Values Brewing for Starbucks Bonds

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. We recently launched credit rating on Starbucks and I am here with Credit Analyst, Joscelyn MacKay to talk about the outlook for Starbucks and why their bonds might look attractive today. Joscelyn, thanks for joining me.

Joscelyn MacKay: Thanks for having me.

Glaser: So, when we looked at Starbucks credit rating, where did we come out with, what were some of the factors that went into your analysis?

MacKay: We initiated a credit rating of A- on Starbucks and that rating was based on our assessment of the firm's wide economic moat and our positive view on the company's credit metrics and financial health going forward.

Glaser: So there has been a lot of talk about competitive threats that are coming up against Starbucks. McDonald's is mentioned probably the most often. Do you think that Starbucks will be able to hold off those potential competitors?

MacKay: In recent years Starbucks has faced a number of competitive threats, and we do believe that McDonald's could be the company's most formidable competitor going forward. That said, we think that Starbucks differentiates itself in its café-like environment that allows the company to charge a premium price, because it attracts a bit of a different clientele.

In addition, we really do believe that Starbucks continues through product innovation to differentiate itself into being the leader in specialty coffee. They have come out with VIA Instant Coffee and particularly their Seattle's Best, which is a secondary brand. It's also distributed through 30,000 quick-service restaurants locations, including Burger King and Subway.

Glaser: So when you think about the kind of capital requirements that Starbucks has, that's a potential drain on finances, are they going to need to spend a lot of money to continue expand?

MacKay: Expansion will be a story going forward, particularly internationally, but we are not talking about the 20% top line growth rates that we saw in recent history. CapEx, historically, equaled about 10% of sales. Going forward, we think that number is going to be closer to 6%. That's going to be driven by our estimate about 400-store growth internationally and about 100 domestically. To put that in perspective, just two years ago Starbucks was growing at a rate of 500 international stores and 800 domestic stores.

Glaser: So what kind of bonds do Starbucks have outstanding?

MacKay: Starbucks just has one bond issue outstanding. It's $550 million in senior notes, due 2017 with a coupon of 6.25%.

Glaser: So do those look attractively priced right now?

MacKay: I think they definitely look attractively priced. They are trading much wider than our A- credit rating would imply, and we think they have got some room to tighten given our positive view of the company going forward.

Glaser: So what does the market view differently than we do on Starbucks?

MacKay: I think, the other rating agencies do have a weaker credit rating on Starbucks. The market's probably anchored on that rating, which should be noted here that other rating agencies don't seem to formally incorporate our analysis of an economic moat, which is probably driving bit of the disconnect here. In addition, the market might be looking at those competitive threats that you mentioned earlier, which we do think are overblown.

Glaser: Other than the competitive threats, are there other risks that Starbucks investors should keep an eye out for?

MacKay: From a debt holders' perspective, in our view even if our growth estimates for Consumer Products International are overestimated, company still generates great free cash flow. We think cash flow is about 10% of sales going forward, which is a $1 billion a year.

From a debt holders' perspective, the primary risk to these bonds would be the company's first time ever dividend that they announced earlier this year in addition to potential share repurchases. That said, even with the company's 35% to 40% of net income target dividend payout range, we think with that $1 billion annual in free cash flow there is plenty of room for a debt service.

Glaser: Joscelyn, thanks so much for talking with me today.

MacKay: Thanks for having me.

Glaser: For Morningstar.com, I am Jeremy Glaser.