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Starbucks Corporation (NASDAQ:SBUX)

F2Q07 Earnings Call

May 3, 2007 5:00 pm ET

Executives

JoAnn DeGrande - Investor Relations

James L. Donald - President, Chief Executive Officer

Michael Casey - Chief Financial Officer, Executive Vice President

Howard Schultz - Chairman of the Board

Martin Coles - President, Starbucks International

Analysts

John Glass - CIBC

Ashley Woodruff - Friedman, Billings, Ramsey Group

Joseph Buckley - Bear Stearns

Jeffrey Bernstein - Lehman Brothers

Steven Kron - Goldman Sachs

Matt DiFrisco - Thomas Weisel Partners

Larry Miller - RBC Capital Markets

Glen Petraglia - Citigroup

David Palmer - UBS

John Ivankoe - J.P. Morgan

Presentation

Operator

Good afternoon. My name is Celeste and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks Coffee Company’s second quarter fiscal 2007 financial results conference call. (Operator Instructions) Ms. DeGrande, you may begin your conference.

JoAnn DeGrande

Thank you. Good afternoon, ladies and gentlemen. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company. With me today are Howard Schultz, our Chairman; Jim Donald, President and CEO; and Michael Casey, Executive Vice President and CFO.

During today’s call, Jim will review key results and accomplishments for the second quarter, and provide some highlights from our three business segments. Michael will discuss results and key drivers for the period. 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 800-641-1687, reservation number 4132464, through 5:30 p.m. Pacific Time on Thursday, May 10th, and on the investor relations page at Starbucks.com through 5:00 p.m. Pacific Time on Thursday, June 7th.

In addition, today’s remarks will be available on the investor relations portion at starbucks.com by the end of the day and will remain available through Thursday, June 7th.

This conference call includes forward-looking statements about trends and/or expectations regarding store openings, comparable store sales, net revenue, earnings per share, 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 SEC, 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 would like now to turn the call over to Jim Donald.

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James L. Donald

Thanks, JoAnn. Good afternoon, everyone. Starbucks’ second quarter financial performance demonstrates our success in achieving a balance between driving solid top and bottom line growth while expanding globally and enhancing our brand with new offerings, which we feel are complementary to our core business and accretive to our bottom line.

We are very pleased with our financial results for the second quarter, especially in light of the fact that we were up against last year’s exceptionally strong second quarter.

Today, we reported: net revenues of $2.3 billion dollars, up 20% from the same period in fiscal 2006; net earnings were $151 million dollars, up 18% from the second quarter of fiscal 2006; Earnings per share were $0.19, up 19% from the same period of fiscal 2006; new store openings continued at a strong pace, as we opened 560 stores during the second quarter, bringing our total to 13,728 locations in 39 countries. We continue to see significant opportunity in store development both domestically and internationally.

We delivered comparable store sales growth of 4% for the quarter, 1% transaction and 3% ticket. Our two year comparable store sales growth was 14% for the second quarter.

Our focus remains on growing our business by providing our customers the traditional coffeehouse offerings they’ve come to expect, from Starbucks handcrafted espresso beverages to seasonal and promotional offerings.

We’ve also built and continue to grow a platform of food and merchandise that complements our coffee and enhances our customers’ overall experience. Premium coffees, handcrafted espresso beverages, prepared lunches, warm breakfast sandwiches and carefully selected entertainment options delivered with exceptional service all create that special Starbucks Experience for our customers.

Starbucks has the unique ability to leverage its business by building a total customer experience both inside and outside of our stores. We have done this with products like Bottled Frappuccino beverages here in the U.S. and Discoveries, our ready-to-drink product in Japan and Taiwan, as well as with music, film and most recently, literature.

We will continue to explore ways to enhance our customers’ experiences and create long-term shareholder value, all while remaining mindful of our core -- premium coffee.

April 1st marked the midpoint of our fiscal year and our solid first half results position us well to reach our ambitious fiscal year 2007 growth targets.

Let’s take a look at what contributed to our financial results, beginning with the U.S. business.

In the U.S., we’re continuing our track record of opening stores where our customers want us to be and offering products that match consumer needs. U.S. Company-operated retail revenue growth of 18% for the quarter was led by the addition of 1,042 new Company-operated stores in the last twelve months and comparable store sales growth driven by sales of both our seasonal and core handcrafted beverages, and by our expanded food offerings.

The 3% comparable store sales growth recorded for the quarter was driven by ticket and represents very solid growth when you consider it comes on top of last year’s incredibly strong second-quarter comparable store sales growth of 10%.

Let me give you a brief recap of what was happening in our stores during the quarter. The introduction of the Cinnamon Dolce Latte last year was one of the most successful new promotional beverage offerings in Starbucks history. So this year, we built upon the popularity of the Cinnamon Dolce Latte by introducing a version made with sugar free syrup, which was met with strong customer acceptance.

In addition, food provided a greater contribution to overall sales. We rolled out our lunch program to 250 more Starbucks locations this past quarter, providing added convenience to our customers, which translated into strong revenue contribution and an increase in average check. We now offer lunch at more than 4,400 Starbucks stores in the U.S., about 70% of our U.S. Company-operated locations.

Moving on to our warmed breakfast offerings, during the second quarter we brought warming to approximately 500 more stores, giving us a quarter-end total of more than 1,700 stores. We entered three new markets -- Los Angeles with 136 stores, Boston with 94 stores and Fresno with 59 stores.

Similar to our lunch program, we are pleased with the customer acceptance and with the revenue generation that warming provides. We remain enthusiastic about this program and plan to continue an aggressive rollout to more stores in the U.S. in the future. As a result, we expect to have warming in nearly half of our U.S. Company-operated stores by the end of fiscal 2007.

Now let me give you a brief snapshot of our spring promotional campaign that features beverages, food, unique merchandise and in-store marketing to build a complete customer experience focused on Latin America.

As you may know, Latin America is a very important region of origin for Starbucks and one that has a rich coffee culture. This promotion celebrates that coffee culture with the flavors of Latin America in our beverages, select bakery offerings, CDs and unique merchandise created by exceptional artists from Costa Rica. Early indications are that this holistic approach to the promotion is resonating with our customers and is adding fun and excitement in the stores for our partners.

As we look ahead, expansion in the U.S. continues to drive the need for increased roasting plant capacity. By the end of the year, we expect to break ground on a new roasting plant in South Carolina. This would be Starbucks’ fourth roasting plant in the U.S. and fifth plant worldwide. The South Carolina roasting plant will support the southeastern part of the U.S. and is scheduled to begin operation in early 2009.

Before I move on to International, I’d like to recap some highlights from our Music and Entertainment business during the quarter. As we have said in the past, Starbucks has a unique place in the daily lives of our customers. Our stores serve as a gathering place where people come to share a sense of community and connection over a cup of coffee. This makes our stores an ideal channel to present our customers with music, movies and literature that are complementary to their lives and to the Starbucks Experience.

This quarter, our Music and Entertainment business recognized many successes, from the sales of A Long Way Gone, which landed on the New York Times Bestseller list and ultimately hit number one, to the sale of the DVDs Happy Feet and Will Smith’s Pursuit of Happyness to selling 10% of Nora Jones’ national new CD release, Not Too Late, which has sold, by the way, more than 1 million copies.

We believe that the Starbucks environment lends itself well to presenting our customers with these relevant forms of entertainment, and the success of this platform speaks for itself.

I’d like to turn to the International business, starting with some observations from my trip to China last week. During my trip, I attended the Boao Forum for Asia. This annual conference provides an opportunity for more than 1,300 official delegates from government leaders to top corporate executives to industry experts to discuss the economic growth and the development of Asia.

I’m happy to say that today, I am even more excited about our opportunities in China than I was in the past. I also participated in the opening celebrations for our first regional support center in Guangzhou and the opening of our 500th store in the Greater China Region.

The most striking observation to me was how well our stores in China are executing on the Starbucks experience. Our partners are doing a wonderful job delivering high quality beverages and providing legendary service. I was also impressed by the level of commitment our partners had to their local communities, really helping to make Starbucks not only a destination in the communities but an integral part of those communities.

Because of these factors, Starbucks is continuing to see strong acceptance from our customers in China. In fact, when I was behind the counter at one of our stores, I heard a familiar accent. I looked up, I introduced myself to the customer and she was from Long Island. She asked to take a picture with me back to Long Island to put it in her Starbucks store. Now to me, this is proof that Starbucks truly is the third place for our customers, somewhere that’s comfortable for them when they are far away from home.

Turning to the second quarter results, it was another strong sales period for our International business. International Company-operated retail revenues were $327 million dollars, up 32% from the same period in fiscal 2006.

Continued rapid expansion of our global footprint and strong comparable store sales growth combined to deliver outstanding revenue growth in the International segment. We introduced the Starbucks experience to thousands of new customers. We opened 147 new stores during the quarter, bringing our store count outside the U.S. to nearly 4,000 locations in 38 countries. And we delivered comparable store sales growth of 7% -- 5% transaction, 2% ticket.

Our second-quarter results also demonstrated that we are still very much in a growth phase with this business, which requires substantial investment to build the foundation for the future.

If we take a look at the two largest markets contributing to our International retail revenues, the U.K. and Canada, the key drivers behind sales for the quarter were a combination of hand-crafted espresso and tea beverages, as well as food items.

Looking forward, we recently opened our first store in Bucharest, Romania, marking our entry into Central Europe. We also recently announced that through our relationship with HMS Host, we plan to open Starbucks locations in the airports in both Copenhagen and Amsterdam, our first entries into Scandinavia and The Netherlands respectively.

We are excited about the opportunities in all of these new markets and this is just another affirmation of the tremendous global prospect for Starbucks.

As we have said numerous times, our International business represents the future growth engine of the Company and we will continue to invest ahead of the curve to build the infrastructure and foundation for our growth, on the way to our ultimate store target of at least 20,000 stores outside the U.S.

I want to shift from International to our Global Consumer Products business, and remind everybody that that spans both the U.S. and International.

For the second quarter, Global CPG reported net revenues of $79 million dollars, due in part to sales of Discoveries, the line up of ready-to-drink beverages in Japan, which continue to climb, nearly tripling in unit volume year-over-year. The growth was fueled by expanded distribution to additional cities, including Osaka and Nagoya. During the quarter, we launched a third Discoveries flavor in Tokyo -- Qandi, which is a caramel flavor.

Looking ahead, the expansion of our packaged coffee distribution through our partnership with Kraft into Canada and the U.K. has taken off at a fast clip and we see additional expansion opportunities ahead. The availability of Starbucks packaged coffee in grocery stores will allow coffee-lovers in these markets to enjoy the authentic great taste of Starbucks coffee in the comfort of their own homes.

I’d like to discuss some accolades that Starbucks has recently received. In combination with our solid financial performance and the strength of our commitment to our guiding principles, several prestigious organizations, including Business Ethics, Fortune Magazine, DiversityInc, Financial Times and the U.S. Environmental Protection Agency, recognized Starbucks during the quarter.

Our awards ranged from Business Ethic’s “100 Best Corporate Citizens” to Fortune Magazine’s “2nd Most Admired Companies in America” to ranking 6th in the “Top 25 Green Power Partners,” by the U.S. Environmental Protection Agency. Coming off our recognition last quarter as one of Fortune’s “Best Companies to Work For,” this quarter Starbucks was recognized in the U.K. and Mexico as one of the “Five Best Places to Work”, coming in at number two in Mexico after only five years in operation.

Additionally, we recently climbed a remarkable 13 spots and were ranked as one of the “World’s Most Valuable Brands” by Millward Brown, one of the world’s leading research companies that evaluates companies based on their marketing, their media and their brand performance. This type of recognition would not be possible without the support of all of our dedicated partners.

Before I close and turn the call over to Michael, I wanted to mention the upcoming arrival of our CFO designate, Pete Bocian. Pete will be joining Starbucks in the next few weeks and will work closely with Michael through the end of the fiscal year. We are very excited to have Pete on board and we look forward to introducing him to the financial community in the near future.

So in summary, we are pleased with our second quarter results and we are also pleased to have two of the most difficult quarterly comparisons in the Company’s history behind us. We believe that in addition to our ultimate goal of 40,000 stores worldwide, we can extend the brand to best-of-class products and present Starbucks in terms of new channels of distribution that no other retailer has done before.

We also know that although we are a coffee company, we also have the license to do things beyond coffee because of the trust around the experience and the Starbucks brand. Our long-term strategy, level of execution and passion are all elements that make this company sustainable.

I believe that these things will help our brand endure the test of time. Starbucks will be recognized not only for creating shareholder value, but also for creating a company that our customers, our partners and our shareholders will continue to be proud of.

As we enter the second half of the fiscal year, we will continue to focus on our core business and driving solid execution at all levels, and believe we are well positioned to reach our ambitious fiscal year 2007 growth targets.

With that, Michael will now review our financial results for the quarter. Michael.

Michael Casey

Thank you, Jim. Today I will begin by providing additional detail on some of the significant factors impacting our financial performance, followed by an outlook for the second half of the fiscal year.

As reported, consolidated top line growth was 20%, with 4% comparable store sales growth for the second quarter, both consistent with our targets.

Consolidated operating income increased 19% to $241 million for the 13 weeks ended April 1, 2007 from $202 million in the prior year. As a percentage of total net revenues, operating margin at 10.7% was equal to last year’s second-quarter margin, halting three consecutive quarters of year-over-year declining operating margins.

Higher cost of sales, including occupancy, were offset by both lower store operating expenses and lower general and administrative expenses as a percentage of total revenues.

The increase in consolidated cost of sales including occupancy costs as a percentage of total revenues was driven primarily by rising costs in the U.S. business. I will cover the main drivers behind these rising costs in my U.S. business segment remarks.

Consolidated store operating expenses and general and administrative expenses as a percentage of total net revenues decreased, primarily due to higher provisions in the prior year for incentive compensation based on exceptionally strong performance.

Consolidated earnings per share were a strong $0.19 in the second quarter of fiscal 2007, compared to $0.16 for the comparable period in fiscal 2006, an increase of 19%. I mentioned the strong $0.19 earnings per share because it caused the year-to-date earnings to round to $0.46, which is a penny more than the sum of the first and second quarters’ EPS results.

Now let me move to second-quarter results from our operating segments.

Beginning with the U.S. operating segment, total net revenues, which account for approximately 79% of consolidated total net revenues, increased by 19% to $1.8 billion in the second quarter of fiscal 2007.

Company-operated retail revenues rose 18% to $1.6 billion for the quarter, driven by the opening of 1,042 new Company-operated retail stores in the last 12 months, and comparable store sales growth of 3% for the quarter. The increase in comparable store sales was due to a 3% increase in average value per transaction.

U.S. specialty revenues grew by 23% to $194 million in the second quarter. Within specialty revenues, licensing revenues increased 29% to $105 million, primarily due to higher product sales and royalty revenues from the opening of 768 new licensed retail stores in the last 12 months.

Foodservice and other revenues increased 17% to $89 million mainly due to the addition of new accounts and the growth in existing foodservice accounts.

U.S. cost of sales, including occupancy costs, as a percentage of total revenues increased to 39.6% compared to 37.7% in the comparable period a year ago. This was primarily due to the following: first, a shift in sales to food and merchandise, which are higher cost products than beverages; second, higher rent expense due to an increase in both average square footage per store and cost per square foot, driven primarily by growth in higher priced real estate markets; and third, increased distribution costs related to our growing store base and the expansion of our food programs.

U.S. store operating expenses improved to 41.0% of related Company-operated retail revenues in the second quarter of fiscal 2007 from 42% in the prior year, primarily due to higher provisions a year ago for incentive compensation based on exceptionally strong performance in fiscal 2006. However, there continued to be higher payroll expenditures in 2007 as a result of the Company’s October wage increase for hourly store partners and, to a lesser degree, the second-quarter wage increase for our store management partners.

U.S. operating income increased to $268 million during the quarter, from $231 million during the same period in fiscal 2006. Due to the cost pressures I just mentioned in cost of sales and occupancy, operating margin decreased to 15.0% of related revenues for the second quarter of fiscal 2007 from 15.3% a year ago.

Now moving to the International segment. International total revenues, which account for approximately 17% of consolidated net revenues, increased 30% to $387 million in the second quarter of fiscal 2007. International Company-operated retail revenues increased 32% to $327 million in the second quarter of 2007, mainly due to the opening of 237 new Company-operated retail stores in the last 12 months, comparable store sales growth of 7% for the quarter, and favorable foreign currency exchange for the British pound sterling.

The comparable store sales increase resulted from a 5% increase in the number of customer transactions, coupled with a 2% increase in the average value per transaction, demonstrating the health and strength of our International retail business, which bodes well for the future.

International specialty revenues for the quarter increased 21% to $60 million, primarily due to higher product sales and royalty revenues from the opening of 456 licensed retail stores in the last 12 months and growth in new and existing foodservice accounts.

Operating income for International operations was $21 million in the second quarter of this year compared to $19 million in fiscal 2006. The operating margin decreased to 5.5% of related revenues from 6.5% in fiscal 2006. This decrease was primarily due to higher other operating expenses and general and administrative expenses as a percentage of total net revenues. Growth in both of these categories was driven by increased payroll-related expenditures to support continued growth and systems infrastructure development. We continue to invest in people and systems to position the business to capture the significant global opportunity in front of us.

In the second quarter, this included increased investments in emerging markets such as China, as well as for more established, yet still growing markets such as the U.K. and Europe, and increased spending for global store development capabilities in support of rapid international store growth.

As we have said previously, our ongoing investments in international infrastructure can be expected to cause variability in quarterly operating margins.

Now let me move on to our third business segment, the Consumer Products Group. CPG total net revenues, which account for approximately 4% of consolidated total net revenues, increased to $79 million in the second quarter of fiscal 2007. This was due mainly to increased product sales and royalties in our International ready-to-drink business, partially offset by decreased shipment volumes in the U.S. to Kraft, our distribution partner for packaged coffee and tea.

Note that sales of packaged coffee and tea from Kraft to grocery retailers actually grew during the quarter over the prior year, but lower inventory levels throughout the U.S. distribution system resulted in lower shipment volumes. These movements in inventory levels throughout the system are normal and can cause variability in quarterly CPG revenues.

Operating income for CPG of $38 million for the second quarter was unchanged from the same period a year ago. The operating margin decreased to 47.8% of related revenues from 48.6% in fiscal 2006, primarily due to higher other operating expenses.

The increase in other operating expenses was due to higher marketing expenditures to support continued expansion of ready-to-drink beverages in the Asia-Pacific region. Partially offsetting the increases in other operating expenses was higher income from equity investees, attributable to our ready-to-drink beverage business in the U.S.

Over the years, we have achieved strong growth and profitability from our CPG products in the U.S. and we are enthusiastic about the strong early results as we introduce these products into markets outside of the country.

Turning now to a brief review of our year-to-date results, our consolidated operating income increased 16% to $561 million in the first half of this year from $482 million in the first half of last year. Operating margin was 12.2% compared to 12.6% in the first half of last year, which was the highest operating margin ever reported by the Company for the first six months of a fiscal year. Net earnings rose 18% during the first half of the fiscal year, earnings per share increased 21% and we opened 1,288 net new stores.

We are pleased with our financial performance in the first half of the year, given the tough comparisons from the prior year. This positions us well as we enter the second half of the fiscal year when we expect modest year-over-year operating margin improvement primarily in the fourth quarter, despite the recent increase in dairy prices.

Now for a few comments on the Starbucks balance sheet. During the second quarter of fiscal 2007, Starbucks repurchased 14.3 million shares of common stock for a total cost of $465 million under authorized share repurchase programs. Along with the 3.6 million shares repurchased in the first quarter, the total spent on share repurchase through the first half of this fiscal year was $594 million.

Even more noteworthy, since the inception of Starbucks’ initial authorized share repurchase plan in 2001, the Company has returned over $3 billion to shareholders through the repurchase of 120 million shares.

And on May 1, with 1.1 million shares available for repurchase under the previous authorization, the Board of Directors authorized the repurchase of up to 25 million additional shares.

In late March 2007, Starbucks established a commercial paper program, which allows the Company to issue unsecured commercial paper notes, up to a maximum aggregate amount outstanding at any time of $1 billion. This program is a cost effective alternative to the Company's borrowings under its revolving credit facility, and does not change the overall borrowing capacity.

At the end of the fiscal second quarter, the outstanding balance on the Company’s credit revolver was $847 million and there were no outstanding borrowings under the commercial paper program. Following quarter end, borrowings have begun through the program, which are effectively re-financing earlier borrowings under the credit facility.

Starbucks’ solid balance sheet, continuing strong cash flows, and borrowing capacity allow us to continue to fund our operations, selectively invest in new growth opportunities and opportunistically repurchase shares.

Let me now recap for you the key highlights of our fiscal second quarter: we achieved very strong results in the quarter, especially considering the extremely difficult prior year comparisons.

Operating margin was equal to last year’s record Q2 margin, halting operating margin declines the previous 3 quarters. Building on the strengthening operating margin in Q2, we expect modest improvement in operating margin over the balance of the year, despite the more challenging cost environment we face, particularly in the areas of labor costs and dairy.

We continue to experience very strong growth internationally, both in retail stores and in CPG, boding well for the future growth and profitability and underscoring the huge opportunity Starbucks has around the world

We continue to successfully execute our aggressive growth plans in the U.S. and overseas, adding 560 stores in the quarter and 1,288 for the first 6 months of this fiscal year, and 2,503 in the last 12 months.

In summary, we are achieving our growth and earnings targets, trending toward improving operating margins, and rapidly expanding the Starbucks brand in the U.S. and around the world.

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 continue to target earnings per share in the range of $0.87 to $0.89, based on results from the first half of our fiscal year and our current outlook for the balance of the year which, among other things, factors in the impact of rising dairy costs.

With that, I would like to ask the Operator to queue the first question.

Question-and-Answer Session

Operator

(Operator Instructions)

Your first question comes from John Glass with CIBC.

John Glass - CIBC

Thanks. Your traffic in the U.S. was flat I think probably for the first time ever, or at least in a long time. I am wondering if you could address that. I understand tough comparisons but we have seen those before in the company’s history.

I guess specifically, you’ve got this warming and breakfast program now which I would think would maybe offset some of those tough comparisons, drive more customers into the store. Can you talk about is that then your experience, or is that more of a substitution purchase?

Maybe also could you talk about what else happens when they purchase a sandwich -- do they buy a smaller drink or the same size drink? Is it changing the dynamic of other purchases as well? Thanks.

James L. Donald

John, we are seeing some incremental pick-up with the purchase of a warming sandwich, but by and large, we have seen a headwind in previous years, but as Michael stated, the headwind last year on 10% comps and the transaction growth that we experienced with that was a primary driver. It is not a weather issue. We had pockets of the stores throughout the U.S. that actually were shut down, but the primary driver of that was the headwind of the strong tropical sales growth last year.

John Glass - CIBC

And just your view on if breakfast sandwiches do actually add traffic to the store versus just the ticker?

James L. Donald

Traffic, traffic to ticket, and we are seeing incremental beverage too, but we are seeing and one of the reasons that we continue to be very bullish on our warming sandwich is that, I think Michael and I can give you an example. In New York just last year, we are seeing customers that before we put warming in were coming to our store with a warming sandwich from another venue, and so we are seeing us capturing that customer all in one fell swoop, so we are seeing that continue to generate transaction.

John Glass - CIBC

Thank you.

Michael Casey

John, just for a data point, we had 8% transaction growth in our U.S. retail stores in the second quarter of last year.

John Glass - CIBC

Thank you.

Operator

Your next question comes from the line of Ashley Woodruff with FBR.

Ashley Woodruff - Friedman, Billings, Ramsey Group

Thanks. Actually, a follow-up on that question. You said the reason for the flat traffic is really the more difficult comparison. I guess as you look out over the rest of the year, comparisons do get easier. Are you optimistic that you can start to positive traffic growth again, or is this a trend that we should look for more growth coming from check rather than traffic?

James L. Donald

The overall comparable guideline, we are very comfortable with the 3% to 7%, and there is nothing more to say other than that we think we will be in that 3% to 7% growth range. Michael, did you have anything to add to that?

Michael Casey

I’ll just add that of the 3% average ticket increase that we have had, about 1.5% of that is from the price increase that we took, but the other 1.5% is from the attachment of things like music, food, et cetera, so it is contributing to the same-store sales and the growth of the business.

Operator

Your next question comes from the line of Joseph Buckley with Bear Stearns.

Joseph Buckley - Bear Stearns

A follow-up on that again; just on the breakfast sandwiches, and I realize it is not driving your whole system, but the markets where you have it, is your traffic up in that morning day part, or is this an add-on sale that to your point, Jim, customers are buying their food at Starbucks as opposed to somewhere else?

James L. Donald

No, Joe, the traffic is up in those markets. We are seeing an increase in transaction count.

Joseph Buckley - Bear Stearns

Okay, and just one more question on G&A. Obviously pretty well controlled, very well controlled again in the quarter. Tell us how we should think about it going forward. Is it plateau-ing here? Because in prior year investments, and -- is it likely to stay very well-controlled or is it plateau-ing here and likely to start ramping up again sometime soon as you grow?

Michael Casey

I think you should reasonably expect that the G&A is going to continue to grow with the business, but it is going to grow at a slower rate, such that as a percentage of revenue, it will continue to decline, as it has over the last four or five years.

I also think you can expect to see a shift in the G&A from -- in previous years, we’ve built G&A in the U.S. business unit and in our corporate headquarters. More recently, the growth has been in our international business as we develop those markets and it has been very tightly contained, as you can tell from the segment reporting in our U.S. business and in our headquarters operations.

Joseph Buckley - Bear Stearns

Thank you.

Operator

Your next question comes from the line of Jeffrey Bernstein with Lehman Brothers.

Jeffrey Bernstein - Lehman Brothers

Thank you. Just a follow-up, actually, on Michael’s comments earlier about the strong balance sheet. We have been hearing from a more mature restaurants concepts taking on leverage to generate value, especially if stock is sitting at more depressed valuations. Obviously Starbucks is still clearly in the growth stages and investing heavily across the globe, but I am just wondering if there is an opportunity to take on some leverage, perhaps a more aggressive share repurchase? Obviously it was aggressive this past quarter, but that or other means of returning capital. I’m just wondering if you could talk about the uses of cash and the opportunity for more aggressive use of the balance sheet. Thanks.

Michael Casey

Our priorities are very clear, that our first priorities are to satisfy the operational requirements of our business, the maintenance of our existing storage, the growth of new storage, purchase of equity in our international licensees when those opportunities present themselves.

And after that, we have -- and support operations like IT infrastructure and the new roasting plant that we will be building here in the next year or so. And then after that, we consider the possibility of share repurchase and we have done that quite aggressively over the last few years.

We have a fairly extensive capital structure and financial framework review and concluded we are way too early in our growth cycle to consider any different kind of use of the balance sheet.

We have no intentions to leverage up the balance sheet for more aggressive share repurchase.

Jeffrey Bernstein - Lehman Brothers

Thank you.

Operator

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

Steven Kron - Goldman Sachs

Great, thanks very much. A couple of questions, actually; first, on the margin line, it seems like on the store operating expense and on the G&A line year over year, you’ve had some benefit from just lapping higher incentive compensation. Just a question for you, Michael. As we get to the back half here and we are expecting margin expansion again and the comps are going to be a little bit easier on a year-over-year basis, might we expect that incentive compensation on a year-over-year basis will start to pick back up?

Michael Casey

I don’t think so. Not to the level that it was last year. We continue to accrue incentive compensation through the first half of this year, just not at the elevated levels that were associated with the outstanding performance last year. But we expect to have a normal incentive compensation accrual through the remainder of this year.

Steven Kron - Goldman Sachs

Okay, and then if I can just ask a question on the international business, given certainly the increased international store growth and the impressive comps that you guys have been able to post there, I was wondering if you could just provide us a little bit more granularity on maybe regional strength -- what markets are really driving the 7% comp this period and the 8% in the prior period?

Michael Casey

It is really overall, and we’ve made a point not to all out individual markets for comp store sales growth, but just to name two that are very significant due to their size, the U.K. has been very strong and Canada has been very strong. We have had strength in the rest of our business as well, but those have been the drivers because of the strength of the comp and the size of the market.

Howard Schultz

Just a little color on the U.K., when we introduced the Starbucks Card in the U.K., and I think this bodes well for other international markets as well, we had a very similar response to the card from our U.K. customers that we had in the early stages of our U.S. business, and we saw a lift in business since that card has been launched.

I think again it demonstrates that there is a very similar way in which customer behavior responds to the Starbucks experience outside of North America and that Starbucks Card continues to be a very important marketing tool, customer loyalty tool. And the more we learn about how to use that card effectively with our U.S. business, the more effective it is going to be in leveraging the learning outside, and the U.K. is a great example.

I also want to mention we just are getting ready to open up our 700th store in Japan as well. If you look around the globe, despite the large numbers in Japan and the U.K., there isn’t any market in the world that we are approaching anything close to market saturation, so as we look around, despite the fact that we are getting ready to open up before the end of the calendar year, other new markets, there is just so much opportunity for us in the markets that we are in. As we mentioned in the prepared text, China with its 500th store continues to be a very, very large prize for the company and we are in literally the embryonic stages of what we believe is going to be an enormous opportunity for our company and long-term for our shareholders.

Steven Kron - Goldman Sachs

Thanks a lot.

Operator

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

Matt DiFrisco - Thomas Weisel Partners

I have a question, but first a bookkeeping request; can you give us the comp broken out by domestic and international from 2Q of ’06, and then just tell us what you have upcoming in 3Q?

Michael Casey

In the second quarter -- in the third -- you want the second quarter of ’06?

Matt DiFrisco - Thomas Weisel Partners

Yes, second quarter of ’06 and 3Q as well.

Michael Casey

In the second quarter of ’06, the total company comp was 10%. The U.S. same-store sales growth was 10%, and the international same-store sales was 9%. That is Q2 of ’06.

Matt DiFrisco - Thomas Weisel Partners

Okay, and then can you tell me what 3Q is, what we have coming up that we are going to be lapping now?

Michael Casey

Yes, the total same-store sales growth was 6%, the U.S. was 9%, and international was 6%.

Matt DiFrisco - Thomas Weisel Partners

Okay. My question is with respect to the margins on the domestic side of the business, if I look at the overall basket, is it more of I guess the decline in the last two quarters, is it reflective of selling more food that might be coming out to be lower margin, or your comp just being a lower margin comp, or is it more so, or is there a productivity thing where maybe the new stores, the higher rent and you are yet to get the full volume off of that rent? So maybe the new store productivity is falling off a little bit, which would be the bigger reason for the margin decline.

Michael Casey

I think the biggest reason is cost pressures. It is cost pressures in the area of wages, where we have invested in the wages of both our hourly and our management partners, and external pressure such as fuel and distribution charges, more so than any of the three things that you mentioned.

Matt DiFrisco - Thomas Weisel Partners

Can you give us what your wage rate increase was in the quarter?

Michael Casey

It was between 4% and 5%.

Matt DiFrisco - Thomas Weisel Partners

Thank you very much.

Operator

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

Larry Miller - RBC Capital Markets

Michael, just to back up, my records show that you had a 6% comp in the third quarter in the U.S. and a 7% international. I think you might have said 9% in the U.S. Is that correct, a year ago?

Michael Casey

That’s what I said.

Larry Miller - RBC Capital Markets

Okay, sorry, I thought you might have said 9%. I had a question around dairy. Obviously dairy prices are rising --

James L. Donald

Hold on, hold on.

Michael Casey

I did say 9%. I could be wrong but the sheet that I’m reading says it was 6% consolidated, 9% in the U.S., and 6% in international in the third quarter of last year. Okay, so maybe my sheet is wrong.

Larry Miller - RBC Capital Markets

I don’t think that’s right, because you’d be closer to 9% then.

Michael Casey

Yes.

Larry Miller - RBC Capital Markets

I guess you can clarify that later.

Michael Casey

In any case, it’s in last year’s press release, and we can all look at it.

Larry Miller - RBC Capital Markets

I have 6 and 7, U.S. - international. I just want to ask about dairy costs. They are obviously rising right now. In the past, I think maybe in ’05 you hedged, you had a swap on dairy. Are there any thoughts of doing that if dairy prices were to keep rising?

Michael Casey

We did a very small, very small hedging operation with regard to dairy about 18 months ago, but we couldn’t get sufficient interest from a counter party to make it be significant for us, and so that never amount to more than about 5% of our dairy usage, and it’s trailed off. We are looking at other alternatives but we don’t have one that I would say is likely in the immediate future.

Larry Miller - RBC Capital Markets

Thanks very much.

Operator

Your next question comes from the line of Glen Petraglia with Citigroup.

Glen Petraglia - Citigroup

Thanks. Howard or Jim, I’m curious to know what you guys think is the greatest challenge as you try to continue to grow in the U.S., let’s call it high-teens to 20%. What are the greatest challenges that you face in trying to achieve that growth, and perhaps what sort of things might we see at the store level over the course of the next six to 12 months that might potentially reinvigorate transaction growth at the U.S.?

Howard Schultz

First, I wouldn’t extrapolate one month of flat transaction growth as the endpoint or conclusion that anyone should reach on this. If you look at the long history of Starbucks, transaction growth has been high single digits and we’ve had low single digits, and so this is one quarter, one period.

As we look forward, specifically at the U.S. market and the opportunities that we have, we maintain our optimism and our belief that we are still in the early stages of the growth in terms of units. Certainly we’ve said that by publicly saying that we believe that we can ultimately have close to 20,000 stores or more and we are not even close to that today, but in terms of the next six to 12 months specifically, I think we’ve done a fairly good job in preparing for the summer, given the issues we faced last year.

I think operationally, we’ve really taken a step back and looked at all the things that we faced last year and we are well-prepared, from an operational focus, and I think our food and beverage team have done a marvelous job in getting ready for innovative ways in which we are going to expose the market to new flavors. So we are prepared for a good summer.

And then, as we look to the fall and Christmas, those plans have been completely in place now for a while. We have some exciting things coming that I can’t share with you on the phone today, but we feel really kind of locked and loaded for the summer, the fall and Christmas, and feel like we are in a very good place.

I think if you look at, if you take away from the quantitative issues just for a moment, the thing that strikes me about this quarter that I think is interesting that perhaps we are not discussing too much, is we get into the book business and we take a book that was going to have a printing of 9,000 copies before we get involved. It’s a story that is a very tough story about a child soldier, and that book goes to number one two out of the last three weeks at the New York Times specifically because Starbucks became a market maker. It is not unreasonable to really look at us as a market maker on products and services. I think it demonstrates the unique power that we have in the marketplace from a brand position when we get behind something. And perhaps most importantly, the unique level of trust and confidence that our customers have.

I think specifically how that goes back to your question is we are examining lots of ways around coffee and our core business that we can leverage that trust around innovation and really build positions for the company that no other company can get close to because of the heritage and tradition. And then we are looking at day part more closely than ever before, unique products and services for those day parts that we feel in the past that we have not really focused on in terms of segmentation.

In short, this is kind of a long-winded answer, in short we feel really poised for the second half of the year to take advantage of the things that the summer, fall and Christmas season should provide us.

James L. Donald

The only thing I would add to that is that as we go through quarter by quarter, actually month by month, quarter by quarter, we take a step back from each of these areas and we see and put our diagnostics skills on things we do well and things we don’t do so well. I am sure one of the questions that are sitting out there is as we prepare for summer, what are we going to do different than we did last year? As we went through the summer selling season with cold-blended beverages, we talk about we had a bottleneck, if you will, in the a.m. due to an unusually large request of this product during that time period.

In order to continue to grow our business each and every day, just like we did then, we took a step back as soon as the season ended, we took a look at all of our stores, small and large volume stores, got the best practices on the cold-blended side of what these stores were doing, both in deployment of hours as well as the ergonomics, the flow, if you will, of the line-up behind the counter, and then we look at increasing the number of the cold beverage stations as well.

So that is just one example of the -- not difficulty, but the way we look at this business to continue to get and be in the range that we talk about each and every quarter.

Glen Petraglia - Citigroup

Thanks.

Operator

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

David Palmer - UBS

Thanks. A question on international; you mentioned with regard to that segment that you are reinvesting in the infrastructure, which sounds a lot like building the pipeline. I wonder -- I know it’s early to be talking about fiscal ’08 and beyond, but this year you are I think 75% or so of your unit growth is domestic, and I’m wondering if you could characterize if that percentage is going to be somewhat more international weighted next year, particularly with company stores?

Michael Casey

I think in the relatively near future, the weighting is going to shift toward international, but it is not going to be rapid, mainly because we expect to continue to grow at a very rapid rate in the U.S. and we have the organization to do that.

International is a little bit like chasing a moving train. While those numbers are increasing, the U.S. business is going to continue to build stores and open new markets at a very rapid rate. So there will be a shift but it will be gradual.

David Palmer - UBS

Just a separate question; on the breakfast sandwiches, I’m wondering how much of the drag on margins is really from the rollout and early adoption phases of these sandwiches, and how much of it is really just from the fact that you are selling more of these as a percentage of your overall sales? The reason I ask is because you are going to start to lap the initial rollout -- in the next one or two quarters, you started them rolling out last year, and I’m wondering if that might provide some margin relief, or if we are just going to continue to see margins on the cost of sales line go the wrong way through fiscal ’08 as you roll these out?

Michael Casey

You raise a good point. The margin impact at the gross margin level, it will be fairly permanent. There is no question that the food and the merchandise, which we are building that business, has a lower gross margin than the handcrafted beverages, so there is a piece there that is somewhat structural, and a few tenths of a percent of revenue.

On an overall basis, however, as we get more stores and get more skilled at running the warming program and continue the refinements of the lunch program, there should be some relief in operating margin as a result of those two programs becoming more mature and we’re more skilled at rolling them out.

James L. Donald

We’ve lapped areas now.

Michael Casey

Yes, that’s a good point, Jim. We’ve lapped several markets and in those markets, we can see a definite year-over-year improvement in the warming program. But we also measure warming individually and in each market and it is contributing and it is producing a very satisfactory store level margin.

David Palmer - UBS

Thank you. That’s helpful.

Operator

Your next question comes from the line of John Ivankoe with J.P. Morgan.

John Ivankoe - J.P. Morgan

Thanks, just a couple of quick ones; the first is actually on store pricing in the U.S. Many companies take pricing when they think their structural costs have gone up. Most of the world is in an inflationary commodity environment, inflationary labor environment. Could you make your comments on pricing as you begin to think about lapping over the current 1.5%-plus that you have in the stores now?

Howard Schultz

We have no plans to increase prices at this time and don’t believe that would be appropriate.

John Ivankoe - J.P. Morgan

Okay. Second comment, we’ve been hearing a lot in the last two weeks about some geographic weakness, specifically in markets like California and Florida. I’ve seen you do very well in certain economies.

Howard Schultz

Where did you hear that? Other Starbucks or other companies?

John Ivankoe - J.P. Morgan

Other companies.

Howard Schultz

I’m sorry. I thought you said it was us.

John Ivankoe - J.P. Morgan

In the last couple of weeks, a number of restaurant companies have mentioned it on their calls. Are you seeing any type of geographic trend that is interesting in the last few months like that?

James L. Donald

Not anything that’s interesting. Nothing to show a cause for concern. It’s pretty consistent around geographic region to geographic region.

John Ivankoe - J.P. Morgan

Okay, and the final question, Howard, maybe this will take more than a couple of seconds to answer, is on China. Certainly we look at the overall consolidated results and they do speak for themselves in terms of what your revenue growth is and what have you, but what can you provide us with, either qualitatively or quantitatively, in terms of how the China market is going for you and how rapidly perhaps you can grow it in the future and how meaningful you might think it could be to the global business in the next -- pick the number of years, three to five years.

Howard Schultz

I’ll start and Jim can pick up because he just returned last week from China. We have said almost very consistently throughout the last year or so that as we look around the world, like many other western companies and consumer brands, that China ultimately could potentially be the second-largest market in the world for Starbucks.

I think perhaps the main point that we can provide today is, which we couldn’t do three or four years ago, and maybe even 18 months ago for that matter, is just the level of acceptance and perhaps the right word would be the relevancy of the Starbucks experience in China.

Depending on what number you believe, there is north of 200 million Chinese people and that number’s growing, who we believe are the core customer today for Starbucks. I think what we’ve been able to do is make sure that as we enter China and continue to do business there that we do not become a fad that becomes hot and then all of a sudden is out of favor, but most importantly that we integrate our company, the experience, and Starbucks’ values into the lifestyle of the Chinese consumer and the behavior of how our customers are using the place.

I think what’s probably most important is that not only have we achieved relevancy and success in the two most important major cities in Beijing and China, but now in I think 17 provinces, we have demonstrated throughout China and South China that Starbucks is going to be successful throughout greater China, and that includes Hong Kong and Taiwan.

And so the foundation we are building in terms of infrastructure, the investments we’ve made, both in a Chinese-centric team based on China, as well as people with five and 10 and 15 years tenure from Starbucks U.S. that have moved to China, that we believe that this is going to be a big pay-off for the company at some point, and we are positioned as well as or perhaps better than most U.S. and western consumer brands that will be accepted and build a major business in China.

I can’t give you the numbers because I think over time, not unlike the mistake we made early on in America, we underestimated the size of the market. We are trying not to do that. We are dreaming very big in China. We are investing heavily ahead of the growth curve.

I think from a shareholder perspective, this is really going to pay off because this is a very, very big prize and we think we are going to achieve it.

John Ivankoe - J.P. Morgan

How many stores are you opening a year now in China?

Howard Schultz

I’m looking to Michael to see if he’s going to let me tell you the number. I think that the number that we have internally is about 100. If you look at the history of Starbucks, I think the one thing that you can really look at is that we have really under-promised and over-delivered when it’s come to store count.

James L. Donald

To that point, as I sat and talked to the Mayor of Guangzhou, and this is in southern China, and looked at that whole quarter of Shenzhen, Guangdong, and Guangzhou, I told the mayor that there is the potential of doubling those stores over the next 18 months to two years, and he said that’s not fast enough, and he told me areas that quite frankly surprised me, and we look at it.

And the only reason I bring that up from a shareholder perspective is that when we go to these countries, when the government is asking us to become more of a part of the communities, when the customers at this conference that I was at talk about the Starbucks experience and talk about the ability to customize a beverage, it’s the place to go. It tells me that we are well on our way.

But its’ the combination of, as Howard said, investing ahead of the curve not only in infrastructure and people, but also in the communities that we are in because now we’ve become “please come in and help us and we’ll in turn give back to you”, so it’s really a great formula and it’s a combination that’s working.

Michael Casey

Just one more point to make on that, in the last six months or so, we’ve gained operational control of the Beijing market, which will allow us to have greater influence over the growth rate in that market. And in the last 12 months, we’ve gained operational control in southern China and we have geared up both of those markets for more rapid growth than they’ve experienced just six or 12 months ago.

Howard Schultz

Martin Coles, the President of Starbucks International, is in the room and I think he wanted to just add something to your question about China.

Martin Coles

Just for perspective on the new store growth, in China currently we are opening for every, for all of our international store count, roughly 20% of that count is actually new stores being opened in China. We expect there to be around 200 stores open in China during fiscal 2008 and I think again, looking forward, roughly 20% of our new store count will be in China.

JoAnn DeGrande

Operator, that concludes the call for today. Before we shut down, I would like to just clarify the comps from last third quarter of fiscal ’06, if I may please, back to an earlier question. The consolidated comp was 6%, the U.S. comp was 6%, and international was 7%, so I apologize for the error.

Thank you all for joining us today. We hope you will join us again. Next quarter we have our third quarter fiscal ’07 financial results due to report on Wednesday, August 1st. Thank you very much.

Operator

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

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