An overview of the valuation landscape, highlights and metrics

After strong gains in the second quarter of 2013, Q3 global economic performance exhibited more tepid performance due to lingering uncertainty surrounding a number of major fiscal policy issues. There were signs, however, that the economic recovery was gaining traction and broadening geographically. The upturn was modest by historic standards but GDP forecasts edged upward during the quarter and consumer confidence returned to levels consistent with previous recoveries. Improved economic data, particularly within the manufacturing sector, contributed to improved fundamentals for equities during Q3. With low inflation and subdued labour costs there was no immediate pressure to raise short-term interest rates, although increases continue to be anticipated prior to 2015. The net effect of the announcements regarding US Federal Reserve tapering its quantitative easing program and the prospect of a US government shutdown, which came into effect October 2, were largely offsetting and not really relevant to multiples, which are long term in nature.

What factors contributed to the modest increase in multiples during Q3? It is not clear why multiples continue to rise. We will provide a historical review in Q1 2014 to look specifically at this.

These statistics are without removal of surplus cash and therefore certain multiples overstate the value of the operating businesses and the multiples.

How can you lose an arbitration but still wind up ahead? The recent decision in Starbucks Corp. v Mondelez International Inc. provides us with a good example.

Starbucks steadfastly believes that the company is better off as a result of its decision to repatriate the packaged home coffee business. The cost was determined in an arbitration where it was determined that Starbucks must pay a total of US$2.76 billion (US$2.23 billion in damages plus US$527 million in pre-judgment interest and attorneys' fees) to Kraft Foods.

Here is the story. Kraft Foods (which operates primarily as Mondelez International Inc. today) and Starbucks first joined forces in 1998 with an agreement to distribute Starbucks' branded roast and ground coffee through the grocery store channel. At that time the business was estimated to be generating about US$50 million in annual revenue. The partnership appeared to run successfully for approximately 12 years, at which point the grocery channel had grown nearly 10-fold to about US$500 million in revenue.

Starbucks first alerted Kraft of its displeasure with the agreement in January 2010 and in August 2010 proposed a payment of US$750 million to terminate the partnership. The offer was summarily rejected by Kraft on the basis that the compensation offered fell well short of the distribution contract's true value. In November 2010 Starbucks again attempted to end the contract with Kraft, this time citing a breach of the contract and accusing Kraft of failure to perform pursuant to the terms of their deal. Kraft strenuously disputed these allegations and initiated arbitration proceedings to challenge Starbucks' attempts to terminate the agreement.

It has been widely speculated that Starbucks' real interest in discontinuing the distribution deal was driven by the success of its packaged coffee and tea products in the grocery channel, and its ambitions to take that initiative private. We understand that Starbucks likely would not have been able to pursue certain high-growth "in-home" coffee opportunities within the bounds of its contract with Kraft and profitability within an expanding industry would have stagnated. Starbucks seems to have bought itself strategic flexibility and increased profits — it simply "paid it forward." We note, with the benefit of hindsight, that:

  • Sales of coffee in single-serve coffee pods had begun to grow rapidly at the time of the contract's termination. The distribution agreement with Kraft, however, limited Starbucks to selling pods that worked only in Kraft's Tassimo machines. At the same time, Green Mountain Coffee was almost single-handedly increasing sales in that part of the market with its competitive Keurig machine, which used K-Cup packs, leaving Starbucks in danger of losing momentum in a booming business.
  • Since taking the business back from Kraft, Starbucks' packaged coffee and single-serve offerings have grown by US$3.2 billion in revenue and by 47% in profitability and the company has sold more than a billion K-Cup packs. Its market share of such single-serving pods has grown 18.4%.

Was it worth it?

The original distribution agreement with Kraft was set to automatically renew for successive 10-year periods with no expiration date. Although the next renewal date was less than two years away when Starbucks broke off its arrangement with Kraft, the only circumstances under which this contract would not have been automatically renewed were a "valid termination" (presumably a breach by one party or the other, as suggested by Starbucks). In the alternative, Starbucks could take over the business by paying Kraft the "fair market value" of the business along with, in certain instances, a premium.

If Starbucks' US$2.8-billion settlement (which was almost double the amount anticipated by industry experts) is viewed instead as the purchase price in a quasi-M&A deal, the cost begins to appear less onerous. Reuters estimated that Starbucks' at-home coffee business generated EBITDA of about US$277 million in the most recent fiscal year. By applying the Starbucks' current valuation multiple of about 19x Enterprise Value to EBITDA, the implied value of the old Kraft business becomes close to US$5.3 billion today. Starbucks seems to have come out ahead in this dispute by buying back a tremendously high-growth market category at a bargain price.

Will breaking the contract and this brew damage Starbucks' reputation? We guess not.