FOOL CONFERENCE CALL SYNOPSIS*
By Jeff Fischer (TMF Jeff)

Starbucks Corp.
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2401 Utah Avenue South
P.O. Box 34067
Seattle, WA 98134
Phone: (206) 447-1575
http://www.starbucks.com

ALEXANDRIA, VA (July 24, 1998)/FoolWire/ -- Specialty coffee products leader Starbucks announced third quarter '98 net consolidated revenues of $334.4 million, up 37% from $244.2 million last year. Excluding charges, net earnings rose 47% -- rising to $20.9 million from $14.2 million in '97. Again sans charges, diluted earnings per share were $0.23 vs. $0.17, for an increase of 35%. Comparable same store sales climbed 7%.

For the nine months ended June 28, 1998, consolidated net revenues rose 36% to $951 million from $700.7 million during the same period last year. Pro forma net earnings were $55.8 million, or $0.61 per share -- that's 49% above the $37.3 million achieved last year. Comparable same store sales rose 6% over the nine-month period.

The Biz. CEO Howard Schultz discussed the company's unlimited unit growth potential in the United States and international markets. As well, the company has successfully only begun to market Starbucks related products through new distribution channels, and results are showing excellent acceptance of all products. The equity in the Starbucks brand is carrying into other markets with little advertising expense. The company will aim to leverage itself in this way in international markets as well. Starbucks sees unlimited potential for new products that fit with its core business, which is essentially sharing the coffee and coffee related experience.

Major accomplishments and product sales. In the past quarter Starbucks opened 118 new stores, with 93 in continental North America and 25 in international markets. It currently has 1,778 owned and licensed stores system-wide, 117 of them in international markets. Starbucks serves seven million customers per week in nine countries.

During the quarter, two product line extensions successfully launched. Starbucks released Power Frappuccino, a bottled cold Frappuccino drink geared toward the health conscious, and it introduced and added the Siren's Note coffee blend.

frap
Bottled Frappuccino dominates the ready-to-drink coffee category, with 90% U.S. market share and year-over-year sales growth of 150%. This product category used to be nonexistent in this country. Through increased channel presentation and repeat purchases, sales in locations that have been selling for over 12 months are also growing, and the introduction of the vanilla Frappuccino has gone well, with sales representing nearly 25% of the product mix. For the peak selling season, the entire line was packaged differently, and radio advertising will be tested in a handful of markets this summer.

ice cream and related
Now in its third year, Starbucks ice cream remains the number-one branded coffee ice cream in the country. This demonstrates the power of the Starbucks trademark. The company will continue to leverage its name to introduce "Best of Class" products. Frozen Frappuccino bars were introduced early this year, and now the first non-coffee core product, called Chocolate Chocolate Fudge, is being tested to see how well a Starbucks candy bar type product is accepted. Early results are encouraging.

grocery stores
Starbucks has already established a presence in 3,500 supermarkets in the western U.S., exceeding its early distribution goal. Starbucks' entry has fueled sales growth and increased the specialty coffee market in the regions by 25% in dollar sales. Before the arrival of Starbucks in this market, the industry had been relatively flat. The initial trade response has been very favorable. The evolution of the equity of the Starbucks brand, beyond retail stores, is demonstrating that the company name is truly gaining momentum and that the brand is developing a trust with consumers outside Starbucks stores. Starbucks is going to prosper as a brand that lives outside of its retail stores as well as in. The company will leverage the integrity of the Starbucks name to build beyond the current product offerings. Management is excited by the early success in of coffee sales in supermarkets.

food program
Finally, Starbucks continues the rollout of its core food program, focused on the morning and day market. Test markets performed well in D.C., Chicago, Dallas, Colorado and elsewhere. The company plans to introduce the program to all major targeted markets by the end of the next fiscal year.

International markets and more. Starbucks issued 1.8 million shares of stock for the Seattle Coffee Company and acquired 61 locations to achieve overnight major exposure in London. Seattle Coffee Co. had claimed many of the best new retail locations in London, so now Starbucks is in a strong position in one of the most important markets in Europe. The company will leverage its strong position in London to help it move into the rest of Europe.

Starbucks expects to have 80 to 90 locations in the U.K. by the end of the year, with the first new Starbucks-branded location opening by the end of September. The conversion of Seattle Coffee Co. stores will begin in fiscal '99 and be completed by the end of that fiscal year. Starbucks expects to have at least 500 stores in Europe and 500 in the Pacific Rim by the end of 2003.

Recently, the company signed a licensee agreement to open Starbucks in New Zealand and Malaysia, and the first stores for both locations will open by the end of the calendar year. The first Thailand store opened last week to a strong welcome. At the end of the quarter, there were 21 Starbucks in Japan, 11 in Hawaii, 10 in Singapore, 4 in the Philippines, and 4 in Taiwan. The reception throughout these countries has been exceptional. The equity of the brand has traveled to international markets without one dollar of advertising. In the past nine months Starbucks opened 33 locations in this area, so it will make its goal of opening at least 40 in the Pacific Rim this year.

Starbucks also announced a strategic alliance with Canadian Airlines, which mirrors a successful relationship with United Airlines and Horizon Air. Finally, Starbucks is sponsoring the largest national concert tour this summer, the Tour of Lilith Fair, which plays in more than 57 venues. Starbucks' beverages are served at all of them.

Internet Presence. The company will have a much expanded presence on the Internet at http://www.starbucks.com. The current site is a teaser for an expanded site that launches this fall. This new medium will be a marketing and communications tool as well as a long-term business opportunity to sell coffee. The site will add retail sales eventually. Following early success on AOL (achieving more than 1 million hits to date), Starbucks is excited about its new Internet site and the possibility to build an online community around its products and brand. The site should formally launch by September 30.

Tiazzi. Tiazzi recently launched and is receiving a strong welcome thanks in part to promotion and coupons to try the drink. Tiazzi represents the idea of constant self-renewal that Starbucks embodies -- not to embrace the status quo, not to rest on past success, but always to be a step ahead of any competition, sometimes by means of surprising customers with drinks no one else has considered. Starbucks must leverage its foot traffic, and Tiazzi introduces another beverage choice aside from coffee.

Coming new products and concepts. This fall an entirely new product category will be introduced -- a new family of coffees. After significant research and development, Starbucks believes that these new coffees will attract customers who have not yet developed a palate for current Starbucks blends. The new coffees will be of the highest quality, per the usual, but mix blending and roasting in order to capture a flavor and attract a palate that, to date, Starbucks might be missing because of a focus on roast product.

Another new concept is a European style cafe, called Cafe Starbucks, which will offer the usual complete line of coffee and beverages and will also sell food. Cafe Starbucks will have waited table service and sell pastry, bread, have salad services, and finally hot meals, too. Also, two locations will offer beer and wine, and -- the company is excited about this -- an alcohol enhanced coffee beverage that will be a signature and proprietary product. This new "evening minded" alcohol product and Cafe Starbucks are the result of thousands of customers asking for food and for an evening component that goes beyond the core menu of today. Cafe Starbucks is only testing in three markets, but could eventually be a significant growth opportunity. Food represents little more than Starbucks leveraging its core business in the simplest way, while at the same time redefining what Starbucks does every day and adding a significant evening and day aspect to the company's locations that could fuel growth.

Strategic direction. The strategic direction and core values of Starbucks continue to grow and expand, and each new venture is another growing arm of the business that connects to the whole. Starbucks knows the retail experience and serves it as well as possible, but management isn't going to rest on its laurels. Instead, it drives to get closer to customers and to provide more and better products. A new and growing position in alternate retail channels allows the company to take the brand into wholesale, grocery and convenience store locations, serving millions -- many of whom might never have been inside a Starbucks store. The company won't pursue growth that dilutes the integrity of the core brand. It always wants great and enduring brand awareness, and is become an enduring global brand.

Los numeros. Michael Casey, VP and CFO, reported financial numbers by business segment, which are available in the quarterly earnings announcement. Retail sales grew 34%, driven by the addition of new stores and same store sales growth of 7%. 4% of this increase is due to a higher number of sales transactions combined with an increase in the average dollar amount per transaction.

Specialty sales revenue grew 68% (to $47 million), driven by new grocery store sales, as well as increased sales to joint ventures and licensees and a chain of wholesale clubs. Direct response sales decreased 8% to $4 million.

Cost of sales including occupancy expenses was 43.4% of net revenue vs. 42.5% in fiscal '97. It was actually 42.9% excluding the cost of the merger with the Seattle Coffee Co. The slight increase is the result of higher coffee costs, partially offset by higher selling prices that were initiated late last year. A moving average cost accounting system for green coffee means that Starbucks' coffee cost fluctuates much less than the C coffee contract on the market.

Store operating expenses would have been 37.7% of retail sales (without the merger) due to lower advertising costs partially offset by higher payroll expenditures. General & administrative expenses increased to 6.2% of net revenue (from 5.8%) due primarily to systems related expenses.

Quarter three operating margins of 9.7% was 0.5% better than last year when excluding charges. The tax rate was higher this year by 1.5% due to costs associated with the recent merger, but this should return to the lower 38.5% tax level in the coming quarters.

nine month figures
For the past nine months, revenue grew 36% to $951 million due to new store openings and a 6% increase in same store sales. Specialty sales grew 58% to $123.8 million -- this area saw revenues increase across the board as the new grocery stores added a great deal to sales. Direct response sales decreased 11% to $15.6 million.

General and administrative expenses rose to 6.1% of sales from 5.8%, due again to systems related expenses. Operating income, excluding one-time charges, rose 53% to $87.3 million. Operating margin of 9.2% was 1.1 points higher than last year. Excluding costs, net earnings year-to-date total $55.8 million, or $0.61 per share compared to $0.45 last year.

balance sheet
At the end of Q3, Starbucks had $125 million in cash and investments, $766 million in equity, and essentially no long-term debt. Inventories were $152 million. Current cash and cash generated through operations should be enough to fund all of fiscal '98 and '99 barring unforeseen initiatives. Management continues to expect same store sales growth in the mid-single digits with monthly anomalies possible and even likely.

coming earnings and growth
Management continues to remain confident of being able to achieve $0.89 to $0.94 in earnings per share this fiscal year [the current average analyst estimate is $0.93, and ranges from $0.90 to $0.97], including 6 cents of operating dilution due to the acquisition of the Seattle Coffee Co. Looking to fiscal '99, Starbucks should open at least 400 new stores in continental North America, putting the company at least one year ahead of its 2,000 store goal. It also plans to open 100 new stores in international markets next year, with a slight majority in the Pacific Rim and the remainder in the U.K. (visit the Fool U.K. to talk all things U.K.).

Starbucks expects revenue to grow around 30% in fiscal '99, and management reminds that revenue from joint ventures with Pepsi and Dreyers, as well as sales at the 175 licensed locations, are no longer included in company revenues. These represent about $500 million worth of branded Starbucks sales that won't show on the top line.

Starbucks expects some improvement of gross margin next year mainly due to recent coffee market trends (lower prices), but it takes time for changes in coffee costs to flow to Starbucks bottom line. The company already has a substantial majority of its 1999 coffee needs filled at fixed prices, taking advantage of recent pricing trends. Starbucks expects operating and net margins to improve due to the gross margin improvement and thanks to a slight improvement in expenses. The Pepsi and Dreyers partnerships will be positive to earnings in fiscal '99, while international sales will still be dilutive but should begin to breakeven by the end of fiscal '99, excluding England.

Management is targeting earnings for fiscal '99 of $1.20 to $1.25 per share [the current average estimate is $1.24, and ranges from $1.17 to $1.30], including dilution from the Seattle Coffee Co. This represents 35% growth over fiscal '98 EPS -- on target. Earlier quarters in the year should grow slightly less aggressively than the annual rate, and later quarters slightly more so [this is the seasonal effect of Frappuccino sales, etc]. Please note that these estimates could change, depending on the situation.

CEO Summary. This call marks the six year anniversary of the public company and conference calls, and Starbucks is already a much different entity than it was when it began. It is working to be the leading coffee brand around the globe and it has already, obviously, made tremendous progress. The brand now needs to be nurtured.

Starbucks has the opportunity to extend the equity of the brand to new channels of distribution all over the world. It will have Starbucks locations across the globe and then it will take the brand and put it on best of class products to be sold throughout other retail channels around the world as well, creating profit centers around the globe.

Answers to Questions

Coffee and cream prices. Coffee prices have declined, but price reductions haven't had a significant impact on Starbucks in the grocery store channel. The company does need to be sensitive to the prices that other coffee companies are charging in grocery stores, and will be. Right now, though, transaction growth and retail sales are strong and there is no need or plan to lower prices.

Ice cream profitability targets should be met this year, and as Starbucks ice cream is already granted premium prices, the current high cream costs don't impact the ice cream pricing policy. Ice cream prices shouldn't rise this calendar year.

Division profits. Starbucks sees increased profitability from its joint ventures and from existing international locations, though adding new international locations is dilutive at first, as England will be next year. The company expects grocery sales to be additive to earnings next year, ice cream already is additive and will be next year, and the PepsiCo joint venture is breakeven and should be additive next year. International and U.K. sales should both be dilutive next year, but Asia will probably be additive in 2000 -- that could go either way. You pay while building, but current older locations are fueling earnings growth and provide the cash to grow.

Next year trends. The expectation for higher growth in earnings during the second half of next year is due more to sales growth issues, not margin issues. It has to do in part with the timing of the cold bottled Frappuccino business (it's much more busy in the summer) and other programs.

Speed of service. The company is working to improve the speed of service at locations. Some solutions involve improved technology, reducing the time to make drinks. Also, Starbucks has found that baristas with headsets [oh no! something a la McDonald's!] can break into a line for orders and reduce the waiting time 20%. Finally, Smart Cards will very much reduce cashier time. The company is testing several.

Heatwave. Heat is generally good for summer business, as it leads to more sales of Frappuccino and iced drinks. But the heatwave in Texas, for example, is a bit toooooo hot, and can decrease foot traffic. A hot summer is good for business as long as it isn't so hot that it keeps people indoors.

Traffic. The average Starbucks customer comes to a store 18 times a month, and Starbucks serves 7 million customers a week in the world.

Market share. The market share of the company is 5% or less of all the coffee consumed in North America, so the opportunity for Starbucks to expand is obviously tremendous. For a start, the new coffee family introduced later this calendar year will serve customers with tastes that go beyond the current offerings. The company is also prepared for the holiday and winter season -- it has done its homework.

Same store sales. All regions participated with the same positive same store sales comparisons, and all regions are showing positive growth. Western Canada was the strongest due to weaker results last year, but all regions were consistenly strong.

End.

Related Links:

Quarter Three Earnings Report.
An array of SBUX information.
Recent Book from Starbucks CEO (proceeds go to charity)

(Starbucks is a holding in the Motley Fool's real-money Fool Portfolio. Fool on!)

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