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    MARKET EDGES

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Conclusion:  A tremendous quarter for Starbucks, posting 1QFY11 EPS of $0.45 for the quarter versus expectations of $0.39.  Global comparable sales came in at 7% versus the Street at 5.5%.  The results are incredibly impressive and it seems this routine trumping of Street expectations is creating high standards.  Starbucks has beaten the consensus same-store sales number for the past 8 consecutive quarters.  Upside momentum may slow in the near-term, but I continue to think the company will live up to those high standards longer-term.

Starbucks registered record consolidated operating margin of 17% despite strong margin growth in the year ago quarter and rocketing coffee prices during the first quarter of fiscal 2011.  From a top line perspective, the company is maintaining healthy traffic trends with 5% of the global comparable sales result coming via transaction counts.  The company expects low-to-mid single-digit comparable store sales growth for the year.   While it would seem that comps may slow somewhat given the difficulty of the year-over-year compares, the company was facing a difficult compare in 1Q and successfully grew comps on a one-year basis.

With expectations ratcheted up by the soundness of this beat, investors may be somewhat disappointed that EPS and margin guidance for the year are quite conservative.  Despite the $0.45 in EPS for 1QFY11, the high end of the EPS guidance range of $1.43 to $1.47 was left unchanged.   Additionally, for the full year, SBUX is guiding to year-over-year growth in consolidated operating margins of 50-100 basis points (relative to the 340 bp increase in 1QFY11).  The commodity outlook does get more difficult as the year continues as management guided to a $0.17 per share negative commodity impact in the remaining three quarters versus a $0.03 per share hit in the first quarter.   SBUX has locked in essentially all of its coffee costs, however, so at least that uncertainty is taken care of for FY11. 

The international segment also posted record results with operating margins improving 720 bps YOY to 16.3%.  Management attributed this exceptional performance to its more disciplined approach around operations.  The company is sharing its best practices from the U.S. business, which is now yielding record results internationally.  Despite this strong quarterly performance, the company is still only in the early phases of its international growth potential as it still has room to refine operations and significant opportunities to expand its footprint.

The CPG segment is clearly an area where Starbucks sees a lot of white space for the business to expand, particularly in international markets such as India and Russia.   CEO Howard Schultz stressed the importance for Starbucks that they connect with customers through various channels.  In that sense, it seems logical that the company is looking to gain more control over that side of the business and ending its distribution agreement with Kraft is just one step in that process.   Although Starbuck’s investment in the CPG channel will take a toll on margins in FY11, transitioning to the direct model will give the company control over all things coffee in the grocery aisle and will be accretive beyond FY11.

I am confident that SBUX will continue to produce strong financial results, but it certainly seems implied by the reiteration of EPS guidance, and the forecast of a $0.20 cents impact on EPS from increased commodity costs, that momentum may slow somewhat in the next few quarters.  Given the level at which the company has been performing over the last few years, a slowdown from here is not catastrophic, but will perhaps bring investor expectations down slightly. 

While the stock could take a pause as the company feels the impact of higher commodity costs, we believe the next leg of significant growth for the company will play out subsequent to the consolidation of the distribution business from Kraft.  We will address Starbuck’s opportunity for continued upside in a detailed Black Book report due out in the coming weeks.  We feel the direction SBUX is headed is positive for the company and has positive implications for PEET; the clear market share loser is GMCR.

SBUX’s performance this quarter is a classic example of how well a company can execute when they focus on the core business.  Just a few years ago, management was overly focused on unit growth and the company has reaped great rewards from their focus on beverages; it is a beverage company!  Now, juxtapose SBUX’s clearly successful strategy with that of MCD, which is putting too much of an emphasis on its non-core business.  I continue to believe that issues will emerge as a result of MCD’s loss of focus on its core business over the coming quarters.

Howard Penney

Managing Director