Starbucks - 10-Q quarterly report FY

 

 

(Exact Name of Registrant as Specified in its Charter)

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

(206) 447-1575
(Registrant’s Telephone Number, including Area Code)

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.

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Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

The unaudited consolidated financial statements as of July 3, 2005, and for the 13-week and 39-week periods ended July 3, 2005, and June 27, 2004, have been prepared by Starbucks Corporation (“Starbucks” or the “Company”) pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”) and, in the opinion of management, reflect all adjustments and accruals, which are of a normal recurring nature, necessary for a fair presentation of the balance sheet, and statements of earnings and cash flows of the Company for the interim periods.

The financial information as of October 3, 2004, is derived from the Company’s audited consolidated financial statements and notes for the fiscal year ended October 3, 2004 (“Fiscal 2004”), included in Item 8 in the Fiscal 2004 Annual Report on Form 10-K/A (Amendment No. 1) (“2004 10-K/A”). The information included in this Form 10-Q should be read in conjunction with management’s discussion and analysis and notes included in the 2004 10-K/A.

The earnings for the 13-week and 39-week periods ended July 3, 2005, are not necessarily indicative of the earnings that may be achieved for the entire fiscal year ending October 2, 2005.

Certain reclassifications of prior year’s balances have been made to conform to the current format. Specifically, Starbucks has reclassified its auction rate securities of $154.1 million, previously classified in “Cash and cash equivalents,” as “Short-term investments — available-for-sale securities” on the consolidated balance sheet as of October 3, 2004. The Company had historically classified these securities as cash equivalents based on management’s ability to liquidate its holdings during the predetermined interest rate reset auctions, which generally occurred within 90 days of acquiring the securities. Although management had determined the risk of failure of an auction process to be remote, the definition of a cash equivalent in Statement of Financial Accounting Standards No. 95, “Statement of Cash Flows” (“SFAS 95”), requires reclassification to short-term investments.

The Company has made corresponding adjustments to its consolidated statement of cash flows for the 39 weeks ended June 27, 2004 to reflect the gross purchases, sales and maturities of auction rate securities as investing activities rather than as a component of cash and cash equivalents. There was no impact on previously reported net earnings, cash flows from operating activities or shareholders’ equity as a result of this reclassification.

Additionally, the Company has reclassified its distributions received from equity investees on the consolidated statement of cash flows, from investing activities to operating activities, for the 39 weeks ended June 27, 2004. These distributions represented returns on the underlying equity investments, and therefore have been reclassified to be in accordance with the provisions of SFAS 95. There was no impact on the previously reported consolidated statements of earnings or consolidated balance sheets as a result of this reclassification.

On February 7, 2005, the Office of the Chief Accountant of the SEC issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease accounting issues and their application under generally accepted accounting principles in the United States of America (“GAAP”). In light of this letter, the Company’s management initiated a review of its lease-related accounting and determined that its then-current method of accounting for leasehold improvements funded by landlord incentives or allowances under operating leases (tenant improvement allowances) and its then-current method of accounting for rent holidays were not in accordance with GAAP.

The Company had historically accounted for tenant improvement allowances as reductions to the related leasehold improvement asset on the consolidated balance sheets and capital expenditures in investing activities on the consolidated statements of cash flows. Management determined that the appropriate interpretation of Financial Accounting Standards Board (“FASB”) Technical Bulletin No. 88-1, “Issues Relating to Accounting for Leases,” requires these allowances to be recorded as deferred rent liabilities on the consolidated balance sheets and as a component of operating activities on the consolidated statements of cash flows. Additionally, this adjustment results in a reclassification of the deferred rent amortization from “Depreciation and amortization expenses” to “Cost of sales including occupancy costs” on the consolidated statements of earnings.

The Company had historically recognized rent holiday periods on a straight-line basis over the lease term commencing with the initial occupancy date, or Company-operated retail store opening date. The store opening date coincided with the

commencement of business operations, which is the intended use of the property. Management re-evaluated FASB Technical Bulletin No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases,” and determined that the lease term should commence on the date the Company takes possession of the leased space for construction purposes, which is generally two months prior to a store opening date. Excluding tax impacts, the correction of this accounting requires the Company to record additional deferred rent in “Accrued occupancy costs” and “Other long-term liabilities” and to adjust “Retained earnings” on the consolidated balance sheets as well as to correct amortization in “Cost of sales including occupancy costs” on the consolidated statements of earnings.

As a result of the above, the Company previously restated its consolidated balance sheet as of October 3, 2004 in its 2004 10-K/A. Following is a summary of the effects of the lease accounting corrections and the retroactive adjustments as discussed in Note 4 from the Company’s acquisition of 100% of its licensed operations in Germany on the Company’s consolidated statements of earnings for the 13 and 39 weeks ended June 27, 2004 (in thousands, except share data):

Following is a summary of the effects of the lease accounting corrections, adjustments for the Germany acquisition, and the reclassifications for auction rate securities and distributions from equity investees as discussed in Note 1, on the Company’s consolidated statement of cash flows for the 39 weeks ended June 27, 2004 (in thousands):

The Company maintains several stock compensation plans under which, among other instruments, incentive stock options and non-qualified stock options may be granted to employees, consultants and non-employee directors. The Company also maintains employee stock purchase plans (“ESPP”). Starbucks accounts for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, because the stock option grant price equals the market price on the date of grant, and any purchase discounts under the ESPP are within statutory limits, no compensation expense is recognized by the Company for stock-based compensation.

Had compensation cost been recognized based upon the estimated fair value on the grant date of stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock Based Compensation,” (“SFAS 123”) as amended by SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure,” the Company’s net earnings and earnings per share by using the Black-Scholes option valuation model would have been as follows (in thousands, except earnings per share):

The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and the Company’s actual experience under the plans.

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), a revision of SFAS 123. SFAS 123R will require Starbucks to, among other things, measure all employee stock-based compensation awards using a fair value method and record such expense in the Company’s consolidated financial statements. The provisions of SFAS 123R, as amended by SEC Staff Accounting Bulletin No. 107, “Share-Based Payment,” are effective no later than the beginning of the next fiscal year that begins after June 15, 2005, and Starbucks will adopt the new requirements in its first fiscal quarter of 2006 using the modified prospective transition method. The adoption of SFAS 123R will reduce the Company’s future net earnings. Management continues to evaluate the impacts of SFAS 123R and related interpretations to quantify the expected financial impacts.

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143” (“FIN 47”). FIN 47 requires the recognition of a liability for the fair value of a legally-required conditional asset retirement obligation when incurred, if the liability’s fair value can be reasonably estimated. FIN 47 is effective for fiscal years ending after December 15, 2005. The Company has not yet determined the impact of adoption on its consolidated statement of earnings and balance sheet.

In December 2004, the FASB issued Staff Position No. FAS 109-1, “Application of SFAS No. 109, Accounting for Income Taxes, to the Tax Deduction on Qualified Production Activities provided by the American Jobs Creation Act of 2004” (“FSP 109-1”). FSP 109-1 states that qualified domestic production activities should be accounted for as a special deduction under SFAS No. 109, “Accounting for Income Taxes,” and not be treated as a rate reduction. The provisions of FSP 109-1 are effective immediately. The Company continues to evaluate the impact of the new Act, which will allow Starbucks to qualify for a benefit beginning in fiscal 2006.

In December 2004, the FASB issued Staff Position No. FAS 109-2, “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004” (“FSP 109-2”). The American Jobs Creation Act allows a special one-time dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. The Company may elect to repatriate earnings in either fiscal 2005 or fiscal 2006. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. Although FSP 109-2 is effective immediately, it allows companies additional time beyond the enactment date to evaluate the effects of the provision on its plan for investment or repatriation of unremitted foreign earnings. The Company continues to evaluate the impact of the new Act to determine whether it will repatriate foreign earnings and the impact, if any, this pronouncement will have on its consolidated financial statements. In addition, the U.S. Treasury Department is

expected to provide additional clarifying guidance on certain elements of the repatriation provision. Earnings under consideration for repatriation range from $0 to $100 million and the related income tax effects from such repatriation cannot be reasonably estimated at this time. As provided in FSP 109-2, Starbucks has not adjusted its tax expense or deferred tax liability to reflect the repatriation provision.

In November 2004, the FASB issued Statement No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS 151”). SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS 151 are effective for fiscal years beginning after June 15, 2005. The adoption of SFAS 151 in fiscal 2006 is not expected to have a significant impact on the Company’s consolidated balance sheet or statement of earnings.

On April 6, 2005, Starbucks acquired substantially all of the assets of Ethos Brands, LLC, (“Ethos”), a privately held bottled water company based in Santa Monica, California, for $8 million. The earnings of Ethos are included in the accompanying consolidated financial statements from the date of acquisition.

In November 2004, Starbucks increased its equity ownership from 18% to 100% for its licensed operations in Germany. As a result, management determined that a change in accounting method, from the cost method to the consolidation method, was necessary and included adjusting previously reported information for the Company’s proportionate share of net losses of 18% as required by APB Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.” The cumulative effect of the accounting change for prior periods resulted in a reduction of retained earnings of $3.6 million as of October 4, 2004. See Note 19 in the Company’s 2004 10-K/A for additional information.

Inventories consist of the following (in thousands):

As of July 3, 2005, the Company had committed to fixed-price purchase contracts for green coffee totaling $261 million. The Company believes, based on relationships established with its suppliers, the risk of non-delivery on such purchase commitments is remote.

The Company manages its exposure to various risks within the consolidated financial statements according to an umbrella risk management policy. Under this policy, Starbucks may engage in transactions involving various derivative instruments, with maturities generally not longer than five years, to hedge assets, liabilities, revenues and purchases.

Starbucks and its subsidiaries, which include entities that use their local currency as their functional currency, enter into cash flow derivative instruments to hedge portions of anticipated revenue streams and inventory purchases. Current forward contracts hedge monthly forecasted revenue transactions denominated in Japanese yen and Canadian dollars, as well as forecasted inventory purchases denominated in U.S. dollars, euros and Swiss francs, for foreign operations. Additionally, the Company has swap contracts to hedge a portion of its forecasted U.S. fluid milk purchases. The effect of these swaps will fix the price paid by Starbucks for the monthly volume of milk purchases covered under the contracts on approximately 10% and 6% of its forecasted U.S. fluid milk purchases in fiscal 2005 and 2006, respectively.

The Company had accumulated net derivative losses of $3.7 million, net of taxes, in other comprehensive income as of July 3, 2005, related to cash flow hedges. Of this amount, $2.8 million of net derivative losses will be reclassified into earnings within 12 months. No cash flow hedges were discontinued during the 13-week or 39-week periods ended July 3, 2005, and June 27, 2004. Current contracts will expire within 15 months.

Net investment derivative instruments hedge the Company’s equity method investment in Starbucks Coffee Japan, Ltd. to minimize foreign currency exposure to fluctuations in the Japanese yen. The Company applies the spot-to-spot method for these forward foreign exchange contracts, and under this method the change in fair value of the forward contracts attributable to the changes in spot exchange rates (the effective portion) is reported in other comprehensive income. The remaining change in fair value of the forward contract (the ineffective portion) is reclassified into earnings in “Interest and other income, net.” The Company had accumulated net derivative losses of $3.8 million, net of taxes, in other comprehensive income as of July 3, 2005, related to net investment derivative hedges. Current contracts expire within 21 months.

The following table presents the net gains and losses reclassified from other comprehensive income into the statements of earnings during the periods indicated for cash flow and net investment hedges (in thousands):

Property, plant and equipment are recorded at cost and consist of the following (in thousands):

Starbucks may acquire shares of its common stock under its authorized share repurchase program and depending on market conditions. Share repurchases are funded through cash, cash equivalents and available-for-sale securities. Starbucks acquired 16 million shares at an average price of $50.47 for a total cost of $807 million during the 39-week period ended July 3, 2005. Starbucks acquired 2 million shares at an average price of $37.29 for a total cost of $82 million during the 39-week period ended June 27, 2004. As of July 3, 2005, the Company had 12.6 million additional shares authorized for repurchase.

Comprehensive income includes all changes in equity during the period, except those resulting from transactions with shareholders and subsidiaries of the Company. It has two components: net earnings and other comprehensive income. Accumulated other comprehensive income reported on the Company’s consolidated balance sheets consists of foreign currency translation adjustments and the unrealized gains and losses, net of applicable taxes, on available-for-sale securities and on derivative instruments designated and qualifying as cash flow and net investment hedges. Comprehensive income, net of related tax effects, is as follows (in thousands):

The unfavorable translation adjustment change for the 13-week period ended July 3, 2005 of $21.1 million was primarily due to the strengthening of the U.S. dollar against the euro and British pound sterling. The unfavorable translation adjustment change for the 13-week period ended June 27, 2004 of $4.7 million was primarily due to the strengthening of the U.S. dollar against the Canadian dollar and Japanese yen.

For the 39-week period ended July 3, 2005, the unfavorable translation adjustment change of $4.8 million was primarily due to the strengthening of the U.S. dollar against the euro. The favorable translation adjustment change for the 39-week period ended June 27, 2004, of $15.9 million was primarily due to the weakening of the U.S. dollar against the British pound sterling and Japanese yen.

The components of accumulated other comprehensive income, net of tax, were as follows(in thousands):

The following table presents the calculation of net earnings per common share — basic and diluted (in thousands, except earnings per share):

Options with exercise prices greater than the average market price were not included in the computation of diluted

earnings per share. For the 13-week period ended July 3, 2005, these options totaled 6.7 million and for the 13-week period ended June 27, 2004, these options totaled thirteen thousand during which periods the average market price of the Company’s common stock was $52.01 and $39.84, respectively. For the 39-week period ended July 3, 2005, these options totaled 5.6 million and for the 39-week period ended June 27, 2004, these options totaled one hundred twenty thousand during which periods the average market price of the Company’s common stock was $53.48 and $35.74, respectively.

The Company has unconditionally guaranteed the repayment of certain Japanese yen-denominated bank loans and related interest and fees of an unconsolidated equity investee, Starbucks Coffee Japan, Ltd. The guarantees continue until the loans, including accrued interest and fees, have been paid in full, with the final loan amount due in 2014. The maximum amount is limited to the sum of unpaid principal and interest amounts, as well as other related expenses. These amounts will vary based on fluctuations in the yen foreign exchange rate. As of July 3, 2005, the maximum amount of the guarantees was approximately $9.8 million. Since there has been no modification of these loan guarantees subsequent to the Company’s adoption of FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indebtedness of Others,” Starbucks has applied the disclosure provisions only and has not recorded the guarantee on its consolidated balance sheet.

During the 39-week period ended July 3, 2005, Starbucks entered into commitments under which it unconditionally guaranteed its proportionate share, or 50%, of bank line of credit borrowings of certain unconsolidated equity investees. The Company’s maximum exposure under these commitments is approximately $4.7 million, excluding interest and other related costs, and the majority of these commitments expire in 2007. As of July 3, 2005, the Company recorded $2.7 million to “Equity and other investments” and “Other long-term liabilities” on the consolidated balance sheet for the fair value of the guarantee arrangements.

Coffee brewing and espresso equipment sold to customers through Company-operated and licensed retail stores as well as equipment sold to the Company’s licensees for use in retail licensing operations are under warranty for defects in materials and workmanship for a period ranging from 12 to 24 months. The Company establishes an accrual for estimated warranty costs at the time of sale, based on historical experience. Product warranty costs and changes to the related accrual were not significant for the 39-week period ended July 3, 2005.

On June 3, 2004, two current employees of the Company filed a lawsuit, entitled Sean Pendlebury and Laurel Overton v. Starbucks Coffee Company, in the U.S. District Court for the Southern District of Florida claiming the Company violated requirements of the Fair Labor Standards Act (FLSA). The suit alleges that the Company misclassified its retail store managers as exempt from the overtime provisions of the FLSA and that the managers are therefore entitled to overtime compensation for any week in which they worked more than 40 hours during the past three years. Plaintiffs seek to represent themselves and all similarly situated U.S. current and former store managers of the Company. Plaintiffs seek reimbursement for an unspecified amount of unpaid overtime compensation, liquidated damages, attorney’s fees and costs. Plaintiffs also filed on June 3, 2004 a motion for conditional collective action treatment and court-supervised notice to additional putative class members under the opt-in procedures in section 16(b) of the FLSA. On January 3, 2005, the district court entered an order authorizing nationwide notice of the lawsuit to all current and former store managers employed by the Company during the past three years. The Company filed a motion for summary judgment as to the claims of the named plaintiffs on September 24, 2004. The court denied that motion because this case is in the early stages of discovery, but the court noted that the Company may resubmit this motion at a later date. Starbucks believes that the plaintiffs are properly classified as exempt under the federal wage laws and that a loss in this case is unlikely. Due to the early status of this case, the Company cannot estimate the possible loss to the Company, if any. Trial currently is set for early 2006, and the Company intends to vigorously defend the lawsuit.

In addition to the lawsuit described above, the Company is party to various legal proceedings arising in the ordinary course of its business, but it is not currently a party to any legal proceeding that management believes would have a material adverse effect on the consolidated balance sheet or statement of earnings of the Company.

Segment information is prepared on the basis that the Company’s management reviews financial information for operational decision making purposes. The tables below present information by operating segment (in thousands):

The table below represents information by geographic area (in thousands):

Revenues from foreign countries are based on the geographic location of the customers and consist primarily of revenues from the United Kingdom and Canada, which together account for approximately 80% of foreign net revenues. No customer accounts for 10% or more of the Company’s revenues.

In July 2005, Starbucks increased its equity ownership to 51% and 100% in its licensed operations in Southern China and Chile, respectively, for a combined total of approximately $15 million. Previously, the Company owned 5% in Coffee Concepts (Southern China) Limited and 15% in Sur-Andino Café S.A. Retroactive application of the equity method of accounting for these investments, which were previously accounted for under the cost method, is not expected to significantly impact the Company’s previously reported consolidated balance sheets or statements of earnings. The Company will use the consolidation method to account for its 51% ownership in Southern China and its 100% ownership in Chile.

This information should be read in conjunction with the consolidated financial statements and the notes included in Item 1 of Part I of this Quarterly Report and the audited consolidated financial statements and notes, and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K/A for the fiscal year ended October 3, 2004.

Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. Fiscal year 2004 had 53 weeks, with the 53^rd week falling in the fiscal fourth quarter. The fiscal year ending on October 2, 2005 will include 52 weeks.

On February 7, 2005, the Office of the Chief Accountant of the SEC issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease accounting issues and their application under generally accepted accounting principles in the United States of America (“GAAP”). The Company’s management determined that its then-current method of accounting for leasehold improvements funded by landlord incentives or allowances under operating leases (tenant improvement allowances) and its then-current method of accounting for rent holidays were not in accordance with GAAP. As a result, the Company restated its consolidated financial statements for the fiscal year ended October 3, 2004. For additional information, see Note 2 to the audited consolidated financial statements in the Company’s Annual Report on Form 10-K/A for the fiscal year ended October 3, 2004.

See Note 2 in Item 1 of this Report for a summary of the effect of this change on the Company’s consolidated statement of earnings and cash flows for the 13 and 39 weeks ended June 27, 2004.

During both the 13 and 39-week periods ended July 3, 2005, all areas of Starbucks business, from U.S. and International Company-operated retail operations to the Company’s specialty businesses, delivered strong financial performance. Starbucks believes the Company’s ability to achieve the balance between growing the core business and building the foundation for future growth is the key to increasing long-term shareholder value. Starbucks quarterly and year-to-date fiscal 2005 performance reflects the Company’s continuing commitment to achieving this balance.

The primary driver of the Company’s revenue growth continues to be the opening of new retail stores, both Company-operated and licensed, in pursuit of the Company’s objective to establish Starbucks as one of the most recognized and respected brands in the world. With a presence in 35 countries, management continues to believe that the Company’s long-term goal of 15,000 Starbucks retail locations throughout the United States and at least 15,000 stores in International markets is achievable.

In addition to opening new retail stores, Starbucks is targeting to increase revenues generated at new and existing Company-operated stores by attracting new customers and increasing the frequency of visits by current customers. The strategy is to increase first year average store sales and comparable store sales by continuously improving the level of customer service, introducing innovative products and improving the speed of service through training, technology and process improvement.

In licensed retail operations, Starbucks shares operating and store development experience to help licensees improve the profitability of existing stores and build new stores, which is expected to generate additional royalty income and product sales. The Company’s strategy is to selectively increase its equity stake in licensed international operations as these markets develop.

The combination of more retail stores, higher revenues from existing stores including comparable store sales growth of 7% and growth in other business channels in both the United States and International operating segments resulted in a 21% increase in total net revenues for the 13 weeks ended July 3, 2005, compared to the same period of fiscal 2004. This was slightly above the Company’s three to five year revenue growth target of approximately 20%. Comparable store sales growth was 8% for the 39 weeks ended July 3, 2005, compared to the same period of fiscal 2004.

Since additional retail stores can leverage existing support organizations and facilities, the Company’s infrastructure can be expanded more slowly than the rate of revenue growth and generate margin improvement. For the 13 weeks ended July 3, 2005, operating income as a percentage of total net revenues increased to 12.5% from 11.6% in the same period of fiscal 2004, and net earnings increased by 29%, compared to the same period in fiscal 2004. For the 39 weeks ended July 3, 2005, operating income as a percentage of total net revenues increased to 12.4% from 11.8% in the same period of fiscal 2004, and net earnings increased by 29%, compared to the same period in fiscal 2004. These results demonstrated the Company’s ability to improve operating margin while at the same time making strategic investments in the core retail business and in emerging specialty channels. The Company’s International operations delivered improved operating results, primarily due to leverage gained on most operating expenses distributed over an expanded revenue base. In recent fiscal years, the Company made substantial infrastructure investments in corporate and regional support facilities and personnel, as well as established more efficient distribution networks. Such investments were necessary to support the Company’s planned international expansion, which is now realizing substantial benefit from this foundation.

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 statement of earnings (amounts in thousands):

Total net revenues for the 13 weeks ended July 3, 2005, increased 21% to $1.6 billion from $1.3 billion for the corresponding period of fiscal 2004, driven by increases in both Company-operated retail revenues and specialty operations.

During the 13-week period ended July 3, 2005, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 22% to $1.4 billion for the 13 weeks ended July 3, 2005, from $1.1 billion for the same period in fiscal 2004. The increase was primarily attributable to the opening of 713 new Company-operated retail stores in the last 12 months and comparable store sales growth of 7% for the 13 weeks ended July 3, 2005. The increase in comparable store sales was due to a 4% increase in the average value per transaction and a 3% increase in the number of customer transactions. The increase in average value per transaction was primarily attributable to a beverage price increase in October 2004 in the Company’s U.S. and Canadian markets. Management believes increased traffic in Company-operated retail stores continues to be driven by sustained popularity of core products, new product innovation, a high level of customer satisfaction and improved speed of service through enhanced technology, training and execution at retail stores.

The Company derived the remaining 15% of total net revenues from its specialty operations. Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 16% to $245 million for the 13 weeks ended July 3, 2005, from $211 million for the corresponding period of fiscal 2004.

Licensing revenues, which are derived from retail store licensing arrangements, grocery and warehouse club licensing, and certain other branded-product operations, increased 17% to $170 million for the 13 weeks ended July 3, 2005, from $145 million for the corresponding period of fiscal 2004. The increase was primarily attributable to higher product sales and royalty revenues from the opening of 839 new licensed retail stores in the last 12 months.

Foodservice and other revenues increased 14% to $75 million for the 13 weeks ended July 3, 2005, from $66 million for the corresponding period of fiscal 2004. The increase was primarily attributable to the growth in new and existing U.S.

and International foodservice accounts.

Cost of sales including occupancy costs decreased to 40.6% of total net revenues for the 13 weeks ended July 3, 2005, compared to 41.0% for the corresponding period of fiscal 2004. The decrease was primarily due to a higher average revenue per retail transaction, offset in part by higher average rent expense in International markets. Dairy costs were moderately lower for the 13 weeks ended July 3, 2005, compared to the same period in fiscal 2004.

Store operating expenses as a percentage of Company-operated retail revenues decreased to 40.2% for the 13 weeks ended July 3, 2005, from 40.4% for the corresponding period of fiscal 2004, primarily due to higher average revenue per retail transaction, partially offset by higher payroll expenditures. In order to facilitate ongoing, accelerated retail store growth, the Company has been increasing the number of assistant store managers and opening a higher number of drive-thru locations over the past year, which has contributed to the higher payroll expenditures.

Other operating expenses (expenses associated with the Company’s specialty operations) decreased to 19.8% of total specialty revenues for the 13 weeks ended July 3, 2005, compared to 21.0% in the corresponding period of fiscal 2004. The decrease was primarily due to lower expenditures within the grocery and warehouse club channels, partially offset by higher costs associated with expanding emerging specialty businesses, such as music and consumer products.

Depreciation and amortization expenses increased to $85 million for the 13 weeks ended July 3, 2005, compared to $73 million for the corresponding period of fiscal 2004. The increase was primarily due to the opening of 713 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses decreased to 5.3% for the 13 weeks ended July 3, 2005, from 5.5% for the corresponding 13-week period of fiscal 2004.

General and administrative expenses increased to $91 million for the 13 weeks ended July 3, 2005, compared to $73 million for the corresponding period of fiscal 2004. The increase was primarily due to higher provisions for incentive compensation and increased charitable commitments. As a percentage of total net revenues, general and administrative expenses increased to 5.7% for the 13 weeks ended July 3, 2005 from 5.6% for the corresponding period of fiscal 2004.

Income from equity investees increased to $18 million for the 13 weeks ended July 3, 2005, compared to $13 million for the corresponding period of fiscal 2004. The increase was primarily due to volume-driven operating results for The North American Coffee Partnership, which produces bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drink, and improved operating results from international investees, particularly Korea and Japan.

Operating income increased 30% to $200 million for the 13 weeks ended July 3, 2005, compared to $153 million for the corresponding 13-week period of fiscal 2004. As a result of lower store and other operating expenses as a percentage of related revenues, operating margin increased to 12.5% of total net revenues for the 13 weeks ended July 3, 2005, compared to 11.6% for the corresponding period of fiscal 2004.

Interest and other income decreased 27% to $3 million for the 13 weeks ended July 3, 2005, compared to $4 million for the corresponding 13-week period of fiscal 2004, primarily due to higher realized losses on sales of securities and lower realized foreign currency exchange gains compared to fiscal 2004. Starbucks funded the majority of its share repurchases during the 13 weeks ended July 3, 2005, through the sales of its available-for-sale securities, which contributed to the increased amount of realized losses.

Income taxes for the 13-week periods ended July 3, 2005 and June 27, 2004 both resulted in an effective tax rate of 38.1%.

SEGMENT RESULTS

Segment information is prepared on the basis that the Company’s management reviews financial information for operational decision-making purposes. The following tables summarize the Company’s statements of earnings by segment (amounts in thousands):

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

United States total net revenues increased by $219 million, or 20%, to $1.3 billion for the 13 weeks ended July 3, 2005, compared to $1.1 billion for the corresponding period of fiscal 2004.

United States Company-operated retail revenues increased by $194 million, or 20%, to $1.1 billion for the 13 weeks ended

July 3, 2005, compared to $947 million for the corresponding period of fiscal 2004, primarily due to the opening of 585 new Company-operated retail stores in the last 12 months and comparable store sales growth of 7% for the quarter. The increase in comparable store sales was due to a 4% increase in the average value per transaction, including 3% attributable to a beverage price increase in October 2004, and a 3% increase in the number of customer transactions.

Total United States specialty revenues increased $25 million, or 14%, to $198 million for the 13 weeks ended July 3, 2005, compared to $173 million in the corresponding period of fiscal 2004. United States licensing revenues increased $17 million, or 16%, to $129 million, compared to $112 million for the corresponding period of fiscal 2004. The increase was primarily due to higher product sales and royalty revenues as a result of opening 519 new licensed retail stores in the last 12 months, and, to a lesser extent, growth in the grocery and warehouse club business. United States foodservice and other revenues increased 12%, to $69 million from $61 million in fiscal 2004, primarily due to growth in new and existing foodservice accounts.

United States operating income increased by 30% to $245 million for the 13 weeks ended July 3, 2005, from $189 million for the same period in fiscal 2004. Operating margin increased to 18.3% of related revenues from 16.9% in the corresponding period of fiscal 2004, primarily due to leverage from strong revenue growth and cost control throughout all areas of the business.

International operations (“International”) sells coffee and other beverages, whole bean coffees, complementary food, coffee brewing equipment and merchandise through Company-operated retail stores in Canada, the United Kingdom, Thailand, Australia, Singapore, Germany and China. Specialty operations in International primarily include retail store licensing operations in more than 25 other countries and foodservice accounts in Canada and the United Kingdom. Certain of the Company’s International operations are in various early stages of development that necessitate a more extensive support organization relative to the current levels of revenue and operating income, than in the United States.

International total net revenues increased $64 million, or 32%, to $262 million for the 13 weeks ended July 3, 2005, compared to $198 million for the corresponding period of fiscal 2004.

International Company-operated retail revenues increased $54 million, or 34%, to $215 million for the 13 weeks ended July 3, 2005, compared to $161 million for the corresponding period of fiscal 2004, primarily due to the opening of 128 new Company-operated retail stores in the last 12 months, comparable store sales growth of 7% for the quarter and favorable foreign currency exchange rates for both the Canadian dollar and the British pound sterling. The increase in comparable store sales resulted from a 4% increase in the number of customer transactions coupled with a 3% increase in the average value per transaction.

Total International specialty revenues increased $10 million, or 25%, to $47 million for the 13 weeks ended July 3, 2005, compared to $38 million in the corresponding period of fiscal 2004. The increase was primarily due to higher product sales and royalty revenues from opening 320 new licensed retail stores in the last 12 months and growth in new and existing international foodservice accounts.

International operating income increased by 41% to $19 million for the 13 weeks ended July 3, 2005, compared to $13 million in the corresponding period of fiscal 2004. Operating margin increased to 7.2% of related revenues from 6.8% in the corresponding period of fiscal 2004, due to leverage gained on fixed costs distributed over an expanded revenue base and increased income from equity investees, particularly in Korea and Japan.

Unallocated corporate expenses pertain to certain functions, such as executive management, accounting, administration, tax, treasury, and information technology infrastructure, which are not specifically attributable to the Company’s operating segments, and include related depreciation and amortization expenses. Unallocated corporate expenses increased to $64 million for the 13 weeks ended July 3, 2005, compared to $49 million in the corresponding period of fiscal 2004, primarily due to higher payroll-related expenditures and increased charitable commitments. The higher payroll-related expenditures resulted from modest headcount growth and higher provisions for incentive compensation. Total unallocated corporate expenses as a percentage of total net revenues increased to 4.0% for the 13 weeks ended July 3, 2005 compared to 3.7% for the corresponding period of fiscal 2004.

CONSOLIDATED RESULTS

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 statement of earnings (amounts in thousands):

Total net revenues for the 39 weeks ended July 3, 2005, increased 23% to $4.7 billion from $3.8 billion for the corresponding period of fiscal 2004, driven by increases in both Company-operated retail revenues and specialty operations.

During the 39-week period ended July 3, 2005, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 23% to $4.0 billion for the 39 weeks ended July 3, 2005, from $3.2 billion for the same period in fiscal 2004. The increase was primarily attributable to the opening of 713 new Company-operated retail stores in the last 12 months and comparable store sales growth of 8% for the 39 weeks ended July 3, 2005. The increase in comparable store sales was due to a 4% increase in the number of customer transactions and a 4% increase in the average value per transaction. Management believes increased traffic in Company-operated retail stores continues to be driven by sustained popularity of core products, new product innovation, a high level of customer satisfaction and improved speed of service through enhanced technology, training and execution at retail stores. The increase in average value per transaction was primarily due to a beverage price increase in October 2004 in the Company’s U.S. and Canadian markets.

The Company derived the remaining 15% of total net revenues from its specialty operations. Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 18% to $711 million for the 39 weeks ended July 3, 2005, from $602 million for the corresponding period of fiscal 2004.

Licensing revenues, which are derived from retail store licensing arrangements, grocery and warehouse club licensing, and certain other branded-product operations, increased 22% to $489 million for the 39 weeks ended July 3, 2005, from $401 million for the corresponding period of fiscal 2004. The increase was primarily a result of higher product sales and royalty revenues from the opening of 839 new licensed retail stores in the last 12 months.

Foodservice and other revenues increased 11% to $222 million for the 39 weeks ended July 3, 2005, from $201 million for the corresponding period of fiscal 2004. The increase was primarily attributable to the growth in new and existing U.S.

and International foodservice accounts.

Cost of sales including occupancy costs as a percentage of total net revenues decreased to 40.9% for the 39 weeks ended July 3, 2005, from 41.1% for the corresponding period of fiscal 2004. The decrease was primarily due to higher average revenue per retail transaction, offset in part by higher initial costs associated with the continued expansion of the lunch program in Company-operated stores.

Store operating expenses as a percentage of Company-operated retail revenues increased to 40.0% for the 39 weeks ended July 3, 2005, from 39.5% for the corresponding period of fiscal 2004. The increase was primarily due to higher payroll-related expenditures, as well as higher maintenance and repair expenditures to ensure a consistent Starbucks Experience in existing stores. The higher payroll-related expenditures were primarily the result of increasing the number of assistant store managers, opening a higher number of drive-thru locations over the past year, and extended store operating hours. The Starbucks Experience, or third place experience after home and work, is built upon superior customer service as well as clean and well-maintained Company-operated retail stores.

Other operating expenses (expenses associated with the Company’s specialty operations) decreased to 19.6% of total specialty revenues for the 39 weeks ended July 3, 2005, compared to 21.4% in the corresponding period of fiscal 2004. The decrease was primarily due to lower expenditures within the grocery and warehouse club channels and efficiencies gained from expansion of the foodservice distribution network, partially offset by higher costs associated with the expanding emerging specialty businesses, such as music and consumer products.

Depreciation and amortization expenses increased to $252 million for the 39 weeks ended July 3, 2005, compared to $215 million for the corresponding period of fiscal 2004. The increase was primarily due to the opening of 713 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses decreased to 5.3% for the 39 weeks ended July 3, 2005, from 5.6% for the corresponding 39-week period of fiscal 2004.

General and administrative expenses increased to $256 million for the 39 weeks ended July 3, 2005, compared to $224 million for the corresponding period of fiscal 2004. The increase was primarily due to higher payroll-related expenditures and professional fees in support of both domestic and international expansion, as well as increased charitable commitments. As a percentage of total net revenues, general and administrative expenses decreased to 5.4% for the 39 weeks ended July 3, 2005 from 5.8% for the corresponding period of fiscal 2004.

Income from equity investees increased to $47 million for the 39 weeks ended July 3, 2005, compared to $35 million for the corresponding period of fiscal 2004. The increase was primarily due to volume driven operating results for The North American Coffee Partnership, which produces bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drink, and improved operating results from international investees, particularly in Japan and Korea.

Operating income increased 29% to $584 million for the 39 weeks ended July 3, 2005, compared to $452 million for the corresponding 39-week period of fiscal 2004. Operating margin increased to 12.4% of total net revenues for the 39 weeks ended July 3, 2005, compared to 11.8% for the corresponding period of fiscal 2004, primarily due to strong revenue growth and cost control throughout most areas of the business, partially offset by higher retail store operating expenses as discussed above.

Interest and other income increased to $12 million for the 39 weeks ended July 3, 2005, compared to $11 million in the corresponding period of fiscal 2004, primarily due to interest income earned on higher cash and liquid investment balances for the 39 weeks ended July 3, 2005, compared to the corresponding period in fiscal 2004. Partially offsetting this increase were higher realized losses on available-for-sale securities and foreign exchange losses versus gains in fiscal 2004.

Income taxes for the 39 weeks ended July 3, 2005 resulted in an effective tax rate of 37.8%, compared to 38.1% in the corresponding period of fiscal 2004.

SEGMENT RESULTS

Segment information is prepared on the basis that the Company’s management reviews financial information for operational decision-making purposes. The following tables summarize the Company’s statements of earnings by segment (amounts in thousands):