Starbucks Corporation
Q2 2008 Earnings Call Transcript

Published: 1 May 2008

[Operator:]

Good afternoon. My name is Christian and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks Coffee Company second quarter fiscal 2008 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, Chairman, President and CEO; and Pete Bocian, Executive Vice President and CFO. Q&A will follow today’s prepared remarks. 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 22250367 through 9

[Howard Schultz:]

Thank you, JoAnn and good afternoon, ladies and gentlemen. I hope you’ve had a chance to read the release we’ve issued just a little while ago. During today’s call I will give you an update on the progress we’ve made since our January 30th conference call in laying the foundation for a renewed customer experience at Starbucks. Pete will then take you through a review of our second-quarter results, provide an update on the full year, and then spend most of his time walking you through our three-year financial targets, including the key financial metrics for the company looking out to 2011. These will include our targets representing a significant slowing of store expansion in the U.S. while accelerating International unit growth and our expectations for revenues, operating margins and EPS coming off a plan that requires less capital expenditures and delivers significant free cash flow into the future. As you think through all of what we are sharing with you today, I want you to have an understanding of the main considerations we -- meaning our Board of Directors and our management team -- took into account in developing our plans for the rest of 2008 and for the 2009-2011 period, and we will discuss all these over the course of this call. To put it simply, our approach has been one of balance, recognizing current economic conditions and their impact on the operating environment while also remaining highly focused and committed to the long-term significant opportunities for our business. We have a very realistic view of the current and growing pressures on consumers in the U.S. and increasingly in other key markets around the world where we operate. And we are intent on best managing our plans to match the demand we see, scaling back our openings, and rigorously managing our expenditures in all areas where they are not critical to our mission. At the same time, we want to continue to innovate and invest in those areas that preserve and reinvigorate the uniqueness of the Starbucks Experience through our transformation agenda, so that we continue to grow our business and are well-positioned when economic conditions improve. You will see all of this reflected in our targets for revenue, CapEx, margins, EPS, and cash flow, which we are sharing with you today. With that, I would like to first comment briefly on our announcement last week of Q2 preliminary results and our revised outlook for fiscal 2008. Once our second-quarter results were in, and in light of the deteriorating retail operating environment in the U.S., we updated our view of the year and felt it was the right thing to do to quickly communicate our revised outlook to you. In our press release, we identified the impact of Q2 EPS from investments we made as part of our transformation agenda, along with costs associated with the rationalization of our store portfolio. And while they had a negative affect on our second-quarter bottom line, we firmly believe that these investments are necessary and prudent as we work hard to transform the way we do business. I should also mention that the benefits from these initiatives, such as the launch of Pike Place Roast, are not yet reflected in our results but they will be over time. While we are not going to use the economy as an excuse, it is important to keep in mind that our second quarter results do reflect the sharp weakening U.S. consumer environment. Like most other retailers and restaurants, we are experiencing a down-turn in customer traffic, demonstrated in reduced frequency of customer visits that we believe ties to a real reduction in consumers’ discretionary spending habits. With no immediate signs of recovery, this underscores why, as I will discuss, we have reviewed all aspects of our operations to make sure we are best utilizing our resources and we are working hard to reduce expenses in non-critical areas. At the same time, as I have said, it is incumbent upon us to maintain our focus on transforming our business for the future, so that we can deliver strong, sustainable performance over the long-term. And we are making significant progress on the plan we announced to do this when I came back as CEO just 14 weeks ago, which centers on three things

[Peter J. Bocian:]

Thanks, Howard and good afternoon, everyone. We recognize we have given you a lot of information in the last week -- particularly today with the communication of our long-range financial targets. I plan to spend most of my time today on the long range targets, but will also provide a recap of our fiscal 2008 second quarter and give you our latest full view on the full year. Then we will move into Q&A and recognizing there will be a greater number of questions today, we have allocated additional time for Q&A and plan to keep the call open until 3

[Howard Schultz:]

Thank you, Pete. Let me once again emphasize that 2008 is a year of transition for Starbucks; a year for us to re-energize and sharpen the focus on our brand and our business. Since I returned as CEO in January, we have taken decisive steps towards transforming Starbucks for the future. We are aggressively pursuing initiatives that will position us to capture the long-term opportunity. This is balanced with what we believe to be a realistic expectation about the impact of the current economic environment. The next few years will be a period of sensible, strategic and exciting growth for Starbucks, centered on strengthening our business model, enabling us to maintain our position as one of the worlds’ most recognized and respected brands, and to increase shareholder value in a way that is sustainable and in line with what you expect from us. With that, I am happy to open it up for Q&A.

[Operator:]

(Operator Instructions) Our first question is from the line of John Glass with Morgan Stanley.

[John Glass:]

Thanks very much. Pete, I wanted to go back to your long-term earnings outlook and it seems as if you are calling for over 20, even 25% earnings growth on the out years, so can you help us break down operating profit growth and what the buy-back contribution is? It would seem that it is going to be heavily reliant on buy-backs, but -- and can you also talk about maybe your decision to use buy-backs versus say a dividend policy to communicate the maturation of the business to investors?

[Peter J. Bocian:]

I think the first is there is share repurchase in the long-range plan but I would characterize it as 10% growth coupled with operating margin expansion off of an ’08 baseline, right? So your 20% is off ’08. If you move back to ’07, not as dramatic. So my view is we’ve got to improve, stabilize the U.S. operating margins, improve the U.S., get the lift out of consumer products group, contribute the G&A, and operating margin will improve over the horizon. In addition then, we get some lift out of share repurchases and out of the tax rate over time. Relative to your second question, historically we have used share repurchases. We’ll continue to dialog with the board. The good news is with the $800 million per year of capital that we expect to spend, there should be a lot more free cash flow. So I will leave it as there will be we expect significant value to return to the shareholders. Historically we’ve used share repurchases -- not in a position today to really talk in detail around dividend but we’ll have the dialog with the board over time.

[John Glass:]

If I could just follow-up with one other question -- to what extent have you considered expanding the role of licensing in the U.S. as the business is maturing, the returns have gone down? You talk about no sacred cows -- would you consider relicensing or refranchising a portion of the U.S. business?

[Howard Schultz:]

When we look at licensing as a part of the portfolio, I think one thing that we can look back on is that perhaps the number of licenses and some of the license partners was too much, and we want to dial that back. I think we have to make sure that the level of execution and the experience is compatible with what we believe to be the most important component. And when we’ve had issues and tension, more often than not it’s been on those licensed stores. So we want to be very prudent in not chasing an economic model that in any way would dilute the integrity of the experience.

[John Glass:]

Thank you.

[Operator:]

Our next question is from the line of Joseph Buckley with Bear Stearns.

[Joseph Buckley:]

Thank you. A couple of questions -- the CapEx number in ’08 not changing you attribute to capital spending related to the transformation agenda. What exactly is that? What is the CapEx on the transformation side?

[Peter J. Bocian:]

Yeah, you’re correct. The CapEx would have gone down based on lower company-operated store openings. The CapEx we are talking about when you think about the clover, so putting the clover machine in the stores, Mastrena has a capital component, the beverages that Howard described leveraged some of the infrastructure but could have their own unique capital components as well. So that’s really where call it the back-fill is happening. And then we plan to incorporate all of those within the $800 million each year looking forward.

[Joseph Buckley:]

Okay, and then a question on the international side for the quarter, you mentioned the margins being hit by some of the rationalizations and you made reference to softness in some of the key international markets, I guess the U.K. specifically. Talk about what you did in the quarter -- did you have store closings in the U.K. or Canada and what’s kind of the game plan there going forward?

[Peter J. Bocian:]

Without naming the market, we are looking at the stores, it was not Canada or the U.K., and rationalizing and not dissimilar to the 100 stores that we’ve talked about for the U.S. So there is some element of that and it was fairly material when you look at the size of the impact for international in the quarter. So what I tried to do was bridge you, relatively speaking, that on a full-year basis if you normalize roughly speaking for the store rationalization and then some element of transformation. For example, we did have the Espresso Excellence training in Canada, as an example, which had an impact in the quarter. If you normalize for those, we had a great first quarter relative to 180 basis points. We are back kind of in the 100 basis point range after Q2 excluding the items I talked about. Howard, do you want to talk about the U.K. traffic a little bit?

[Howard Schultz:]

Well, I think what we’ve shared with you today is that there is some sign, and I wouldn’t get too excited about it today because we don’t have enough information but there is some sign that there is a softening in the U.K. business due to the economic issues facing that consumer. And as we speak to other retailers, both U.S. and abroad that are doing business there, we are not alone. It is really yet to be seen whether or not that is going to be a mirror image of what we have experienced here or whether or not that is going to be a short-term situation. We don’t know.

[Joseph Buckley:]

I see. Just one more question on the store rationalization; so did you close stores in some international markets during the quarter?

[Peter J. Bocian:]

We took charges against the P&L relative to eventually being in a position to do that.

[Joseph Buckley:]

Okay. Thank you.

[Operator:]

Our next question is from the line of Nicole Miller with Piper Jaffray.

[Nicole Miller:]

I just wanted to ask about the executive succession planning at the end of this three-year turnaround phase and what is really the milestone that you are looking to achieve to measure a successful turnaround?

[Howard Schultz:]

Well, you are talking about successful turnaround or succession planning?

[Nicole Miller:]

I guess two questions then, however you’d like to address it -- both.

[Howard Schultz:]

Well, in terms of succession planning, I’ve made a commitment to the board and to our people that I am here for the long-term and I have a -- there’s no -- I’m not looking behind me to say once we do X or Y, it’s time for me to find a successor. I am here for the long-term to lead the company back to the position it’s been and deeply committed to that process. The management team is strong. There’s lots of people within our organization that are heavily tenured and the organization I think is organized the right way but we are all looking at the same thing and that is a deep, comprehensive, and individual commitment to the long-term. In terms of milestones, prior to this past period, call it 18 months, we had the kind of relationship with our customers and our people and with our shareholders that basically exceeded expectations and we want to get back to the point where the level of confidence that you have in us is tied to where it once was. And we realize we have some work to do, but I don’t want to get into the specifics. We know that we’ve got negative traffic. We are not accustomed to that. We’re not happy with it. This is a management team in a company that is used to winning and we are built for that and we want to do that again.

[Nicole Miller:]

Thank you. I appreciate that color. Just a quick question on the numbers side -- when you talked about the free cash flow, you didn’t mention paying down debt, so I guess we’re to assume that you are implying that you will be at a net interest expense situation in the P&L. Is that right?

[Peter J. Bocian:]

We have some long-term debt, about $550 million and then we have some short-term. Keeping that kind of leverage across the horizon is probably a good assumption.

[Nicole Miller:]

Okay, and then just my last question on the numbers -- what are the conditions under which the U.S. operating margin could expand? Or asked another way, what are the constraints?

[Peter J. Bocian:]

First, we do believe ’08 is a recalibration versus ’07. Then we are cautious on how fast the economy turns and what the new kind of increase in traffic per year will be going forward. That said, we are very optimistic about all the innovation. We just haven’t baked it all in to the financial targets. So what I would describe as the up-side would be the innovation and/or the environment being better than we have baked in. So I view it as we’ve tried to be relatively conservative. You can discuss that against different measures of how bad the economy -- one person expects it to be but we’ve tried to bake in relatively conservative, which says we maintain the U.S. operating margins that we expect in ’08 and you can pretty much figure those out based on our directional guidance, and then maintain those through the horizon. There is a lot of opportunity I believe with the innovation to hit a home run. We haven’t baked it in.

[Nicole Miller:]

And how do commodities play a factor?

[Peter J. Bocian:]

We have some element of coffee and diary increases baked in. We also on the other hand have supply chain efficiencies and other procurement savings baked in, so I think not a material hit across the horizon. But we do expect to get efficiencies to offset what could happen. So we are not expecting dramatic changes and we’ve done a pretty good job in coffee, for example. If you look at this year, we may take a penny hit in coffee, which is pretty good given the size of the commodity. Dairy is going to be about $0.03 for the year. So overall, I think the team has done a great job in the coffee space and managing it. We can afford it to increase some over the horizon and then we are working on a number of things in procurement, supply chain, and cost and expense to mitigate it if it was bigger than our plan.

[Nicole Miller:]

Thank you very much.

[Operator:]

Our next question is from the line of Jeffrey Bernstein with Lehman Brothers.

[Jeffrey Bernstein:]

Great. Thank you. Actually, a couple of questions -- one just on international, as it becomes a larger portion of your business. Can you talk about maybe some of the markets where you are actually seeing the greatest success, perhaps a couple of key sales and margin levels? I think you mentioned international represents, or will represent 40% of your global portfolio, up from the current 30. So I was just wondering as an add-on, what about the percentage of profit from international? And then I had a follow-up.

[Howard Schultz:]

I’ll start and then Pete can jump in. When you look back on the fact that we opened our first international store in August of ’96 in Japan, and now in 44 countries, I think the headline reads that Starbucks has proven that the experience we’ve created in our stores is highly relevant and with great acceptance across very different markets, cultures, and whether we are pioneering in China or going to Western Europe where coffee has been there for hundreds of years have demonstrated great success. We’ve had unique experiences in many places with the upside probably the greatest in China in terms of number of stores and the real big prize there. But then you look at a country like Mexico where we probably in the initial business plan at most probably had 100 to 150 stores. We’ve been there five years. We’re close to 250 stores, just named best company to work for in Mexico, fantastic business there and that business will grow north of 500 stores. And there’s many markets like that, so I look at the U.K. and Japan, which have about 800 and 700 stores respectively, we’re still not showing any signs of hitting the wall in terms of saturation except of the near-term issue about the economy in the U.K. You know, we are very bullish on the international opportunity and the fact that we think we really haven’t gotten the economic leverage that Pete talked about in his formal remarks, which I think he’ll talk about now.

[Peter J. Bocian:]

I think to date, certainly the fact that it is heavily licensed means we don’t count the system sales so the revenue is not as big as the revenue of the U.S., but as you look out, when you run the numbers, a 20% growth rate with 100 basis points of op margin getting to 12% in 2011, that pot of operating income is big for the company. So you’ve got a compound annual growth rate of over 30% on the OI. So it moves -- it won’t be as big on the revenue side as the store portfolio by the nature of how we count the revenue, but it will move to a more material part of the company. And then I think the message is also that given the amount of licensed, I would argue at 12%, we still have room to go because we don’t count all the revenue, therefore we should have a much higher percent of revenue in reported and op income. So my view is this is a stake in the ground for the next three years. We’ve been treading water kind of OI as a percent of revenue in international for a couple of years and we need to do both -- grow at a healthy rate and then get the op margin expansion and it helps broaden the portfolio so we are not so U.S. dependent relative to where the profit comes.

[Jeffrey Bernstein:]

And in terms of those most successful international markets, are you seeing operating margins above the U.S.?

[Peter J. Bocian:]

What I’ve talked about before is that -- and this will be against an ’07 U.S., is that Canada is approaching the U.S. kind of margins. There is still more challenges around the spread. From a company-owned market, the U.K. is improving but behind Canada, and then the other big market that will be company-owned will be China, and I would describe that as in the early stages. Don’t need as much revenue to get store profitability but a lot of infrastructure to make sure we do it right. So you look at it, those are the three big ones. Then you move into the license space and some of the countries that Howard was talking about, whether it was Japan or Mexico. You know, we’re getting the royalty and the components of the license relationship.

[Howard Schultz:]

One thing I would also add is that we are beginning to leverage the relationships that we have with our partners. So as an example, perhaps our best -- one of our best-performing partners is our partner in Mexico and the Middle East. In both those cases, our Mexico partner is our partner in Brazil and will be our partner as we open up Argentina. The Middle East business, which has been a great business for us with the Alshaya group is also our new partner in Russia. So our partners want more geography and I think that bodes well for the fact that this is a business that they believe in and I think these are still the embryonic stages of the growth and development of our international business.

[Jeffrey Bernstein:]

And Howard, just one follow-up; I’m just wondering if you can give any greater detail kind of from a U.S. base, but the consumer research you guys have been talking about recently showing that U.S. traffic declines are due more to economic pressures rather than the substitution with --

[Howard Schultz:]

Well, I’m glad you asked me that question because I had heard that there is some cynicism from the research and I just -- it’s just black and white. It speaks for itself. So we went out. We’ve done more research in the last three months than we’ve done in a number of years, given the uncertainty of the economy and where the business is and the fact that we want to make some very big bets on the innovation pipeline. But the first thing we wanted to really understand is that given the compression in traffic, we wanted to specifically understand what is driving customers to either come less frequently or not come at all. And the unequivocal data, and we’ve shared this with our board and obviously our management team, is the fact that the economy is the top box why people are not coming as often or not coming for that treat. And then specifically when we asked are you going to other establishments in view of the fact that you are not coming to Starbucks, there is no indication whatsoever that we are losing business specifically to any one competitor or a new category of competitors. And there is no silver lining in the fact that we have less customers coming to our stores now but the fact that it is -- the economy does demonstrate to us that we have a strong headwind that we need to understand and we are dealing with and it is different than any other time in our history. And as a result of that, we are trying to operate differently.

[Jeffrey Bernstein:]

So does that change your thought process in terms of offering greater value if they are not trading down, per se?

[Howard Schultz:]

Well, I think that what we saw with the launch of Pike Place Roast is that we are getting some incrementality as a result of that brewed coffee and its unique taste, and also potentially we are getting people who have not come before because they’ve been an espresso-based drinker or perhaps they are trading down. But we haven’t seen that in terms of the average ticket. When we launch the Italian beverage in California this summer, we will price that beverage to be what we would view as an affordable luxury and something that will be I think very interesting for our customers in view of the fact that it will be less expensive than Frappuccino.

[Jeffrey Bernstein:]

Thank you.

[Operator:]

Our next question is from the line of Steven Kron with Goldman Sachs.

[Steven Kron:]

Just looking at your targets a few years out of 11.5% in the U.S. and just looking at that compared to even just last year at 14.5, you know, 300 basis point degradation there. Just looking or assuming the sales improvements by that point will have kicked in and you know, the expense rationalization that you talk about, can you talk about some of the offsets here? I mean, are you expecting a mix change like the new products that you are introducing might be a lower margin product or what’s going to prevent those margins from getting back? And I know you talked about maybe that’s upside but it just struck me as a number that seemed pretty low, given where the business was just in fiscal ’07.

[Peter J. Bocian:]

I think clearly the recalibration in ’08 is the negative traffic on the store base, as there are other pressures, whether it’s dairy, whether it’s natural wage pressures that happen every year. So I view ’08 as a starting point and then, taking conservative growth rates from there. Clearly if we can beat the growth rates or they return to the comps of old and we are not putting that in the plan, that would be upside. But I think it’s important that we are recalibrated on improving op income in the U.S. without significant comps from the new ’08 baseline. I recognize it doesn’t look favorable against ’07 but I am trying to recalibrate our expectations going forward, and then looking for some element of upside if economy/innovation is better.

[Steven Kron:]

So there is nothing else from the expense side that we should be expecting, whether it’s a mix shift in cost of sales absent commodity inflation will continue to be a headwind or other types of store operating expenses?

[Peter J. Bocian:]

No, it’s really just the moderating of the growth rate is not -- you know, doesn’t cover as much of the cost and expense that could and will increase somewhat over the horizon.

[Howard Schultz:]

I also want to add that this is a time when I think our management team and our board wants to create expectations that at a minimum we meet and we want to be conservative in our approach, especially in view of the fact that no one, at least around this table, can predict when the economy is going to change.

[Steven Kron:]

Okay, fair enough. And then I guess Howard, obviously you mentioned this is a business that’s built on transactions and you are focused back on your beverage, further emphasis on the beverage side of the business. It seems as though a lot of new products coming through over the course of the next 12 to 18 months, perhaps maybe fast-tracking some of the products, bringing them to market a little bit quicker. I guess in light of that, can you maybe discuss how your comfort level with the amount of testing you are doing on a lot of these products before bringing them into the stores, given that it is maybe on an faster profile?

[Howard Schultz:]

Sure, yeah. Well, let’s start with health and wellness first. We did a very good job of testing that under the radar in a number of stores over the past few months, coupled with the very strong response we got from research. And as I said in my remarks, that category really speaks volumes to our customers need states and we believe strongly that we provide our customers with a reason to come to Starbucks that is incremental to their coffee need. The product tested well and exceeded the expectations we had in terms of units per day. We think we’ve done a great job in terms of the flavor and I think it is important to note that we are not introducing a product -- we are creating a new platform in the company around beverages and food. And the food program is done. It is all ready to go. We will launch that in September, followed by the second tranche of food, which will come in the fall that will replace the breakfast sandwich. But health and wellness beverages, we think we’ve hit the mark and it’s spot-on in terms of the trend. The energy beverage, this is almost a $5 billion category, again leveraging Pepsi’s distribution system as well as their manufacturing capability and leveraging the fact that we have license to play in that space and perhaps we should have been in it sooner, but we also will be the first retail establishment to create that product customized for our customer than then the halo that I think we’ll get off Pepsi’s system, like we did with bottled Frappuccino should drive traffic into our stores. It’s also a younger customer, should be incremental. Third, the Italian beverage is something we discovered. We couldn’t be more excited about it. You know, the proof of everything is how it tastes and this is a product that is very unique in flavor, in profile, in texture and we think we’ve got it right. Not everything is equal here in terms of its -- you know, what we think it’s going to do but we haven’t had a lot of innovation at Starbucks for quite some time. We’ve been in the business of building flavors and line extensions, and we’re getting back off our heels and back on the offense and we are going to innovate like hell and bring new products and new excitement both to our customers and our people and we are going to get it right.

[Steven Kron:]

Okay. Thanks very much.

[Operator:]

Our next question is from the line of Carol Lintz with Pioneer Investment.

[Carol Lintz:]

I have a couple of questions; first, in your capital spending budget, how much of that is going to be for maintenance capital spending on the existing units? Second, in the food program, will this require additional equipment to be brought into the store or will food be brought in pre-prepared? And finally, in the new Italian beverage that is Cappuccino like, you mentioned I believe that the pricing is at a lower level than the current Frappuccino line. What impact would that have on margins?

[Howard Schultz:]

Let me just take the back end -- so the new beverage, it’s not Frappuccino like or Cappuccino like. It is a summer beverage that is both indulgent but low calorie and refreshing, and will be priced at an attractive price point. And I’m not going to speak to margins on that for a whole host of reasons, but it meets the requirements that we’ve always had for our beverage business. In terms of food, there is no new equipment that is required for the food program. We are going to -- the food program will be enabled by the existing equipment and warming that we have in existing stores.

[Peter J. Bocian:]

Just adding on that, we did slow down or stop the rollout of warming until we had a clear view of the breakfast sandwich replacement, so we will pick that up but there’s I think 3300 stores today that are already warming enabled and that’s all we need to have for the new food rollout. On your capital question, I defined of the $800 million per year about 70% is store and I just, rule of thumb, half and half between new store and renovation, roughly speaking.

[Operator:]

Our next question is from the line of Larry Miller with RBC Capital Markets.

[Larry Miller:]

Thank you very much. I had a couple of questions on the international margins. First of all, I was under the impression that they were structurally lower than the U.S. and it sounds like that is going to reverse over the next couple of years when you get to 12% and the U.S. business 11%, so maybe you could help me understand why that might be. Thanks.

[Peter J. Bocian:]

I didn’t want to get here by the U.S. going down and international going up, so that’s the first data point and we’ll work on the U.S. But structurally, it’s actually the opposite, right? We count less of the system, less of the revenue for international. The profit dollars per revenue we count is higher in a license model, so structurally the question I’ve often got is why is international better than U.S.? Because of the nature of the structure, so I think this plan shows good progress towards what should be a higher operating margin type model driven by the percent of licensed, and as I mentioned earlier, we’ve been running about 40-60 -- 40% company-owned, 60% licensed historically. And then over this horizon, moving to 65%-plus licensed, so we’ve been getting more leverage out of the structural relationship.

[Operator:]

Our next question is from the line of Matt Difrisco with Oppenheimer.

[Matt Difrisco:]

Thank you. My question is I think Howard, you made a comment earlier in the call here about Pike’s and you made a note that it didn’t start until April and this is one of the key initiatives. I’m just curious; the comment said that it was being well-received. Is that incremental or do you think that is somewhat substituting? And then I have a little bit of a follow-on there.

[Howard Schultz:]

Thank you. So it’s a little bit more than three weeks in and we are getting some incrementality from the beverage, and so the encouraging news is that we are seeing -- first of all, we think we are, as I said in my remarks, under-represented in the brewed coffee space, which we think is a huge opportunity for us which we haven’t focused on probably for 20 years. All of the emphasis and all of the excitement has always been on espresso and espresso beverages and that’s where innovation has come. This is the first time we’ve really I think created a new coffee that we think really speaks distinctively to doing something that really differentiates itself from everyone else. The response has been very positive. We have gotten incrementality, strongest has been in the Northeast and we are early in but we are enthused.

[Operator:]

Our next question is from the line of John Ivankoe with J.P. Morgan.

[John Ivankoe:]

Thank you. First a clarification, if I may; Pete, I just want to make sure that I heard you right regarding the international margins. Did you say that if it was excluding I guess store closure and transformation charges that margins would have been up 100 basis points in the second quarter, or would that be for the first half of 2008?

[Peter J. Bocian:]

For the first half. We had a very strong Q1, some of it is related to timing but we were up -- so I said year-to-date, try to give you a sense of the size of the store rationalization and the transformation that all happened in Q2.

[Operator:]

Our next question is from the line of Sharon Zackfia with William Blair.

[Sharon Zackfia:]

Good afternoon. Howard, I’m curious -- as you’ve been implementing a lot of these initiatives in the U.S., have you seen any negative ramifications in terms of customer confusion or slower lines, reduced throughput?

[Howard Schultz:]

No. I think we have a tool that we use, which we call customer voice, and that tool is for us to gauge the experience that our customers are having in the stores and whether or not -- and we obviously monitor this very, very often, both in terms of comparing it both in the near-term and over the long-term, and since espresso excellence training has come about, there is clearly a noticeable difference in the level of engagement. I think sometimes the lines have been a little bit longer because we are asking people to customize milk, to make shots in espresso shot glasses as opposed to in a paper cup. But we’ve encouraged our people to just say to the customer I’m sorry, you might be waiting a little bit longer, but we want to make the drink perfect for you. And if anything, I think people have seen the fact that Starbucks is making a concerted effort to elevate the experience and the quality and so the short answer is we haven’t seen anything that would give us pause that the transformation and the things that we are doing and bringing to the stores is causing anything but a net positive for us.

[Operator:]

(Operator Instructions) Our next question is from the line of Gary Magnusson with Smith Barney.

[Gary Magnusson:]

Howard, with hiring back Arthur, have you explored -- I was sort of surprised with the slowdown in the store count in the U.S. and was wondering what you think about the possibility of locations in smaller towns? Can you give us some color just on the slowdown and maybe speeding up later on in the future?

[Howard Schultz:]

Well, first off, we think it is absolutely the most disciplined and prudent decision to slow the U.S. growth down and to rationalize the store base. I think that’s going to help us in terms of -- on a number of issues, but Arthur was the initial architect for both store design, real estate selection, construction, and really I think is the right person to come back and really author this new strategy for the company. And the thing that he is working on is no longer domestic but he is working on the global portfolio of the company, and the areas that we are focused on in addition to the rationalization of the stores, more importantly than that is the future of the company and we are looking at different store formats, new store designs, and ways in which that we can create a local relevance to offset the growth and perhaps the ubiquity of the company. And that’s what Arthur’s strength is and there’s lots of learnings that we have that we think we can bring to the marketplace. We have not talked about the innovation in terms of store design and what we have planned. That will be for future calls. But we do believe strongly that this is the prudent thing to do at this time to slow down the U.S. growth.

[Operator:]

Our next question is from the line of Colin Guheen with Cowen.

[Colin Guheen:]

A quick question -- on the international investment, as you increase the number of stores, is there any change in where you are investing in company-owned stores? Any markets that are getting extra stores?

[Peter J. Bocian:]

No, I think for the next three years, the major company-operated markets will be Canada, U.K., China, and then Japan is a big market that is a licensed partner. So no real dramatic change in where the investment in -- if we looked Canada and the U.K., we’ve talked about before probably 30%, 40% built out of what we think is the potential, so we’ll continue to invest in those countries stepping through the horizon, but no dramatic change, though you do see five points higher license content, so there will be some movement between company-owned and licensed over time.

[Operator:]

Our next question is from the line of Mark Greenberg with Deutsche Bank.

[Mark Greenberg:]

Thank you. Back to the research question, I’m wondering looking either just exclusively at research or perhaps broadening out to deteriorating financial metrics, is there anything that you would see from a data standpoint that would cause you to think that perhaps store saturation and competition were responsible for some of the decline in comp store sales. And if that were the case, would you begin again to redress your store plans, specifically actually cutting the overall store base?

[Howard Schultz:]

Well, there is no evidence based on the research that we just completed that the issue is based on competition, which I’ve already stated. So I can’t speak to the hypothetical because it doesn’t exist. What we view right now is something I’ve been saying since my return as CEO and it’s not with arrogance or hubris -- this is about Starbucks. This is about our ability to create excitement and demand in our stores and do the things that we’ve always done really well that unfortunately we haven’t done all that well over the last year, year-and-a-half. But the experience that we create in our stores has been the brand. We don’t believe that when we are at our best that we are second to anyone and we are going to get back to doing what we have always done well, and that is create a differentiation in the marketplace around coffee, the coffee experience, and innovation. So we don’t view the competitive landscape or what you cited about saturation as the issue. The primary issue that we are facing, which we have not faced before, and that’s new, is the fact that this downturn in the economy, unlike anything else that we have experienced before, in which we have been able to manage through other downturns and economic cycles, this is one that has affected us and we are managing through it in the best way we can and we are not alone. We are a part of a lot of other retail companies and consumer brands that are facing similar things, and when we look at mid-single-digit negative traffic, although that’s a number that we are not accustomed to and make no mistake about it, not satisfied with, in the landscape of other retailers we are faring much better than most.

[Peter J. Bocian:]

And the only thing I would add is that we are going to continue to look hard at the performance of the stores. When you look at the 100 that we’ve talked about for this year in the U.S., that’s way above historical trends in terms of what we’ve been looking to close in a year, or looking at. And you couple that with the international discussion we’ve had throughout the call, we’ll continue to take a hard look at the store performance, trying to factor in the relative economic environment and the long-term viability of that store.

[Howard Schultz:]

I think we’ll take one more question.

[Operator:]

Our final question is from the line of David Palmer with UBS.

[David Palmer:]

Howard, just to beat on this horse a little bit longer, the Starbucks same-store sales has been slowing more than what we see, for instance, in the casual dining segment, which one would think is a fairly discretionary occasion for the consumer. In fact, the same-store sales now trending worse than the entire industry so what I’m wondering is, do you think -- and maybe you see a correlation with the type of stores, whether they are near shopping, is it the fact that perhaps you just -- your stores tend to get that type of traffic, that shopping traffic and that’s what you are linking to the problem as much or more than $3.50 drink is too much for somebody at any one point.

[Howard Schultz:]

Let me try and answer this in a way that hopefully will relieve the concerns that you have. First and foremost, please make it crystal clear -- we are not satisfied with the down turn in traffic in our stores and we are working diligently to reverse that. We are not using the economy as an excuse but clearly the headwind of the economy has had a significant effect on our business. And you just have to look to South Florida and California. There is a direct correlation in terms of the downturn in our business and the acuteness of the compression in traffic in those markets, and specifically those markets are the ones that have been most drastically affected by the sub-prime mortgage issue. Conversely, if you look at the Northeast, New England and New York, where we are continuing to have strong comp-store sales, those are markets that have not been affected. And then if you look at the landscape of traditional retailers, not casual dining. We’re not in a casual dining business, nor do I think that’s a good correlation. If you look at the high-end retailers or premium brands that are retailing product, whether it’s Coach, Nordstrom, Crate and Barrel, Williams-Sonoma -- if you look at those numbers, many of those businesses are at negative double-digit comps. So where we are looking at so much data as a company and trying to understand where we fit into all this, we don’t have empirical analysis but we strongly believe it is not the competition. The research strongly suggests that. We don’t believe that we’ve saturated the market but we do believe that we have a headwind the likes of which we’ve never seen. It’s not short-term in nature. There’s a deep concern that the consumer has and we are being affected by the fact that Starbucks Coffee and a premium coffee experience has over time been an affordable luxury and at this time, it isn’t for some people and they are cutting out the occasion or are less frequent, and that’s why we are bringing the kind of innovation we are to address multiple need states, multiple day parts, and new categories that are exactly what our customers have told us in terms of health and wellness, energy, and a new product that we are pretty excited about that doesn’t exist in the U.S. And I’ll also say that this is just the beginning of the innovation. We haven’t talked about a lot of things that are going to come in calendar ’09. With that, we’ll conclude the call and I’ll just give it to JoAnn to close this.

[JoAnn DeGrande:]

Thanks, Howard. Thank you for joining us today. That does close out our second quarter earnings conference call and we hope you’ll join us on Wednesday, July 30th when we announce our Q3 earnings and have our call that afternoon as well. Thanks again.

[Operator:]

Ladies and gentlemen, this concludes today’s Starbucks Coffee Company conference call. You may now disconnect.