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Valuing Brand Leveraging Strategies with Real Options

Presentation at PUC-RIO October 8, 2012. Valuing Brand Leveraging Strategies with Real Options. Lenos Trigeorgis (joint work with Francesco Baldi). Agenda. 1. Introduction/Motivation Brand equity development and leveraging as multistage option

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Valuing Brand Leveraging Strategies with Real Options

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  1. Presentation at PUC-RIO October 8, 2012 Valuing Brand Leveraging Strategieswith Real Options Lenos Trigeorgis (joint work with Francesco Baldi)

  2. Agenda 1 Introduction/Motivation Brand equity development and leveraging as multistage option Valuation of Starbucks’ brand leveraging options and impact on share price (under growth scenario –June 2007) Revised appraisal based on alternative forward brand leveraging strategies (under downturn conditions –Dec 2008) Assessment of risks underlying brand leveraging strategies Conclusions/Implications 2 3 4 5 6

  3. Introduction/Motivation 1 • In today’s knowledge economy, the sources of competitive advantage have shifted from tangible to intangible assets (Foray and Lundvall, 1996; Eustace, 2000) • 50-90% of corporate value derives not from (physical) assets in place, but from leveraging IP/intangible assets • Brand represents a key market-based intangible asset that can shape a firm’s competitive advantage • Given high market uncertainty (changes in customer needs or product opportunities), it is crucial for managers to pursue a flexible brand leveraging strategy (Ambler, 2000; Fisher, 2007)

  4. Some challenging marketing issues: How can a parent brand be exploited as a flexible platform in pursuing brand expansion or extension opportunities? How can the firm activelymanage such embedded marketing flexibility? How can management assess the risks posed from leveraging brand assets? (Aaker, 2004) We revisit brand valuation and management, merging ideas from marketing and finance to understand marketing flexibility. We build on two key ideas: (1) effective brand management presupposes brand equity valuation ability (Keller and Lehmann, 2003); (2) brand is an intangible asset that can be leveraged (similar to tangible assets) providing managers with important leveraging (brand expansion and extension) options (Srivastava, Shervani and Fahey, 1998) Introduction/Motivation 4

  5. Main Research Challenges • Keller and Lehmann (2006): “How do you assess the option value of the extension potential of a brand?” Brand – whose equity can be developed and leveraged over its life-cycle - should be actively managed contingent on future developments • In developing a dynamic or active brand management, we also respond to a second research challenge (Keller and Lehmann, 2006): “How should a brand be built and managed as a growth platform?”

  6. Dominant Literature Streams/ Brand Equity Measures

  7. A Conceptual Framework

  8. Intangibles • 1. Infrastructure-related IA • Firm Reputation • Skilled/Motivated Human Capital • Organizational Capabilities, Culture and Processes • Info. Systems, Control and Decision-Support Systems • Commercial Licenses and Generic Assets 2. Technology-related IA • Research & Development • Patents and Licenses • Industrial Secrets • Databases/Software • Technology or Production Know-how • Design/Styling 3. Marketing (or Customer)-related IA • Name/Logo of Company • Brand/Expansion & Extension • Loyal Customer Base & Cross-Selling Potential • Promotion & Advertising/ Marketing Strategies • Product Guarantees • Graphics, Label & Packaging • Public Relations

  9. Brand Equity Life-cycle Development - Staging 2 • I. Launch –quality perception created such that the consumer, through feeling of superior performance, can positively assess the brand and store it in memory • II. Reinforcement– positive attitudes stored in memory influence consumption behavior (if readily retrievable). Managerial actions foster attitude accessibility making the brand easy to remember (maintaining consistent brand image) • III. Leveraging/Exploitation – strong parent brand equity leveraged by (i) Brand expansion of existing products to new markets or customers (new geographic areas, market segments or distribution channels) (ii) Brand extension of parent brand to new products (line or categories) • Brand equity built during first two stages and exploited during the third. Brand equity development like compound (multi-stage) growth option

  10. Brand Development as Multistage Option

  11. Expanded Brand Equity Value (BEV) Matrix

  12. Brand Equity Leveraging Options E = Max(- I + e*V; 0) (1) (2) (3) (4) (5)

  13. Expanded Brand Equity Value (E-BEV)

  14. Valuing Starbucks’ Brand • Starbucks is the world’s leading retailer of specialty coffee with one of the most recognizable brands (83% of U.S. adults are aware of Starbucks and 85% of Starbucks customers will recommend Starbucks to others) • Besides the high quality of its coffee, complementary products and services (which can be replicated), Starbucks’ brand is based on providing a broader coffee-related “third place experience” (third gathering place outside of home and work) that creates an emotional connection with consumers (non-replicable) “The human connection: it’s the foundation of everything we do. One customer, one community, one great cup of coffee at a time. That seemingly simple relationship, which today develops in more than 10,500 Starbucks stores around the world, inspires millions of people to embrace us as their neighborhood gathering place. That same connection is at the heart of our passion to innovate and grow in new markets, with new tastes, new sounds and new experiences.” --Howard Schultz (Chairman) and Jim Donald (President and CEO), Starbucks Corporation 2005 Annual Report • Starbucks replicated its business model at new locations in US and around the world building on its third-place experience, constantly increasing its range of products and services in innovative ways (from refined and enlarged beverage and food menus to new products ranging from appliances, to CDs, WiFi services, movies and books)

  15. Initial Valuation: June 1, 2007 (Up market) Current Price ($30) vs. Analyst’s target ($42). What Can Explain the $12 Premium? Is it Brand/ IA Options? 3

  16. BRAND EXPANSION BRAND EXTENSION • Geographic Retail Expansion (Own Stores) • (a) US; (b) International • (2) New Mkt Seg./Licensed Stores • (a) US (airports, B&N) • (b) International (JVs) • New Distribution Channels • (a) Grocery Channel (Kraft) • (b) Vending Machines (Pepsi) • (c) Ready-To-Drink (Disc, soda) • (d) Foodservice distr. (rest., hotels) • Entertainment business • (a) Music • i. CDs Sales via Stores • ii. Online Downloads . via Starbucks.com • iii. via iTunes (Apple) • (b) Movies & Books • (i) via Stores; (ii) via iTunes New MARKETS (CUSTOMERS) • Warm Breakfast • & Lunch PARENT-BRAND BUILDING (coffee-related & compl. products/3rd place exper.) Existing Line Extension New Categories Existing New PRODUCTS Expanded BEV Matrix for

  17. Basic Inputs for DCF Valuation

  18. Standard DCF (g=6%) and Base DCF (g=0%) June 2007

  19. Base DCF for • Base DCF under no-growth (g=0) gives firm value $15B • Expected Capex to support growth beyond year 5 is I5 = $15.1B ($12B in PV) --allocated to various expansion and extension plans according to their relative weight • (Gross) PV of CFs from tangible assets in place and the parent brand (V1) is $27B (NPV = V – I or V = NPV + I) • Equity value (reflecting TA and parent brand), after adjusting for net debt and leases ($3.1B), is EV = $23.9B

  20. Brand Equity Value (June 1, 2007) • Starbucks’ brand leveraging options value (PVGO) is $9.85B or $12.5/share (about 40% of Po of $30 or 30% of total long-term value of E-EV of $33.75B(=$23.9+9.85) –and equal to the differential between analysts target price of $42 and current price of $30) • Expanded Equity Value, from adding the incremental value of the brand expansion and extension options (PVGO of $9.85B) to the company’s (gross) equity value reflecting its Net Assets in Place and parent brand value ($23.9B), is $33.75B or $43/share (close to median analysts’ target) • The Expanded-BEV of Starbucks, reflecting the parent brand value PBV (estimated based on DCF by BrandFinance Ltd at $6.2B) plus the incremental value of the brand expansion & extension options of $9.85B, is $16B or $21/share (about half of Starbucks target value of $42 and about 2/3 its current price of $30)

  21. Revised Valuation on Dec 31, 2008 (Down Market) 4

  22. By Dec. 2008, Starbucks faced a more challenging economic, competitive and operating environment: general economic slowdown –reduced customer demand/visits; fiercer competition –competitors (McDonald’s, Dunkin’ Donuts) counter-offer with more affordable premium coffee; increase in dairy costs –price raises Founder Howard Schultz fires his CEO Jim Donald who had “become delirious with success” and takes over. Since previous valuation shares dropped to 1/3 in year and half, from $29.13 on June 1, 2007 to $9.46 as of Dec. 31, 2008 Analysts’ views: Morgan Stanley: a) reducing growth or closing stores not enough; b) 1-year target view of $13 based on store closures and product plans Deutsche Bank: overexpansion is source of value destruction Revised Valuation of Brand Options Under Economic Downturn (Dec. 31, 2008) 24

  23. A revised DCF gives $6.7B ($9.00), close to Po of $9.46. Base equity value under no growth is higher, $6.9B ($9.32). Should S maintain its current (though scaled-down) growth strategy (g=2%), it would be destroying value Cost-cutting (e.g., limited store closings) and beverage and food innovation to differentiate store experience not adequate for company recovery According to analysts, Starbucks should: stop focusing excessively on coffee (saturation); expand selectively to contain brand erosion and management distraction; leverage the customer base by becoming a total stomach destination (not just for great coffee but also for a great quality meal) Revised Valuation of Brand Leveraging Options under Economic Downturn (Dec. 31, 2008) 25

  24. Base V(t2) = $13.7B Competitive erosion yield () 5%; revised  of main business (V1(t2)) rose (from 30%) to 80%;  of digital music (V2(t2)) rose (from 60%) to 120% (SEE NEXT TABLE SUMMARY) In revising the brand leveraging options platform, the Expanded Equity Value (E-EV) differs depending on alternative brand leveraging strategy management chooses to implement under different future scenarios We thus consider a menu of various option-based brand leveraging strategies underlying alternative static or dynamic managerial approaches associated with brand portfolio leveraging strategies Each of these strategies (S1 to S7) focuses on a different type of brand expansion/extension scenario with differing degrees of flexibility Revised Valuation of Brand Options under Downturn (3) 26

  25. Basic Inputs for Option Valuation 27

  26. Alternative Brand Strategies in Downturn (Dec 2008) Option-based brand strategy, brand expansion/extension type involved, associated brand portfolio strategy style, company value (total and per share) deriving from that strategy with associated option value creation (or destruction), and related brand risk exposure

  27. Alternative Brand Strategies in Downturn (Dec 2008) Static or Commitment Strategies (S1 & S2) • S1: If S commits to full “grow-as-usual” brand expansion and extension portfolio strategy (incl. entertainment), simply scaled-down under worsened economic conditions (g=2%), company value drops to $6.27B ($8.45/share –below Po of $9.46), avalue destruction of -$4.55B. No new brand offerings. • S2: If S executes only its scaled-down brand expansion plans (in core business) but drops all brand extension plans (in entertainment), company value is preserved ($7.02B), confirming Po of $9.46. This reaffirms current market valuation by analysts (from standard DCF). Value loss is -$3.80B. 29

  28. Expanded BEV and Risk Exposure for Alternative Brand Leveraging Strategies (S1 – S7) PRICE AS OF DEC 31, 2008

  29. Alternative Brand Strategies in Downturn (Dec 2008) Basic Flexible Strategies (S3-S5) • S3: Value impact is + if brand expansion options accounted for. E-EV of flexible strategy involving brand expansion options (while dropping all brand extension plans) is $11.68B, with value gain of $0.86B. Share price rises to $15.74. Existing branded products expanded with no new offerings *If this strategy is committed now, it reduces to S2 (= committed NPV of S3) • S4: If S, besides maintaining all brand expansion options, maintains a line extension option into warm lunch (following warm breakfast), E-EV rises to $11.77B (or $15.86). Value gain is $0.95B • S5*: This is base-case all-growth (all expansion and extension) options strategy from previous plan, scaled down. Revised equity value is $11.92B. The combined valueof all scaled-down brand leveraging options (PVGO) is $1.10B (vs. 9.85B). The additional category extension options in entertainment (over S4) do not generate any significant increase in share price ($16.06 vs. $15.86 under S4) • *If this strategy is committed now, it reduces to S1 (= committed NPV of S5*) 32

  30. Alternative Brand Strategies in Downturn (Dec 2008) Upscale Flexible Strategies (S6-S7) • S6: This strategy eliminates brand extension plans (skips entertainment) but enhances food items (upscale meals). In counter-response to McDonald’s and Dunkin’ Donuts’ new premium coffee and breakfast items, Starbucks can stage horizontal extension of its warm breakfast line with warm lunch and follow-on upscale quality meals (a compound option). E-EV is improved ($12.93B). Value creation doubles ($2.11B vs. 1.10B), with P at $17.43. • S7: This “vertical” strategy additionally entails upscale coffee extension also, launching a separate new luxury brand for coffee-related products (e.g., STARbeans) via acquiring smaller, elite players. Super-premium coffee might overcome the saturation concern. This upscale coffee & meals strategy is most value enhancing (PVGO=$2.79B), resulting in E-EVof $13.61B ($18.34). 34

  31. Upscale Coffee & Meals Extension Strategy (S7)

  32. Sensitivity of E-EV to  (S5*) and Sales

  33. EV/Sales Multiples for Comparable Unbranded (Private) and Branded Firms in Specialty Coffee

  34. Industry Characteristic Curve for Branded Firms (Food & Beverages, 2009)

  35. Risk Analysis of Brand Leveraging Strategies 5 • In choosing among brand leveraging strategies, management must also consider the resulting business risk exposure • A brand equity management tool should provide guidance on how to manage growth (expansion and extension) as well as assessing embedded risks. An options portfolio perspective allows assessing the risk of expanding, extending or abandoning a brand • We can estimate brand equity risk exposure or delta [the sensitivity of brand leveraging options portfolio value ( ) to changes in the underlying company base value ( )] over a specified period as:

  36. Risk Analysis of Brand Leveraging Strategies A risk exposure analysis of above 7 brand leveraging strategies (S1-S7) was performed to assess their embedded option sensitivity to small changes in parent brand building activities. None of the brand strategies in Dec. 31, 2008 is in the low risk category. Implementation of any of these strategies would expose the company to high or medium brand equity risk: • Static/commitment strategies (S1, S2) are highly vulnerable to how brand development varies according to changing business conditions. These static strategies are value destructive and highly risky under current economic downturn circumstances. • Flexible strategies (S3 - S7) involve lower (medium) risk, being less sensitive to changing business conditions and are + value creating.

  37. Brand Equity Risk Map for • A brand equity risk map for Starbucks’ alternative brand strategies (S1-S7) plots brand equity risk ( ) against change in company base value ( ). The slope of each line measures the degree of brand option sensitivity to small changes in base equity value • Above the 45° line are the more risky “static” (commitment) strategies (high risk region), while below this line are flexible brand strategies with lower brand equity risk exposure (mediumandlow risk region)

  38. Conclusions 6 • We developed a framework that values brand development and leveraging as a multi-stage growth options portfolio (of brand expansion and extension options) • A real options analysis of brand equity provides guidance on how to value and manage brands strategically • Viewing brand as a platform for exploiting brand expansion or extension options necessitates a dynamic view of brand equity mgt; if management can actively/flexibly manage its brand depending on future contingent circumstances, it can enhance brand equity worth and lead to better brand management • A real options analysis of the brand strategy decision process can be a useful tool for assessing and comparing brand-related opportunities and risks and for valuing and managing strong brand companies

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