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Starbucks Corporation (NASDAQ:SBUX)

F3Q07 Earnings Call

August 1, 2007 5:00 pm ET

Executives

JoAnn DeGrande - IR

Jim Donald - President, CEO

Martin Coles - COO

Michael Casey - EVP, CFO, Chief Administrative Officer

Howard Schultz - Founder and Chairman

Analysts

Jeffrey Bernstein - Lehman Brothers

Matthew DiFrisco - Thomas Weisel Partners

Ashley Woodruff - FBR Capital Markets

Larry Miller - RBC Capital Markets

Steven Kron - Goldman Sachs

David Tarantino - Robert W. Baird

John Glass - CIBC World Markets

Sharon Zackfia - William Blair

Glen Petraglia - Citigroup

Joe Buckley - Bear Stearns

Andrew Barish - Banc of America

Presentation

Operator

At this time, I would like to welcome everyone to Starbucks Coffee Company's third quarter fiscal 2007 financial results conference call. (Operator Instructions). Ms. DeGrande, you may begin your conference.

JoAnn DeGrande

Thank you. Good afternoon. This is JoAnn DeGrande, Director of Investor Relations at Starbucks Coffee Company, and with me today are Jim Donald, President and CEO; Martin Coles, President of Starbucks Coffee International and Chief Operating Officer; Michael Casey, Executive Vice President and CFO.

During today's call, Jim will review key results and accomplishments for the third quarter and provide some highlights from our U.S. and CPG business segments. Martin will review the performance of our international operations and Michael will discuss results and the key drivers for the period. Chairman Howard Schultz will participate in the Q&A 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 4132558 through 5:30 pm Pacific time on Wednesday August 8, and on the Investor Relations page at Starbucks.com through 5 pm Pacific time on Friday, August 31. In addition, today's remarks will be available on the Investor Relations portion of Starbucks.com by the end of the day and will remain available through Friday, August 31.

This conference call includes forward-looking statements about trends and/or expectations regarding store openings, comparable store sales, net revenue, earnings per share, effective tax rate, operating margin, cost of sales, including occupancy costs 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 risk 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 to turn the call over to Jim.

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Jim Donald

Thanks, JoAnn. Good afternoon everyone. Starbucks' third quarter performance demonstrates continued success in achieving a balance between driving strong top line growth, rapidly expanding our global reach, and delivering solid bottom line performance in a challenging environment. Our fundamentals remain strong in the investments and the steps that we're taking will maintain our momentum and continue to prepare us for the future.

We began to quarter of the year laying the groundwork for fiscal 2008 and beyond with a management realignment that will further bolster our operational focus in preparation for future growth, which I will discuss in greater detail later in the call. Michael will discuss our fiscal 2008 targets, which we believe demonstrate our ongoing confidence in the future of our business.

Let's take a look at the consolidated results for the third quarter of 2007. Today, we reported net revenues of $2.4 billion, up 20% from the same period in fiscal 2006; operating income of $245 million up 14% from a year ago; earnings per share of $0.21 compared to $0.18 a year ago, and we delivered comparable store sales growth of 4% for the quarter, a 3% increase in the average value per transaction and a 1% increase in transactions.

New store openings continued at a robust pace as we opened a third quarter record 668 stores, bringing our total to 14,396 locations in 42 countries. Included in this total is the opening of the 500th store with Seattle's Best Coffee location. This milestone reflects how Starbucks can successfully grow complementary platforms that reach a broader customer base.

It's important to note that even with more than 14,000 locations worldwide, we still see significant store development opportunity, both domestically and internationally. Going forward, we are committed to achieving a balance between growth, brand sustainability and presenting premium products to our customers, all while driving long-term shareholder value. This balance allows Starbucks to deliver a truly unique experience, whether you're visiting one of our retail stores in the U.S. or abroad, or if you are enjoying one of Starbucks' many products offered outside of our retail stores.

Let's take a look at the U.S. business. Company-operated U.S. retail revenue growth of 19% was driven by the opening of 1,116 new company-operated stores in the last 12 months. During the third quarter specifically, we opened 285 new company-operated locations.

Turning to comparable store sales growth for the U.S. segment, the third quarter saw trends similar to those in the second quarter. The average value per transaction increased 3% while traffic grew less than 1%, resulting in a 4% comparable store sales growth. During the quarter, sales of our core handcrafted espresso-based beverages and premium food offerings were the primary drivers of the growth in same-store sales.

Beverage is at the heart of what we do and offering our customers the variety that is uniquely Starbucks is what sets us apart from others. We are aggressively focusing our efforts on fewer, more powerful and differentiated beverage offerings and promotions going forward. This will reduce SKU count while driving profitability and business growth through both ticket and transaction. Our promotions will be more relevant, they will remain in our stores for a longer duration which ensures our customers and our baristas more time to experience, enjoy and connect over their favorite core or featured beverage.

Moving onto food, again this quarter we saw strong revenue contribution and an increase in average ticket from our food platform. During the quarter, we extended lunch to more than 260 additional U.S. locations. We also effectively enhanced our lunch offerings with innovative new selections of salads and wraps and extended our very successful parfait menu. Today, our lunch platform and its performance is stronger than ever, offering more variety and great tasting options based on fresh ingredients. At the end of the quarter, lunch was available at more than 4,600 stores, or 71% of our company-operated locations in the U.S.

During the quarter, we extended our warmed breakfast option to another 929 locations in the US, launching the program for the first time in Philadelphia, New Jersey, Delaware, and San Diego. At the end of the quarter, our warmed breakfast sandwiches were available to customers in more than 2,600 Starbucks locations in the U.S. That's approximately 41% of our U.S. company operated store base. We believe our food offerings enhance the Starbucks experience and this is proven by the strong customer acceptance that has translated into revenue generation and a higher average ticket.

The U.S. retail business provides a solid foundation for future growth as evidenced by the strong 19% year-over-year increase in company-operated U.S. retail revenue for the quarter. Over the next several years in the U.S., we expect to open approximately 1,700 new stores per year, which is the same as our fiscal 2007 target. We have worked hard to expand our internal store development capabilities and increase the number of U.S. stores that we open each year. We have demonstrated the success of those efforts through a meaningful ramp-up in store openings which has brought us to what we believe is an appropriate level of U.S. store openings at 1,700 stores annually. This current pace of openings will allow us to grow rapidly while managing the pressure that new stores put on existing stores. We continue to believe in and intend to capture the substantial opportunity to grow in the U.S. market.

Lastly from a margin perspective, we are experiencing rising dairy and supply chain costs. In response to these cost pressures, yesterday we implemented a price increase across our handcrafted and brewed beverages in our company-operated stores throughout the U.S. This increase varies by beverage and region and averages $0.09, or about 3% on beverage sales.

Moving on to music and entertainment, many of you recall that during the second quarter, Starbucks and Concord Music Group announced the formation of a new record label, Hear Music, and the first artist signed to the Hear Music label was none other than Paul McCartney. During the third quarter, Paul McCartney's Memory Almost Full debuted at number 3 on the Billboard Top 200 chart. This first release from the Hear Music label brought Paul his highest chart debut in 10 years. Additionally, last week, we announced our second artist signed to the Hear Music label, Joni Mitchell. Music has and always will be an important part of the coffeehouse culture and we look forward to presenting our customers with more unique entertainment options in the future.

Let me shift to the Global Consumer Products segment, which spans both the U.S. and international markets. During the third quarter, CPG reported net revenues of $87 million, up 24% from the third quarter of fiscal 2006, primarily due to higher sales volume of the packaged coffee. Starbucks remains the market leader in the U.S. premium packaged coffee segment with 7.5 million pounds sold during the third quarter, an 8% increase year over year. Seattle's Best Coffee achieved record market share with 1.7 million pounds sold, which is an increase of 35% over last year.

Within the U.S., the ready-to-drink category maintained its market leadership position and is a major component of CPGs' operating income. Beyond the U.S., a significant RTD growth opportunity exists within our international markets which continue to perform well ahead of our expectations. By the end of the fiscal year, we expect to achieve 99% distribution in convenience stores throughout Japan. Our RTD business in Japan has consistently grown through the third quarter, despite increased competition in that market. In May, we launched two Starbucks discovery flavors in Korea and have received strong customer acceptance.

With the addition of Starbucks discovery offerings to our existing bottled Frappuccino and Starbucks DoubleShot platforms in Korea, this is the first time all three RTD product lines are available in the same market.

In line with our goal of seeking new opportunities to extend the Starbucks brand into new products and channels, we recently announced an exciting new development and distribution agreement with Hershey's for the creation and marketing of a new Starbucks-branded premium chocolate platform in the United States. This alliance brings together two great brands to introduce distinctive and unique chocolate experiences to a broad range of channels, such as grocery and club. Those stores are the initial stores on the rollout. Hershey's chocolate expertise and distribution and selling capabilities, combined with Starbucks coffee expertise and the strength of our brand, will help transform the high-growth, premium chocolate arena.

This new agreement with Hershey's is another strategic alliance which showcases the ongoing development potential for our CPG segment. CPG represents an unprecedented opportunity to leverage our brand to additional consumer touch points beyond our retail stores. Our CPG product has built strong market share in the U.S. and we plan to continue this growth and expand this opportunity internationally.

Before I turn the call over to Martin, I'm going to take a few minutes to discuss our recent management realignment. A little over a year ago, I brought the senior management team together to discuss our long-term strategic plan, specifically challenging us to determine the best management structure in order to accomplish and support our aggressive growth objectives. The outcome from that initial discussion followed by significant planning led to these important changes. This new alignment was implemented to support the future growth and evolution of Starbucks as a global business, one we plan to double over the next four to five years, and to ensure we deliver a consistent Starbucks experience in all our stores throughout the world.

Importantly, this realignment also provides a strong example of the depth and the strength of our leadership team. We have hired people ahead of the growth curve and invested in their development and immersed them in the Starbucks culture and as a result, we've been able to complete this realignment entirely with current Starbucks leaders. This management structure positions us well to enhance the Starbucks experience worldwide through all of our business channels.

We will continue to do what we do best: serve premium quality coffee and introduce relevant, innovative, handcrafted beverages complemented by our expanded food offerings served in an inviting environment. We began as a small company in Seattle, we have grown into a global company with very ambitious goals, both financially and socially. These change the strength in our foundation and prepare us for our next phase of growth.

With that, Martin Coles, our new Chief Operating Officer, will review some key highlights from our international segment, a business that continues to strengthen, fueled by rapid retail expansion and healthy comparable store sales growth. Over the past several years, we have worked diligently to build a strong foundation for our international business to allow us to capture the significant opportunities ahead. While we have made great progress, we know we're still in the very early stages of international growth. I truly believe that we're in a great position to achieve sustainable growth well in the future.

Martin Coles

Thank you, Jim. Good afternoon, everyone. I'm very happy to be with you here today to discuss the strong performance that we've seen in our international markets this quarter. I would like to remind you that it was less than four years ago that Starbucks Coffee International became a profitable business. Since then, we've driven accelerated store openings, we've delivered strong comparable store sales growth, 5% or more during every quarter; we've entered several new major market and we've increased equity ownership in select key markets. In essence, we've established the platform from which we believe Starbucks International will ultimately grow to at least five times our current size.

The timing couldn't be better for turning the International business over to Jim Alling, currently the President of our U.S. operations. Not only has Jim led the rapid expansion of the U.S. retail business for a number of years, but he has also driven significant growth in Starbucks foodservice and licensed businesses; on both of these areas, where building relationships with key industry partners is critical to success. This skillset, together with many others that Jim possesses, translates extremely well in Jim's new role where building relationships is a key component to our success. I look forward to continuing to work closely with Jim as we grow in existing markets, we open new markets, and ultimately, we operate as a truly global company.

In our record third quarter, International net revenues increased by 28% to $432 million when compared to the same period in fiscal 2006. Record levels of store openings, along with solid comparable store sales growth, drove this outstanding performance. This quarter, we opened nearly 200 locations in international markets, which included the opening of our 700th location in Japan. Our international operations delivered 7% comparable store sales growth for the third quarter, with a 5% increase in customer transactions, and a 2% increase in the average value per transaction or ticket.

So, now turning to new markets. During the quarter, we introduced Starbucks to Romania in the city of Bucharest, as well as opening airport locations in both the Netherlands, at Amsterdam's Schiphol Airport and Denmark in Copenhagen's International Airport. While we've only opened a total of four stores in these markets, the extremely strong early reception demonstrates yet again the powerful global demand for the Starbucks experience.

This experience is especially true in Brazil, a market we opened just eight months ago and one that continues to see very strong customer acceptance which has driven positive brand perception in that market and where we now have five stores open. Excitingly, just recently, we announced Alsea, our long-term business partner in Mexico, the expansion of our business relationship to bring the Starbucks experience to Argentina. We're extremely positive about the opportunity that Argentina represents as it's the third largest economy in Latin America and has a very strong coffeehouse culture. We look forward to sharing our progress with you during future calls. As I mentioned, Alsea also manages Starbucks stores in Mexico where the business is performing extremely well and where the market has grown to nearly 140 locations in less than five years, a pace that has significantly exceeded our original expectations.

We are committed to building the foundation for long-term, sustainable growth and profitability internationally. We do expect variability in our international margins due to continuing investments in building the foundation for our newer markets, which include China and Brazil, as well as other countries where we will open in the near future, such as Russia before the end of this calendar year, and Argentina. You may have read that we recently withdrew our application to enter India as we refocus our efforts in Asia Pacific, which is a key region for our company, but we remain very excited about potential of this country and we plan to open that market in the next year or two.

As a growth company with a long-term perspective, we pay particular attention to the fine balance between managing short-term costs while continuing to invest for our future. Over the long term, we expect significant margin expansion in our International segments while we continue to invest ahead of the curve. During this period of rapid expansion, we will continue to strengthen our operations, our supply chain capability, and our new store pipeline. These efforts have been and will be applied to our total International segment regardless of ownership structure and assist us in achieving our goal of delivering a constant, consistent and excellent experience for our customers around the world.

We believe we have been successful internationally by focusing on making Starbucks stores a gathering place in neighborhoods throughout the world while building in appropriate localization to demonstrate our understanding and respect of local tradition. Our three largest markets of Canada, United Kingdom and Ireland and Japan are perfect examples of this practice with each performing exceptionally well and all three driving the consistent Starbucks experience our customers both expect and demand.

So, in closing, as Jim mentioned earlier, our International business is still in the very early stages of expansion and represents a tremendous source of growth for the company. At the end of the third quarter, we had more than 4,000 locations in International markets with a long runway ahead to reach our long-term target of at least 20,000 locations outside of the United States. We are confident in and we are energized about the future of the International business which is clearly demonstrated by our plans to increase store count by at least 20% per year over the next several years.

We see strong customer acceptance in every market we serve, from China, a strong tea drinking community to Brazil, a country with a long and solid coffee culture. We're driving success by focusing on the core elements that create the Starbucks experience for consumers around the world. Those core elements, not surprisingly, just as with the US, are great partners who create the human connection over premium quality coffee in our third-place environment. After ten years, our international journey is still in the very early stages and the best is yet come.

On a personal note, as I set out on the next leg of my Starbucks journey as Chief Operating Officer, I'm humbled and I'm honored at the same time at the privilege and I'm extremely mindful of the responsibility this new role carries. Starbucks is a pioneer in developing the specialty coffee market, something that never existed in the marketplace before. I'm very excited to help take our company into the next very important stage of growth and I look forward to speaking with you in the near future.

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

Michael Casey

Thank you, Martin. Today, I will provide additional detail on some of the significant factors that impacted our financial performance in the third quarter of fiscal 2007, review our targets for the remainder of fiscal 2007 and introduce the company's growth targets for fiscal 2008.

Consolidated top line growth for the third quarter of fiscal 2007 was 20%, with 4% comparable store sales growth, both consistent with our stated targets. Consolidated earnings per share were $0.21 in the third quarter compared to $0.18 for the comparable period in fiscal 2006, representing an increase of 17%. External cost pressures, primarily within the U.S. business, challenge the flowthrough to earnings.

Consolidated operating income increased 14% to $240 million for the 13 weeks ended July 1, 2007, from $215 million in the prior year. As a percentage of total net revenues, operating margin declined to 10.4% from last year's third quarter margin of 10.9%. This decline was due to higher cost of sales, including occupancy, offset in part by leverage gained in general and administrative expenses, store operating expenses and other operating expenses.

Consolidated cost of sales, including occupancy costs as a percentage of total net revenues increased to 42.6% from 41.0%, driven primarily by higher costs in our U.S. business, which I will discuss in that segment. In addition, flowthrough to earnings was negatively impacted by net interest and other expense in the current quarter due to higher borrowings outstanding, compared to net interest and other income in the third quarter of fiscal 2006, as well as a higher effective tax rate this year. While the third quarter effective tax rate was lower than the two prior fiscal 2007 quarters, we do still expect the effective tax rate for the full fiscal year to be approximately 37%.

Let me now move to third quarter results for our operating segments. For the U.S. operating segment, total net revenues increased by 18% to $1.8 billion in the third quarter of fiscal 2007. Company-operated retail revenues rose 19% to $1.6 billion for the quarter, driven by the opening of 1,116 new company-operated retail stores in the last 12 months and comparable store sales growth of 4% for the quarter. The growth in same-store sales was driven by a 3% increase in average value per transaction and growth in transactions of less than 1%.

U.S. specialty revenues grew by 11% to $194 million in the third quarter. Within specialty revenues, licensing revenues increased 14% to $110 million, primarily due to higher product sales and royalty revenues from the opening of 777 new licensed retail stores in the last 12 months.

U.S. cost of sales, including occupancy costs, as a percentage of total revenues increased to 40.3% compared to 38.6% in the comparable period a year ago. This was primarily due to the following three factors: First, higher dairy costs which caused approximately 50 basis points of the increase. In June, Class 1 dairy prices were 66% higher than the prior year and are expected to be approximately 100% higher than the prior year in August and September. Second, a shift in our sales mix to higher-cost products, primarily food and merchandise, which also contributed approximately 50 basis points to the increase. Third, higher rent expense, which similar to last quarter, was due to several factors, including growth in higher-priced commercial real estate markets. We expect these trends to continue in the fourth quarter.

U.S. store operating expenses improved 70 basis points to 41.5% of related U.S. retail revenues, resulting primarily from a sharpened focus on discretionary spending, particularly within regional overhead, and leverage from the October 2006 price increase. Partially offsetting these reductions were higher payroll-related expenditures in fiscal 2007 stemming from the company's October 2006 wage increase for hourly store partners and the second quarter salary increase for our store management partners.

U.S. other operating expenses improved to 26.7% of related specialty revenues in the third quarter of fiscal 2007 from 29.1% in the prior year, primarily due to lower marketing and advertising costs in the current year related to the entertainment business, and again, controlled discretionary spending.

U.S. general and administrative expenses as a percentage of U.S. total net revenues declined to 1.2% from 1.6%, primarily due to decreased salary and related benefits expenses and lower professional fees for special projects.

U.S. operating income increased to $253 million during the quarter from $225 million during the same period of fiscal 2006 due to the cost pressures I mentioned earlier in cost of sales and occupancy. Operating margin decreased to 13.8% of related revenues for the third quarter of fiscal 2007 from 14.5% a year ago.

As Jim noted, we implemented a price increase on beverages in our U.S. retail stores yesterday to help offset the impact of steeply rising dairy costs this calendar year. We have discussed these rising costs on the past two earnings calls and dairy has clearly been prevalent in the media for the past few months so we know this is no surprise to you. We look at price increases as one of the several tools we have available to help offset rising costs and one that we execute thoughtfully and carefully to protect our brand and the health of our business. However, we also recognize that the price increase could have a modest negative impact on transaction growth.

We anticipate that the net benefit of approximately of the 3% price increase on beverages, combined with controlled spending across the business, will offset the fourth quarter impact of higher dairy costs year-over-year.

Turning now to the International segment. International total revenues increased 28% to $432 million in the third quarter of fiscal 2007. International company-operated retail revenues increased 30% to $365 million in the third quarter of fiscal 2007, mainly due to the opening of 253 new company-operated retail stores in the last 12 months; comparable store sales growth of 7% for the quarter and favorable foreign 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, reflecting another quarter of strong growth in our International retail business.

International specialty revenues for the quarter increased 18% to $67 million, primarily due to higher product sales and royalty revenues from opening 466 new licensed retail stores in the last 12 months.

International operating income was $32 million in the third quarter, compared to $29 million in fiscal 2006. The operating margin decreased to 7.5% of related revenues from 8.6% in fiscal 2006. The year-over-year margin compression was primarily due to increased costs associated with store renovation and maintenance expenses and higher rent expense as a percentage of total revenue. Also impacting the margin was an increase in utility costs due to rising energy prices and consumption.

International general and administrative expenses as a percentage of International total revenues improved 40 basis points, demonstrating the beginning of leverage from our investments. Over time, we expect further leverage from investments in our International business and significant margin improvement in fiscal 2008.

Now, a few comments on our third business segment, Global Consumer Products Group. CPG total net revenues increased 24% to $87 million in the third quarter of fiscal 2007. This was driven primarily by increased sales of packaged coffee and tea in the U.S. Also contributing to revenue growth in this segment was increased product sales and royalties in the international ready-to-drink business.

Our packaged coffee and tea and ready-to-drink businesses demonstrate the vast opportunity within CPG. The premium packaged coffee and tea business, which has built leading market share over time in the U.S., is in its very early stages of international expansion. Similarly, our RTD business in international markets is relatively new and in a short time has had a notable impact with plenty of room to grow.

Operating income for CPG was $42 million in the third quarter of fiscal 2007 compared to $39 million in fiscal 2006. The operating margin decreased to 48.1% of related revenues from 55.6% in fiscal 2006, primarily the result of lower sales volumes for the North American Coffee Partnership which produces ready-to-drink beverages, including Starbucks' bottled Frappuccino coffee drinks and Starbucks' DoubleShot.

Now, I want to make a few comments on Starbucks' balance sheet and capital structure. During the third quarter of fiscal 2007, Starbucks repurchased 2.5 million shares of common stock under authorized share repurchase programs. This brings total share repurchases for the first three quarters of the fiscal year to 20.3 million shares, and the total year-to-date cost to the company was $671 million. The number of shares remaining available for repurchase under authorized plans at the end of the third quarter was approximately 26 million.

As we mentioned in our second quarter 2007 10-Q filing, with limited borrowing capacity remaining in the under the company's credit facility, significant additional share repurchases in excess of cash flow was limited in the third quarter, absent any additional borrowing authorizations. With that in mind, management is currently evaluating a range of alternatives for raising long-term financing to enable Starbucks to pay down short-term debt and to take advantage of opportunities for repurchasing shares.

In determining the appropriate capital structure for the company, we consider how additional debt and stock repurchases would increase distribution to shareholders and reduce our cost of capital. But we also evaluate our cash flow and how much financial flexibility we should retain, given our high rate of growth and the possible opportunities that lie ahead of us. Balancing these two factors, we believe that leverage and coverage ratios roughly commensurate with a high triple-B credit rating, are appropriate for the company.

Given the opportunistic nature of our stock repurchase program, you might see short-term moderate deviations away from our average credit ratio levels. If this were to occur, we would plan to restore our credit ratios back to the normal levels over a short to medium term.

I'd now like to turn to our fiscal 2007 targets. We're targeting the opening of at least 2,400 new stores on a global basis with modest upside potential in international licensed store openings given the strong year-over-year performance in store development to date. We continue to expect comparable store sales growth in the 3% to 7% range and we continue to expect total net revenue growth of approximately 20%. We continue to target earnings per share in the range of $0.87 to $0.89. However, as I recently commented, the upper end of that range will be very challenging, given the current operating environment, which includes, among other things, rising dairy costs and soft transaction growth in our U.S. business.

I will now share with you our first look at our fiscal 2008 financial targets. Over the past few years, we have continued to bolster our store development capabilities which has allowed us to increase store openings consistently over time. We will continue this growth pattern in fiscal 2008 as we plan to ramp up our store openings to approximately 2,600 net new stores on a global basis, an increase of 200 stores compared to our fiscal 2007 target.

Our International store openings will accelerate while the level of U.S. store openings will stabilize at 2007 levels. Accordingly, 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 600 licensed stores. We expect comparable store sales growth in the range of 3% to 7%. We're targeting total net revenue growth of approximately 18% and we are targeting earnings per share growth faster than revenue growth at approximately 20% to 22%.

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 Jeffrey Bernstein - Lehman Brothers.

Jeffrey Bernstein - Lehman Brothers

Just a question on the U.S. traffic, which was obviously a hot topic last quarter. Seems to have been modestly positive, but still looks like a deceleration on a two-year average basis from the prior quarter or two. Just wondering if you can give some color commentary in terms of your thoughts, whether you believe the further consequential lease sale was due to macro factors -- which are obviously impacting all of retail -- or whether it's something more Starbucks-specific.

Whichever it is, where do you see it heading from here and do you think increase in pricing, what kind of impact is that going to have on the traffic? I know you mentioned it was kind of negative in the near term. Thanks.

Michael Casey

Well, you're correct to pick up on the fact that the U.S. traffic was slightly better in the third quarter than it was in the second quarter, but continues to be impacted by a number of factors. There's not a single thing that impacts the traffic. It is important to note that there was not a decline in the traffic count, but it was steady with last year.

It's clear that there is an increased competitive environment. There is an increased pressure on consumers from macroeconomic factors. But in all of those areas, we believe that we have a competitive advantage of being the coffee experts and being able to generate incremental traffic as we go forward, particularly in our core beverages, our core espresso beverages and the things that are uniquely Starbucks.

Jim Donald

I will add to that the differentiation is still going to be what we call the Starbucks experience as we continue to innovate around our core beverages, and as I mentioned, give our partners, our baristas, more time to connect with the core of coffee of what we're offering for our customers, and also the connection with our customers.

Howard Schultz

Jim, I would add one other thing, and that is that the equity of the Starbucks brand over the last two decades has been defined by the experience. As long as we can continue to drive that experience and differentiate ourselves from all others, we will continue to be the leader. We have no intention whatsoever of giving that leadership position away.

Jim Donald

Thank you, Howard.

Jeffrey Bernstein - Lehman Brothers

So to follow-up with the 3% price increase on the beverages, I know you mentioned it could have a near-term negative impact on traffic. I'm just kind of wondering (1) , whether that has the potential to push traffic negative, kind of what's the balance between what you think a 3% price increase would do to traffic? Whether it's one-to-one or slightly more, slightly less?

Jim Donald

I made that comment, and I did it to acknowledge the fact that we recognize the possibility. Historically, we have not had a significant decrease in traffic as a result of price increases early in the price increase cycle. We think that there's been modest negative impact on traffic over an extended period of time from a price increase followed by recovery. At higher levels of same-store sales growth, those minor changes have been pretty much not noticeable.

We're not expecting a significant traffic decline with the coming price increase, but we recognize that it's the first time we've taken two price increases as close together as these two and just want to acknowledge the possibility that it might have a short-term negative impact on traffic.

Operator

Your next question comes from Matthew DiFrisco - Thomas Weisel Partners.

Matthew DiFrisco - Thomas Weisel

Just looking at a couple of the drivers to fiscal 3Q on the margin front, labor, and you used controlled discretionary spending as a reference in store operating expense; and then also with the lower advertising with respect to the other operating expense line as well as things that helped you a little bit in the third quarter.

Are these things that are going to come back in the fourth quarter as expense lines and somewhat deferred, or were they basically rationalized and not going to come back on the income statement?

Michael Casey

Well, I think you mentioned three things, one of which was higher year-over-year, and that's the salary and benefits within the store operating expenses. As I mentioned in the prepared remarks, that's directly due to the across the board wage increase that we implemented, and to the increase for our management personnel in the second quarter. So, that is likely to continue.

The controlled discretionary spending I think is a discipline that we have been developing over the last six to 12 months, and I would definitely expect it to continue. We're learning how to be more effective and to control those expenses fairly tightly.

Matthew DiFrisco - Thomas Weisel

How about the marketing dollars? What's the relationship?

Michael Casey

The marketing that I mentioned is primarily related to our entertainment business where we were spending against Akeelah and the Bee at this time a year ago and we didn't have a similar promotion or a similar activity in the stores this year.

Matthew DiFrisco - Thomas Weisel

Just as a follow-up, longer-term as we think out into '08 and beyond, in this new direction, with maybe a flat line number of stores opening domestically and just the overall maturation of your store base domestically, how fast do you think we can get back to, or is it correct to assume that we should be looking towards a 16% margin again in the U.S. side of the business in '08 possibly?

Michael Casey

I think that's a little bit too difficult to predict. We do expect total company margin improvement in 2008 compared to 2007, and we do expect modest margin improvement within our U.S. business. Beyond that, I don't think it's appropriate to get any more specific at this time.

Operator

Your next question comes from Ashley Woodruff - FBR Capital Markets.

Ashley Woodruff - FBR Capital Markets

On your comment on slowing the U.S. store growth modestly, you mentioned cannibalization as one of the issues. Historically when you've opened new stores, you've always typically cannibalized existing stores. Is the difference now that the stores that were cannibalized, were they not ramping up as much, or is it just the new stores aren't I guess opening at the same type of volumes?

Jim Donald

If you look at the cannibalization factor today as we did several years ago, and it's more in pockets than it is across the company, but, we're seeing in these pockets certain cannibalization dependent upon where those stores are located. But we don't see this as an issue that basically overrides the opportunities that we see for continuing our growth.

As we go forward, we're going to continue to infill markets where the opportunities exist, factoring in some form of potential cannibalization in our plans, whether they are total overall revenue or 3% to 7% comps.

Operator

Your next question comes from Larry Miller - RBC Capital Markets.

Larry Miller - RBC Capital Markets

First, if I could clarify something please. Michael, are you going to be running around 5% or so price in the fiscal fourth quarter, is that correct?

Michael Casey

No, that's not correct. Thank you for bringing that up. I did want to clarify that. We have an effective price increase of approximately 1.5% prior to today and an approximately 2.5% price increase that was implemented yesterday. So, that's a total of about 4%.

Operator

Your next question comes from Steven Kron - Goldman Sachs.

Steven Kron - Goldman Sachs

Just going back to the U.S. traffic number, one of the reasons you cited was competition. It seems as though in your prepared remarks, you talked about going back your core beverage business perhaps with renewed vigor and trying to increase the differentiation factor. Can you first comment on are you allocating increased resources to this product development cycle? And you also mentioned SKU count reduction. Are you pulling items as we speak from your menus?

Jim Donald

What we've done is, we're not allocating resources directly into the R&D piece, but we've taken the whole R&D piece on a global basis now and we're leveraging synergies across the world into creating this innovation platform that won't be necessarily U.S. or international in nature, but altogether. There's not additional resources that are being put into that, other than through the normal course of business.

The reduction in whether it's promotion or SKUs are basically looking at running our business in a way that our partners can continue to complement the Starbucks experience through the connection with the customers, through each other, through the partners, but also to make sure that the speed with service, getting our customers in and out of our stores as well as the quality of the beverage is improved. We think that by creating less complexities that we'll give our partners more time to achieve this.

Operator

Your next question comes from David Tarantino - Robert W. Baird.

David Tarantino - Robert W. Baird

Could you give us an update on the effectiveness of the changes that you made in managing the cold-blended business this year versus last year, and how that might benefit traffic in the current quarter?

Jim Donald

Compared to last year, we believe through training and education that we have completely resolved any traffic issues related to execution in blended beverages. I think the impact was both in the third quarter and in the fourth quarter last year. So, we do not expect any impact from that whatsoever.

Howard Schultz

That was done in different factions, whether it was using best practices, looking at the deployment when those beverages were being sold, as well as rolling out additional cold-blended beverage stations, a little over 2,000 stores this year versus 900 stores last year.

Operator

Your next question comes from John Glass - CIBC.

John Glass - CIBC World Markets

Last year, you talked at the analyst meeting about a 20% top line and 20% to 25% bottom growth rate for three to five years, and now you're talking about 18% top line and 20% to 22%, at least for '08. I guess my question is then, is this a permanent slowdown in the growth rate of your business in your view, or is it just the recognition that there are some temporary pressures both on the top and bottom line and we might resume that 20% to 25% in the future?

Included in that answer, could you talk about, are you assuming greater leverage in getting to the 20% to 22% earnings growth rate, either next year or in the future?

Michael Casey

Well, we are expecting leverage and we are expecting to grow the bottom line faster than the top line. The change from 20% to 25% to 20% to 22% is basically a refinement and recognizing what our capabilities are, and perhaps at 25% we had put more strain on the system than we needed to. But we still think the 20% to 22% is a world-class growth rate for a large company like ourselves and we are just going to strive to maintain that going forward.

I don't expect that the bottom line growth rate, absent some transformation in the business, is going to reaccelerate up to the 25% level again, but it's certainly not impossible and it could happen in any given year. I wouldn't plan on it consistently over a number of years.

Howard Schultz

Michael, when you add into the factor that we're going to increase our international business five times more than it is today, we're going to double the size of the company in four to five years, some of these issues are just the law of large numbers. If you really get underneath and look at the way in which the company is growing and the runway that we have, I think it's really important to point out how optimistic we are about the opportunities we have and how I think going back two, three, four years, the question was about international, whether or not we could extend the Starbucks platform and equity of the experience internationally. Now, there's no question that that is here and we've got a strong runway to take advantage of it.

So I really would not get hung up on whether it's 18% or 19% or 20%. On a macro level, there are very few consumer brands and certainly very few consumer retail companies that have the opportunity we have to build a global business from the size we are today.

Operator

Your next question comes from Sharon Zackfia - William Blair.

Sharon Zackfia - William Blair

When you look at the business, how do you try to assess what might be a self-imposed strain versus external competitive or macro environment issues? If you can give us a sense of that.

Jim Donald

Did you say self-imposed strain?

Sharon Zackfia - William Blair

Yes, in terms of just growing so quickly in the U.S.

Jim Donald

Well, first of all, our partners tell us if there's areas out there such as the complexities or the growing too fast, I mean, when you look at every component of our business, whether it's store development where we now have a pipeline out 18 to 24 months, whether it's this innovative pipeline that we said in the past, we have probably over 100 particular promotions or items in that pipeline, we don't see the strain there.

We see the strain where we try to maybe accelerate it too fast without having that focus at store level or the bench that's in place. I want to say that we've basically satisfied our bench and the need to listen to our partners to reduce some of those complexities to eliminate some of that internal strain. But, I won't say that that's creating any kind of angst in terms of business.

On the external front, when you look at what you might call the competitive environment, we're seeing this category of super-premium coffee being offered now in more locations than ever before. But, we see that as a positive step in that the coffee category is large. Super-premium is small but growing. But if that continues to populate itself with different independent coffeehouses or QSRs, that's a good thing. I think it bodes well for all the sellers of super-premium quality coffee. So, from that competitive strain, I think that we're not seeing that as necessarily something that's pushing against the sides, but actually helping to fuel us as we continue to grow.

Michael Casey

To further that, when we look at the places where you would think the competitive pressures would be the greatest, in most cases, that's where we are performing the best. So, while we can't totally eliminate any impact from competitors, every time we look to pin it down or to identify it, the analysis turns out it's just the opposite; that the markets where the identified competitors are strongest is where we're the strongest.

Jim Donald

U.S. and international.

Michael Casey

Yes, both international and U.S.

Howard Schultz

Michael, let's get a little more specific about that. I think what I would like to just try to explain is, the coffee category, the specialty coffee category, despite the growth and development of Starbucks and others, it's still in its infant stages and as we've talked in previous years, we have less than 10% share of total coffee consumption in North America, less than 1% internationally.

What we've seen, as Michael and Jim have just talked about in specific areas where there's been more awareness created by others, whether it's advertising or promotion over the short and long term, we have benefited and we've seen that specifically in U.S. markets and we've certainly seen it in international.

So, this whole cloud that many have tried to create about competitive pressures forcing us to slow down our growth or look at cannibalization differently is really not the case and this is just a moment in time when we're looking at our business perhaps in a different way, which is appropriate and I think timely.

Also, because of the international opportunity, we have the opportunity to stabilize the U.S. growth at 1,700 stores and take advantage of the huge opportunity we have internationally, which is in its embryonic stage.

Operator

Your next question comes from Glen Petraglia - Citigroup.

Glen Petraglia - Citigroup

Just going back to cannibalization, going back six or nine months ago you were speaking about filling in markets and you're continuing talking about filling in markets. But clearly, flat to modestly up transactions in the last few quarters have surprised you, and you've made the comments about opening up a consistent 1,700 units a year which would in essence reduce cannibalization or eliminate some of the pressures on your existing stores.

Has the rate of cannibalization this year surprised you, and what sort of implications does that have going forward?

Jim Donald

Glen, we were talking about cannibalization many years ago and basically looking at the same impact that it would have on these stores that we were opening when we were opening 300 to 400 stores. What we're seeing today as we look at all of the drivers, and we've mentioned earlier on the call, be it macroeconomic conditions or whatever the cause may be, is cannibalization today is about the same impact as it was many, many years ago. So we don't necessarily see that.

As Howard mentioned, as this super-premium category gets larger, we're seeing the opportunities in all of our market areas still continuing to be in the very early stages.

Operator

Your next question comes from Joe Buckley - Bear Stearns.

Joe Buckley - Bear Stearns

First, the cost side on the G&A side, you've really done a great job controlling costs. Are there more opportunities to cut costs year-over-year, short-term fourth quarter? How do we think about 2008 on that front?

And then one on the International side. Your International company openings, I noticed you're holding flat, you're holding stable for 2008. Also, it looks like you might be struggling a little bit or have a lot of openings in the fourth quarter to make your '07 number. So if you could comment on that.

International operating income growth, fairly modest again this quarter. So, if you would address that as well.

Michael Casey

I will take the first one about the opportunity to cut costs. I think we've developed a good cost control mentality that allows us to get leverage in the fixed cost areas without choking the growth of the business. 20% top line growth consistently year in and year out cannot be achieved if you have a cost-cutting mentality.

Our mentality has been to maintain modest growth and to leverage the people that we have and to leverage the facilities that we have. So I think going forward, you can continue to expect to see leverage on unallocated corporate G&A, U.S. G&A, and international G&A, but not cuts from, on an absolute basis, from the current level because that would in essence make it much more difficult for you to achieve the top line growth that we have targeted for ourselves.

Martin Coles

Hi, Joe, thanks for the question internationally. We are actually running at an all-time record in terms of store openings if you look at the entire fiscal year, and this touches virtually every one of our countries, whether they're licensed operations, JV's, or wholly owned.

The other piece that we've accelerated just for perspective is the rate at which we touch the stores for a refurb. So we actually again are running at record levels there. I don't see that changing frankly as we go into 2008. So we see ourselves significantly ramping up in 2008.

Michael had mentioned as we believe there's probably some positive even to our own estimates as we get to the last couple of months of this year. So, we're building as fast as we can in the right way into the right locations in every international market, whether it's company-owned or whether it's license or JV. Again, we're doing more work than ever before just in terms of making sure that we touch the stores and refurbish the stores on a very aggressive program. So we're able to keep the experience fresh for our customers in every country in the world.

Michael Casey

If you notice the numbers that I referred to on how many stores in the various categories that we've opened in the last 12 months, the U.S. businesses actually has a trailing 12 months run rate higher than next year's target in both licensed stores and in company-owned stores. So, we feel very solid about those run rates and that capability and capacity, and that's as a result of having consciously ramped up that capacity and capability over the last three or four years from a time when we were opening maybe 1,000 stores not that long ago in the U.S. market in total.

International is going through that same phase and it would be natural to expect on a quarter-over-quarter basis in general there to continue to ramp up. So we're not at next year's run rate yet, but we're taking the steps that we will get us to next year's run rate in time to deliver our next year's targets.

Operator

Your final question comes from Andrew Barish - Banc of America.

Andrew Barish - Banc of America

Just a question really pertaining to the U.S. business, as you get to a little bit more of a level of maturity here with the comps. Have you guys thought about the marketing/advertising strategy? Are there any thoughts on maybe stepping that up in different ways than you've done in the past?

Jim Donald

In the past and from day one, our marketing and advertising strategy is one that is envied by many and it's one that's basically been built through our grassroots efforts of our store partners and the connections they have with their customers.

We have done external advertising, such as billboards during the holiday seasons and through our CPG business, we have done some type of cable presentations for our bottled Frappuccino and DoubleShot. But we don't necessarily see the need to take that investment. As we grow our store base, we continue to grow our presence in our communities around the world and the Starbucks experience that we continue to see, as Howard mentioned in the call, is completely different than the rest of our competitors as a way to market Starbucks and continue to drive transaction count.

JoAnn DeGrande

That concludes our third quarter earnings call today. We invite you to join the webcast of our fourth quarter and fiscal 2007 year end financial results on Thursday, November 15. Thanks for joining us today.

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