Why did Starbucks' gross margin improve in fiscal 1997, and will that continue?

Cost of sales and related occupancy costs fell to 44.7% of net revenues from 48.2%, mainly because green coffee costs were lower in the period and existing inventories and fixed-price contracts cushioned the late-year price spike. Management warned that higher-cost coffees began flowing through cost of sales in the fourth quarter and expects cost of sales as a percentage of revenue to rise in fiscal 1998, so the margin benefit is not expected to persist.

How is Starbucks funding its expansion, and does it need outside capital?

Management plans to fund roughly $200 million of fiscal 1998 capital expenditures primarily from operating cash flow, supplemented by additional debt or equity if necessary. Cash and investments totaled $158.8 million at year end, and management believes this, plus operating cash flow, is sufficient for core business needs through fiscal 1998. Faster expansion, new joint ventures, or other new business opportunities could require outside funding.

What does the call of the convertible debentures mean for shareholders?

The $165 million 4 1/4% convertible subordinated debentures were called on October 21, 1997, and substantially all were expected to convert into about 7.1 million common shares. This eliminates the associated interest expense, which management expects to fall in fiscal 1998, but it also increases the outstanding share count, which dilutes existing shareholders' ownership and per-share earnings.

Is Starbucks facing material risks from competition or same-store sales pressure?

Management acknowledged that cannibalization from clustering new stores in existing markets, increased competition in specialty coffee beverages, and higher costs for sites and qualified personnel could pressure comparable store sales growth, which slowed to 5% from 7%. Supermarkets were identified as the greatest competitive challenge in whole bean coffee, and a major competitor with greater resources could enter the beverage market at any time. The company also disclosed that its ability to pass on higher coffee prices may be limited.

SBUX 10-K FY1997 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed December 23, 1997. Cited figures are marked; the original filing is the authoritative source.

Starbucks Corporation's fiscal 1997 Form 10-K (fiscal year ended September 28, 1997) shows a company in rapid expansion with strong top-line growth and improving profitability.

Net revenues rose 39% to $966.9 million^a, driven by a net addition of new company-operated stores (341 opened in fiscal 1997, ending at 1,270 stores) and a 5% increase in comparable store sales. Net earnings grew 36% to $57.4 million, and fully diluted EPS rose to $0.70 from $0.54, though fiscal 1996 included a one-time $9.2 million pre-tax gain on the Noah's investment, so underlying growth was stronger than the headline figure suggests. Operating margin improved to 9.1% from 8.2%, largely because cost of sales fell to 44.7% of revenues from 48.2% on lower green coffee costs.

The outlook raises caution flags for investors. Management expects gross margins to compress in fiscal 1998 as higher-cost coffees flow through cost of sales, coffee prices remain high relative to history, and comparable store sales growth may face downward pressure from store cannibalization and competition. Store operating expenses rose to 37.3%^b of retail sales from 35.1%, reflecting higher advertising and payroll costs.

The company plans at least 350 new North American stores in fiscal 1998, targets 2,000 locations by 2000, and expects capital expenditures of about $200 million^c, to be funded from operating cash flow supplemented by debt or equity if necessary. Balance sheet and capital structure matter for the outlook. Cash and investments totaled $158.8 million, working capital declined to $177.6 million, and $165 million of 4 1/4% convertible subordinated debentures were called for redemption on October 21, 1997, with substantially all expected to convert into about 7.1 million common shares, which would reduce future interest expense but add dilution.

The company has never paid a cash dividend and intends to retain earnings. Management judged the year 2000 cost impact and legal exposure immaterial, and the company is the subject of no material pending litigation.

02—Key points

Key Highlights

Net revenues increased 39% to $966.9 million in fiscal 1997, with retail sales up 38% to $828.1 million and specialty sales up 50% to $117.6 million.
Net earnings rose 36% to $57.4 million, and fully diluted EPS increased to $0.70 from $0.54, though fiscal 1996 included a $9.2 million pre-tax Noah's gain.
Operating income grew 55% to $88.2 million, with operating margin expanding to 9.1% from 8.2% as cost of sales fell to 44.7% of revenues from 48.2%.
Comparable store sales grew 5% (versus 7% in fiscal 1996), and the company opened 341 stores, ending the year with 1,270 company-operated North American stores.
Management expects gross margin compression in fiscal 1998 as higher-cost green coffee flows through cost of sales, and store operating expenses rose to 37.3% of retail sales.
Capital expenditures reached $169.7 million in fiscal 1997, with roughly $200 million planned for fiscal 1998 to support at least 350 new stores.
The $165 million 4 1/4% convertible debentures were called on October 21, 1997, with substantially all expected to convert into about 7.1 million shares, lowering interest expense but increasing share count.

03—Questions

Frequently Asked Questions

Why did Starbucks' gross margin improve in fiscal 1997, and will that continue?
Cost of sales and related occupancy costs fell to 44.7% of net revenues from 48.2%, mainly because green coffee costs were lower in the period and existing inventories and fixed-price contracts cushioned the late-year price spike. Management warned that higher-cost coffees began flowing through cost of sales in the fourth quarter and expects cost of sales as a percentage of revenue to rise in fiscal 1998, so the margin benefit is not expected to persist.
How is Starbucks funding its expansion, and does it need outside capital?
Management plans to fund roughly $200 million of fiscal 1998 capital expenditures primarily from operating cash flow, supplemented by additional debt or equity if necessary. Cash and investments totaled $158.8 million at year end, and management believes this, plus operating cash flow, is sufficient for core business needs through fiscal 1998. Faster expansion, new joint ventures, or other new business opportunities could require outside funding.
What does the call of the convertible debentures mean for shareholders?
The $165 million 4 1/4% convertible subordinated debentures were called on October 21, 1997, and substantially all were expected to convert into about 7.1 million common shares. This eliminates the associated interest expense, which management expects to fall in fiscal 1998, but it also increases the outstanding share count, which dilutes existing shareholders' ownership and per-share earnings.
Is Starbucks facing material risks from competition or same-store sales pressure?
Management acknowledged that cannibalization from clustering new stores in existing markets, increased competition in specialty coffee beverages, and higher costs for sites and qualified personnel could pressure comparable store sales growth, which slowed to 5% from 7%. Supermarkets were identified as the greatest competitive challenge in whole bean coffee, and a major competitor with greater resources could enter the beverage market at any time. The company also disclosed that its ability to pass on higher coffee prices may be limited.

04—Continue

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