for these stores were high, there must have been improvements in comparable stores to offest these expenses.
Credit was given for well-reasoned arguments supporting interpretations of any of the signals so long as they were consitent with the assessment of good vs bad news.
e. What do you think are management’s beliefs about actual firm value relative to Starbucks’ current stock price?. On what information do you base this assessment? 2 points
Probably undervalued: Starbucks has announced a stock split. In addition, they are inclined to take on new debt in the event of cash shortfalls rather than issue potentially dilutive securities. Finally, the stock is recommneded a buy by most analysts following the firm. More data related to the exercise of stock options would be useful
Name ______
Question 4 (20 points): Forecasting
a. Making use of the information available to you produce a line-by-line forecast of 1998 earnings. Show calculations and explicit assumptions in the space provided. 10 points
Begin with a sales forecast based on e.g.,
- sum of forecasts of new store sales, plus old store sales including comparable store growth of 5%, plus forecasts of other sales.
- sum of retail, specialty and direct repsonse sales, adjusted for assumed growth rates.
- Use of Foster model (see part b).
Illustration:
Sales 1727 32% forecasted growth, i.e., (1308 X 1.32)
CGS (includes occupancy costs) (763.6) 42.2% of sales, same as last year
Gross profit 963.4
Store operating expenses (552.8) 32% of sales, similar to last year
Other operating expenses (57) 3.3% of sales
General and administrative (101.9) 5.9 % of sales
Depr. and amortization ( 90.1) 15% of beginning PPE
Operating income 161.5
Net interest (revenue-expense) 7.5 assumes 0 expense and revenue = 6.6%% of investments (not a function of sales!).
Pretax earnings 169
Income taxes (67.6)use 40% average over recent years but note that
mangement expexcts it to be lower this year.
Net income* 102
Might also include an estimate of merger expense in anticipation of Pasqua coffee purchase.
Points were awarded for including the line item and making an explicit assumption in arriving at an estimate.
Name ______
Question 4: Forecasting (continued)
b. A time-series regression of seasonal differences in Starbucks quarterly sales on the once-lagged series of these differences yields an intercept of 4.67 (t value =1.51) and a slope coefficient of .96 (t value=14.08). Using these results and the information provided in the pre-reading material, estimate 1998 annual sales using the Foster model. Show your calculations below then breifly assess the accuracy of the estimate by comparing it to sales forecast you produced above. 5 points
First quarter: 405.6
Second quarter:295.2 + 5.84 +.095(405.6-321.3) = 381.12
Third quarter:334.4 + 5.84 +.095(381.12-295.2) = 421.86
Fourth quarter:357.7 + 5.84 +.095(421.86-334.4) = 446.6
Total 1,655
No penalty for carry through errors.
c. After adjusting third quarter 1998 earnings for the charge to income for the purchase of Seattle Coffee Co., A time-series regression of seasonal differences in quarterly EPS on the once-lagged series of these differences yields an intercept of .036 (t value =5.24) and a slope coefficient of .077 (t value=1.37). The model produces the second, third and fourth quarter fiscal 1999 earnings estimates as shown below. 3 pts
Dec –99 actual
/ 0.30Mar - 99 estimate / 0.19
June – 99 estimate / 0.27
Sep - 99 estimate / 0.32
1999 estimated annual earnings / 1.08
Compare this Foster model estimate to the consensus analyst forecast of fiscal 1999 annual earnings per share. What assumptions are analysts likely to be making about the expected levels of the components of ROE that differ from what is implied about these levels in the Foster model estimates? Explain briefly.
Foster model implies a continuation of past relations with some recent embedded improvements. Note the management claims growth severely distorts seasonal patterns in earnings. Given analysts are forecasting earnings of 1.21 it appears they have in mind significant improvements in asset turnovers and/or profit margins.
d. Based on your own estimate of 1999 earnings, do you have more confidence in the analyst estimate or the forecast from the Foster model? Justify your answer briefly. 2 pts
Name ______
Question 5 (15 points): Partial DCF Analysis - Calculating Free Cash Flow
Making use of the line-by-line forecast of earnings produced in part a of question 4 and additional information provided company financials produce a forecast of Starbucks’s "free cash flow" for 1998. Use the back of this page for calculations if additional space is required and explicitly state any assumptions you make in arriving at the estimate.
NI 102 from question 4 part a.
- interest adjustment (4.5) 7.5 X (1-.4) (note subtract)
+ depr 90.1 from question 4 part a
Cash flow before investment 187.6
- non-cash current assets (65.75) keep at 15.7% of sales as last year
+ non-cash current liabilities 57.37Keep at 13.7% of sales as last year
+ deferred taxes0assume 0
CAPX (250)management estimate
Increase in operating cash ( 5)
Free cash flow (78.03)
Alternatively, You could work down to EBILAT using sales, expenses and adjusted taxes. Thereafter, all calculations from dpreciation to CAPX above would be the same.
2 points were deducted for:
NI (or Sales and expenses) from part 4a are not used.
Depreciation from part 4a not used.
1 point was deducted for:
Failure to adjust net income for interest net of tax.
Failure to use management’s estimate of 250 million for CAPX.
Note that if one assumes the same margins and turnovers from last year cash flow from operations will not be sufficient to meet investment needs.
Name ______
Question 6 (23 points): Accounting-Based Valuation
- The risk free rate is 4.75% and the historical market risk premium is 7.6% . The latest estimate CAPM beta for Starbucks is 1.25, suggesting a cost of equity capital estimate of approximately 14.25%. Note, however that Starbuck’s market value of equity places it in the highest decile of firm size, arguing for a lower cost of equity capital. Assume a 13% cost of capital until otherwise indicated. Consensus analysts estimates of Starbucks fiscal 1999 and 2000 earnings per share are $1.21 and 1.58, respectively. Based on management’s stated dividend policy, calculate analysts’ implied forecasts of abnormal ROEs for 1999 and 2000.
3 points
1999 forecasted ROE = 1.21 /(8.86) = .1366 abnormal ROE = .0066
2000 forecasted ROE = 1.58/(8.86+1.21) = .1569 abnormal ROE = .1569-.13 = .0269
Points were deducted for failure to update book value in 2000.
- Assume that after 2000 earnings grow at a rate of 32% through the year 2005, i.e., consistent with the consensus analyst forecast of long-term earnings growth. Assume dividend policy does not change during this period. Using this information, calculate forecasted abnormal ROEs from 2001 to 2005. Use the back of this page to show calculations if necessary and place your estimates in the table below. 4 points
Forecasts from part a
/Forecasts of abnormal ROEs for the years 2000 thru 2004
Year / 1998 / 1999 / 2000 / 2001 / 2002 / 2003 / 2004 / 2005Earnings / .78 / 1.21 / 1.58 / 2.0856 / 2.753 / 3.634 / 4.7968 / 6.33
Beginning Book Value* / 8.86 / 10.07 / 11.65 / 13.7356 / 16.489 / 20.123 / 24.92
ROE** / 0.136 / 0.157 / 0.179 / 0.200 / 0.220 / 0.238 / 0.254
Abnormal ROE / 0.007 / 0.027 / 0.049 / 0.070 / 0.090 / 0.108 / 0.124
Growth in BV / 1 / 1.137 / 1.315 / 1.550 / 1.861 / 2.271 / 2.813
* Beginning book value in year t = book value in year t-1 plus earnings for year t, - dividends e.g., beginning book value for the year 2000 is 1.21 + 8.86 – 0 as the firm does not pay dividends.
** ROEt = earningst/beg bvt
points we’re deducted for mismatching earnings and book value. Carry through errors from previous questions were not penalized. Note, points were not deducted for students taking the early exam on which beginning book value for 1999 was inadvertantly place in the column for 1998.
Name ______
Question 6 Valuation (continued)
c. Consider the behavior of ROEs and abnormal ROEs forecasted through the year 2005 in parts a and b. Is this behavior typical for a firm? Discuss what you believe analysts are assuming about changes in the components of Starbucks ROE over the next few years and indicate whether you believe analysts are justified in these assumptions. Support your answer with facts from the case or pre-reading material. 4 points
No, this behavior is not observed for the typical firm as ROE’s tend to mean revert toward an industry level. It is clear from analysts’ forecasts of earings that they are expecting increases in margins and trunovers and, perhaps, even leverage in the future. Increasing ROEs are not unusual for a profitable “rising star” that is still in the beginning of its growth period. As Starbucks expands, many of its fixed cost will be spread across a larger base of sales, leading to improved margins. Moreover, benefits from joint promotions and increasing brand recognition should sustain high prices and generate comparable store sales growth, leading to ncreased turnover. Proper levering off of the Kraft agreement should also significantly increase turnover.