Starbucks Corporation (SBUX) Q2 2012 Earnings Report, Transcript and Summary

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to the Starbucks Coffee Company's Second Quarter Fiscal Year 2012 Earnings Conference Call. [Operator Instructions] Ms. DeGrande, you may begin your conference.

Thank you, Mike. Good afternoon. This is JoAnn DeGrande, Director of Investor Relations for Starbucks Coffee Company. Joining me on the call today is Howard Schultz, Chairman, President and CEO; and Troy Alstead, CFO. Before we get started, I'd like to remind you that this conference call will include forward-looking statements, which are subject to various risks and uncertainties that could cause our actual results to differ materially from these statements. Any such statements should be considered in conjunction with cautionary statements in our earnings release and risk factor discussions in our filings with the SEC, including our last annual report on Form 10-K. Starbucks assumes no obligation to update any of the forward-looking statements or information. Please refer to the financial statements accompanying the earnings release to find disclosures and reconciliations of non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures. This conference call is being webcast, and an archive of the webcast will be available on our website at www.starbucks.com under Investor Relations. With that, let me turn the call over to Howard Schultz. Howard?

Thank you, JoAnn, and welcome to everyone on today's call. I'm very pleased to report the record second quarter fiscal 2012 results that Starbucks announced today. As we sit here today, Starbucks has 17,420 stores in 58 countries, serving nearly 60 million customers each week. Our record Q2 revenues and earnings were driven by strong overall global comparable store sales growth, a significant increase in our CPG, what we refer to as Channel Development segment revenues and operational excellence. A strong top line combined with increased efficiencies and continued discipline around controlling costs enabled us to deliver second quarter EPS of $0.40 to our shareholders. I'm particularly pleased that we were able to accomplish these results despite the challenges posed by high-legacy commodity costs and a particularly difficult consumer environment in Western Europe, further highlighted by the recessionary news out of England just this morning. I would not ordinarily begin a call with discussion of one particular market, but we had such a memorable trip to China last week that I wanted to share a few of the details with you upfront. Starbucks' business in China is strong and poised for significant disciplined profitable growth. We have seen a tremendous increase in momentum in China since my last trip, as more and more Chinese consumers frequent our stores and connect with the Starbucks brand and store experience. You almost have to see the customer engagement for yourself to fully appreciate the transformation. In the past, our typical core customer in China was an expat or tourist visiting a store in Shanghai or Beijing. Today, without question, we have made the significant transition to serving local Chinese customers who enjoy a wide variety of locally relevant products and a welcoming third place environment. We are well on our way to achieving…

Thanks, Howard, and good afternoon, everyone. You can see based on Howard's remarks why we are so optimistic about what the future holds for Starbucks, and why we have communicated such aspirational growth targets for this year and beyond. But before I move to that, I'd like to take you through our fiscal second quarter results. Today, we reported second quarter records for revenues, operating income and earnings per share. We continue to drive strong incremental traffic despite lapping significant comp growth from the past 2 years, and we continue to offset uncontrollable headwinds, particularly the struggling global economy and high coffee costs with operational efficiencies and innovation. Our second quarter consolidated net revenues were $3.2 billion, up 15% from $2.8 billion a year ago. Revenue increase was primarily driven by a 7% increase in global comparable store sales, attributable to a 6% increase in traffic and a 1% increase in average ticket. Higher channel development revenues and solid gains in our licensed stores also contributed to the global revenue increase. Operating income for the second quarter reached $430 million, a 14% increase over last year's second quarter. Consolidated operating margin was 13.5%, which was equal to the second quarter of last year. Higher commodity costs, primarily coffee, had a negative impact on operating income of $64 million and added 200 basis points of pressure on operating margin. Primarily offsetting this was increased sales leverage throughout much of the P&L, driven by our strong top line results. Our consolidated G&A spend for the second quarter was 6.5% of net revenue, flat for the second quarter of last year. 3/4 of our total $207 million expense in G&A in Q2 are presented in our financial statements in other, and as a percentage of total net revenues, declined slightly over the second…

[Operator Instructions] Your first question comes from the line of Keith Siegner from Credit Suisse. Keith Siegner - Crédit Suisse AG, Research Division: Just one quick question on one of the opportunities that we've talked about a little bit in the past. And Howard, you said coffee is at the center of everything you do. But to some extent, so is tea, and it continues to feel like a little bit of an untapped opportunity. And I know there's a new individual kind of in charge of tea. And I was just wondering if you have any thoughts about maybe what is the opportunity in tea, how should we think about that, and how are you approaching that opportunity either the rest of this year or into next year?

Thank you for the question, Keith. Let's level set [ph]. First off, Tazo, within the Starbucks family currently represents on its own $1 billion business in terms of its brand position, in terms of revenue from our store base and in CPG. The acquisition of Evolution is not only to expand and explore the opportunities within juice. But when I talked about this publicly, we spoke about the significant interest and the study we've done around health and wellness. Obviously, we think that the medicinal qualities and the efficacy of tea will play a very large role in the overall category of health and wellness at Starbucks. Today is not the day to talk specifically about Tazo and our future plans, but I can tell you that we recognize the unique opportunities we have with Tazo in multiple channels of distribution as part of our health and wellness initiative, and there'll be more about that in the months and quarters ahead.

Your next question comes from the line of John Ivankoe from JPMorgan. John W. Ivankoe - JP Morgan Chase & Co, Research Division: I just wanted to get a sense of timing of what's happening in EMEA. The transformational agenda in the U.S. obviously bore fruit very, very quickly, and it included some of your very substantial reorganization of the way that the overall division was managed. So I guess the question is how far along are you in the process, kind of deciding what you want to do in Europe, with being a smaller business but a more profitable business? I mean, I guess to some extent, that was the case in the U.S., be a possibility at least in the short term, and I think in the press release, you talked about new regional strategic initiatives. Is that the type of thing that's already at its peak in the P&L right now, or we could expect margins to increase or might they even get worse in the near term as you continue to invest and figure out what you want to do there?

John, this is Howard. First off, let's split off EMEA into 2 parts, the Western Europe and the Middle East. The Middle East market for Starbucks, in which we have hundreds of stores in the Gulf, is quite healthy, and we continue to feel very bullish about that part of the equation. With regard to Western Europe, let me walk you through what we've done in anticipation of the transformation of that business. First off, one of our most senior and most experienced executives and operators, who is at our side co-authoring the U.S. transformation is Michelle Gass. She has moved to become the President of that region, and she's living in the U.K. In addition to that, the largest company-owned market within that region is the U.K., and we've also moved one of our strongest retail operators from the U.S., Kris Engskov [ph], who is managing the U.K. business reporting to Michelle. I think we -- in a sense, we've seen this movie before, and I'm proud to say it had a very good and positive ending in terms of what we were able to do in the U.S. I think there are many similarities in terms of the downturn in the economy and consumer confidence. And I think that we all feel quite optimistic over the long term that we're going to be able to not only turn this business around, but it's going to be a profitable market for Starbucks. Having said that, the situation is very, very tough and it's not one Europe. The situation in Greece, the situation in Portugal, the situation in Spain, I can go on and on, and then just this morning, we wake up to the news of an announcement of a double-dip recession in Great Britain. So what we've said early on within the U.S. transformation is that we were not going to use the economy as an excuse for our inability to transform and succeed in that market, and we're not using it internally as well. But we can't ignore the headwinds. But I think the short version is that we have put in place a strategic plan that we feel is going to address the issues at hand, in many ways takes a lot of the proven successes we had in the U.S. with Michelle in the lead, and she is getting all the support and resources from the corporation. We also think that we should invest into the market in terms of innovation and be very strategic in how we're going to grow the market. But the short version here is that it's going to take a while. We are cautiously optimistic and we think over the long term, we will succeed in this market, but it's -- this is not going to happen overnight.

Your next question comes from the line of Greg Badishkanian from Citigroup.

Just wondering maybe if you could talk a little bit about potential weather impact in the quarter in the U.S. and maybe how same-store sales trended or throughout the quarter or by geographic region or some other color based on that.

In all due respect, we do not allow weather to enter the equation of Starbucks comp store sales internally, and we're certainly not going to allow it to enter the conversation publicly. We are going to succeed in good and bad weather. I don't think the weather had any significant impact on comps. I think that 8% comps in the U.S. business on the backdrop of the economic issues is a stunning number. And to be honest with you, I was a little bit surprised to see some of your reactions in terms of disappointment.

Your next question comes from the line of John Glass from Morgan Stanley.

The Channel Development category has a number of moving pieces. I think you've actually added several even this past quarter and so it's very difficult, I think, to track it. So 2 questions, one is general and one is more specific. Generally, Troy or whoever would like to take this, could you sketch out maybe the next few quarters if there are major milestones in which pieces of these businesses should drop in? Or if you want to maybe just more generally talk about what you think the revenue from the Channel Development category ought to grow over, say, the next 4 quarters? That's the general one. And specific to that in the K-Cup business, it looks like the 230 million that you shipped in 5 months is a slight deceleration from the previous comments like on a monthly basis. I'm not sure if there's channel loading or that -- not. Can you talk about what the revenue associated with that was specifically? And I think before you said $0.03 to $0.05 accretion, this year, is that still the right way to look at that?

John, let me start with part of the answer, and then I'm going to turn it over Jeff Hansberry to take more of it. First of all, we have all along said we anticipate a $0.03 to $0.05 of incremental profit impact this year from Starbucks K-Cups, and then a quarter ago I said we expected, given the rapid acceleration and great customer response to that product launch, that we expected the top end of that range and that's still what we expect at this point in time for this year, given the launch as it's progressing throughout the year, right near the top end of that incremental impact is what we would expect. Now certainly, as we move into 2013 and with greater distribution, continued growth and velocity and at that point in time presence in the Starbucks stores we'd certainly expect an additional increment in 2013, and that's something will talk about a bit later. Channel Development continues to be our fastest revenue growing business, and I would expect that to continue to be true as we face the quarters and years ahead for quite some time. There's one mechanical element that everyone should remember, which is we have just as of one month ago lapped the point in time a year ago where we've brought into our P&L and onto our revenue line the packaged coffee revenues as we brought that business back in-house. And so that the consolidation impact will go away from this point forward, so there's a little bit of a trend difference that simply happens as a result of that accounting. But beyond that, Channel Development is progressing rapidly as a bright spot for us, and I'll ask Jeff to address more specifically some elements of his business.

Thanks, Troy. Hi, John. So with regard to K-Cup, we actually shipped more K-Cups in the second quarter than we did in the first. We're very pleased with the progress that we're making on K-Cup and in fact, in the last 4 weeks versus the 4 weeks prior to that, we actually grew share by 210 basis points. So we're continuing to see a very solid ramp in our share growth. We're now getting to the point where we've got distribution built out -- actually continuing to build some additional distribution. We are now turning on our marketing and merchandising efforts. So we expect our K-Cup business to continue to grow going forward.

And your next question comes from the line of Jason West from Deutsche Bank.

Just a -- I have question on the coffee side. You gave a number, Troy, of about $100 million incremental benefit on the commodity. That's a little bit lower than we might have thought, given how far coffee prices have come down. So can you talk a little bit about if -- I'm assuming the average for fiscal '13 is quite a bit above where the current price is on coffee. And could you talk about the outlook for pricing in the retail stores in light of lower prices on coffee.

Thanks, Jason. Yes, what we expect now is that, firstly [ph] we're past the peak of the year-over-year impact, negative impact on our P&L. The peak of that was really the first quarter. The second quarter also included quite an increment of extra expense due to commodities. And that will ease as we go through the balance of this year. There's still some incremental costs, but it will get a bit easier for us. We are now price protected about 11 months of our needs of fiscal 2013, while there's still some open position that it could impact cost for that year. That has given us fairly good visibility now into what that increment looks like. And that's what led to that estimate of at least $100 million benefit to our P&L next year. Now to your point, yes, our average cost in 2013 is higher than where the cost is traded on the open market today. And that's because, as we have said all along, we've been buying throughout this market and buying on the way down. And part of that is about giving us access to and ensuring the supply of the best coffee in the world. That's always our top priority when we're buying coffee. And the second priority is we're moving risk from the P&L and managing that long-term coffee exposure that has led us to that strategy of buying throughout and buying long. That also suggest to me that if coffee prices remain where they are today, I would expect tailwinds in 2013 as I mentioned earlier. And again, it remain where they are today. And that's not a prediction. I don't have that kind of crystal ball. But if they did, that would also suggest better coffee prices for us coming in 2014. So we see the light at the end of the tunnel on commodities, and we're looking forward to that turning around for us on the P&L.

And your next question comes from the line of Michael Kelter from Goldman Sachs.

I wanted to ask about the unit development. You raised your guidance to 1,000 units, which was up a lot from last year's 100 or 200. Where do we go from here? For the Americas, for example, is that a stable number, 500, or is that the start of a ramp back up? And when you look beyond that to Asia and emerging markets more broadly, it looks like that's wide open to you. How quickly do you plan to ramp that up over the next several years, and what's the limiter?

Michael, it's Howard. I can't give you a specific number, but let me just share with you what kind of goes into our thinking in terms of the future. A few things. One is that we're quite encouraged that in the U.S., the stores that we've opened over the last 12 months and then in the last 24 are performing extraordinarily well in terms of a class of stores. And in many ways, as good as any new class we've seen in a decade. So any thought of saturation or inability to find quality real estate and continue to expand in the U.S. or for that matter, North America should be taken off the table. I think we're quite encouraged with what's going on in the Americas on a macro level in markets like Brazil. And we touched on that earlier in our prepared comments, we have less than 100 stores in Brazil, and we're seeing very, very strong sales results, and we're going to accelerate under Cliff's leadership the number of stores we can open in Brazil, and in addition to that, places like Argentina and others. We just had a meeting with our Mexican partner, and he feels very strongly that he too can accelerate his growth. And then you get to Asia and China, and we didn't speak specifically about India. But the prospect of having thousands of stores in China alone is no longer a statement that we don't -- it's not a dream. This is a reality. We are -- we've turned the corner in terms of the iconic nature of the brand, the position, the leadership team. And we feel very strongly that we're going to be able to do that effectively. And then John and his team are getting ready to open up India with really the #1 partner in that nation, which is Tata, and we should have great results there. So net-net, I can't envision in the coming years that we would open up less stores than we've just announced and feel very good about the teams that are in place and the trends that are in place. And having just returned from China last week, which was just an extraordinary trip, eye-opener for all of us, I think we are on the cutting edge of becoming really one of the most admired Western brands to enter China in a very long time.

Your next question comes from the line of Sara Senatore from Sanford Bernstein. Sara H. Senatore - Sanford C. Bernstein & Co., LLC., Research Division: I want to go back to Europe, understanding that Middle East and I think that Eastern Europe probably are, as well, are pretty strong for you. Is there anything -- the one thing -- the one distinction between Western Europe and the U.S. a couple of years ago is that you're such a dominant brand and retailer in the U.S., whereas in Europe, it feels like maybe it's a little bit more competitive. So can you just talk broadly about that market and whether or not structurally, there are differences there that might make it harder for you to get margins up? And likewise, whether or not it says anything about how competitive maybe the consumer products market is, given that my sense was that the Krueger partnership would be particularly well-suited to Europe.

I mean, thank you for the question. That's Cliff who was the resident U.K. person with that around the table and used to run that region for us. So Cliff, you want to take that?

Yes, I'd like to take it. Thank you, Sara, for the opportunity. I think all the things you said about the dominant position we've had here and the competition in Europe is very, very true, and the economy across each of the markets we're all too well aware of. In each of the markets now, we have very strong leaders. And we, through Michelle, have a very strong president. And we know what we need to do there, and I believe that the team are equipped to do that. And making local -- ourselves locally relevant, whether that's the strength of the coffee in the U.K., or the varietals in France, the fruit assortments in each of those markets, is really the key to this because as you say, very competitive. We focused totally and very intensely on the U.S., Michelle was my business partner at that time as we focused market-by-market here in the U.S. And now that segment tends to come to vary [ph] in Europe, and it is going to have to be country-by-country to beat local competition. And sometimes, that is national chains and sometimes that is very local players. But I think they are very well equipped to do it. And I would just make a comment, having been in the U.K. recently, that places like London are still thriving because of global money and just the strength of those economies. When you get outside of the main cities, it is quite depressing at the moment with streets upon streets of shops with for sale and closure signs, which I think just goes to show how deep that recession is in the U.K. And they are going to do hard work but they're well equipped to do it. I'm absolutely confident that the relevance of the Starbucks proposition from the quality of the coffee to the third place to the people bringing it to the customer, they'll have a great experience, and we will win in each of those markets over time.

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

I too have a question on Europe. I know you have a long-term goal of reaching mid-teens margins in that division, and you're talking about certain investments that you're making in this year. Is the thought that some of these bigger margin improvements towards these ultimate goals can really begin in earnest in fiscal '13? And separately, as we think about your business, oftentimes, McDonald's will talk about things that it can do almost a Plan B from its own marketing when things get tough to stabilize sales, maybe give up a little bit on the margin but also create a little bit of a floor on sales. Is there a Plan B for Starbucks when things get tough? Are there things that you can do to help your business in Europe?

Let me at least take the first part of that question. And I would just say that the investments we're making in Europe are very much about addressing the critical issue we face in the consumer environment at this point in time. And what we're seeing is a very quick response to that. Our consumer -- customer satisfaction scores improved more meaningfully in the second quarter in the U.K. than they had in years. So we know that reaction is already happening. I would expect that the payback would produce and come over time. And I would also react a little bit to your words of the goal of mid-teen margins in Europe. We don't have a goal. We actually have a plan to get to mid-teen margins. We have a vision toward the elements and how that margin march will happen over a period of time, including improvement in top line through our engagement with customers, a disciplined focus on the middle of the P&L as a part of that effort, improvement in the overall infrastructure, supply chain, G&A and otherwise over time. So we have a very well-thought through plan that we are as confident as ever. What we can't control and predict it so much is the macro environment but needless to say, our plan A is approaching investments in Europe both from customer side, the P&L side and the infrastructure side remains the same and I think you'll see us approach that consistently from here forward.

Let me add one thing. I think many of you were around 3 years ago, 4 years ago on conference calls just like this when the headlines around Starbucks and the inability of us potentially to navigate through the financial crisis and, to be honest, some self-induced mistakes. I don't know how many of you would honestly say today that you thought that we would be able to not only transform the business but in fact, produce record revenue and record profits. I will tell you unequivocally, and you can hold us to this, that we will turn the European business around in the same way that we turned the U.S. business around. I can't tell you when and I can't tell you with specificity what the margins are going to be but we will emerge as the leader in Europe the same way we emerged as the constant leader in the U.S. The advantage that we have going forward in Europe versus the U.S. is that we have fantastic JV partners in many of these markets, who will understand consumer behavior based on living in those markets, have the leverage and the understanding of how to navigate through the storm, they've seen it before. We also have less of a store base so the problem is not as big. And then lastly, we are looking for ways to leverage licensed partners in very unique types of real estate. For example, we just opened in train stations in France with a license partner, and we are opportunistically looking at ways to offset the burden on the P&L that we have today with many of the company-owned stores based on license opportunities that we have not yet taken advantage of. The one thing we learned in the U.S. that if we would've known, we would've invested heavily ahead of the problem, which we did not do. And so we're confident we will turn this around, and we're going to be opportunistic about our abilities and when we come out of this, we're in a stronger position. But please, I don't want anyone to leave this phone call with any feeling whatsoever about the lack of confidence that we have as a management team, with Michelle and Kris [ph] in that region, that we will absolutely turn the situation in Europe around despite the significant headwinds that we are facing.

Your next question comes from the line of Sharon Zackfia from William Blair. Sharon Zackfia - William Blair & Company L.L.C., Research Division: I'm going to shift back to the Americas, and the comp obviously was very strong and has been very strong for quite a while. And Troy, when we saw you recently, the day part still seemed like it was relatively skewed to the morning as it has been forever. So I'm just curious on throughput in the morning, what you're seeing there? Obviously, there's continued improvement getting those lines to move faster. How much faster we can go, kind of where the ceiling is on the morning?

Sharon, this is Cliff. Let me just set up the day for you because you're absolutely right, morning remains our strongest period, and we continue to see increased transactions in the morning. But I'm delighted to say we are seeing growth in all day parts, and that is very encouraging because we are focused on building capacity in the morning to deal with the increasing customers coming through. At the same time, as you know, we've worked with our food programs to stretch some of those other day parts whether it's bistro boxes in a lunch program or Cake Pops in the more afternoon treat. And as you know we're trying a few things to lengthen the day and for the evening. And I have to say very encouraged by all of those. Since time, the work we started 3 years ago, 4 years ago now with lean and improving our efficiencies so that we can get people through more quickly while paying much more personal attention to them, we have -- still have considerable runway. And although we're achieving really record transactions every day on our New York stores, we are confident we can continue to do that. So we'll grow our transactions, I'm confident, and we'll continue to focus on food attach for all day parts. So we have a lot of runway ahead of us.

Your next question comes from the line of Bonnie Herzog from Wells Fargo.

I wanted to ask a question about your packaged coffee business. And just in terms of what you're seeing, I guess what appears to be moderating pricing yet faster volume growth. What are the drivers of this? And then do you think you're achieving the right balance here between pricing and then volume growth for this business?

Jeff?

Bonnie, it's Jeff Hansberry. We think that we are, and we have seen recent continued share growth in the Starbucks packaged coffee brand. And that coming through Q2, it's very significant and important for us at this milestone quarter as we cycle through our first full year of a direct model, and at the same time moved into Starbucks Blonde Roast, which represents an opportunity for us to better serve a broader segment of coffee customers outside of our retail stores, where we're seeing growth driven by not only the introduction of Blonde Roast but also we have grown share by over 100 basis points during the quarter -- during a period when we faced a significant competitive launch by the Gevalia brand. So we feel like we're striking the right balance, maintaining loyalty with our current customers and bringing new customers to the Starbucks franchise while maintaining and defending our premium position.

So that concludes our call today. We're out of time, but we thank you all for joining us, and we'll speak to you again in late July for our Q3 earnings call. Have a great evening.

This concludes today's Starbucks Coffee Company's Second Quarter Fiscal Year 2012 Earnings Conference Call. You may now disconnect.