Business context and reporting period
Starbucks Corporation’s unaudited Form 10-Q covers the quarter and first three quarters of fiscal 2018 ended July 1, 2018, compared with the periods ended July 2, 2017. Starbucks operates company-owned stores and licensed stores and sells packaged coffee, foodservice and other products. Results include full consolidation of East China from the second quarter after Starbucks acquired the remaining 50% interest in the joint venture on December 31, 2017.
Financial performance
| Metric | Quarter ended July 1, 2018 | Prior-year quarter | First three quarters of FY2018 | Prior-year period |
|---|---|---|---|---|
| Revenue | $6.310B | $5.662B | $18.416B | $16.689B |
| Operating income | $1.038B | $1.044B | $2.927B | $3.112B |
| Operating margin | 16.5% | 18.4% | 15.9% | 18.6% |
| Net earnings attributable to Starbucks | $852.5M | $691.6M | $3.763B | $2.096B |
| Diluted EPS | $0.61 | $0.47 | $2.67 | $1.43 |
| Operating cash flow | Not separately stated | Not separately stated | $3.504B | $3.159B |
Quarterly revenue grew 11.5%; comparable sales increased 1%, with transactions down 2% and average ticket up 3%. For the first three quarters, revenue grew 10.4%. Reported nine-month earnings include a $1.376B non-taxable gain from remeasuring Starbucks’ prior East China interest and $496.3M in net divestiture gains; the reported earnings increase therefore does not represent underlying operating growth alone.
Quarterly operating income was nearly flat, while margin contracted 190 basis points. Management cited partner investments, a food-related product-mix shift, East China consolidation effects and costs of anti-bias training, partly offset by lower restructuring and impairment expenses. For the first three quarters, the operating margin decline was 270 basis points. Higher depreciation and amortization and general and administrative expense also weighed on margins.
Balance sheet, liquidity and capital allocation
- At July 1, 2018, cash and cash equivalents were $1.892B; total cash and investments were approximately $2.2B, down from approximately $3.2B at fiscal year-end.
- Current assets were $5.583B and current liabilities $5.552B. Debt comprised $300M of commercial paper, $349.8M current maturities and $6.149B long-term debt—approximately $6.8B in total carrying value.
- Operating cash flow for the first three quarters was $3.504B. Investing activities used $1.697B, including $1.311B net cash for the East China acquisition and $1.408B of capital expenditures. Financing activities used $2.368B, including $4.062B of share repurchases and $1.260B of cash dividends, partly offset by debt issuance.
- Starbucks had $300M outstanding under its $3B commercial paper program and reported compliance with debt and credit facility covenants. It also had $2B and $1B revolving credit facilities available, subject to their terms.
- Management expected FY2018 capital expenditures of approximately $2.0B and stated that operating cash flows, existing cash and investments, and borrowing capacity should fund foreseeable needs and shareholder distributions.
Material changes and unusual items
- The East China transaction added $301M of revenue and $19.2M of net earnings in the quarter; for the first three quarters it contributed $602.6M of revenue and $45.5M of net earnings. Consolidation increased reported retail revenue but reduced margins compared with the former equity-method arrangement.
- Starbucks sold its Tazo brand, its Taiwan joint venture interest and its Brazil company-operated retail operations, converting Brazil to a licensed market. The nine-month divestiture gain primarily reflects Tazo and Taiwan, partly offset by the Brazil sale loss.
- The U.S. Tax Cuts and Jobs Act lowered the applicable FY2018 blended federal corporate tax rate to 24.5% from 35%. The reported effective tax rate was 17.0% for the quarter and 22.4% for the first three quarters. The company recorded provisional tax benefits and transition-tax expense and said its estimates could change.
- Starbucks repurchased 73.0M shares for $4.1B in the first three quarters and authorized an additional 100M shares for repurchase. The quarterly dividend declared was $0.36 per share.
- Teavana store closures drove restructuring activity; expected total lease-exit costs were approximately $134.7M. A $28.5M goodwill impairment was recorded for the Switzerland retail reporting unit during FY2018.
Outlook, management commentary and risks
- FY2018 outlook: consolidated revenue growth in the high single digits; global comparable-store sales growth just below the long-term 3%–5% target; and moderate operating-margin decline, excluding specified prior-year transaction, integration, restructuring and impairment costs.
- Management forecast FY2018 EPS of $3.26–$3.28, including a $0.99 benefit from the East China acquisition gain and a $0.03 impact from May 29 anti-bias training. It expected an approximately 23% FY2018 effective tax rate. If the Nestlé global coffee alliance closed in late FY2018, management expected an additional $0.02–$0.03 EPS dilution for the year.
- Key operating risks discussed include coffee, dairy and other commodity prices and availability; foreign currency and economic conditions; competition and customer acceptance; execution and integration of East China and other initiatives; and technology, food safety and labeling risks.
- In California Proposition 65 litigation concerning acrylamide warnings on coffee, the court ruled against defendants on the remaining liability defense. The case was proceeding to a remedies and damages phase. Starbucks said it could not reasonably estimate potential loss and recorded no contingency; potential penalties, warnings and related costs could be significant.
- Management said disclosure controls were effective. East China, which contributed $3.5B of assets at July 1, was excluded from the internal-control evaluation while the company documents and tests its controls.
Most important facts for investors to verify
- How much of reported revenue and earnings growth reflects East China consolidation, acquisition/divestiture gains and tax effects versus comparable-store and underlying operating performance.
- Whether traffic trends and comparable sales improve, and whether partner investment, food mix and East China consolidation continue to pressure margins.
- Debt, interest expense, cash levels and capital returns relative to operating cash flow and planned capital expenditures.
- The final FY2018 tax-rate impact and whether the Nestlé alliance closes on the anticipated timetable and affects EPS as forecast.
- Developments and potential financial or operating consequences in the California Proposition 65 case, along with East China internal-control integration.