Starbucks F1Q07 (Qtr End 12/31/06) Earnings Call Transcript

Jan.31.07 | About: Starbucks Corporation (SBUX)
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Starbucks Corporation (NASDAQ:SBUX)

F1Q07 Earnings Call

January 31, 2007 5:00 pm ET


JoAnn DeGrande - Director, Investor Relations

James L. Donald - President, Chief Executive Officer, Director

Howard Schultz - Chairman of the Board

Michael Casey - Chief Financial Officer, Executive Vice President, Chief Administrative Officer


Larry Miller - Prudential Equity Group

Glen Petraglia - Citigroup

John Glass - CIBC

Jeffrey Bernstein - Lehman Brothers

Howard Penney - Prudential Equity Group

Sharon Zackfia - William Blair

Matt DiFrisco - Thomas Weisel Partners

Ashley Woodruff - Friedman, Billings, Ramsey Group



Good afternoon. My name is Carrie and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks first quarter earnings conference call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session.

(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 today are Howard Schultz, Chairman; Jim Donald, President and CEO; Michael Casey, Executive Vice President and CFO; and Kelly Hall, Vice President, Corporate Finance.

During today’s call, Jim will review key results and accomplishments for the first quarter, and provide some highlights from our U.S. retail business as well as our global consumer products group. Howard will provide a brief update on our literary initiatives within our music and entertainment business and an overview of the performance of our international business. Michael will then highlight the key drivers behind our first quarter fiscal year 2000 [sic] results, and we will limit today’s call to one hour including Q&A.

As a reminder to all listeners, this call is being broadcast live over the Internet. A replay will be available via telephone at 800-642-1687, reservation number 4132389, through 5:30 p.m. Pacific Time on Wednesday, February 7th, and on the investor relations page at through 5:00 p.m. Pacific Time on March 2nd.

In addition, today’s remarks will be available on the investor relations portion of by the end of the day and will remain available through Friday, March 2nd.

This conference call includes forward-looking statements about trends in or expectations regarding store openings, comparable store sales, net revenue, earnings per share, effective tax rate, store operating expenses, operating margin, and commodity costs. These forward-looking statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. Additional information concerning factors that could cause actual results to differ materially from those in the forward-looking statements are contained in the company’s filings with the Securities and Exchange Commission, including the risks factors section of Starbucks' annual report on Form 10-K for the fiscal year ended October 1, 2006.

The company assumes no obligation to update any of these forward-looking statements.

With that, I will now turn the call over to Jim.



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James L. Donald

Thanks, JoAnn. Good afternoon, ladies and gentlemen. I am very pleased to review our results following another strong quarter for Starbucks. Let me recap some of the key financial highlights, which we reported today: Net revenues for the first quarter were $2.4 billion, up 22% from last year; Comparable store sales grew 6%, and was composed of a 4% increase in the number of transactions and a 2% increase in the average value per transaction; Net earnings for the first quarter were $205 million, compared to $174 million in fiscal 2006; and earnings per share for the first quarter were $0.26, compared to $0.22 in fiscal 2006.

These results, all well within our fiscal 2007 financial targets, follow an exceptionally strong fiscal 2006 first quarter. We recognize that the outstanding first half of fiscal 2006 created tough year-over-year comparisons for both quarter one and quarter two. And as quarter one proved, we were up to the challenge, delivering solid results.

Contributing to our financial results during the quarter was the opening of a record 728 new stores -- that’s a little over eight stores a day. This number represents the most stores opened during one quarter in Starbucks history! By the end of the fiscal period, we were serving our customers nearly 44 million times per week at 13,168 locations in 39 countries.

Throughout today’s call you will hear that our strategic roadmap is built on a balanced approach to rapid growth and targeted investments. We will talk about investments we have made in our partners, our infrastructure and in our coffee procurement. I believe these investments, balanced with our aggressive growth targets, will enable our strong management team to remain focused on leading the Company in a direction that will build strong shareholder value well into the future.

Now I’ll review some of the key drivers behind our first quarter results, starting with our U.S. business. Because U.S. Company-operated retail represents nearly 90% of U.S. revenues, that’s where I will focus my remarks.

Our strong 21% U.S. retail revenue growth was generated by record store openings and solid comparable store sales growth of 6%. Handcrafted beverages, including core and seasonal holiday offerings, as well as food and merchandise all contributed to same store sales growth.

Our food program again this quarter was a significant contributor to our U.S. retail revenues. These offerings are complementary to our core and seasonal beverages and are meeting our customers’ demands as evidenced by strong sales. We have remained focused on expanding our lunch program which is now offered in more than 4,100 Starbucks locations in the U.S. This is an increase of approximately 860 stores compared to the first quarter of fiscal 2006, which represents 69% of our Company-operated U.S. retail stores.

And, we expect over time that nearly all our Company-operated U.S. retail stores will offer the lunch program. As a reminder, this program adds approximately $30,000 in average annual sales to stores offering lunch items.

During the first quarter, we significantly expanded the number of stores offering warmed breakfasts by adding more than 200 locations in New York and approximately 90 locations in Indiana, as well as adding over 260 stores in existing markets through infill.

At the end of the first quarter nearly 1,200 Starbucks locations were offering warmed breakfast items, compared to only 225 stores a year ago. Based on the strong customer acceptance we have experienced, we have aggressive plans to continue rolling out our Warming platform over the next few years. We expect over time that most of our Company-operated U.S. retail stores will offer the Warming program. Warmed sandwiches add approximately $35,000 in incremental average annual sales to these stores.

Merchandise also contributed to same store sales growth during the first quarter. Customers had the opportunity to purchase coffee-relevant merchandise as well as holiday treats perfect for the gift-giving season.

And what would the Holiday season be without the Starbucks Card? I am happy to tell you that again this year the Starbucks Card -- the cornerstone of our holiday gift program -- proved to be extremely popular. During the first quarter, customers activated nearly 20 million cards representing a value of nearly $300 million. This is an increase of approximately 30% in both activations and value when compared to the first quarter of last year. At the end of the quarter, approximately $410 million was loaded onto Starbucks Cards waiting to be redeemed, a 40% increase compared to $293 million at the end of the first quarter last year.

Since the introduction of the Starbucks Card, more than 115 million cards have been

activated. After more than five years, the Starbucks Card has proven to be one of the most highly demanded cards in the marketplace. It has not only created a loyal following among our current customer base, but it continues to draw new customers into our stores, and it’s our premium beverages, legendary service and unique Starbucks Experience that keeps them coming back. The strong growth of accounts, the stickiness our card creates with our customers, and the frequency of use clearly separates us from other programs.

Over the years, we have sought out opportunities to integrate the Starbucks Card into our in-store promotional campaigns around the seasons and holidays. During fiscal year 2007, you will see us expand our promotional efforts even further as we introduce programs to build customer awareness of the Starbucks Card as a year-round special gift for birthdays, special occasions, holidays, or just because.

Let me now shift from the U.S. to our newest reporting segment, which spans a broader geography: our Global Consumer Products Group.

The unique aspect of this business is that Starbucks was able to develop an entirely new distribution channel for our products outside our retail stores -- something never really done to this extent before by restaurateurs, retailers or other consumer brands. We have been able to leverage our retail products and, on a parallel track, we created a channel as vibrant and robust as our retail stores.

Not only is it a very cost effective and profitable channel, but it also provides Starbucks with the opportunity to reach a wider consumer base, building customer awareness and providing additional brand touch points.

The mission of CPG is to extend the Starbucks Experience to our customers whenever they want it and wherever they happen to be -- at home, in the office, or on the road. In other words, anywhere outside of their Starbucks store.

This is achieved through business partnerships with both domestic and international companies who provide distribution and marketing for this broad array of products. In these relationships, Starbucks provides roasted coffee, as a key ingredient for a variety of coffee-based products and finished products, such as packaged coffee. Starbucks manages the brand integrity and through these partnerships, we are able to leverage our business partners’ manufacturing and distribution capabilities.

CPG is made up primarily of: Packaged Coffee & Tea and Ready-to-Drink coffee products in both domestic and international markets, as well as ice cream in the U.S. Through our CPG channel in the U.S. market, last year alone we connected with our customers approximately 550 million additional times outside our retail stores.

Our Consumer Products Group introduced Starbucks branded coffees into our International Club distribution channel in two new countries, Korea and the U.K., expanding the distribution to four countries. This provides more opportunities to extend the brand in non-retail locations outside the U.S.

In Korea, we added Starbucks DoubleShot to the product offerings following the introduction of bottled Starbucks Frappuccino to this market in fiscal 2006. Customer acceptance of these products has been very encouraging and sales volumes continue to rise.

We are still in the early stages of development in our Consumer Products Group, both domestically and internationally, and with many new, innovative products in the pipeline and opportunities to extend our products to new channels, we are very excited about this business.

At Starbucks, we are constantly looking for ways to broaden our appeal to our customer demographic by offering products that range from indulgent treats to health conscious choices. Today, our customers are able to choose from tens of thousands of possible beverage combinations, allowing them to customize their drink specifically for them. The quality of our offerings will always be our top priority and a point of differentiation for us.

As an innovator, we are always looking at our products to ensure we remain ahead of the curve. Now, while that’s not new for Starbucks, in the spirit of that effort, I am proud to say that during the first quarter, we made significant advances with the introduction of zero grams trans fat food offerings in 50% of our U.S. Company-operated stores. We are working with our regional bakers to move closer to our goal of offering food with zero grams trans fat in 100% of our U.S. Company-operated locations. We are also actively engaged with our licensed store partners and are aiming to have all licensed stores in the U.S. hit the zero trans fat gram target as well.

Internationally, we are making great strides in reducing trans fats in multiple markets. For instance, in both Canada and China we expect to see substantial reductions in trans fat content this year. Providing our customers with quality products that meet their needs is just one way we fuel ongoing revenue growth within our retail business.

Our winter promotion also embraces this health and wellness direction by bringing back a customer favorite from last year, Cinnamon Dolce Latte, and providing the option for our customers to order it as a sugar-free beverage. Additionally, we are featuring two new whole grain pastries: Five-Fruit Banana Muffin and Reduced Fat Cinnamon Chip Mini Loaf.

Following our winter promotion, we have an exciting Spring campaign commencing in early April built around a celebration of the Latin American culture. We will feature innovative new beverages and pastry items along with some of the finest Latin American coffees.

Before I close, I would like to touch on an important aspect of the Starbucks brand: our coffee procurement practices. They are built around our commitment to pay premium prices for high quality coffee, which not only serves the short- and long-term economic interests of coffee farmers and suppliers, it also serves Starbucks needs by creating an incentive for farmers to improve quality and increase production. That in turn contributes to a more sustainable supply of the high-quality coffee we depend on to support future growth in our business and in shareholder value.

Looking forward, we continue to believe we have a long runway for future growth. This growth opportunity is largely due to the hard work, dedication and support of all of our partners throughout the organization. With that in mind, in the first fiscal quarter, we implemented a broad-based wage increase for our hourly U.S. and Canadian retail partners, which represents the majority of our employee base. And in the second quarter, we are increasing wage rates for our store management team.

The work environment and benefits Starbucks provides its partners are very important to us, and it appears that those efforts have been recognized and are appreciated by our partners. Recently Starbucks was recognized for the 9th year as one of FORTUNE Magazine’s “100 Best Companies to Work For.” Starbucks ranked number 16 this year and we were one of only three companies with more than 100,000 employees that made the list. In fact, Starbucks has more partners than the top nine rated companies combined. This recognition is a testament to the value of Starbucks culture.

With that, I’d like to turn the call over to Howard.

Howard Schultz

Thank you, Jim, nice job. Before I review our International business, I’d like to take a minute to update you on Starbucks literary initiatives in our U.S. retail stores. As you know, in early October, Starbucks announced the integration of books into our overall Entertainment offerings. Our first selection was a novel by best-selling author Mitch Albom entitled For One More Day. Starbucks stores alone sold more than 92,000 copies through the beginning of January, which demonstrates the significant role our stores now play as a nontraditional bookseller.

This successful entry provided us encouragement to introduce another title, A Long Way Gone, to be featured in our retail stores. Beginning in early February, we will introduce first-time author Ishmael Beah who tells a powerful story of hope and redemption from the perspective of a child soldier’s rare first-hand account of fighting as a boy in the war-torn country of Sierra Leone.

This is an inspirational memoir and we believe introduces millions of our customers to quality entertainment that not only supports new and emerging talent but also provides customers the opportunity to discover and discuss relevant new literary works.

Additionally, for every copy of A Long Way Gone in Starbucks stores that we sell, we will donate $2 to the United States fund for UNICEF, with a minimum donation of $100,000. UNICEF helps children around the world overcome obstacles of poverty, violence, disease and discrimination. UNICEF played a key role in the rehabilitation of Mr. Beah, and their mission aligns with our commitment to support communities in which we operate.

Now turning to our International business. Overall, International performance was driven by rapid retail store expansion and strong revenue and comparable store sales growth. International opened a record 223 stores during the quarter. Our international expansion has been driven by a focus on the core elements that create the Starbucks Experience for people around the world.

We have been very mindful of launching into new markets, choosing business partners that provide significant business expertise and have similar values. As we’ve done numerous times in the past, we increase our equity ownership in markets where it makes good business sense.

Our experience in some of our established international markets continues to show us there is more potential than we originally believed possible. For example, Mexico and the Philippines are two great examples of markets that have surprised us in their acceptance of the Starbucks brand and their capacity for more stores in more cities. We opened in Mexico only four years ago and today there are 116 Starbucks stores in that country, which means that we’ve opened an average of nearly 30 locations a year.

As for the Philippines, this was a market whose capacity we initially estimated at approximately 25 stores, yet here we are providing the Third Place experience in more than 100 stores, and still expanding.

Experiences like this make us highly confident that we will be able to meet our long-term goal of at least 20,000 locations in International markets.

Our commitment to Starbucks growth around the world is evidenced by continued strong store openings and market expansion. During the first quarter of fiscal 2007, our International team continued their focus on respectfully building out existing markets, as well as opening locations in new markets and delivered a record number of new store openings, including two new countries: Brazil and Egypt.

Entry into these two countries had their own special significance: the rich Brazilian coffee culture was an attractive and natural fit for Starbucks, and the opening of Egypt represents our first entry into Africa. Both of these new market openings were greeted with an enthusiastic reception from these communities and the stores are doing very well in these initial months.

Turning to China, as you know this market is a top priority for us as we believe it can ultimately be one of our largest markets outside of the United States. I ended the calendar year with another visit to that country and while I was there, I visited numerous stores, our Greater China Support Center in Shanghai, and hosted several partner forums. I also delivered keynote addresses at three prestigious Universities: Shantou, Fudan and Beijing University to speak to business school students to both seed the brand with this important audience and, most importantly, to recruit some of the sharpest, youngest minds to come to work for Starbucks.

You may recall we began fiscal 2007 with the acquisition of a 90% interest in our Beijing operations. We are very enthusiastic and ready to take this market to the next level. Now, with managing control, we are able to begin utilizing some of our own infrastructure investments we’ve put in place over the last year to lead the Greater China market in building a consistent operating platform and delivering legendary service to our customers. We see many unique opportunities to further enhance the Starbucks Experience in Beijing in preparation for the Summer Olympics in 2008.

We remain on track and very enthusiastic about our plans to enter Russia. We will open in that market with our long-time Middle Eastern partner, M.H. Alshaya. We first established a partnership with them in 1999 when we entered Kuwait, and we have since continued to build out additional markets in the region with them. Customers in Moscow will have the opportunity to enjoy the Starbucks Experience this calendar year.

And as we’ve discussed with you in the past, we see great opportunities for Starbucks stores in India. We remain optimistic that we will be able to open doors to the first Starbucks location in India as well by the end of calendar 2007.

We are excited about the potential in all these new markets and look forward to the upcoming store openings.

In summary, on our International presence, we now have 3,767 stores in International locations. We still have a lot of growth ahead of us to reach our ultimate goal of 20,000 stores in International markets, and we are well on our way to hitting our aggressive store opening target for this fiscal year. This is just another affirmation of the tremendous global opportunity that Starbucks has around the world.

Beyond store expansion, some of you may remember that during our last quarterly conference call we spoke about the immediate success that we had at the launch of the Starbucks Card in the U.K. I just want to spend a few minutes talking about that. In fact, the Starbucks Card introduction resulted in such strong customer demand that we needed to place an emergency rush order on more cards during the first week of the launch.

I am happy to say that the success of the card continued through the holiday season with approximately 112,000 activations and nearly 50,000 reloads since the card was introduced during mid-November, which represents more than $3.8 million in activations and reloads in just over six weeks.

This is especially exciting for us because it wasn’t long ago, as Jim mentioned in his remarks -- five years, in fact -- that Starbucks became a market leader with the introduction of the Starbucks value card concept in the United States. Since then, stored value cards have become increasingly popular throughout a wide variety of consumer businesses.

We have introduced a platform that can now be used across borders in the U.S., Canada, Greece, Australia, Thailand and the U.K., and beginning next month, we will add Hong Kong to that list with our planned launch of the Global Starbucks Card.

We have experienced the success of the Starbucks Card in the U.S. where it has created a loyal following. In fact, customers who use the Starbucks Card in the U.S. have told us that they visit our stores more frequently, spend more each time they visit and overall are more pleased with Starbucks after using the Card. We truly feel this same sentiment will travel very well to our International markets, especially with the introduction and expansion of the global card.

This platform gives Starbucks the opportunity to capture a wider base of loyal customers around the world and this is another way to make our Starbucks customers feel at home when they travel and are away from their local Starbucks.

As I look back on our results for the first quarter, I am confident that we have set the foundation for another solid year for Starbucks. I am very proud of the accomplishments we’ve made during this quarter. The energy and passion I see throughout the Company on a daily basis truly inspires me and our partners and proves that our wage increase for our store partners was an appropriate priority, and I think once again shows the conscience and soul of the Company. Respected, valued, passionate partners working for our company impart that feeling to our customers, which we believe allows us to continue providing legendary service around the world and in turn delivers long-term shareholder value.

Our dedicated partners make Starbucks what it is today: a growth company with a globally recognized and respected brand. There continues to be a tremendous appetite, both internally and externally, for the growth and development of our company internationally, and to me, it’s greater and clearer than ever before.

As I look ahead, I am confident that we have the ability to deliver on both our short-term and long-term aggressive international growth targets.

With that, I will turn the call over to Michael Casey, who has got a bad cold, so bear with his hoarse voice.

Michael Casey

Thank you, Howard. During today’s call, I will provide additional detail on some of the significant factors impacting our financial performance for the first quarter and share with you my observations on the quarter as well as our outlook for the remainder of the year.

Jim already recapped our 22% top line revenue growth and 6% comparable store sales results for the first quarter, so let me move directly to the consolidated operating income, which increased 14% to $320 million for the 13 weeks ended December 31, 2006, from $280 million in the prior year. As expected, operating margin decreased from a record 14.5% in the prior year to 13.6%, primarily due to higher cost of sales including occupancy costs and higher store operating expenses as a percentage of total net revenues. Partially offsetting those higher costs were lower general and administrative expenses.

The increase in cost of sales including occupancy costs was driven by higher rent expense, a shift in sales to higher cost products and increased distribution costs. Store operating expenses increased primarily due to the investment in our U.S. and Canadian store partners through a wage increase. We are partially funding these wage increases through the October 2006 price increase and our decision not to hold a leadership conference this year, which was originally planned in the second quarter.

Training and leadership development continue to be a priority for us, however we believe we can support those efforts through other initiatives in fiscal 2007. We carefully prioritize investments in our business to ensure we are optimizing the benefit to the business, and believe allocating funds to our valued store partners in the form of wage increases was the best investment to make.

General and administrative expenses decreased primarily due to higher charitable contributions in the first quarter of fiscal 2006 and higher provisions for incentive compensation due to exceptional performance in the prior year.

These items were partially offset by increased payroll-related expenditures and higher professional fees in support of our continued global growth and systems infrastructure development in the current year. Also of note, G&A expense as a percent of total revenue for the quarter was at a historical low level, a result of strong revenue growth and controlled spending during the period.

And finally, earnings per share were $0.26 in the first quarter of fiscal 2007, compared to $0.22 per share for the comparable period in fiscal 2006, an increase of 18%.

Turning now to our first quarter highlights from our operating segments. Beginning in the fiscal fourth quarter of 2006, as reported in our 10-K, we are now reporting a third segment, the Global Consumer Products Group, in addition to the United States and International segments. Segment information for the first-quarter of the prior year has been restated to reflect these changes.

Please note that we will provide comparable segment information for fiscal years 2005 and 2006 in mid-February. Until then, keep in mind that all previously published quarterly financial results reflect the Company’s prior operating segment reporting structure.

Let me begin with the U.S. operating segment. Total net revenues increased by 20% to $1.9 billion for the first quarter of fiscal 2007. The opening of 928 new company-operated retail stores in the last 12 months, and comparable store sales growth of 6% for the quarter, led to growth in Company-operated retail revenues of 21% to $1.7 billion for the quarter. The increase in comparable store sales was comprised of a 3% increase in the number of customer transactions combined with a 3% increase in the average value per transaction.

U.S. specialty revenues grew by 13% to $200 million in the first quarter. Within specialty revenues, licensing revenues increased 18% to $113 million, primarily due to higher product sales and royalty revenues from the opening of 758 new licensed retail stores in the last 12 months.

Food service and other revenues increased 7% to $86 million, due mainly to the addition of new accounts and growth in existing accounts.

U.S. cost of sales including occupancy costs as a percentage of total revenues increased to 39.3% compared to 39.0% in the comparable period a year ago, primarily due to a shift in the sales mix to higher cost products, higher rent expense and increased distribution costs. The increase in rent expense was due to the acceleration in our new store development pipeline, as we have increased the number of stores under construction incurring rent expense, and to several less significant factors.

The impact from a shift in sales reflects a growing percentage of sales from food in the past year, as we have expanded the number of stores offering lunch and, to a much lesser degree, expanded the Warming program. At the end of the first quarter, lunch was offered in 69% of our U.S. Company-operated retail stores compared to 59% a year ago.

Finally, increased distribution costs were primarily the result of higher fuel costs as well as expense associated with additional consolidated distribution centers to support our growing store base.

Store operating expenses grew primarily due to higher payroll expenditures as a result of a wage increase for the Company’s hourly store partners. Investment in our valuable store partners through a wage rate increase was a top priority for the Company as we entered the new fiscal year and, with our continued aggressive growth in retail stores, as evidenced by the record number of store openings in the quarter, the investment in our future store leaders is also critical.

As I mentioned earlier in my comments on the consolidated results, we took proactive steps to help offset the rising store operating costs with our October 3, 2006 beverage and whole bean price increase in our retail stores. We also made the decision not to hold the leadership conference planned for 2007 to redirect those costs toward the wage increase.

Additionally, we have sharpened management focus on more effective store labor deployment through closer adherence to our standards, and we started to see the benefits as the first quarter progressed.

U.S. operating income increased to $325 million during the quarter from $298 million during the same period in fiscal 2006. The operating margin decreased to 17.5% of related revenues for the first quarter of fiscal 2007 from 19.3% for the first quarter of fiscal 2006, which was a record high for the U.S. operating margin.

Now moving to the International segment. International total net revenues increased 32% to $405 million in the first quarter of fiscal 2007. International Company-operated retail revenues increased 35%, to $347 million in the first quarter of 2007, mainly due to the opening of 249 new Company-operated retail stores in the last 12 months, comparable store sales growth of 8% for the quarter, and favorable foreign currency exchange for the British pound sterling and Canadian dollar.

The comparable store sales increase resulted from a 6% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction.

International specialty revenues for the quarter increased 20% to $59 million, primarily due to higher product sales and royalty revenues from opening 432 licensed retail stores in the last 12 months and growth in new and existing foodservice accounts.

Operating income for International operations was $33 million in the first quarter of fiscal 2007 compared to $34 million in fiscal 2006. The operating margin decreased to 8.2% of related revenues from a record first quarter level of 10.9% in fiscal 2006. This decrease was primarily due to higher cost of sales including occupancy costs.

Higher cost of sales including occupancy costs was primarily due to accounting corrections totaling $3.4 million, and to rising energy and fuel prices driving utilities rates and distribution costs higher.

Now let’s move to our newest operating segment, the Global Consumer Products Group, or CPG as we commonly refer to it. Jim already provided an overview of the components of this business. However, before I review the results from this segment, let me briefly explain the unique economics of this business as compared to our U.S. and International segments.

CPG is a very profitable business for Starbucks. As you can see from the segment financials, this operating unit has much lower revenues than our U.S. and International segments, yet it contributes strong profits to the enterprise. A significant portion of this business is leveraged through our business partnerships with great companies such as Kraft, Pepsi, and others. These relationships allow us to leverage our partners’ existing infrastructures and extend the Starbucks brand in an efficient way, resulting in a very modest cost structure within the Starbucks income statement.

Additionally, our joint venture partnerships, such as with Pepsi, are included on a net basis within the income from equity investees line, with no related revenue.

Now to review this segment’s results for the first quarter of fiscal 2007. CPG total net revenues increased 13% to $91 million in the first quarter of fiscal 2007. This increase was driven mainly by volume growth in the U.S. and International packaged coffee business through licensed grocery and warehouse club channels. I should point out that this 13% year-over-year revenue growth is compared with exceptionally strong sales for the first quarter of fiscal 2006, which benefited from production declines experienced by other coffee brands resulting from Hurricane Katrina.

Operating income for CPG was $42 million in the first quarter of fiscal 2007 compared to $43 million in the first fiscal quarter of 2006. The operating margin decreased to 45.8% of related revenues from 52.9% in fiscal 2006, primarily due to higher cost of sales, lower income from equity investees and higher other operating expenses.

Cost of sales increased primarily due to the mix of revenues in the quarter. Our sales into Kraft Foods’ distribution system does not directly align with their sales to the customer, which sometimes creates a timing shift between quarters in our recognition of associated revenue.

Income from equity investees declined primarily as a result of lower sales volumes for the Starbucks Ice Cream Partnership as well as the North American Coffee Partnership, which produces Starbucks ready-to-drink beverages, as previously mentioned.

In addition, other operating expenses increased primarily due to higher marketing expenditures in support of further development and expansion of ready-to-drink beverages in the Asia-Pacific region, where we first came to market in late fiscal 2005.

During the first quarter of fiscal 2007, Starbucks repurchased 3.6 million shares of common stock for a total cost of $130 million, and reduced the outstanding balance on our credit revolver by $335 million to $365 million outstanding. Our solid balance sheet, continuing strong cash flows and borrowing capacity allow us to continue to fund the growth of our existing business, selectively invest in new growth opportunities, such as our recent acquisition of 90% ownership in our Beijing operations, and opportunistically repurchase shares.

Before reviewing our full-year targets, I would like to point out four very positive indicators of ongoing strength coming out of the first quarter.

Number one, record quarterly store openings demonstrates the strength of our store development capabilities and the continued customer demand for Starbucks locations, both domestically and in international markets. In the first quarter, we achieved 30% of our full-year store opening target.

Number two, total net revenue growth of 22% and comparable store sales growth of 6% validates our ambitious targets.

Number three, we continued to make strategic investments in our business while delivering 18% earnings per share growth over strong growth in the first quarter of last year.

And four, for the consolidated business we controlled general and administrative expenses at a record low percent of revenue.

On the other side of the ledger, we have two specific opportunities to improve our performance, which I would like to share with you.

As our U.S. retail business evolves and our product offerings expand, we are experiencing a shift to a greater mix of food in our stores. This places some pressure on gross margins when compared to our highest margin products, beverages. Yet, the impact to the U.S. operating margin is mitigated by lower operating expenses associated with food than beverages.

Historically, we have seen our food programs improve in the second year of operations and beyond as we better understand our customers’ needs and are able to adapt our product mix and offerings. The Warming program is no exception.

We have mentioned numerous times that our International business is subject to unevenness in margin performance among periods, which is driven by investment opportunities that may arise during any given quarter. We continue to see strong customer demand internationally and we are investing to ensure we can meet that demand and appropriately support both new and expanding markets. Over time, we expect to get leverage from these investments.

Finally, as you probably know, dairy prices took a dramatic rise as we entered the second fiscal quarter, and based on what we are seeing today, we believe they will continue to be volatile and unfavorable through the remainder of our fiscal year. We have taken this impact into account in our full-year targets.

Looking ahead to the balance of fiscal 2007, we continue to be very confident in our ability to achieve our aggressive growth targets for the year. We are on track to hit our store opening targets for the year, entering the last three-quarters of fiscal 2007 at an accelerated pace.

Average unit volumes in our retail stores continue to be strong. Investment in our future growth engine, the International business, will be ongoing since we are still in the early stages of growth for that business.

As Howard noted earlier, our increase in equity ownership in Beijing is just one example of how we are opportunistically building out that market as part of our long-term growth strategy in International markets.

And for our consolidated business, we expect favorable store operating expense comparisons starting in the second quarter, and we expect modest improvements in operating margin in the second half of the fiscal year.

Turning now to our fiscal 2007 targets: we continue to target opening approximately 2,400 new stores on a global basis. In the United States, we plan to open approximately 1,000 Company-operated locations and 700 licensed locations. In International markets, we plan to open approximately 300 Company-operated stores and 400 licensed stores.

We continue to expect total net revenue growth of approximately 20% and comparable store sales growth in the 3% to 7% range.

We now expect the effective tax rate to be approximately 37% for the full fiscal year, with quarterly variations. This is a decrease from our previously stated full-year estimate of 38%, due in part to increased effectiveness of the Company’s long-term tax planning strategies.

And we continue to target earnings per share in the range of $0.87 to $0.89, based on first quarter results and our current outlook for the balance of the year which, among other things, factors in the impact of rising dairy costs and the favorable impact of a lower effective tax rate.

As stated earlier on the call, our first half performance in fiscal 2006 was particularly strong, making for a more challenging comparison.

With that, I would like to ask the Operator to queue the first question. Please ask one question at a time and re-queue for additional questions.

Question-and-Answer Session


(Operator Instructions)

Your first question comes from Larry Miller.

Larry Miller - Prudential Equity Group

I just have a question about the cost of sales, Michael, if you could help me understand that better. It sounds like, if I’m hearing you correctly, that there are some inefficiencies as you are rolling out lunch, and that might be a bigger impact than say the mix shift from adding food. Could you help me dimensionalize what might actually be going on behind that line and what we could expect going forward, when you might lap the bulk of the lunch rollout? Thank you.

Michael Casey

I think you’ve hit on a good point, in that in the beginning of our food program, and I think this was true of lunch here several years ago and warming today, we’re not as efficient as we are once we’ve lapped ourselves in various markets. But as far as cost of goods sold is concerned, I don’t think it’s a major influence.

The major factor in the cost of goods sold is in the occupancy line and in the overall mix toward the food business, not particularly the lunch or warming is excessively inefficient. It’s just that there’s more food in the mix than there was before, and the food products have a lower gross margin than the hand-crafted beverages.


Your next question comes from Glen Petraglia with Citigroup.

Glen Petraglia - Citigroup

Good afternoon. Could you maybe comment on the increased wage rates that you’ve put in place? Should that in any way imply that you’re having a harder time finding qualified employees in this low unemployment environment? Thanks.

James L. Donald

Not at all. We continually look at our wage rates throughout the world, I would say, and we are constantly using this to benchmark against other companies in the industry. We want to become, we want to remain ahead of what we consider to be our competition and actually look at paying a rate that retains and attracts.

We didn’t see any of this happening to create this. We did this because of what we were hearing from some of our partners. What we do is when our partners are bringing up issues, we listen to what they say, we put down the effort and the time to get to the root of the problem, and we saw some opportunities.

We in no way though did this as a reaction to what was happening in the market, but rather to be proactive in getting this out and, again, addressing the concerns of our partners.

But our turnover and our attrition has remained constant for the most part for the last four to five years.


Your next question comes from John Glass with CIBC.

John Glass - CIBC

Thanks. I wanted to ask about the wage increase as well. Could you compare the relative size of the manager wage increase, which I think you talked about in this quarter, the second quarter, versus the increase you did last quarter? Does the lack of the leadership conference, does that cover it for a quarter or does that cover the wage increase for the balance of this year? How long is that benefit, that offset take place? Thanks.

James L. Donald

The wage increase for the managers is significantly less than the wage increase for the hourly, because there’s just so many more hourly employees than there are managers.

With regard to the leadership conference, that helps offset the impact of the wage increase in the second quarter, but only in the second quarter. Going forward, we expect the benefit to, we expect the offset to come from the price increase, as it did in the first quarter, and as we continue to be more efficient with our labor force going forward.

Howard Schultz

I want to add one thing. This historically, for those of you who have followed the company for many years, I think there has been a direct correlation and relationship to our ability to build long-term value for our shareholders while building long-term value for our people.

I think one of the reasons why we’ve continued to do as well as we have is because the people who represent the company to our customers every day have a high degree of trust and confidence in the intent of Starbucks to do the right thing.

As Jim said, it wasn’t the pressure of our inability to attract the right person. It’s being proactive and recognizing we’re asking our people to do more, the marketplace is getting more competitive in the future and we want to stay ahead of the curve. We also want to demonstrate to our people that we are in the business of taking care of them as well as our shareholders.


Your next question comes from Jeffrey Bernstein with Lehman Brothers.

Jeffrey Bernstein - Lehman Brothers

Thank you. Just a question on the overall G&A expenses. Obviously you experienced tremendous savings on that line on an absolute dollar basis as well as a percentage basis, looking like it’s down below 5%. I know you mentioned benefiting from charitable contributions last year, incentive compensation last year. I’m just wondering if you could talk about your outlook for that line item going forward. Would you expect similar significant savings in coming quarters, or would this quarter be more of an anomaly and not sustainable going forward? Thanks.

James L. Donald

The year-over-year absolute dollar decline was due primarily to the exceptional items that weren’t in that line item last year. But as a percentage of sales, we can expect it to be well-controlled and favorable through the remainder of the year as a percentage of sales.

Remembering that the first quarter is always the lowest percentage. The subsequent quarters are a little bit higher, but on a year-over-year basis, we’re expecting leverage in the G&A line throughout the year.

Jeffrey Bernstein - Lehman Brothers

As we have seen over the last year.

James L. Donald

Yes, as we have generally seen over the last several years.


Your next question comes from Howard Penney with Prudential Equity Group.

Howard Penney - Prudential Equity Group

Thanks very much. Howard, years ago you basically successfully killed the hopes of any potential competitor from becoming a national coffee company, and really it’s unlikely that there will ever be another company that’s as successful as Starbucks, has the brand awareness, financial resources that Starbucks has. Having witnessed other companies that run into troubles with continued aggressive growth targets, I would like to hear your response on two things: one, how do you prevent the natural pitfalls of aggressive growth targets leading to larger organizations, and again, knowing that you’ve sort of -- there isn’t really anybody out there doing what you’re doing today on the scale that you’re doing, why do you continue to push the limits of growth and maybe focus a little bit more on profitability and reallocating some dollars towards those markets where there really is some huge potential, China, Russia and what not? Thanks very much.

Howard Schultz

That’s a lot of question, Howard. Let me try and answer that this way. First off, I think that we have been public since 1992, and I think no matter what year you examine the company, we have been an aggressive growth company going after unique opportunities. I think very few people early on believed that we could have 1,000 stores, let along 13,000 today and going to 40,000.

But clearly the size of the prize is much bigger than we ever imagined. The reception that we have garnered around the world in country after country is more enthusiastic than we had originally planned.

So we’re sitting with one of the world’s most recognized and respected brands, with a concept that is as relevant around the world as it is in Seattle or your hometown, and a demand for the product from customers that we believe it is our responsibility to take advantage of.

I think candidly, one of the challenges that we have had over the years, which continues, which we’ve talked about both internally and externally is how do you get big and stay small? How do you maintain trust with your people, trust with the customer, and how do you provide a company in which the brand is not defined by size or scale but by one customer, one cup of coffee and one partner at a time? I think we’ve done that.

Specifically to your question about -- this is not an either/or situation. I think we have managed to create a balance between significant growth and development, and at the same time, demonstrating profitability in multiple channels of distribution as well as now our international business.

I don’t think we’re trading off one for the other. In fact, I think we’re doing things that demonstrate that we can do both and we’ve done both for over a decade now. But I think the short answer is the opportunity is larger than we originally thought. The acceptance we’ve gotten around the world is significant, and we’re continuing to take advantage of it and we think that’s our responsibility, both to our shareholders and our people.

If there ever was a situation where we felt the growth was doing to dilute the integrity of the brand or prevent us from creating long-term value for our shareholders, we would slow it down or stop it. That has not been the case, so we’re in a unique position, domestically and around the world, and these are still the early days for the growth and development of Starbucks and we want to take advantage of it and we’re well-positioned to do it because we’ve made the investments over the years ahead of the growth curve.


Your next question comes from Sharon Zackfia with William Blair.

Sharon Zackfia - William Blair

Good afternoon. I wanted to touch a little bit on the labor deployment. I’m curious, as you try to become more efficient with labor in the stores, how you balance the risk of slowing down customer through-put and how you monitor that?

James L. Donald

Sharon, that’s exactly what that is, is the balance. When we look at labor deployment we, through out scheduling means as well as our own intuition, schedule for the business hours that are at their peak. In addition to that, we make sure that at those peak times, that the deployment occurs where the bottleneck is. So it’s not something that you just rubber-stamp out. It’s different by week, it’s different by month, it’s different by quarter, it’s different by store. So every store manager has the say and the authority to bring in or to possibly reduce at a certain hour or bring them back in in the evenings.

It’s done on a store-by-store, market-by-market basis.

Howard Schultz

Sharon, congratulations on becoming a partner of the firm.


Your next question comes from Matt DiFrisco with Thomas Weisel Partners.

Matt DiFrisco - Thomas Weisel Partners

Hi. Either Howard or Jim, if you could just answer this question, regarding as you’re getting larger and exposing yourself or trying to garner a greater demographic, how do you view now the price value equation and your ability to take price on, not only the beverage products but also things that might not be direct core items, such as food? Is there an opportunity there? If you need that, do you think that’s a lever that could be used greater in ’07 if there were a national minimum wage increase or greater labor pressure?

James L. Donald

Regardless of our size, we’re mindful of what we want to do on taking price. We’ve only taken two price increases since I’ve been here in 2002, and in both cases, one was commodity driven back in 2004, and while we did see some slight commodity increases in ’06, we were also helping what the first question was about, take advantage of the ability to help offset some of the increases for our partners.

But we don’t take price increases with a grain of salt and we want to make sure that when we do this, there is a reason to justify the means.

Howard Schultz

I would just add that I think if you look at the landscape of consumer brands at retailers and restaurants, I think we’d all be hard-pressed to find many companies that have been able to take price and maintain the customer relationship and profile. So the pricing power of Starbucks has remained because the loyalty and trust that people have in the experience of the brand, we take the responsibility of price increases very carefully and judicially.

We think there are other ways in which we can gain leverage in the future, and want to use price as a last resort. Having said that, we recognize that there are sometimes fewer opportunities, and in this case we took one this year basically to pay for the wages.

Michael Casey

I would just add, there seems to be sort of an implication about profitability. I would just add that double-digit pre-tax profit, approximately 25% return on equity and a top-line growth in excess of 20% is a better formula than passing up some of the opportunities that are being presented to us on a daily basis in order to increase that pre-tax margin by a percentage point or so in the short-term.


We have time for one more question. Your last question comes from Ashley Woodruff with FBR.

Ashley Woodruff - Friedman, Billings, Ramsey Group

Thanks. I have a question on the higher occupancy expense. Is that simply a function of pre-opening holiday rent that you have to expense, and so that should kind of taper off as you open more stores? Or is that a function of opening stores at a more accelerated rate and having to pay more for sites, or not being able to negotiate the same rent deals as in the past?

James L. Donald

It’s not the latter, it’s the former. There have been a couple of changes in the situation versus let’s say a couple of years ago. One, we have accelerated our opening schedule, so we have more stores at any given time that are in the construction process. For example, at the current year, we have over 700 stores at one point in time or another in construction, or in the process of construction during the first quarter.

Including as an example the fact that we acquired about 60 stores from Barney’s in Florida earlier in the year and we were carrying those stores during the process of construction as they were being converted to Starbucks stores.

So there’s more regular stores, there’s the Barney’s acquisition, and then there’s the change in accounting that took place about a year or so ago where historically, if you had a 10-year lease and 10 years worth of rent, you’d expense it over the 10 years. Now, we’re required to expense rent from the date of possession, so when we take possession of a property, it may be two months before it opens, we’re now expensing the rent during that period in time when historically, we weren’t. So that makes a difference too, and it’s exacerbated by the fact that we’ve accelerated development and we’ve done some strategic, multi-unit acquisitions for conversion.

Thank you all very much. We look forward to seeing you, talking to you next quarter.

JoAnn DeGrande

We’ll talk to you again on our fiscal second quarter 2007 webcast on May 2, 2007. Thanks for joining us.


This concludes today’s Starbucks first quarter earnings conference call. You may now disconnect.



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