Tag: starbucks

Return On Invested Capital

Return On Invested Capital

Shot-termism runs deep when managers plan, execute, and report their performance in earnings per share (EPS). For example, when a company acquires a target, managers and investors often focus on whether the transaction will dilute EPS over the first year or two.

This is despite research demonstrating that increased EPS does not prove value creation. In other words, deals that increase EPS and deals that reduce EPS are equally likely to create or destroy value.

Note: Buffett’s 1984 letter is helpful in understanding the concept of value creation.

So what drives value?

Value is driven by 3 things: growth, return on invested capital (ROIC), and the cost of capital (COC).

Not all growth are equal.

Value creation happens when ROIC > COC and a company invests for growth.

Mastercard is an example where ROIC significantly exceeds COC.

Value is destroyed when ROIC < COC and a company invests for growth.

Airlines is an example where ROIC persistently stays below COC

Value doesn’t change when ROIC = COC, it doesn’t matter if the company invests for growth.

High ROIC companies create value by focusing on growth (i.e. expanding), while lower ROIC companies create more value by increasing ROIC (i.e. downsizing).

Here comes the formula for ROIC: after-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

Note that Joel Greenblatt applies the formula slightly differently: before-tax operating profits divided by the capital invested in working capital and property, plant, and equipment (PPE).

This method is helpful for comparing earnings power across different time periods, without being affected by varying tax rates.

Operating profits

Operating profits is also known as earnings before interests and taxes (EBIT).

It is a ‘cleaner’ figure to measure the true earnings power of a company when compared to net income. It includes all expenses needed to keep the business running.

Example of an Income Statement

Going below operating income, we can see items such as interest revenue/expenses and extraordinary items. For example, sales of business assets would come below the operating income.

This income from selling business assets is not conducted in the normal operations of a business and does not reflect the ‘true earning power’ of a business.

You may refer to my earlier post— Finding the next multi-bagger by understanding operating expenses for deeper understanding.

Invested capital

Invested capital represents what the business has invested to run its operations—largely PPE and working capital.

Let’s use Costco as an example for this.

Costco (COST) Hits Record High After 'Impressive' Earnings - Bloomberg
Photo of Costco

To open a new store, Costco will have to buy shelves, cashiers, and perhaps land to build its store. This would constitute its PPE investments.

Working capital is money a business need to operate its business.

Generally, having a new store would require the business to lock-in additional money to stock up inventory.

If it offers credit terms (i.e. allows customers to pay in installments), more working capital is required. This is because they would be required to pay suppliers first while waiting for customers to pay them or they would be waiting for the inventory sitting on the shelves to be sold.

Oh, but Costco is rather different.

In fact, they are quite the opposite.

Before its customers start shopping, they collect a membership fee. Their customers are effectively financing their growth by injecting cash into Costco even before they start buying its goods.

Because of their size, they are able to negotiate favorable terms by paying suppliers approximately 1 month after they get the inventory. On the other hand, customers have to pay immediately when they purchase from Costco.

This means that Costco’s suppliers are also financing their growth when they’re able to delay payment to their suppliers.

Their inventory turn—how fast they clear their shelves—is also one of the best in the industry.

Capital doesn’t stay locked up in Costco for very long.

And when cash isn’t locked up in a business, it can be distributed to shareholders, buy back shares, or be reinvested for growth!

Working capital needs or the lack thereof is one of the most overlooked metrics amongst others.

Starbucks in recent years is also showing early indications that it will benefit from working capital improvements. With its membership—prepaid cards gaining wide popularity.

Coffee addicts lovers are effectively financing Starbucks growth by putting in cash before they make their purchase.

If you think Apple Pay, Google Pay, and Samsung Pay is popular, wait till you see ‘Starbucks pay’.

Starbucks's mobile payments system has more users than Apple's, Google's -  Vox

Conclusion

In conclusion, ROIC measures the earning power of a business. The lesser capital it requires to generate that additional amount of revenue, the more money is leftover to be distributed to shareholders.

High ROIC combined with growth and a strong moat will compound your capital nicely for years to come when you pay a fair price.

You read my earlier posts on this topic:


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Investing in companies that will emerge stronger after Covid-19

Investing in companies that will emerge stronger after Covid-19

Since Covid-19 caused countries to go into shutdown, we have seen the conversation amongst investors shift abruptly from a company’s growth prospects to “How long can they survive without revenue coming in?“.

Many businesses have closed amidst this crisis. At the height of the pessimism during March 2020, many investors were shocked to discover the high cash burn-rate of many F&B companies. With no revenue, many restaurants and entertainment companies had to furlough, retrench employees in an attempt to preserve cash. Cash flow is the lifeblood of any company, and this crisis has placed many companies on the verge of going into insolvency.

We have no certainty as to when this pandemic will end, and predicting the end of the outbreak is beyond our control. That being said, investors looking to invest in industries caught directly in this crisis would have to ask this important question: are they able to raise capital?

How much can the company borrow? – Debt to EBITDA ratio

We can use the Debt to EBITDA ratio to estimate how much capital a company can raise. EBITDA stands for Earnings Before Interest, Tax, Depreciation, and Amortization. It is an estimate of the amount of cash inflow from business operations that the company could use to repay debt.

For simplicity purposes, a Debt to EBITDA ratio of 3 tells us that it would take 3 years for the company to repay its debt. Naturally, the lower the ratio, the better it is.

Generally, an investment-grade company would have a Debt to EBITDA ratio below 3. A ratio between 4 to 5 represents an elevated risk for rating agencies and creditors. Anything above 5 indicates significant financial difficulties and the strong likelihood that the company will be unable to borrow additional funds.

Debt to EBITDARisk Level
< 3Low Risk
3 to 5Elevated Risk
> 5Unlikely to be able to borrow further
Debt to EBITA and Corresponding Risk Level

A company with a Debt to EBITDA ratio of 1, could easily double or triple the amount of debt by borrowing from the capital markets before it will hit the threshold of 3. Compared to a company with a ratio of 5, they are unlikely to be able to raise debt to tie through this crisis.

Using Starbucks (SBUX) as an example, the 5 years average EBITDA is approximately $5.8 billion. With its long-term debt at $11.1 billion, it gives SBUX a comfortable ratio of 1.9. Given this, SBUX could likely borrow an additional $6.3 billion before it hits the Debt to EBITDA ratio of 3.

Note: To adopt a more conservative approach, we could use Earnings before Interest, Tax, Depreciation, Amortization, and Rent (EBITDAR) if the company has lease agreements in place. Likewise, we will add the total operating lease to the debt figures as the company still have to pay for its rent during the shutdown. However, given today’s unique circumstances, we have seen many restaurants such as The Cheesecake Factory getting away with paying rent.

SBUX has also iterated in their latest conference call on 28 Apr 2020 that they remain committed to a leverage cap of 3 times rent-adjusted EBITDA.

How much more interest expense can they bear? – Interest Coverage Ratio

We would also need to look at the Interest Coverage Ratio. This measures the company’s ability to meet its interest obligations. A ratio for 8 indicates that the company is able to meet its interest payments 8 times over.

For this, we refer to the guidance provided by the rating agencies. Generally, anything above 3.5 would be considered safe. And anything below 1.5 would be considered extremely risky.

Credit Score

A company with an interest coverage ratio of 20 times would have greater capacity to incur interest expense. Compared to a company with a ratio of 1.5, creditors would be very concern on their ability to pay their interest obligations.

Continuing with the SBUX example, on average they made $4 billion in operating profits per year and incurred $300 million of interest expense in 2019. Giving them a cushy interest coverage ratio of 13.3x.

This means that they are able to pay their interest expense 13.3 times over, putting them in a comfortable position to raise additional capital.

Also, SBUX would be able to bear an additional interest expense of $200 million before their interest coverage ratio drop to 8x (which is still super cushy). Even if SBUX were to raise debt at 5%, it is able to borrow up to $4 billion dollars ($200 million divided by 5%).

At the height of the uncertainty, CEO Kevin Johnson stated that SBUX has a strong balance sheet. If required, the company has the ability to borrow an additional $3 billion very quickly. This is on top of the $2.5 billion in cash SBUX has in its bank. Thus, allaying fears that the company may face insolvency issues due to the shutdown.

In determining a company’s ability to raise capital, we will need to examine the debt to EBITDA ratio and the interest coverage ratio together. This will give us a rough idea of how much the company can borrow and at what interest rates.

Is the capital raised sufficient?

Lastly, we will need to determine if the capital raised is sufficient to last the company through this difficult moment. Sometimes the company will provide the burn-rate (e.g. how much cash each store burns per month) during earnings call and from there we can have a rough idea.

Otherwise, we can simply estimate the amount of cash required for the business to stay afloat. In this estimation, we can assume that the company will cut all non-essential expenses such as marketing, expansion plans, etc. The cost of goods sold will be reduced significantly due to the shutdown. We will also not include non-cash expenses such as depreciation, amortization, and stock-based compensation.

In the case of SBUX, the company has stated that it is burning $125 million of cash per week. The company expects the burn rate to decline as they open more stores from next week onwards. Given their capital of up to $6 billion, they are able to survive for 44 months, or 3.7 years in the worst-case scenario.

This puts SBUX in a comfortable position to go through this crisis. In fact, it will likely come out stronger as the company has the strength to expand into prime locations as weaker F&B establishment collapse during this crisis.

The company has also seen increasing traction in customers becoming Starbucks members and adopting digital payments. Customers who are members are more likely to be returning customers, as they enjoy the reward program Starbucks offer.

During the shutdown, 90-day active Starbucks Rewards members, increased to 19.4 million in the US, up 15% from a year ago. The membership card value has seen an increase from $1.2 billion to $1.4 billion. Effectively, the customers are providing a free loan to Starbucks.

To sum it up, Covid-19 is a black swan event and since then, many companies have raised capital by either borrowing or issuing shares. And as shareholders, we are the lowest in the pecking order when it comes to capital protection. To avoid severe dilution or total capital loss, I would prefer companies with a strong balance sheet, and the capability to raise cash in the debt market at favorable rates if necessary.

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