Starbucks Corporation (NASDAQ:SBUX)
F2Q06 Earnings Conference Call
May 3, 2006, 4:30 p.m. EST
Howard Schultz - Chairman
Jim Donald - President and Chief Executive Officer
Michael Casey - Executive Vice-President and Chief Financial Officer
Mary Akman - Vice-President Corporate Development and Investor Relations
JoAnn DeGrande - Director, Investor Relations
Jeffrey Bernstein - Lehman Brothers
John Glass - CIBC
Steven Kron - Goldman & Sachs
Matthew DiFrisco - Thomas Weisel Partners
Sharon Zackfia - William Blair
David Palmer - UBS
Ashley Woodruff - Bears Stearns
Glen Petraglia - Citigroup
John Ivankoe - J.P. Morgan
Good afternoon ladies and gentlemen. My name is Myles and I will be your conference operator this afternoon. At this time, I would like to welcome everyone to the Starbucks Second Quarter 2006 Earnings Conference Call. All lines have been placed on mute to prevent any background noise.
After the speaker’s remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press star, then the number two. We respectfully request that you limit yourself to just one question at a time. Thank you.
I will now turn the call over to Ms. JoAnn DeGrande, Director of Investor Relations. Please proceed, Madam.
Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice-President and CFO, and Mary Akman, Vice-President Corporate Development and Investor Relations.
During today’s call, Jim will review key results and accomplishments on a consolidated basis, as well as provide some highlights from our U.S. business. Howard will provide an update on our latest music and entertainment initiative, and comment on our international business, and Michael will highlight the key drivers behind our second quarter results, as well as discuss fiscal 2006 growth targets.
We will limit today’s call to one hour, including Q&A.
Please note that today we released our April revenues in conjunction with our fiscal second quarter results.
As a reminder to all listeners, this call is being broadcast live over the internet. A replay will be available via telephone at 800-642-1687, reservation number 3728538, through 5:30 p.m. Pacific time on Wednesday, May 10th, on the internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, May 31st.
In addition, today’s remarks will be available on the investor relations portion of starbucks.com by the end of the day, and will remain available through Wednesday, the 31st of May.
This conference call includes forward-looking statements such as anticipated store openings, comparable store sales expectations, trends in or expectations regarding the company’s revenue and expense growth, capital expenditures, effective tax rate and earnings per share results. These statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risk factor section of Starbucks’ annual report on form 10K for the fiscal year ended October 2, 2005. The company assume no obligations to update any of these forward-looking statements.
Let me now turn the call over to Jim.
Thank you, JoAnn, good afternoon ladies and gentlemen. Starbucks’ tremendous second quarter financial results reflected successful execution on all business fronts. Last year during this time, we spoke to you about investing in the business and building a solid foundation to support our aggressive future growth plans.
A year later, we are pleased to report record revenues and earnings during the second quarter. This places us in a solid position as we enter the second half of fiscal 2006. Our robust second quarter delivered net revenue growth of 24% to $1.9 billion, net earnings growth of 27% to $127 million, and second quarter earnings per share of $0.16.
A continued focus on store development resulted in 424 new store openings during the second quarter – that number surpasses any other second-quarter store opening pace in the Company’s history. Additionally, stores that have been open for at least 13 months delivered strong comparable store sales growth of 10%.
We ended the quarter with 11,225 Starbucks locations in 37 countries, serving more than 40 million customers per week.
More recently, April revenues grew 23% over the same period a year ago to $597 million, comparable store sales increased 6% and we added another 152 stores during the month.
Starbucks product innovation pipeline is robust and extends out further into the future than at any other time in the Company’s history. We are well situated to achieve our aggressive financial targets for fiscal 2006 and to continue meeting our long-term growth goals.
Now let’s review some of the key drivers behind our second quarter results. The quarter started off with a new beverage, Cinnamon Dolce Latte – which turned out to be a big hit with our customers. In fact, the Cinnamon Dolce Latte was one of the most successful new promotional beverage offerings in Starbucks history.
This flavor profile provided a feeling of warmth and comfort during the cold of winter with sweet baked flavors reminiscent of a hot, buttery cinnamon pastry. The Cinnamon Dolce Latte, along with Starbucks Reduced Fat Coffee Cake trio, generated enthusiasm among both our customers and partners and contributed to our strong comparable store sales growth during this period.
Our stores also featured a nostalgic treat for customers of all ages -- Starbucks Cupcake Originals. We featured two cupcake flavors nationwide, including Vanilla Sunshine and Chocolate Chocolate, which instantly became popular with our customers, often in the afternoon day part when they were seeking that special indulgence.
We kicked off our 2006 Annual Brewing Event on March 14th, which provided our customers the opportunity to purchase best-in-class brewing equipment and accessories -- specially designed to prepare the best coffee at home -- at very attractive prices. The Brewing Event spanned the last three weeks of our second quarter and contributed positively to our quarterly results.
Additionally, Starbucks hosted our first ever National Coffee Break. Through in-store signage, a press release and word-of-mouth, we invited customers into our stores for a complimentary cup of freshly brewed coffee. These two events raised awareness of our coffee expertise and provided an opportunity for our partners to share with our customers their passion for great coffee - while driving traffic into our stores.
Adding to the new merchandise in our stores during the quarter we featured several CDs, including Back to Bedlam by James Blunt, 3121 by Prince, Timeless by Sergio Mendes and Starbucks Hear Music Opus collection -- Tony Bennett.
Turning now to the food programs in our stores, we continued expansion of our lunch program during the second quarter, adding more than 200 additional locations throughout the U.S. and Canada. This brings the total to more than 3500 stores, or 62% of our North American Company-operated locations.
While we continue to in-fill existing markets, we are also realizing operational efficiencies gained from our experience with this program. We have consolidated our lunch vendors, improved our order management and fine-tuned our selections for those core lunch offerings. We are seeing tremendous success with the lunch program, which reflects customer acceptance and solid execution by our store partners.
Additionally, we continued the expansion of our Warming Program to new cities this year, which will provide more customers the option to enjoy warm, savory breakfast sandwiches along with their favorite Starbucks beverage.
Last quarter, I reported on our expansion of Warming to more than 50 stores in Portland, Oregon, and since then we have received extremely positive feedback from our customers in that market. Building on that momentum, in early April, we introduced Warming in more than 100 stores in San Francisco, and the early results indicate strong customer acceptance in this market as well.
Later this quarter we will introduce Warming to Chicago, which will bring us to our previously stated goal of 600 stores offering this program by the end of the fiscal year. Similar to our experience with the lunch program, we are pleased with sales and operational efficiencies gained as we have expanded the Warming program to additional markets.
Now let’s take a look at what’s currently in our stores and what’s ahead. Inspired by the successful launch of our Green Tea Frappuccino blended crème last year, we have created two new green tea beverages -- one hot and one cold. The new Tazo Green Tea Latte is a delicious blend of lightly sweetened matcha green tea with a hint of tropical melon flavor and fresh steamed milk. The new Blackberry Green Tea Frappuccino Blended Crème adds a delicious twist to last year’s favorite by adding the fresh light taste of blackberry syrup made with real blackberry juice.
Again this year, for those looking for a lower calorie, non-coffee option, we are also featuring Tazo Shaken Iced Green Tea and Tazo Shaken Green Tea Lemonade. These flavors blend perfectly to deliver the ultimate in summer refreshment.
Customers will be able to choose from a large selection of serveware and Mother’s Day gift options in fresh spring colors and floral patterns. However, our merchandise offerings does not stop there -- customers can choose from a large selection of CD titles, including the soundtrack from our first entry into film, Akeelah and the Bee and Tony Bennett’s Through the Years. We are also excited to showcase our second CD in the Starbucks Hear Music Debut series -- Sonya Kitchell’s Words Came Back To Me.
Summer is just around the corner, and quite frankly, I can hardly contain my excitement for the new offerings that we’ll be introducing during our two summer promotional phases; one’s launching in mid-May and the second in late June. Let me start by telling you about the new… no, I’m going to stop right there. I can’t go there. Since we are only 2 weeks away from the first phase, let me just say that these will be some of the freshest, most exciting new beverage introductions I’ve ever seen, inspired by colors and flavors of the world. So let the anticipation build.
We will also offer a fresh new selection of merchandise, including serveware in bright summer colors, a new selection of CD titles and, late in the summer, the DVD of Akeelah and the Bee.
While our retail stores continue to be the primary driver of our results, exciting things are also happening in our non-retail businesses. During the quarter, the North American Coffee Partnership, a joint venture between Starbucks Coffee Company and the Pepsi-Cola Company, introduced several new ready-to-drink beverages: Starbucks Iced Coffee, an entirely new canned coffee product, and two line extensions within our ready-to-drink platforms -- Starbucks DoubleShot Light espresso drink and Starbucks Strawberries & Crème Frappuccino crème beverage.
At the end of April, these products were introduced into grocery and convenience stores nation-wide. Brand extensions such as these allow us to introduce innovative products and extend the Starbucks Experience to our customers at any place and any time they choose. The 95% U.S. market share we hold in this category is indicative of the broad acceptance of our ready-to-drink beverages.
We have created a solid foundation that has positioned us well for growth; however, we understand that it is extremely important to always provide social, environmental and economic support for the communities in which we operate.
With our purchase last year of Ethos Water, Starbucks has set a goal to support water projects around the world. As we’ve said before, five cents from the sale of each bottle of Ethos Water will support the goal of donating $10 million from 2005 through 2010 to non-profit organizations that are helping to alleviate the world water crisis. Starbucks participated in several events during the quarter which aligned with our efforts to bring clean water to children and communities who need the support.
On March 22nd, Starbucks honored World Water Day through “Walks for Water,” an event established to build awareness of the 1.1 billion people worldwide who lack access to clean drinking water. Nearly 2,000 Starbucks partners and customers participated in the three-mile walk which took place in 11 cities around the U.S.
In addition to participating in “Walks for Water,” we contributed to our previously stated goal of donating at least $10 million between 2005 and 2010 through two grants to water programs from the Ethos Water Fund of the Starbucks Foundation. These grants, which represented a total commitment of $2.1 million, will support programs in Western Ethiopia and four provinces in the Sumatra region of Indonesia.
Starbucks is committed to positively contributing to the world we live in, and is dedicated to becoming a leader in helping to provide clean drinking water to children and their communities around the world.
Starbucks is in a great position for both near-term and long-term growth, but at the same time that we are keeping a close eye on our performance and reaching our financial targets, we are always mindful of our social and environmental commitments.
We understand that it’s important for us to earn our success every day -- not only through product innovation and delivering the Starbucks Experience, but also through focused efforts supporting Corporate Social Responsibility. These efforts extend throughout our business ensuring that we conduct ourselves in ways that provide social, environmental and economic benefits for the communities in which we operate.
We firmly believe that our strong commitment to CSR not only benefits Starbucks, but also our customers, partners, suppliers and shareholders.
Before I conclude my comments, I’d like to share with you my thoughts on recent developments in the Specialty Coffee Industry. Over the past couple of months, there has been a lot of buzz about other players entering the premium coffee space. And as we have said consistently over the years, we welcome the broadening field.
As more competitors enter the premium quality coffee space, Starbucks benefits as well. Our company has played a pivotal role in the creation of the specialty coffee market, and as Starbucks and others continue to generate awareness for specialty coffee around the world, the category will continue to grow as consumer demand grows. We believe the combination of Starbucks’ highest quality coffee, unwavering focus on coffee education and the personal interaction between our customers and baristas -- what we call the Starbucks Experience -- demonstrates our coffee expertise, differentiates us from others and provides the foundation for future growth. Our opportunities are immense with this growing population of educated, aware specialty coffee consumers.
We are extremely pleased with our second quarter results, and we enter the second half of the fiscal year with a continued focus on execution. Achieving exceptional results again this quarter is attributable to doing more of the same that we talked about last quarter -- the continued hard work and commitment of our partners, a keen focus on our coffee core, a robust pipeline of innovations and initiatives, and diligent execution at all levels of this business. This is true for the U.S. as well as our International markets.
Howard will now share some International highlights after a brief update on our Entertainment initiatives. Howard.
Thank you, Jim, and nice job. Good afternoon, everyone. Before I discuss our International business, I’d like to take a minute to update you on our most recent Music and Entertainment initiative -- specifically, our entry into film. You will recall that last quarter I spoke to you about the transformative marketing and distribution partnership Starbucks embarked upon with Lionsgate Entertainment to introduce the new film, Akeelah and the Bee.
During the second quarter, our retail stores launched a truly innovative and interactive in-store marketing campaign in advance of the film’s opening at the box office. Through unique in-store placements and techniques that have not really been used before, our customers had the opportunity to challenge themselves by expanding their vocabulary and spelling aptitude with complex, difficult-to-spell words printed on in-store items such as flash cards, magnets, coasters, and cup sleeves.
In addition, the film’s soundtrack is available in our stores and the DVD of Akeelah and the Bee will be available late this summer. All these efforts are directed at raising our customers’ interest and to encourage them to see this very inspiring movie.
Akeelah and the Bee opened in theatres last Friday following enthusiastic pre-opening reviews from popular movie critics Ebert & Roeper, along with a strong endorsement from Oprah Winfrey as well. We are pleased with the initial reception to the inspiring story that embraces the human spirit and we anticipate that word-of-mouth from this week’s first weekend audience will build additional interest.
It’s important to remember that Starbucks invested no cash in the production of this film, and we will be an equity participant in the film’s success. We have no plans to invest capital in future movie projects as well. The unique economic partnership model we have forged clearly speaks to the power of the Starbucks brand and the value of our broad customer reach.
The positive experience we have had in our first film venture -- invigorated by our customer’s enthusiastic response to our in-store marketing efforts -- led to the announcement earlier this week of the next step in our music and entertainment strategy.
Starbucks has formed a unique relationship with the William Morris Agency, one of the world’s largest diversified talent and literary agencies, to leverage their skills and talent in identifying music, film and book projects for Starbucks to consider for marketing and distribution in our stores.
Our entry into film has given us the confidence to seek other entertainment and literary opportunities in the future that are complementary to the Starbucks Experience and that share the same human values and relevant messaging that is core to our brand.
After the initial announcement of our involvement with Akeelah and the Bee, Starbucks was deluged with material from film distributors interested in becoming our next movie partner. Our partnership with William Morris recognizes our need to align ourselves with a firm who has the expertise and capacity to manage this type of work.
Starbucks has a unique place in the daily lives of our customers -- as a gathering place to share a sense of community and connection over a cup of coffee. This makes our stores an ideal channel to present them with relevant and complementary forms of entertainment.
We highly value the trust our customers have placed in us and we embrace the opportunity to be part of their entertainment discovery. We are committed to selecting music, movie or literature projects that will represent the quality and substance reflective of the Starbucks brand. I look forward to updating you on our progress in the future.
Turning to international, and now moving on to a global update. We continue to deliver excellent performance in our International business as we build out the platform for our future growth. Let me share with you some business updates, as well as my observations over the last quarter as I traveled through several cities in Asia-Pacific and the Middle East.
Our global footprint continues expanding with the opening of 135 new stores in international markets during the quarter, which marks a second-quarter record for International store openings. We now have 3,275 locations outside the United States, and this broad base includes a combination of in-fill in our more mature markets such as Canada and Japan, as well as strong openings in China and Taiwan, where we have significant growth opportunities.
The additional new stores and strong comparable store sales growth combined to deliver outstanding revenue growth in the international segment.
It was an active quarter in our Asia Pacific region, so I will spend most of my discussion highlighting events and activities in that region. Beginning with China, I visited Beijing, Shanghai, Chongqing, and Chengdu during the quarter, and I have to say, my enthusiasm for the business, which has already been strong, continues to build. I must say that I think we have a really unique dynamic opportunity in many areas of our business. We have maintained our store expansion and now have more than 175 locations in Mainland China, 63 in Hong Kong and more than 170 in Taiwan.
During the quarter we entered the province of Shenyang, a major industrial city known for transportation, technology, trade and culture. We have also further strengthened our leadership team in China by bringing on vice presidents of finance and marketing who held previous leadership roles in that market with industry leaders. They join Jinlong Wang, our recently-appointed president of China, forming a leadership team who not only boasts local market experience but also brings a broad range of depth and industry experience and expertise. Our business in China is performing well and we remain confident in the growth opportunities ahead.
As many of you know, during his recent visit to the United States, the first stop for China’s President Hu was Seattle, Washington, and I was fortunate to have the opportunity to participate along with other local business leaders, dignitaries and elected officials in several events to honor his visit.
Not only was this an incredible experience for me but it was also great exposure for Starbucks, as President Hu mentioned the company twice during two of his formal speeches. In addition to toasting the luncheon attendees with Starbucks coffee, President Hu commented -- which was just an unbelievable opportunity for all of us to witness, and I quote -- If I were not serving in this office, I would certainly prefer to go into one of the coffee shops run by Starbucks -- end quote. I think this is indicative of the way in which we have entered China and the respect that we have gained in a very short period of time.
We are very appreciative of Starbucks acceptance in China and we embrace the opportunity before us in leading the emergence of a coffee culture in that country. This is yet another further confirmation that the Starbucks Experience translates well into other countries and cultures around the world.
Asia Pacific ended the quarter with 1,597 locations, 21% growth from a year ago.
The Europe and Middle East region -- which represents some of the broadest diversity in language, culture and landscape -- now totals nearly 900 stores, which represents 23% growth over the past twelve months.
In March, the Middle East was the site of our third annual Global Advisory Council meeting -- a gathering of our Joint Venture Partners from the international markets in which we do business. The meeting, held in Dubai, was hosted by Mohammed Alshaya, CEO of the Alshaya Group, our partner for the Middle East and Turkey, and one of our longest standing JV partners. Joining me at this council meeting were nearly two dozen members of Starbucks’ senior management team, including Jim Donald, Michael Casey and Martin Coles, as well as the presidents of our international markets.
The purpose of the two-day meeting was to discuss global growth plans, key business strategies and future opportunities for Starbucks -- but even more importantly was the sharing of best practices among all of us. I must admit I was overwhelmed with the enthusiasm of this group and the strategic alignment we all share. The passion and commitment for delivering the highest quality products and legendary service, as well as the appetite for continued store growth, was universal among all partners.
This meeting truly demonstrated that Starbucks management team and JV partners are aligned in our commitment to the company’s international growth strategy and delivering the Starbucks Experience around the world. This gathering of our key partners also presented the ideal opportunity to acknowledge and celebrate the tremendous contribution to the company’s success by one particular leader, and that was Yuji Tsunoda, the CEO/COO and representative director of Starbucks Japan.
Yuji is part of the original team that spurred Starbucks international growth and he has played an integral role in the development and success of Starbucks Japan. He embraced and infused Starbucks values in our partners and customers throughout Japan while building a profitable business with more than 600 stores in Japan today.
We truly appreciate his hard work, commitment and dedication to our company. Thank you, Yuji! As Yuji transitions out of his role and retires as CEO and COO in June of this year, we welcome his successor, Mercy Corrales, whose operational expertise and deep knowledge of the retail industry will provide solid leadership as Starbucks Japan enters its second decade of operations later this year.
With the well-planned leadership transition, we are confident Starbucks Japan will continue their successful efforts at further building the Starbucks brand, opening new stores, introducing innovative beverage and food offerings, and delivering the Starbucks Experience.
These are very exciting times for all of us at Starbucks. Looking at where we are today, I am proud of the fact that we have built a company that recognizes the fiduciary responsibility of generating profits and building shareholder value, as we’ve done as a public company since 1992, while integrating a social conscience in everything that we do.
Looking ahead, the ambition and the level of enthusiasm to continue to grow presents us with greater opportunity than ever before. With a long growth trajectory and so much opportunity ahead, we will strive to continue to provide the highest quality products and service and protect our brand and reputation as we innovate and grow into the future.
I will now turn the call over to Michael Casey
Thank you, Howard. This afternoon, I will provide highlights of our financial performance for the second quarter, both consolidated and by segment, give a brief update on the impact of stock-based compensation expense, and review our targets for the remainder of the year.
Our continued attention to execution again produced outstanding top line and bottom line growth. Revenues were very strong in both company-operated and specialty businesses, and in our international and U.S. markets. Operating flow-through remained strong and we continued to make important investments in our future.
Consolidated net revenues for the quarter were $1.9 billion, up 24% compared to the corresponding 13-week period in fiscal 2005 -- well above our 20% revenue growth target.
Company-operated retail revenues increased 25% to $1.6 billion for the quarter, driven by the opening of 874 new company-operated retail stores in the last 12 months, and 10% comparable store sales growth for the quarter.
Comparable stores sales were led by an 8% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction. This marks Starbucks’ 57th consecutive quarter of publicly reported positive comparable store sales growth.
Licensing revenues grew 25% to $202 million for the quarter, driven by higher product sales and revenues from the opening of 1,090 new licensed retail stores in the last 12 months, and continued growth in the licensed grocery and warehouse club businesses.
Starbucks whole bean and ground coffee is now available in approximately 29,000 grocery and warehouse locations, and Seattle’s Best Coffee is available in almost 23,000 grocery and warehouse club locations.
Operating income was up 28% to $202 million for the quarter, from $157 million in the prior year. As a percentage of total net revenues, operating margin increased to 10.7%, from 10.4% in the prior year, primarily due to lower cost of sales including occupancy costs, partially offset by higher corporate and international general and administrative expenses.
Cost of sales including occupancy costs as a percentage of total net revenues decreased due to fixed rent costs in the current year being distributed over an expanded revenue base, as well as a favorable year-over-year comparison in occupancy costs resulting from intensified store maintenance activities in fiscal 2005. These favorable items, together with other lesser improvements, offset higher green coffee costs in the second quarter.
General and administrative expenses increased due to higher payroll-related expenditures from stock-based compensation, additional employees to support continued global growth, and higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006.
As we discussed last quarter, the company adopted the new expensing requirements for stock-based compensation this fiscal year, with no restatement of prior period results. Our broad-based equity compensation is a long-standing part of Starbucks culture and success, and options are granted to partners at all levels of the organization, including eligible part-time employees. Last November, the company granted options to nearly 58,000 partners.
The pre-tax stock-based compensation expense recognized for the second quarter was $28 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the first half of fiscal 2006, stock-based compensation was $33 million, net of tax, or $0.04 per share -- in line with our expectations. Our strong results for the first half of the fiscal year have tended to make this expense less visible than it might otherwise have been.
As we previously disclosed, for the entire fiscal year, we expect stock-based compensation to reduce EPS by approximately $0.09 per share. Please refer to page 9 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings.
Turning now to operating segment results for the second quarter, total net revenues for our United States operating segment increased by 23% to $1.6 billion in the second quarter of fiscal 2006. Company-operated retail revenues grew 23% to $1.3 billion, primarily due to the opening of 660 new company-operated retail stores in the last 12 months and comparable store sales growth of 10% for the quarter. The increase in comparable store sales was comprised of an 8% increase in the number of customer transactions and a 2% increase in average value per transaction.
U.S. specialty revenues grew by 21%, to $232 million in the second quarter. Within specialty revenues, licensing revenues increased 26% to $156 million, primarily due to higher product sales and royalty revenues from the opening of 685 new licensed retail stores in the last 12 months, and growth in the licensed and grocery warehouse club business.
U.S. store operating expenses as a percentage of related retail revenues improved to 42.0% in the second quarter of fiscal 2006 from 42.1% in the prior year. This slight improvement was primarily due to higher costs in the prior year associated with the North American leadership conference, and leverage gained from higher retail revenues. These favorable variances were almost entirely offset by increased payroll-related expenditures from higher provisions for incentive compensation based on the company’s strong operating results in fiscal 2006 and recognition of stock-based compensation expense.
Regional leadership conferences will be held during our third fiscal quarter in 2006, whereas in fiscal 2005, the leadership conference took place in the second fiscal quarter. In fiscal 2007, the leadership conference will shift back to the second quarter and will be held in an international location for the first time.
U.S. operating income increased 36% to $266 million during the quarter. Operating margin expanded by 1.5 percentage points to 16.9% of related revenues for the second quarter of fiscal 2006. This improvement was primarily due to leverage gained from fixed costs, including occupancy, depreciation, and general and administrative expenses, distributed over an expanded revenue base in the current year period, and to higher costs in the prior year period for intensified store maintenance activities in company-operated retail stores.
Now moving to our international segment. International total net revenues increased 30% to $315 million in the second quarter of fiscal 2006. International company-operated retail revenues increased 31%, to $262 million in fiscal 2006, primarily due to the opening of 214 new company-operated retail stores in the last 12 months and comparable store sales growth of 9% for the quarter. The increase in comparable store sales resulted from a 7% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction.
International specialty revenues for the quarter increased 24% to $54 million, primarily due to higher product sales and royalty revenues from opening 405 licensed retail stores in the last 12 months and expansion of our Canadian grocery and wholesale club business.
Operating income for international operations increased 29% to $22 million in the second quarter of fiscal 2006 from $17 million in fiscal 2005. International operating margin decreased slightly to 7.1% of related revenues from 7.2% in fiscal 2005, primarily due to higher general and administrative expenses and an increase in other operating expenses for expanding infrastructure to support global growth, as well as increased retail store operating expenses due to higher provisions for incentive compensation.
These items were partially offset by lower costs of sales including occupancy costs due primarily to leverage gained from fixed costs distributed over an expanded revenue base, as well as improvements in our food program. As our store base continues to increase rapidly, we continue to invest in our international infrastructure including investments in emerging markets, such as China.
In addition to our excellent results in the second quarter of fiscal 2006, our year-to-date results are also noteworthy.
Our consolidated operating income increased 25% to $482 million in the first half of this year from $384 million in the first half of last year, and the operating margin increased to 12.6% from 12.4% -- the highest operating margin ever reported by the company for the first six months of a fiscal year.
Net earnings rose 23% and during the first half of the fiscal year, we opened 984 net new stores. We are very pleased with our strong financial performance in the first half, which positions us well as we enter the second half of the fiscal year.
I will turn now to an overview of our updated fiscal 2006 growth targets, based on our very strong second quarter performance and our latest forecast for the balance of the fiscal year:
- We continue to target opening at least 1,800 new stores on a global basis. In the United States, we plan to open approximately 700 company-operated locations and 600 licensed locations. In international markets, we plan to open approximately 150 company-operated stores and 350 licensed locations;
- We anticipate robust revenue growth will continue, and we are targeting total net revenue growth of approximately 20% on a quarterly basis and for the full year. Today we reported April comparable store sales growth of 6%, and we continue to expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies, for the rest of the fiscal year;
- As we discussed on last quarter’s conference call, in the second half of fiscal 2006, a key area of increased investment for us will be infrastructure to support the significant opportunity we foresee in China. Looking back just a year ago, we were leveraging our existing Asia-Pacific team and corporate staff to initiate our greater China strategy. Today, we have filled most key management positions and have built a very talented regional support group who are on the ground in Mainland China, focused solely on developing that market. We expect the impact of this higher level of investment to be reflected in international segment expenses and operating margin throughout the remainder of fiscal 2006;
- Based on our excellent second quarter results and our continued positive outlook for the balance of the year, we have raised and tightened our earnings per share target range to $0.71 to $0.72 per share for fiscal 2006, up from our previous target of $0.68 - $0.70 per share, and an increase of $0.07 - $0.08 per share over our original fiscal 2006 goal set last July. Our EPS goals for the second half of the year are generally unchanged and continue to reflect our expectation for strong operating results throughout the business. On a quarterly basis we are targeting earnings per share of $0.17 for Q3, which is the high end of our previous range, and we continue to target a range of $0.16 - $0.17 per share for Q4. I want to remind listeners again that our fiscal 2006 earnings targets include stock compensation expense estimated at approximately $0.02 per share per quarter, and $0.09 per share for the full year, and as a result EPS growth rates compared to fiscal 2005 are decreased due to this accounting change;
- The effective tax rate is expected to remain approximately 38% in fiscal 2006, with quarterly variations; and,
- Capital expenditures are now expected to be in the range of $750 million to $775 million in fiscal 2006, which is a $50 million increase to our previous target range largely due to a land and building purchase in support of our expansion of our corporate facilities here in Seattle.
Before I turn the call back over to the operator for the Q&A, I’d like to make one final comment. On a personal note, after more than ten exciting years as Starbucks’ chief financial officer, we have decided to initiate the process of identifying the next chief financial officer. We are going to consider both internal and external candidates with the goal of having someone in position by the end of the year, but we will take whatever time is required to find the right person and fully immerse him or her in the company’s business and culture. I will be actively involved in the transition and, beyond that, I will continue with my other executive responsibilities and new projects and initiatives as they come up. We are committed to making this transition as seamless and effective as our recent CEO transition proved to be.
With that, I would like to ask the operator to queue the first question. Please ask one question at a time and re-queue for additional questions.
Your first question comes from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein - Lehman Brothers
Great, thanks very much. I just had a question on the international margins. I know you gave some detail in your commentary, but just looking between the first quarter and the second quarter, obviously there was tremendous expansion in the first quarter, tougher second quarter. I’m just wondering if you could walk through some of the delta’s.
Secondly, what would you expect for the back half of the year? I know you made some commentary that you’re going to be investing more for the back half of the year. I’m just wondering what your outlook would be. Thank you.
We made tremendous progress over the last three years in our international business, both in growing the revenue base and improving the margins. I think the year, the quarter over quarter improvement in the first quarter was very strong, and we have always expected that this operating margin will improve gradually, but not necessarily up significantly every quarter. We don’t expect any backward movement in the operating margin in international business. We expect to continue to have improvement when you look at it over six or nine months at a time, but not necessarily each and every quarter.
As I mentioned, we are primarily building our organization to support the tremendous opportunity that we foresee in China. We’ve been talking about that for the last several quarters, and we’ve been working diligently at that. We’re now starting to see some of the expense related to the people that we’ve hired. They came on payroll a little bit later than we had originally expected, but they’re up and running and we think forming a new base from which we will continue to grow the business with the team that’s currently in place.
So we don’t call margins by quarter specifically, but looking over an extended period of time, we expect to see continued improvement in the operating margins.
Your next question comes from John Glass with CIBC.
John Glass - CIBC
Thank you. My question has to do with the growth in the specialty line, especially the licensed line. Last quarter it grew at an exceptionally strong rate, somewhere above 30%. This quarter it’s a little bit more in the 20 range, so what is a normalized growth level? I guess if last quarter was exceptionally strong, why was it? Because the number of units didn’t grow faster last quarter than in prior quarters, or is this an anomaly from a low -- I’m trying to understand, I guess the one rate growth of that line, particularly in the U.S.
We have the same business parameters in our licenses business as we do in our company-owned, and we had a particularly strong holiday season which carried over to our licensed stores as well as our company-owned stores.
The number of stores that are open at the end of a period isn’t necessarily indicative of the sales weeks during that period, because the opening pace skewed, bowed and backed. But I think a growth rate in the 20% range is a reasonable target going forward. The 30% year over year growth in that line was unusual.
Your next question comes from Steven Kron with Goldman & Sachs.
Steven Kron - Goldman & Sachs
Good afternoon. I have a question, Howard, on the entertainment business and drilling down a little bit on the Akeelah and the Bee experience. Box-office receipts in the first weekend seemed to be disappointing to those that kind of look at that industry. It sounds like you had a pretty positive experience. I guess in your stores, how did the results from the experience of Akeelah kind of compare to your expectations? How are you from a big picture standpoint measuring the success on Starbucks’ ability to kind of build awareness in the entertainment industry?
I appreciate the question. I think going into this, all along, as we look at scripts and screen movies, which dates back almost 12 months before we made the decision on this movie, we were looking for a movie that really had a lot of hope attached to it, was inspirational and really was the kind of story that was compatible with what our customers and, most importantly, our people, would expect us to be part of.
So although we clearly were interested in the box-office receipts, that was just one of a number of ways in which we were going to measure success. I would admit that the box-office receipts were less than perhaps Lionsgate or the industry had thought, but there were other competing factors. Lionsgate has a long history with movies that have a unique level of word of mouth, most specifically Crash, which opened in a similar fashion. I think this movie is going to have a long tail to it.
I think on a go-forward basis, what we’re looking to do as we have done with music, as we now have done with a film, and we keep mentioning that we are also looking for the possibility of bringing a book into our store, we are looking for things that could add texture to the equity of the brand and the experience to bring value to our customers, and we think we are in a unique position. I think our customers have come to expect us to not only provide a great cup of coffee but we are an integral part of their life and their lifestyle, and we want to be able to, when we find interesting stories and interesting pieces of content, to bring it to the marketplace.
As I said in the script, we do not see ourselves as becoming an entertainment company. We are very mindful that our core business is coffee and the coffee experience, but we all feel that this is highly complementary to who we are, what we do, and it ultimately will reinforce our position in the marketplace. So we feel really positive about the experience. We are learning a lot and we look forward to other projects.
Your next question comes from Matthew DiFrisco with Thomas Weisel Partners.
Matthew DiFrisco - Thomas Weisel Partners
Just looking at the income statement, it looks like there might have been a reclassification or something going on with the depreciation. If you could just clarify that for us, I might have missed something in the release. Then, if you could just comment on you’ve touched on also in your prepared remarks about the brewing sale or promotion having a positive benefit to Q1. Did it have an impact on the April comparable sales number released today as well?
I’ll take the first one. There has been no reclassification or change in depreciation. The numbers are consistent with the growth in primarily company-owned stores, which raised that number.
The brewing event, the timing was such that most of the business last year came into this quarter this month that we just finished. I think it was a week off, maybe eight days. So when you look at what the value of that was, again we are pleased to see that we captured the bulk of that last month but still had a great month this year with our 60% comps.
I’ll go a step further. We were very, very pleased with 60% comps, and if anyone on the call is disappointed, you’re off-base.
Your next question comes from Sharon Zackfia with William Blair.
Sharon Zackfia - William Blair
Good afternoon. I have been -- or I continue to be impressed with your COGS performance. It keeps improving quarter after quarter. I’m just wondering how low can that go, and is there some sort of comp where you start to get leverage in all those six expenses that you are talking about in the text and the press release?
I am not sure we can set a limit on how low the cost in related occupancy can go. The benefit we’ve been getting in the last several quarters is attributable primarily to the average unit volumes, particularly in our U.S. stores, which are now over $1 million, significantly noticeably over $1 million per store, and allows us to get leverage in a number of categories of the occupancy line, which is part of cost of goods sold.
We believe in our North American business, we are getting leverage in G&A and I believe we would be getting leverage in G&A overall if it weren’t for the adoption of stock-based compensation expensing this year.
We are also getting some benefit this year in cost of goods sold from favorable dairy costs, relative to a year ago. Those are the primary drivers. We continue to believe, absent some see-change in one of our basic commodities, that we can continue to do a better job than the COG occupancy line because we intend to continue to grow our average unit volumes and we think we can become more efficient in a number of the programs that we initiated the last two years, like drive-thru stores, lunch, warming -- those are places where we are still learning and continuing to get better.
Your next question comes from David Palmer with UBS.
David Palmer - UBS
Congratulations on the quarter, everybody. Michael, congratulations on I guess your CFO career. I guess it’s not your total career.
Thank you. I do want to clarify. I am going to continue to be here doing many other things as we identify a new CFO.
David Palmer - UBS
I was going to ask about the COGS line, and one thing I was curious about too is the dairy inflation, how that might evolve, along with coffee inflation over the next twelve months, but I want to save my big question for perhaps warming, and if you have any sort of preliminary timetable about how you might roll that out, how many quarters and years it might take to get across the system. Thank you.
We are going to take a similar approach to the approach that we took to Lunch. We are going to move slowly. We are going to continuously improve the selection of the products, the way we do procurement, the way we do distribution, the way we do training. It could easily take two or three years to roll it out completely. And we still haven’t made the final decision that we’re going to go everywhere with Warming. We have had great initial success in the markets that we have gone to. We are planning to do some additional markets yet to be identified next year, but beyond that, we are going to take it as it goes.
Let me add to that one. There is no race to get this rolled out. Every market that we go into, we are actually five or six steps better from all the things that Michael has mentioned. We want to make sure though that we are continuing to enhance the customer’s experience when they come in in the morning to pick up their beverage and their sandwich, be it quality of the product and the speed with service.
So as we take notes from every launch, we continue to raise the bar.
Your next question comes from Ashley Woodruff with Bears Stearns.
Ashley Woodruff - Bears Stearns
Thank you. I wonder if we could talk a little bit about pricing. The last time you took a price increase was October 2004, which was four years after your previous price increase, and I think at that time you began to think that perhaps you should take pricing a little more frequently, so your customer would get more accustomed to it. As you start to plan for 2007, can you talk about whether pricing plays a role in that?
We do not currently have any plans to change our pricing structure, specifically in the United States. Occasionally in one of the international markets, there will be a price increase but it doesn’t affect the big picture in the normal course of business related to whatever is happening in that marketplace. But I assume your primary question is related to company-owned stores in the U.S., and we have no plans in the foreseeable future to take a price increase. Not this year, and not in our current thinking for 2007.
Your next question comes from Glen Petraglia with Citigroup.
Glen Petraglia - Citigroup
Good afternoon. My question is regarding the store target for this year. It would seem that the 1800 new store target is somewhat conservative, given that in the past, store openings have generally been a little more prevalent in the second half of the year. If you could comment on that, please.
First of all, I have to say that the 1800 is probably one of our most ambitious goals that we have rolled out, and we are very pleased to see that as we have gone from quarter to quarter, we have been able to exceed our quarterly targets. We look at what has created that, it’s combining the partners in the areas of store development, in the areas of filling the bench to make sure that our partners are ready to take these stores as they come open. We will continue to keep with our 1800 store rollout and when we see the opportunities to accelerate that on a market-by-market basis, we will do that, provided that the store will be ready in its entirety and that the store partners will be ready to staff that store to deliver the Starbucks Experience.
One of the things we have talked about frequently in this call and previously is execution, and that applies to lots of different areas, but one of the ways it applies to store development is we have become much more systematic. We are planning much better, so I do not think you will see an acceleration toward the end of the year to the same extent in the future that you have seen in the past, because we are just planning better, we are executing better. We are not getting behind and therefore we do not have to catch up. So I think you will see a pretty -- eventually I believe we will raise those store targets for future years, but I do not think 1800 is conservative by any measure.
Your next question comes from John Ivankoe with J.P. Morgan.
John Ivankoe - J.P. Morgan
Thank you. A question for you, Howard. Could you talk about the special challenges in China as you see that might be structural in the market and what you have done differently with Starbucks and your organization there to allow you to achieve your goals?
I think that there are special challenges, and this is a very unique environment. I think, John, you and I spoke privately -- there is such a rush to China and I think a lot of companies will succeed and many will fail. I think that one of the things that we recognized early on, and that’s from the benefit of having very good JV partners and Chinese Starbucks people on the ground, was the importance of very high-level relationships with the government and the importance of interpersonal relationships with senior people from Starbucks. We have been to China many, many times this fiscal year and in years past, primarily to build relationships and to demonstrate a deep level of respect for not only the marketplace but the culture and the way the Chinese people perceive their business and outsiders.
I think the work we have done this year in hiring very senior Chinese people who are leading our business, a dedicated Chinese team, coupled with a philanthropic effort that we put forth earlier in the year, in which we created a $5 million education fund for those young children, specifically girls in rural China that may not have a chance for education, really demonstrated to senior Chinese officials and business leaders that Starbucks was trying to build a business here the right way. We have a long way to go. I think we have built a very solid foundation. You have heard us say before that this potentially will be the largest market in the world for Starbucks outside of North America. I think we are off to a great start, and we are seeing real traction and acceptance.
I think we have a lot of work to do, but we have done a lot of things right.
Myles, that wraps up the call, please.
Thank you for listening to our earnings call today. We hope you will join the webcast of our third quarter fiscal 2006 financial results on August 2, 2006, and note that at that time we will release revenues for July as well. Thank you for joining us today.
Ladies and gentlemen, we do appreciate your joining us. This does conclude our Starbucks second quarter 2006 earnings conference call. You may now disconnect.
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