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Starbucks Corporation (NASDAQ:SBUX)

F3Q09 Earnings Call

July 21, 2009 5:00 pm ET

Executives

JoAnn DeGrande - Director, Investor Relations

Howard Schultz - Chairman of the Board, President, Chief Executive Officer

Troy Alstead - Chief Financial Officer, Executive Vice President, Chief Administrative Officer

Clifford Burrows - President, Starbucks Coffee US

Analysts

John Ivankoe - J.P. Morgan

Jeffrey Bernstein - Barclays Capital

Matt Difrisco - Oppenheimer

Joseph Buckley - Banc of America

David Tarantino - Robert W. Baird

Larry Miller - RBC Capital Markets

Sharon Zackfia - William Blair

Tom Forte - Telsey Advisory Group

John Glass - Morgan Stanley

David Palmer - UBS

Steven Kron - Goldman Sachs

Operator

Good afternoon. My name is Cara and I will be your conference operator today. At this time, I would like to welcome everyone to Starbucks Coffee Company’s third quarter fiscal 2009 earnings conference call. (Operator Instructions) Ms. DeGrande, you may begin your conference.

JoAnn DeGrande

Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me here today in Seattle is are Troy Alstead, CFO; and joining us from New York are Howard Schultz, Chairman, President and CEO; and Cliff Burrows, President of our U.S. business. Cliff will participate in Q&A, which will follow today’s prepared remarks.

Before we get started, let me remind you that this conference call will contain forward-looking statements. Forward-looking statements are subject to various risks and uncertainties that could cause our actual results to differ materially from these statements and should be considered in conjunction with cautionary statements and risk factor discussions and our filings with the SEC, including our last annual report on Form 10-K and subsequent reports on Form 10-Q.

Starbucks assumes no obligation to update any of these forward-looking statements or information. Please refer to the investor relations section of Starbucks’ website at starbucks.com to find disclosures and reconciliations of non-GAAP financial measures mentioned on today’s call, along with their corresponding GAAP measures.

Now, let me turn the call over to Howard Schulz. Howard.

Howard Schultz

Thank you, JoAnn and good afternoon, everyone. Over the past 16 months, Starbucks has faced both the headwind of the global economy, just as all businesses have, and our own unique set of challenges. Today I am pleased to report results for the third quarter that point to positive momentum from the comprehensive set of actions we’ve taken to transform the business.

Now at the outset, let me say that a lot of hard work still lies ahead. One quarter does not make a trend but I speak with you today with a sense of confidence based on results, results that give us tangible evidence that our transformation initiatives are beginning to be reflected in our financial and operating performance.

Today I will take you through the business highlights for the quarter and make a few remarks on the operating environment and trends that we are observing. Then I will turn it over to Troy who will review the financial results in depth.

Let me touch on a few highlights of the quarter to frame my comments today. First of all, comparable store sales came in at a negative 5%. This was a sequential quarter improvement from negative 8% in the second quarter of ’09. We saw comp sales improve steadily month by month within the quarter.

In terms of EPS, we are reporting a $0.20 profit on a GAAP basis versus a loss of $0.01 in Q308. Non-GAAP EPS came in at $0.24 versus $0.16, up 50% year over year. Non-GAAP operating margin improved to 10.6% versus 6.9% in Q308 and we saw non-GAAP U.S. operating margins improve to 13.4% from 8.8% in Q308.

We also reported Q3 cost savings of approximately $175 million well ahead of our target of $150 million.

While we remain cautious about the economy, the consumer facing initiatives we have implemented are beginning to deliver improvement in comp trends. This improvement, combined with operating cost savings and disciplined management through the middle of our P&L, has resulted in strong flow-through to Starbucks profitability.

Let me now focus on the improving performance of our U.S. business and developments during the third quarter that speak to recent trends.

First, we are seeing improving transaction and ticket performance on a sequential quarterly basis, building on the progress we made in the second quarter. Significantly, all regions in the U.S. are showing both qualitative and quantitative gains. Our partners have embraced the challenge of putting themselves in the shoes of our customers and are driving meaningful operational improvements.

Since closing all U.S. stores for three hours in February 2008 for Espresso Excellence retraining, we have improved staffing models, provided increased rigor around store standards and reinforced our passion for delivering the best customer experience, all of this has significantly improved store economics.

Since January 2009, not only have we seen improving transaction trends on a sequential quarter basis but our research tells us we are making real progress on every measure of customer satisfaction, including partner friendliness, up 7 percentage points; taste of beverage, up 7 points; speed of service, up 11 points; and most importantly, overall customer satisfaction, up 9 points.

These are statistically significant scores, especially considering today’s challenging operating environment and this has been incredibly important work. I just want to take my hat off to our leadership team and personally acknowledge all our partners for making this happen.

We are also confident that the margin improvement in the U.S. business is not simply a Q3 phenomenon. The majority of cost reductions we’ve achieved come from a new way of operating and serving our customers. Over the quarter, we began to roll out our better way initiatives, a series of process improvements in our stores using lean principals.

We’ve been seeing encouraging results over the past couple of quarters, not just improving efficiency and reducing costs but most importantly we are improving customer engagement.

Even as we make considerable progress in improving our bottom line, we remain as focused as ever on initiatives that will remind our customers what sets Starbucks apart. We are doing this through immediate traffic driving strategies and enhanced customer experience, and longer term brand-building.

As you know, extraordinary advertising dollars have been spent by fast-food companies trying to attract coffee consumers during this quarter. Many commentators and industry watchers have been concerned that this marketing spend would have a negative adverse impact on Starbucks.

To the contrary, it appears that the various marketing campaigns and all the media coverage about coffee has created unprecedented awareness for the coffee category overall and has actually had a positive result on Starbucks' business.

Adding to the awareness has been our own successful multi-channel advertising campaign which we began in May that takes our message directly to consumers and our partners.

The work showcases our exceptional coffee, the unique Starbucks experience, and the values that have been part of our brand from the beginning.

We are spending in innovative ways to reach consumers effectively and with optimal impact.

Last week we became the most popular brand page on Facebook, with over 3.5 million fans, the number one brand on Facebook. And with over 250,000 Twitter followers, Starbucks is a recognized leader in social media. We were just named the number one brand in a new social media engagement report developed by [Alchimeda Group] and [Wet Paint]. The key here is that we are connecting directly with our loyal customers who will be driving our future growth.

We have also struck a unique, multi-faceted sponsorship with MSNBC’s Morning Joe, a natural fit with our brand and our coffee-house culture. From a marketing perspective, this is the kind of unique branded content approach that will help further differentiate us in the future.

While we do believe we have benefited from our own marketing efforts, as well as the current competitive environment, what’s most important is what our customers think about Starbucks. We were extremely pleased last quarter to get the Zagat rating for best coffee in our category and for most popular quick refreshment chain overall. It was an important validation of our brand health and customer satisfaction and the successful focus of our advertising in the last few weeks of the quarter.

We’ve made a concerted effort to upgrade the quality of our food and rationalize our supplier base. We began delivering a completely reinvented pastry case to customers in May and rolled out the new offerings nationwide on June 30th. These enhancements to our bakery offerings and our recent real food simply delicious launch are receiving positive feedback from customers, our partners, dieticians, and nutritionists. We have focused on improving quality and taste by using simpler recipes and more natural ingredients and we’ve continued to introduce more healthy items like our salads and our own [Bavano] Smoothies.

Another significant effort to strengthen the customer experience is our long-term store development strategy. The most visible of these efforts is our new store design concepts. In addition to revitalizing our existing store economic model, we’ve developed a handful of new state-of-the-art store designs which we have begun to open in Seattle, Paris, and Tokyo. The stores present the brand in a way that promotes the business and is devoted to elevating our coffee, all while connecting to the character of the neighborhood with sustainable and fresh design.

You also may have heard about a new coffee house we are about to open in Seattle, 15th Avenue Coffee and Tea. Inspired by Starbucks, this concept is a unique expression of our commitment to premium quality, passionate partners, and the customer experience. It will allow us to focus on all three day parts and give us the flexibility to offer customers new opportunities for discovery and a high level of interaction.

These stores, as with all stores we open, are an investment geared to generate cash and drive customer behavior over the long-term, underscoring the special qualities that are unique to Starbucks.

Each of these new stores is generating promising revenue, community interest, and overall positive buzz for the brand.

We continue to focus on providing value to our customers, an area where we have made much progress against the misperceptions about Starbucks' value proposition. In addition to telling our story through advertising, we are having good success with our seasonal value promotions. We kicked off the summer with the Grande Iced Coffee for less than $2 and food and beverage pairings will continue. We are currently offering our Treat Receipt opportunity. On the loyalty piece of our value approach, we continue to innovate with the Starbucks card program, driving more and more registered card users into our programs.

Our customers enjoy the relevance of the new cards, such as the Product Red card, and the new form factor, the mini-card, each of which is generating new registered card members as we speak today.

Finally, let me share with you a few of our coffee initiatives. I will start with a quick update on Starbucks Via ready brew. We are moving forward on our North American launch of Starbucks Via ready brew in the fall. We continue to see strong sales in the early launch markets of Chicago, Seattle and London. Our learnings from these markets validate the assumptions we made earlier in the year -- customers and our partners are passionate about the taste and the convenience. We are pleased with the sales volume both in our stores and with our select channel partners and we are confident we have success on our hands and will support it with a major push this fall.

Instant coffee is a $17 billion category ready and ripe for innovation and given the size of the prize, we will make a meaningful marketing investment in Q1 2010. With Via, Starbucks is building a new category and we expect our marketing investments for Via in 2010 to pay significant dividends in 2011 and beyond.

We’ve just launched a summer promotion where we are featuring three African whole bean coffees. As the largest purchaser of fair trade coffee in the world, a close partner with Conservation International and through our partnership with Product Red, we are committed to differentiating ourselves from the competition in the values of how we partner with farmers around the world, and we are looking forward to delivering on a commitment that we’ve made to have all of our espresso roast in the U.K. 100% fair trade certified before the end of the year.

We also feel very good about the progress we are making with the Clover brewing machines. We have successfully launched in Seattle, Boston, and San Francisco. Clover has now been integrated effectively into over 50 stores and is resonating with customers who appreciate small batch coffees. The Clover brewing method innovation allows us to brew the cleanest, best-tasting cup of coffee that brings out the flavor of these special, small batch coffees. We plan to add Clover to 250 additional stores in 2010.

Shifting to the international business, I am pleased to report that we are seeing margin improvement and traction from cost control efforts across the international business. While most companies continued to confront a challenging global economy, we are making progress in several key markets, including the U.K. and China.

We are seeing trends in our U.K. business consistent with the U.S. business, with comp growth improvement throughout the quarter and on a sequential quarterly basis. In China, we continue to see positive comps and improvements in profitability and remain convinced that China offers an important growth opportunity for Starbucks.

We’ve been in France now for five years and we just opened our 50th store there at Paris Disney. Over time we’ve gained loyal customers in France, once considered impossible for us to penetrate and we are pleased with the development of this market. Troy will speak in more detail to the international results.

Our consumer products business also delivered solid results in the quarter in spite of increasingly competitive environment, especially in packaged coffee. We will soon introduce new packaging that will feature a bounce back coupon printed right on the package that will offer grocery customers and wholesale customers a free brewed coffee in our retail stores. This is another innovative way for us to leverage our multiple channels in way our competition cannot. Even more important, this business contributes significant revenues and profits and a large footprint gives us important marketing and brand-building leverage.

In conclusion, I am really pleased to report that the transformation of Starbucks Coffee Company is well underway. The transformation agenda we laid out 16 months ago has helped us focus on the most important success factors for our company, while also enabling us to continue nurturing and building our brand and is clearly resonating with our customers.

Yet as I told our board of directors last week, while we are quite pleased with our performance and results this quarter and encouraged by the improving store traffic and average ticket trends we are seeing, we know that we have more work to do to build on recent momentum and accelerate our progress.

In closing, while we remain cautious about the timing of the global economic recovery, our plan is built to ensure that Starbucks is well-positioned to benefit as economies improve. And in the meantime, we will remain laser focused on what Starbucks Coffee Company is and always has been about -- coffee excellence, our customers, our partners, our values, healthy innovation and now as well an even greater rigor around operational improvement that has become embedded into Starbucks Coffee Company and our culture.

Now I’ll turn it over to Troy who will give you details on our Q3 results, as well as provide insight into how we believe this performance positions us for full-year performance and our outlook from 2010. Troy.

Troy Alstead

Thanks, Howard and good afternoon, everyone. I share Howard’s enthusiasm around our third quarter results, particularly the notable improvement in operating margin we achieved, which demonstrates the traction we are getting from operational efficiency initiatives.

In an uncertain economic environment with seemingly conflicting indicators reported almost daily, we remain focused on strengthening our business model and managing what we can control and impact.

Starbucks' third quarter performance demonstrates solid progress in our efforts to drive efficiencies in margin improvement and to move the business toward a healthier, more sustainable model, one that we are committed to achieving.

It was not quite one year ago that we began reshaping our store portfolio and our cost structure, beginning with the July 2008 decision to close approximately 600 U.S. company-operated stores, significantly reduced the size of our Australia footprint, and reduce our leadership and non-retail organization by around 1,000 positions.

Then, earlier this year, we decided to close an additional 200 stores in the U.S. and approximately 100 in international markets. At that time, we also articulate an aggressive cost reduction plan to align the cost structure with the company’s current growth trajectory, while also implementing a number of initiatives to enhance our operational effectiveness.

Third quarter results reflect the commitment and success of our partners in driving significant improvements throughout the business.

Let me begin with a review of results for the consolidated business -- third quarter revenues were $2.4 billion, down 6.6% from $2.6 billion a year ago. This was driven by a 5% decline in comparable store sales in the quarter, comprised of a 4% decrease in traffic and a 2% decrease in the average value per transaction.

We reported consolidated operating income of $204 million in the third quarter, which includes $52 million of restructuring charges, nearly all related to lease exit and other costs associated with the store closures.

Excluding those charges, non-GAAP operating income was $256 million. As I noted earlier, in Q3 fiscal 2008 we announced the first and most significant stage of our restructuring, which resulted in $168 million in restructuring charges and an operating loss in that quarter a year ago of $21.6 million.

Consolidated operating margin was 8.5% on a GAAP basis and 10.6% on a non-GAAP basis, which represented a 370 basis point improvement from a 6.9% non-GAAP margin reported a year ago.

As with last quarter, we are realizing the benefits derived from the operational efficiencies we had been implementing in our business. I will provide more detail around that shortly.

Earnings per share was $0.20 for the third quarter, compared to a $0.01 per share loss in last year’s fiscal third quarter. Non-GAAP EPS was $0.24, a 50% improvement over non-GAAP EPS of $0.16 a year ago. Non-GAAP EPS a year ago excluded $0.14 of restructuring charges and an additional $0.03 attributed to transformation agenda initiatives.

Let me now move on to third quarter results from our operating segments, which I will review on a non-GAAP basis. Total U.S. net revenues for the quarter were $1.8 billion, compared with $1.9 billion a year ago. Company-operated retail revenues declined 6.8% to $1.6 billion for the quarter, primarily due to a 6% decline in comparable store sales. The comp decline was driven by a 4% decrease in traffic and a 2% decrease in the average value per transaction.

Ticket continued to be impacted by our value offerings, such as pairings in the third quarter ice coffee promotion, as well as discounts associated with our loyalty program. While these programs had an effect on ticket, they were important strategic initiatives to deliver an improved value proposition to our customers, given the current environment, and our customers’ response validates that relevance.

It is also worth noting that when looking at two-year comp trends, we delivered a sequential quarter improvement of about 2 percentage points in Q3 when compared to two-year comp trends for Q2. Let me also point out that same-store sales trends improved each month within the third quarter and were less negative at the end of the quarter than at the beginning, both on a one-year and two-year basis.

While we remain cautious, we are very encouraged by these trends.

As a percentage of total U.S. revenues, U.S. cost of sales including occupancy improved 210 basis points to 41.0% compared to 43.1% in the comparable period a year ago, driven by lower cost of sales.

Favorable dairy costs year-over-year contributed to the improvement and we achieved significant benefit from better management of waste in coffee, dairy, and food.

Building on the strong momentum from the second quarter, we continued to drive savings in store operating costs. U.S. store operating expenses as a percentage of related U.S. retail revenues were 41.8%, a 250 basis point improvement from the prior year, primarily due to traction gained from our initiatives to optimize labor.

U.S. operating income was $244 million for the quarter, up 43% from the same period in fiscal 2008. The operating margin improved 460 basis points to 13.4% of related revenues from 8.8% a year ago. Margin expansion was primarily the result of the successful execution of the cost savings initiatives that I spoke about, which is reflected in the improvement of cost of sales and store operating expenses.

We are very pleased to report significant margin expansion in a declining revenue environment.

Moving now to results from our international segment, international total net revenues declined 11% to $477 million in the third quarter of fiscal 2009, almost entirely driven by foreign currency impact due to the stronger U.S. Dollar compared with the British Pound and Canadian Dollar. Also contributing to the revenue decline was a 2% decrease in comparable store sales, comprised of a 1% decline in traffic and a 2% decrease in ticket.

We are encouraged by these results as they represent a sequential improvement in comp trends from the first half of the year.

And similar to our experience in the U.S. this quarter, international comp trends improved within the quarter, driven by improvement in the U.K.

International operating income increased 8.7% to $38.9 million in the third quarter of fiscal 2009, compared to $35.8 million a year ago. Operating margin improved by 140 basis points to 8.1%, its highest level since Q1 of fiscal 2008.

About half of the improvement was driven by reductions in G&A expenses, which reflects the benefit from the reduction in our support organization as part of the January 2009 restructuring.

Operational improvements at the store level in our company-operated markets also contributed to the third quarter margin improvement.

Before I move on, let me add a brief comment on China -- despite the economic pressures there, China has continued delivering positive comp growth and improving profitability year over year. While today our presence there is relatively small, this remains an important emerging market for our future international growth.

Now for a review of results from the global consumer products group -- CPG total net revenues increased 17% to $106 million in the third quarter of fiscal 2009, due primarily to higher coffee sales to a grocery distribution partner. While competition impacts to coffee continues to heat up, we are actively pursuing a number of initiatives to drive sales, including new packaging in the fall, increased promotions and targeted couponing, and expansion of our viral marketing efforts.

Operating income for CPG was $49.2 million in the third quarter, compared to $48.7 million in the same period a year ago. The operating margin was 46.3% of related revenues, compared with 53.7% for the prior year period.

The margin compression was driven by lower income from equity investees related to expenses associated with the dissolution of our previous ice cream partnership, increased marketing spend for ready-to-drink products in Japan, and higher green coffee costs.

Now for a few additional comments on the company’s liquidity -- Starbucks continues to be in an excellent financial position, generating solid operating cash flows and maintaining strong liquidity. We used our operating cash flow to reduce our short-term debt from $226 million at the end of Q2 to a zero balance at the end of this quarter.

Our cash and liquid investments were $337 million at the end of Q309 and we had $985 million borrowing capacity available to us under the company’s credit facility.

As I indicated earlier, we have clearly captured our partners’ attention and commitment toward our cost-savings efforts. This heightened discipline and execution has allowed us to over-achieve on our quarterly savings targets again this quarter.

Following go the $75 million Q1 savings, and the $120 million in Q2, we delivered a $175 million reduction in our cost structure in Q3. We now expect to deliver $180 million in the fourth quarter for a total of approximately $550 million in savings for the year, exceeding the $0.5 billion we initially targeted.

Let me now review our year-to-date progress in each of the four targeted areas of cost savings.

The largest component of the savings is costs associated with right-sizing our support structure. This has been achieved through headcount reduction in our corporate support areas and groups outside the retail structure, along with downsizing our corporate facilities.

In the third quarter, we delivered approximately $60 million in savings in this category. The second biggest cost savings category is our in-store opportunities in labor efficiencies and waste reduction. In the third quarter, we realized approximately $60 million in savings, which impacts store operating expenses and cost of sales.

Cost benefits associated with store closures contributed approximately $30 million in the third quarter and savings realized in our supply chain in the areas of procurement, manufacturing, and logistics delivered around $25 million.

As you can see, we have made significant progress in reshaping our cost structure and driving real and sustainable cost discipline throughout the organization. The over-achievement of our original savings target is directly linked to the drive and focus of our partners throughout Starbucks who are committed to strengthening the business for the future.

We are well on our way to exceeding our commitment to removing $500 million from our cost structure in fiscal 2009.

With three-quarters of our fiscal year behind, we enter this final quarter cautiously optimistic. While the external operating environment is still very uncertain, we are pleased with the progress we have made to improve the economics of our store portfolio and better align our cost structure to deliver operating income growth.

Also as discussed earlier, we are encouraged by the improved traffic trends within the third quarter as we think this bodes well for the balance of the year.

As we approach the end of our fiscal year, I would like to share with you our current view on how fiscal 2009 will close out. Our outlook still assumes continued pressure on the business from the challenging operating climate we are in. We also recognize that historically, our fourth quarter margins decline when compared to third quarter due to seasonal variances in our U.S. business.

Transactions decline a bit and operating expenses rise, causing a normal seasonal deleveraging effect on margins.

With those factors in mind, we expect full-year non-GAAP EPS of $0.74 to $0.75, and fourth quarter non-GAAP EPS of $0.19 to $0.20.

Now, in addition to that EPS target, consistent with our prior messages, we continue to make progress on our targeted store closures. As we finish the fiscal year, we now expect to have all U.S. closures complete by the end of the fourth quarter.

Internationally, of the approximately 100 targeted closures, we expect approximately 60 to be closed by fiscal year end and the remaining 40 to close in the first half of fiscal 2010.

You will once again find a detailed schedule of the targeted fiscal year-end store counts in our earnings release.

Capital expenditures are now expected to come in around $550 million, about $50 million lower than our prior outlook. And as previously communicated, I expect cash flow from operations to be over $1 billion and free cash flow in excess of $0.5 billion, highlighting our ability to generate strong cash flow.

Now, I would like to provide you with a high level initial look at a few fiscal 2010 targets. As a reminder, we are still early in our fourth fiscal quarter of 2009 and are still working through our plans for 2010, so while I will give you transparency today into some initial earnings targets, more details on our targets for 2010 will come at a later date.

Given the recent trajectory of our business, we are cautiously optimistic as we move closer to our fiscal 2010. However, we also recognize the significant economic headwinds the consumer continues to face.

Given those factors, we expect our fiscal 2010 non-GAAP EPS growth to be in the range of 13% to 18%. This does not include a $0.02 to $0.03 per share expected impact from restructuring charges in the first half of the year related to the remaining international store closures. However, that EPS range does include the impact from an additional week in the fourth quarter, as 2010 is a 53-week fiscal year for us, which will contribute roughly $0.02 per share to non-GAAP EPS. This EPS growth will be driven by margin improvement as we still expect revenues to be soft, given the macro environment.

I will point out that the first quarter of 2010 in particular will be impacted by a number of things. Q1 of fiscal 2009 included significant expenses for a couple of items which we do not expect to repeat; specifically, the leadership conference and unusually high impairments.

While we did achieve some cost reductions in Q1 of 2009, the first quarter of 2010 will benefit from the higher run-rate of cost reductions we have been building toward over the course of this year.

And finally, as Howard indicated, we will launch Avia in Q1 of 2010 and recognizing the size of the opportunity available to us in this category, we intend to spend significantly higher marketing dollars than in a typical quarter to support the launch.

We are still in the process of putting our new store plans together so I cannot provide specifics at this time. However, I will point out that we do expect to grow store counts year over year, driven primarily by international growth and some growth in the U.S.

We are encouraged by the effectiveness of our cost savings initiatives and in the resulting margin improvement in FY09. These efforts have had a positive impact on our new store economic model.

Further, the new store design concepts we have rolled out today have been met with strong enthusiasm from our customers.

Together, all those factors bolster our confidence in targeted growth in the future and we intend to pursue opportunities for more stores in the U.S. and around the world.

Let me underscore that we are committed to a responsible, profitable store growth plan.

Building on the momentum we’ve gained in recent quarters, we expect continued margin improvement in both the U.S. and international business segments in 2010.

I previously outlined for you our longer term targets, that we expect the U.S. business to return to operating margin in the mid-teens and for the international business to improve over time to operating margin also in the mid-teens. I expect 2010 to represent a meaningful step in that direction for both those business segments.

In the U.S. segment, we expect full-year, non-GAAP margin improvement of 150 to 200 basis points and international full-year non-GAAP margin improvement of 200 to 250 basis points.

Further, with our consumer products business already at its long-term target operating margin, we expect it to remain in the range of 45% to 50%.

In summary, I would like to wrap up with a few comments on our year-to-date results. Starbucks' nine-month performance reflects significant progress toward the plan we set out to transform our business to one that is more efficient and sustainable regardless of the macro climate. We have reshaped the business model to drive margin expansion and earnings growth, even in this difficult economic environment.

We have exceeded our targets on cost savings and we’ve been focused on controlling what we can control. We are cautious on the macro environment but we are also encouraged by the trends we are seeing in the business and by the response our customers have had to the initiatives we’ve launched.

Moving forward, we will continue to look for opportunities to become more efficient while not losing sight of the fact that innovation and communication of our message are important pillars to our future success.

With that, let me now turn the call back over to the Operator to begin Q&A. Cara.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question will come from the line of John Ivankoe with J.P. Morgan.

John Ivankoe - J.P. Morgan

Thank you very much. Great quarter. Congratulations on the results. You’ve obviously done a very good job of really attacking some near-term cost-savings initiatives and I was curious about if you could quantify and put some timing around some more medium and longer term initiatives that might seem to be some very big opportunities, both in the U.S. and international.

And with that I’m specifically relating to further work you may do on the supply chain, a possible new point of sale system in the U.S. and whether it makes sense for the company to begin to rethink how the international business is organized, especially between the relationship between a company and license ownership. Thanks.

Troy Alstead

Thanks, John. Let me speak first to the U.S., where we have put most of our attention this year around the cost-savings initiatives and have had just great traction in it, we feel very good about that. We are ahead of schedule, as you’ve heard. And what I’ll tell you most important in all this to me is not the $0.5 billion we’ve pulled out this year but it’s the fact that we have traded in the company an entirely new focus and a new set of disciplines around being more efficient in what we do and doing that at the same as we improve service to the customer.

So I fully expect that as we head into 2010 and beyond, this new frame of mind we have from the store partners all the way up to our support center will result in more savings initiatives that come about. I’m not putting a new target on that. I think that’s what’s driving the margin expansion targets that I put out there for you but they will continue to grow and I think it becomes a way of life for us now and over time, of course, there’s cost inflection that hits various parts of the P&L.

I think we have some new tools now and some new muscle we’ve built this year to help offset and combat that in the years ahead.

Internationally, I would say that’s even more significant because with our focus more on the U.S. this year, much of what we’ve done around the U.S. is beginning to get traction and roll out more significantly in our international markets, and so I think we’ve got opportunity to drive that same set of thinking and capabilities internationally and again, that’s behind the more significant margin expansion that I’ve talked about there.

And all these things we believe over time push us towards those longer term operating margin targets that I’ve laid out.

Operator

Your next question comes from the line of Jeffrey Bernstein with Barclays Capital.

Jeffrey Bernstein - Barclays Capital

Thank you. Actually just one follow-up on that, and then a separate question -- the follow-up I think relates to the conversion opportunity from the company-operated to license, both in the U.S. and I believe outside the U.S., the opportunity there.

And then the question more directly just related to the free cash flow usage, it seemed like you were reiterating at least $500 million this year. I’m just wondering whether the priority would be around long-term debt pay-downs, whether you have been active or would consider a more aggressive share repurchase and/or dividend opportunities. Thanks.

Howard Schultz

Troy, why don’t you take the latter and I’ll address the licensing issue of U.S. and international business.

Troy Alstead

Sure. Let me speak first to the free cash flow and you’re right in that we are reiterating both our cost saves targets for this year -- in fact, expanding that number from what we had originally targeted. And with that, the strength of the cash flow in 2009 and I expect it to be even stronger as we move into 2010, as I’ve said before.

But I’m not ready at this point to say how that cash will be used. I think we are fortunate in that we have a business model that is a very strong generator of cash. At this point in time with the difficult visibility we have given the economy, I’m not prepared to talk about what happens with it but it is something that we’ll come back to as we get into 2010 and talk more about at that time. Howard.

Howard Schultz

You know, what I would say is if you examine what we have been able to accomplish in a very short time in the U.S. business, one of the primary reasons that we’ve been able to accomplish that has been the nimbleness and the effectiveness of being able to do this in a company-owned system, versus if we were franchised or licensed in the U.S., it would have been much more difficult because we would not have had the controls that we have now to really affect the kind of comprehensive change.

So having said that, our commitment to the U.S. business is as it is.

With regard to the international business, there’s a lot of focus and attention on gaining more leverage and return on capital in the international business and as a result of that, we are looking at that with a fresh view. I’m not suggesting anything significant will change in the short-term but we recognize that there are opportunities in the international business that might prevail.

Operator

Your next question comes from the line of Matt Difrisco with Oppenheimer.

Matt Difrisco - Oppenheimer

Thank you. Troy, can you give us a little bit of a range of what you are using in that 2010 EPS guidance for 13% to 18% and associated with those margins, what is your required or what’s the range that same-store sales could sort of flex between in order to stay within that target, or when do we exceed or have to contract that guidance if the comp goes in either direction?

Troy Alstead

Well, Matt, I’m not going to provide comp guidance right now, and for two reasons; really, we’ve built that range given the lack of visibility we have in where the consumer is headed and where this economy is headed next year. We have assumed that it will remain tough and soft as we enter that span of time and put out that target range for earnings growth, given our confidence in our ability to drive toward that target, even in a soft revenue environment.

And I think one point I’ll mention is I know in the past we have provided some relationships between comp growth and how that translates to EPS, but I just want to underscore one thing, and that is everything we have done in transforming the business this year has been to break down that relationship and really find ways through everything we do to turn comp growth into a stronger leverage and profitability down the bottom line. And so historically some of those relationships don’t hold any longer and we are not through our work yet, so I’m not quite ready to put that out there.

And I’ll also remind you, we’re still in 2009. I wanted to give you some visibility into what we see in 2010 but more details will come once we actually get into that fiscal year.

Matt Difrisco - Oppenheimer

Would it be safe to say then that looking at the profitability that you are determining from that 13% to 18%, it’s not assuming that the fully annualized number of presumably about $720 million or greater from all these savings on an annual basis wouldn’t be dropped down to -- straight to the EBITDA line. It looks like you are absorbing some of that in either reinvestment or conservative further hard economic times to absorb some of that.

Troy Alstead

Well, I would say that there’s a whole lot of moving pieces to what we see in 2010 and our plans aren’t built yet. Part of what you point out is true in that we will annualize these cost savings and you’ve done the math right, that annualizes to, given the original cost structure to more than $700 million, just building from the 550 or so this year. But there were a lot of other moving pieces to what we see next year, including dairy costs and coffee and a whole lot of other things that move the [P&L] down. So I just want to be clear -- it’s not only one thing going on. It’s a whole lot of things that shape our plans and as we get more visibility into that, we’ll do our best to share what we can.

Matt Difrisco - Oppenheimer

I understand. Appreciate your conservativeness too. Thanks.

Operator

Your next question comes from the line of Joseph Buckley with Banc of America.

Joseph Buckley - Banc of America

Thank you. First, just a bookkeeping question, and sorry, forgive me if you covered this but the interest income and other net line, it looks like you picked up about $21 million -- did something unusual flow into that line this quarter?

Troy Alstead

Joe, there’s a couple of things going on there. One is foreign exchange, which impacts that line, had a positive impact there and that’s a part of that income that you see there. And the other piece of it relates to, and this gets awfully complex to try to explain on a call but it’s an offset to a higher charge that sits up in G&A. We have a tracking portfolio around our deferred compensation plan. One side of the entry ends up in G&A above the operating income line; the other side of it ends up below the line in that line you are referring to, so they offset to net earnings but it did boost net interest and other to some extent in the quarter and that’s why that looks a bit unusual.

Joseph Buckley - Banc of America

Okay, but most of it is offset in G&A that otherwise would have been a little lower presumably?

Troy Alstead

Yeah, about half of it is offset in G&A.

Joseph Buckley - Banc of America

Okay. And then just a question -- you mentioned dairy a couple of times. With dairy costs down so dramatically, I was wondering if you could maybe quantify the impact on the quarter and talk a little bit about what you are thinking for next year on dairy -- are you anticipating it goes back up to more normal ranges or stays low?

Troy Alstead

Well, yeah, dairy’s been favorable this year and as I said before, it’s been favorable to our P&L all year and in the third quarter. As we look into 2010, it’s difficult to have visibility into where dairy goes but we believe that just given the lapping some very favorable costs in dairy in 2009 that dairy perhaps is neutral to somewhat unfavorable to our P&L in 2010, just on a relative basis -- not in a big way, by the way, but just given the visibility we have right now.

So at this early point, given that we are still in 2009, that’s how much forward visibility we have into dairy.

Joseph Buckley - Banc of America

Okay. And then -- you know, let me stop there. Thank you.

Operator

Your next question comes from the line of David Tarantino with Robert W. Baird.

David Tarantino - Robert W. Baird

Good afternoon. Congratulations on a great quarter. Howard, a question on your advertising strategy -- first, could you comment on your view on the effectiveness of what you’ve done so far around driving traffic into the retail stores? And then secondly with the big push behind Via in 2010, can you maybe talk about your thought process in choosing to allocate the marketing dollars there as opposed to trying to drive more traffic into the retail stores?

Howard Schultz

You know, it’s very hard to specifically quantify the effectiveness of advertising in the midst of the quarter that we just finished because it’s very fresh. However, when you look at the landscape of retailers and restaurants that have reported traffic and comps, you know, I think we are quite pleased with the fact that it really appears as if the things that we have been doing, both in-store and out-of-store, are resonating with our customers, as well as -- you know, I’ve been in this business almost 30 years. It is literally an unprecedented amount of dollars that have been spent against coffee, the likes of which I have never seen before. And I think that level of awareness and trial and the differentiation between our experience and perhaps others, as well as for the first time Starbucks externally advertising and telling our message in a very different way, not on price but really on our values, our quality and differentiation, I think has really added value.

I think the thing that has surprised us perhaps is the pride and the excitement that our own internal partners have had as a result of the campaign and how it really kind of turned everybody on and was a real spark.

So we have every intention of continuing it and we think we’ve created a platform that a lot of other things that we will see between now and the end of the year can live on that platform.

With regard to Via, we are going to create I think a very creative campaign that will be different than what we’ve done to date and we’ll take advantage of the social media that we’ve become very good at, as well as traditional levels of media.

Via I think has given us an opportunity to recognize we’ve got a very big category without a lot of innovation and the fact that people have so much trust in our brand and the coffee delivers. We have something that I think people want to hear about and the three test markets justify the expense and the commitment that we are going to make.

Operator

Your next question comes from the line of Larry Miller with RBC Capital Markets.

Larry Miller - RBC Capital Markets

Thanks. Congratulations on the progress you guys are making. I just was wondering if you might tell us how you might approach pricing in fiscal 2010 and give us a sense of what you think check might look like -- it’s been negative for I think for or five quarters, and maybe you can remind me why that is. Thanks.

Howard Schultz

Troy, I think I’ll give this to Cliff, okay?

Troy Alstead

Yes, please.

Clifford Burrows

In response to your question, in terms of pricing this year, we have been looking to deliver not in a traditional way of discounting but in terms of building loyalty with our customers and helping to really deliver value for them at a time when everybody is looking for value in this economy. And we believe there’s been the right mix as we’ve tried and introduced many different aspects of this around our value propositions from food pairings to the $1.95 iced coffee and indeed with the rewards card for registered cardholders. And all of those have had an impact on ticket as Troy said earlier in the call but we believe they are fundamental in building the relationship with our customers and I think the evidence is there that we’ve made steady progress throughout this time and we will continue to look at how we can best serve our customers by adding value.

Troy Alstead

And I might just add on to Cliff’s comments to your specific question about what changes, and that is that to ticket, to Cliff’s point, we’ve had a few things impacting our average ticket this year. One, which you’ve heard from us earlier today and that’s our very strategic conscious move into value and loyalty, and also this goes back to our strategic move over the course of the last year to focus on coffee in our stores, to slim down the entertainment presence in our stores and the other merchandise SKUs, and that has had some impact on ticket. Of course as we, just due to the arithmetic as we move through the next several quarters, we will lap some of those strategic decisions and so some of that impact will just naturally go away as we go throughout the course of the next several quarters.

Larry Miller - RBC Capital Markets

Great. I don’t know if I’m still on, if I can just sneak in one more -- I was just curious because I think there was some data during -- that came out in the quarter, NPD in fact, that said the coffee segment was contracting but Howard, you said that the advertising that your fast food competitors, not that you are fast food obviously but the fast food guys are doing, was actually help driving the category, so can you help me understand what you are looking at when you are talking about that specific comment?

Howard Schultz

What I’m saying is that during the quarter, we experienced a level of unprecedented investment in advertising by a whole host of companies, really raising a level of awareness and trial into the category. And as a result of that, we believe that that, coupled with our own message, which for the first time we really began to tell our story from soil to cup, the quality of our partners, the experience, that we benefited from that. And I think sometimes people forget that despite the 50-plus countries and the thousands of stores that we have, that we have less than 10% share of U.S. coffee consumption and less than 1% share of coffee consumption outside of North America, so the size of the prize is still very large for Starbucks and the level of awareness that has been created has been a benefit to us.

Operator

Your next question comes from the line of Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair

Good afternoon. I was wondering if you could comment on whether the relative sequential strength was more from beverages or food in the June quarter --

Howard Schultz

Could you repeat that? We couldn’t hear you?

Sharon Zackfia - William Blair

Can you hear me now?

Howard Schultz

Yes.

Sharon Zackfia - William Blair

I was wondering if you could comment whether the relative strengthening in comps came primarily from beverages or more from food?

Howard Schultz

Okay. Cliff.

Clifford Burrows

We really have seen this year that our big focus has been beginning of the year on beverage and as the year has gone on, we’ve looked at not only the value equation but we’ve introduced our real food, simply delicious and we have seen greater attachment due to the introduction of those new food items and although it is early days yet, we are very encouraged by the uptake.

Operator

Your next question comes from the line of Tom Forte with Telsey Advisory Group.

Tom Forte - Telsey Advisory Group

Great. Thank you very much. I wanted to take this opportunity to ask you about for the new food offerings, the changes as far as the calorie counts, the ingredients, things of that nature. Somewhat definite forward-thinking but how do you know the customer demand for that product versus say some of the maybe the more indulgent items that complement coffee traditionally?

Howard Schultz

I think Cliff will answer that as well. Go ahead, Cliff.

Clifford Burrows

I was going to say in our dialog with our customers using such vehicles as myidea.com, one of the things our customers have been talking to us about regularly and also in conversations in stores is that they are looking for healthier foods, foods which support their lifestyle and not only have there been general trends but I would say our customers are generally forward-thinking in this area and this has given us an opportunity to really focus on our bakery range at the moment around this taking out artificial ingredients and focus on a much healthier product which also has helped us with not only rationalizing the ingredients but also rationalizing our supplier base so they taste better and they support their healthier lifestyle that our customers are looking for.

Howard Schultz

One thing I would add is we did -- we really have done more research this year than perhaps any year in my memory and one of the things that is so clear that has come out of the research is the fact that our customers really want healthier alternatives in their daily life and they really provide a lot of insight in the fact that they want Starbucks to provide that to them, both in terms of food and beverage. And so I think we’ve got a long runway of opportunity from what we’ve built already in the June 30th transformation of food to link that to other food and beverage opportunities as we go forward.

Operator

Your next question comes from the line of John Glass of Morgan Stanley.

John Glass - Morgan Stanley

Thanks very much. Could you talk about how much, maybe quantify the advertising spending you have done to date, maybe even frame it as a percentage of sales if you don’t want to get into specific numbers? Then can you maybe frame what you might spend next year based on the success in the Via launch? And if I could just sneak in a second one -- are you willing to talk about the order of magnitude of sequential improvement in sales this quarter? Or are you talking about one of the metrics, for example, traffic or ticket actually turning positive? Is it that close to zero, let’s say?

Howard Schultz

Troy, could I just take the first piece and I’ll give it right back to you?

Troy Alstead

Yeah, let me tackle the -- yes, please.

Howard Schultz

With regard to the advertising dollars, I think what’s really important to note is that what we really have done this year is reallocated much of the money that was spent in the field and brought it back and gave us the ability to have a one-voice message across multiple platforms and leverage the marketing campaign and the advertising campaign. We have not -- we did not reallocate any increase in dollars.

And with regard to Via and what we are going to spend in 2010, it’s too early to talk about that. I’ll give it to Troy.

Troy Alstead

And then your question, John, within the quarter, no, I don’t -- I’m not prepared to get anymore specific than that right now. We saw comp trends improve in the quarter and the components of which is something that I don’t want to talk about quite yet but it was an encouraging move. While it remained negative comp growth, it did improve as we progressed through the quarter.

Howard Schultz

And I also say that our digital team at Starbucks has done a fantastic job in integrating Starbucks in a unique way in social media and the statistics that I laid out in my prepared remarks about Facebook and Twitter and how we’ve been evaluated by external entities really does demonstrate that not only are we investing in the brand in traditional advertising but we are getting enormous leverage in social media as a result of how we have integrated ourselves in a way that is authentic and very trusting by that audience.

Operator

Your next question comes from the line of David Palmer with UBS.

David Palmer - UBS

Thanks. Congratulations on the quarter. Just thinking long-term, as you think -- you know, let’s just go out to fiscal 2011 and beyond, what do you think about Starbucks' earning algorithm? What could it be? For instance, is it going to be, do you think, a long-term double-digit EPS grow again? More modest double-digit EPS growth? What will be the big drivers of the new growth? For instance, are you thinking that you might be able to add significant sales per store from new day parts or products at the retail store, or perhaps maybe it’s international or the CPG area? What are kind of the big dreams and where do you think this will gel for you in terms of growth? Thanks.

Howard Schultz

Troy, do you want to start?

Troy Alstead

Yes, I’ll start and David, there’s a lot there. I’ll tell you, in the midst of this transformation we are going through and coming off the heels of what we feel is an encouraging quarter, not quite ready to go all the way to 2011 yet. But what I will say is we are going to grow earnings. We fully expect that. That’s behind the targets we’ve laid out for you in 2010 and without having finished those plans or beyond, we are building this business so that we can drive margin improvement and drive growth in the top line in our future, and that will come through new store growth in the U.S. and increasingly importantly overseas. We expect it will come from growth through the non-store channels. We have a very valuable and important and I think in many geographies around the world, under-utilized and under-appreciated so far consumer products business, which gives us a great avenue for growth in the years ahead.

So there’s a number of pieces that fit into that equation that will be about driving earnings growth and revenue growth at this company in the years ahead, without trying to get too specific in the numbers for you.

Howard.

Howard Schultz

I think it’s important to say something perhaps a little bit unexpected and that is, there’s no victory lap going on at Starbucks here. We have a lot of work to do. I said in my comments that one quarter does not make a trend. We realize how tough the environment is in terms of the economy. We realize that there are competitors out there that have a much bigger appetite and advertising muscle than we do, and so we’ve got to be very careful here to recognize that the headwind is still in front of us and it’s too early to think about 2011.

David Palmer - UBS

Thanks.

Operator

Your next question comes from the line of Steven Kron with Goldman Sachs.

Steven Kron - Goldman Sachs

A few questions related to sales, maybe just to put a little bit more context around then -- can you quantify for us, Troy, if you can what you think the same-store sales lift that you may have received in the U.S. coming from store closures? That’s the first question.

Second one, two and three are really related to the price mix balance here -- I guess can you talk a little bit about the attachment, the pace of acceleration of attachments in the bundled products in the breakfast area? Is that still growing as a percentage of your total sales? Like is the mix still building there or has that since kind of plateaued? And the second component to that is on the pricing side -- where are you right now in this kind of more targeted, market-based, if you will, pricing that you guys talked about and was there any impact to net pricing in the quarter? Thanks.

Troy Alstead

Thanks, Steve. I’ll address the closures question and perhaps the other parts of it, and then I think Cliff, I may have you weigh in on the pairings in the attach, and our experience there and perhaps on pricing.

So first on the question about closures, to total comp growth the impact has been very small, a fraction of a percentage point. And the reason that’s the case is, the stores we’re closing, they are not particularly low comp growth stores. They are low volume stores and stores that lose money and so they economically don’t make sense to keep open which is why they have entered on our closure list. But it’s important to note that we’re not closing stores in order to drive comp growth. As we pull those stores out of the mix, the overall comp number just does not change meaningfully -- again, it’s significantly less than one percentage point impact as we do the analysis related to closing those stores.

No in terms of pairings, and I’ll perhaps say something here and then allow Cliff to add some more texture, we went into that in order to provide an important value message to customers and then tangibly to, as you point out, improve the attach rate. And over time, over time -- certainly not immediately but over time to have this be one avenue of helping us draw customers and traffic back into the stores. And as we’ve said before, we are successful at seeing the needle move on driving that attach rate and it gave us courage to recognize that we have a tool that we can use amongst some other things to improve that attach rate to food.

But again I’ll say our goal here is to drive food but it’s also to drive the beverage component and move both sides of it as we go through.

Cliff, do you want to expand on that?

Clifford Burrows

Thank you, Troy. I think you summed it up well, that the pairings was a great opportunity for us to deliver value to our customers. The great thing is it has resonated with our customers because we did the pairings primarily around the breakfast offer and we offered variety from whether it’s oatmeal, breakfast sandwiches, or indeed coffee cake, so trying to deliver something for people in all parts of the country in all day parts, and that has worked well.

With regard to attach, it really isn’t significant in terms of scale but it is a great new avenue for us to build that dialog and we will continue to explore how best to bring to those pairings and value to our customers.

With regard to pricing, we began a pricing initiative on May the 5th and we shared it with you on the last call. We’ve done that in several markets. But this is about building price as a component for the long-term and we are working strategically to optimize it, our pricing benefits for both our customers and our shareholders. The goal is to learn from the initiative and the tests we’ve done and scale up our approach to other cities and stores in the future, but it really is too soon to share any detail on this because we are really evaluating the initiatives we’ve taken, as I say, started on May the 5th in several cities.

So more to come on that in due course.

JoAnn DeGrande

Thank you, Cliff. This is JoAnn in Seattle and that about wraps up our call for today. Thank you all for joining us and we’ll talk to you again in November when we announced our fourth quarter and fiscal year-end earnings. Thank you.

Operator

This concludes today’s Starbucks Coffee Company’s conference call. You may now disconnect.

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