Will a $2.7 Billion Fine Significantly Dampen Starbucks' Performance?

Starbucks  was faced with paying a fine and fees of as much as $2.7 billion for ending its relationship with Kraft Foods in the packaged coffee supply business. After the arbitrator's ruling, Starbucks restated its 4th quarter profit to a $2.1 billion loss. However, the market did not seem pessimistic about this because Starbucks experienced a mere 0.11% decline in after-hours trading. It still trades at more than $81 per share, at a valuation of 25.5 times its forward earnings.

A business partnership turned sour
Since 1998, Kraft had marketed and distributed Starbucks' coffee bags in supermarkets. The business had experienced good growth, increasing sales from $50 million in 1998 to around $500 million in 2010. However, Starbucks' Chairman and CEO Howard Schultz felt dissatisfied with the partnership, and he demanded total control of the consumer-packaged business and capsule supply for Tassimo, Kraft's single-serve coffee machines.

The contract would not have expired until 2014, but Starbucks ended the deal three years early. Previously, Starbucks said that it offered Kraft $500 million as a settlement, but Kraft claimed that a fair payment would be around $1.5 billion.  Initially, the judge had allowed Starbucks to end the relationship without paying anything. However, the arbitration forced Starbucks to pay $2.7 billion, including a fine and fees. The proceeds will go to Kraft's spin-off, Mondelez International

Not very good news for Starbucks' shareholders
For fiscal 2013, Starbucks has returned as much as $1.2 billion to shareholders via both share buybacks and dividends. It recently announced a 24% increase in its quarterly dividend to $0.26 per share. However, the fine will lower Starbucks' cash position materially, wiping out nearly $2.6 billion of its cash on hand.

Thus, in the short run, the fine will dampen Starbucks' share repurchases and dividend payments. It also limits the company in expanding its business. Nevertheless, this only affects Starbucks for the short run. Over the long run, I still believe that Starbucks will keep growing significantly. It is a cash cow, generating nearly $2 billion in free cash flow in the past year. 

Mondelez will have more power to enhance its global growth
Mondelez, with a similar market capitalization, has a lower valuation. The company trades for about 20 times its forward earnings at the current market price. The fine will increase the cash position of Mondelez from $3.7 billion to $6.4 billion, giving the company more power to expand its business in emerging markets and provide cash returns to its shareholders.

In the third quarter, Mondelez experienced 10.7% growth in emerging markets, driven by double-digit growth in the Brazil, Russia, India, and China, or BRIC, markets. The company also authorized a $6 billion share repurchase, which could provide shareholders with as much as a 9.7% yield. Currently, Mondelez's dividend yields around 1.70%. 

Dunkin' Brands uses too much leverage
Dunkin' Brands , a much smaller competitor of Starbucks, also enjoys a high valuation. At a $5.1 billion market capitalization, Dunkin' Brands is valued at nearly 26.8 times its forward earnings. It also offers investors a dividend yield of around 1.60%. The company has repurchased a lot of shares in the past two years--it bought back 15 million shares back in August 2012 and an additional 400,000 shares during 2013. 

Investors might like Dunkin' Brands because of its asset-light franchise business model, which allows the company to produce sustainable cash flow and leverage up its balance sheet. However, Dunkin's leverage ratio seems high already at more than 4.8 times its net debt divided by earnings before interest, taxes, depreciation, and amortization, or net debt/EBITDA. I would feel more comfortable if Dunkin' Brands used its cash flow to delever its balance sheet, which would make the company's financial position much stronger.

My Foolish bottom line
I am not worried about the legal dispute's effect on Starbucks over the long run. Long-term investors should not be scared of a $2.7 billion fine. Nevertheless, in the short run, the fine will lower Starbucks' ability to expand its business and return cash to shareholders. I would prefer to wait for some more price contraction for Starbucks before initiating any long position.

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The article Will a $2.7 Billion Fine Significantly Dampen Starbucks' Performance? originally appeared on Fool.com.

Anh HOANG has no position in any stocks mentioned. The Motley Fool recommends Starbucks. The Motley Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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