Starbucks Corporation (NASDAQ:SBUX)
Q3 2006 Earnings Conference Call
August 2, 2006 4:30 pm ET
Howard Schultz - Chairman
Jim Donald - President and Chief Executive Officer
Michael Casey - Chief Financial Officer, Executive Vice President, Chief Administrative Officer
Mary Ekman - Vice President of Corporate Development and Investor Relations
JoAnn DeGrande - Director, Investor Relations
Matthew Difrisco - Thomas Weisel Partners
Joseph Buckley - Bear, Stearns & Co.
John Glass - CIBC World Markets
Jeffrey Bernstein - Lehman Brothers
Steven Kron - Goldman Sachs
David Palmer - UBS
Sharon Zackfia - William Blair & Co.
Glen Petraglia - Citigroup
John Ivankoe - JPMorgan Chase & Co.
Dan Geiman - McAdams Wright Ragen
Good afternoon, my name is Judy and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks third 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.
I will now turn the call over to JoAnn DeGrande, Director, Investor Relations. Ma’am, you may begin your conference.
Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations with Starbucks Coffee Company. With me today are Howard Schultz, Chairman; Jim Donald, President and CEO, Michael Casey, Executive Vice President and CFO; and Mary Ekman, Vice President of Corporate Development and Investor Relations.
During today’s call, Jim will review key results and accomplishments, as well as provide some highlights from our U.S. retail business. Howard will provide an update on our international business, and Michael will highlight the key drivers behind our third quarter results, comment on fiscal 2006 growth targets, and introduce our fiscal 2007 growth targets.
We will limit today’s call to one hour, including Q&A.
I would like to remind you that today we released our July revenues in conjunction with our fiscal third quarter results.
As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available by telephone at 800-642-1687, reservation number 3728558, by 5:30 Pacific time on Wednesday, August 9th; on the Internet and on the investor relations page at starbucks.com through 5:00 p.m. Pacific time on Wednesday, August 30th.
In addition, today’s remarks will be available on the Investor Relations portion of starbucks.com by the end of the day today and will remain available through Wednesday, August 30th.
This conference call includes forward-looking statements such as anticipated store openings, comparable stores sales expectations, trends in or expectations regarding the company’s net revenue, estimate stock-based compensation expense, expected capital expenditures, expected effective tax rate, and earnings per share results.
These forward-looking 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 factors section of Starbucks Annual Report on Form 10-K for the fiscal year ended October 2, 2005.
The company assumes no obligation to update any of these forward-looking statements.
I will now turn the call over to Jim.
Thank you, JoAnn, and good afternoon, ladies and gentlemen.
Our third quarter financial results continue to demonstrate our dedicated focus on successful execution across all our business fronts.
Let me begin with an overview of our solid third quarter financial results. Again this quarter, our partners successfully delivered the Starbucks Experience through product innovation and solid execution to more than 40 million customers around the world weekly, resulting in net revenue growth of 23% to $2 billion, net earnings of $145 million, and third quarter earnings per share of $0.18.
For the quarter, Starbucks delivered strong comparable store sales of 6%, solidly within our 3% to 7% target range.
Our robust store expansion continued with the opening of 559 new locations worldwide -- that is the highest level of store openings in a third-quarter period in the company’s history. Our store development partners demonstrated once again excellent dedication, drive, focus and skill by opening 395 stores in the United States and 164 locations in international markets.
Speaking of international, a few of our international markets hit significant milestones recently: Starbucks Japan now has more than 600 locations; the U.K. opened its 500th store during the quarter; and I just recently participated in the opening celebration of our 100th store in the Philippines.
What is notable about the 100th store opening in the Philippines is that when we initially opened that market, we anticipated a maximum of 50 Starbucks stores -- this again demonstrates the strength in Starbucks worldwide acceptance and the depth of our global store opportunity.
Today, we also announced July results with a 20% increase in revenues for the month and comparable store sales growing 4% -- marking the 175th consecutive month of positive comparable store sales growth. I have yet to find another company in our peer universe that has delivered a similar record of positive comparable store sales growth over such a sustained period. During July, we added 162 new stores.
There has been a lot of news in the past few months around fears of an economic slowdown. We are aware of softening retail sales and declines in traffic at many retail-oriented businesses, which have been attributed to overall economic conditions.
While you may have drawn your own conclusions that Starbucks comparable store sales results are reflecting those macroeconomic factors, we believe our results are related more to a different set of factors and, as I will explain, we believe the opportunity for improvement remains in our control.
Starbucks U.S. comparable store sales growth for the quarter was well within our target range of 3% to 7% -- but it would be remiss if we did not acknowledge that our July comp growth of 4% is below the level achieved for the first nine months of fiscal 2006.
Unlike many retailers, to date, based on the best data available to us, we are not seeing any signs that macroeconomic trends are having a significant impact on Starbucks business. Yet, we do remain mindful and cautious about the external environment and we are aware of issues facing the consumer.
We believe our recent slower comp growth, while still very healthy, reflects some internal challenges our stores are facing with meeting customer demand for cold blended beverages. Currently, we are experiencing stronger than expected -- it is actually unprecedented -- customer demand for blended beverages during morning peak hours. While we have made tremendous progress on our service with speed initiatives during our peak espresso periods, we still have work to do with service efficiencies around our Frappuccino blended beverage preparation.
Last year we spoke to you about the growing popularity of our blended beverages. In fact, during our Spring and Summer 2006 promotional periods, we introduced a number of new and exciting blended beverage offerings which have been very well received. In light of the increasing demand for our blended beverages, we have recognized the opportunity to refine and improve our Cold Beverage Station to make drink preparation more efficient and improve service over time but, in retrospect, we did not move aggressively enough.
Currently, we have deployed the Cold Beverage Station to 1,070 locations -- about 18% of our company-operated locations in the U.S. and Canada. This is one example of how we are beginning to make progress toward increasing service efficiencies in this category.
What is key here is that blended beverage sales are showing strong growth, but we are experiencing the softest overall comparable transaction growth in stores with the highest blended sales. Because of this, we believe we are losing some espresso business due to longer than normal wait times, in both cafes and drive-thru’s during peak morning hours.
It is also possible that we are not maximizing the blended beverage business due to this capacity constraint.
We believe that our July comparable store sales growth is under pressure because we are challenged to meet customer demand for our Frappuccino beverages. Customers are embracing these cold blended beverages as a morning staple to a degree that we had not anticipated, and it is clear to us that the opportunity for improvement remains in our control.
We recognize the opportunity ahead of us and we know what our challenge is. That is to take the efficiencies and learnings from stores providing the best service with speed during periods of peak customer demand for cold beverages and applying them broadly to our company-operated stores across the U.S. and Canada.
These learnings include equipment improvements, ergonomic engineering, more effective labor deployment and partner training. We know it is not just our job to create customer demand through innovation, we also have to satisfy that demand and we are actively working to alleviate new capacity constraints that develop as our business grows.
Now, let me take a step back and review the drivers behind the third quarter’s strong results.
During the quarter, Starbucks company-operated retail locations in the U.S. delivered $1.4 billion in revenues, proving the positive effect of the variety and integration of beverage and food offerings, intended to keep our stores fresh, our partners engaged and our customers excited.
The synchronized promotions across all in-store products created the perfect ambiance for the impending change from winter to spring and then to summer. Key drivers behind this quarter were innovations across our core beverage platforms as well as food.
To kick-off our summer promotion, we literally went bananas and not just domestically but globally. Using fresh banana puree, the Banana Frappuccino Blended Beverage Platform included Banana Coconut Frappuccino Blended Coffee, made with the finest Latin American coffees, and Bananas & Crème Frappuccino Blended Crème, an indulgent treat for those seeking a non-coffee option.
The promotion was accompanied by food offerings that complement our beverage innovations. The Reduced Fat Banana Chocolate Chip Coffee Cake and the Banana Crème Crunch Bar, they were immediate hits with our customers. It is important to note that our entire line-up of food offerings provides a meaningful contribution to our comparable store sales growth and to retail revenues.
We talk a lot about innovation, not only how it touches nearly all aspects of our business but also as a driver to our success. During the final days of the third quarter, we took innovation to a new level by introducing Frappuccino Juice Blends in two popular flavors
-- Tangerine and Pomegranate.
The platform is off to a strong start, offering our customers a refreshing, juice-based option. These new beverages, made with freshly brewed Tazo tea and real fruit juices, are naturally cholesterol and fat free, low in calories and are non-dairy -- offering expanded choices for our customers.
As with most of our new beverages, we introduced two food items that pair well with these beverages. The Pineapple Crumb Cake and the Caramel Nut Bar were introduced this quarter to accompany the Frappuccino Juice Blends.
As I mentioned earlier, our food offerings continue to contribute to sales. Our lunch program is tracking extremely well, and during the third quarter, lunch offerings were added to 283 locations, including more than 80 stores in the Fresno, California area.
Overall, we have increased the store count in our lunch program by 29% to 3,800 Starbucks stores when compared to the third quarter of fiscal 2005. Currently, lunch is offered in 64% of our company-operated locations in the U.S. and 72% of our company-operated locations in Canada.
Another growing component of our food offerings is our Warming Program. During the quarter, we launched warming in both San Francisco and Chicago, adding 252 stores. In its first month, Chicago has proven to be one of our top new markets with volumes slightly exceeding our prior market entries.
Over the last year, our first two markets that offered the Warming Program -- Seattle and Washington, D.C. have seen an incremental revenue contribution on average of approximately $35,000 annually.
As of the end of the third quarter, nearly 600 stores offered customers the opportunity to order warmed breakfast sandwiches.
Additionally, at the end of June, in order to refine our selection of offerings and provide a broader assortment to our customers, we began testing two new breakfast sandwiches in our first three warming markets -- that would be Seattle, Washington, D.C. and Portland. Those were the Virginia Ham Bagel and, just for a limited time, the Chicken Apple Sausage Bagel.
Before I close, I would like to briefly mention the great selection of merchandise and music in our stores. Summer was not only evident in our expanded refreshing blended beverages, but also in our merchandising with fresh, colorful signage, serveware, our city-specific Bearista Bears, and summer travel games.
Our selection of CDs included new titles from some of our favorite artists, such as Tony Bennett, Marvin Gaye and Bruce Springsteen, as well as new emerging artists like Sonya Kitchell, KT Tunstall and Corinne Bailey Rae.
The third quarter’s consistent performance positions us well on the way to achieving our fiscal 2006 goals and towards pursuing Starbucks continued global opportunities as we look ahead to fiscal 2007.
As of the end of the third quarter, we are on track to meet or exceed our original targets for store growth, revenue growth, comparable store sales growth and EPS.
We know that our partners’ dedication, the drive, the focus and the execution set Starbucks apart. We, Starbucks, we are a unique company. It is a place that offers legendary service, providing customers with the human connection that is sometimes lost in the hustle and bustle of their busy daily lives.
It is a place with strong focus on innovation and customization, providing customers with the offerings they truly desire, and it is a company that, at the end of the day, continues to grow aggressively, ultimately delivering value to our shareholders.
This is what makes Starbucks unique and able to perform well in a tough economic environment.
With that, I will turn the call over to Howard.
Thank you, Jim, and good afternoon, everyone.
We are very pleased with the financial results our international segment delivered during the quarter, which positions us well as we enter the final quarter of fiscal 2006. During the third quarter, not only did our international segment deliver strong net revenue growth of 37% and operating income growth of 55%, we have also exceeded our company-operated store opening targets for the fiscal year. This demonstrates strong performance amidst tremendous growth and is especially significant, as we mark the 10th anniversary this month of our first market outside North America -- that was Japan.
It was exactly 10 years ago today that we celebrated the opening of our first store in Tokyo. As Jim mentioned earlier, a decade later, Starbucks Japan now has more than 600 locations.
Overall, we now have more than 3,400 stores in 36 countries outside the U.S., compared to nearly 2,800 stores in 34 countries a year ago. This is just the beginning. In addition to the great opportunity remaining to infill existing markets, as we have shared with you in the past, there are several new markets we intend to enter in the next few years. In fact, preparations are well underway to open our first store in Brazil later in the calendar year.
We are now realizing the unique benefits of leveraging our enterprise capabilities in international store development. We will continue to focus on building out new and existing markets worldwide, as well as increasing equity ownership in existing markets where it makes business sense.
We are pleased that Starbucks is seen as a strong community partner of choice, which is evident by the growing interest for our stores from communities and cities throughout the world. It was not that long ago that many of you asked “Will the Starbucks brand and experience be accepted globally?”
Today, our stores are considered a great community gathering place and Starbucks is becoming an integral part of communities around the world. In fact, many communities are approaching us, seeking our presence because we are seen as a terrific partner in communities where we have an opportunity to really integral in the daily lives of the local population.
This acceptance validates the strength of our brand, and that the Starbucks experience is translated in unique and rewarding ways across many different languages, communities and life styles worldwide.
We have spoken many times about our excitement for the growth opportunities China presents, and you know of our investment in the infrastructure there to prepare for capturing those opportunities. At the end of the quarter, we had 246 stores in mainland China, including Hong Kong, and 177 locations in Taiwan, for a total of 423 stores in greater China.
We are equally excited about two other major markets we intend to enter during 2007 -- India and Russia. You have heard us speak about these in the past, but it is important for you to know that the planning and research is well underway.
We are in discussions with potential joint venture partners in each of these markets. Meanwhile, we are scouting locations, meeting with government officials -- all toward gaining additional market knowledge and building critical relationships to make our market entries a success.
Specific to India, there has been a great deal of information and speculation around exciting expansion opportunities for U.S. companies. Undoubtedly you have all read the same articles we have been reading, which cite India as a land of opportunity and a competitive challenge to China.
As the world’s second most populous country, with more than 1 billion people and growing at 6% per year, we see unique and great opportunity for bringing the Starbucks experience to this market.
Much like China, India has traditionally been a tea culture, yet there is a growing coffee culture emerging, especially among the country’s young adults. Also like China, there is a growing interest in Western consumer brands and luxury products.
U.S. companies continue to outsource more work to India’s labor force, providing increased job opportunities, often higher wages, and building increasing awareness of Western culture and products. All of this is very exciting and Starbucks plans to be part of India’s growing economy. We look forward to sharing more details with you closer to the store opening date.
Let me talk a little bit about Russia. Russia also holds exciting opportunities for Starbucks. Similar to China and India, the people of Russia have enthusiastically embraced international brands, especially premium and luxury products. Not only has Russia realized a positive economic change over the last five years, resulting in an expanded middle and wealthy class, the country has been identified by an association of international retailers as one of the top two most attractive development markets for global retailers.
A little more than a year ago, we brought the Starbucks brand to Russia for the first time through our Foodservice relationship with Marriott International. The Renaissance Moscow Hotel exclusively serves Starbucks coffee and espresso in its restaurants, coffee shops and catering business under the Starbucks “We Proudly Brew” brand.
This relationship is the first step in building awareness of the Starbucks brand, as we see that market in advance of our retail expansion.
Also paving the way for our entry into Russia was a recent trademark ruling in favor of Starbucks against a third party’s attempt to register a trademark using the Starbucks name and logo.
As you know, we are dogmatic about protecting Starbucks intellectual property, and we are very pleased to now have full ownership of Starbucks trademarks in Russia.
So we are well underway, laying the groundwork for our entry into Russia in fiscal 2007. We will be sure to update you on the progress as we move in closer to a store opening date.
In summary, let me just echo, for our International business, some of what Jim said earlier about operations in the U.S. -- we will continue to focus on the basics: execution across all levels of the business, commitment to our partners and communities in which we operate and a continued focus on delivering our legendary service to more and more customers worldwide.
Over the past several years, we have worked diligently to build a strong foundation for our international business to allow us to capture the significant opportunities that lie ahead. While we have made great progress, we know we are still in the early stages of our international growth.
I truly believe that we are in a great position to achieve sustainable growth well into the future and I am truly excited about the opportunities that lie ahead. With more than 3,400 stores in 36 countries, we are clearly in the embryonic phase of our long-term goal of at least 15,000 stores outside the United States.
I will now give the call to Michael Casey.
Thank you, Howard.
This afternoon, I will provide highlights of our financial performance for the third quarter, both consolidated and by segment, and I will review our targets for the remainder of fiscal 2006, as well as introduce the company’s growth targets for fiscal 2007.
Let me begin by emphasizing the continued broad-based strength of our revenue growth. Consolidated net revenues for the 13 weeks ended July 2, 2006 were a record $2.0 billion, up 23% compared to the same period in fiscal 2005, and above our 20% annual revenue growth target.
Company-operated retail revenues increased 22% to $1.7 billion for the quarter, driven by the opening of 955 new company-operated retail stores in the last 12 months, and 6% comparable store sales growth for the quarter.
Comparable store sales growth consisted of a 4% increase in the number of customer transactions, coupled with a 2% increase in the average value per transaction.
Specialty revenues grew 23% to $303 million for the quarter. Within specialty revenues, licensing revenues grew 27% to $216 million for the quarter, driven by higher product sales and royalty revenues from the opening of 1,158 new licensed retail stores in the last 12 months.
I would now like to spend a little time reviewing our financial highlights.
Operating income increased 8% to $215 million in the quarter, from $200 million in the prior quarter. Excluding $27.4 million of stock-based compensation expense, operating income increased by 21.2%. As a percentage of total net revenues, the operating margin declined 153 basis points to 10.9% from a third quarter record high of
12.5% in the prior year.
Of the reported 153 basis point decline, 139 basis points or 91% was due to the cost of stock-based compensation, which was not expensed last year. The remaining 14 basis point decline was the net result of a 29 basis points higher COGS and related occupancy due to green coffee costs, 47 basis points higher store operating expense due to payroll-related expenses, and 38 basis points higher other operating expenses due to marketing and payroll-related costs; offset by leverage on G&A, and depreciation, as well as growth in our income from equity investees.
I do not often review income from equity investees, but with a 42% increase year over year, I felt it was appropriate for me to provide a few comments.
This line item represents our proportionate share of equity investees’ earnings. The strong growth reflected in this period was primarily related to volume-driven results coming from the North American Coffee Partnership, which included contributions from the introduction of our new ready-to-drink iced coffee and two new line extensions in our bottled Frappuccino coffee drink and Starbucks DoubleShot espresso drink product offerings.
Also contributing to the growth was improved results from our international investees, particularly Japan.
As we have discussed in previous quarters, the company adopted the new expensing requirement for stock-based compensation this fiscal year, with no restatement of prior period results.
The pre-tax stock-based compensation expense recognized for the third quarter was $27 million, or $18 million net of tax, for an EPS impact of $0.02 per share. For the three quarters of fiscal 2006, stock-based compensation was $51 million, net of tax, or $0.07 per share -- in line with our expectations.
Our strong results in the first three quarters 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 10 of the press release for a break-out of how this expense is allocated to our consolidated statement of earnings.
For the quarter, the effective tax rate was 33.7% compared to 38.1% for the corresponding period in fiscal 2005. This decline in the rate was mainly due to the settlement of a multi-year income tax audit in a foreign jurisdiction, for which Starbucks had previously established a contingent liability.
The settlement allowed us to release the contingent liability and amounted to a one-time benefit in earnings per share of $0.01 in the third quarter.
Turning now to operating segment results for the third quarter.
Total net revenues for the United States operating segment increased by 20% to $1.6 billion in the third quarter of fiscal 2006. Company-operated retail revenues grew 19% to $1.4 billion, primarily due to the opening of 727 new company-operated retail stores in the last 12 months and comparable store sales growth of 6% for the quarter.
The increase in comparable store sales was comprised of a 5% increase in the number of customer transactions and a 1% increase in the average value per transaction.
U.S. specialty revenues grew by 22% to $241 million in the third quarter. Within specialty revenues, licensing revenues increased 26% to $162 million, primarily due to higher product sales and royalty revenues from the opening of 730 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse businesses.
U.S. store operating expenses as a percent of related retail revenues increased to
42.1% in the third quarter of fiscal 2006, from 40.7% in the prior year. The increase was primarily related to payroll-related expenditures due to the recognition of stock-based compensation expense and higher employee health benefit costs.
In addition, regional leadership conferences for retail management employees were held during the third quarter this year compared to the second quarter in fiscal 2005. These increases were partially offset by lower marketing expenses.
U.S. operating income increased 8% to $264 million during the quarter from $245 million during the same period in fiscal 2005. The operating margin decreased to
16.5% of related revenues for the third quarter from 18.3% for the third quarter of fiscal 2005. The decrease was primarily due to the higher store operating expenses I just noted, and to an increase in cost of sales, including occupancy costs from higher green coffee costs and higher distribution and utilities expenses, which were due in part to higher fuel costs.
Now moving to the International segment.
Our international total revenues increased 37% to $358 million in the third quarter of fiscal 2006. International company-operated retail revenues increased 38% to $297 million in fiscal 2006, mainly due to the opening of 228 new company-operated retail stores in the last 12 months, and comparable store sales growth of 7% for the quarter.
The comparable store sales increase resulted from a 4% increase in the number of customer transactions combined with a 3% increase in the average value per transaction.
International specialty revenues for the quarter increased 30% to $61 million, primarily due to higher product sales and royalty revenues from the opening of 428 licensed retail stores in the last 12 months, and to sales of ready-to-drink products introduced in Japan, Taiwan and Korea in the fall of last year.
Operating income for international operations increased 55% to $29 million in the third quarter this year from $19 million in fiscal 2005, with the operating margin increasing to 8.2% of related revenues from 7.2% in fiscal 2005.
The operating margin improvement is primarily driven by lower cost of sales, including occupancy costs from leverage gained on fixed rent, production, and distribution costs distributed over an expanded revenue base.
Partially offsetting this improvement was an increase in other operating expenses for marketing and advertising related to the reintroduction of one of our ready-to-drink chilled coffee products in Japan, as well as increased payroll-related expenditures to support global expansion.
Our ongoing investment in our international infrastructure, including investments in emerging markets such as China, will continue and can be expected to cause variability in future quarterly operating margins.
During the third quarter, the company repurchased 4.9 million shares of Starbucks stock at a cost of approximately $176 million, under an authorized share repurchase program. Our repurchase activity continued through July and with only 3.4 million shares remaining available under the existing authorization, today we announced the Board’s authorization to repurchase up to an additional 25 million shares of the company’s common stock.
Since the inception of our share repurchase program in 2001, Starbucks has returned approximately $2.1 billion to shareholders through the repurchase of 92.3 million shares through August 1, 2006.
Before I discuss our targets for 2006 and 2007, I want to call your attention to an accounting change from the Financial Accounting Standards Board related to Asset Retirement Obligations, which we will adopt at the end of fiscal 2006.
As we have been disclosing in our SEC filings, the FASB’s Interpretation Number 47 requires that an estimate of the cost of future asset retirements to be accrued in advance of their settlement. For Starbucks, as for other retailers with a large number of leased store locations, the primary amounts that will be accrued are for the costs of removing leasehold improvements at the termination of a lease.
The initial impact of adopting these new requirements will be to record, at the end of the fourth quarter of 2006, the cumulative catch-up amount as a below-the-line, non-cash adjustment to earnings after income taxes.
We are currently in the process of estimating the cumulative catch-up amount, but it is expected to total $0.05 per share or less. Beginning in fiscal 2007, this accounting change will be reflected in the company’s financial statements and will not have a material impact on the company’s results.
I will turn now to an overview of our updated fiscal 2006 growth targets, based on our strong third quarter performance and our latest forecast for the balance of the year.
We have made great progress in building up our store development capabilities and in leveraging strong relationships with licensed partners to support our continued, rapid retail store expansion.
We now expect to open at least 2,000 net new stores on a global basis in fiscal 2006, an increase of 200 stores over our previous target of 1,800.
In the United States, we plan to open approximately 750 company-operated locations and 650 licensed locations. In international markets, we plan to open approximately 200 company-operated stores and 400 licensed stores.
Robust revenue growth is expected to continue in the fourth quarter, and we continue to target total net revenue growth of approximately 20% for the full year. Today we reported July comparable store sales growth of 4%, and we continue to expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies, for the remainder of fiscal 2006.
Based on our third quarter results and our continued positive outlook for the balance of the year, we are now targeting earnings per share in the range of $0.72 to $0.73 per share for fiscal 2006.
Excluding the $0.01 per share one-time benefit in the third quarter, this new EPS target is unchanged from our previous target range of $0.71 to $0.72 per share. This target also does not include the cumulative impact expected in the fourth quarter upon the adoption of FIN 47, which I just mentioned.
I want to remind listeners again that our fiscal 2006 earnings targets include stock-based 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.
Primarily driven by the acceleration in new store development, capital expenditures are now expected to be approximately $800 million in fiscal 2006, which is an increase over our previous target range of $750 million to $775 million.
Let me now share a first look at our fiscal 2007 financial targets.
Best-in-class store development capabilities and expanding a talented bench of partners to manage our stores is a core competitive advantage for Starbucks, and has allowed for continued acceleration of our store growth plans over the years.
Accordingly, we are now planning to ramp up our net new store openings to approximately 2,400 new stores on a global basis in fiscal 2007, an increase of 400 stores compared to our newly raised fiscal 2006 target.
In the United States, we plan to open approximately 1,000 company-operated locations and 700 licensed locations. In International markets, we plan to open approximately 300 company-operated locations and 400 licensed stores.
We are targeting total net revenue growth of approximately 20% to continue in fiscal 2007, and we again expect comparable store sales growth in the range of 3% to 7%, with monthly anomalies.
We are targeting earnings per share of $0.87 to $0.89 for fiscal 2007, which reflects growth of approximately 20% to 25% compared to our fiscal 2006 earnings per share target range of $0.72 to $0.73 per share, when adjusted to exclude the one-time tax benefit of $0.01 recorded in the fiscal 2006 third quarter.
Please keep in mind that performance in the first half of fiscal 2006 was particularly strong, so year over year EPS growth comparisons will be more challenging for those periods.
For fiscal 2007, we are targeting an effective tax rate of approximately 38%, with quarterly variations likely.
Finally, capital expenditures are expected to be in the range of $950 million to $1 billion in fiscal 2007. These capital investments will go toward supporting the addition of at least 1,300 new company-operated stores next year, to maintenance of our existing growing retail store base, and to further building infrastructure to support our rapidly growing global business.
With that, I would now 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 the line of Matt Difrisco from Thomas Weisel.
Matthew Difrisco - Thomas Weisel Partners
Can you hear me now? Just curious, when the guidance was given for the guidance range of 3% to 7%, with monthly anomalies -- is that also inclusive, then would you consider a below 3% as a monthly anomaly, but still being able to make the earnings target for one month?
Yes, that would be a possibility. It is not something that we expect, but we are not predicting each and every month. We are talking about a range, and that range is 3% to 7%.
I think that has been our range for -- I do not have the exact time, but at least more than five years, I would say. Could you correct me, Mary, do you know? How long has it been?
At least three years.
At least three? Okay. At least three years. Thank you.
Your next question comes from Joe Buckley with Bear, Stearns.
Joseph Buckley - Bear, Stearns & Co.
Thank you. I just wanted to go with your comments on the July same-store sales number. First, do you think the increase in the cold blended beverages is seasonal? Is that something that will fade as we move into colder weather? I am curious how you measure or how you came to the conclusion of the bottleneck. Is that something you could measure in some way?
Joe, we do measure and it is measured by region, actually. We have insight into our stores across the country. The way we got that information was just by seeing the results that I talked about. Actually, we get into it by city, by store, by district, and we can tell you by store what is happening with espresso, we can tell you what is happening with cold blended.
When you look at cold blended, it too is a seasonal offerings that we come out with. I think what we are finding is that our innovative prowess has created some unbelievable opportunities for us in the Frappuccino juice blend, that quite frankly have done quite well and created some of this.
On top of that, what I said earlier was that we were somewhat surprised that the need stage for this happened earlier in the day, in our a.m. business, when we were cranking out our espresso and our coffee drinks.
We measure these transactions per half hour, and we measure these transactions per half hour versus a year ago, so we are able to see down to that transaction what that effect was.
We sort our stores by those that are in the warmer weather zones versus ones that are in colder weather zones, or less warm. We can see the growth in the blended beverage, the accelerated growth in the blended beverages in the warmer markets. We can see it spreading over into the earlier day-parts, particularly the morning, when we did not expect it.
We can see in the colder markets that we are not getting quite that up-tick in blended beverage business, but we are maintaining a stronger transaction growth. So it is the comparison of those two that leads us to that conclusion.
Your next question comes from John Glass from CIBC.
John Glass - CIBC World Markets
I would like to actually just follow up on that. If your conclusion is correct about the blended beverage business slowing down comps, what are you going to do about it specifically? How soon can you do something about it? Could you also overlay that on the drive-thru -- is the drive-thru blended business slowing it down more specifically than non-drive-thru blended business?
The drive-thru is actually part of the fix, because we are opening new drive-thru’s with separate stations, John, that we talked about before, and so that partner, the barista that is behind the drive-thru does not have to swim upstream while crossing over with some of our other partners behind the counter.
We have already started to roll out more cold blended beverage stations. We are looking at a third barista mode at the automated espresso machines that we are putting in. We are looking at the engineering behind the blenders themselves creating more efficiency and reducing the amount of time that it takes to blend. We are also looking at deployment.
Through each one of these areas, as we are rolling it out now past 1,070 stores, we are able to see that towards the end of the summer, we will be able to make a difference. Actually now, but for next year as we gear up again, we will be in much better shape.
Your next question comes from Jeffrey Bernstein with Lehman Brothers.
Jeffrey Bernstein - Lehman Brothers
Thank you. Actually, a question on the food business. As you continue to expand the lunch rollout, and breakfast seems to be meeting or exceeding expectations, I just wonder if you could provide a little bit more detail in terms of your thoughts for both segments, if we were to look out a few years from now. How do you see each business evolving? When we should expect either or both to be system wide, what type of contribution we should expect -- any thoughts on the direction of those businesses would be great. Thank you.
We have taken a very pragmatic approach to warming and to lunch. We want to make sure we could execute, first and foremost, the warming as it is taking some of our partners' behind-the-counter functions more so in a manner than the ready-to-eat cold sandwiches.
We see opportunities out in and amongst the areas that we have not launched yet, and we are we are still taking this pragmatic approach because it is not something that we have to do coast-to-coast and it is not something we would normally put in coast-to-coast, but we want to make sure we are in the right market.
If the customer has that opportunity to participate in creating this, continuing to create the surprise and adding value to their trip, and roll that out as we see the areas being primed for this -- this is not something we pull the trigger and off it goes.
We go into the area well in advance of the products, train our partners both on the deployment of the actual bringing the lunch and the warming sandwich into the flow of what they are doing now, and make sure they get that before we just punch the button.
As we roll this out, we are continuing to look at the markets we know have a need for it right now, and not necessarily trying to put it coast to coast in all of our stores across the U.S. and Canada.
If I had to make a little bit of a projection, we are currently in the mid-60’s -- 60% of our stores have the lunch program. I would think that over the next year or two, we could get up into the mid-70’s, but not necessarily have a lunch program in all of our stores, because of a variety of traffic patterns, lease restrictions, et cetera. But the warming program, which is now doing even better than it was a year ago, I could see at some point in time, two or three years down the road, that we could have the warming program in all of the company-owned stores.
It will take a while to get there, but I think that is the goal that we would probably shoot for, given the success that we have seen so far.
As Jim says, we are not going to rush. We are going to continue to improve and continue to roll out on a market-by-market basis.
The future of food in our stores is not necessarily one that we are looking to get in this business. We are looking to continue to add to the quality of our service, the quality of our beverage, and to have that be a complement to, and not necessarily reign at the end of the day.
Your next question comes from Steven Kron with Goldman Sachs.
Steven Kron - Goldman Sachs
I had two quick ones, if I might. First, you talked last call about back-half investments in infrastructure in the international business. I was a little surprised to see margins up 100 basis points. I would have thought there was going to be more of an offset. Did you pull back a little bit this quarter? Was there a reallocation of infrastructure investment?
Secondly, real quickly, on the accelerated development, are there additional costs that we need to think about from a personnel or a training perspective that will affect margins?
On your first question, we absolutely did not pull back on the international development at all. We have just been able to grow revenue at a faster rate than that infrastructure has grown.
I think if you looked at the G&A, you probably saw year-over-year increase in the G&A and in the other operating expenses, is where you see some of that infrastructure build. We are not pulling back even a little bit on the international infrastructure.
With regard to the accelerated store growth, I do not think you will see any difference on our P&L. We have been increasing our store count basically for as long as I can remember, and we have learned how to do it and how to build in advance for it. We have been building that capability by adding people, adding assistant store managers gradually.
We are practically at the opening rate in this quarter that we are projecting for next year, so this has been gradual and I do not think you will see any difference in the P&L ratios.
Your next question comes from David Palmer with UBS.
David Palmer - UBS
Thank you. A big question on international and a quick one on warming. This is the third year in a row you have had great contributions from international in terms of profitability. I think it is contributing 20% to 25% of your profit growth each of the last three years.
Assuming the fourth quarter has a decent margin, it looks like your margin for international will be approaching about 10%. That is obviously up from 0 in '03. My question is about the incremental profit contributions in the future. What should we expect here? You are going to be making a lot of investments for growth, going for big growth in China -- how should we think about the contribution of profit in China?
Secondly, with regard to stores and the warming, I am curious to know, are you thinking -- and maybe even doing this already -- putting an effort in terms of lunch or even dinner day-part offerings there and getting any results since you have that warming equipment? Thank you.
Let me start on the international side, at first on the qualitative response to your question and then give it to Michael on the economic response.
I think the big headline here, if you go back three years ago where we had not made money and where we are today, is the level of acceptance, and most specifically the relevancy, of the Starbucks experience in which we have been able to land so softly and so easily in so many different types of markets.
When you look at the countries that we are in and the level of coffee education from a market as mature as France and Spain, and then you look at China and Malaysia and Singapore and even Japan, for that matter, it is really remarkable.
That speaks to the fact that the third-place experience, Starbucks is a place between home and work, is as relevant in these countries as they have been in the U.S. That has given us the ability to ramp up and also create the kind of unit economics that, candidly, we did not expect.
I think that, going away from this call, I know many of you will probably focus on 4% comps, but for me the headline is we have just announced an increase in stores for '06, an increase in stores for '07 and, most importantly, the fact that our international business is firing on all cylinders and we just announced the interest in Russia and India on top of the way in which we are being embraced all over the world, and specifically with now over 400 stores in greater China.
With that, I will let Michael take the economic side, but we could not be more enthused and excited about what is happening internationally, which complements, obviously, the growth in development that we have had over the last 30 years in the U.S.
I have received the question about the international margins pretty frequently, and I try to be very consistent with the answer. International margins are a difficult balancing act for us. We would like to get continuous improvement in the margins but we also recognize the tremendous opportunity the international marketplaces provide for us.
If we were to be just looking at a steady state, I think I could predict pretty regular increases in the international margins in the direction of the U.S. margins, but not getting there for quite a while just because of the difference in scale.
You have to layer on to that the fact that we see an opportunity for five or 10 times the number of stores in places like China that we have today. We want to build the type of organization and infrastructure that will support that.
The bigger the opportunity, the more we are going to invest and we will also be layering in investments in some of the countries that Howard just mentioned that will not contribute any sales or profitability in the short term but will be laying the groundwork to be able to continue this high level of growth, not just in the next five years, but in 2012 through 2017.
It is a balancing act between investment in great potential for the long-term and the fact that we do want to be mindful of short-term profitability.
What I think I can say to quantify it a little bit is that if you look at any 12-month period compared to the 12-month period before that, I would expect the operating margins to improve. In other words, that there is a general upward bias in margins, but I would be hesitant to predict that every quarter the margins would show improvement quarter over quarter, because we are going to make the investments when we need to and to the extent that we think is appropriate for the opportunity.
Was there a warming question?
Yes, whether or not it would expand lunch or dinner.
In the U.S. or internationally?
Warming in general.
Warming right now is being expected and continued to roll out in our morning day-parts only. However, we are testing and looking at, and even looking at some of the current sandwiches that we have in our stores as being applicable to warming. We have some markets that are looking at that. That is something that we are currently under review.
We want the same quality that we have in warming to transfer over to our lunch operations, but we are currently in the stage of just testing and rolling it out in just very, very, very small markets and stores.
Your next question comes from Sharon Zackfia with William Blair.
Sharon Zackfia - William Blair & Co.
On the cold beverage bottleneck in the morning, can you help quantify for us how much Frappuccinos are actually up year over year in that day-part? As you measure that, how much you think that is dragging on your comps?
I do not think we can quantify either one of those here on the call.
We have looked at it on a market-by-market basis and we think it is putting downward pressure on same-store sales, but I would be hesitant to try to quantify it.
Sharon Zackfia - William Blair & Co.
Can I ask a follow-up question, since I did not get that one answered?
Sharon Zackfia - William Blair & Co.
On the domestic margins, on the gross margin side, in the past you have used price to defend your margins domestically. Is that something you are contemplating with green coffee working against you now?
We always feel that given that situation in our stores, pricing is an alternative but it is not one that we are choosing to employ at the present time.
Your next question comes from Glenn Petraglia with Citigroup.
Glen Petraglia - Citigroup
Michael, if you could help me think about green coffee. I think you generally purchase 12 to 18 months ahead. What sort of headwind, or how long should we be thinking about the headwind from green coffee to last? I know prices are down from their peak last year but in your purchasing, are you hitting that peak at this point in time?
I think we are at the point where the peak, the year-over-year differential between this year's green coffee and last year's green coffee is probably at its peak. On an absolute basis, we expect green coffee costs to continue to gradually increase through next year, through next fiscal year.
We have taken that into account in setting our targets for next year. We have had great transparency for the increase this year, having talked about it a year ago in July, that we expected it and it is basically tracking exactly the way we expected it to be.
Following or either late in 2007, or following in 2008, we would expect to start to get flattening or a turn in green coffee costs.
Your next question comes from John Ivankoe with JPMorgan.
John Ivankoe - JPMorgan Chase & Co.
Thank you. I am not sure anyone has ever opened 1,000 units in the United States on a company-owned basis in a given year. Certainly it is an impressive goal for you to do that and I am sure accomplish that.
Could you just give us a sense, in terms of if anything changes about those units in '07 relative to '06 or previous years, whether on a location basis or through any new markets, drive-thru versus non-drive-thru? Finally, just slightly separately, if you expect any measurable cannibalization to increase, based on the units you have opened in '06 and '07? Thank you.
We are looking at close to the same mix of drive-thru’s versus our regular stores as this year. I think currently we have 1400 drive-thru’s and we are looking at about a 50% portfolio going through forward with next year.
Again, we have put a team in place to go out well ahead of where we currently were and identify these new stores, and it is not like we do not know where those stores are today. Those stores have been identified, so we are very comfortable that they will open.
We are also very comfortable that the effect of cannibalization that we have had in the past will not be much different than it currently is today and going forward. We are not seeing that as something that we are putting any type of that cannibalization into our plan. Our comps for next year are 3% to 7% range, and we are very comfortable with that number for '07.
I would just add one thing that I think is a subtlety, and that is, I think three or four years ago, our ability to select the kind of locations that perhaps we are selecting today, we could not do with a level of confidence. Specifically, what I am thinking about or trying to explain, is the fact that our customer base is much, much broader today than it ever has been, which gives us great flexibility to achieve the kind of unit economics that we have in the past with a much broader set of the nation's population.
That has been demonstrated over the last 12 to 18 months in significant ways, where our unit economics, in places that we probably could not have even thought of going three or four years, ago exist today and that opens up very, very big opportunities for us.
We are still looking at a 2-to-1 sales-to-investment ratio for '07 as well.
I think you should repeat that, because not only do I not think there are many companies opening 1000 stores, but I am not sure there is anyone in our space that has that kind of sales-to-investment ratio.
At this time, we have time for one more question. That comes from Dan Geiman with McAdams Wright Ragen.
Dan Geiman - McAdams Wright Ragen
Good afternoon. Just going back to the cold beverages and the capacity constraints there, just trying to get a better feel for when you saw signs of those capacity constraints in prior months. Did you see them earlier this year, May and June? Last year, last summer? Or did they kind of sneak up on you?
When we started to study it, we looked back and we can see evidence of the beginning of this trend as early as April. Quite honestly, we did not recognize it because we did not look hard enough, until we basically got into July and started to do the analysis which showed there was that variance.
While we do not generally like to talk about weather as an impact on our business, the fact that it has been hotter this year than it has ever been before, and we have been so innovative with our blended beverages, that there was more of a shift from hot espresso beverages to cold Frappuccino-type beverages in the morning peak, which is the key, than we anticipated.
Had we known, I think we could have done better training and better deployment to have avoided it, and we would have accelerated the rollout of the cold beverage stations.
We wish we had the benefit of hindsight.
It is interesting. This morning at 5:45 a.m., across the street in Seattle, I stood in line as a group of customers were buying our juice-blended Frappuccinos, six of them, at quarter-to-six in the morning. It was perfect timing for me to be a part of that.
Just to clarify one other thing, we think we are doing a pretty good job of speed of service within the Frappuccino beverages when we are focused on those, like the afternoon when we are expecting the business.
The challenge becomes greater when the Frappuccino business shifts into the morning, when we are geared for espresso speed, and then the challenge is to manage both the Frappuccino at high speed and the blended -- and the espresso beverages at high speed simultaneously. That is the challenge.
What is reassuring about this is we have seen it in our espresso beverage as we implemented basically the same tools, whether it was automated espresso, labor deployment -- we were able to see those lines come down and the transaction rates grow.
We are confident we will able to do the same in cold blended.
This concludes today’s Q&A session. I will now turn the call back over for any closing remarks.
Thank you. Thank you all for joining us for the earnings call today and we hope you will join us again for the webcast of our fourth-quarter and fiscal 2006 financial results. We will be back with you on Thursday, November 16, 2006. Thank you.
This concludes today's conference call. You may disconnect at this time.
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