SBUX - Onward and Upward...

First, it’s safe to say MCD is not hurting SBUX.  U.S. same-store sales declined 6%, in line with my expectations and 200 bps better than Q2.  Traffic was down 4% in the quarter, which showed a sequential improvement from 1Q and 2Q when transactions were down 6% and 5%, respectively.  International same-store sales declined 2%, better than the -3% number in 1H09 and consolidated same-store sales improved 300 bps on a sequential basis from Q2 to -5%. 

Management commented on its earnings call that same-store sales improved on a sequential basis throughout the quarter in both the U.S. (as indicated by my May “Grass Roots” survey) and internationally, reflecting better traffic trends.  In the prior three quarters, SBUX had attributed the soft international same-store sales trends to weakness in the U.K. and Canada, which make up about 80% of the comparable sales store base.  Today, management stated that the U.K. market, like the U.S., has stabilized and is improving on a sequential basis. 

The strong operating model returns.  SBUX 3Q EPS came in at $0.24 versus my estimate of $0.22 and the street at $0.19.  SBUX reported a return to double digit operating margins and the U.S. segment’s first quarter of margin expansion following 12 quarters of decline.  Consolidated operating margin came in at 10.6%, excluding restructuring charges, with the U.S. segment posting a 13.4% number (up 460 bps YOY). 

Going forward, the company’s operating margins will continue to benefit from its cost savings initiatives.  That being said, the company delivered $175 million of savings in Q3 versus its $150 million goal and now expects to implement $550 million of cost savings in FY09, exceeding its prior $500 million target.  This reduced cost structure will result in an excess of $700 million in annualized cost savings in FY10 and beyond.

As a result of stabilizing sales trends and increased cost savings, SBUX now expects FY09 EPS of $0.74-$0.75, excluding restructuring charges, versus the street at $0.71.  The company is guiding to 13%-18% non-GAAP EPS growth in FY10 with U.S. segment operating margins growing 150-200 bps.  Management stated on its earnings call that SBUX should take a meaningful step in FY10 toward achieving mid-teen operating margins in its U.S. and international segments.  For reference, that is relative to the 13.4% and 8.1% operating margins reported in Q3 in those respective segments.  SBUX did not provide any same-store sales guidance for FY10 but its FY10 margin guidance is based on a continuation of the current soft sales environment.  Achieving mid-teen operating margins will ultimately rely on positive comparable sales growth.

A strong cash flow story.  I knew SBUX would pay down debt in the quarter but the company exceeded my expectations on this measure as well by reducing its short-term borrowings to a zero balance at the end of Q3.  The company expects the balance to remain below $50 million for the remainder of the fiscal year.  SBUX again lowered its FY09 capital spending needs to $550 million from $600 million, thereby improving SBUX’s free cash flow position.  The company continues to expect its FY09 free cash flow to exceed $500 million. 

Advertising.  CEO Howard Schultz stated that he is seeing an unprecedented level of investment in coffee advertising by a host of companies, the likes of which he has never seen.  He thinks this increased level of spending around coffee builds awareness and trial for the entire category and has benefited SBUX, particularly following the launch of the company’s own national advertising campaign in May.  To me, this means that MCD’s increased spending around its specialty beverage platform is not hurting SBUX as so many people had expected.  Instead, it is increasing trial at SBUX.