Leading analyst Jamie Rollo at Morgan Stanley said that Whitbread has been a good owner of Costa, but there is room for improvement in its international strategy, with China unlikely to move the profit dial.
He said: “Since its acquisition in 1995, the number of Costa shops has grown from 41 to over 2,000, Costa has become the UK market leader, expanded into 26 other countries overseas, and now makes around £90m EBIT. It has a strategy to nearly double its store size and system sales over 2011-16, something we think will also double profits too. Costa has benefitted from Whitbread’s systems and processes, the pool of management that a FTSE-100 company attracts, and purchasing economies. Its capital investment has not been constrained, and its continuity of ownership has allowed it to take steady market share in the UK and make investments in some potentially risky emerging markets.
“Costa’s international expansion has been fairly slow, and Costa does not make money in its overseas equity businesses. Outside the UK it only has equity stores in China and Poland. Poland was an acquisition that has been a mixed success, and the outlets are branded Coffee Heaven by Costa.”
Rollo said that China was unlikely to move the profit dial.
He said: “The revenue per store is lower than the UK, the target EBIT per store is even lower at £28k vs £83k (mainly as the JV partners take half), and it is only targeting 500 stores by 2016. Even assuming 50 stores in each of the 20 tier I and II cities it is targeting generate the target profit, that is up to £30m outlet profit, less £10m of central costs, which is £20m.
“We think it will take perhaps 10 years to get to 1,000 outlets, suggesting a five year profit target of perhaps £10m is reasonable. First of all, Whitbread has to prove it can actually generate a profit in China though. This gives an EBIT range of £10-20m, around 10% of Costa profits in 5-10 years’ time. On a post-tax multiple of 20, China could be worth 100-200p per share. Costa is in 25 other markets, but all via franchise, which are a small revenue share, and these stores only make £6-7m EBIT.”
Rollo said that he believed Costa may also need to step up investment in developed markets.
He said: Costa may soon run out of growth in the UK. The company has mainly focused overseas on more emerging markets such as China, Russia, and India, and admits the expansion here has been slow, spend per head is low, and its choice of franchising or JV partner shares the profits with local players.
“We think one possible way to balance the heavy reliance on UK equity stores is to expand in other developed markets via equity. This may well entail higher investment (both capital on shop fittings and revenue spend on head office costs), and potentially some start-up losses.
“However, while higher risk, there could be a bigger profit pool in say France and Germany than in China. After all, Costa is already generating c. £80m EBIT in its UK equity stores, around 10 times what it might make in China in 3-5 years. Costa is currently trialing a store in Paris.”
Starbucks plans to invest $1.2bn capex this year, which compares to Costa’s $80m.
The analyst said: “Starbucks is of course much larger (around 8x Costa’s outlet count), and is investing in other areas such as the supply chain. As a percentage of EBITDA, Starbucks’ capex was 40% in 2012, and Costa’s around 50%. However, Costa should arguably be investing more aggressively given its smaller scale, and we note it is in 26 countries compared with Starbucks’ 61 countries.
“Costa today reminds us a bit of Starbucks 10 years ago, when its success in the US was so tremendous it neglected its overseas expansion, and with hindsight grew too quickly in the US. Starbucks today trades on a premium multiple, but it troughed at just 10x P/E post the downturn.”
