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.

Yes þ     No o

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

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o     

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):

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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 2, 2006, and for the 13-week and 39-week periods ended July 2, 2006, and July 3, 2005, have been prepared by Starbucks Corporation (“Starbucks” or the “Company”) under the rules and regulations of the Securities and Exchange Commission (the “SEC”). In the opinion of management, the financial information for the 13-week and 39-week periods ended July 2, 2006, and July 3, 2005, reflects all adjustments and accruals, which are of a normal recurring nature, necessary for a fair presentation of the financial position, results of operations and cash flows for the interim periods.

The financial information as of October 2, 2005, is derived from the Company’s audited consolidated financial statements and notes for the fiscal year ended October 2, 2005 (“Fiscal 2005”), included in Item 8 in the Fiscal 2005 Annual Report on Form 10-K (“10-K”). The information included in this Form 10-Q should be read in conjunction with management’s discussion and analysis and notes to the financial statements in the 10-K.

Certain reclassifications of prior year’s balances have been made to conform to the current format.

The results of operations for the 13-week and 39-week periods ended July 2, 2006, are not necessarily indicative of the results of operations that may be achieved for the entire fiscal year ending October 1, 2006.

In January 2006, Starbucks increased its equity ownership to 100% in its operations in Hawaii and Puerto Rico. Previously the Company owned 5% of both Coffee Partners Hawaii and Cafe´ del Caribe in Puerto Rico. Because Coffee Partners Hawaii was a general partnership, the equity method of accounting was previously applied. Retroactive application of the equity method of accounting for the Puerto Rico investment, which was previously accounted for under the cost method, resulted in a reduction of retained earnings of $0.5 million as of April 2, 2006. Previously reported earnings per share amounts were not impacted as a result of this acquisition.

As shown in the tables below, the cumulative effect of the accounting change for financial results previously reported under the cost method and as restated in this report under the equity method reduced net earnings by $34 thousand for the 13 weeks ended January 1, 2006, and $97 thousand for the fiscal year ended October 2, 2005 (in thousands):

The following table summarizes the effects of the investment accounting change on net earnings for the periods indicated (in thousands):

The Company maintains several equity incentive plans under which it may grant non-qualified stock options, incentive stock options, restricted stock or stock appreciation rights to employees, non-employee directors and consultants. The Company also has employee stock purchase plans (“ESPP”).

Prior to the October 3, 2005 adoption of the Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment” (“SFAS 123R”), Starbucks accounted 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 equaled the market price on the date of grant, and any purchase discounts under the Company’s stock purchase plans were within statutory limits, no compensation expense was recognized by the Company for stock-based compensation. As permitted by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), stock-based compensation was included as a pro forma disclosure in the notes to the consolidated financial statements.

Effective October 3, 2005, the beginning of Starbucks first fiscal quarter of 2006, the Company adopted the fair value recognition provisions of SFAS 123R, using the modified-prospective transition method. Under this transition method, stock-based compensation expense was recognized in the consolidated financial statements for granted, modified, or settled stock options and for expense related to the ESPP, since the related purchase discounts exceeded the amount allowed under SFAS 123R for non-compensatory treatment. Compensation expense recognized included the estimated expense for stock options granted on and subsequent to October 3, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of October 3, 2005, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123. Results for prior periods have not been restated, as provided for under the modified-prospective method.

Total stock-based compensation expense recognized in the consolidated statement of earnings for the 13 weeks ended July 2, 2006, was $27.4 million before income taxes and consisted of stock option and ESPP expense of $24.7 million and $2.7 million, respectively. Total stock-based compensation expense recognized in the consolidated statement of earnings for the 39 weeks ended July 2, 2006, was $78.0 million before income taxes and consisted of stock option and ESPP expense of $70.6 million and $7.4 million, respectively. The related total tax benefit was $9.3 million and $26.6 million for the 13 weeks and 39 weeks ended July 2, 2006, respectively. Capitalized stock-based compensation at July 2, 2006 was $1.2 million, and was included in property, plant and equipment, and inventory on the consolidated balance sheet.

Prior to the adoption of SFAS 123R, Starbucks presented all tax benefits resulting from the exercise of stock options as operating cash inflows in the consolidated statements of cash flows, in accordance with the provisions of the Emerging Issues Task Force (“EITF”) Issue No 00-15, “Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option.” SFAS 123R requires the benefits of tax deductions in excess of the compensation cost recognized for those options to be classified as financing cash inflows rather than operating cash inflows, on a prospective basis. This amount is shown as “Excess tax benefit from exercise of stock options” on the consolidated statement of cash flows.

For option grants made in November 2003 and thereafter, the Company may provide for immediate vesting upon retirement for optionees who have attained at least 10 years of service and are age 55 or older. Prior to adoption of SFAS 123R, the Company amortized the expense over the related vesting period with acceleration of expense upon retirement. With the adoption of SFAS 123R, the accounting treatment for retirement features changed. Expense for awards made prior to adoption of SFAS 123R is still amortized over the vesting period until retirement, at which point any remaining unrecognized expense is immediately recognized. For awards made on or after October 3, 2005, the related expense is recognized either from grant date through the date the employee reaches the years of service and age requirements, or from grant date through the stated vesting period, whichever is shorter.

The following table shows the effect on net earnings and earnings per share had compensation cost been recognized based upon the estimated fair value on the grant date of stock options, and ESPP, in accordance with SFAS 123, as amended by SFAS No. 148 “Accounting for Stock-Based Compensation — Transition and Disclosure” (in thousands, except earnings per share):

Disclosures for the periods ended July 2, 2006 are not presented because the amounts are recognized in the consolidated financial statements.

The fair value of stock awards was estimated at the date of grant using the Black-Scholes-Merton (“BSM”) option valuation model with the following weighted average assumptions for the 13 weeks ended July 2, 2006 and July 3, 2005:

The fair value of stock awards was estimated at the date of grant using the BSM option valuation model with the following weighted average assumptions for the 39 weeks ended July 2, 2006 and July 3, 2005:

The expected term of the options represents the estimated period of time until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For 2006, expected stock price volatility is based on a combination of historical volatility of the Company’s stock and the one-year implied volatility of its traded options, for the related vesting periods. Prior to the adoption of SFAS 123R, expected stock price volatility was estimated using only historical volatility. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent remaining term. The Company has not paid dividends in the past and does not plan to pay any dividends in the near future.

The BSM option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, particularly for the expected term and expected stock price volatility. The Company’s employee stock options have characteristics significantly different from those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimate. Because Company stock options do not trade on a secondary exchange, employees do not derive a benefit from holding stock options unless there is an increase, above the grant price, in the market price of the Company’s stock. Such an increase in stock price would benefit all shareholders commensurately. See Note 9 for additional details.

Revenues from the Company’s stored value cards, such as the Starbucks Card, are recognized when tendered for payment, or upon redemption. Outstanding customer balances are included in “Deferred revenue” on the consolidated balance sheets. There are no expiration dates on the Company’s stored value cards, and Starbucks does not charge any service fees that cause a decrement to customer balances.

While the Company will continue to honor all stored value cards presented for payment, management may determine the likelihood of redemption to be remote for certain card balances due to, among other things, long periods of inactivity. In these circumstances, to the extent management determines there is no requirement for remitting card balances to government agencies under unclaimed property laws, card balances may be recognized in the consolidated statements of earnings in “Income and other income, net.” For the 13 weeks and 39 weeks ended July 2, 2006, income recognized on unredeemed stored value card balances was $1.1 million and $3.4 million, respectively. There was no income recognized on unredeemed stored value card balances during the 13 weeks or 39 weeks ended July 3, 2005.

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109,” which seeks to reduce the diversity in practice associated with the accounting and reporting for uncertainty in income tax positions. This Interpretation prescribes a comprehensive model for the financial statement recognition, measurement,

presentation and disclosure of uncertain tax positions taken or expected to be taken in income tax returns. FIN 48 is effective for fiscal years beginning after December 15, 2006 and the Company will adopt the new requirements in its fiscal first quarter of 2008. The cumulative effects, if any, of adopting FIN 48 will be recorded as an adjustment to retained earnings as of the beginning of the period of adoption. The Company has not yet determined the impact, if any, of adopting FIN 48 on its consolidated financial statements.

In November 2005, the FASB issued Staff Position No. FAS 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). The Company has elected to adopt the alternative transition method provided in FSP 123R-3 for calculating the tax effects of stock-based compensation under SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in-capital pool (“APIC pool”) related to the tax effects of stock-based compensation, and for determining the subsequent impact on the APIC pool and consolidated statements of cash flows of the tax effects of stock-based compensation awards that are outstanding upon adoption of SFAS 123R.

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 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for fiscal years ending after December 15, 2005, and Starbucks will adopt the new requirements at the end of its fiscal fourth quarter of 2006. The Company is in the process of determining the impact of adoption on its consolidated financial statements and currently estimates the cumulative impact upon adoption to total $0.05 per diluted share or less.

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 law allows the Company to make an election to repatriate earnings through fiscal 2006. FSP 109-2 provides accounting and disclosure guidance for the repatriation provision. Although FSP 109-2 was effective upon its issuance, 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. During the Company’s fiscal third quarter of 2006, Starbucks completed its evaluation and decided not to elect repatriation of earnings under this provision.

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, which includes subsidiaries that use their local currency as their functional currency, enters into cash flow derivative instruments to hedge portions of anticipated revenue streams and inventory purchases. Current forward contracts, which comprise the majority of the Company’s derivative instruments, 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. The Company also has swap contracts to hedge a small portion of its forecasted U.S. fluid milk purchases and futures contracts to hedge the variable price component for certain of its price-to-be-fixed green coffee purchase contracts.

The Company had accumulated net derivative losses of $6.1 million, net of taxes, in other comprehensive income as of July 2, 2006, related to cash flow hedges. Of this amount, $3.4 million of net derivative losses pertain to hedging instruments that will be dedesignated within 12 months and will also continue to experience fair value changes before affecting earnings. No cash flow hedges were discontinued and no ineffectiveness was recognized during the 13-week or 39-week periods ended July 2, 2006, and July 3, 2005. Current contracts will expire within 27 months.

Net investment derivative instruments are used to hedge the Company’s equity method investment in Starbucks Coffee Japan, Ltd. as well as the Company’s net investments in its Canadian and United Kingdom subsidiaries, to minimize foreign currency exposure. 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 $3.7 million, net of taxes, in other comprehensive income as of July 2, 2006, related to net investment derivative hedges. Current contracts expire within 36 months.

The following table presents the net gains and losses reclassified from other comprehensive income into the consolidated statements of

earnings during the periods indicated for cash flow and net investment hedges (in thousands):

Inventories consist of the following (in thousands):

The Company had committed to fixed-price purchase contracts for green coffee totaling $388 million and $261 million as of July 2, 2006 and July 3, 2005, respectively. The Company believes, based on relationships established with its suppliers in the past, the risk of nondelivery on such purchase commitments is remote.

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

As of July 2, 2006 the Company had $200 million outstanding under its $500 million revolving credit facility, which was entered into in August 2005. In addition, a letter of credit of $11.9 million was outstanding as of July 2, 2006, which reduces the borrowing capacity under the credit facility. As of October 2, 2005, the Company had $277 million outstanding, with no outstanding letters of credit. During the 39-weeks ended July 2, 2006, the Company had additional borrowings of $378 million under the credit facility and made principal repayments of $455 million. Interest expense on the Company’s short-term borrowings for the 13 weeks and 39 weeks ended July 2, 2006 was $0.6 million and $4.7 million, respectively. The weighted average contractual interest rates at July 2, 2006 and October 2, 2005 were 5.5% and 4.0%, respectively. The credit facility contains provisions that require the Company to maintain compliance with certain covenants, including the maintenance of certain financial ratios. As of July 2, 2006 and October 2, 2005, the Company was in compliance with each of these covenants.

Under the Company’s authorized share repurchase program, Starbucks acquired 11.1 million shares at an average price of $32.03 for a total amount of $354 million during the 39-week period ended July 2, 2006. Starbucks acquired 32.0 million shares at an average price of $25.24 for a total amount of $807 million during the 39-week period ended July 3, 2005. As of July 2, 2006, the Company had 11.0

million additional shares authorized for repurchase. Share repurchases were funded through cash, cash equivalents, available-for-sale securities and borrowings under the revolving credit facility and were part of the Company’s active capital management program.

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 favorable translation adjustment change for the 13-week period ended July 2, 2006, of $15.6 million was primarily due to the weakening of the U.S. dollar against several currencies, such as the euro, British pound sterling, Japanese yen and Canadian dollar. 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 favorable translation adjustment change for the 39-week period ended July 2, 2006, of $17.4 million was primarily due to the weakening of the U.S. dollar against several currencies, such as the euro, British pound sterling, Canadian dollar and Korean won. The unfavorable translation adjustment change for the 39-week period ended July 3, 2005, of $4.8 million was primarily due to the strengthening of the U.S. dollar against the euro.

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

Stock options to purchase the Company’s common stock are granted at prices at or above the fair market value on the date of grant. Options generally become exercisable in three or four equal installments beginning a year from the date of grant and generally expire 10 years from the date of grant. Options granted to non-employee directors generally vest over one year. Nearly all outstanding stock options are non-qualified stock options.

The fair value of each stock option granted is estimated on the date of grant using the BSM option valuation model. 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 experience. Options granted are valued using the multiple option valuation approach, and the resulting expense is recognized using the graded, or accelerated, attribution method, consistent with the multiple option valuation approach. Compensation expense is recognized only for those options expected to vest, with forfeitures estimated at the date of grant based on the Company’s historical experience and future expectations. Prior to the adoption of SFAS 123R, the effect of forfeitures on the pro forma expense amounts was recognized as the forfeitures occurred.

A summary of the Company’s stock option activity during the 39 weeks ended July 2, 2006 is presented in the following table:

The aggregate intrinsic value in the table above is before applicable income taxes and represents the amount optionees would have received if all options had been exercised on the last business day of the period ended July 2, 2006, based on the Company’s closing stock price of $37.76. As of July 2, 2006, total unrecognized stock-based compensation expense related to nonvested stock options was approximately $95 million, before income taxes, and is expected to be recognized over a weighted average period of approximately 23 months. During the 39 weeks ended July 2, 2006, the total intrinsic value of stock options exercised was $264 million. During the 39 weeks ended July 2, 2006, the total fair value of options vested was $15 million.

The Company issues new shares of common stock upon exercise of stock options.

As of July 2, 2006, there were 61.9 million shares of common stock available for issuance pursuant to future stock option grants. Additional information regarding options outstanding as of July 2, 2006, is as follows:

The Company has an employee stock purchase plan allowing eligible employees to contribute up to 10% of their base earnings toward the quarterly purchase of the Company’s common stock. The employee’s purchase price is 85% of the lesser of the fair market value of the stock on the first business day or the last business day of the quarterly offering period. Employees may purchase shares having a fair market value of up to $25,000 (measured as of the first day of each quarterly offering period for each calendar year). The total number of shares issuable under the plan is 32.0 million. There were 1.1 million shares issued under the plan during the 39 weeks ended July 2, 2006 at an average price of $26.11. Since inception of the plan, 15.9 million shares have been purchased, leaving 16.1 million shares available for future issuance.

Starbucks has an additional employee stock purchase plan in the United Kingdom that allows eligible U.K. employees to save toward the purchase of the Company’s common stock. Under the Save-As-You-Earn (“SAYE”) plan the employee’s purchase price is 85% of the fair value of the stock on the first business day of a three-year offering period. The total number of shares issuable under the plan is 1.2 million. There were 35,190 shares issued under the plan during the 39 weeks ended July 2, 2006 at an average price of $8.84, and 1.1 million shares remain available for future issuance. During fiscal 2004, the Company suspended future offerings under this plan. The last offering was made in December 2002 and matured in February 2006.

A new employee stock purchase plan, the U.K. Share Incentive Plan, was introduced during fiscal 2004 to replace the SAYE plan. It allows eligible U.K. employees to purchase shares of common stock through payroll deductions during six-month offering periods at the lesser of the fair market value of the stock at the beginning or at the end of the offering period. The Company will award one matching share for each six shares purchased under the plan. The total number of shares issuable under the plan is 1.4 million. There were 11,138 shares issued under the plan during the 39 weeks ended July 2, 2006 at an average price of $26.42. As of July 2, 2006, 1.38 million shares were available for future issuance.

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

Potential dilutive shares consist of the incremental common shares issuable upon the exercise of outstanding stock options (both vested and non-vested) using the treasury stock method. Potential dilutive shares are excluded from the computation of earnings per share if their effect is antidilutive. For the 13-week period ended July 2, 2006, antidilutive options totaled 433 thousand, and for the 13-week period ended July 3, 2005, totaled 13.4 million. For the 39-week period ended July 2, 2006, antidilutive options totaled 10.0 million, and for the 39-week period ended July 3, 2005, totaled 11.3 million.

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 2, 2006, the maximum amount of the guarantees was approximately $6.8 million. Because 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.

Starbucks has commitments under which it has unconditionally guaranteed its proportionate share, or 50%, of certain borrowings of unconsolidated equity investees. The Company’s maximum exposure is approximately $7.3 million, excluding interest and other related costs and the majority of these commitments expire in 2007 and 2011. As of July 2, 2006, the Company recorded $3.0 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 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 months 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 2, 2006.

On June 3, 2004, two then-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 each manager therefore is entitled to overtime compensation for any week in which he or she worked more than 40 hours during the three years before joining the suit as a plaintiff, and for as long as they remain a manager thereafter. 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 three years before the suit was filed. 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 was 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. The Company cannot estimate the possible loss to the Company, if any. Trial is currently set for May 2007. The Company intends to vigorously defend the lawsuit.

On March 11, 2005, a former employee of the Company filed a lawsuit, entitled James Falcon v. Starbucks Corporation and Does 1 through 100, in the U.S. District Court for the Southern District of Texas claiming that the Company violated requirements of the FLSA. Specifically, the plaintiff claims that the Company misclassified its retail assistant store managers as exempt from the overtime provisions of the FLSA and that each assistant manager therefore is entitled to overtime compensation for any week in which he or she worked more than 40 hours during the three years before joining the suit as a plaintiff, and for as long as they remain an assistant manager thereafter. On August 18, 2005, the plaintiff amended his complaint to include allegations that he and other retail assistant store managers were not paid overtime compensation for all hours worked in excess of 40 hours in a work week after they were re-classified as non-exempt employees in September 2002. In both claims, Plaintiff seeks to represent himself and a putative class of all current and former assistant store managers employed by the Company in the United States from March 11, 2002 until the present. He also seeks, on behalf of himself and the class, reimbursement for an unspecified amount of unpaid overtime compensation, liquidated damages, injunctive relief, and attorney’s fees and costs. On September 13, 2005, the plaintiff filed a motion for conditional collective action treatment and court-supervised notice to all putative class members under the opt-in procedures in section 16(b) of the FLSA. On November 29, 2005, the court entered an order authorizing notice to the class of the existence of the lawsuit and their opportunity to join as plaintiffs. The Company has a policy requiring that all non-exempt partners, including assistant store managers, be paid for all hours worked, including any hours worked in excess of 40 per week. The Company also believes that this policy is, and at all relevant times has been, communicated and followed consistently. Further, the Company believes that the plaintiff and other assistant store managers were properly classified as exempt under the FLSA prior to September 2002. The Company cannot estimate the possible loss to the Company, if any, and believes that a loss in this case is unlikely. No trial date has been set. The Company intends to vigorously defend the lawsuit.

On October 8, 2004, a former hourly employee of the Company filed a lawsuit in San Diego County Superior Court entitled Jou Chau v. Starbucks Coffee Company. The lawsuit alleges that the Company violated the California Labor Code by allowing shift supervisors to receive tips. More specifically, the lawsuit alleges that since shift supervisors direct the work of baristas, they qualify as “agents” of the Company and are therefore excluded from receiving tips under California Labor Code Section 351, which prohibits employers and their agents from collecting or receiving tips left by patrons for other employees. The lawsuit further alleges that because the tipping practices violate the Labor Code, they also are unfair practices under the California Unfair Competition Law. In addition to recovery of an unspecified amount of tips distributed to shift supervisors, the lawsuit seeks penalties under California Labor Code Section 203 for willful failure to pay wages due. Plaintiff also seeks attorneys’ fees and costs. On March 30, 2006, the Court issued an order certifying the case as a class action, with the plaintiff representing a class of all persons employed as baristas in the state of California since October 8, 2000. The size of the class has yet to be determined. The Company cannot estimate the possible loss to the Company, if any. The Company believes its practices comply with California law, and the Company intends to vigorously defend the lawsuit. Trial is currently set for May 2007.

The Company is party to various other 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 financial position or results of operations 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):

No customer accounts for 10% or more of the Company’s revenues. 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 76% of foreign net revenues.

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 for the fiscal year ended October 2, 2005.

Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. Fiscal year 2005 had 52 weeks and the fiscal year ending on October 1, 2006 will also include 52 weeks.

During both the 13 weeks and 39 weeks ended July 2, 2006, the Company’s focus on execution in all areas of its business, from U.S. and International Company-operated retail operations to the Company’s specialty businesses, delivered strong financial performance. Management believes that its 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 2006 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 support of the Company’s objective to establish Starbucks as one of the most recognized and respected brands in the world. Starbucks has opened 1,543 new stores in the first three quarters of this fiscal year and expects to open at least 2,000 total new stores during fiscal 2006. With a presence today in 37 countries, serving more than 40 million customers per week, 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 service with speed 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. Internationally, the Company’s strategy is to selectively increase its equity stake in licensed international operations as these markets develop. In January 2006, the Company increased its equity ownership from 5% to 100% in its operations in Hawaii and Puerto Rico.

The combination of more retail stores, comparable store sales growth of 6% and growth in other business channels in both the U.S. and International operating segments resulted in a 23% increase in total net revenues for the 13 weeks ended July 2, 2006, compared to the same period of fiscal 2005. The Company’s three to five year revenue growth target is approximately 20%. Comparable store sales growth for the remainder of fiscal 2006 is expected to be in the range of 3% to 7%, with monthly anomalies.

For the 13 weeks ended July 2, 2006, operating income as a percentage of total net revenues decreased to 10.9% from 12.5% in the

same period of fiscal 2005, primarily due to the recognition of stock-based compensation. For the 39 weeks ended July 2, 2006, operating income as a percentage of total net revenues decreased to 12.0% from 12.4% in the same period of fiscal 2005, due to the recognition of stock-based compensation. Net earnings increased by 16% and 21% during the 13 weeks and 39 weeks ended July 2, 2006, respectively. Reported margin and net earnings increases include the effects of stock-based compensation in the 13 weeks and 39 weeks ended July 2, 2006, while stock-based compensation expense was not included in the Company’s consolidated financial results in fiscal 2005.

CONSOLIDATED RESULTS

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

Net revenues for the 13 weeks ended July 2, 2006, increased 23% to $2.0 billion from $1.6 billion for the corresponding period of fiscal 2005, driven by increases in both Company-operated retail revenues and specialty operations. Net revenues are expected to grow approximately 20% in fiscal 2006 compared to fiscal 2005.

During the 13-week period ended July 2, 2006, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 22% to $1.7 billion for the 13 weeks ended July 2, 2006, from $1.4 billion for the same period in fiscal 2005. The increase was primarily attributable to the opening of 955 new Company-operated retail stores in the last 12 months and comparable store sales growth of 6% for the quarter. The increase in comparable store sales was due to a 4% increase in the number of customer transactions and a 2% 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, and a high level of customer satisfaction.

The Company derived the remaining 15% of total net revenues from channels outside the Company-operated retail stores, collectively known as “Specialty Operations.” Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 23% to $303 million for the 13 weeks ended July 2, 2006, compared to $245 million for the corresponding period of fiscal 2005.

Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club, and certain other branded-product licensed operations, increased 27% to $216 million primarily due to higher product sales and royalty revenues from the opening of 1,158 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse club business. Foodservice and other revenues increased 15% to $86 million primarily due to growth in the U.S. foodservice business.

Cost of sales including occupancy costs increased to 41.0% of total net revenues for the 13 weeks ended July 2, 2006, compared to 40.6% in the corresponding 13-week period of fiscal 2005. This increase was due to higher green coffee costs.

Store operating expenses as a percentage of Company-operated retail revenues increased to 41.3% for the 13 weeks ended July 2, 2006, from 40.2% for the corresponding period of fiscal 2005, primarily due to higher payroll-related expenditures from the recognition of stock-based compensation expense and higher employee benefits costs. In addition, the Company held regional leadership conferences for its retail management employees during its third fiscal quarter of 2006, which replaced a North American leadership conference held during the fiscal second quarter of 2005.

Other operating expenses (expenses associated with the Company’s specialty operations) increased to 23.0% of total specialty revenues for the 13 weeks ended July 2, 2006, compared to 19.8% in the corresponding period of fiscal 2005. The increase was primarily due to higher marketing and advertising costs related to Starbucks ready-to-drink coffee beverages in Japan, Taiwan and Korea as well as in the emerging U.S. Entertainment business. In addition, the recognition of stock-based compensation expense increased payroll-related expenditures.

Depreciation and amortization expenses increased to $99 million for the 13 weeks ended July 2, 2006, compared to $85 million for the corresponding period of fiscal 2005. The increase was primarily due to the opening of 955 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses decreased to 5.0% for the 13 weeks ended July 2, 2006, from 5.3% for the corresponding 13-week period of fiscal 2005.

General and administrative expenses increased to $115 million for the 13 weeks ended July 2, 2006, compared to $91 million for the corresponding period of fiscal 2005. The increase was primarily due to higher payroll-related expenditures from stock-based compensation and additional employees to support continued global growth. As a percentage of total net revenues, general and administrative expenses increased to 5.9% for the 13 weeks ended July 2, 2006, from 5.7% for the corresponding period of fiscal 2005.

Income from equity investees increased 42% to $26 million for the 13 weeks ended July 2, 2006, compared to $18 million for the corresponding period of fiscal 2005. The increase was primarily due to volume-driven results for The North American Coffee Partnership, which produces bottled Frappuccino^® and Starbucks DoubleShot^® coffee drinks, and improved results from international investees, particularly in Japan.

Operating income increased 8% to $215 million for the 13 weeks ended July 2, 2006, compared to $200 million for the corresponding 13-week period of fiscal 2005. Operating margin decreased to 10.9% of total net revenues for the 13 weeks ended July 2, 2006, compared to 12.5% for the corresponding period of fiscal 2005, primarily due to the recognition of stock-based compensation.

Interest and other income increased to $5.0 million for the 13 weeks ended July 2, 2006, compared to $3.2 million in the corresponding period of fiscal 2005, primarily due to an increase in foreign exchange gains.

Income taxes for the 13 weeks ended July 2, 2006, resulted in an effective tax rate of 33.7%, compared to 38.1% for the corresponding 13-week period of fiscal 2005. The decline in the effective tax rate was primarily due to the settlement in the current period of a multi-year income tax audit in a foreign jurisdiction for which the Company had established a contingent liability. The Company currently estimates that its effective tax rate for the fourth quarter of fiscal 2006 will approximate 38%.

Net earnings for the 13 weeks ended July 2, 2006, increased 16% to $145 million from $126 million for the same period in fiscal 2005. Earnings per share were $0.18 for the 13 weeks ended July 2, 2006, including a $0.01 per share benefit from the tax settlement discussed above, compared to $0.16 per share for the comparable period in fiscal 2005.

SEGMENT RESULTS

Segment information is prepared on the basis that the Company’s management reviews financial information for operational decision-making purposes. The tables below present operating segment results net of intersegment eliminations for the 13 weeks ended July 2, 2006 and July 3, 2005 (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 20% to $1.6 billion for the 13 weeks ended July 2, 2006, compared to $1.3 billion for the corresponding period of fiscal 2005. United States Company-operated retail revenues increased by $223 million, or 19%, to $1.4 billion, primarily due to the opening of 727 new Company-operated retail stores in the last 12 months and comparable store sales growth of 6% for the quarter. The increase in comparable store sales was due to a 5% increase in the number of customer transactions and a 1% increase in the average value per transaction.

Total United States specialty revenues increased by 22% to $241 million for the 13 weeks ended July 2, 2006, compared to $198 million in the corresponding period of fiscal 2005. United States licensing revenues increased 26% to $162 million from $129 million in fiscal 2005, primarily due to higher product sales and royalty revenues as a result of opening 730 new licensed retail stores in the last 12 months and, to a lesser extent, growth in the licensed grocery and warehouse club business. United States foodservice and other revenues increased to $79 million, or 15%, from $69 million in fiscal 2005, primarily due to growth in new and existing foodservice accounts.

United States operating income increased by 8% to $264 million for the 13 weeks ended July 2, 2006, from $245 million for the same period in fiscal 2005. Operating margin decreased to 16.5% of related revenues from 18.3% in the corresponding period of fiscal 2005. The decrease was primarily due to higher store operating expenses from increased payroll-related expenditures and costs incurred related to regional leadership conferences, which were held during the third fiscal quarter of fiscal 2006, compared to the second quarter in fiscal 2005. Additionally, costs of sales including occupancy increased due to higher green coffee costs and higher distribution and utilities costs.

International operations (“International”) sells coffee and other beverages, whole bean coffees, complementary food, coffee brewing equipment and merchandise through Company-operated retail stores in the United Kingdom, Canada, Thailand, Australia, Hawaii, Germany, Singapore, China, Puerto Rico, Chile and Ireland. Specialty Operations in International primarily include retail store licensing operations in 25 other countries and foodservice accounts in Canada and the United Kingdom. The Company’s International store base continues to increase rapidly and Starbucks is achieving a growing contribution from established areas of the business while at the same time investing in emerging markets and channels, such as China. Certain of these markets are in various early stages of development that require a more extensive support organization, relative to the current levels of revenue and operating income, than in the United States. This continuing investment is part of the Company’s long-term, balanced plan for profitable growth.

International total net revenues increased by 37% to $358 million for the 13 weeks ended July 2, 2006, compared to $262 million for the corresponding period of fiscal 2005.

International Company-operated retail revenues increased by 38% to $297 million, primarily due to the opening of 228 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 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 by 30% to $61 million for the 13 weeks ended July 2, 2006, compared to $47 million in the corresponding period of fiscal 2005. The increase was primarily due to higher product sales and royalty revenues from opening 428 licensed retail stores in the last 12 months and sales of ready-to-drink coffee beverages introduced in Japan, Taiwan and Korea in the fall of 2005.

International operating income increased by 55% to $29 million for the 13 weeks ended July 2, 2006, compared to $19 million in the corresponding period of fiscal 2005. Operating margin increased to 8.2% of related revenues from 7.2% in the corresponding period of fiscal 2005. This improvement was primarily due to lower costs of sales including occupancy costs due primarily to leverage gained from fixed costs distributed over an expanded revenue base. The improvement was offset in part by higher marketing expenditures in support of the re-introduction of one of the Company’s ready-to-drink coffee beverages in Japan and higher payroll-related expenditures to support global expansion. As discussed above, the Company continues to invest in its international infrastructure including investments in emerging markets. The timing and magnitude of these investments can be expected to cause variation in future quarterly operating margins for the International segment.

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 $79 million for the 13 weeks ended July 2, 2006, compared to $64 million in the corresponding period of fiscal 2005, primarily due to higher payroll-related expenses from stock-based compensation and additional employees to support continued rapid global growth. Total unallocated corporate expenses as a percentage of total net revenues were 4.0% for both the 13 weeks ended July 2, 2006 and July 3, 2005.

CONSOLIDATED RESULTS

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