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Starbucks Corporation (NASDAQ:SBUX)

F1Q10 Earnings Call

January 20, 2010 5:00 pm ET

Executives

JoAnn DeGrande – Investor Relations

Tory Alstead – Chief Financial Officer, Executive Vice President & Chief Administrative Officer

Clifford Burrows – President Starbucks Coffee US

Howard Schultz – Chairman of the Board, President & Chief Executive Officer

John Culver – President Starbucks Coffee International

Analysts

Matthew Difrisco – Oppenheimer & Co.

John Ivankow – JP Morgan

Joseph Buckley – Bank of America Merrill Lynch

[Sarah Sinatory – Sanford Bernstein]

Jeffery Bernstein – Barclays Capital

Sharon Zackfia – William Blair & Company, LLC

Steven Kron – Goldman Sachs

David Palmer – UBS

John Glass – Morgan Stanley

Operator

At this time, I would like to welcome everyone to Starbucks Coffee Company’s first quarter fiscal year 2010 conference call. All lines are being placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question and answer session. (Operator Instructions) Ms. DeGrande you may begin the conference.

JoAnn DeGrande

JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me here in Seattle today, are Troy Alstead, CFO, and Clifford Burrows, President of our US business. And joining us from London are Howard Schultz, Chairman, President and CEO and John Culver, President of our Starbucks International business. Both Cliff and John will be available during our Q&A session following our prepared remarks.

Before we get started, I would like to 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 in our earnings release and risk factor discussions in our filings with the SEC, including our last annual report on Form 10K.

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 www.starbucks.com and to the financial statements accompanying the earnings release to find disclosures and reconciliations of non-GAAP financial measures that are mentioned on today’s call with the corresponding GAAP measures.

Before I turn the call over to Howard, let me highlight two up-coming events. First, we will be filing Starbucks proxy statements this Friday, January 22nd, which is associated with the second event, which is Starbucks 2010 Annual Meeting of Shareholders, to be held at 10 am in Seattle on Wednesday, March 24th. The meeting will be available via webcast. Now, I would like to turn the call over to Howard.

Howard Schultz

As part of our renewed focus on Starbucks international business, I’m here in Europe for the next 10 days with John Culver, President of Starbucks International. Visiting countries where Starbucks has operations or is considering new opportunities. It’s been a little bit more than two years since I returned to Starbucks as President and CEO. Very soon after my return, it became apparent to our leadership team and to me, that Starbucks would have to undergo a significant transformation in order to address the myriad of challenges confronting our business.

For the first time we were beginning to see traffic in our US stores slow, competitors were focusing their efforts on taking share from us and like many fast growing companies before us, we had allowed success to make us complacent. What we did not know two years ago, was that we would have to undergo this top to bottom transformation against the backdrop of the worst global economic crisis of our generation.

Today, I am pleased to report continued progress in our efforts to transform Starbucks and return this company to sustainable profitable growth, while at the same time remaining true to our core values and guiding principles. The numbers tell the story of and extremely strong quarter. Consolidated net revenues increased 4% to $2.7 billion. Comparable store sales increased 4% and reflected our first positive quarterly comp growth in eight quarters. Consolidated operating margin almost tripled to 13% from 4.5% in Q1of fiscal ’09. EPS increased to $0.32 a share compared to $0.09 share in Q1 of ’09. A new quarterly record for us despite the continued economic challenges confronting business and consumers around the world.

This was very satisfying quarter by any standard and follows three successive quarters of continued improvement in our business. Our US Company operated stores reached a significant milestone in Q1 as all regions reported positive comp growth and our US licensed stores also delivered strong results. As in prior quarters, our business this quarter benefited mightily from continued innovation from the success of our company wide efforts to improve customer experience from our continued laser focus on controlling operating costs and improving operating efficiency and from the impact of decisive actions we took early in 2008.

Today, I want to recognize and extend my heartfelt thanks to our Starbucks partners around the globe who have delivered these results. Much was asked of our partners and they have rose to the occasion time and time again. Before moving on to the business highlights of the quarter I want to make it clear that despite our strong showing we have much more work to do and we will have to perform this work in a largely uncertain and unchartered economic environment.

The global economic crisis has profoundly shaken consumer confidence and retailers who want to stay relevant in the future will have no choice but to recognize and respond to this new reality. At Starbucks, we know that to continue and to accelerate our recent momentum we will have to continue to improve, continue to innovate, and continue to focus on strengthening our connection to our customers. We know that our success in the past is no assurance of our success in the future. Simply stated, we know that we have to earn our business every day and we are committed to doing just that. With this unequivocally clear, let me now turn to our highlights of the quarter. Then I will turn it over to Troy to discuss the financial results in greater detail.

Beginning with our holiday performance, our holiday performance was among the best in our history thanks to improved merchandising, a highly effective, well designed in store customer experience, compelling value offers, disciplined inventory control and above all else, energized, passionate Starbucks partners who exceeded the expectations of our customers. Our strong holiday performance continued the momentum we established in our stores during the fall with the North American launch of Starbucks VIA and as I said on our last call, we have developed new muscle in how to go to market at retail as evidenced by the fantastic customer and partner response to Starbucks VIA in our stores.

Our customers responded enthusiastically to all of our holiday innovations and initiatives this year. Our holiday beverage platform which this year included caramel brulee latte was a big hit, delivering 30% up lift in holiday beverage sales compared to last holiday season. We offered a relevant and more focused merchandise selection, including a selection of gifts for under $10. A Starbucks card beat sales targets with over $500 million loaded in the first fiscal quarter and our legendary Christmas sled holding coffee, a seasonal favorite, celebrating its 25th Anniversary this year not only handily beat sales targets but also sold over 300, 000 of this extraordinary blend in one single day.

In the quarter we also advanced our partnership with Product Red by leveraging our strong Facebook presence to connect with consumers in 156 countries for a global, virtual sing-a-long to raise money for the global fund. This effort was the largest global campaign ever on the Facebook platform and further strengthens Starbucks unique connection with our customers. I am particularly pleased to report that to date our partnership with Product Red has helped to provide over $7 million days of life saving medicine in Africa.

We continue to see continued improvement in our US customer satisfactions results. The measures we tracked speed of service, friendliness of our people specifically the barristers, accuracy of beverage, taste of beverage, and overall satisfaction all continue to show improvement from a year ago. Our customers continue to respond very positively to the healthier products and choices we are making available to them through our revamped food program. Tory will provide details on our continued progress toward delivering a leaner, better and more efficient operating structure. However, the improvements in our operations to date, combined with the permanent operating cost savings, we have implemented and the improvement in store traffic we are seeing gives us confidence that our US business is well positioned to continue delivering solid operating margins and income into the future.

In the final days of the fiscal first quarter, we launched next evolution of our customer loyalty program, My Starbucks Rewards. The program has been simplified and offers more benefits to customers based on transaction frequency. Since then, we have doubled the number of cards registered for the new program over last year and thousands of our customers are already earning their way towards highest level of rewards.

The company continues to be the most popular brand on Facebook, with sites now launched in 14 countries and we are the biggest brand within our category on Twitter, adding more than 1000 new followers each day. The importance of our social media expertise continues to grow, and we evolve the conversation with our core customers. Starbucks continues to be recognized for the way we’re engaging and we’re seeing it pay off in ways we have not anticipated.

In addition to the popularity of social network communities, our iPhone applications, which we launched near the end of September have been helping customers find our stores, determine nutritional information and reload their Starbucks cards. In the few months since we launched the apps we have had over 1.2 million downloads, we were featured in Apple’s holiday campaign, and we were featured on iTunes as a top 10 productivity essential. Earlier this month, we were named the most popular US chain for a location based mobile application. More signs of the growing relevance of the Starbucks brand and experience.

In Q1, Starbucks international business showed improvement thanks largely to improved operations and execution. Here in the UK we believe we are seeing the beginnings of a turnaround with very strong growth in traffic in the quarter contributing significantly to the 4% growth in comparable sales reported by our international segment. Since last quarter, we launched a new locally relevant beverage within the UK called Flat Light, bringing innovation needed to establish cultural relevance and connection with consumers in unique ways depending on market and customer trends.

We also opened a new neighborhood focused store on Conduit Street in London to a very strong reception. Conduit Street is one of the latest of a series of new stores in which we are pushing the envelope in coffee innovation, design, sustainability and the overall customer experience by relying on local artisans and innovative concepts and we create further differentiation with these stores. We are also bringing in to integrating what we have learned to existing stores to upgrade or refurbish for remodels.

As the largest purchaser of fair trade coffee in the world, nowhere is the consumer impact more relevant than in the UK. All of our espresso based beverages are now Fair Trade certified coffee here and we have recently extended our partnership within the UK on Product Red. So, while we are off to a good start in reenergizing our UK business, we have much more work to do outside the US and the leadership team and I have identified a number of areas for improvement in our international market and global consumer products business. We are dedicated to bringing the same laser focus we brought to our US business in fiscal 2008 and 2009 to these businesses in 2010 and beyond.

For example, we are developing a new regional support model for our international business with an amplified focus on local relatives. France and Germany are beginning to perform better as a result of structural changes like these that we made last summer and I look forward to traveling to both countries in the next few days to meet our teams on the ground, talking to customers as we make plans in the coming months and quarters to enhance that business just like we did in the US over the last two years. Canada our oldest, and currently largest market outside the US, posted strong sales within the quarter driven by holiday offerings. The Canadian market is also benefiting from the implementation of many of the initiatives rolled out within the US which initiatives should gain further traction in the remainder of the fiscal year. In fact, we expect Canada to be one of the strongest Starbucks markets in fiscal 2010.

We are also focusing on China and continue to believe that China will become our largest market in the world outside the US and while we are seeing solid performance in this market we know that we are not yet remotely where we want to be or where we could be. Over the coming months, we will be in a position to tell you more about the changes we are implementing in China to better leverage and capitalize on one of the biggest opportunity the company has.

Our consumer products and food service division continues to be a promising business for us globally. However, our performance this quarter was somewhat disappointing and for the first time we are exploring opportunities to expand with a variety of offerings down grocery aisles domestically and internationally. Our retail launched the Starbucks VIA in North America was a highlight of Q1 bringing lots of excitement to our partners and a powerful halo to the brand. Our research has suggested that a significant percentage of customers who sample Starbucks VIA become repeat purchases and after only three months, VIA is now available in nearly 15,000 locations across the US and Canada. This includes company operated and licensed locations, Costco, Target, REI and online at Amazon.com, Cooing.com and OfficeDepot.com.

We followed the North American retail launch with the release of the very popular new skew and that was decaf VIA in November. Our customers have told us that their most frequent usages of VIA are in their homes or at work as a single serve option they savor for its flavor and taste and because it does not require costly, proprietary brewing equipment. Building on the broad customer acceptance through our retail channels, we are ramping up VIA launch efforts to our retail company operated stores outside of North America and poised to introduce distribution of VIA through North America and international channels in the third quarter of this fiscal year.

We are also planning to introduce additional premium coffee varietals and form factors to aggressively go after the at home and office single serve markets, as well as the $21 billion instant coffee category. VIA continues to excite and represent a major significant opportunity for the company.

Finally, as Seattle’s Best Coffee, we need accelerate the growth of a significant, yet underinvested brand within our portfolio. SBC is currently in 9,000 Subway restaurants and gaining further traction in food service channels across North America. We also announced a new line of SBC branded ice latte coffee drinks that will be available in major grocery, convenience and other retail stores marking the entrance of the SBC brand into the $1.4 billion US ready to drink coffee category. Our research strongly suggests that we have an opportunity to position SBC with new customers and we plan to create compelling franchising and distribution opportunities in 2010 and beyond. We believe that SBC has the opportunity to capture new customers, position us to enter new channel to ultimately increase our overall share of the coffee market.

Looking ahead, continued innovation, continued enhancement of the customer experience, and stream lined, more efficient cost structure have brought Starbucks to a significant milestone and a return to profitable growth. While we are encouraged by our recent progress, we are aware of the profound economic uncertainty that exists in the world and that to continue to succeed we must continue improve, continue to innovate, and continue to maintain our laser focus on serving customers and strengthening our connection to them.

We also recognize that we must now apply the same rigor that enabled us to transform our US business to our international and consumer products business in order to take full advantage of the significant growth opportunities in multiple channels that exist around the world. Finally, I want to emphasize how personally proud and appreciative I am to the loyalty, the commitment, the passion and the tireless effort of our partners all over the world who have enabled us to make the kind of progress we have made in transforming the company, despite the formidable headwinds we have had to navigate within. Because of our partners, Starbucks today is a better and stronger company than it has ever been and I am more optimistic than ever about its future.

Now, I would like to turn it over to Troy in Seattle and as I do I want to wish Tory a happy 18th anniversary with Starbucks.

Tory Alstead

As Howard indicated we are very encouraged by our first quarter results building on the positive momentum created in the back half of fiscal 2009 and reaching an important milestone in the return to positive comparable store sales growth for the first time in two years. Today I will provide additional details on our fiscal first quarter performance and I will update you on our expectations for the balance of fiscal 2010 given the improving trends in the first quarter.

First quarter revenues were $2.7 billion up 4% from $2.6 billion a year ago. The revenue increase was primarily driven by a 4% increase in comparable store sales and favorable foreign exchange offset in part by a smaller store base and softness in specialty revenues. The comp growth was attributable to a 1% increase in traffic and a 4% increase in the average value per transaction.

We reported consolidated operating income of $353 million in the first quarter including $18 million of restructuring charges. These restructuring charges were primarily related to lease exit and other costs associated with store closures the majority of which were in our international segment. Excluding those charges, non-GAAP operating income was $371 million. This compares to first quarter fiscal 2009 operating income of $118 million and non-GAAP operating income of $193 million.

Consolidated operating margin was 13.0% on a GAAP basis and 13.6% on a non-GAAP basis which represented a 620 basis point improvement from the 7.4% non-GAAP operating margin reported a year ago. In line with recent quarters we are realizing the benefits from the operational efficiencies we implemented in our business throughout fiscal 2009. These efficiencies have created additional sales leverage within our business model which became more visible this quarter with the return to positive comp growth.

Earnings per share was $0.32 for the first quarter compared to $0.09 per share in last year’s fiscal first quarter. Non-GAAP EPS was $0.33 compared to non-GAAP EPS of $0.15 a year ago. The strength of this quarter was driven primarily by the comps store sales growth and the operational improvements we have made within the business. Of note included in this quarter’s earnings was roughly $0.02 per share related to the France, Spain and Portugal transaction completed at the beginning of the quarter. That $0.02 net benefit includes an accounting gain reported in other income and a favorable impact on the effective tax rate for the quarter. This earnings favorability is strictly related to the transaction completed in the first quarter and is not reflective of ongoing financial impact from operations.

I will now review the non-GAAP results from our operating segments beginning with the US business. Total US net revenues for the quarter were $1.9 billion, a 1% increase from a year ago. Company operated US retail revenues increased 2% to $1.8 billion for the quarter primarily due to a 4% increase in comp sales offset by a reduction in the number of stores. The comp increase was driven entirely by an increase in the average value per transaction.

Sequential quarter same store sales trends continued the momentum from previous quarters with the one year comp improving for the fourth straight quarter and the two year comp improving for the third straight quarter and the encouraging comp performance was broad based. These trends confirm that the underlying business is healthy and that the momentum we are seeing is sustainable.

VIA drove nearly have the increase in the average value per transaction while changes in our pricing architecture improved holiday offerings and the final leg of our warming oven roll out contributed to the remainder of the increase. Building on Howard’s comments earlier about VIA, customer adoption and higher than excepted single serve at home usage has helped drive revenue beyond our expectations while cannibalization of our in store package coffee sales has been very small.

US cost of sales including occupancy was 39.1% of revenues in the first quarter, a significant improvement of 470 basis points compared to the year ago period. Most of the improvement was the result of supply chain efficiencies, lower food costs from our redesigned food program and the implementation of in store programs that have driven measurable reductions in coffee, food and diary waste. Favorable commodity costs and sales leverage in relation to our occupancy costs have also contributed to the improvement.

US store operating expenses were 36.6% of total revenues, a 350 basis point improvement over last year primarily driven by the continued application of lean principles in our store operating model plus the effect of company operated store closures. I will point out here that we improved labor management and labor costs in our stores over the past year at the same time we have seen a dramatic improvement in customer satisfaction scores.

US operating income was $342 million for the quarter, more than double last year’s $165 million in operating income. The operating margin improved 910 basis points to 17.7% of related revenues from 8.6% a year ago. This quarter’s US operating margin was the highest quarterly operating margin in four years. The US operating margin improvement is largely the result of the comp store sales growth as well as the work we started at the beginning of fiscal 2009 to better align our cost structure to the changing business environment.

As a reminder, we reported $580 million in savings in fiscal ’09 but only $75 million fell in to the first quarter with the cumulative impact growing as the year progressed. We were also lapping some significant and unusual costs from the first quarter of last year, particularly the leadership conference in New Orleans, the Starbucks card program through Costco and significant merchandise markdowns. As a result we expect our first quarter fiscal 2010 results to reflect by far the greatest year-over-year margin improvement of any quarter this year.

The strong US results are further confirmation that the actions we have undertaken to improve the business have been successful. Another positive indicator is the strong performance of the fiscal 2009 new store age class. Based on performance to date, this age class is on track to meet our targeted two to one sales to investment ratio and to post the first positive year one profit contribution for a new store age class in the past three years.

Moving forward in the US we will continue to execute on our three key focus areas: the customer experience; operational excellence; and relative innovation and while we are excited about the success we have had in turning the business around we recognize that opportunity still exists for improvement and that it will take a relentless focus throughout the business to have long term success in an increasingly competitive environment. We are confident in our ability to introduce innovative products and concepts and to provide our customers with an experience that is unmatched by others.

Moving now to results in our international segment. International total net revenues increased 19% to $591 million in the first quarter of fiscal 2010 driven by favorable foreign currency translation, the acquisition of the France market and positive comparable store sales of 4%. The comp growth was driven by a 4% increase in traffic while the average value per transaction remained flat compared to last year. A number of international markets contributed to the solid traffic gains for the quarter with the UK, Canada and China posting the largest increases.

Howard’s earlier remarks referenced the encouraging traffic trends in the UK. Our business in Canada, similar to the US benefitted from a strong holiday line up and China’s comps have remained strong throughout the economic slowdown underscoring the increasing strength of the brand and the size of the long term opportunity in that market.

International operating income was $54 million in the first quarter of fiscal 2010, a significant increase from $15 million posted last year. Operating margin improved by 610 basis points to 9.1% and finished at its highest level since the first quarter of fiscal 2008. Key drivers of the margin improvement included operational efficiencies designed to reduce waste, a smaller negative impact from store impairments, improved labor management and sales leverage.

The improved health of the international business is encouraging and we continue to make progress towards double digit margins in 2011 on the way to our long term mid teens target. We are focused on growing the international business in a disciplined manner utilizing the key learnings we’ve obtained from our experience in the US. We will leverage the skills and expertise of the global organization while striving to offer locally relevant products and concepts in each market. The international opportunity is enormous and we are putting the appropriate resources behind it.

Now moving to the results of the global consumer products group. GPG total net revenues decreased 4% to $197 million in the first quarter of fiscal 2010 primarily due to lower revenues across multiple lines of business including packaged coffee in the grocery channel and US food service. The food service revenue decline is primarily related to continued softness in the hospitality industry while the packaged coffee business continues to experience the effects of the challenging consumer environment and increasing competition. Despite the growing competition we continue to maintain a dominate position in terms of market share and we are increasing our marketing innovation spending to reinforce our category leadership and drive future growth.

Operating income for CPG was $67 million in the first quarter, a 10% decrease from last year. The operating margin declined from 220 basis points to 34.1%. The softness in packaged coffee was a significant contributor to the margin compression and was driven primarily by increased marketing expenses and a mixed shift to the lower margin club channel versus groceries.

We ended the quarter in excellent financial condition with $1.4 billion in cash and short term investments, no short term borrowings outstanding and only modest long term debt on the balance sheet. As I mentioned last quarter and perhaps to head off the questions I expect to get as soon as we move in to Q&A, we continue to evaluate with our board the appropriate uses of excess cash and expect to conclude the work on our distribution strategy in the coming months.

The business is a very strong producer of cash flow which enables investment in our existing business, investment in new stores, investment in innovation and new growth platforms and we expect excess cash beyond those requirements that would be available to return to shareholders. Given the strong performance in the first quarter and our return to profitable sales growth, we are updating our outlook in a few key targets for the balance of fiscal 2010.

We now expect revenue growth to be in the mid single digits for the year driven by modestly positive comparable store sales growth, the extra week of this fiscal year and approximately 300 net new stores. While the first quarter showed measurable progress and we reached a significant milestone by generating positive comps, we are still accurately aware that the consumer faces a difficult environment with high unemployment among the many concerns. We believe this uncertain environment is still having a negative impact on our customers.

With respect to commodities and foreign currency we except the balance of the year to be flat compared to last year with unfavorable dairy costs offset by favorable coffee costs and foreign currency. This compares to a favorable impact of roughly $0.01 in the first quarter driven by both commodities and foreign exchange. Based on first quarter trends, we now expect fiscal 2010 non-GAAP operating margin improvement of roughly 400 basis points in the US and in line with prior guidance 200 to 250 basis points in international. The operating margin from the CPG segment is expected to be approximately 35% at the low end of its recent range. All together we expect this will get us to a consolidated operating margin in the range of 11% to 12%.

We now expect earnings per share to be in the range of $1.05 to $1.08 per share on a non-GAAP basis. Similar to the targets we provided last quarter, this range includes roughly $0.03 per share benefit from the addition of a 53rd fiscal week and excludes roughly $0.03 in restructuring expenses mostly related to international store closings.

Finally, for fiscal 2010 we expect cash flow from operations to be roughly $1.5 billion and free cash flow to be approximately $1 billion. As I have stated before, earnings comparisons become more difficult as we move through the year and we begin lapping the increased cost savings and improved comp trends from last year. Additionally, we had some contribution to earnings in the first quarter that we expect will not be repeatable as we move through the year such as the non-recurring benefit from the France, Spain and Portugal transaction that I noted earlier.

It is also important to highlight some of the investments we will be making back in to the business later this year. With the health of the business rapidly returning, we do intend to increase spending in support of key growth platforms and initiatives which we expect will drive revenue and earnings growth in 2011 and beyond. First, fiscal 2009 was a year in which we adjusted our marketing strategy towards a broader brand building campaign. We have started to see benefits from this change in strategy including a contribution to the recently improved revenue trends.

As a result of these learnings, we intend to significantly increase our overall market spend for the balance of the year. We estimate marketing expenditures to be roughly $0.04 per share higher in the balance of fiscal 2010 than in the last three quarters of fiscal 2009 with most of the increased spending coming in the second and third fiscal quarters and the benefits coming in Q4 and beyond.

It is worth noting that these increases in marketing expenses are in addition to the increase related to VIA. As I have explained in the past we do expect to spend heavily against VIA throughout the year some of which occurred in the first quarter with the North America retail launch and some of which will occur in the second and third fiscal quarters as we launch in our CPG channels. Although VIA is outperforming our expectations we still expect it to be profit neutral for fiscal 2010 as the performance upside will be allocated back in to increased marketing spend as we invest to support this critical growth platform.

The other area where we plan to increase our investment is in our existing store portfolio to bring a refreshed look to many of our stores that will incorporate pieces of the innovative new design concepts we have highlighted on previous calls. This is an important element to the health of our brand and we believe will contribute to growth in the years ahead. As Howard mentioned earlier in his comments about the dedication of our partners, I’d like to add that from a business perspective we are always focused on making the right investments. One of the most vital investments that sometimes is overlooked is the investment we make in our partners.

Given the sequential improvement we are seeing in our business it is even more important to honor the deep commitment of our partners and business leaders. We have been able to compensate them through a discretionary match to the company’s 401K savings plan, funding merit increases for eligible partners and discretionary bonuses to our field partners and business leaders. These compensation elements are important for us as a company to retain our partners and increase performance so we can continue to drive positive momentum in our business.

We feel that these are the right investments for the future and while this will increase spending in the current year the projected long term return on investment is significant. We still have tremendous opportunities to grow the business long term and it is imperative that we invest now in order to drive profitable growth in the future. The first quarter was confirmation that the steps we’ve taken to improve the business have been successful. We recognize that there are still areas for improvement and we continue to face a challenging economy and consumer environment.

We are confident in the strategies that we have adopted and we will continue to sharpen our focus on execution while we deepen our focus on driving growth as we move forward. With that now let me turn the call back over to the operator to begin Q&A.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Matthew Difrisco – Oppenheimer & Co.

Matthew Difrisco – Oppenheimer & Co.

I guess just towards the G&A question it looks like you grew that about 30% or so in absolute dollars. Is that fully the marketing expense also incorporated in that G&A or is that somewhat allocated across G&A but also in some of the retail stores? Then, I just wanted to be clear, you mentioned something about cards loaded in the beginning of the call over $500 million, could you put that in to relation on growth year-over-year because I think there was a spreadsheet released as of December 27th it looks like your activations are down year-over-year. I just want to know what you have as far as balances on a year-over-year basis?

Tory Alstead

Let me take the G&A one first in particular and Matt it is really not particularly driven in the quarter by what you mentioned. There are two drivers that really push G&A, one is an item you’ve heard me talk about before and this is the most significant thing in G&A and that is we have a deferred compensation plan and a tracking portfolio that impacts our P&L in a couple of difference places. Now, each quarter the net impact to the bottom line is zero but in this particular quarter the impact is to drive G&A costs up and that was the most significant G&A contributor to that.

The offset to that by the way is in other income which you’ll also notice was an unusually high increase in other income this quarter. That is really a complete and opposite offset to that increase in G&A. That is the single biggest item in G&A. Another component of G&A is really related to incentive compensation plans which are accruing at a higher rate given the record earnings the company reported in the quarter.

Matthew Difrisco – Oppenheimer & Co.

Then what about the balance on the cards?

Tory Alstead

The card balances were reasonably close in the quarter. We don’t have specific numbers I can produce for you right now. I would remind you that last year in the first quarter we had a heavily discounted card program through Costco which was conscious decision in that first quarter of 2008 to really drive traffic in what was an extremely difficult quarter. We did not continue that program this year and so offered no discounts through the card program so we are very, very pleased we had the great reaction we did to cards even without that heavy discounting going on.

Matthew Difrisco – Oppenheimer & Co.

There was a headline that came across about VIA going out to the grocery stores. I was listening to the call and feverishly putting down notes but I didn’t get the date when you said you were going to introduce that in to the grocery.

Howard Schultz

We have not announced the date for grocery nor have we announced where internationally VIA will be. We said it will be in Q3.

Operator

Your next question comes from John Ivankow – JP Morgan.

John Ivankow – JP Morgan

First just a quick question on VIA. When we look at the US comp I think you mentioned that a half of the price increase, in other words two points, of the comp came from VIA in the first quarter. Did I hear that correctly?

Tory Alstead

It is a little bit less than two points but it is about half that increase in the average ticket was driven by VIA and just the great volumes that we sold in the quarter higher than we expected.

John Ivankow – JP Morgan

Just going forward Troy or Howard, when we think about VIA in fiscal 2010 do you think there is a lot of trial and there won’t be as much repeat or is there room for that number to expand as we move throughout fiscal ’10 in terms of contribution of comp?

Howard Schultz

I think it is still early to be able to kind of articulate what is going to happen but I think the really positive news that we have is two things, trial leads to purchase and we also saw and that is apparent in the average ticket that the people who bought the trial size of three began to trade up to the 12 in subsequent purchases. We have no reason to believe that will change and as Troy said we’re going to spend against VIA both in terms of our retail stores and the introduction at grocery because we feel that we’ve got a very significant opportunity to build a major platform for the company but we have to invest spend against it.

John Ivankow – JP Morgan

Just a quick one also on the pricing architecture if you could remind us how many stores in effect it was in the first quarter and what you think the possible contribution of overall pricing based on the new architecture could be for fiscal ’10?

Tory Alstead

By the end of the first quarter we had rolled the revised pricing architecture across most of the US, 90% plus of our stores across the US and we’ll complete that roll out really during the second quarter. What I’ll point out as we talked about before John is that it is an initial rearchitecture of pricing that as you know includes many prices coming down really responding to customers’ request for value and reacting to that and providing that to them in our stores, adjusting some of the more complex costly products to make up in the mix of things and that was an impact in the quarter but second or perhaps third on the list of things that impacted our average ticket.

I will also point out that the work on pricing now continues forever. We believe we have created some competencies here and built a muscle that will allow us to continually rearchitect pricing based on value, based on customer reaction, based on particular markets and demographics that is an important new tool in our tool belt here going forward.

John Ivankow – JP Morgan

Several years ago when you took pricing there was an effect on value perception at the customer level. Did you experience any change in value perception with the new architecture?

Tory Alstead

What we have seen with value perception this year is it actually improved. The snapshot of our customers most recently would say they believe Starbucks is offering better value today than we were a year ago and I think that is a reflection of everything we have been doing in our business in terms of how we’re communicating, how we’re differentiating the things that make Starbucks different so that top half of that valuation equation, not just the pricing piece of it but really the differentiating quality elements then also what we have done earlier in the year around parings, the pricing architecture which had some things going up but many, many products in every market coming down. The net effect of all of that has been an improving perception of value among our customers.

Operator

Your next question comes from Joseph Buckley – Bank of America Merrill Lynch.

Joseph Buckley – Bank of America Merrill Lynch

I guess a question just clarification on the France, Portugal Spain deal, so it was $0.02 of onetime EPS benefit in the quarter? And, talk about the benefits going forward why you did the deal and what we might see flow through the numbers for the balance of the year on an operating basis not a onetime basis?

Tory Alstead

You’re right on the non-recurring element of the transaction and that was really just the painful transaction accounting relative to that acquisition. On an ongoing basis Spain adds to our top line as we consolidate the revenues from that market and is accretive to earnings overall. It is very, very small in the big scheme of our business, not something that you’ll see pop through the results by any means in the short term but the most important element of that transaction that we completed was really fine tuning our international ownership to put us in a position to own and operate the markets where we see the biggest ultimate long term opportunity.

We’ve got great top line in France, we’ve had great reception in the market and we believe in the long term it is a very, very significant, large and deep market for us. It is a place where it is appropriate and we can make the right investments to drive the right long term returns out of that market. That same transaction had us put in the hands of our long partner, excellent partner that we’ve had on the Iberian Peninsula full ownership of Spain and Portugal which also serves our ownership strategy in the right way, smaller markets where they bring great capabilities to bear it puts them in their hands. The big benefits here in France are not so much what you’ll see in fiscal ’10 it is the long term opportunity for us to go after what we think is a big, big market.

JoAnn DeGrande

Joe just to clarify Troy’s initial comment, the consolidation is France not Spain.

Howard Schultz

I just want to add one thing, when we look at France I think we are significantly under stored versus the opportunity and France has among the highest level of transactions throughout Europe in the system.

Operator

Your next question comes from [Sarah Sinatory – Sanford Bernstein].

[Sarah Sinatory – Sanford Bernstein]

I just wanted to ask you actually about the traffic versus ticket in the US, the comp coming from ticket but obviously I think we’d like to see traffic as the more sustainable driver so can you talk a little bit about what you have in place to drive traffic and why you think that balance looked different in the US versus the UK?

Clifford Burrows

I’ll take the US comment first, we have seen over the last four quarters steady improvement in our US store traffic and that continued to the net position of flat transactions in quarter one so we are pleased with the progress so it is a trend which we obviously plan to work on continuing and the ticket Troy has talked about VIA, holiday and the work around pricing.

Howard Schultz

In international we saw as Troy said earlier, we saw the exact opposite. We saw strong transaction growth overall in our international markets across all international markets and as Tory stated it was right at 4% for the quarter.

Tory Alstead

I think whether we are talking about the US business or the international business we recognize all too well that transaction as a catalyst for growth is something that we have to get. I think it is important to remind everybody we’re dealing with 10% unemployment throughout America and most retailers are not only reporting down traffic but down comps so to get to this level compared to where we were a year to a year and a half ago is quite something. But we certainly recognize the vital importance of creating incrementally for traffic in 2010 and that is where our sites are set.

Operator

Your next question comes from Jeffery Bernstein – Barclays Capital.

Jeffery Bernstein – Barclays Capital

Actually just one clarification and then a question, the clarification in terms of the cost savings I think Tory you mentioned that you were lapping the least amount of savings from a year ago. I think we had said in the past that $260 million was what was going to roll over from fiscal ’09 in to fiscal ’10 from those savings. I am just wondering whether you had found additional cuts? I know you said that there were likely to see additional cuts in fiscal ’10 above and beyond the roll over. I just want to clarify that.

Then just separately on Seattle’s Best, it seems like a great opportunity in the very early days. I’m just wondering if you can give some long term color on the opportunity whether it be grocery, restaurants or actual stores in terms of market share or whether or not there is any risk to cannibalizing the core brand? How you think about growth and development of that brand over the next many years?

Howard Schultz

I think as we look at the portfolio of opportunities that we have and the way in which the coffee market has evolved over the last say five to 10 years, it is clear to us that SBC is just a hidden treasure for the company in terms of its mass appeal. Starbucks coffee in terms of its taste and robustness compared to SBC, SBC is much more approachable as a flavor profile. As a result of that we think that we can distribute SBC in multiple channels of distribution where Starbucks would not be available or appropriate.

A good example of that is what I talked about originally in my comments and that was Subway. We’re talking to other QSRs about the opportunity that might exist for SBC to be available in those QSRs in which they want to go after the breakfast business not unlike what McDonalds has done. We think there is opportunities to create a franchise system for SBC and certainly a different approach to the grocery channel domestically and internationally at different price points in different kinds of coffee both in varietals lends and form factors that Starbucks would not be available in.

These are early days. Michelle Gass one of our most senior, strongest executives in the company has had a myriad of job opportunities and has always done well is now leading that effort and what we said to her was take the shackles off SBC and grow it as if you own it and we think we’re on to a very big opportunity that is much, much larger than the business today that is complementary to Starbucks and will be significant competitor to other brands that exist on the shelf today.

Tory Alstead

To your cost question you are correct really in the numbers you quote. In the first quarter of last year we had reported about $75 million of our cost program which ramped up throughout the year for a total of $580 by the end of the year. Now, just those actions in 2009 gave us really a great head start in 2010. By annualizing what we did last year that results in a carryover essentially, a lapping effect really of greater than $200 million of more savings that come through the P&L this year and that has given us a real head start for those margin improvement targets and EPS growth targets that I have articulated.

Now, in terms of finding more I will tell you we are relentlessly focused on our P&L and ways to improve it. I would not articulate it as cuts however any longer, there was some element of that in the first wave but now this is much, much more about searching for efficiencies in our massive supply chain, in procurement, in distribution, about continuing to uncover ways to be more effective in operating our stores, to reduce waste, to improve the cost structure of the company and to really turn over every rock we can in terms of efficiencies and productivity.

That work will continue, it will continue this year and in the years ahead. To us it is just an important additional tool in addition to innovating and driving the top line to help us offset and overcome the natural cost increases that happen through inflation on the P&L.

Operator

Your next question comes from Sharon Zackfia – William Blair & Company, LLC.

Sharon Zackfia – William Blair & Company, LLC

I was hoping you could maybe give us an update on the pilot of the new POS system, what the anticipated roll out of that is in the US and what you are seeing so far in terms of benefit from the new POS?

Clifford Burrows

We are in the early phases of piloting this. We’ve put it out in some stores close to us here in Seattle and they’ve operationally now worked through that. I am delighted to say that we’ve extended that to about 130 of our stores and we’ve found very effective ways of deploying it and really that is a focus for us and a primary platform focus for the US retail in the coming three quarters and we’re looking to have that roll out completed.

There are many benefits to both the training and operating the system and then indeed supporting the system and the data we get from it. In terms of quantifying those benefits it really is too early but I do see benefits coming from both the partner who is operating the new system and in terms of the ease, accuracy and speed of customer service. So there will be more upside to share with you and really once we’ve quantified that in coming quarters but I see the benefit coming in really FY 2011.

Operator

Your next question comes from Steven Kron – Goldman Sachs.

Steven Kron – Goldman Sachs

I was wondering if you guys can comment a little bit on how same store sales may have tracked through the quarter? I ask kind of in the context of your guidance for the year of modestly positive same store sales. Is there anything in your business that is giving you a little bit more of a cautionary tone specifically as it relates to VIA recognizing that sometimes when you launch a new product you may have a bit of spike based on the promotional activities surrounding that product in your stores. Can you talk a little bit about how things tracked at least directionally throughout the quarter?

Then just a follow up question on the margins if I can, it looks like you carried a lot of overage you saw in the first quarter to your increase in operating margin guidance of 400 basis points for the US, didn’t seem like you carried over overage from the international business which I suspect was probably better than expected at least internal projections. Can you talk a little bit about what might be an offset?

Howard Schultz

I’d like to take the comp question if you don’t mind and you can answer the later. I think we don’t want to get in to the sequential growth of the quarter in terms of comps. It maintained a level of consistency throughout the quarter. I think the modest guidance that we want to give on comps I think is the absolute right approach given the high level of uncertainty in the economy and the strong level of unemployment that exists and could get greater. So I think we still have a lot to prove, these are still early days.

The kind of comp quarter that we posted, the first comp positive in eight quarters does not make a trend and we want to be very careful in how we’re providing guidance being highly thoughtful and disciplined in our approach.

Tory Alstead

Then to the question about the margins and international in particular international did have a great first quarter there is no question. The improvement in margin was very, very strong and we’re very pleased by how we’re getting closer to that next milestone for us which will be double digits on the way to our long term target of getting that business in to the mid teens. We also recognize as you’ve heard from us before that this year is largely about international to a great degree where we have focused heavily in the last two years on restructuring and transforming our US business we’re seeing the results of that payoff tremendously for us.

Now, we’re turning that same level of focus and attention to international which means there may be as we concurrent with driving improving margins in the business we may be making some investments back in to that business just as a year and a half and two years ago we made investments in to the US. That is what leads us to what we think is a very quite strong and solid margin improvement for the year of 200 to 250 basis points but moderated and reflective of our interest to improve the business at the same time that we heavily invest against it for the long term opportunity that we see ahead of us there.

Operator

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

David Palmer – UBS

A question on the sales mix and particularly on brewed coffee, how much has your brewed coffee increased as a percent of your sales mix over the last year, maybe a little longer if you want to go two years? And to the degree that brewed is increasing how much of that do you think is really getting the same folks that might have been having other espresso based beverages to trade down to brew rather than trade out during tough economic times or are you perhaps attracting new users to the brand?

Tory Alstead

What I would say to that is if you look over the last year or two our mix of brewed coffee has not changed meaningfully. Occasionally perhaps around the edges a bit here and there but it has not been a big trend that I would tell you about in the business so I don’t think that is a particularly meaningful thing to speak to. We’ve always said as over the past year we’ve looked at our business and tried to understand impacts on the business trade down was not a meaningful element that we could find in the business. We’ve analyzed it everywhere we can and there probably was some of it but it was just not something that jumped out in particular.

It has always been about largely preserving a core customer, a core Starbucks customer but losing some of their frequency. Much of our efforts in the past year of rebuilding that trust and that relationship with customers has been about regaining frequency but again, without material or substantial changes particularly in that brewed coffee mix.

Clifford Burrows

Just to share what we have focused on is the quality in the cup, the freshness and availability of our brewed coffee. So in terms of certainly the relationship with the brewed coffee customer and their satisfaction with both the availability and the freshness of the coffee in the cup we’ve had great positive feedback on that. And, as we shared about a year ago our key focus was around retaining our existing customers. We recognized that the competition had grown in the market and we reset our standards and we’ve delivered against that to essentially maintain our customers and make sure we satisfy them when they come in to our stores.

Operator

Your final question comes from John Glass – Morgan Stanley.

John Glass – Morgan Stanley

Could you talk about the learning specifically that you plan on taking from the US in to the international markets? Is it as simple as taking the playbook that you had in international and applying it to each market or is it somewhat unique problems in each market or unique opportunities? And, can you do it all at once or do you have to address a single market at a time? It sounds like you’ve worked on Canada do you do it in that order or can you go at everything at once in 2010?

Howard Schultz

Let me start and I will give it to Troy and perhaps John will chime in as well. I think one thing that you need to realize is that 18 months ago the entire company’s focus, the leadership team and certainly my priority personally was restoring the health and strength of the US business and the focus and the attention and the transformation took a comprehensive effort of basically the entire company. As a result of that we did not pay as much attention and certainly as much focus on the international business as we did on the US, we just didn’t have enough resources.

Now that the US business has come back the way it is and we feel it is healthy and on solid ground we’re doing two things, one is we’re doing a comprehensive audit of all the things that we did in the US business that worked, that got our customers back, that put lean in our store and things that not only were consumer facing but also behind the customer as well. What you said was appropriate, there is not one international there are many, many different countries with different complex issues, different ownership structures but a store, is a store, is a store and we believe that we can provide many of the opportunities throughout international that we brought to the US business.

I think one thing is just focus as we did on the US business on international. The fact that I am here with John and visiting the European countries and we’re going to shift our focus to the international market should be a very strong signal that we are intent on leveraging the strength of the business on to international. We do think that we can do multiple countries in multiple regions at once but this is not going to happen overnight it is a journey and it is going to take a while for it to emulate the kind of numbers that we posted in the US business.

But, there isn’t one international. We have some markets that are very, very strong and some that are under pressure because of the local economy like in western Europe and then some markets like Asia, specifically China where we’ve got very strong comps and very strong profitability at the unit level.

Tory Alstead

I think the only thing Howard I would add and perhaps underscore a bit is if you go back two years ago when we really began this work in the US the first and foremost focus was very heavily around the customer, the customer experience in store, the elevation of the product and the product quality and our partner experience. Of course we’ve consistently also moved in to managing the P&L and disciplines around growth but I think first and foremost remembering that focus on the customer as we bring those lessons to bear outside of the US is critically important.

Then, disciplines around new store growth, focus on unit economics, the cost to build stores, store profitability, driving same stores sales again, I think the bread and butter of a retail business like ours but those things that were perhaps a bit lacking in the focus and ability to manage a couple of years ago are now very accurately focused on them in the US and bringing that to bear in the UK, in Canada, in China and so on. That’s where we see the opportunity over time.

Howard Schultz

I think the headline I would just close with is in 50 countries outside of the US the Starbucks experience, the sense of community, the third place and the relationship with our partners demonstrates the high degree of relevancy of the Starbucks experience. Where here in the UK, we’re serving over two million customers a week, we have a high level of transactions in France and I mentioned other countries as well. We’ve cracked the code on the ability of the Starbucks brand and Starbucks store experience to be accepted.

Now, we have to elevate the customer experience and do the kind of work behind the scenes and the cost structure, the expense control and the kind of marketing that makes us highly relevant on a local level. But, we’ve got great upside here not only in our stores but most importantly on a complementary basis to bring the consumer products group in to the international business and in some cases you might see us do it ahead of or in parallel with store growth which would be a strategic change for the company

JoAnn DeGrande

Thank you all for joining us today. This concludes our first quarter fiscal 2010 earnings call. We’ll speak with you again end of April when we report Q2 earnings. Thank you.

Operator

This concludes today’s Starbucks coffee company’s conference call. You may now disconnect.

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Source: Starbucks Corporation F1Q10 (Qtr End 12/27/09) Earnings Call Transcript
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