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Starbucks 10-K 2006
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Table of Contents

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
Form 10-K
þ  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For The Fiscal Year Ended October 1, 2006
OR
o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from      to     .
Commission File Number: 0-20322
     
WASHINGTON
  91-1325671
(State or other jurisdiction of incorporation or organization)   (IRS Employer Identification No.)
2401 Utah Avenue South
Seattle, Washington 98134
(Address of principal executive offices, zip code)
 
(REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE):
(206) 447-1575
 
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
Common Stock, $0.001 Par Value Per Share
 
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
None
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes þ No o
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
 
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation of S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ
 
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). Yes o No þ
 
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the last business day of the registrant’s most recently completed second fiscal quarter, based upon the closing sale price of the registrant’s common stock on March 31, 2006 as reported on the National Market tier of The NASDAQ Stock Market, Inc. was $28.2 billion.
 
As of December 8, 2006, there were 754,857,728 shares of the registrant’s Common Stock outstanding.
 
 
Portions of the definitive Proxy Statement for the registrant’s Annual Meeting of Shareholders to be held on March 21, 2007 have been incorporated by reference into Part III of this Annual Report on Form 10-K.


 

 
STARBUCKS CORPORATION
 
FORM 10-K
For the Fiscal Year Ended October 1, 2006
 
 
         
Table of Contents   PAGE
 
   
 
 
  Business   2
  Risk Factors   10
  Unresolved Staff Comments   14
  Properties   15
  Legal Proceedings   15
  Submission of Matters to a Vote of Security Holders   15
     
   
 
 
  Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities   17
  Selected Financial Data   18
  Management’s Discussion and Analysis of Financial Condition and Results of Operations   19
  Quantitative and Qualitative Disclosures About Market Risk   36
  Financial Statements and Supplementary Data   37
    Reports of Independent Registered Public Accounting Firm   70
  Changes in and Disagreements with Accountants on Accounting and Financial Disclosure   72
  Controls and Procedures   72
  Other Information   72
     
   
 
 
  Directors and Executive Officers of the Registrant   73
  Executive Compensation   73
  Security Ownership of Certain Beneficial Owners and Management and Related Shareholder Matters   73
  Certain Relationships and Related Transactions   73
  Principal Accountant Fees and Services   73
     
   
 
 
  Exhibits and Financial Statement Schedules   73
     
  75
 
 
     
  77
 
 
 EXHIBIT 10.4
 EXHIBIT 10.12
 EXHIBIT 21
 EXHIBIT 23
 EXHIBIT 31.1
 EXHIBIT 31.2
 EXHIBIT 32


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PART I
 
 
 
Starbucks Corporation (together with its subsidiaries, “Starbucks” or the “Company”) was formed in 1985. Starbucks purchases and roasts high-quality whole bean coffees and sells them, along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended beverages, a variety of complementary food items, coffee-related accessories and equipment, a selection of premium teas and a line of compact discs, primarily through Company-operated retail stores. Starbucks also sells coffee and tea products and licenses its trademark through other channels and, through certain of its equity investees, Starbucks produces and sells ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, and a line of superpremium ice creams. All channels outside the Company-operated retail stores are collectively known as “Specialty Operations.” The Company’s objective is to establish Starbucks as one of the most recognized and respected brands in the world. To achieve this goal, the Company plans to continue rapid expansion of its retail operations, to grow its Specialty Operations and to selectively pursue other opportunities to leverage the Starbucks brand through the introduction of new products and the development of new channels of distribution. The Company’s brand portfolio includes superpremium Tazo® teas, Starbucks Hear Music® compact discs, Seattle’s Best Coffee® and Torrefazione Italia® coffee.
 
 
Beginning in the fiscal fourth quarter of 2006, the Company increased its reporting segments from two to three to include a Global Consumer Products Group (“CPG”) segment in addition to the United States and International segments. This additional operating segment reflects the culmination of internal management realignments in fiscal 2006, and the successful development and launch of certain branded products in the United States and internationally commencing in fiscal 2005 and continuing throughout fiscal 2006. Additionally, with the 100% acquisition of the Company’s operations in Hawaii in fiscal 2006 and the shift in internal management of this market to the United States, these operations have been moved from the International segment into the United States segment. Segment information for all prior periods presented has been revised to reflect these changes.
 
The United States and International segments both include Company-operated retail stores and certain components of Specialty Operations. Specialty operations within the United States include licensed retail stores, foodservice accounts and other initiatives related to the Company’s core business. International specialty operations primarily include retail store licensing operations in more than 25 countries and foodservice accounts in Canada and the United Kingdom. The CPG segment includes the Company’s grocery and warehouse club business as well as branded products operations worldwide. Information about Starbucks revenues, earnings before income taxes, depreciation and amortization, income from equity investees, equity method investments, identifiable assets, net impairment and disposition losses and capital expenditures by segment is included in Note 19 “Segment Reporting” to the consolidated financial statements included in Item 8 of this Annual Report on Form 10-K (“Form 10-K” or “Report”).
 
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The following table shows the Company’s revenue components for the fiscal year ended October 1, 2006:
 
                 
    % of
    % of
 
    Total Net
    Specialty
 
REVENUES   Revenues     Revenues  
   
Company-operated retail
    85%          
                 
Specialty:
               
Licensing:
               
Retail stores
    7%       45%  
Grocery and warehouse club
    4%       24%  
Branded products
    <1%       2%  
                 
Total licensing
    11%       71%  
Foodservice and other:
               
Foodservice
    4%       27%  
Other initiatives
    <1%       2%  
                 
Total foodservice and other
    4%       29%  
Total specialty
    15%       100%  
                 
Total net revenues
    100%          
 
 
 
COMPANY-OPERATED RETAIL STORES
 
The Company’s retail goal is to become the leading retailer and brand of coffee in each of its target markets by selling the finest quality coffee and related products and by providing each customer a unique Starbucks Experience. The Starbucks Experience, or third place after home and work, is built upon superior customer service as well as clean and well-maintained Company-operated retail stores that reflect the personalities of the communities in which they operate, thereby building a high degree of customer loyalty. Starbucks strategy for expanding its retail business is to increase its market share primarily by opening additional stores in existing markets and to open stores in new markets where the opportunity exists to become the leading specialty coffee retailer. In support of this strategy, Starbucks opened 1,040 new Company-operated stores during the fiscal year ended October 1, 2006 (“fiscal 2006”). Starbucks Company-operated retail stores, including 11 Seattle’s Best Coffee® (“SBC”) stores and 4 Hear Music retail stores, accounted for 85% of total net revenues during fiscal 2006.
 
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The following table summarizes total Company-operated retail store data for the periods indicated:
 
                           
    Net Stores Opened
     
    During the
     
    Fiscal Year Ended     Stores Open as of
   
   
    Oct 1, 2006   Oct 2, 2005     Oct 1, 2006   Oct 2, 2005
 
 
United States (1)
    810     580       5,728     4,918
International:
                         
United Kingdom
    47     45       514     467
Canada
    74     62       508     434
Thailand
    22     14       85     63
Australia
    25     14       83     58
Germany
    24     9       68     44
China
    14     18       38     24
Singapore
    5     (3 )     37     32
Puerto Rico (1)
    6     5       17     11
Chile
    6     1       16     10
Ireland
    7     1       8     1
     
     
Total International
    230     166       1,374     1,144
 
 
Total Company-operated
    1,040     746       7,102     6,062
 
 
 
(1) International store data has been adjusted for the acquisitions of the Puerto Rico and Hawaii operations by reclassifying historical information from Licensed stores to Company-operated stores. United States store data was also adjusted to align with the Hawaii operations segment change by reclassifying historical information from International Company-operated stores to the United States.
 
Starbucks retail stores are typically located in high-traffic, high-visibility locations. Because the Company can vary the size and format, its stores are located in or near a variety of settings, including downtown and suburban retail centers, office buildings and university campuses. While the Company selectively locates stores in shopping malls, it focuses on locations that provide convenient access for both pedestrians and drivers. With the flexibility in store size and format, the Company also locates retail stores in select rural and off-highway locations to serve a broader array of customers outside major metropolitan markets and further expand brand awareness. To provide a greater degree of access and convenience for nonpedestrian customers, the Company has increased development of Drive-Thru retail stores. At the end of fiscal 2006, the Company operated approximately 1,600 Drive-Thru locations.
 
All Starbucks stores offer a choice of regular and decaffeinated coffee beverages, a broad selection of Italian-style espresso beverages, cold blended beverages, iced shaken refreshment beverages, a selection of teas and distinctively packaged roasted whole bean coffees. Starbucks stores also offer a selection of fresh pastries and other food items, sodas, juices, bottled water, coffee-making equipment and accessories, a selection of compact discs, games and seasonal novelty items. Each Starbucks store varies its product mix depending upon the size of the store and its location. Larger stores carry a broad selection of the Company’s whole bean coffees in various sizes and types of packaging, as well as an assortment of coffee and espresso-making equipment and accessories such as coffee grinders, coffee filters, storage containers, travel tumblers and mugs. Smaller Starbucks stores and kiosks typically sell a full line of coffee beverages, a limited selection of whole bean coffees and a few accessories such as travel tumblers and logo mugs. In the United States and in International markets, approximately 3,800 stores and 1,300 stores, respectively, carry a selection of prepared sandwiches and salads. Starbucks continues to expand its food warming program in select markets in the United States, with approximately 640 stores as of October 1, 2006 providing warm food items including breakfast sandwiches.
 
The Company’s retail sales mix by product type during fiscal 2006 was as follows: 77% beverages, 15% food, 3% whole bean coffees and 5% coffee-making equipment and other merchandise.
 
 
Specialty Operations strive to develop the Company’s brands outside the Company-operated retail store environment through a number of channels. Starbucks strategy is to reach customers where they work, travel, shop and dine by
 
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establishing relationships with prominent third parties that share the Company’s values and commitment to quality. These relationships take various forms, including licensing arrangements, foodservice accounts and other initiatives related to the Company’s core businesses. In certain situations, Starbucks has an equity ownership interest in licensee operations. During fiscal 2006, specialty revenues (which include royalties and fees from licensees, as well as product sales derived from Specialty Operations) accounted for 15% of total net revenues.
 
 
In its licensed retail store operations, the Company leverages the expertise of its local partners and shares Starbucks operating and store development experience. Licensee partners are typically master concessionaires, which can provide improved access to desirable retail space, or prominent retailers with in-depth market knowledge and access. As part of these arrangements, Starbucks receives license fees and royalties and sells coffee, tea, compact discs and related products for resale in licensed locations. Employees working in licensed retail locations are required to follow Starbucks detailed store operating procedures and attend training classes similar to those given to employees in Company-operated stores.
 
During fiscal 2006, 733 new Starbucks licensed retail stores were opened in the United States and, as of October 1, 2006, the Company’s licensees operated 3,168 stores. During fiscal 2006, 426 new International licensed stores were opened. At October 1, 2006, the Company’s International operating segment had a total of 2,170 licensed retail stores. Product sales to and royalty and license fee revenues from U.S. and International licensed retail stores accounted for 45% of specialty revenues in fiscal 2006.
 
At fiscal year end 2006, Starbucks total licensed retail stores by region and specific location were as follows:
 
                     
Asia Pacific   Europe/Middle East/Africa   Americas
 
Japan
  650   Spain   55   United States   3,168
China
  223   Turkey   51   Canada   178
Taiwan
  175   Greece   50   Mexico   101
South Korea
  174   Saudi Arabia   46   Peru   9
Philippines
  98   United Arab Emirates   44   The Bahamas   5
Malaysia
  71   Kuwait   36        
New Zealand
  45   Switzerland   27        
Indonesia
  45   France   26        
        Austria   11        
        Lebanon   11        
        Bahrain   8        
        Qatar   8        
        Cyprus   7        
        UK   6        
        Jordan   5        
        Oman   4        
        Ireland   1        
 
 
Total
  1,481   Total   396   Total   3,461
 
 
 
 
In grocery and warehouse club stores throughout the United States, the Company sells a selection of Starbucks® whole bean and ground coffees, as well as Seattle’s Best Coffee and Torrefazione Italia branded coffees and a selection of premium Tazo® teas through a licensing relationship with Kraft Foods Inc. (“Kraft”). Kraft manages all distribution, marketing, advertising and promotion of these products. In International markets, Starbucks also has licensing arrangements with other grocery and warehouse club stores. By the end of fiscal 2006, the Company’s coffees and teas were available in approximately 31,900 grocery and warehouse club stores, with 30,000 in the United States and 1,900 in International markets. Revenues from this category comprised 24% of specialty revenues in fiscal 2006.
 
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The Company has licensed the rights to produce and distribute Starbucks branded products to two partnerships in which the Company holds 50% equity interests. The North American Coffee Partnership with the Pepsi-Cola Company develops and distributes ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks. The Starbucks Ice Cream Partnership with Dreyer’s Grand Ice Cream, Inc., develops and distributes superpremium ice creams.
 
Starbucks and Jim Beam Brands Co., a unit of Fortune Brands, Inc., manufacture and market Starbucks-branded premium coffee liqueur products in the United States and Canada. The Company introduced a coffee liqueur product nationally during the fiscal second quarter of 2005, and launched a coffee and cream liqueur product in the second quarter of fiscal 2006 in restaurants, bars and retail outlets where premium distilled spirits are sold. During the fiscal fourth quarter of 2006, the Company launched Starbuckstm Coffee Liqueur and Cream Liqueur in Canada. The Company does not and will not sell the liqueur products in its Company-operated or licensed retail stores.
 
In September 2005, the Company launched Starbucks Discoveriestm, a ready-to-drink chilled cup coffee beverage in refrigerated cases of convenience stores in Japan, through a manufacturing and distribution agreement with Suntory Limited, and in Taiwan, through separate co-packing and distribution agreements with Uni-President Enterprises Corporation and the Company’s equity investee, President Starbucks Coffee Taiwan Ltd. In fiscal 2006, the Company entered the ready-to-drink coffee category in South Korea through a licensing agreement with Dong Suh Foods Corporation to import bottled Starbucks Frappuccino® coffee drinks produced in the United States.
 
Collectively, the revenues from these branded products accounted for 2% of specialty revenues in fiscal 2006.
 
 
The Company sells whole bean and ground coffees, including the Starbucks, Seattle’s Best Coffee and Torrefazione Italia brands, as well as a selection of premium Tazo® teas, to institutional foodservice companies that service business, industry, education and healthcare accounts, office coffee distributors, hotels, restaurants, airlines and other retailers. The majority of the Company’s direct distribution accounts are with SYSCO Corporation’s and U.S. Foodservice’stm national broadline distribution networks and Starbucks foodservice sales, customer service and support resources are aligned with those of SYSCO Corporation and U.S. Foodservice. Starbucks and Seattle’s Best Coffee are the only superpremium national-brand coffees actively promoted by SYSCO Corporation. The Company’s total worldwide foodservice operations had approximately 16,200 accounts at fiscal year end 2006, and revenues from these accounts comprised 27% of total specialty revenues.
 
 
Included in this category is the Company’s emerging entertainment business, which encompasses multiple music and technology based initiatives designed to appeal to new and existing Starbucks customers. Among these initiatives are strategic marketing and co-branding arrangements, such as the 24-hour Starbucks Hear Musictm digital music channel 75 available to all XM Satellite Radio subscribers, and the availability of wireless broadband Internet service in Company-operated retail stores located in the United States and Canada. Additionally, the entertainment business includes the innovative partnerships of Starbucks Hear Music with other music labels for the production, marketing and distribution of both exclusive and nonexclusive music, music programming for Starbucks stores worldwide, and CD sales through the Company’s website at Starbucks.com/hearmusic. In the first quarter of fiscal 2007, Starbucks and Apple® announced the availability of the Starbucks Hear Music catalog on the iTunes® Store, giving iTunes users the ability to preview, buy and download a wide variety of popular Starbucks Hear Music® titles.
 
The Company has a strategic agreement with Chase Bank USA, N.A. and Visa to issue the Starbucks Card Duettotm Visa® (the “Duetto Card”) in the United States, and a similar arrangement with Royal Bank of Canada and Visa Canada Association to issue the Duetto Card in Canada. The Duetto Card is a first-of-its-kind card, combining the functionality
 
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of a credit card with the convenience of a reloadable Starbucks Card. Through these arrangements, Starbucks primarily receives commissions for each activated customer account and payments based on credit card usage.
 
Collectively, the operations of these other initiatives accounted for 2% of specialty revenues in fiscal 2006.
 
 
Starbucks is committed to selling only the finest whole bean coffees and coffee beverages. To ensure compliance with its rigorous coffee standards, Starbucks controls its coffee purchasing, roasting and packaging, and the distribution of coffee used in its operations.
 
The Company purchases green coffee beans from coffee-producing regions around the world and custom roasts them to its exacting standards for its many blends and single origin coffees.
 
The supply and price of coffee are subject to significant volatility. Although most coffee trades in the commodity market, coffee of the quality sought by the Company tends to trade on a negotiated basis at a substantial premium above commodity coffee prices, depending upon the supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence prices of green coffee through agreements establishing export quotas or by restricting coffee supplies.
 
The Company depends upon its relationships with coffee producers, outside trading companies and exporters for its supply of green coffee. With green coffee commodity prices at relatively low levels in recent years, the Company has used fixed-price purchase commitments in order to secure an adequate supply of quality green coffee, bring greater certainty to the cost of sales in future periods, and promote sustainability by paying a fair price to coffee producers. As of October 1, 2006, the Company had $546 million in fixed-price purchase commitments which, together with existing inventory, is expected to provide an adequate supply of green coffee through fiscal 2007. The Company believes, based on relationships established with its suppliers, the risk of non-delivery on such purchase commitments is remote. During the first few months of fiscal 2006, green coffee commodity prices increased moderately. Since then, commodity prices have stabilized but still remain above the historically low levels experienced in recent years. Based on its market experience, the Company believes that fixed-price purchase commitments are less likely to be available on favorable terms when commodity prices are high. If prices were to move higher during fiscal 2007, Starbucks would likely return to its previous practice of entering into price-to-be-fixed purchase contracts to meet a large part of its demand. These types of contracts state the quality, quantity and delivery periods but allow the price of green coffee over a market index to be established after contract signing. The Company believes that, through a combination of fixed-price and price-to-be-fixed contracts it will be able to secure an adequate supply of quality green coffee. However, an increased use of price-to-be-fixed contracts instead of fixed-price contracts would decrease the predictability of coffee costs in future periods.
 
During fiscal 2004, Starbucks established the Starbucks Coffee Agronomy Company S.R.L., a wholly owned subsidiary located in Costa Rica, to reinforce the Company’s leadership role in the coffee industry and to help ensure sustainability and future supply of high-quality green coffees from Central America. Staffed with agronomists and sustainability experts, this first-of-its-kind Farmer Support Center is designed to proactively respond to changes in coffee producing countries that impact farmers and the supply of green coffee.
 
In addition to coffee, the Company also purchases significant amounts of dairy products to support the needs of its Company-operated retail stores. Dairy prices in the United States, which closely follow the monthly Class I fluid milk base price as calculated by the U.S. Department of Agriculture, rose in both fiscal 2004 and 2005, then declined in 2006. Should prices rise significantly in the future, Starbucks profitability could be adversely affected. In the United States, the Company purchases substantially all of its fluid milk requirements from two dairy suppliers. The Company believes, based on relationships established with these suppliers, that the risk of non-delivery of enough fluid milk to support its U.S. retail business is remote.
 
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The Company also purchases a broad range of paper and plastic products, such as cups, lids, napkins, straws, shopping bags and corrugated paper boxes from several companies to support the needs of its retail stores as well as its manufacturing and distribution operations. The cost of these materials is dependent in part upon commodity paper and plastic resin costs, but the Company believes it mitigates the effect of short-term raw material price fluctuations through strategic relationships with key suppliers. In the United States, the Company is contractually required to purchase all of its cups, lids, straws and cutlery from a single supplier. Any material interruption in the supply of these products to the Company, if not offset by sufficient purchases from other suppliers, could materially adversely affect the Company’s supply chain and its ability to serve its U.S. retail customers. The Company believes, based on its relationship with this supplier, that the risk of non-delivery of enough of these products to support its U.S. retail business is remote.
 
Products other than whole bean coffees and coffee beverages sold in Starbucks retail stores are obtained through a number of different channels. Beverage ingredients, other than coffee and milk, including leaf teas and the Company’s menu of ready-to-drink beverages, are purchased from several specialty manufacturers, usually under long-term supply contracts. Food products, such as fresh pastries and lunch items, are generally purchased from both regional and local sources. Coffee-making equipment, such as drip and French press coffeemakers, espresso machines and coffee grinders, are generally purchased directly from their manufacturers. Coffee-related accessories, including items bearing the Company’s logos and trademarks, are produced and distributed through contracts with a number of different suppliers.
 
 
The Company’s primary competitors for coffee beverage sales are restaurants, specialty coffee shops and doughnut shops. In almost all markets in which the Company does business, there are numerous competitors in the specialty coffee beverage business, and management expects this situation to continue. Although competition in the beverage market is currently fragmented, competition is increasing, particularly from competitors in the quick-service restaurant sector who are focusing on growing the specialty coffee part of their business. A major competitor with substantially greater financial, marketing and operating resources than the Company could enter this market at any time and compete directly against Starbucks.
 
The Company’s whole bean coffees compete directly against specialty coffees sold through supermarkets, specialty retailers and a growing number of specialty coffee stores. Both the Company’s whole bean coffees and its coffee beverages compete indirectly against all other coffees on the market. The Company believes that its customers choose among retailers primarily on the basis of product quality, service and convenience, and, to a lesser extent, on price.
 
Starbucks believes that supermarkets are the most competitive distribution channel for specialty whole bean coffee, in part because supermarkets offer customers a variety of choices without having to make a separate trip to a specialty coffee store. A number of coffee manufacturers are distributing premium coffee products in supermarkets. Regional specialty coffee companies also sell whole bean coffees in supermarkets.
 
In addition to the competition generated by supermarket sales of coffee, Starbucks competes for whole bean coffee sales with franchise operators and independent specialty coffee stores. In virtually every major metropolitan area where Starbucks operates and expects to expand, there are local or regional competitors with substantial market presence in the specialty coffee business. Starbucks Specialty Operations also face significant competition from established wholesale and mail order suppliers, some of whom have greater financial and marketing resources than the Company.
 
Starbucks faces intense competition from both restaurants and other specialty retailers for suitable sites for new stores and qualified personnel to operate both new and existing stores. There can be no assurance that Starbucks will be able to continue to secure adequate sites at acceptable rent levels or that the Company will be able to attract a sufficient number of qualified personnel.
 
 
The Company owns and/or has applied to register numerous trademarks and service marks in the United States and in nearly 180 additional countries throughout the world. Rights to the trademarks and service marks in the United
 
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States are generally held by a wholly owned affiliate of the Company and are used by the Company under license. Some of the Company’s trademarks, including Starbucks®, the Starbucks logo, Frappuccino®, Seattle’s Best Coffee® and Tazo® are of material importance to the Company. The duration of trademark registrations varies from country to country. However, trademarks are generally valid and may be renewed indefinitely as long as they are in use and/or their registrations are properly maintained.
 
The Company owns numerous copyrights for items such as product packaging, promotional materials, in-store graphics and training materials. The Company also holds patents on certain products, systems and designs. In addition, the Company has registered and maintains numerous Internet domain names, including “Starbucks.com” and “Starbucks.net.”
 
 
Starbucks research and development efforts are led by food scientists, engineers, chemists and culinarians in the Research and Development department. This team is responsible for the technical development of food and beverage products and new equipment. The Company spent approximately $6.5 million, $6.2 million and $4.7 million during fiscal 2006, 2005 and 2004, respectively, on technical research and development activities, in addition to customary product testing and product and process improvements in all areas of its business.
 
 
Starbucks business is subject to seasonal fluctuations. Significant portions of the Company’s net revenues and profits are realized during the first quarter of the fiscal year, which includes the holiday season. In addition, quarterly results are affected by the timing of the opening of new stores, and the Company’s rapid growth may conceal the impact of other seasonal influences. Because of the seasonality of the business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.
 
 
As of October 1, 2006, the Company employed approximately 145,800 people worldwide. In the United States, Starbucks employed approximately 123,600 people, with 116,100 in Company-operated retail stores and the remainder in the Company’s administrative and regional offices, and store development, roasting and warehousing operations. Approximately 22,200 employees were employed in International, with 21,200 in Company-operated retail stores and the remainder in the Company’s regional support facilities and roasting and warehousing operations. At fiscal year end, employees at nine of the Company’s Canadian stores were represented by a union. Starbucks believes its current relations with its employees are good.
 
 
Starbucks Form 10-K reports, along with all other reports and amendments filed with or furnished to the Securities and Exchange Commission (“SEC”), are publicly available free of charge on the Investor Relations section of Starbucks website at http://investor.starbucks.com or at www.sec.gov as soon as reasonably practicable after these materials are filed with or furnished to the SEC. The Company’s corporate governance policies, ethics code and Board of Directors’ committee charters are also posted within this section of the website. The information on the Company’s website is not part of this or any other report Starbucks files with, or furnishes to, the SEC.
 
Starbucks demonstrates its commitment to corporate social responsibility (“CSR”) by conducting its business in ways that produce social, environmental and economic benefits to the communities in which Starbucks operates. The Company aligns its principles for social responsibility with its overall strategy and business operations. As a result, Starbucks believes it delivers benefits to the Company and its stakeholders — partners, customers, suppliers, shareholders, community members and others — while distinguishing Starbucks as a leader within the coffee industry. Providing open communication and transparency helps the Company be accountable to its stakeholders. To support this goal, Starbucks publishes a CSR Annual Report. Starbucks fiscal 2006 CSR Annual Report will be available online at
 
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www.starbucks.com/csr beginning March 14, 2007. To request a printed copy of the report, which will be available in late March 2007, please call 1-800-23-LATTE (1-800-235-2883) or email your request to info@starbucks.com.
 
 
This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements generally are identified by words such as “believe”, “expect”, “anticipate”, “estimate”, “intend”, “strategy”, “may”, “will likely” and similar words or phrases. A forward-looking statement is neither a prediction nor a guarantee of future events or circumstances, and those future events or circumstances may not occur. Investors should not place undue reliance on the forward-looking statements, which speak only as of the date of this Report. Starbucks is under no obligation to update or alter any forward-looking statements, whether as a result of new information, future events or otherwise. These forward-looking statements are all based on currently available operating, financial and competitive information and are subject to various risks and uncertainties. The Company’s actual future results and trends may differ materially depending on a variety of factors including, but not limited to, the risks and uncertainties discussed below. The risks below are not the only ones the Company faces. Additional risks and risks that management currently considers immaterial may also have an adverse effect on the Company.
 
 
A health pandemic is a disease that spreads rapidly and widely by infection and affects many individuals in an area or population at the same time. If a regional or global health pandemic were to occur, depending upon its duration and severity, the Company’s business could be severely affected. Starbucks has positioned itself as a “third place” between home and work where people can gather together for human connection. Customers might avoid public gathering places in the event of a health pandemic, and local, regional or national governments might limit or ban public gatherings to halt or delay the spread of disease. A regional or global health pandemic might also adversely impact the Company’s business by disrupting or delaying production and delivery of materials and products in its supply chain and by causing staffing shortages in its stores. The impact of a health pandemic on Starbucks might be disproportionately greater than on other companies that depend less on the gathering of people together for the sale, use or license of their products and services.
 
 
Management believes the price of Starbucks stock reflects high market expectations for its future operating results. In particular, any failure to meet the market’s high expectations for Starbucks comparable store sales growth rates, earnings per share and new store openings could cause the market price of Starbucks stock to drop rapidly and sharply.
 
•  Starbucks is subject to a number of significant risks that might cause the Company’s actual results to vary materially from its forecasts, targets, or projections, including:
 
  •  declines in actual or estimated comparable store sales growth rates and expectations;
 
  •  failing to meet annual targets for store openings, as a result of delays in store openings or failing to identify and secure sufficient real estate locations;
 
  •  negative trends in operating expenses or failing to continue to increase net revenues and operating income in any or all of Starbucks United States, International and CPG operating segments;
 
  •  failing to penetrate and expand into emerging International markets, such as China;
 
  •  opening less productive stores and cannibalizing existing stores with new stores;
 
  •  higher costs associated with maintaining and refurbishing the Company’s existing base of Company-operated retail stores;
 
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  •  failing to anticipate, appropriately invest in and effectively manage the human, information technology and logistical resources necessary to support the growth of its business, including managing the costs associated with such resources;
 
  •  failing to integrate, leverage and generate expected rates of return on investments, including expansion of existing businesses and expansion through domestic and foreign acquisitions;
 
  •  failing to generate sufficient future positive operating cash flows and, if necessary, secure adequate external financing to fund its growth;
 
  •  declines in general consumer demand for specialty coffee products;
 
  •  failing to meet customer demand efficiently during peak periods;
 
  •  lack of customer acceptance of new products;
 
  •  lack of customer acceptance of Starbucks products in new markets;
 
  •  failing to consistently provide high quality products and innovate new products and business processes to retain the Company’s existing customer base and attract new customers;
 
  •  increases in the price of high quality arabica coffee, dairy products, fuel, energy or other consumables, and the Company’s inability to obtain a sufficient supply of such commodities and consumables as its business grows;
 
  •  failing to manage the impact of any adverse publicity regarding the Company’s business practices or the health effects of consuming its products;
 
  •  increased labor costs, including significant increases in health care benefits and worker’s compensation insurance costs;
 
  •  litigation against Starbucks, particularly any class action litigation;
 
  •  unfavorable general economic conditions in the markets in which Starbucks operates, including, but not limited to, changes in interest rates, unemployment rates, disposable income and other events or factors that adversely affect consumer spending;
 
  •  unanticipated changes in executive management;
 
  •  any material interruption in the Company’s supply chain, such as material interruption of roasted coffee supply due to the casualty loss of any of the Company’s roasting plants, or material interruption in the supply of fluid milk or paper and plastic products such as cups, lids, napkins, straws, shopping bags and corrugated paper boxes, in each case due to the inability of one or more key suppliers to fulfill the Company’s requirements;
 
  •  the impact of initiatives by competitors and increased competition generally;
 
  •  failing to manage the impact on Starbucks business of factors such as labor discord, war, terrorism, political instability in certain markets and natural disasters; and
 
  •  interruptions in service by common carriers that ship goods within the Company’s distribution channels.
 
 
Starbucks believes it has built an excellent reputation globally for the quality of its products, for delivery of a consistently positive consumer experience and for its corporate social responsibility programs. The Starbucks brand has been highly rated in several global brand value studies. Management believes it must preserve and grow the value of the Starbucks brand to be successful in the future, particularly outside of North America, where the Starbucks brand is less well known. Brand value is based in part on consumer perceptions as to a variety of subjective qualities, and can be damaged badly even by isolated business incidents that degrade consumer trust, particularly if the incidents receive considerable publicity or result in litigation. Consumer demand for the Company’s products and its brand equity could diminish significantly if
 
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Starbucks fails to preserve the quality of its products, is perceived to act in an unethical or socially irresponsible manner or fails to deliver a consistently positive consumer experience in each of its markets.
 
 
The Company’s financial performance is highly dependent on its United States operating segment, which comprised 79% of consolidated total net revenues in fiscal 2006. Any substantial or sustained decline in these operations, if not offset by increased financial performance elsewhere, could materially adversely affect the Company’s business and financial results.
 
 
The Company’s future growth depends increasingly on the growth and operations of its International operating segment. Some or all of the Company’s International market business units (“MBUs”), which Starbucks generally defines by the countries or regions in which they operate, may not be successful in their operations or in achieving expected growth. Starbucks may find business partners who do not share its cultural, marketing or operating philosophies or who are unable to operate the MBU profitably. Some factors that will be critical to the success of International MBUs are different than those affecting the Company’s U.S. stores and licensees. Tastes naturally vary by region, and consumers in new international markets into which Starbucks and its licensees expand may not embrace Starbucks products to the same extent as consumers in the Company’s existing markets. Occupancy costs and store operating expenses are also sometimes higher internationally than in the United States due to higher rents for prime store locations or costs of compliance with country-specific regulatory requirements. Because many of the Company’s International operations are in an early phase of development, operating expenses as a percentage of related revenues are often higher, compared to U.S. operations. The Company’s International operations are also subject to additional inherent risks of conducting business abroad, such as:
 
  •  foreign currency exchange rate fluctuations;
 
  •  changes or uncertainties in economic, social and political conditions in the Company’s markets;
 
  •  interpretation and application of laws and regulations;
 
  •  restrictive actions of foreign or United States governmental authorities affecting trade and foreign investment, including protective measures such as export and customs duties and tariffs and restrictions on the level of foreign ownership;
 
  •  import or other business licensing requirements;
 
  •  the enforceability of intellectual property and contract rights;
 
  •  limitations on the repatriation of funds and foreign currency exchange restrictions;
 
  •  lower levels of consumer spending on a per capita basis than in the United States;
 
  •  difficulty in staffing, developing and managing foreign operations due to distance, language and cultural differences; and
 
  •  local laws that make it more expensive and complex to negotiate with, retain or terminate employees.
 
•  The China market is important to the Company’s long-term growth prospects — doing business there and in other developing countries can be challenging.
 
Starbucks expects the People’s Republic of China to be its largest market outside of the United States. Any significant or prolonged deterioration in U.S.-China relations might adversely affect the Company’s China business. The Company’s growing investments in its China operations will increase the Company’s exposure in this market.
 
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Many of the risks and uncertainties of doing business in China are solely within the control of the Chinese government. China’s government regulates the business conducted by Starbucks through its subsidiaries, joint ventures and authorized licensees by restricting the scope of the Company’s foreign investments within China and the food and beverage, retail, wholesale and distribution business conducted within China. Although management believes it has structured the Company’s China operations to comply with local laws, there are substantial uncertainties regarding the interpretation and application of laws and regulations and the enforceability of intellectual property and contract rights in China. If China’s governmental authorities were ultimately to conclude that Starbucks has not complied with one or more existing or future laws or regulations, or if their interpretations of those laws or regulations were to change over time, the Company’s affiliates could be subject to fines and other financial penalties or forced to cease operations entirely. Moreover, it could adversely affect the Company’s business if it is unable to enforce its intellectual property and contract rights in China’s courts.
 
Additionally, Starbucks plans to enter selected markets in other developing countries (such as Russia and India) as an important part of the projected growth of the International operating segment. Some of those markets pose legal and business challenges similar to the China market, such as substantial uncertainty regarding the interpretation and application of laws and regulations and the enforceability of intellectual property and contract rights.
 
 
The Company’s long-term goal is to open approximately 20,000 Starbucks stores in the United States and at least 20,000 stores in International markets. Starbucks expects annual total net revenue growth of approximately 20% and annual earnings per share growth of approximately 20-25% for the next three to five year period. Effectively managing growth on this scale is challenging, particularly as Starbucks expands into new markets internationally, and it becomes increasingly difficult to ensure a consistent supply of high quality raw materials, to hire sufficient numbers of key employees to meet the Company’s growth targets, to maintain an effective system of internal controls for a globally dispersed enterprise and to train employees worldwide to deliver a consistently high quality product and customer experience. Achieving the Company’s growth targets is also dependent on its ability to open more new stores in the current year as well as future years than it opened in prior years.
 
•  The loss of key personnel or difficulties recruiting and retaining qualified personnel could jeopardize the Company’s ability to meet its growth targets.
 
The success of the Company’s efforts to grow its business depends on the contributions and abilities of key executive and operating officers and other personnel. Starbucks must continue to recruit, retain and motivate management and operating personnel sufficient to maintain its current business and support its projected growth. A shortage or loss of these key employees might jeopardize the Company’s ability to meet its growth targets.
 
 
There are numerous competitors in almost every market in which Starbucks operates and in which it expects to expand in both the specialty coffee beverage business and the specialty whole bean coffee business. This is especially true in the major metropolitan areas where Starbucks operates and expects to expand, in virtually all of which there are local or regional competitors with substantial collective market presence. Although competition in the specialty coffee beverage market is currently fragmented, competition is increasing, particularly from competitors in the quick-service restaurant sector who are focusing on growing the specialty coffee beverage part of their businesses. A major competitor with substantially greater financial, marketing and operating resources than Starbucks could enter this market at any time and compete directly against Starbucks. The Company’s whole bean coffees compete directly against specialty coffees sold through supermarkets, specialty retailers and a growing number of specialty coffee stores. Some of the Company’s competitors in these whole bean specialty coffee distribution channels have greater financial and marketing resources than Starbucks. Both the Company’s whole bean coffees and its coffee beverages compete indirectly against all other coffees on the market. Starbucks also faces well-established competitors in many international markets. If Starbucks fails to maintain
 
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and build market share in the specialty coffee market and the coffee market generally, it could harm the Company’s business and financial results.
 
 
Some of the Company’s products contain caffeine, dairy products, sugar and other active compounds, the health effects of which are the subject of increasing public scrutiny, including the suggestion that excessive consumption of caffeine, dairy products, sugar and other active compounds can lead to a variety of adverse health effects. There has also been greater public awareness that sedentary lifestyles, combined with excessive consumption of high-calorie foods, have led to a rapidly rising rate of obesity. Particularly in the United States, there is increasing consumer awareness of health risks, including obesity, due in part to increasing publicity and attention from health organizations, as well as increased consumer litigation based on alleged adverse health impacts of consumption of various food products. While Starbucks has a variety of beverage and food items that are low in caffeine and calories, an unfavorable report on the health effects of caffeine or other compounds present in the Company’s products, or negative publicity or litigation arising from other health risks such as obesity, could significantly reduce the demand for the Company’s beverages and food products.
 
•  Significant increases in the market price or decreases in availability of high quality arabica coffee could harm the Company’s business and financial results.
 
The supply and price of coffee are subject to significant volatility. Although most coffee trades in the commodity market, high-altitude arabica coffee of the quality sought by Starbucks tends to trade on a negotiated basis at a substantial premium above commodity coffee prices, depending on the supply and demand at the time of purchase. Supply and price can be affected by multiple factors in the producing countries, including weather, political and economic conditions. In addition, green coffee prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence prices of green coffee through agreements establishing export quotas or restricting coffee supplies. Any significant increase in the market price or any significant decrease in the availability of high quality arabica coffee could adversely affect the Company’s business and financial results. Starbucks also purchases large quantities of dairy products — particularly milk. Any significant increase in the market price or decrease in availability of dairy products could harm the Company’s business and financial results.
 
 
The management of Starbucks is responsible for establishing and maintaining effective internal control over financial reporting. Internal control over financial reporting is a process to provide reasonable assurance regarding the reliability of financial reporting for external purposes in accordance with accounting principles generally accepted in the United States of America. Internal control over financial reporting includes maintaining records that in reasonable detail accurately and fairly reflect the Company’s transactions; providing reasonable assurance that transactions are recorded as necessary for preparation of the financial statements; providing reasonable assurance that receipts and expenditures are made in accordance with management authorization; and providing reasonable assurance that unauthorized acquisition, use or disposition of the Company assets that could have a material effect on the financial statements would be prevented or detected on a timely basis. Because of its inherent limitations, internal control over financial reporting is not intended to provide absolute assurance that a misstatement of the Company’s financial statements would be prevented or detected. The Company’s rapid growth and entry into new, globally dispersed markets will place significant additional pressure on the Company’s system of internal control over financial reporting. Any failure to maintain an effective system of internal control over financial reporting could limit the Company’s ability to report its financial results accurately and timely or to detect and prevent fraud.
 
 
Not applicable.
 
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The following table shows properties used by Starbucks in connection with its roasting and distribution operations:
 
                 
    Approximate Size
    Owned or
   
Location   in Square Feet     Leased   Purpose
 
 
Kent, WA
    332,000     Owned   Roasting and distribution
Kent, WA
    402,000     Leased   Warehouse
Renton, WA
    125,000     Leased   Warehouse
York County, PA
    365,000     Owned   Roasting and distribution
York County, PA
    297,000     Owned   Warehouse
York County, PA
    42,000     Leased   Warehouse
Carson Valley, NV
    360,000     Owned   Roasting and distribution
Portland, OR
    80,000     Leased   Warehouse
Basildon, United Kingdom
    141,000     Leased   Warehouse and distribution
Amsterdam, Netherlands
    94,000     Leased   Roasting and distribution
 
 
 
The Company leases approximately 1,000,000 square feet of office space and owns a 200,000 square foot office building in Seattle, Washington for corporate administrative purposes.
 
As of October 1, 2006, Starbucks had more than 7,100 Company-operated retail stores, of which nearly all are located in leased premises. The Company also leases space in approximately 120 additional locations for regional, district and other administrative offices, training facilities and storage, not including certain seasonal retail storage locations.
 
 
See discussion of Legal Proceedings in Note 18 to the consolidated financial statements included in Item 8 of this Report.
 
 
No matters were submitted to a vote of security holders during the fiscal fourth quarter of 2006.
 
 
The executive officers of the Company are as follows:
 
             
Name   Age   Position
 
 
Howard Schultz
  53   chairman of the Board of Directors
James L. Donald
  52   president, chief executive officer and director
James C. Alling
  45   president, Starbucks Coffee U.S. 
Martin Coles
  51   president, Starbucks Coffee International
Gerardo I. Lopez
  47   senior vice president; president, Global Consumer Products
Michael Casey
  61   executive vice president, chief financial officer and chief administrative officer
Paula E. Boggs
  47   executive vice president, general counsel and secretary
Dorothy J. Kim
  44   executive vice president, Supply Chain Operations
David A. Pace
  47   executive vice president, Partner Resources
 
 
 
Howard Schultz is the founder of the Company and the chairman of the board. From the Company’s inception in 1985 to June 2000, he served as chairman of the board and chief executive officer. From June 2000 to February 2005, Mr. Schultz also held the title of chief global strategist. From 1985 to June 1994, Mr. Schultz was the Company’s president. From January 1986 to July 1987, Mr. Schultz was the chairman of the board, chief executive officer and president of Il Giornale Coffee Company, a predecessor to the Company. From September 1982 to December 1985, Mr. Schultz was the director
 
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of retail operations and marketing for Starbucks Coffee Company, a predecessor to the Company. Mr. Schultz also serves on the board of directors of DreamWorks Animation SKG, Inc.
 
James L. Donald joined Starbucks in October 2002 and has been president and chief executive officer and a director of the Company since April 2005. From October 2004 to April 2005, Mr. Donald served as ceo designate. Prior to that, Mr. Donald served as president, North America from the time he joined the Company in October 2002. From October 1996 to October 2002, Mr. Donald served as chairman, president and ceo of Pathmark Stores, Inc. and prior to that time he held a variety of senior management positions with Albertson’s, Inc., Safeway, Inc., and Wal-Mart Stores, Inc.
 
James C. Alling joined Starbucks in September 1997 as senior vice president, Grocery and was promoted to president, Starbucks Coffee U.S. in October 2004. Mr. Alling held a number of positions as senior vice president from September 1997 until November 2003, when he was promoted to executive vice president, Business and Operations — United States. Prior to joining Starbucks, Mr. Alling held several senior positions at Nestlé from 1985 to 1997 and served as vice president and general manager of several divisions, including ground coffee.
 
Martin Coles joined Starbucks in April 2004 as president, Starbucks Coffee International. Prior to joining Starbucks, Mr. Coles served as an executive vice president of Reebok International, Ltd. from December 2001 to February 2004, including as president and chief executive officer of the Reebok® brand from June 2002 to February 2004 and executive vice president of Global Operating Units from December 2001 to May 2002. From February 2001 to December 2001, Mr. Coles was senior vice president, International Operations for Gateway, Inc. From February 2000 to January 2001, Mr. Coles was president and chief executive officer of Letsbuyit.com. From September 1992 to February 2000, Mr. Coles held several executive level general management, sales and operations positions for NIKE Inc.’s Global and European operations.
 
Gerardo I. Lopez joined Starbucks in October 2004 as senior vice president; president, Global Consumer Products. Prior to joining Starbucks, Mr. Lopez was an executive with the Handleman Entertainment Resources division of Handleman Company, serving as president from November 2001 to September 2004 and as senior vice president and general manager from May 2000 to November 2001. From April 1997 to May 2000, Mr. Lopez was an executive with International Home Foods, Inc. serving as president of its International division from April 1999 to May 2000 and as senior vice president and general manager of its SouthWest Brands division from April 1997 to April 1999. Previously, Mr. Lopez held positions of increasing responsibility with Frito-Lay, Inc., Pepsi-Cola Company and The Procter & Gamble Company. Mr. Lopez serves on the board of directors of TXU Corp.
 
Michael Casey joined Starbucks in August 1995 as senior vice president and chief financial officer and was promoted to executive vice president, chief financial officer and chief administrative officer in September 1997. Prior to joining Starbucks, Mr. Casey served as executive vice president and chief financial officer of Family Restaurants, Inc. from its inception in 1986. During his tenure there, he also served as a director from 1986 to 1993, and as president and chief executive officer of its El Torito Restaurants, Inc. subsidiary from 1988 to 1993. Mr. Casey serves on the board of directors of The Nasdaq Stock Market, Inc.
 
Paula E. Boggs joined Starbucks in September 2002 as executive vice president, general counsel and secretary. Prior to joining Starbucks, Ms. Boggs served as vice president, legal, for products, operations and information technology at Dell Computer Corporation from 1997 to 2002. From 1995 to 1997, Ms. Boggs was a partner with the law firm of Preston Gates & Ellis. Ms. Boggs served in several roles at the Pentagon, White House and U.S. Department of Justice between 1984 and 1995.
 
Dorothy J. Kim joined Starbucks in November 1995 and was promoted to executive vice president, Supply Chain Operations in December 2004. From April 2003 to December 2004, Ms. Kim was senior vice president, Global Logistics, Planning and Procurement. From April 2002 to April 2003, Ms. Kim was vice president, Supply Chain and Coffee Operations, Logistics, and from October 2000 to April 2002, Ms. Kim was vice president, Supply Chain and Coffee Operations, Finance and Systems. Prior to becoming a vice president, Ms. Kim held several positions in retail planning and operations.
 
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David A. Pace joined Starbucks in July 2002 as executive vice president of Partner Resources. From 2000 to 2002, Mr. Pace was the president of i2 Technologies. From 1999 to 2000 Mr. Pace served as the chief human resources officer for HomeGrocer.com. From 1995 to 1999, he served as senior vice president of human resources for Tricon Restaurants International (now YUM! Brands, Inc.).
 
There are no family relationships between any directors or executive officers of the Company.
 
 
Item 5.  Market for the Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities
 
SHAREHOLDER INFORMATION
 
 
The Company’s common stock is traded on the Global Select Market of The NASDAQ Stock Market, Inc. (“NASDAQ”), under the symbol “SBUX.” The following table shows the quarterly high and low closing sale prices per share of the Company’s common stock as reported by NASDAQ for each quarter during the last two fiscal years:
 
                 
    High     Low  
 
 
October 1, 2006:
               
Fourth Quarter
  $ 38.02     $ 29.55  
Third Quarter
    39.63       34.93  
Second Quarter
    37.63       30.24  
First Quarter
    31.96       24.91  
October 2, 2005:
               
Fourth Quarter
  $ 26.35     $ 23.08  
Third Quarter
    28.13       22.78  
Second Quarter
    30.80       24.79  
First Quarter
    31.94       23.53  
 
 
 
As of December 8, 2006, the Company had approximately 16,653 shareholders of record. Starbucks has never paid any dividends on its common stock. The Company presently intends to retain earnings for use in its business and to repurchase shares of common stock and, therefore, does not anticipate paying a cash dividend in the near future.
 
The following table provides information regarding repurchases by the Company of its common stock during the 13-week period ended October 1, 2006:
 
 
                                 
                Total Number
    Maximum
 
                of Shares
    Number of
 
                Purchased as
    Shares that May
 
    Total
    Average
    Part of Publicly
    Yet Be
 
    Number of
    Price
    Announced
    Purchased
 
    Shares
    Paid per
    Plans or
    Under the Plans
 
Period (1)   Purchased     Share     Programs (2)     or Programs (2)  
 
 
 
July 3, 2006 – July 30, 2006
    6,601,624     $ 34.54       6,601,624       29,440,530  
July 31, 2006 – August 27, 2006
    7,262,404       30.87       7,262,404       22,178,126  
August 28, 2006 – October 1, 2006
    690,000       31.48       690,000       21,488,126  
                                 
Total
    14,554,028       32.57       14,554,028          
 
 
 
(1)  Monthly information is presented by reference to the Company’s fiscal months during the fourth quarter of fiscal 2006.
 
(2)  The Company’s share repurchase program is conducted under authorizations made from time to time by the Company’s Board of Directors. The shares reported in the table are covered by Board authorizations to repurchase shares of common stock, as follows: 20 million shares publicly announced on May 5, 2005, 10 million shares publicly announced on September 22, 2005 and 25 million shares publicly announced August 2, 2006. Shares remaining for repurchase relate to the August 2, 2006 authorization, which has no expiration date.
 
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In thousands, except earnings per share and store operating data
 
The following selected financial data are derived from the consolidated financial statements of the Company. The data below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors,” and the Company’s consolidated financial statements and notes. In particular, see Note 1 to the consolidated financial statements included in Item 8 of this Report for a description of accounting changes that materially affect the comparability of the data presented below.
 
                                         
    Oct 1, 2006
    Oct 2, 2005
    Oct 3, 2004
    Sept 28, 2003
    Sept 29, 2002
 
AS OF AND FOR THE FISCAL YEAR ENDED (1)   (52 Wks)     (52 Wks)     (53 Wks)     (52 Wks)     (52 Wks)  
   
 
RESULTS OF OPERATIONS
                                       
Net revenues:
                                       
Company-operated retail
  $ 6,583,098     $ 5,391,927     $ 4,457,378     $ 3,449,624     $ 2,792,904  
Specialty:
                                       
Licensing
    860,676       673,015       565,798       409,551       311,932  
Foodservice and other
    343,168       304,358       271,071       216,347       184,072  
                                         
Total specialty
    1,203,844       977,373       836,869       625,898       496,004  
                                         
Total net revenues
    7,786,942       6,369,300       5,294,247       4,075,522       3,288,908  
                                         
                     
Operating income
    893,952       780,518       606,494       420,672       313,301  
Gain on sale of investment (2)
                            13,361  
Earnings before cumulative effect of change in accounting principle
    581,473       494,370       388,880       265,177       210,460  
Cumulative effect of accounting change for FIN 47,
net of taxes (3)
    17,214                          
Net earnings
  $ 564,259     $ 494,370     $ 388,880     $ 265,177     $ 210,460  
Earnings per common share before cumulative effect of change in accounting principle — diluted
  $ 0.73     $ 0.61     $ 0.47     $ 0.33     $ 0.26  
Cumulative effect of accounting change for FIN 47,
net of taxes — per common share
    0.02                          
Net earnings per common share — diluted
  $ 0.71     $ 0.61     $ 0.47     $ 0.33     $ 0.26  
Cash dividends per share
                             
                     
BALANCE SHEET
                                       
Working capital (4)
  $ (405,832 )   $ (17,662 )   $ 604,636     $ 335,767     $ 328,777  
Total assets
    4,428,941       3,513,693       3,386,266       2,775,931       2,249,432  
Short-term borrowings (5)
    700,000       277,000                    
Long-term debt (including current portion)
    2,720       3,618       4,353       5,076       5,786  
Shareholders’ equity
  $ 2,228,506     $ 2,090,262     $ 2,469,936     $ 2,068,507     $ 1,712,453  
                     
STORE INFORMATION
                                       
Percentage change in comparable store sales (6)
                                       
United States
    7 %     9 %     11 %     9 %     7 %
International
    8 %     6 %     6 %     7 %     1 %
Consolidated
    7 %     8 %     10 %     8 %     6 %
Stores opened during the year: (7)(8)
                                       
United States
                                       
Company-operated stores
    810       580       521       514       507  
Licensed stores
    733       596       417       315       264  
International
                                       
Company-operated stores
    230       166       144       126       118  
Licensed stores
    426       330       262       246       288  
 
 
Total
    2,199       1,672       1,344       1,201       1,177  
 
 
 
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    Oct 1, 2006
    Oct 2, 2005
    Oct 3, 2004
    Sept 28, 2003
    Sept 29, 2002
 
AS OF AND FOR THE FISCAL YEAR ENDED (1)   (52 Wks)     (52 Wks)     (53 Wks)     (52 Wks)     (52 Wks)  
   
 
Stores open at year end:(8)
                                       
United States
                                       
Company-operated stores
    5,728       4,918       4,338       3,817       3,239  
Licensed stores
    3,168       2,435       1,839       1,422       1,033  
International
                                       
Company-operated stores
    1,374       1,144       978       834       708  
Licensed stores
    2,170       1,744       1,414       1,152       906  
 
 
Total
    12,440       10,241       8,569       7,225       5,886  
 
 
 
(1) The Company’s fiscal year ends on the Sunday closest to September 30.
 
(2) On October 10, 2001, the Company sold 30,000 of its shares of Starbucks Coffee Japan, Ltd. at approximately $495 per share, net of related costs, which resulted in a gain of $13.4 million.
 
(3) As discussed in Note 1 “Asset Retirement Obligations” under the Notes to Consolidated Financial Statements included in Item 8, “Financial Statements and Supplementary Data” of this Form 10-K, Starbucks adopted FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations — an interpretation of FASB Statement No. 143” at the end of the fourth fiscal quarter of 2006.
 
(4) Working capital deficit as of October 1, 2006 was primarily due to increased current liabilities from short term borrowings under the revolving credit facility. See (5) below.
 
(5) In August 2006, the Company increased its borrowing capacity under the five-year revolving credit facility to $1 billion and had borrowings of $700 million outstanding as of October 1, 2006.
 
(6) Includes only Starbucks Company-operated retail stores open 13 months or longer. Comparable store sales percentage for fiscal 2004 excludes the extra sales week.
 
(7) Store openings are reported net of closures.
 
(8) International store information has been adjusted for the fiscal 2006 acquisitions of Hawaii and Puerto Rico and fiscal 2005 acquisitions of Germany, Southern China and Chile licensed operations by reclassifying historical information from Licensed stores to Company-operated stores. United States store information was also adjusted to align with the Hawaii operations segment change by reclassifying historical information from International Company-operated stores to the United States.
 
Item 7.  Management’s Discussion and Analysis of Financial Condition and Results
of Operations
 
 
Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. The fiscal years ended on October 1, 2006 and October 2, 2005, included 52 weeks. The fiscal year ended October 3, 2004, included 53 weeks, with the 53rd week falling in the fiscal fourth quarter.
 
 
During the fiscal year ended October 1, 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 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 pursuit of the Company’s objective to establish Starbucks as one of the most recognized and respected brands in the world. Starbucks opened 2,199 new stores in fiscal 2006 and plans to open approximately 2,400 in fiscal 2007. With a presence in 37 countries, serving customers more than 40 million times per week, management
 
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continues to believe that the Company’s long-term goal of approximately 20,000 Starbucks retail locations throughout the United States and at least 20,000 stores in International markets is achievable.
 
In addition to opening new retail stores, Starbucks works 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 comparable store sales by continuously improving the level of customer service, introducing innovative products and improving speed with service through training, technology and process improvement.
 
Global comparable store sales for Company-operated markets increased by 7%, making fiscal 2006 the 15th consecutive year with comparable store sales growth of 5% or greater. Comparable store sales growth for fiscal 2007 is expected to be in the range of 3% to 7%.
 
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, and subsequent to the end of fiscal 2006 purchased a 90% stake in its previously-licensed operations in Beijing, China.
 
The combination of more retail stores, comparable store sales growth of 7% and growth in other business channels in the U.S., International, and CPG operating segments resulted in a 22% increase in total net revenues for fiscal 2006, compared to fiscal 2005. The Company expects revenue growth of approximately 20% in fiscal 2007, consistent with its three to five year revenue growth target.
 
Operating income as a percentage of total net revenues decreased to 11.5% in fiscal 2006 from 12.3% in fiscal 2005, due to the recognition of stock-based compensation. Net earnings increased by 14% in fiscal 2006, compared to fiscal 2005. Reported operating margin and net earnings include the effects of stock-based compensation in fiscal 2006, while stock-based compensation expense was not included in the Company’s consolidated financial results in fiscal 2005.
 
 
In January 2006, Starbucks increased its equity ownership to 100% in its operations in Hawaii and Puerto Rico and applied the consolidation method of accounting from the acquisition date. Previously the Company owned 5% of both Coffee Partners Hawaii and Café 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. 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 $97 thousand for the fiscal year ended October 2, 2005 and $93 thousand for the fiscal year ended October 2, 2004. Previously reported earnings per share amounts were not impacted.
 
On October 18, 2006, the Company acquired 90% equity ownership of the licensed operations of 61 Starbucks retail stores in Beijing and Tianjin, China (See Note 20 “Subsequent Event”).
 
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RESULTS OF OPERATIONS — FISCAL 2006 COMPARED TO FISCAL 2005
 
The following table presents the consolidated statement of earnings as well as the percentage relationship to total net revenues, unless otherwise indicated, of items included in the Company’s consolidated statements of earnings (amounts in thousands):
 
                                                 
    Oct 1, 2006
    % of
    Oct 2, 2005
    % of
    Oct 3, 2004
    % of
 
FISCAL YEAR ENDED   (52 Wks)     Revenues     (52 Wks)     Revenues     (53 Wks)     Revenues  
 
 
STATEMENTS OF EARNINGS DATA
                                               
                         
Net revenues:
                                               
Company-operated retail
  $ 6,583,098       84.5 %   $ 5,391,927       84.7 %   $ 4,457,378       84.2 %
Specialty:
                                               
Licensing
    860,676       11.1       673,015       10.5       565,798       10.7  
Foodservice and other
    343,168       4.4       304,358       4.8       271,071       5.1  
                                                 
Total specialty
    1,203,844       15.5       977,373       15.3       836,869       15.8  
                                                 
Total net revenues
    7,786,942       100.0       6,369,300       100.0       5,294,247       100.0  
                                                 
Cost of sales including occupancy costs
    3,178,791       40.8       2,605,212       40.9       2,191,440       41.4  
Store operating expenses
    2,687,815       40.8  (1)     2,165,911       40.2  (1)     1,790,168       40.2  (1)
Other operating expenses
    260,087       21.6  (2)     197,024       20.2  (2)     171,648       20.5  (2)
Depreciation and amortization expenses
    387,211       5.0       340,169       5.3       289,182       5.5  
General and administrative expenses
    473,023       6.1       357,114       5.6       304,293       5.7  
                                                 
Subtotal operating expenses
    6,986,927       89.7       5,665,430       88.9       4,746,731       89.7  
                                                 
Income from equity investees
    93,937       1.2       76,648       1.2       58,978       1.1  
                                                 
Operating income
    893,952       11.5       780,518       12.3       606,494       11.5  
Interest and other income, net
    12,291       0.1       15,829       0.2       14,140       0.2  
                                                 
Earnings before income taxes
    906,243       11.6       796,347       12.5       620,634       11.7  
Income taxes
    324,770       4.1       301,977       4.7       231,754       4.4  
                                                 
Earnings before cumulative effect of change in accounting principle
    581,473       7.5 %     494,370       7.8 %     388,880       7.3 %
Cumulative effect of accounting change for FIN 47, net of taxes
    17,214       0.3                          
 
 
Net earnings
  $ 564,259       7.2 %   $ 494,370       7.8 %   $ 388,880       7.3 %
 
 
 
(1) Shown as a percentage of related Company-operated retail revenues.
 
(2) Shown as a percentage of related total specialty revenues.
 
 
Net revenues for the fiscal year ended 2006 increased 22% to $7.8 billion from $6.4 billion for fiscal 2005, driven by increases in both Company-operated retail revenues and specialty operations. Net revenues are expected to grow approximately 20% in fiscal 2007 compared to fiscal 2006.
 
During the fiscal year ended 2006, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 22% to $6.6 billion for the fiscal year ended 2006, from $5.4 billion for fiscal 2005. This increase was primarily due to the opening of 1,040 new Company-operated retail stores in the last 12 months and comparable store sales growth of 7% in fiscal 2006. The increase in comparable store sales was due to a 5% increase in the number of customer transactions and a 2% increase in the average value per transaction. Management believes increased customer traffic continues to be driven by sustained popularity of core products, new product innovation and a high level of customer satisfaction.
 
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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 $1.2 billion for the fiscal year ended 2006, from $977 million for fiscal 2005.
 
Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club and certain other branded product operations, increased 28% to $861 million for fiscal 2006, from $673 million for fiscal 2005. The increase is primarily due to higher product sales and royalty revenues from the opening of 1,159 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 13% to $343 million for fiscal 2006, from $304 million for fiscal 2005. Foodservice and other revenues increased primarily due to growth in new and existing U.S. foodservice accounts.
 
Cost of sales including occupancy costs decreased slightly to 40.8% of total net revenues for fiscal 2006, from 40.9% in fiscal 2005. The decrease was primarily due to fixed rent costs in fiscal 2006 being distributed over an expanded revenue base, as well as increased occupancy costs in fiscal 2005 resulting from intensified store maintenance activities. These favorable items, combined with lower dairy costs, offset higher green coffee costs for fiscal 2006.
 
Store operating expenses as a percentage of Company-operated retail revenues increased to 40.8% for fiscal 2006 from 40.2% for fiscal 2005. The increase was due to the recognition of stock-based compensation expense and to higher provisions for incentive compensation.
 
Other operating expenses, which are expenses associated with the Company’s Specialty Operations, increased to 21.6% of specialty revenues in fiscal 2006, compared to 20.2% in fiscal 2005. The increase was primarily due to the recognition of stock-based compensation expense as well as higher payroll-related expenditures to support the expanding licensed store operations, both in the U.S. and in existing and new international markets.
 
Depreciation and amortization expenses increased to $387 million in fiscal 2006, from $340 million in fiscal 2005. The increase of $47 million was due to the opening of 1,040 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization decreased to 5.0% for fiscal 2006, from 5.3% for fiscal 2005.
 
General and administrative expenses increased to $473 million in fiscal 2006, compared to $357 million in fiscal 2005. The increase was due to higher payroll-related expenditures from the recognition of stock-based compensation expense, additional employees to support continued global growth, and higher professional fees in support of global systems infrastructure development. As a percentage of total net revenues, general and administrative expenses increased to 6.1% for fiscal 2006, from 5.6% for fiscal 2005.
 
Income from equity investees increased to $94 million in fiscal 2006, compared to $77 million in fiscal 2005. The increase was primarily due to favorable volume-driven operating results for The North American Coffee Partnership, which produces ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, as well as improved operating results from international investees, including Korea and Japan, mainly as a result of new store openings.
 
Operating income increased 15% to $894 million in fiscal 2006, from $781 million in fiscal 2005. The operating margin decreased to 11.5% of total net revenues in fiscal 2006, compared to 12.3% in fiscal 2005, due to the recognition of stock-based compensation expense.
 
Net interest and other income, which primarily consists of interest income, decreased to $12 million in fiscal 2006, from $16 million in fiscal 2005. The decrease was primarily due to higher interest expense on the Company’s revolving credit facility, as well as lower interest income earned due to lower average investment balances, offset in part by the recognition of $4.4 million of income on unredeemed stored value card balances in fiscal 2006. There was no income recognized on unredeemed stored value card balances in fiscal 2005.
 
Income taxes for fiscal 2006 resulted in an effective tax rate of 35.8%, compared to 37.9% in fiscal 2005. The decline in the effective tax rate was due to the reversal of a valuation allowance in fiscal 2006 that had been established in fiscal 2005,
 
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the settlement in the third quarter of fiscal 2006 of a multi-year income tax audit in a foreign jurisdiction for which the Company had established a contingent liability, and to increased effectiveness of the Company’s long-term tax planning strategies. The effective tax rate for fiscal 2007 is expected to be approximately 38%, with quarterly variations.
 
OPERATING SEGMENTS
 
Segment information is prepared on the same basis that the Company’s management reviews financial information for operational decision-making purposes. Beginning in the fiscal fourth quarter of 2006, the Company increased its reporting segments from two to three to include a Global CPG segment in addition to the United States and International segments. This additional operating segment reflects the culmination of internal management realignments in fiscal 2006, and the successful development and launch of certain branded products in the United States and internationally commencing in fiscal 2005 and continuing throughout fiscal 2006. Additionally, with the 100% acquisition of the Company’s operations in Hawaii in fiscal 2006 and the shift in internal management of this market to the United States, these operations have been moved from the International segment into the United States segment. Segment information for all prior periods presented has been revised to reflect these changes.
 
The following tables summarize the Company’s results of operations by segment for fiscal 2006 and 2005 (in thousands):
 
                                     
    52 Weeks Ended     52 Weeks Ended  
   
   
 
    Oct 1, 2006   Oct 2, 2005   % Change     Oct 1, 2006     Oct 2, 2005  
   
   
 
                  As a % of
 
UNITED STATES                 U.S. Total Net Revenues  
 
 
Net revenues:
                                   
Company-operated retail
  $ 5,495,240   $ 4,539,455     21.1 %     88.9 %     89.1 %
Specialty:
                                   
Licensing
    369,155     277,987     32.8       6.0       5.4  
Foodservice and other
    314,162     280,073     12.2       5.1       5.5  
                 
                 
Total specialty
    683,317     558,060     22.4       11.1       10.9  
                 
                 
Total net revenues
    6,178,557     5,097,515     21.2       100.0       100.0  
Cost of sales including occupancy costs
    2,374,485     1,944,356             38.4       38.1  
Store operating expenses
    2,280,044     1,848,836             41.5  (1)     40.7  (1)
Other operating expenses
    190,624     150,712             27.9  (2)     27.0  (2)
Depreciation and amortization expenses
    284,625     250,339             4.6       4.9  
General and administrative expenses
    93,754     85,362             1.5       1.7  
Income from equity investees
    151     592                    
                 
                 
Operating income
  $ 955,176   $ 818,502     16.7 %     15.5 %     16.1 %
 
 
 
(1) Shown as a percentage of related Company-operated retail revenues.
 
(2) Shown as a percentage of related total specialty revenues.
 
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    52 Weeks Ended     52 Weeks Ended  
    Oct 1, 2006   Oct 2, 2005   % Change     Oct 1, 2006     Oct 2, 2005  
             
                  As a % of International
 
INTERNATIONAL                 Total Net Revenues  
 
 
Net revenues:
                                   
Company-operated retail
  $ 1,087,858   $ 852,472     27.6 %     83.5 %     83.4 %
Specialty:
                                   
Licensing
    186,050     145,736     27.7       14.3       14.2  
Foodservice and other
    29,006     24,285     19.4       2.2       2.4  
                 
                 
Total specialty
    215,056     170,021     26.5       16.5       16.6  
                 
                 
Total net revenues
    1,302,914     1,022,493     27.4       100.0       100.0  
Cost of sales including occupancy costs
    625,008     511,761             48.0       50.1  
Store operating expenses
    407,771     317,075             37.5  (1)     37.2  (1)
Other operating expenses
    50,900     32,061             23.7  (2)     18.9  (2)
Depreciation and amortization expenses
    66,800     56,705             5.1       5.5  
General and administrative expenses
    78,337     53,069             6.0       5.2  
Income from equity investees
    34,370     30,477             2.6       3.0  
                 
                 
Operating income
  $ 108,468   $ 82,299     31.8 %     8.3 %     8.0 %
 
 
 
                                     
                  As a % of
 
GLOBAL CONSUMER PRODUCTS GROUP                 CPG Total Net Revenues  
 
 
Net revenues:
                                   
Specialty:
                                   
Licensing
  $ 305,471   $ 249,292             100.0 %     100.0 %
                 
                 
Total specialty
    305,471     249,292             100.0       100.0  
                 
                 
Total net revenues
    305,471     249,292     22.5 %     100.0       100.0  
Cost of sales
    179,298     149,095             58.7       59.8  
Other operating expenses
    18,563     14,251             6.1       5.7  
Depreciation and amortization expenses
    108     76                    
Income from equity investees
    59,416     45,579             19.4       18.2  
                 
                 
Operating income
  $ 166,918   $ 131,449     27.0 %     54.6 %     52.7 %
 
 
 
                                       
                    As a % of
 
UNALLOCATED CORPORATE                   Total Net Revenues  
 
 
Depreciation and amortization expenses
  $ 35,678     $ 33,049             0.4 %     0.5 %
General and administrative expenses
    300,932       218,683             3.9       3.4  
               
               
Operating loss
  $ (336,610 )   $ (251,732 )           (4.3 )%     (3.9 )%
 
 
 
(1) Shown as a percentage of related Company-operated retail revenues.
 
(2) Shown as a percentage of related total specialty revenues.
 
 
The Company’s United States operations (“United States”) represent 83% of Company-operated retail revenues, 57% of total specialty revenues and 79% of total net revenues. United States operations sell 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 licensed retail stores, foodservice accounts and other initiatives related to the Company’s core business.
 
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United States total net revenues increased 21% to $6.2 billion for the fiscal year ended 2006, compared to $5.1 billion for fiscal 2005.
 
United States Company-operated retail revenues increased 21% to $5.5 billion for the fiscal year ended 2006, compared to $4.5 billion for fiscal 2005. United States Company-operated retail revenues increased primarily due to the opening of 810 new Company-operated retail stores in the last 12 months and comparable store sales growth of 7% for fiscal 2006. The increase in comparable store sales was due to a 5% increase in the average value per transaction and a 2% increase in the number of customer transactions. Management believes increased customer traffic continues to be driven by new product innovation, continued popularity of core products and a high level of customer satisfaction.
 
Total United States specialty revenues increased 22% to $683 million for the fiscal year ended 2006, compared to $558 million in fiscal 2005. United States licensing revenues increased 33% to $369 million, compared to $278 million for fiscal 2005. United States licensing revenues increased due to increased product sales and royalty revenues as a result of opening 733 new licensed retail stores in the last 12 months. Foodservice and other revenues increased 12% to $314 million from $280 million for fiscal 2005. United States foodservice and other revenues increased primarily due to growth in new and existing foodservice accounts.
 
United States operating income increased 17% to $955 million for the fiscal year ended 2006, from $819 million for the fiscal year ended 2005. Operating margin decreased to 15.5% of related revenues from 16.1% in fiscal 2005. The decrease was due to the recognition of stock-based compensation expense.
 
 
The Company’s International operations (“International”) represent the remaining 17% of Company-operated retail revenues and 18% of total specialty revenues as well as 17% of total net revenues. International operations sell 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, Germany, China, Singapore, Puerto Rico, Chile and Ireland. Specialty Operations in International primarily include retail store licensing operations in more than 25 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. The Company’s International operations 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 27% to $1.3 billion for the fiscal year ended 2006, compared to $1.0 billion for fiscal 2005. International Company-operated retail revenues increased 28% to $1.1 billion for the fiscal year ended 2006, compared to $852 million for fiscal 2005. International Company-operated revenues increased due to the opening of 230 new Company-operated retail stores in the last 12 months, comparable store sales growth of 8% for fiscal 2006, and the weakening of the U.S. dollar against the Canadian dollar. The increase in comparable store sales resulted from a 5% increase in the number of customer transactions and a 3% increase in the average value per transaction.
 
Total International specialty revenues increased 26% to $215 million for the fiscal year ended 2006, compared to $170 million for fiscal 2005. International licensing revenues increased 28% to $186 million for the fiscal year ended 2006, compared to $146 million in fiscal 2005. International licensing revenues increased due to higher product sales and royalty revenues from opening 426 new licensed retail stores in the last 12 months. International foodservice and other revenues increased 19% to $29 million for the fiscal year ended 2006, compared to $24 million in fiscal 2005. International foodservice and other revenues increased primarily due to growth in the total number of foodservice accounts.
 
International operating income increased to $108 million for the fiscal year ended 2006, compared to $82 million in fiscal 2005. Operating margin increased to 8.3% of related revenues from 8.0% in fiscal 2005, primarily due to lower cost of sales including occupancy costs due to leverage gained from fixed costs distributed over an expanded revenue base, as
 
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well as lower dairy costs. These improvements were partially offset by higher store operating expenses and other operating expenses due to higher payroll-related expenditures primarily to support global expansion as well as the recognition of stock-based compensation expense.
 
 
The Company’s CPG segment represents 25% of total specialty revenues and 4% of total net revenues. CPG operations sell a selection of whole bean and ground coffees as well as a selection of premium Tazo® teas through licensing arrangements with Kraft and other grocery and warehouse club stores in United States and international markets. CPG operations also produce and sell ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, and Starbucks® superpremium ice creams, through its joint venture partnerships, and Starbuckstm Coffee and Cream Liqueurs through a marketing and distribution agreement. Through other manufacturing, distribution and co-packing agreements, the Company produces and sells ready-to-drink products in international locations.
 
CPG total net revenues increased 23% to $305 million for the fiscal year ended 2006, compared to $249 million for fiscal 2005, primarily due to volume growth in the licensed grocery and warehouse club business as well as sales of ready-to-drink coffee beverages introduced in Japan, Taiwan and Korea in the fall of 2005.
 
CPG operating income increased to $167 million for the fiscal year ended 2006, compared to $131 million for fiscal 2005. Operating margin increased to 54.6% of related revenues, from 52.7% in fiscal 2005, primarily due to higher income from the Company’s equity investees and lower cost of sales as a percentage of revenues. The increase in equity investee income was primarily due to volume-driven results for The North American Coffee Partnership, which produces ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks Doubleshot® espresso drinks. Lower cost of sales was due to a sales mix shift to products with higher gross margins.
 
 
Unallocated corporate expenses pertain to corporate administrative functions that support but are not specifically attributable to the Company’s operating segments, and include related depreciation and amortization expenses. Unallocated corporate expenses increased to $337 million for the fiscal year ended 2006, from $252 million in fiscal 2005. The increase was due to higher payroll-related expenditures from the recognition of stock-based compensation expense and to additional employees, as well as higher professional fees primarily in support of global systems infrastructure development. Total unallocated corporate expenses as a percentage of total net revenues were 4.3% for the fiscal year ended 2006, compared to 3.9% for fiscal 2005.
 
RESULTS OF OPERATIONS — FISCAL 2005 COMPARED TO FISCAL 2004
 
 
Net revenues for the fiscal year ended 2005 increased 20% to $6.4 billion from $5.3 billion for the 53-week period of fiscal 2004, driven by increases in both Company-operated retail revenues and specialty operations. Net revenues increased 23% when calculated on a comparative 52-week basis for both fiscal 2005 and 2004.
 
During the fiscal year ended 2005, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 21% to $5.4 billion for the fiscal year ended 2005, from $4.5 billion for the 53-week period of fiscal 2004. Company-operated retail revenues increased 23% when calculated on a comparative 52-week basis for both fiscal 2005 and 2004. This increase was primarily due to the opening of 746 new Company-operated retail stores in the last 12 months and comparable store sales growth of 8% for the 52 weeks ended October 2, 2005. The increase in comparable store sales was due to a 4% increase in the number of customer transactions and a 4% increase in the average value per transaction. Comparable store sales growth percentages were calculated excluding the extra week of fiscal 2004. The increase in the average value per transaction was primarily due to a beverage price increase in October 2004 in the Company’s U.S. and Canadian markets.
 
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The Company derived the remaining 15% of total net revenues from channels outside the Company-operated retail stores. Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 17% to $977 million for the fiscal year ended 2005, from $837 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, total specialty revenues increased 19%.
 
Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club and certain other branded-product licensed operations, increased 19% to $673 million for the 52-week period of 2005, from $566 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, total licensing revenues increased 21%, primarily due to higher product sales and royalty revenues from the opening of 926 new licensed retail stores in the last 12 months.
 
Foodservice and other revenues increased 12% to $304 million for the 52-week period of fiscal 2005, from $271 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, foodservice and other revenues increased 15%, primarily attributable to growth in new and existing U.S. and International foodservice accounts and, to a lesser extent, growth in the Company’s emerging entertainment business.
 
Cost of sales including occupancy costs decreased to 40.9% of total net revenues in the 52-week period of fiscal 2005, from 41.4% in the 53-week period of 2004. The decrease was primarily due to higher average revenue per retail transaction, offset in part by higher initial costs associated with the continued expansion of a lunch program in Company-operated retail stores. Approximately 3,800 Company-operated stores had the lunch program at the end of fiscal 2005, compared to approximately 2,600 at the end of fiscal 2004.
 
Store operating expenses as a percentage of Company-operated retail revenues were 40.2% for both the 52-week period of fiscal 2005 and the 53-week period of fiscal 2004, primarily due to higher average revenue per retail transaction in fiscal 2005, offset by higher payroll-related expenditures, as well as higher maintenance and repair expenditures to ensure a consistent Starbucks Experience in existing stores. In order to facilitate ongoing retail store revenue growth, the Company opened a higher number of Drive Thru locations over the past year and extended store operating hours, which contributed to the higher payroll-related expenditures.
 
Other operating expenses, which are expenses associated with the Company’s Specialty Operations, decreased to 20.2% of specialty revenues in the 52-week period of fiscal 2005, compared to 20.5% in the 53-week period of fiscal 2004. The decrease was primarily due to lower expenditures within the grocery, warehouse club and foodservice businesses, partially offset by higher payroll-related expenditures to support the Company’s emerging entertainment business and to support the growth of Seattle’s Best Coffee licensed café operations.
 
Depreciation and amortization expenses increased to $340 million in the 52-week period of fiscal 2005, from $289 million in the 53-week period of fiscal 2004. The increase was primarily from the opening of 746 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization decreased to 5.3% for the 52 weeks ended October 2, 2005, from 5.5% for the corresponding 53-week fiscal 2004 period.
 
General and administrative expenses increased to $357 million in the 52-week period of fiscal 2005, compared to $304 million in the 53-week period of fiscal 2004. The increase was primarily due to higher payroll-related expenditures in support of both domestic and international business growth and increased charitable donations to support multi-year corporate commitments. As a percentage of total net revenues, general and administrative expenses decreased to 5.6% for the 52 weeks ended October 2, 2005, from 5.7% for the 53 weeks ended October 3, 2004.
 
Income from equity investees increased to $77 million in the 52-week period of fiscal 2005, compared to $59 million in the 53-week period of fiscal 2004. The increase was primarily due to volume-driven operating results for The North American Coffee Partnership, which produces ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, and improved operating results from international investees, particularly in Japan and Korea, mainly as a result of new store openings.
 
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Operating income increased 29% to $781 million in the 52-week period of fiscal 2005, from $606 million in the 53-week period of fiscal 2004. The operating margin increased to 12.3% of total net revenues in the 52-week period of fiscal 2005, compared to 11.5% in the 53-week period of fiscal 2004, primarily due to strong revenue growth.
 
Net interest and other income, which primarily consists of interest income, increased to $16 million in the 52-week period of fiscal 2005, from $14 million in the 53-week period of fiscal 2004. The increase was primarily due to higher interest income earned due to higher interest rates in fiscal 2005 compared to fiscal 2004 and to foreign exchange gains in fiscal 2005 compared to losses in fiscal 2004. Partially offsetting these increases were higher realized losses on sales of available-for-sale securities. Starbucks funded the majority of its share repurchases during fiscal 2005 through sales of its available-for-sale securities.
 
Income taxes for the 52 weeks ended October 2, 2005, resulted in an effective tax rate of 37.9%, compared to 37.3% in fiscal 2004. The effective tax rate differs from the statutory rate of 35% due to a variety of factors, including state income taxes, the impact from foreign operations, tax credits and other provision adjustments.
 
OPERATING SEGMENTS
 
Segment information is prepared on the same basis that the Company’s management reviews financial information for operational decision-making purposes. The following tables summarize the Company’s results of operations by segment for fiscal 2005 and 2004 (in thousands):
 
                                     
    52 Weeks
  53 Weeks
        52 Weeks
    53 Weeks
 
    Ended   Ended         Ended     Ended  
             
    Oct 2, 2005   Oct 3, 2004   % Change     Oct 2, 2005     Oct 3, 2004  
             
      As a % of U.S.
 
UNITED STATES     Total Net Revenues  
 
 
Net revenues:
                                   
Company-operated retail
  $ 4,539,455   $ 3,800,367     19.4 %     89.1 %     89.1 %
Specialty:
                                   
Licensing
    277,987     211,269     31.6       5.4       5.0  
Foodservice and other
    280,073     253,502     10.5       5.5       5.9  
                 
                 
Total specialty
    558,060     464,771     20.1       10.9       10.9  
                 
                 
Total net revenues
    5,097,515     4,265,138     19.5       100.0       100.0  
                                     
Cost of sales including occupancy costs
    1,944,356     1,642,745             38.1       38.5  
Store operating expenses
    1,848,836     1,546,871             40.7  (1)     40.7  (1)
Other operating expenses
    150,712     122,335             27.0  (2)     26.3  (2)
Depreciation and amortization expenses
    250,339     209,586             4.9       4.9  
General and administrative expenses
    85,362     80,221             1.7       1.9  
Income from equity investees
    592     564                    
                 
                 
Operating income
  $ 818,502   $ 663,944     23.3 %     16.1 %     15.6 %
 
 
 
(1) Shown as a percentage of related Company-operated retail revenues.
 
(2) Shown as a percentage of related total specialty revenues.
 
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    52 Weeks
  53 Weeks
        52 Weeks
    53 Weeks
 
    Ended   Ended         Ended     Ended  
             
    Oct 2, 2005   Oct 3, 2004   % Change     Oct 2, 2005     Oct 3, 2004  
             
      As a % of International
 
INTERNATIONAL     Total Net Revenues  
 
 
Net revenues:
                                   
Company-operated retail
  $ 852,472   $ 657,011     29.8 %     83.4 %     82.8 %
Specialty:
                                   
Licensing
    145,736     119,325     22.1       14.2       15.0  
Foodservice and other
    24,285     17,569     38.2       2.4       2.2  
                 
                 
Total specialty
    170,021     136,894     24.2       16.6       17.2  
                 
                 
Total net revenues
    1,022,493     793,905     28.8       100.0       100.0  
                                     
Cost of sales including occupancy costs
    511,761     403,870             50.1       50.9  
Store operating expenses
    317,075     243,297             37.2  (1)     37.0  (1)
Other operating expenses
    32,061     26,795             18.9  (2)     19.6  (2)
Depreciation and amortization expenses
    56,705     46,196             5.5       5.8  
General and administrative expenses
    53,069     48,206             5.2       6.1  
Income from equity investees
    30,477     20,961             3.0       2.6  
                 
                 
Operating income
  $ 82,299   $ 46,502     77.0 %     8.0 %     5.9 %
 
 
 
                                     
      As a % of CPG
 
GLOBAL CONSUMER PRODUCTS GROUP     Total Net Revenues  
 
 
Net revenues:
                                   
Specialty:
                                   
Licensing
  $ 249,292   $ 235,204             100.0 %     100.0 %
Total specialty
    249,292     235,204             100.0       100.0  
                 
                 
Total net revenues
    249,292     235,204     6.0 %     100.0       100.0  
Cost of sales
    149,095     144,825             59.8       61.6  
Other operating expenses
    14,251     22,518             5.7       9.6  
Depreciation and amortization expenses
    76     862                   0.3  
Income from equity investees
    45,579     37,453             18.2       15.9  
                 
                 
Operating income
  $ 131,449   $ 104,452     25.8 %     52.7 %     44.4 %
 
 
 
                                       
                    As a % of
 
UNALLOCATED CORPORATE                   Total Net Revenues  
 
 
Depreciation and amortization expenses
  $ 33,049     $ 32,538             0.5 %     0.6 %
General and administrative expenses
    218,683       175,866             3.4       3.3  
               
               
Operating loss
  $ (251,732 )   $ (208,404 )           (3.9 )%     (3.9 )%
 
 
 
(1) Shown as a percentage of related Company-operated retail revenues.
 
(2) Shown as a percentage of related total specialty revenues.
 
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United States total net revenues increased 20% to $5.1 billion for the fiscal year ended 2005, compared to $4.3 billion for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, United States total net revenues increased 22%. United States Company-operated retail revenues increased 19% to $4.5 billion for the fiscal year ended 2005, compared to $3.8 billion for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, United States Company-operated retail revenues increased 22%, primarily due to the opening of 580 new Company-operated retail stores in the last 12 months and comparable store sales growth of 9% for the 52-week period of fiscal 2005. The increase in comparable store sales was due to a 5% increase in the average value per transaction, including 3% attributable to a beverage price increase in October 2004, and a 4% increase in the number of customer transactions.
 
Total United States specialty revenues increased 20% to $558 million for the fiscal year ended 2005, compared to $465 million in the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, United States specialty revenues increased 23%. United States licensing revenues increased 32% to $278 million, compared to $211 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, United States licensing revenues increased 35%, due to increased product sales and royalty revenues as a result of opening 596 new licensed retail stores in the last 12 months. Foodservice and other revenues increased 10% to $280 million from $254 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, United States foodservice and other revenues increased 13%, primarily due to growth in new and existing foodservice accounts, as well as growth in the emerging entertainment business.
 
United States operating income increased by 23% to $819 million for the fiscal year ended 2005, from $664 million for the fiscal year ended 2004. Operating margin increased to 16.1% of related revenues from 15.6% in the 53-week period of fiscal 2004. The increase was primarily due to leverage from strong revenue growth.
 
 
International total net revenues increased 29% to $1.0 billion for the fiscal year ended 2005, compared to $794 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, International total net revenues increased 31%. International Company-operated retail revenues increased 30% to $852 million for the fiscal year ended 2005, compared to $657 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, International Company-operated revenues increased 32%, primarily due to the opening of 166 new Company-operated retail stores in the last 12 months, comparable store sales growth of 6% for the 52-week period of fiscal 2005, and the weakening of the U.S. dollar against both the Canadian dollar and British pound sterling. The increase in comparable store sales resulted from a 4% increase in the number of customer transactions and a 2% increase in the average value per transaction.
 
Total International specialty revenues increased 24% to $170 million for the fiscal year ended 2005, compared to $137 million for the 53-week period of fiscal 2004. Excluding the impact of the extra week in fiscal 2004, International specialty revenues increased 26%. International licensing revenues increased 22% to $146 million for the fiscal year ended 2005, compared to $119 million in the 53-week period of fiscal 2004. Excluding the impact of the extra week in 2004, International licensing revenues increased 24%, due to higher product sales and royalty revenues from opening 330 new licensed retail stores in the last 12 months. International foodservice and other revenues increased 38% to $24 million for the fiscal year ended 2005, compared to $18 million in the 53-week period of fiscal 2004. Excluding the impact of the extra week in 2004, international foodservice and other revenues increased 41%, primarily due to growth in new and existing foodservice accounts.
 
International operating income increased to $82 million for the fiscal year ended 2005, compared to $47 million in the 53-week period of fiscal 2004. Operating margin increased to 8.0% of related revenues from 5.9% in the 53-week period of fiscal 2004, primarily due to leverage gained on most fixed costs distributed over an expanded revenue base.
 
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CPG total net revenues increased 6% to $249 million for the fiscal year ended 2005, compared to $235 million for the 53-week period of fiscal 2004, due to the national rollout of the Starbuckstm Coffee Liqueur during the fiscal second quarter of 2005 and growth in the licensed grocery and warehouse club business.
 
CPG operating income increased by 26% to $131 million for the fiscal year ended 2005, compared to $104 million for the 53-week period of fiscal 2004. Operating margin increased to 52.7% of related revenues from 44.4% in fiscal 2004, primarily due to lower other operating expenses from reduced expenditures within the grocery and warehouse club channels and higher equity investee income from volume-driven operating results for The North American Coffee Partnership, which produces ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks.
 
 
Unallocated corporate expenses increased to $252 million for the fiscal year ended 2005, from $208 million in the 53-week period of fiscal 2004, primarily due to increased charitable commitments as well as higher payroll-related expenditures. Total unallocated corporate expenses as a percentage of total net revenues remained unchanged at 3.9% for the fiscal year ended 2005 and the 53-week period of fiscal 2004.
 
LIQUIDITY AND CAPITAL RESOURCES
 
Components of the Company’s most liquid assets are as follows (in thousands):
 
                 
FISCAL YEAR ENDED   Oct 1, 2006     Oct 2, 2005  
 
 
Cash and cash equivalents
  $ 312,606     $ 173,809  
Short-term investments — available-for-sale securities
    87,542       95,379  
Short-term investments — trading securities
    53,496       37,848  
Long-term investments — available-for-sale securities
    5,811       60,475  
 
 
Total cash, cash equivalents and liquid investments
  $ 459,455     $ 367,511  
 
 
 
The Company manages its cash, cash equivalents and liquid investments in order to internally fund operating needs and pay down short-term borrowings. The $92 million increase in total cash and cash equivalents and liquid investments from October 2, 2005 to October 1, 2006, was primarily due to strong operating cash flows.
 
The Company intends to use its cash and liquid investments, including any borrowings under its $1 billion revolving credit facility, to invest in its core businesses and other new business opportunities related to its core businesses. The Company may use its available cash resources to make proportionate capital contributions to its equity method and cost method investees, as well as purchase larger ownership interests in selected equity method investees and licensed operations, particularly in international markets. Depending on market conditions, Starbucks may repurchase shares of its common stock under its authorized share repurchase program. Management believes that strong cash flow generated from operations, existing cash and liquid investments, as well as borrowing capacity under the revolving credit facility, should be sufficient to finance capital requirements for its core businesses for the foreseeable future. Significant new joint ventures, acquisitions, share repurchases and/or other new business opportunities may require additional outside funding.
 
Other than normal operating expenses, cash requirements for fiscal 2007 are expected to consist primarily of capital expenditures for new Company-operated retail stores and the remodeling and refurbishment of existing Company-operated retail stores, as well as potential increased investments in International licensees and for additional share repurchases, if any. Management expects capital expenditures to be in the range of $950 million to $1.0 billion in fiscal 2007, primarily driven by new store development and existing store renovations.
 
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Cash provided by operating activities totaled $1.1 billion for fiscal 2006. Net earnings provided $564 million and noncash depreciation and amortization expenses further increased cash provided by operating activities by $413 million. In addition, an increase in accrued taxes payable due to the timing of payments provided $133 million.
 
Cash used by investing activities for fiscal 2006 totaled $841 million. Net capital additions to property, plant and equipment used $771 million, primarily from opening 1,040 new Company-operated retail stores and remodeling certain existing stores. During fiscal 2006, the Company used $92 million for acquisitions, net of cash acquired. In addition, the net activity in the Company’s portfolio of available-for-sale securities provided $61 million.
 
Cash used by financing activities for fiscal 2006 totaled $155 million. Cash used to repurchase shares of the Company’s common stock totaled $854 million. This amount includes the effect of the net change in unsettled trades from October 2, 2005. Share repurchases, up to the limit authorized by the Board of Directors, are at the discretion of management and depend on market conditions, capital requirements and other factors. Approximately 21.5 million shares remained available for repurchase as of October 1, 2006.
 
The Company had net borrowings under its credit facility of $423 million during fiscal 2006, which consisted of additional gross borrowings of $1.4 billion offset by gross principal repayments of $993 million. Management increased the Company’s borrowing capacity under its credit facility during the fiscal fourth quarter of 2006, from $500 million to $1.0 billion, as provided in the original credit facility. As of October 1, 2006, a total of $700 million was outstanding under the facility.
 
Partially offsetting cash used for share repurchases were proceeds of $159 million from the exercise of employee stock options and the sale of the Company’s common stock from employee stock purchase plans. As options granted are exercised, the Company will continue to receive proceeds and a tax deduction; however, the amounts and the timing cannot be predicted.
 
The following table summarizes the Company’s contractual obligations and borrowings as of October 1, 2006, and the timing and effect that such commitments are expected to have on the Company’s liquidity and capital requirements in future periods (in thousands):
 
                                         
    PAYMENTS DUE BY PERIOD  
       
          Less than
    1 – 3
    3 – 5
    More than
 
CONTRACTUAL OBLIGATIONS   Total     1 Year     Years     Years     5 Years  
 
 
Debt obligations (1)
  $ 740,480     $ 738,405     $ 1,660     $ 415     $  
Operating lease obligations (2)
    3,892,938       531,634       1,013,312       861,271       1,486,721  
Purchase obligations (3)
    619,862       440,720       153,044       21,761       4,337  
 
 
Total
  $ 5,253,280     $ 1,710,759     $ 1,168,016     $ 883,447     $ 1,491,058  
 
 
 
(1) Debt amounts include principal maturities and expected interest payments. Rates utilized to determine interest payments for variable rate debt are based on an estimate of future interest rates. The amount due in less than one year includes $700 million of short term borrowings under the facility.
 
(2) Amounts include the direct lease obligations, excluding any taxes, insurance and other related expenses.
 
(3) Purchase obligations include agreements to purchase goods or services that are enforceable and legally binding on Starbucks and that specify all significant terms. Purchase obligations relate primarily to green coffee and other commodities.
 
Starbucks expects to fund these commitments primarily with operating cash flows generated in the normal course of business, as well as ongoing borrowings under the facility.
 
 
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. (“Starbucks Japan”). The guarantees continue until the loans, including accrued interest and fees, have been paid in full, with the final loan amount
 
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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 October 1, 2006, the maximum amount of the guarantees was approximately $6.0 million. Since there has been no modification of these loan guarantees subsequent to the Company’s adoption of Financial Accounting Standards Board (“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 guarantees on its balance sheet.
 
 
Coffee brewing and espresso equipment sold to customers through Company-operated and licensed retail stores, as well as 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 to 24 months. Effective fiscal 2006, the Company elected to discontinue repairing brewing machines and instead offer an exchange to customers as a general right of return for any of its products. As a result, Starbucks maintains a sales return allowance based on historical patterns to reduce related revenues for estimated future product returns. Prior to fiscal 2006, the Company established an accrual for estimated warranty costs at the time of sale, also based on historical experience. Product warranty costs and changes to the related accrual were not significant for the periods ended October 1, 2006 and October 2, 2005.
 
 
The Company manages its exposure to various risks within the consolidated financial statements according to an umbrella risk management policy. Under this policy, market-based risks, including commodity costs and foreign currency exchange rates, are quantified and evaluated for potential mitigation strategies, such as entering into hedging transactions. Additionally, this policy restricts, among other things, the amount of market-based risk the Company will tolerate before implementing approved hedging strategies and prohibits speculative trading activity.
 
The Company purchases significant amounts of coffee and dairy products to support the needs of its Company-operated retail stores. The price and availability of these commodities directly impacts the Company’s results of operations and can be expected to impact its future results of operations. For additional details see “Product Supply” in Item 1, as well as “Risk Factors” in Item 1A of this Form 10-K.
 
 
The Company is exposed to market risk related to foreign currency exchange rates, equity security prices and changes in interest rates.
 
 
The majority of the Company’s revenue, expense and capital purchasing activities are transacted in U.S. dollars. However, because a portion of the Company’s operations consists of activities outside of the United States, the Company has transactions in other currencies, primarily the Canadian dollar, British pound sterling, euro and Japanese yen. Under the Company’s umbrella risk management policy, the Company frequently evaluates its foreign currency exchange risk by monitoring market data and external factors that may influence exchange rate fluctuations. As a result, Starbucks may engage in transactions involving various derivative instruments, with maturities generally not exceeding five years, to hedge assets, liabilities, revenues and purchases denominated in foreign currencies.
 
As of October 1, 2006, the Company had forward foreign exchange contracts that qualify as cash flow hedges under Statement of Financial Accounting Standard (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities,” to hedge a portion of anticipated international revenue and product purchases. In addition, Starbucks had forward foreign exchange contracts that qualify as hedges of its net investment in Starbucks Japan, an equity method investment, as well as the Company’s net investments in its Canadian and U.K. subsidiaries. These contracts expire within 33 months.
 
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Based on the foreign exchange contracts outstanding as of October 1, 2006, a 10% devaluation of the U.S. dollar as compared to the level of foreign exchange rates for currencies under contract as of October 1, 2006, would result in a reduced fair value of these derivative financial instruments of approximately $44 million, of which $22 million may reduce the Company’s future earnings. Conversely, a 10% appreciation of the U.S. dollar would result in an increase in the fair value of these instruments of approximately $38 million, of which $20 million may increase the Company’s future earnings. Consistent with the nature of the economic hedges provided by these foreign exchange contracts, increases or decreases in their fair value would be mostly offset by corresponding decreases or increases in the dollar value of the Company’s foreign investment, future foreign currency royalty fee payments and product purchases that would occur within the hedging period.
 
 
The Company has minimal exposure to price fluctuations on equity mutual funds within its trading portfolio. The trading securities approximate a portion of the Company’s liability under the Management Deferred Compensation Plan (“MDCP”). A corresponding liability is included in “Accrued compensation and related costs” on the consolidated balance sheets. These investments are recorded at fair value with unrealized gains and losses recognized in “Interest and other income, net” in the consolidated statements of earnings. The offsetting changes in the MDCP liability are recorded in “General and administrative expenses.”
 
 
The Company’s available-for-sale securities comprise a diversified portfolio consisting mainly of fixed income instruments. The primary objectives of these investments are to preserve capital and liquidity. Available-for-sale securities are investment grade and are recorded on the balance sheet at fair value with unrealized gains and losses reported as a separate component of “Accumulated other comprehensive income.” The Company does not hedge the interest rate exposure on its available-for-sale securities. The Company performed a sensitivity analysis based on a 10% change in the underlying interest rate of its interest bearing financial instruments, including its short-term borrowings and long-term debt, as of the end of fiscal 2006, and determined that such a change would not have a significant effect on the fair value of these instruments.
 
 
The Company’s business is subject to seasonal fluctuations. Significant portions of the Company’s net revenues and profits are realized during the first quarter of the Company’s fiscal year, which includes the holiday season. In addition, quarterly results are affected by the timing of the opening of new stores, and the Company’s rapid growth may conceal the impact of other seasonal influences. Because of the seasonality of the Company’s business, results for any quarter are not necessarily indicative of the results that may be achieved for the full fiscal year.
 
 
Critical accounting policies are those that management believes are both most important to the portrayal of the Company’s financial condition and results, and require management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Judgments and uncertainties affecting the application of those policies may result in materially different amounts being reported under different conditions or using different assumptions.
 
Starbucks considers its policies on impairment of long-lived assets, accounting for self insurance reserves, stock-based compensation and accounting for operating leases to be the most critical in understanding the judgments that are involved in preparing its consolidated financial statements.
 
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When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, an evaluation of recoverability is performed by comparing the carrying values of the assets to projected future cash flows, in addition to other quantitative and qualitative analyses. For goodwill and other intangible assets, impairment tests are performed annually and more frequently if facts and circumstances indicate goodwill carrying values exceed estimated reporting unit fair values and if indefinite useful lives are no longer appropriate for the Company’s trademarks. Upon indication that the carrying values of such assets may not be recoverable, the Company recognizes an impairment loss as a charge against current operations. Property, plant and equipment assets are grouped at the lowest level for which there are identifiable cash flows when assessing impairment. Cash flows for retail assets are identified at the individual store level. Long-lived assets to be disposed of are reported at the lower of their carrying amount or fair value, less estimated costs to sell. Judgments made by the Company related to the expected useful lives of long-lived assets and the ability of the Company to realize undiscounted cash flows in excess of the carrying amounts of such assets are affected by factors such as the ongoing maintenance and improvements of the assets, changes in economic conditions and changes in operating performance. As the Company assesses the ongoing expected cash flows and carrying amounts of its long-lived assets, these factors could cause the Company to realize material impairment charges.
 
 
Starbucks accounts for stock-based compensation in accordance with the fair value recognition provisions of SFAS 123R. The Company uses the Black-Scholes-Merton option pricing model which requires the input of highly subjective assumptions. These assumptions include estimating the length of time employees will retain their stock options before exercising them (“expected term”), the estimated volatility of the Company’s common stock price over the expected term and the number of options that will ultimately not complete their vesting requirements (“forfeitures”). Changes in the subjective assumptions can materially affect the estimate of fair value of stock-based compensation and consequently, the related amount recognized on the consolidated statements of earnings.
 
 
Starbucks leases retail stores, roasting and distribution facilities and office space under operating leases. The Company provides for an estimate of asset retirement obligation (“ARO”) expense at the lease inception date for operating leases with requirements to remove leasehold improvements at the end of the lease term. Estimating AROs involves subjective assumptions regarding both the amount and timing of actual future retirement costs. Future actual costs could differ significantly from amounts initially estimated. In addition, the large number of operating leases, and the significant number of international markets in which the Company has operating leases, adds administrative complexity to the calculation of ARO expense as well as to the other technical accounting requirements of operating leases such as contingent rent.
 
 
The Company uses a combination of insurance and self-insurance mechanisms, including a wholly owned captive insurance entity and participation in a reinsurance pool, to provide for the potential liabilities for workers’ compensation, healthcare benefits, general liability, property insurance, director and officers’ liability insurance and vehicle liability. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities, portions of which are calculated by third party actuarial firms, could be significantly affected if future occurrences and claims differ from these assumptions and historical trends.
 
 
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
 
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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 September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in GAAP, and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. Early adoption is permitted. Starbucks must adopt these new requirements no later than its first fiscal quarter of 2009. Starbucks has not yet determined the effect on the Company’s consolidated financial statements, if any, upon adoption of SFAS 157, or if it will adopt the requirements prior to the first fiscal quarter of 2009.
 
In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). The intent of SAB 108 is to reduce diversity in practice for the method companies use to quantify financial statement misstatements, including the effect of prior year uncorrected errors. SAB 108 establishes an approach that requires quantification of financial statement errors using both an income statement and a cumulative balance sheet approach. SAB 108 is effective for fiscal years beginning after November 15, 2006, and the Company will adopt the new requirements in fiscal 2008. The adoption of SAB 108 is not currently expected to have a significant impact on the Company’s consolidated financial statements.
 
 
The information required by this item is incorporated by reference to the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Commodity Prices, Availability and General Risk Conditions” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Risk Management” in Item 7 of this Report.
 
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CONSOLIDATED STATEMENTS OF EARNINGS
In thousands, except earnings per share
 
                         
FISCAL YEAR ENDED   Oct 1, 2006     Oct 2, 2005     Oct 3, 2004  
 
 
Net revenues:
                       
Company-operated retail
  $ 6,583,098     $ 5,391,927     $ 4,457,378  
Specialty:
                       
Licensing
    860,676       673,015       565,798  
Foodservice and other
    343,168       304,358       271,071  
     
     
Total specialty
    1,203,844       977,373       836,869  
     
     
Total net revenues
    7,786,942       6,369,300       5,294,247  
             
Cost of sales including occupancy costs
    3,178,791       2,605,212       2,191,440  
Store operating expenses
    2,687,815       2,165,911       1,790,168  
Other operating expenses
    260,087       197,024       171,648  
Depreciation and amortization expenses
    387,211       340,169       289,182  
General and administrative expenses
    473,023       357,114       304,293  
     
     
Subtotal operating expenses
    6,986,927       5,665,430       4,746,731  
             
Income from equity investees
    93,937       76,648       58,978  
     
     
Operating income
    893,952       780,518       606,494  
Interest and other income, net
    12,291       15,829       14,140  
     
     
Earnings before income taxes
    906,243       796,347       620,634  
Income taxes
    324,770       301,977       231,754  
     
     
Earnings before cumulative effect of change in accounting principle
    581,473       494,370       388,880  
Cumulative effect of accounting change for FIN 47, net of taxes
    17,214              
     
     
Net earnings
  $ 564,259     $ 494,370     $ 388,880  
     
     
Per common share:
                       
Earnings before cumulative effect of change in accounting principle — basic
  $ 0.76     $ 0.63     $ 0.49  
Cumulative effect of accounting change for FIN 47, net of taxes
    0.02              
     
     
Net earnings — basic
  $ 0.74     $ 0.63     $ 0.49  
     
     
Earnings before cumulative effect of change in accounting principle — diluted
  $ 0.73     $ 0.61     $ 0.47  
Cumulative effect of accounting change for FIN 47, net of taxes
    0.02              
     
     
Net earnings — diluted
  $ 0.71     $ 0.61     $ 0.47  
     
     
Weighted average shares outstanding:
                       
Basic
    766,114       789,570       794,347  
Diluted
    792,556       815,417       822,930  
 
 
 
See Notes to Consolidated Financial Statements.
 
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CONSOLIDATED BALANCE SHEETS
In thousands, except share data
 
                 
FISCAL YEAR ENDED   Oct 1, 2006     Oct 2, 2005  
 
 
ASSETS
               
Current assets:
               
Cash and cash equivalents
  $ 312,606     $ 173,809  
Short-term investments — available-for-sale securities
    87,542       95,379  
Short-term investments — trading securities
    53,496       37,848  
Accounts receivable, net of allowances of $3,827 and $3,079, respectively
    224,271       190,762  
Inventories
    636,222       546,299  
Prepaid expenses and other current assets
    126,874       94,429  
Deferred income taxes, net
    88,777       70,808  
     
     
Total current assets
    1,529,788       1,209,334  
Long-term investments — available-for-sale securities
    5,811       60,475  
Equity and other investments
    219,093       201,089  
Property, plant and equipment, net
    2,287,899       1,842,019  
Other assets
    186,917       72,893  
Other intangible assets
    37,955       35,409  
Goodwill
    161,478       92,474  
     
     
Total assets
  $ 4,428,941     $ 3,513,693  
     
     
         
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
Current liabilities:
               
Accounts payable
  $ 340,937     $ 220,975  
Accrued compensation and related costs
    288,963       232,354  
Accrued occupancy costs
    54,868       44,496  
Accrued taxes
    94,010       78,293  
Short-term borrowings
    700,000       277,000  
Other accrued expenses
    224,154       198,082  
Deferred revenue
    231,926       175,048  
Current portion of long-term debt
    762       748  
     
     
Total current liabilities
    1,935,620       1,226,996  
Long-term debt
    1,958       2,870  
Other long-term liabilities
    262,857       193,565  
     
     
Total liabilities
    2,200,435       1,423,431  
Shareholders’ equity:
               
Common stock ($0.001 par value) and additional paid-in-capital — authorized, 1,200,000,000 shares; issued and outstanding, 756,602,071 and 767,442,110 shares, respectively, (includes 3,394,200 common stock units in both periods)
    756       767  
Additional paid-in capital
          90,201  
Other additional paid-in-capital
    39,393       39,393  
Retained earnings
    2,151,084       1,938,987  
Accumulated other comprehensive income
    37,273       20,914  
     
     
Total shareholders’ equity
    2,228,506       2,090,262  
     
     
Total liabilities and shareholders’ equity
  $ 4,428,941     $ 3,513,693  
 
 
 
See Notes to Consolidated Financial Statements.
 
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CONSOLIDATED STATEMENTS OF CASH FLOWS
In thousands
 
                         
FISCAL YEAR ENDED   Oct 1, 2006     Oct 2, 2005     Oct 3, 2004  
 
 
OPERATING ACTIVITIES
                       
Net earnings
  $ 564,259     $ 494,370     $ 388,880  
Adjustments to reconcile net earnings to net cash provided by operating activities:
                       
Cumulative effect of accounting change for FIN 47, net of taxes
    17,214              
Depreciation and amortization
    412,625       367,207       314,047  
Provision for impairments and asset disposals
    19,622       19,464       17,948  
Deferred income taxes, net
    (84,324 )     (31,253 )     (3,770 )
Equity in income of investees
    (60,570 )     (49,537 )     (31,707 )
Distributions of income from equity investees
    49,238       30,919       38,328  
Stock-based compensation
    105,664              
Tax benefit from exercise of stock options
    1,318       109,978       63,405  
Excess tax benefit from exercise of stock options
    (117,368 )            
Net amortization of premium on securities
    2,013       10,097       11,603  
Cash provided/(used) by changes in operating assets and liabilities:
                       
Inventories
    (85,527 )     (121,618 )     (77,662 )
Accounts payable
    104,966       9,717       27,948  
Accrued compensation and related costs
    54,424       22,711       54,929  
Accrued taxes
    132,725       14,435       7,677  
Deferred revenue
    56,547       53,276       47,590  
Other operating assets and liabilities
    (41,193 )     (6,851 )     3,702  
     
     
Net cash provided by operating activities
    1,131,633       922,915       862,918  
             
INVESTING ACTIVITIES
                       
Purchase of available-for-sale securities
    (639,192 )     (643,488 )     (887,969 )
Maturity of available-for-sale securities
    269,134       469,554       170,789  
Sale of available-for-sale securities
    431,181       626,113       452,467  
Acquisitions, net of cash acquired
    (91,734 )     (21,583 )     (7,515 )
Net purchases of equity, other investments and other assets
    (39,199 )     (7,915 )     (64,747 )
Net additions to property, plant and equipment
    (771,230 )     (643,296 )     (416,917 )
     
     
Net cash used by investing activities
    (841,040 )     (220,615 )     (753,892 )
             
FINANCING ACTIVITIES
                       
Proceeds from issuance of common stock
    159,249       163,555       137,590  
Excess tax benefit from exercise of stock options
    117,368              
Net borrowings under revolving credit facility
    423,000       277,000        
Principal payments on long-term debt
    (898 )     (735 )     (722 )
Repurchase of common stock
    (854,045 )     (1,113,647 )     (203,413 )
     
     
Net cash used by financing activities
    (155,326 )     (673,827 )     (66,545 )
             
Effect of exchange rate changes on cash and cash equivalents
    3,530       283       3,110  
     
     
Net increase in cash and cash equivalents
    138,797       28,756       45,591  
             
CASH AND CASH EQUIVALENTS
                       
Beginning of period
    173,809       145,053       99,462  
     
     
End of period
  $ 312,606     $ 173,809     $ 145,053  
     
     
             
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
                       
Cash paid during the year for:
                       
Interest
  $ 10,576     $ 1,060     $ 370  
Income taxes
  $ 274,134     $ 227,812     $ 172,759  
 
 
 
See Notes to Consolidated Financial Statements.
 
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CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
In thousands, except share data
 
                                                         
                      Other
          Accumulated
       
                Additional
    Additional
          Other
       
    COMMON STOCK     Paid-in
    Paid-in
    Retained
    Comprehensive
       
    Shares     Amount     Capital     Capital     Earnings     Income/(Loss)     Total  
 
 
Balance, September 28, 2003
    787,385,072     $ 787     $ 958,316     $ 39,393     $ 1,055,737     $ 14,274     $ 2,068,507  
Net earnings
                            388,880             388,880  
Unrealized holding losses, net
                                  (4,925 )     (4,925 )
Translation adjustment
                                  19,892       19,892  
                                                         
Comprehensive income
                                                    403,847  
                                                         
Exercise of stock options, including tax benefit of $62,415
    15,416,982       16       172,016                         172,032  
Sale of common stock, including tax benefit of $990
    1,968,144       2       28,961                         28,963  
Repurchase of common stock
    (9,958,510 )     (10 )     (203,403 )                       (203,413 )
     
     
Balance, October 3, 2004
    794,811,688     $ 795     $ 955,890     $ 39,393     $ 1,444,617     $ 29,241     $ 2,469,936  
Net earnings
                            494,370             494,370  
Unrealized holding gains, net
                                  350       350  
Translation adjustment, net of tax
                                  (8,677 )     (8,677 )
                                                         
Comprehensive income
                                                    486,043  
                                                         
Exercise of stock options, including tax benefit of $108,428
    16,169,992       16       239,012                         239,028  
Sale of common stock, including tax benefit of $1,550
    1,563,964       1       34,504                         34,505  
Repurchase of common stock
    (45,103,534 )     (45 )     (1,139,205 )                       (1,139,250 )
     
     
Balance, October 2, 2005
    767,442,110     $ 767     $ 90,201     $ 39,393     $ 1,938,987     $ 20,914     $ 2,090,262  
Net earnings
                            564,259             564,259  
Unrealized holding gains, net
                                  1,767       1,767  
Translation adjustment, net of tax
                                  14,592       14,592  
                                                         
Comprehensive income
                                                    580,618  
                                                         
Stock-based compensation expense
                107,738                         107,738  
Exercise of stock options, including tax benefit of $116,762
    13,222,729       13       235,272                         235,285  
Sale of common stock, including tax benefit of $1,924
    1,544,634       2       42,649                         42,651  
Repurchase of common stock
    (25,607,402 )     (26 )     (475,860 )           (352,162 )           (828,048 )
     
     
Balance, October 1, 2006
    756,602,071     $ 756     $     $ 39,393     $ 2,151,084     $ 37,273     $ 2,228,506  
 
 
 
See Notes to Consolidated Financial Statements.
 
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
Fiscal years ended October 1, 2006, October 2, 2005, and October 3, 2004
 
Note 1: Summary of Significant Accounting Policies
 
 
Starbucks Corporation (together with its subsidiaries, “Starbucks” or the “Company”) purchases and roasts high-quality whole bean coffees and sells them, along with fresh, rich-brewed coffees, Italian-style espresso beverages, cold blended beverages, a variety of complementary food items, coffee-related accessories and equipment, a selection of premium teas and a line of compact discs, primarily through its Company-operated retail stores. Starbucks also sells coffee and tea products and licenses its trademark through other channels and, through certain of its equity investees, Starbucks produces and sells ready-to-drink beverages which include, among others, bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, and a line of superpremium ice creams. All channels outside the Company-operated retail stores are collectively known as “Specialty Operations.” The Company’s objective is to establish Starbucks as one of the most recognized and respected brands in the world. To achieve this goal, the Company plans to continue rapid expansion of its retail operations, to grow its Specialty Operations and to selectively pursue other opportunities to leverage the Starbucks brand through the introduction of new products and the development of new channels of distribution. The Company’s brand portfolio includes superpremium Tazo® teas, Starbucks Hear Music® compact discs, Seattle’s Best Coffee® and Torrefazione Italia® coffee.
 
 
The consolidated financial statements reflect the financial position and operating results of Starbucks, which include wholly owned subsidiaries and investees controlled by the Company.
 
Investments in entities that the Company does not control, but has the ability to exercise significant influence over operating and financial policies, are accounted for under the equity method. Investments in entities in which Starbucks does not have the ability to exercise significant influence are accounted for under the cost method.
 
All significant intercompany transactions have been eliminated.
 
 
Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. The fiscal years ended on October 1, 2006 and October 2, 2005, included 52 weeks. The fiscal year ended October 3, 2004, included 53 weeks, with the 53rd week falling in the fiscal fourth quarter.
 
 
Certain reclassifications of prior year’s balances have been made to conform to the current format.
 
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses. Actual results may differ from these estimates.
 
 
The Company considers all highly liquid instruments with a maturity of three months or less at the time of purchase to be cash equivalents. The Company maintains cash and cash equivalent balances with financial institutions that exceed federally insured limits. The Company has not experienced any losses related to these balances, and management believes its credit risk to be minimal.
 
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The Company’s cash management system provides for the reimbursement of all major bank disbursement accounts on a daily basis. Checks issued but not presented for payment to the bank are reflected as a reduction of cash and cash equivalents on the consolidated financial statements.
 
 
The Company’s short-term and long-term investments consist primarily of investment-grade marketable debt securities as well as bond and equity mutual funds, all of which are classified as trading or available-for-sale. Trading securities are recorded at fair value with unrealized holding gains and losses included in net earnings. Available-for-sale securities are recorded at fair value, and unrealized holding gains and losses are recorded, net of tax, as a separate component of accumulated other comprehensive income. Available-for-sale securities with remaining maturities of less than one year and those identified by management at time of purchase for funding operations in less than one year are classified as short-term, and all other available-for-sale securities are classified as long-term. Unrealized losses are charged against net earnings when a decline in fair value is determined to be other than temporary. Management reviews several factors to determine whether a loss is other than temporary, such as the length of time a security is in an unrealized loss position, the extent to which fair value is less than amortized cost, the impact of changing interest rates in the short and long term, the financial condition and near term prospects of the issuer and the Company’s intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in fair value. Realized gains and losses are accounted for on the specific identification method. Purchases and sales are recorded on a trade date basis.
 
 
The carrying value of cash and cash equivalents approximates fair value because of the short-term maturity of those instruments. The fair value of the Company’s investments in marketable debt and equity securities, as well as bond and equity mutual funds, is based upon the quoted market price on the last business day of the fiscal year. For equity securities of companies that are privately held, or where an observable quoted market price does not exist, the Company estimates fair value using a variety of valuation methodologies. Such methodologies include comparing the security with securities of publicly traded companies in similar lines of business, applying revenue multiples to estimated future operating results for the private company and estimating discounted cash flows for that company. Declines in fair value below the Company’s carrying value deemed to be other than temporary are charged against net earnings. For further information on investments, see Notes 4 and 7. The carrying value of short-term and long-term debt approximates fair value.
 
 
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.
 
The Company follows SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted, which requires that all derivatives be recorded on the balance sheet at fair value. For a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of other comprehensive income (“OCI”) and subsequently reclassified into net earnings when the hedged exposure affects net earnings. For a net investment hedge, the effective portion of the derivative’s gain or loss is reported as a component of OCI.
 
Cash flow hedges related to anticipated transactions are designated and documented at the inception of each hedge by matching the terms of the contract to the underlying transaction. The Company classifies the cash flows from hedging transactions in the same categories as the cash flows from the respective hedged items. Once established, cash flow hedges are generally not removed until maturity unless an anticipated transaction is no longer likely to occur. Discontinued or derecognized cash flow hedges are immediately settled with counterparties, and the related accumulated derivative gains or losses are recognized into net earnings in “Interest and other income, net” on the consolidated statements of earnings.
 
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Forward contract effectiveness for cash flow hedges is calculated by comparing the fair value of the contract to the change in value of the anticipated transaction using forward rates on a monthly basis. For net investment hedges, the spot-to-spot method is used to calculate effectiveness. Under this method, the change in fair value of the forward contract attributable to the changes in spot exchange rates (the effective portion) is reported as a component of OCI. The remaining change in fair value of the forward contract (the ineffective portion) is reclassified into net earnings. Any ineffectiveness is recognized immediately in “Interest and other income, net” on the consolidated statements of earnings.
 
 
Allowance for doubtful accounts is calculated based on historical experience, customer credit risk and application of the specific identification method.
 
 
Inventories are stated at the lower of cost (primarily moving average cost) or market. The Company records inventory reserves for obsolete and slow-moving items and for estimated shrinkage between physical inventory counts. Inventory reserves are based on inventory turnover trends, historical experience and application of the specific identification method. As of October 1, 2006 and October 2, 2005, inventory reserves were $10.5 million and $8.3 million, respectively.
 
 
Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation of property, plant and equipment, which includes assets under capital leases, is provided on the straight-line method over estimated useful lives, generally ranging from two to seven years for equipment and 30 to 40 years for buildings. Leasehold improvements are amortized over the shorter of their estimated useful lives or the related lease life, generally 10 years. For leases with renewal periods at the Company’s option, Starbucks generally uses the original lease term, excluding renewal option periods to determine estimated useful lives. If failure to exercise a renewal option imposes an economic penalty to Starbucks, management may determine at the inception of the lease that renewal is reasonably assured and include the renewal option period in the determination of appropriate estimated useful lives. The portion of depreciation expense related to production and distribution facilities is included in “Cost of sales including occupancy costs” on the consolidated statements of earnings. The costs of repairs and maintenance are expensed when incurred, while expenditures for refurbishments and improvements that significantly add to the productive capacity or extend the useful life of an asset are capitalized. When assets are retired or sold, the asset cost and related accumulated depreciation are eliminated with any remaining gain or loss reflected in net earnings.
 
 
Goodwill and other intangible assets are tested for impairment annually in June and more frequently if facts and circumstances indicate goodwill carrying values exceed estimated reporting unit fair values and if indefinite useful lives are no longer appropriate for the Company’s trademarks. Based on the impairment tests performed, there was no impairment of goodwill in fiscal 2006, 2005 and 2004. Definite-lived intangibles, which mainly consist of contract-based patents and copyrights, are amortized over their estimated useful lives. For further information on goodwill and other intangible assets, see Note 9.
 
 
When facts and circumstances indicate that the carrying values of long-lived assets may be impaired, an evaluation of recoverability is performed by comparing the carrying values of the assets to projected future cash flows in addition to other quantitative and qualitative analyses. Upon indication that the carrying values of such assets may not be recoverable, the Company recognizes an impairment loss by a charge against current operations. Property, plant and equipment assets
 
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are grouped at the lowest level for which there are identifiable cash flows when assessing impairment. Cash flows for retail assets are identified at the individual store level.
 
The Company recognized net impairment and disposition losses of $19.6 million, $19.5 million and $17.9 million in fiscal 2006, 2005 and 2004, respectively, primarily from renovation and remodeling activity and, to a lesser extent, from underperforming Company-operated retail stores, in the normal course of business. Depending on the underlying asset that is impaired, these losses may be recorded in any one of the operating expense lines on the consolidated statements of earnings: for retail operations, these losses are recorded in “Store operating expenses”; for Specialty Operations, these losses are recorded in “Other operating expenses”; and for all other operations, these losses are recorded in either “Cost of sales including occupancy costs” or “General and administrative expenses.”
 
 
The Company uses a combination of insurance and self-insurance mechanisms, including a wholly owned captive insurance entity and participation in a reinsurance pool, to provide for the potential liabilities for workers’ compensation, healthcare benefits, general liability, property insurance, director and officers’ liability insurance and vehicle liability. Liabilities associated with the risks that are retained by the Company are not discounted and are estimated, in part, by considering historical claims experience, demographic factors, severity factors and other actuarial assumptions. The estimated accruals for these liabilities, portions of which are calculated by third party actuarial firms, could be significantly affected if future occurrences and claims differ from these assumptions and historical trends. As of October 1, 2006, and October 2, 2005, these reserves were $113.2 million and $91.6 million, respectively, and were included in “Accrued compensation and related costs” and “Other accrued expenses” on the consolidated balance sheets.
 
 
Consolidated revenues are presented net of intercompany eliminations for wholly owned subsidiaries and investees controlled by the Company and for licensees accounted for under the equity method, based on the Company’s percentage ownership. Additionally, consolidated revenues are recognized net of any discounts, returns, allowances and sales incentives, including coupon redemptions and rebates.
 
 
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 fiscal year ended October 1, 2006, income recognized on unredeemed stored value card balances was $4.4 million. There was no income recognized on unredeemed stored value card balances during the fiscal years ended October 2, 2005 or October 3, 2004.
 
 
Company-operated retail store revenues are recognized when payment is tendered at the point of sale. Starbucks maintains a sales return allowance, based on historical patterns, to reduce retail revenues for estimated future product returns, including defective brewing equipment, related to sales in the normal course of business. Retail store revenues are reported net of sales, use or other transaction taxes that are collected from customers and remitted to taxing authorities.
 
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Specialty revenues consist primarily of product sales to customers other than through Company-operated retail stores, as well as royalties and other fees generated from licensing operations. Sales of coffee, tea and related products are generally recognized upon shipment to customers, depending on contract terms. Shipping charges billed to customers are also recognized as revenue, and the related shipping costs are included in “Cost of sales including occupancy costs” on the consolidated statements of earnings.
 
Specific to retail store licensing arrangements, initial nonrefundable development fees are recognized upon substantial performance of services for new market business development activities, such as initial business, real estate and store development planning, as well as providing operational materials and functional training courses for opening new licensed retail markets. Additional store licensing fees are recognized when new licensed stores are opened. Royalty revenues based upon a percentage of reported sales and other continuing fees, such as marketing and service fees, are recognized on a monthly basis when earned. For certain licensing arrangements, where the Company intends to acquire an ownership interest, the initial nonrefundable development fees are deferred to “Other long-term liabilities” until acquisition, at which point the fees are reflected as a reduction of the Company’s investment.
 
Other arrangements involving multiple elements and deliverables as well as upfront fees are individually evaluated for revenue recognition. Cash payments received in advance of product or service delivery are recorded as deferred revenue.
 
 
The Company expenses most advertising costs as they are incurred, except for certain production costs that are expensed the first time the advertising campaign takes place and direct-response advertising, which is capitalized and amortized over its expected period of future benefits. Direct-response advertising consists primarily of customer acquisition expenses including applications for customers to apply for the Starbucks Card Duettotm Visa®. These capitalized costs are amortized over the life of the credit card which is estimated to be three years.
 
Total advertising expenses, recorded in “Store operating expenses,” “Other operating expenses” and “General and administrative expenses” on the consolidated statements of earnings, totaled $95.4 million, $87.7 million and $67.2 million in fiscal 2006, 2005 and 2004, respectively. As of October 1, 2006, and October 2, 2005, $19.2 million and $11.8 million, respectively, of capitalized advertising costs were recorded in “Prepaid expenses and other current assets” on the consolidated balance sheets.
 
 
Costs incurred in connection with the start-up and promotion of new store openings are expensed as incurred.
 
 
Starbucks leases retail stores, roasting and distribution facilities and office space under operating leases. Most lease agreements contain tenant improvement allowances, rent holidays, lease premiums, rent escalation clauses and/or contingent rent provisions. For purposes of recognizing incentives, premiums and minimum rental expenses on a straight-line basis over the terms of the leases, the Company uses the date of initial possession to begin amortization, which is generally when the Company enters the space and begins to make improvements in preparation of intended use.
 
For tenant improvement allowances and rent holidays, the Company records a deferred rent liability in “Accrued occupancy costs” and “Other long-term liabilities” on the consolidated balance sheets and amortizes the deferred rent over the terms of the leases as reductions to rent expense on the consolidated statements of earnings.
 
For premiums paid upfront to enter a lease agreement, the Company records a deferred rent asset in “Prepaid expenses and other current assets” and “Other assets” on the consolidated balance sheets and then amortizes the deferred rent over the terms of the leases as additional rent expense on the consolidated statements of earnings.
 
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For scheduled rent escalation clauses during the lease terms or for rental payments commencing at a date other than the date of initial occupancy, the Company records minimum rental expenses on a straight-line basis over the terms of the leases on the consolidated statements of earnings.
 
Certain leases provide for contingent rents, which are determined as a percentage of gross sales in excess of specified levels. The Company records a contingent rent liability in “Accrued occupancy costs” on the consolidated balance sheets and the corresponding rent expense when specified levels have been achieved or when management determines that achieving the specified levels during the fiscal year is probable.
 
 
On October 1, 2006, Starbucks adopted FASB Interpretation No. 47 (“FIN 47”), “Accounting for Conditional Asset Retirement Obligations — an interpretation of FASB Statement No. 143,” which 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. The Company’s asset retirement obligation (“ARO”) liabilities are primarily associated with the disposal of leasehold improvements which, at the end of a lease, the Company may be contractually obligated to remove in order to restore the facility back to a condition specified in the lease agreement. The Company estimates the fair value of these liabilities based on current store closing costs, accretes that current cost forward to the date of estimated ARO removal, and discounts the future cost back as if it were performed at the inception of the lease. At the inception of such a lease, the Company records the ARO liability and also records a related capital asset in an amount equal to the estimated fair value of the liability. The ARO liability is accreted to its future value, with the accretion expense recognized as operating expense. The capitalized asset is depreciated on a straight-line basis over the useful life of the asset, which generally mirrors the life of the leasehold improvement. Upon ARO removal, any difference between the actual retirement costs incurred and the recorded estimated ARO liability is recognized as an operating gain or loss in the consolidated statement of earnings. In future periods, the Company may make adjustments to the ARO liability as a result of the availability of new information, changes in labor costs and other factors. The estimate of the ARO liability is based on a number of assumptions requiring management’s judgment, including store closing costs, cost inflation rates and discount rates.
 
The initial impact of adopting FIN 47 resulted in a charge of $27.1 million, with a related tax benefit of $9.9 million, for a net expense of $17.2 million, or $0.02 per diluted share. The net amount was recorded as a cumulative effect of a change in accounting principle on the consolidated statement of earnings. FIN 47 requires that the cumulative approach to adoption be used rather than retrospectively revising prior year financial statements. The adoption increased “Property, plant and equipment, net,” by $15.5 million, increased “Other long-term liabilities” for AROs by $34.2 million, increased “Other assets” for deferred tax assets by $6.8 million, and decreased “Equity and other investments” by $5.3 million. The following table presents, on a pro forma basis, what the ARO liability would have been had FIN 47 been in effect during fiscal 2005 and 2004. These pro forma amounts are estimated based upon the information, assumptions and interest rates used to measure the ARO liability recognized upon adoption of FIN 47 as of October 1, 2006 (in millions):
 
         
 
 
Pro forma ARO liability, October 2, 2005
  $ 29.2  
Pro forma ARO liability, October 3, 2004
    25.2  
Pro forma ARO liability, September 28, 2003
    20.9  
 
 
 
Stock-based Compensation — Change in Accounting Principle
 
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 SFAS No. 123(R), “Share-Based Payment” (“SFAS 123R”), Starbucks accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board
 
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(“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 fiscal 2006 was $105.0 million before income taxes and consisted of stock option and ESPP expense of $94.8 million and $10.2 million, respectively. The related total tax benefit was $36.1 million for fiscal 2006. Capitalized stock-based compensation at October 1, 2006 was $2.1 million, and was included in “Property, plant and equipment, net” and “Inventories” 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 tax effect 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.
 
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.
 
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.
 
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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):
 
                 
FISCAL YEAR ENDED   Oct 2, 2005     Oct 3, 2004  
 
 
Net earnings
  $ 494,370     $ 388,880  
Deduct: stock-based compensation expense determined under fair value method, net of tax
    (58,742 )     (45,056 )
     
     
Pro forma net income
  $ 435,628     $ 343,824  
     
     
Earnings per share:
               
Basic — as reported
  $ 0.63     $ 0.49  
Deduct: stock-based compensation expense determined under fair value method, net of tax
    (0.08 )     (0.06 )
     
     
Basic — pro forma
  $ 0.55     $ 0.43  
     
     
Diluted — as reported
  $ 0.61     $ 0.47  
Deduct: stock-based compensation expense determined under fair value method, net of tax
    (0.08 )     (0.05 )
     
     
Diluted — pro forma
  $ 0.53     $ 0.42  
 
 
 
Disclosures for the year ended October 1, 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 52 weeks ended October 1, 2006, October 2, 2005 and 53 weeks ended October 3, 2004:
 
                         
    EMPLOYEE STOCK OPTIONS   ESPP
        2005
  2004
      2005
  2004
FISCAL YEAR ENDED   2006   (Pro Forma)   (Pro Forma)   2006   (Pro Forma)   (Pro Forma)
 
 
Expected term (in years)
  4.4   3.7   3.7   0.25 – 3.0   0.25 – 3.0   0.25 – 3.0
Expected stock price volatility
  29%   33%   42%   22% – 50%   20% – 40%   19% – 43%
Risk-free interest rate
  4.4%   3.5%   2.5%   2.3% – 5.0%   1.9% – 3.5%   0.9% – 2.3%
Expected dividend yield
  0.0%   0.0%   0.0%   0.0%   0.0%   0.0%
Estimated fair value per option granted
  $9.59   $8.10   $5.30   $6.60   $5.05   $3.38
 
 
 
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 14 for additional details.