UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

Form 10-K

 

 

Commission File Number: 0-20322

 

Starbucks Corporation

(Exact name of registrant as specified in its charter)

 

 

2401 Utah Avenue South
Seattle, Washington 98134
(Address of principal executive offices, zip code)

 

(Registrant’s telephone number, including area code):

(206) 447-1575

 

Securities Registered Pursuant to Section 12(b) of the Act:

Common Stock, $0.001 Par Value Per Share

 

Securities Registered Pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation of S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one)

 

Large Accelerated Filer þ          Accelerated Filer o          Non-Accelerated Filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of the voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter, based upon the closing sale price of the registrant’s common stock on March 30, 2007 as reported on the NASDAQ Global Select Market was $22.7 billion.

 

As of November 16, 2007, there were approximately 730.4 million shares of the registrant’s Common Stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the definitive Proxy Statement for the registrant’s Annual Meeting of Shareholders to be held on March 19, 2008 have been incorporated by reference into Part III of this Annual Report on Form 10-K.

 

 

STARBUCKS CORPORATION

 

Form 10-K

 

For the Fiscal Year Ended September 30, 2007

 

TABLE OF CONTENTS

 

 

PART I

 

 

General

 

Starbucks Corporation (together with its subsidiaries, “Starbucks” or the “Company”) was formed in 1985. Starbucks purchases and roasts high-quality whole bean coffees and sells them, along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended beverages, a variety of complementary food items, coffee-related accessories and equipment, a selection of premium teas and a line of compact discs, primarily through Company-operated retail stores. Starbucks also sells coffee and tea products and licenses its trademark through other channels and, through certain of its equity investees, Starbucks produces and sells ready-to-drink beverages which include, among others, bottled Frappuccino^® beverages and Starbucks DoubleShot^® espresso drinks, and a line of superpremium ice creams. All channels outside the Company-operated retail stores are collectively known as “Specialty Operations.” The Company’s objective is to establish Starbucks as one of the most recognized and respected brands in the world. To achieve this goal, the Company plans to continue expansion of its retail operations, to grow its Specialty Operations and to selectively pursue other opportunities to leverage the Starbucks brand by introducing new products and developing new channels of distribution. The Company’s brand portfolio includes superpremium Tazo^® teas, Starbucks Hear Music^® compact discs, Seattle’s Best Coffee^® and Torrefazione Italia^® coffee.

 

Segment Financial Information

 

Starbucks has three reportable operating segments: United States, International and Global Consumer Products Group (“CPG”). The United States and International segments both include Company-operated retail stores and certain components of Specialty Operations. Specialty Operations within the United States include licensed retail stores, foodservice accounts and other initiatives related to the Company’s core business. International specialty operations primarily include retail store licensing operations in more than 30 countries and foodservice accounts in Canada and the United Kingdom (“UK”). The CPG segment includes the Company’s grocery and warehouse club business as well as branded products operations worldwide. Financial information about Starbucks segments is included in Note 18 to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K (“Form 10-K” or “Report”).

 

Revenue Components

 

The following table shows the Company’s revenue components for the fiscal year ended September 30, 2007:

 

Company-operated Retail Stores

 

The Company’s retail goal is to become the leading retailer and brand of coffee in each of its target markets by selling the finest quality coffee and related products and by providing each customer a unique Starbucks Experience. The Starbucks Experience, or third place after home and work, is built upon superior customer service as well as clean and well-maintained Company-operated retail stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. Starbucks strategy for expanding its retail business is to increase its market share primarily by opening additional stores in existing markets and opening stores in new markets where the opportunity exists to become the leading specialty coffee retailer. In support of this strategy, Starbucks opened 1,342 new Company-operated stores during the fiscal year ended September 30, 2007 (“fiscal 2007”). Starbucks Company-operated retail stores, including 11 Seattle’s Best Coffee^® stores and 4 Hear Music retail stores, accounted for 85% of total net revenues during fiscal 2007.

 

The following table summarizes total Company-operated retail store data for the periods indicated:

 

 

 

 

Starbucks retail stores are typically located in high-traffic, high-visibility locations. Because the Company can vary the size and format, its stores are located in or near a variety of settings, including downtown and suburban retail centers, office buildings and university campuses. While the Company selectively locates stores in shopping malls, it focuses on locations that provide convenient access for both pedestrians and drivers. With the flexibility in store size and format, the Company also locates retail stores in select rural and off-highway locations to serve a broader array of customers outside major metropolitan markets and further expand brand awareness. To provide a greater degree of access and convenience for nonpedestrian customers, the Company continues to expand development of Drive Thru retail stores. At the end of fiscal 2007, the Company operated approximately 2,300 Drive Thru locations, compared to approximately 1,600 at the end of fiscal 2006.

 

All Starbucks stores offer a choice of regular and decaffeinated coffee beverages, a broad selection of Italian-style espresso beverages, cold blended beverages, iced shaken refreshment beverages, a selection of teas and distinctively packaged roasted whole bean coffees. Starbucks stores also offer a selection of fresh pastries and other food items, sodas, juices, bottled water, coffee-making equipment and accessories, a selection of compact discs and seasonal novelty items. Each Starbucks store varies its product mix depending upon the size of the store and its location. Larger stores carry a broad selection of the Company’s whole bean coffees in various sizes and types of packaging, as well as an assortment of coffee and espresso-making equipment and accessories such as coffee grinders, coffee filters, storage containers, travel tumblers and mugs. Smaller Starbucks stores and kiosks typically sell a full line of

coffee beverages, a limited selection of whole bean coffees and a few accessories such as travel tumblers and logo mugs. A selection of prepared sandwiches and salads were carried in approximately 4,800 United States and 1,600 International stores, at the end of fiscal 2007. Starbucks continues to expand its food warming program in the United States, with over 3,000 stores as of September 30, 2007 providing warm food items, primarily breakfast sandwiches.

 

The Company’s retail sales mix by product type was as follows for the periods indicated:

 

 

Specialty Operations

 

Specialty Operations strive to develop the Company’s brands outside the Company-operated retail store environment through a number of channels. Starbucks strategy is to reach customers where they work, travel, shop and dine by establishing relationships with prominent third parties that share the Company’s values and commitment to quality. These relationships take various forms, including licensing arrangements, foodservice accounts and other initiatives related to the Company’s core businesses. In certain situations, Starbucks has an equity ownership interest in licensee operations. During fiscal 2007, specialty revenues (which include royalties and fees from licensees, as well as product sales derived from Specialty Operations) accounted for 15% of total net revenues.

 

Licensing — Retail stores

 

In its licensed retail store operations, the Company leverages the expertise of its local partners and shares Starbucks operating and store development experience. Licensee partners provide improved and, at times, the only access to desirable retail space. Most licensees are prominent retailers with in-depth market knowledge and access. As part of these arrangements, Starbucks receives license fees and royalties and sells coffee, tea, compact discs and related products for resale in licensed locations. Employees working in licensed retail locations are required to follow Starbucks detailed store operating procedures and attend training classes similar to those given to employees in Company-operated stores.

 

During fiscal 2007, 723 Starbucks licensed retail stores were opened in the United States and, as of September 30, 2007, the Company’s U.S. licensees operated 3,891 stores. During fiscal 2007, 506 International licensed stores were opened. At September 30, 2007, the Company’s International operating segment had a total of 2,615 licensed retail stores. Product sales to and royalty and license fee revenues from U.S. and International licensed retail stores accounted for 47% of specialty revenues in fiscal 2007.

 

At fiscal year end 2007, Starbucks total licensed retail stores by region and specific location were as follows:

 

Licensing — Grocery and warehouse club

 

The Company, through a licensing relationship with Kraft Foods, Inc. (“Kraft”), sells a selection of Starbucks, Seattle’s Best Coffee and Torrefazione Italia branded packaged coffees and Tazo^® teas in grocery and warehouse club stores throughout the United States. Kraft manages all distribution, marketing, advertising and promotion of these products.

 

The Company sells packaged coffee and tea internationally both directly to warehouse club customers such as Costco and through an expanded licensing relationship with Kraft. In February 2007, the licensing relationship with Kraft was expanded globally and now also includes distribution of packaged coffee in Canada and the UK.

 

By the end of fiscal 2007, the Company’s coffees and teas were available in approximately 34,000 grocery and warehouse club stores, with 30,000 in the United States and 4,000 in International markets. Revenues from this category comprised 23% of specialty revenues in fiscal 2007.

 

Licensing — Branded products

 

The Company licenses the rights to produce and market Starbucks branded products through several partnerships both domestically and internationally. The North American Coffee Partnership, a joint venture with the Pepsi-Cola Company in which Starbucks is a 50% equity investor, manufactures and markets ready-to-drink beverages, including bottled Frappuccino^® beverages and Starbucks DoubleShot^® espresso drinks. Other partnerships produce and market branded products in these categories: superpremium ice cream (joint venture with Dreyer’s Grand Ice Cream, Inc.), premium coffee liqueur (license agreement with Beam Global Spirits & Wine) and chocolate (license agreement with The Hershey Company). Internationally, the Company licenses Starbucks Discoveries^®, a ready-to-drink chilled cup coffee beverage, in Japan, Taiwan and South Korea.

 

Collectively, the revenues from these branded products accounted for 3% of specialty revenues in fiscal 2007.

 

Foodservice

 

The Company sells whole bean and ground coffees, including the Starbucks, Seattle’s Best Coffee and Torrefazione Italia brands, as well as a selection of premium Tazo^® teas and other related products, to institutional foodservice companies that service business & industry, education, healthcare, office coffee distributors, hotels, restaurants, airlines and other retailers. The majority of the Company’s direct distribution accounts are through national broadline distribution networks with SYSCO Corporation and U.S. Foodservice^tm. Starbucks foodservice sales, customer service and support resources are aligned with those of SYSCO Corporation and U.S. Foodservice. Starbucks and Seattle’s Best Coffee are the only superpremium national-brand coffees actively promoted by SYSCO Corporation.

 

The Company’s total foodservice operations had approximately 18,000 accounts, primarily in the U.S., at fiscal year end 2007, compared to approximately 16,200 accounts at fiscal year end 2006. Revenues from foodservice accounts comprised 26% of total specialty revenues in fiscal 2007.

 

Other Initiatives

 

Included in this category is the Company’s entertainment business, which encompasses multiple music, book, film and technology based initiatives designed to appeal to new and existing Starbucks customers. Among these initiatives are strategic marketing and co-branding arrangements, such as the Starbucks XM Café Channel 45 available to all XM Satellite Radio subscribers and the availability of wireless broadband Internet service in United States and Canadian Company-operated retail stores. The entertainment business also includes the Hear Music label, an innovative record label and partnership between Starbucks Entertainment and Concord Music Group. In fiscal 2007, Starbucks and Apple^® announced an exclusive partnership that lets customers wirelessly browse, preview, buy and download music from the iTunes^® Wi-Fi Music Store onto their wireless devices while at participating Starbucks locations.

 

The Company has a strategic agreement with Chase Bank USA, N.A. and Visa to issue the Starbucks Card Duetto^tm Visa^® (the “Duetto Card”) in the United States, and a similar arrangement with Royal Bank of Canada and Visa

Canada Association to issue the Duetto Card in Canada. The Duetto Card combines the functionality of a credit card with the convenience of a reloadable Starbucks Card. Through these arrangements, Starbucks primarily receives commissions for each activated customer account and payments based on credit card usage.

 

Collectively, the operations of these other initiatives accounted for 1% of specialty revenues in fiscal 2007.

 

Product Supply

 

Starbucks is committed to selling only the finest whole bean coffees and coffee beverages. To ensure compliance with its rigorous coffee standards, Starbucks controls its coffee purchasing, roasting and packaging, and the distribution of coffee used in its operations. The Company purchases green coffee beans from coffee-producing regions around the world and custom roasts them to its exacting standards for its many blends and single origin coffees.

 

The supply and price of coffee are subject to significant volatility. Although most coffee trades in the commodity market, high-altitude arabica coffee of the quality sought by the Company tends to trade on a negotiated basis at a substantial premium above commodity coffee prices, depending upon the supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence prices of green coffee through agreements establishing export quotas or by restricting coffee supplies.

 

The Company depends upon its relationships with coffee producers, outside trading companies and exporters for its supply of green coffee. Due to volatility in green coffee commodity prices, the Company has predominantly used fixed-price purchase commitments in order to secure an adequate supply of quality green coffee, bring greater certainty to its cost of sales in future periods, and promote sustainability by paying an equitable price to coffee producers. As of September 30, 2007, the Company had $324 million in fixed-price purchase commitments which, together with existing inventory, is expected to provide an adequate supply of green coffee through fiscal 2008. The Company believes, based on relationships established with its suppliers, the risk of non-delivery on such purchase commitments is remote. During fiscal 2007, “C” coffee commodity prices traded on the New York Board of Trade within a price range of $1.00 to $1.35 per pound and prices were, on average, approximately 10% higher than in fiscal 2006. In September 2007, prices moved sharply higher as poor weather led to decreased expectations for the next harvest in the world’s largest arabica coffee producer, Brazil. Based on its market experience, the Company believes that fixed-price purchase commitments are less likely to be available on favorable terms when commodity prices are high. If prices were to continue to move higher during fiscal 2008, Starbucks likely would increase the use of price-to-be-fixed purchase contracts to meet its demand for coffee. These types of contracts state the quality, quantity and delivery periods but allow the price of green coffee over a market index to be established after contract signing. The Company believes that, through a combination of fixed-price and price-to-be-fixed contracts it will be able to secure an adequate supply of quality green coffee. However, an increased use of price-to-be-fixed contracts instead of fixed-price contracts would decrease the predictability of coffee costs in future periods. By volume, approximately 20% of the Company’s coffee purchase agreements entered during fiscal 2007 were price-to-be-fixed contracts.

 

During fiscal 2004, Starbucks established the Starbucks Coffee Agronomy Company S.R.L., a wholly owned subsidiary located in Costa Rica, to reinforce the Company’s leadership role in the coffee industry and to help ensure sustainability and future supply of high-quality green coffees from Central America. Staffed with agronomists and sustainability experts, this first-of-its-kind Farmer Support Center is designed to proactively respond to changes in coffee producing countries that impact farmers and the supply of green coffee. During fiscal 2007, the Company announced plans to conduct similar activities in East Africa.

 

In addition to coffee, the Company also purchases significant amounts of dairy products, particularly fluid milk, to support the needs of its Company-operated retail stores. Dairy expense for the U.S. segment represents approximately 75% of the Company’s total dairy expense; therefore significant changes in U.S. dairy prices can have a material impact on total dairy expense. The U.S. segment’s dairy costs, which closely follow the monthly Class I fluid milk base price as calculated by the U.S. Department of Agriculture, can change significantly in the short term. The Company’s U.S. dairy costs rose materially in fiscal 2007 compared to fiscal 2006 and costs accelerated in the

fourth quarter of fiscal 2007 and have remained high, adversely affecting the U.S. segment’s and the Company’s profitability. In the United States, the Company purchases substantially all of its fluid milk requirements from two dairy suppliers. The Company believes, based on relationships established with these suppliers, that the risk of non-delivery of enough fluid milk to support its U.S. retail business is remote.

 

The Company also purchases a broad range of paper and plastic products, such as cups, lids, cutlery, napkins, straws, shopping bags and corrugated paper boxes from several companies to support the needs of its retail stores as well as its manufacturing and distribution operations. The cost of these materials is dependent in part upon commodity paper and plastic resin costs, but the Company believes it mitigates the effect of short-term raw material price fluctuations through strategic relationships with key suppliers.

 

Products other than whole bean coffees and coffee beverages sold in Starbucks retail stores are obtained through a number of different channels. Beverage ingredients, other than coffee and milk, including leaf teas and the Company’s selection of ready-to-drink beverages, are purchased from several specialty manufacturers, usually under long-term supply contracts. Food products, such as fresh pastries, breakfast sandwiches and lunch items, are generally purchased from both regional and local sources. Coffee-making equipment, such as drip and coffee press coffeemakers, espresso machines and coffee grinders, are generally purchased directly from their manufacturers. Coffee-related accessories, including items bearing the Company’s logos and trademarks, are produced and distributed through contracts with a number of different suppliers.

 

Competition

 

The Company’s primary competitors for coffee beverage sales are quick-service restaurants and specialty coffee shops. In almost all markets in which the Company does business, there are numerous competitors in the specialty coffee beverage business, and management expects this situation to continue. The Company believes that its customers choose among retailers primarily on the basis of product quality, service and convenience, and, to a lesser extent, on price. Starbucks has recently experienced significantly greater direct competition from large competitors in the United States quick-service restaurant sector, some of whom have substantially greater financial, marketing and operating resources than the Company. Starbucks also faces well-established competitors in many International markets and increased competition in the U.S. ready-to-drink coffee beverage market.

 

The Company’s whole bean coffees compete directly against specialty coffees sold through supermarkets, specialty retailers and a growing number of specialty coffee stores. Both the Company’s whole bean coffees and its coffee beverages compete indirectly against all other coffees on the market. Starbucks Specialty Operations face significant competition from established wholesale and mail order suppliers, some of whom have greater financial and marketing resources than the Company.

 

Starbucks faces intense competition from both restaurants and other specialty retailers for prime retail locations and qualified personnel to operate both new and existing stores.

 

Patents, Trademarks, Copyrights and Domain Names

 

The Company owns and/or has applied to register numerous trademarks and service marks in the United States and in many additional countries throughout the world. Rights to the trademarks and service marks in the United States are generally held by a wholly owned affiliate of the Company and are used by the Company under license. Some of the Company’s trademarks, including Starbucks, the Starbucks logo, Frappuccino, Seattle’s Best Coffee and Tazo are of material importance to the Company. The duration of trademark registrations varies from country to country. However, trademarks are generally valid and may be renewed indefinitely as long as they are in use and/or their registrations are properly maintained.

 

The Company owns numerous copyrights for items such as product packaging, promotional materials, in-store graphics and training materials. The Company also holds patents on certain products, systems and designs. In addition, the Company has registered and maintains numerous Internet domain names, including “Starbucks.com” and “Starbucks.net.”

Research and Development

 

Starbucks research and development efforts are led by food scientists, engineers, chemists and culinarians in the Research and Development department. This team is responsible for the technical development of food and beverage products and new equipment. The Company spent approximately $7.0 million, $6.5 million and $6.2 million during fiscal 2007, 2006 and 2005, respectively, on technical research and development activities, in addition to customary product testing and product and process improvements in all areas of its business.

 

Seasonality and Quarterly Results

 

Starbucks business is subject to seasonal fluctuations, including fluctuations resulting from the holiday season. The Company’s cash flows from operations are considerably higher in the fiscal first quarter than the remainder of the year. This is largely driven by cash received as Starbucks Cards are purchased and loaded during the holiday season. Since revenues from the Starbucks Card are recognized upon redemption and not when purchased, seasonal fluctuations on the consolidated statements of earnings are much less pronounced. Quarterly results are affected by the timing of the opening of new stores, and the Company’s growth may conceal the impact of other seasonal influences. For these reasons, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.

 

Employees

 

The Company employed approximately 172,000 people worldwide as of September 30, 2007. In the United States, Starbucks employed approximately 144,000 people, with 136,000 in Company-operated retail stores and the remainder in the Company’s administrative and regional offices, and store development, roasting and warehousing operations. Approximately 28,000 employees were employed outside of the United States, with 27,000 in Company-operated retail stores and the remainder in the Company’s regional support facilities and roasting and warehousing operations. The number of the Company’s employees represented by unions is immaterial. Starbucks believes its current relations with its employees are good.

 

Available Information

 

Starbucks Form 10-K reports, along with all other reports and amendments filed with or furnished to the Securities and Exchange Commission (“SEC”), are publicly available free of charge on the Investor Relations section of Starbucks website at http://investor.starbucks.com or at www.sec.gov as soon as reasonably practicable after these materials are filed with or furnished to the SEC. The Company’s corporate governance policies, ethics code and Board of Directors’ committee charters are also posted within this section of the website. The information on the Company’s website is not part of this or any other report Starbucks files with, or furnishes to, the SEC.

 

Starbucks demonstrates its commitment to corporate social responsibility (“CSR”) by conducting its business in ways that produce social, environmental and economic benefits to the communities in which Starbucks operates. The Company aligns its principles for social responsibility with its overall strategy and business operations. As a result, Starbucks believes it delivers benefits to the Company and its stakeholders — employees, business partners, customers, suppliers, shareholders, community members and others — while distinguishing Starbucks as a leader within the coffee industry. Providing open communication and transparency helps the Company be accountable to its stakeholders. To support this goal, Starbucks publishes a CSR Annual Report. Starbucks fiscal 2007 CSR Annual Report will be available online at www.starbucks.com/csr beginning in May 2008.

 

 

This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can be identified by the fact that they do not relate strictly to historical or current facts. They often include words such as “believes,” “expects,” “anticipates,” “estimates,” “intends,” “plans,” “seeks” or words of similar meaning, or future or conditional verbs, such as “will,” “should,” “could” or “may.” A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur. Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this Report. Starbucks is under no obligation

to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. The Company’s actual future results and trends may differ materially depending on a variety of factors, including, but not limited to, the risks and uncertainties discussed below. The risks below are not the only ones the Company faces. Additional risks and risks that management currently considers immaterial may also have an adverse effect on the Company.

 

 

Management believes the price of Starbucks stock reflects high market expectations for the Company’s future operating results. Any failure to meet those expectations, particularly for the growth rates for (i) comparable store sales attributable to number of transactions, average value per transaction, or both, (ii) net revenues, (iii) earnings per share or (iv) net new store openings could cause the market price of Starbucks stock to drop rapidly and sharply.

 

 

 

 

 

 

 

 

 

The Company’s financial performance is highly dependent on its United States operating segment, which comprised 78% of consolidated total net revenues in fiscal 2007. Any substantial or sustained decline in these operations, if not offset by increased financial performance elsewhere, could materially adversely affect the Company’s business and financial results.

 

 

A description of the general competitive conditions in which Starbucks operates appears on page 6 under “Competition.” In the United States, the continued focus by one or more large competitors in the quick-service restaurant sector on selling high-quality specialty coffee beverages at a low cost could attract Starbucks customers and adversely affect the Company’s sales and results of operations. Similarly, continued competition from well-established competitors in international markets could hinder growth and adversely affect the Company’s sales and results of operations in those markets. Increased competition from large competitors with significant resources in the United States ready-to-drink coffee beverage market could adversely affect the profitability of the CPG segment and the Company’s results of operations.

 

 

Starbucks believes it has built an excellent reputation globally for the quality of its products, for delivery of a consistently positive consumer experience and for its corporate social responsibility programs. The Starbucks brand has been highly rated in several global brand value studies. Management believes it must preserve and grow the value of the Starbucks brand to be successful in the future, particularly outside of North America, where the Starbucks brand is less well-known. Brand value is based in part on consumer perceptions as to a variety of subjective qualities. Even isolated business incidents that erode consumer trust, particularly if the incidents receive considerable publicity or result in litigation, can significantly reduce brand value. Consumer demand for the Company’s products and its brand equity could diminish significantly if Starbucks fails to preserve the quality of its products, is perceived to act in an unethical or socially irresponsible manner or fails to deliver a consistently positive consumer experience in each of its markets.

 

 

The Company’s future growth will increasingly depend on the growth and sustained profitability of its International operating segment. Some or all of the Company’s International market business units (“MBUs”), which Starbucks generally defines by the countries or regions in which they operate, may not be successful in their operations or in achieving expected growth, which ultimately requires achieving consistent, stable net revenues and earnings. Some factors that will be critical to the success of International MBUs are different than those affecting the Company’s U.S. stores and licensees. Tastes naturally vary by region, and consumers in new international markets into which Starbucks and its licensees expand may not embrace Starbucks products to the same extent as consumers in the Company’s existing markets. Occupancy costs and store operating expenses are also sometimes higher internationally than in the United States due to higher rents for prime store locations or costs of compliance with country-specific regulatory requirements. Because many of the Company’s International operations are in an early phase of development, operating expenses as a percentage of related revenues are often higher compared to U.S. operations. The Company’s International operations are also subject to additional inherent risks of conducting business abroad, such as:

 

 

 

 

Starbucks expects the People’s Republic of China to be its largest market outside of the United States. The Company’s growing investments in its China operations will increase the Company’s exposure in this market. Any significant or prolonged deterioration in U.S.-China relations might adversely affect the Company’s China business.

 

Many of the risks and uncertainties of doing business in China are solely within the control of the Chinese government. China’s government regulates the business conducted by Starbucks by restricting the scope of the Company’s foreign investments within China and the food and beverage, retail, wholesale and distribution business conducted within China. Although management believes it has structured the Company’s China operations to comply with local laws, there are substantial uncertainties regarding the interpretation and application of laws and regulations and the enforceability of intellectual property and contract rights in China. If China’s governmental authorities were ultimately to conclude that Starbucks has not complied with one or more existing or future laws or regulations, or if their interpretations of those laws or regulations were to change over time, the Company’s affiliates could be subject to fines and other financial penalties, prohibited from opening new stores or forced to cease operations entirely. Moreover, any inability of the Company to enforce its intellectual property and contract rights in China’s courts could adversely affect the Company’s business.

 

Additionally, Starbucks plans to continue entering selected markets in other developing countries, and has recently entered Russia as an important part of the projected growth of the International operating segment. Some of those markets pose legal and business challenges similar to the China market, such as substantial uncertainty regarding the interpretation and application of laws and regulations and the enforceability of intellectual property and contract rights.

 

 

The Company’s growth strategy, including its plans for new stores, foodservice, branded products and other initiatives, relies significantly on a variety of licensee and partnership relationships, particularly in its International markets. Licensees are often authorized to use the Starbucks logo and provide Starbucks-branded beverages, food and other products directly to customers. The Company provides training and support to, and monitors the operations of, these business partners, but the product quality and service they deliver to Starbucks customers may be diminished by any number of factors beyond the Company’s control. Management believes customers expect the same quality of products and service from the Company’s licensees as they do from Starbucks and the Company strives to ensure customers have the same experience whether they visit a Company-operated or licensed store. Any shortcoming of a Starbucks business partner, particularly an issue affecting the quality of the service experience or the safety of beverages or food, may be attributed by customers to Starbucks, thus damaging the Company’s reputation and brand value and potentially affecting the results of operations.

 

The Company’s long-term goal is to open approximately 20,000 Starbucks stores in the United States and at least 20,000 stores in International markets. Starbucks expects to double the size of its business over the next four to five years and achieve higher annual growth in net earnings than revenue. Effectively managing growth on this scale is challenging, particularly as Starbucks expands into new markets internationally, where it must balance the need for flexibility and a degree of autonomy for local management with consistency with the Company’s goals, philosophy and standards. Growth on this scale makes it increasingly difficult to ensure a consistent supply of high quality raw materials, to locate and hire sufficient numbers of key employees to meet the Company’s growth targets, to maintain an effective system of internal controls for a globally dispersed enterprise and to train employees worldwide to deliver a consistently high quality product and customer experience.

 

 

The Company’s future growth depends substantially on the contributions and abilities of key executives and other employees. Starbucks future growth also depends substantially on its ability to recruit and retain high quality employees to work in and manage Starbucks stores. Starbucks must continue to recruit, retain and motivate management and other employees sufficient to maintain its current business and support its projected growth. A loss of key employees or a significant shortage of high quality store employees could jeopardize the Company’s ability to meet its growth targets.

 

 

Some Starbucks products contain caffeine, dairy products, sugar and other active compounds, the health effects of which are the subject of increasing public scrutiny, including the suggestion that excessive consumption of caffeine, dairy products, sugar and other active compounds can lead to a variety of adverse health effects. There has also been greater public awareness that sedentary lifestyles, combined with excessive consumption of high-calorie foods, have led to a rapidly rising rate of obesity. Particularly in the United States, there is increasing consumer awareness of health risks, including obesity, due in part to increasing publicity and attention from health organizations, as well as increased consumer litigation based on alleged adverse health impacts of consumption of various food products. While Starbucks has a variety of beverage and food items that are low in caffeine and calories, an unfavorable report on the health effects of caffeine or other compounds present in the Company’s products, or negative publicity or litigation arising from other health risks such as obesity, could significantly reduce the demand for the Company’s beverages and food products.

 

Similarly, reports, whether true or not, of unclean water supply, food-borne illnesses and food tampering have in the past severely injured the reputations of companies in the food processing, grocery and quick-service restaurant sectors and could in the future affect the Company as well. Any report linking Starbucks to the use of unclean water, food-borne illnesses or food tampering could damage its brand value, immediately and severely hurt sales of its beverages and food products, and possibly lead to product liability claims. Clean water is critical to the preparation of specialty coffee beverages. The Company’s ability to ensure a clean water supply to its stores is limited, particularly in some International locations. If customers become ill from food-borne illnesses, the Company could also be forced to temporarily close some stores. In addition, instances of food-borne illnesses or food tampering, even those occurring solely at the restaurants or stores of competitors, could, by resulting in negative publicity about the foodservice industry, adversely affect Starbucks sales on a regional or global basis. A decrease in customer traffic as a result of these health concerns or negative publicity, or as a result of a temporary closure of any of the Company’s stores, could materially harm the Company’s business and results of operations.

 

A discussion of the sources and availability of coffee of the quality sought by Starbucks and fluid milk appears on page 5 under “Product Supply.” Any significant increase in the market price or any significant decrease in the availability of high-quality arabica coffee or fluid milk could adversely affect the Company’s business and financial results.

 

 

A health pandemic is a disease that spreads rapidly and widely by infection and affects many individuals in an area or population at the same time. If a regional or global health pandemic were to occur, depending upon its duration and severity, the Company’s business could be severely affected. Starbucks has positioned itself as a third place between home and work where people can gather together for human connection. Customers might avoid public gathering places in the event of a health pandemic, and local, regional or national governments might limit or ban public gatherings to halt or delay the spread of disease. A regional or global health pandemic might also adversely impact the Company’s business by disrupting or delaying production and delivery of materials and products in its supply chain and by causing staffing shortages in its stores. The impact of a health pandemic on Starbucks might be disproportionately greater than on other companies that depend less on the gathering of people together for the sale, use or license of their products and services.

 

 

Starbucks relies heavily on information technology systems across its operations, including for management of its supply chain, point-of-sale processing in its stores, and various other processes and transactions. The Company’s ability to effectively manage its business and coordinate the production, distribution and sale of its products depends significantly on the reliability and capacity of these systems. The failure of these systems to operate effectively, problems with transitioning to upgraded or replacement systems, or a breach in security of these systems could cause delays in product sales and reduced efficiency of the Company’s operations, and significant capital investments could be required to remediate the problem.

 

 

Starbucks management is responsible for establishing and maintaining effective internal control over financial reporting. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes: (i) maintaining reasonably detailed records that accurately and fairly reflect the Company’s transactions; and (ii) providing reasonable assurance that the Company (a) records transactions as necessary to prepare the financial statements, (b) makes receipts and expenditures in accordance with management authorizations, and (c) would timely prevent or detect any unauthorized acquisition, use or disposition of Company assets that could have a material effect on the financial statements. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that the Company would prevent or detect a misstatement of the Company’s financial statements or fraud. The Company’s rapid growth and entry into new, globally dispersed markets will place significant additional pressure on the Company’s system of internal control over financial reporting. Any failure to maintain an effective system of internal control over financial reporting could limit the Company’s ability to report its financial results accurately and timely or to detect and prevent fraud. A significant financial reporting failure could cause an immediate loss of investor confidence in Starbucks and a sharp decline in the market price of its common stock.

 

As of September 30, 2007, Starbucks had approximately $5.0 billion in minimum future rental payments under non-cancelable operating leases and $3.1 billion of total liabilities on a consolidated basis. Included in total liabilities are aggregate principal indebtedness of $710 million under outstanding commercial paper and $550 million under ten-year notes issued in an August 2007 underwritten registered public offering. The Company will incur additional operating lease obligations, largely driven by new store openings, and may incur additional indebtedness, subject to the limitations contained in its financing agreements. The recent increase in the Company’s level of financial obligations has had, and any future increase (which may or may not occur) will have, several important effects on the Company’s future operations, such as:

 

 

The Company’s ability to satisfy its lease obligations and make payments of principal and interest on its indebtedness depends on its future performance, which will be subject to general economic conditions, industry cycles and financial, business and other factors affecting its consolidated operations, many of which are beyond the Company’s control. If Starbucks is unable to generate sufficient cash flow from operations in the future to satisfy its financial obligations, it may be required, among other things:

 

 

Such measures might not be sufficient to enable Starbucks to satisfy its financial obligations. In addition, any such financing, refinancing or sale of assets might not be available on economically favorable terms.

 

The Company’s existing strong cash flow and capital structure mitigate the current risk associated with leverage. Management expects future cash flows to be sufficient to meet operating expenses, debt service costs, and capital expenditures required to support projected new store openings and investments in existing and new markets. In addition, management does not expect to increase leverage to levels that would inhibit the Company’s access to capital markets in the event of short-falls in anticipated operating cash flow.

 

 

Not applicable.

 

 

The following table shows properties used by Starbucks in connection with its roasting and distribution operations:

 

 

The Company leases approximately 1.1 million square feet of office space and owns a 204,000 square foot office building in Seattle, Washington for corporate administrative purposes.

 

As of September 30, 2007, Starbucks had more than 8,500 Company-operated retail stores. The Company also leases space in approximately 160 additional locations for regional, district and other administrative offices, training facilities and storage, not including certain seasonal retail storage locations. The Company is constructing a new, owned, 150,000 square foot roasting and distribution plant in St. Matthews, South Carolina. Operations are planned to begin in early 2009.

 

 

See discussion of Legal Proceedings in Note 17 to the consolidated financial statements included in Item 8 of this Report.

 

 

No matters were submitted to a vote of security holders during the fiscal fourth quarter of 2007.

 

Executive Officers of the Registrant

 

The executive officers of the Company are as follows:

 

 

Howard Schultz is the founder of the Company and the chairman of the board. From the Company’s inception in 1985 to June 2000, he served as chairman of the board and chief executive officer. From June 2000 to February 2005, Mr. Schultz held the title of chief global strategist. Mr. Schultz also serves on the board of directors of DreamWorks Animation SKG, Inc.

James L. Donald joined Starbucks in October 2002 and has been president and chief executive officer and a director of the Company since April 2005. From October 2004 to April 2005, Mr. Donald served as ceo designate. Prior to that, Mr. Donald served as president, North America from the time he joined the Company in October 2002. From October 1996 to October 2002, Mr. Donald served as chairman, president and ceo of Pathmark Stores, Inc. and prior to that time he held a variety of senior management positions with Albertson’s, Inc., Safeway, Inc. and Wal-Mart Stores, Inc.

 

Martin Coles joined Starbucks in April 2004 as president, Starbucks Coffee International and was promoted to chief operating officer in September 2007. Prior to joining Starbucks, Mr. Coles served as an executive vice president of Reebok International, Ltd. from December 2001 to February 2004. Prior to joining Reebok International, Mr. Coles held several executive level management sales and operations positions with NIKE Inc., Letsbuyit.com and Gateway, Inc.

 

Launi Skinner joined Starbucks in August 1993 and was promoted to president, Starbucks Coffee U.S. in September 2007. Ms. Skinner previously served as the Company’s senior vice president, Store Development since October 2004. From January 1999 to September 2004, she served as regional vice president for retail operations in several different zones in the western U.S. and Canada. Prior to becoming a regional vice president, she served as a market director.

 

James C. Alling joined Starbucks in September 1997 as senior vice president, Grocery and became president, Starbucks Coffee International in September 2007. Mr. Alling served as president, Starbucks Coffee U.S. from October 2004 to September 2007, executive vice president, Business and Operations — United States from November 2003 to October 2004 and held a number of positions as senior vice president from September 1997 until November 2003.

 

Gerardo I. Lopez joined Starbucks in October 2004 as senior vice president; president, Global Consumer Products and became senior vice president; president, Global Consumer Products and Seattle’s Best Coffee in November 2007. Prior to joining Starbucks, Mr. Lopez was president of the Handleman Entertainment Resources division of Handleman Company, from November 2001 to September 2004 and as senior vice president and general manager from May 2000 to November 2001. Prior to that, Mr. Lopez held a variety of executive management positions with Frito-Lay, Inc., Pepsi-Cola Company and The Procter & Gamble Company.

 

Peter J. Bocian joined Starbucks as executive vice president and chief financial officer designate in May 2007 and became executive vice president, chief financial officer and chief administrative officer in October 2007. Prior to joining Starbucks, Mr. Bocian worked at NCR Corporation since 1983, most recently as senior vice president and chief financial officer since 2004. From 2003 to 2004, he served as NCR’s vice president, finance and interim chief financial officer. From 2002 to 2003, Mr. Bocian was the chief financial officer of NCR’s Retail and Financial Group, covering four business units and from 1999 to 2002, he served as the chief financial officer of NCR’s Retail Solutions Division.

 

Paula E. Boggs joined Starbucks in September 2002 as executive vice president, general counsel and secretary. Prior to joining Starbucks, Ms. Boggs served as vice president, legal, for products, operations and information technology at Dell Computer Corporation from 1997 to 2002. From 1995 to 1997, Ms. Boggs was a partner with the law firm of Preston Gates & Ellis. Ms. Boggs served in several roles at the Pentagon, White House and U.S. Department of Justice between 1984 and 1995.

 

Dorothy J. Kim joined Starbucks in November 1995 and was promoted to executive vice president, Supply Chain Operations in December 2004. From April 2003 to December 2004, Ms. Kim was senior vice president, Global Logistics, Planning and Procurement. From April 2002 to April 2003, Ms. Kim was vice president, Supply Chain and Coffee Operations, Logistics, and from October 2000 to April 2002, Ms. Kim was vice president, Supply Chain and Coffee Operations, Finance and Systems. Prior to becoming a vice president, Ms. Kim held several positions in retail planning and operations.

 

David A. Pace joined Starbucks in July 2002 as executive vice president of Partner Resources. Mr. Pace has notified the Company that he intends to resign for personal reasons effective December 31, 2007. From 2000 to 2002, Mr. Pace was the president of i2 Technologies. From 1999 to 2000, Mr. Pace served as the chief human resources officer for HomeGrocer.com. From 1995 to 1999, he served as senior vice president of human resources for Tricon Restaurants International (now YUM! Brands, Inc.).

 

There are no family relationships among any directors or executive officers of the Company.

 

PART II

 

Item 5.  Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities

 

SHAREHOLDER INFORMATION

 

Market Information and Dividend Policy

 

The Company’s common stock is traded on the NASDAQ Global Select Market (“NASDAQ”), under the symbol “SBUX.” The following table shows the quarterly high and low closing sale prices per share of the Company’s common stock as reported by NASDAQ for each quarter during the last two fiscal years:

 

 

As of November 16, 2007, the Company had approximately 18,500 shareholders of record. Starbucks has never paid any dividends on its common stock. The Company presently intends to retain earnings for use in its business and to repurchase shares of common stock and, therefore, does not anticipate paying a cash dividend in the near future.

 

The following table provides information regarding repurchases by the Company of its common stock during the 13-week period ended September 30, 2007:

 

ISSUER PURCHASES OF EQUITY SECURITIES

 

 

 

Performance Comparison Graph

 

The following graph depicts the Company’s total return to shareholders from September 29, 2002 through September 30, 2007, relative to the performance of the Standard & Poor’s 500 Index, the NASDAQ Composite Index, and the Standard & Poor’s 500 Consumer Discretionary Sector, a peer group that includes Starbucks. All indices shown in the graph have been reset to a base of 100 as of September 29, 2002, and assume an investment of $100 on that date and the reinvestment of dividends paid since that date. Starbucks has never paid a dividend on its common stock. The stock price performance shown in the graph is not necessarily indicative of future price performance.

 

 

 

 

In millions, except earnings per share and store operating data

 

The following selected financial data are derived from the consolidated financial statements of the Company. The data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors,” and the Company’s consolidated financial statements and notes. In particular, see Note 1 to the consolidated financial statements included in Item 8 of this Report for a description of accounting changes that materially affect the comparability of the data presented below.

 

 

 

 

 

 

General

 

Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. Some fiscal years include 53 weeks. The fiscal years ended on September 30, 2007, October 1, 2006 and October 2, 2005, all included 52 weeks. All references to store counts, including data for new store openings, are reported net of related store closures.

 

Management Overview

 

Fiscal 2007 — The Year in Review

 

Starbucks achieved solid performance in fiscal 2007 — meeting its targets for store openings, revenue growth, comparable store sales growth, and earnings per share — despite a challenging economic and operating environment, and significant cost increases from dairy. The Company completed the fiscal year with encouraging trends and momentum in its International business but faced increasing challenges in its U.S. business. While U.S. comparable store sales were within the Company’s stated target range, it was accomplished through two price increases which offset flat-to-negative transaction count trends in the U.S. business. The pressure on traffic is consistent with similar trends reported across both the retail and restaurant industry. Management believes that the combination of the economic slowdown and the price increases implemented in fiscal 2007 to help mitigate significant cost pressures have impacted the frequency of customer visits to Starbucks stores.

 

Consolidated net revenues for fiscal year 2007 increased 21% to $9.4 billion. Company-operated retail revenues in fiscal 2007 rose 21% to $8.0 billion, predominantly due to the opening of 1,342 stores and comparable store sales growth of 5%. The increase in comparable store sales was due to a 4% increase in the average value per transaction and 1% growth in the number of customer transactions. The Company opened a total of 2,571 new company-operated and licensed stores during the year, with 70% in the U.S. and 30% in International markets, to end the year with over 15,000 stores.

 

For fiscal 2007, operating income increased to $1.1 billion, while operating margin contracted 30 basis points to 11.2% of total net revenues. Margin compression was due to higher costs of sales including occupancy costs as a percentage of total net revenues due to a shift in sales to higher cost products and higher distribution costs, rent expense and dairy costs. These cost pressures were offset in part by leveraging general and administrative expenses, store operating expenses, and other operating expenses as a percentage of total net revenues.

 

Net earnings rose to $673 million in fiscal 2007 from $564 million for the previous year. Diluted earnings per share for fiscal 2007 increased to $0.87 compared to $0.71 a year ago. Excluding the cumulative effect of adopting FIN 47 in the fiscal fourth quarter of 2006, earnings grew 16% and diluted earnings per share increased 19%.

 

Fiscal 2008 — The View Ahead

 

Throughout fiscal 2007, Starbucks experienced a consistent weakening in its U.S. business, exiting the year with a negative trend in transactions. Management recognizes that it faces a more challenging environment from an economic, operational and competitive standpoint entering fiscal 2008. In response to those challenges, management intends to focus in the following key areas:

 

 

In setting targets for fiscal 2008, management’s goal was to balance the long-term opportunity for store growth with the near-term realities of the challenging economic and operating environment. For fiscal 2008 the Company is targeting:

 

 

In summary, management believes these targets are balanced for fiscal 2008. The Company intends to continue to build out stores to take advantage of its global opportunity, to better execute in its U.S. business, to grow and deliver significant margin expansion in its International business, and to deliver margin improvement for the Company on a consolidated basis.

 

Operating Segment Overview

 

Starbucks has three reportable operating segments: United States, International and CPG.

 

The United States and International segments both include Company-operated retail stores, licensed retail stores and foodservice operations. The United States segment has been operating significantly longer than the International segment and has developed deeper awareness of, and attachment to, the Starbucks brand and stores among its customer base. As a result, the United States segment has significantly more stores, and higher total revenues than the International segment. Average sales per store are also higher in the United States due to various factors including length of time in market and local income levels. Further, certain market costs, particularly occupancy costs, are lower in the United States segment compared to the average for the International segment, which comprises a more diverse group of operations. As a result of the relative strength of the brand in the United States segment, the number of stores, the higher unit volumes, and the lower market costs, the United States segment has a higher operating margin than the less-developed International segment.

 

The Company’s International store base continues to increase rapidly and Starbucks is achieving a growing contribution from established international markets while at the same time investing in emerging markets, such as China, Brazil and Russia. The Company’s newer international markets require a more extensive support organization, relative to the current levels of revenue and operating income.

 

The CPG segment includes the Company’s grocery and warehouse club business as well as branded products operations worldwide. The CPG segment operates primarily through joint ventures and licensing arrangements with large consumer products business partners, most significantly The North American Coffee Partnership with the Pepsi-Cola Company for distribution of ready-to-drink beverages, and with Kraft Foods Inc. for distribution of packaged coffees and teas. This operating model allows the CPG segment to leverage the business partners’ existing infrastructures and to extend the Starbucks brand in an efficient way. Most of the customer revenues from the ready-to-drink and packaged coffee channels are recognized as revenues by the joint venture or licensed business partner, not by the CPG segment, and the proportionate share of the results of the Company’s joint ventures are included on a net basis in “Income from equity investees” on the consolidated statements of earnings. As a result, the CPG segment reflects relatively lower revenues, a modest cost structure, and a resulting higher operating margin, compared to the Company’s other two reporting segments, which consist primarily of retail stores.

 

Expenses pertaining to corporate administrative functions that support the operating segments but are not specifically attributable to or managed by any segment are not included in the reported financial results of the operating segments. These unallocated corporate expenses include certain general and administrative expenses, related depreciation and amortization expenses and amounts included in “Net interest and other income” on the consolidated statements of earnings.

Acquisitions

 

In the first quarter of fiscal 2007, the Company purchased a 90% stake in its previously-licensed operations in Beijing, China. Due to its majority ownership of these operations, Starbucks applied the consolidation method of accounting subsequent to the date of acquisition.

 

RESULTS OF OPERATIONS — FISCAL 2007 COMPARED TO FISCAL 2006

 

The following table presents the consolidated statement of earnings as well as the percentage relationship to total net revenues, unless otherwise indicated, of items included in the Company’s consolidated statements of earnings (amounts in thousands):

 

 

 

 

Consolidated Results of Operations

 

Net revenues for the fiscal year ended 2007, increased 21% to $9.4 billion from $7.8 billion for fiscal 2006, driven by increases in both Company-operated retail revenues and specialty operations.

 

During the fiscal year ended 2007, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 21% to $8.0 billion for the fiscal year ended 2007, from $6.6 billion for fiscal 2006. The increase was primarily attributable to the opening of 1,342 new Company-operated retail stores in the last 12 months and comparable store sales growth of 5% for the fiscal year ended 2007. The increase in comparable store sales was due to a 4% increase in the average value per transaction and a 1% increase in the number of customer transactions.

 

The Company derived the remaining 15% of total net revenues from channels outside the Company-operated retail stores, collectively known as specialty operations. Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 17% to $1.4 billion for the fiscal year ended 2007, from $1.2 billion for fiscal 2006.

 

Licensing revenues, which are derived from retail store licensing arrangements as well as grocery, warehouse club and certain other branded-product operations, increased 19% to $1.0 billion for the fiscal year ended 2007, from $861 million for fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from the opening of 1,229 new licensed retail stores in the last 12 months and a 20% increase in licensing revenues from the Company’s CPG business.

 

Foodservice and other revenues increased 13% to $387 million for the fiscal year ended 2007, from $343 million for fiscal 2006. The increase was primarily attributable to growth in new and existing accounts in the U.S. foodservice business.

 

Cost of sales including occupancy costs increased to 42.5% of total net revenues for the fiscal year ended 2007, compared to 40.8% for fiscal 2006. The increase was primarily due to a shift in sales mix to higher cost products, the rise in distribution costs, higher rent expense and higher dairy costs. Dairy expense for the U.S. segment represents approximately 75% of the total Company’s dairy expense. For the U.S. segment the average dairy costs per gallon rose 10% in fiscal 2007 compared to fiscal 2006, resulting in approximately $20 million of additional expense.

 

Store operating expenses as a percentage of Company-operated retail revenues decreased to 40.2% for the fiscal year ended 2007, from 40.8% for fiscal 2006, primarily due to higher provisions for incentive compensation in the prior year due to exceptionally strong performance as well as leverage on regional overhead costs in fiscal 2007.

 

Other operating expenses (expenses associated with the Company’s Specialty Operations) decreased to 20.8% of total specialty revenues for the fiscal year ended 2007, compared to 21.1% in fiscal 2006. The decline resulted primarily from controlled discretionary spending in fiscal 2007.

 

Depreciation and amortization expenses increased to $467 million for the fiscal year ended 2007, compared to $387 million for the corresponding period of fiscal 2006. The increase was primarily due to the opening of 1,342 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses decreased to 4.9% for the fiscal 2007, compared to 5.0% for fiscal 2006.

 

General and administrative expenses increased to $489 million for the fiscal year ended 2007, compared to $479 million for fiscal 2006. The increase was primarily due to higher payroll-related expenditures in support of continued global growth, offset in part by unusually high charitable contributions in fiscal 2006. As a percentage of total net revenues, general and administrative expenses decreased to 5.2% for the fiscal year ended 2007, from 6.1% for fiscal 2006.

 

Income from equity investees increased 15% to $108 million for the fiscal year ended 2007, compared to $94 million for fiscal 2006, primarily due to higher equity income from international investees.

 

Operating income increased 18% to $1.1 billion for the fiscal year ended 2007, compared to $894 million for fiscal 2006. Operating margin decreased to 11.2% of total net revenues for the fiscal year ended 2007, from 11.5% for fiscal 2006. Margin compression was due to higher costs of sales and occupancy costs as a percentage of total net revenues due to a shift in sales to higher cost products and higher distribution costs, rent expense and dairy costs.

These cost pressures were offset in part by leveraging general and administrative expenses, store operating expenses, and other operating expenses as a percentage of total net revenues.

 

Net interest and other income was $2 million for the fiscal year ended 2007, compared to $12 million for fiscal 2006. The decrease was primarily due to increased interest expense resulting from a higher level of borrowings outstanding, which include the $550 million of senior notes issued in August 2007, offset in part by a higher amount of income recognized on unredeemed stored value card and gift certificate balances in fiscal 2007 compared to fiscal 2006.

 

Income taxes for the fiscal year ended 2007 resulted in an effective tax rate of 36.3%, compared to 35.8% for fiscal 2006. The effective tax rate for fiscal 2008 is expected to be approximately in line with fiscal 2007, with quarterly variations.

 

Net earnings for the fiscal year ended 2007, increased 19% to $673 million from $564 million for fiscal 2006. Diluted earnings per share increased to $0.87 for the fiscal year ended 2007, compared to $0.71 per share for fiscal 2006. Excluding the cumulative effect of adopting FIN 47 in fourth quarter 2006, earnings before cumulative effect of change in accounting principle grew 16% and diluted earnings per share increased 19%.

 

Operating Segments

 

Segment information is prepared on the same basis that the Company’s management reviews financial information for operational decision-making purposes. Starbucks has three reportable operating segments: United States, International and CPG. “Unallocated Corporate” includes expenses pertaining to corporate administrative functions that support the operating segments but are not specifically attributable to or managed by any segment and are not included in the reported financial results of the operating segments. Operating income represents earnings before “Net interest and other income” and “Income taxes.” The following tables summarize the Company’s results of operations by segment for fiscal 2007 and 2006 (in thousands):

 

United States

 

 

 

 

 

The United States operating segment (“United States”) sells coffee and other beverages, complementary food, whole bean coffees, and coffee brewing equipment and merchandise primarily through Company-operated retail stores. Specialty operations within the United States include licensed retail stores, foodservice accounts and other initiatives related to the Company’s core business.

 

United States total net revenues increased 19% to $7.3 billion for the fiscal year ended 2007, compared to $6.2 billion for fiscal 2006.

 

United States Company-operated retail revenues increased 19% to $6.6 billion for the fiscal year ended 2007, compared to $5.5 billion for fiscal 2006, primarily due to the opening of 1,065 new Company-operated retail stores in the last 12 months and comparable store sales growth of 4% for fiscal 2007, nearly all resulting from an increase in the average value per transaction. The U.S. Company-operated retail business experienced deteriorating trends in transactions late in the year, driven by, management believes, the U.S. economic slowdown combined with two price increases in U.S. retail stores implemented in fiscal 2007. Management believes that several initiatives underway in the U.S. business, namely an enhanced focus on operational excellence in the stores, a more robust marketing strategy, meaningful product innovation and a renewed focus on the core beverage and coffeehouse experience, will help address those challenges in the U.S. retail business. In addition, in fiscal 2008 the Company plans to slightly reduce the pace of new store openings in the U.S. from the previous year in order to ensure the selection of store location and store format are the best fit for its customers and the business.

 

Total United States specialty revenues increased 15% to $788 million for the fiscal year ended 2007, compared to $683 million in fiscal 2006. United States licensing revenues increased 19% to $439 million, compared to $369 million for fiscal 2006 primarily due to higher product sales and royalty revenues as a result of opening 723 new licensed retail stores in the last 12 months. United States foodservice and other revenues increased 11% to $349 million, from $314 million in fiscal 2006, primarily due to growth in new and existing foodservice accounts.

 

United States operating income increased 12% to $1.1 billion for the fiscal year ended 2007, compared to $955 million for fiscal 2006. Operating margin decreased to 14.6% of related revenues from 15.5% in fiscal 2006. The decrease was due to higher cost of sales including occupancy costs, primarily due to a shift in sales mix to higher cost products such as food and merchandise, higher distribution costs, higher rent expense and higher dairy costs. Partially offsetting these were lower store operating expenses, lower general and administrative expenses, and lower other operating expenses as a percentage of total net revenues. The decline in store operating expenses as a percentage of total net revenues was primarily due to higher provisions for incentive compensation in the prior year as well as leverage on regional overhead costs in fiscal 2007. General and administrative expenses were lower primarily due to decreased salary and related benefits expense as well as lower professional fees. The decline in other operating expenses as a percentage of total net revenues was primarily due to controlled discretionary spending in the current year.

International

 

 

 

 

The International operating segment (“International”) sells coffee and other beverages, complementary food, whole bean coffees, and coffee brewing equipment and merchandise through Company-operated retail stores in Canada, the UK and eight other markets. Specialty operations in International primarily include retail store licensing operations in more than 30 other countries and foodservice accounts, primarily in Canada and the UK. The Company’s International store base continues to increase rapidly and Starbucks is achieving a growing contribution from established areas of the business while at the same time investing in emerging markets and channels. Many of the Company’s International operations are in early stages of development that require a more extensive support organization, relative to the current levels of revenue and operating income, than in the United States. This continuing investment is part of the Company’s long-term, balanced plan for profitable growth.

 

International total net revenues increased 30% to $1.7 billion for the fiscal year ended 2007, compared to $1.3 billion for fiscal 2006.

 

International Company-operated retail revenues increased 32% to $1.4 billion for the fiscal year ended 2007, compared to $1.1 billion for fiscal 2006. The increase was primarily due to the opening of 277 new Company-operated retail stores in the last 12 months, comparable store sales growth of 7% for fiscal 2007 and favorable foreign currency exchange for the British pound sterling. The increase in comparable store sales resulted from a 5% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction.

 

Total International specialty revenues increased 20% to $259 million for the fiscal year ended 2007, compared to $215 million in fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from opening 506 new licensed retail stores in the last 12 months.

International operating income increased 27% to $138 million for the fiscal year ended 2007, compared to $108 million in fiscal 2006. Operating margin decreased to 8.1% of related revenues from 8.3% in fiscal 2006, primarily due to higher cost of sales including occupancy costs due in part to a shift in sales mix to higher cost products such as food and merchandise and higher distribution costs. Partially offsetting this increase was lower general and administrative expenses as a percentage of total net revenues.

 

Global Consumer Products Group

 

 

The CPG operating segment sells a selection of whole bean and ground coffees and premium Tazo^® teas through licensing arrangements in United States and international markets. CPG also produces and sells ready-to-drink beverages through its joint ventures and marketing and distribution agreements. CPG “General and administrative expenses,” previously included in “Other operating expenses,” are now presented separately.

 

CPG total net revenues increased 20% to $366 million for the fiscal year ended 2007, compared to $305 million for fiscal 2006. The increase was primarily due to increased sales of U.S. packaged coffee and tea as well as increased product sales and royalties in the international ready-to-drink business.

 

CPG operating income increased by 10% to $184 million for the fiscal year ended 2007, compared to $167 million in fiscal 2006. Operating margin decreased to 50.1% of related revenues, from 54.6% in fiscal 2006. Contraction of operating margin was primarily due to slower growth in income from the North American Coffee Partnership, an equity investee, which produces ready-to-drink beverages.

 

Unallocated Corporate