Starbucks, management discussion

From Starubucks 10-Q, filed 2007-05-11


General
Starbucks Corporation’s fiscal year ends on the Sunday closest to September 30. Fiscal year 2006 had 52 weeks and the fiscal year ending on September 30, 2007 will also include 52 weeks. All references to store counts, including data for new store openings, are reported net of related store closures.
Management Overview
During both the 13 and 26 week periods ended April 1, 2007, the Company’s continued focus on execution in all areas of its business, from U.S. and International Company-operated retail operations to the Company’s specialty operations, delivered solid 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 quarterly and year-to-date fiscal 2007 performance reflects the Company’s ongoing 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 1,288 new stores in the first half of fiscal 2007 and plans to open approximately 2,400 stores in fiscal 2007.
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 of service through training, technology and process improvement.
Global comparable store sales for Company-operated markets increased by 4% for the 13-week period ended April 1, 2007, and increased 5% over the first half of fiscal 2007. Comparable store sales growth for fiscal 2007 is expected to be in the target 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 the first quarter of fiscal 2007, the Company purchased a 90% stake in its previously-licensed operations in Beijing and Tianjin, China.

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Starbucks has three reportable segments: United States, International and the Global Consumer Products Group (“CPG”).
The United States and International segments both include Company-operated retail stores, licensed retail stores and foodservice operations. The United States segment has been operating significantly longer than the International segment and has developed deeper awareness of, and attachment to, the Starbucks brand and stores among its customer base. As a result, the United States segment has significantly more stores, higher average sales per store, and higher total revenues than the International segment. Further, certain market costs, particularly occupancy costs, are lower in the United States segment than in the markets of the International segment. As a result of the relative strength of the brand in the United States segment, the number of stores, the higher unit volumes, and the lower market costs, the United States segment has a higher operating margin than the less-developed International segment.
The Company’s International store base continues to increase rapidly and Starbucks is achieving a growing contribution from established international markets while at the same time investing in emerging markets, such as China. The Company’s newer international markets require a more extensive support organization, relative to the current levels of revenue and operating income. The Company’s ongoing investments in International infrastructure can be expected to cause variability in quarterly operating margins for the International segment.
The CPG segment includes the Company’s grocery and warehouse club business as well as branded products operations worldwide. The CPG segment operates primarily through joint ventures and licensing arrangements with large consumer products business partners, most significantly The North American Coffee Partnership with the Pepsi-Cola Company for distribution of ready-to-drink beverages, and with Kraft Foods Inc. for distribution of packaged coffees and teas. This operating model allows the CPG segment to leverage the business partners’ existing infrastructures and to extend the Starbucks brand in an efficient way. Most of the customer revenues from the ready-to-drink and packaged coffee channels are recognized by the joint venture or licensed business partner, not by the CPG segment, and the results of the Company’s joint ventures are included on a net basis in “Income from equity investees” on the consolidated statements of earnings. As a result, the CPG segment reflects relatively lower revenues, a modest cost structure, and a resulting higher operating margin, compared to the Company’s other two reporting segments, which consist primarily of retail stores.
The combination of more retail stores, comparable store sales growth of 4% and growth in other business channels resulted in a 20% increase in total net revenues for the 13-week period ended April 1, 2007, compared to the same period of fiscal 2006. The Company expects consolidated total net revenue growth of approximately 20% in fiscal 2007.
Operating income as a percentage of total net revenues was 10.7% for both the 13 weeks ended April 1, 2007 and April 2, 2006, due to higher cost of sales including occupancy costs offset by lower store operating expenses and lower general and administrative expenses as a percentage of total net revenues. For the second half of fiscal 2007, the Company expects modest improvement in year-over-year operating margin, primarily in the fourth quarter, despite the more challenging cost environment, particularly in labor and dairy costs. Net earnings increased by 18% in the 13-week period ended April 1, 2007, compared to the same period in fiscal 2006.

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Results of Operations for the 13 Weeks Ended April 1, 2007 and April 2, 2006
CONSOLIDATED RESULTS
The following table presents the consolidated statements of earnings as well as the percentage relationship to total net revenues of items included in the Company’s consolidated statements of earnings (amounts in thousands):

13 Weeks Ended 13 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
STATEMENTS OF EARNINGS DATA

As a % of total net revenues
Net revenues:

Company-operated retail
$ 1,922,705 $ 1,599,844 20.2 % 85.2 % 84.8 %
Specialty:

Licensing
234,807 202,354 16.0 10.4 10.7
Foodservice and other
98,082 83,624 17.3 4.4 4.5


Total specialty
332,889 285,978 16.4 14.8 15.2


Total net revenues
2,255,594 1,885,822 19.6 100.0 100.0


Cost of sales including occupancy costs
944,746 760,873 41.9 40.3
Store operating expenses (1)
780,985 665,273 34.6 35.4
Other operating expenses (2)
75,661 63,648 3.4 3.4
Depreciation and amortization expenses
113,385 94,508 5.0 5.0
General and administrative expenses
126,104 119,611 5.6 6.3


Subtotal operating expenses
2,040,881 1,703,913 19.8 90.5 90.4
Income from equity investees
26,261 19,985 1.2 1.1


Operating income
240,974 201,894 19.4 10.7 10.7
Interest and other income, net
(592 ) 3,063 0.0 0.2


Earnings before income taxes
240,382 204,957 10.7 10.9
Income taxes
89,542 77,641 4.0 4.1


Net earnings
$ 150,840 $ 127,316 18.5 % 6.7 % 6.8 %




(1) As a percentage of related Company-operated retail revenues, store operating expenses were 40.6% for the 13 weeks ended April 1, 2007, and 41.6% for the 13 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 22.7% for the 13 weeks ended April 1, 2007, and 22.3% for the 13 weeks ended April 2, 2006.
Net revenues for the 13 weeks ended April 1, 2007, increased 20% to $2.3 billion from $1.9 billion for the corresponding period of fiscal 2006, 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 13-week period ended April 1, 2007, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 20% to $1.9 billion for the 13 weeks ended April 1, 2007, from $1.6 billion for the same period in fiscal 2006. The increase was primarily attributable to the opening of 1,279 new Company-operated retail stores in the last 12 months and comparable store sales growth of 4% for the 13 weeks ended April 1, 2007. The increase in comparable store sales was due to a 3% increase in the average value per transaction and a 1% increase in the number of customer transactions.
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 16% to $333 million for the 13 weeks ended April 1, 2007, from $286 million for the corresponding period of fiscal 2006.
Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club and certain other branded-product operations, increased 16% to $235 million for the 13 weeks ended April 1, 2007, from $202 million for the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from the opening of 1,224 new licensed retail stores in the last 12 months.
Foodservice and other revenues increased 17% to $98 million for the 13 weeks ended April 1, 2007, from $84 million for the corresponding period of fiscal 2006. The increase was primarily attributable to growth in new and existing accounts in the U.S. foodservice business.
Cost of sales including occupancy costs increased to 41.9% of total net revenues for the 13 weeks ended April 1,

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2007, compared to 40.3% for the corresponding period of fiscal 2006. The increase was primarily due to a shift in sales to higher cost products, increased distribution costs due to the Company’s expanding store base and food programs, and higher rent expense attributed to growth in higher priced real estate markets.
Store operating expenses as a percentage of Company-operated retail revenues decreased to 40.6% for the 13 weeks ended April 1, 2007, from 41.6% for the corresponding period of fiscal 2006. This decrease was primarily due to higher provisions for incentive compensation in the prior year due to exceptionally strong performance.
Other operating expenses, expenses associated with the Company’s specialty operations, increased to 22.7% of total specialty revenues for the 13 weeks ended April 1, 2007, compared to 22.3% in the corresponding period of fiscal 2006. The increase was primarily due to higher marketing costs related to market expansion of ready-to-drink coffee beverages in the Asia-Pacific region.
Depreciation and amortization expenses increased to $113 million for the 13 weeks ended April 1, 2007, compared to $95 million for the corresponding period of fiscal 2006. The increase was primarily due to the opening of 1,279 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses were 5.0% for both periods.
General and administrative expenses increased to $126 million for the 13 weeks ended April 1, 2007, compared to $120 million for the corresponding period of fiscal 2006. The increase was primarily due to higher payroll-related expenditures and professional fees in support of continued global growth, partially offset by lower provisions for incentive compensation due to exceptional performance in the prior year. As a percentage of total net revenues, general and administrative expenses decreased to 5.6% for the 13 weeks ended April 1, 2007, from 6.3% for the corresponding period of fiscal 2006.
Income from equity investees increased 31% to $26 million for the 13 weeks ended April 1, 2007, compared to $20 million for the corresponding period of fiscal 2006. The increase was primarily from the North American Coffee Partnership, which produces ready-to-drink beverages, including Starbucks bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks, and higher equity income from international investees.
Operating income increased 19% to $241 million for the 13 weeks ended April 1, 2007, compared to $202 million for the corresponding period of fiscal 2006. Operating margin was 10.7% of total net revenues for both the 13 weeks ended April 1, 2007, and April 2, 2006. For the 13 weeks ended April 1, 2007, higher cost of sales including occupancy costs were offset by lower store operating expenses and lower general and administrative expenses as a percentage of total net revenues.
Net interest and other income decreased to expense of $0.6 million for the 13 weeks ended April 1, 2007, compared to income of $3.1 million for the corresponding period of fiscal 2006, primarily due to higher borrowings and higher interest rates on the Company’s revolving credit facility.
Income taxes for the 13 weeks ended April 1, 2007, resulted in an effective tax rate of 37.2%, compared to 37.9% for the corresponding period of fiscal 2006. The Company currently estimates that its effective tax rate for fiscal year 2007 will approximate 37%, with quarterly variations.
Net earnings for the 13 weeks ended April 1, 2007, increased 18% to $151 million from $127 million for the same period in fiscal 2006. Diluted earnings per share increased by 19% to $0.19 for the 13 weeks ended April 1, 2007, compared to $0.16 per share for the comparable period in fiscal 2006.

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SEGMENT RESULTS
Segment information is prepared on the 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 (in thousands):
United States

13 Weeks Ended 13 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of U.S. total net
revenues
Net revenues:

Company-operated retail
$ 1,595,389 $ 1,351,563 18.0 % 89.2 % 89.5 %
Specialty:

Licensing
104,790 81,451 28.7 5.8 5.4
Foodservice and other
89,251 76,584 16.5 5.0 5.1

Total specialty
194,041 158,035 22.8 10.8 10.5

Total net revenues
1,789,430 1,509,598 18.5 100.0 100.0


Cost of sales including occupancy costs
707,957 569,264 39.6 37.7
Store operating expenses (1)
653,791 568,088 36.5 37.6
Other operating expenses (2)
52,020 48,109 2.9 3.2
Depreciation and amortization expenses
84,429 69,534 4.7 4.6
General and administrative expenses
23,651 23,587 1.3 1.6

Subtotal operating expenses
1,521,848 1,278,582 19.0 85.0 84.7


Income from equity investees
— 27 0.0 0.0

Operating income
$ 267,582 $ 231,043 15.8 % 15.0 % 15.3 %



(1) As a percentage of related Company-operated retail revenues, store operating expenses were 41.0% for the 13 weeks ended April 1, 2007, and 42.0% for the 13 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 26.8% for the 13 weeks ended April 1, 2007, and 30.4% for the 13 weeks ended April 2, 2006.
The United States operating segment (“United States”) sells 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.
United States total net revenues increased 19% to $1.8 billion for the 13 weeks ended April 1, 2007, compared to $1.5 billion for the corresponding period of fiscal 2006.
United States Company-operated retail revenues increased 18% to $1.6 billion for the 13 weeks ended April 1, 2007, compared to $1.4 billion for the corresponding period of fiscal 2006, primarily due to the opening of 1,042 new Company-operated retail stores in the last 12 months and comparable store sales growth of 3% for the quarter resulting from a 3% increase in the average value per transaction.
Total United States specialty revenues increased 23% to $194 million for the 13 weeks ended April 1, 2007, compared to $158 million in the corresponding period of fiscal 2006. United States licensing revenues increased 29% to $105 million, compared to $81 million for the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues as a result of opening 768 new licensed retail stores in the last 12 months. United States foodservice and other revenues increased 17% to $89 million, from $77 million in fiscal 2006, primarily due to growth in new and existing foodservice accounts.
United States operating income increased 16% to $268 million for the 13 weeks ended April 1, 2007, compared to $231 million for the same period in fiscal 2006. Operating margin decreased to 15.0% of related revenues from a record second quarter high of 15.3% in the corresponding period of fiscal 2006. The decrease was due to higher cost of sales including occupancy costs, primarily due to a shift in sales to higher cost products, such as food and merchandise, higher rent expenses and increased distribution costs due to expansion of the Company’s store base

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and food programs. Partially offsetting this was lower store operating expenses as a percentage of total net revenues, primarily resulting from higher provisions for incentive compensation in the prior year due to exceptionally strong performance.
International

13 Weeks Ended 13 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of International total
net revenues
Net revenues:

Company-operated retail
$ 327,316 $ 248,281 31.8 % 84.5 % 83.3 %
Specialty:

Licensing
51,205 42,725 19.8 13.2 14.3
Foodservice and other
8,831 7,040 25.4 2.3 2.4

Total specialty
60,036 49,765 20.6 15.5 16.7

Total net revenues
387,352 298,046 30.0 100.0 100.0


Cost of sales including occupancy costs
189,184 144,816 48.8 48.6
Store operating expenses (1)
127,194 97,185 32.9 32.6
Other operating expenses (2)
16,769 11,376 4.3 3.8
Depreciation and amortization expenses
20,649 16,286 5.3 5.5
General and administrative expenses
25,342 18,184 6.5 6.1

Subtotal operating expenses
379,138 287,847 31.7 97.8 96.6


Income from equity investees
12,916 9,125 3.3 3.1

Operating income
$ 21,130 $ 19,324 9.3 % 5.5 % 6.5 %



(1) As a percentage of related Company-operated retail revenues, store operating expenses were 38.9% for the 13 weeks ended April 1, 2007, and 39.1% for the 13 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 27.9% for the 13 weeks ended April 1, 2007, and 22.9% for the 13 weeks ended April 2, 2006.
The International operating segment (“International”) sells coffee and other beverages, whole bean coffees, complementary food, coffee brewing equipment and merchandise through Company-operated retail stores in Canada, the United Kingdom, China, Thailand, Australia, Germany, Singapore, Puerto Rico, Chile and Ireland. Specialty operations in International primarily include retail store licensing operations in more than 25 other 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. Many of the Company’s International operations are in 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 30% to $387 million for the 13 weeks ended April 1, 2007, compared to $298 million for the corresponding period of fiscal 2006.
International Company-operated retail revenues increased 32% to $327 million for the 13 weeks ended April 1, 2007, compared to $248 million for the corresponding period of fiscal 2006. The increase was primarily due to the opening of 237 new Company-operated retail stores in the last 12 months, comparable store sales growth of 7% for the quarter and favorable foreign currency exchange for the British pound sterling. The increase in comparable store sales resulted from a 5% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction.
Total International specialty revenues increased 21% to $60 million for the 13 weeks ended April 1, 2007, compared to $50 million in the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from opening 456 new licensed retail stores in the last 12 months and growth in new and existing foodservice accounts.
International operating income increased 9% to $21 million for the 13 weeks ended April 1, 2007, compared to $19

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million in the corresponding period of fiscal 2006. Operating margin decreased to 5.5% of related revenues from 6.5% in the corresponding period of fiscal 2006, primarily due to higher other operating expenses and general and administrative expenses as a percentage of total net revenues resulting from increased payroll-related expenditures to support continued rapid international store growth.
Global Consumer Products Group

13 Weeks Ended 13 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of CPG total net
revenues
Net revenues:

Specialty:

Licensing
$ 78,812 $ 78,178 0.8 % 100.0 % 100.0 %

Total specialty
78,812 78,178 0.8 100.0 100.0

Total net revenues
78,812 78,178 0.8 100.0 100.0


Cost of sales
47,605 46,793 60.4 59.9
Other operating expenses
6,872 4,163 8.7 5.3
Depreciation and amortization expenses
21 27 0.0 0.0

Subtotal operating expenses
54,498 50,983 6.9 69.1 65.2


Income from equity investees
13,345 10,833 16.9 13.8

Operating income
$ 37,659 $ 38,028 (1.0 %) 47.8 % 48.6 %

The Global Consumer Products Group (“CPG”) sells a selection of whole bean and ground coffees as well as a selection of premium Tazo® teas through licensing arrangements in United States and international markets. CPG also produces and sells ready-to-drink beverages which include, among others, Starbucks bottled Frappuccino® coffee drinks, Starbucks DoubleShot® espresso drinks, Discoveries™ products, Starbucks® superpremium ice creams and Starbucks™ Coffee and Cream Liqueurs through its joint ventures and marketing and distribution agreements.
CPG total net revenues increased 1% to $79 million for the 13 weeks ended April 1, 2007, compared to $78 million for the corresponding period of fiscal 2006. The increase was primarily due to increased product sales and royalties in the International ready-to-drink business. Partially offsetting this was decreased shipments into the U.S. packaged coffee and tea distribution system, despite higher sales to grocery retailers, resulting in lower inventory levels throughout the system.
CPG operating income was $38 million for the 13 weeks ended April 1, 2007, relatively flat with the corresponding period of fiscal 2006. Operating margin decreased to 47.8% of related revenues, from 48.6% in fiscal 2006, primarily due to increased other operating expenses. The increase in other operating expenses was due to higher marketing expenditures to support continued international expansion of ready-to-drink beverages. Partially offsetting the increase in other operating expenses was higher income from equity investees attributable to the ready-to-drink beverage business in the U.S.
Unallocated Corporate

13 Weeks Ended 13 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of total net
revenues
Depreciation and amortization expenses
$ 8,286 $ 8,661 0.4 % 0.5 %
General and administrative expenses
77,111 77,840 3.4 4.1

Operating loss
$ (85,397 ) $ (86,501 ) 1.3 % (3.8 %) (4.6 %)

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 decreased to $85 million for the 13 weeks ended April 1, 2007, compared to $87 million in the corresponding period of fiscal 2006. The decrease was primarily due to higher provisions for incentive

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compensation in the prior year due to exceptional performance. Total unallocated corporate expenses as a percentage of total net revenues decreased to 3.8% for the 13 weeks ended April 1, 2007, from 4.6% for the 13 weeks ended April 2, 2006.
Results of Operations for the 26 Weeks Ended April 1, 2007 and April 2, 2006
CONSOLIDATED RESULTS
The following table presents the consolidated statements of earnings as well as the percentage relationship to total net revenues of items included in the Company’s consolidated statements of earnings (amounts in thousands):

26 Weeks Ended 26 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
STATEMENTS OF EARNINGS DATA

As a % of total net revenues
Net revenues:

Company-operated retail
$ 3,929,516 $ 3,227,827 21.7 % 85.2 % 84.5 %
Specialty:

Licensing
488,729 421,504 15.9 10.6 11.0
Foodservice and other
193,072 170,583 13.2 4.2 4.5


Total specialty
681,801 592,087 15.2 14.8 15.5


Total net revenues
4,611,317 3,819,914 20.7 100.0 100.0


Cost of sales including occupancy costs
1,929,569 1,538,911 41.8 40.3
Store operating expenses (1)
1,552,952 1,287,439 33.7 33.6
Other operating expenses (2)
148,199 122,796 3.3 3.2
Depreciation and amortization expenses
223,581 185,796 4.8 4.9
General and administrative expenses
241,332 242,936 5.2 6.4


Subtotal operating expenses
4,095,633 3,377,878 21.2 88.8 88.4
Income from equity investees
45,014 39,705 1.0 1.0


Operating income
560,698 481,741 16.4 12.2 12.6
Interest and other income, net
5,847 3,411 0.1 0.1


Earnings before income taxes
566,545 485,152 12.3 12.7
Income taxes
210,753 183,680 4.6 4.8


Net earnings
$ 355,792 $ 301,472 18.0 % 7.7 % 7.9 %




(1) As a percentage of related Company-operated retail revenues, store operating expenses were 39.5% for the 26 weeks ended April 1, 2007, and 39.9% for the 26 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 21.7% for the 26 weeks ended April 1, 2007, and 20.7% for the 26 weeks ended April 2, 2006.
Net revenues for the 26 weeks ended April 1, 2007, increased 21% to $4.6 billion from $3.8 billion for the corresponding period of fiscal 2006, 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 26-week period ended April 1, 2007, Starbucks derived 85% of total net revenues from its Company-operated retail stores. Company-operated retail revenues increased 22% to $3.9 billion for the 26 weeks ended April 1, 2007, from $3.2 billion for the same period in fiscal 2006. The increase was primarily attributable to the opening of 1,279 new Company-operated retail stores in the last 12 months and comparable store sales growth of 5% for the 26 weeks ended April 1, 2007. The increase in comparable store sales was due to a 3% increase in the average value per transaction and a 2% increase in the number of customer transactions.
The Company derived the remaining 15% of total net revenues from its specialty operations. Specialty revenues, which include licensing revenues and foodservice and other revenues, increased 15% to $682 million for the 26 weeks ended April 1, 2007, from $592 million for the corresponding period of fiscal 2006.
Licensing revenues, which are derived from retail store licensing arrangements, as well as grocery, warehouse club and certain other branded-product operations, increased 16% to $489 million for the 26 weeks ended April 1, 2007, from $422 million for the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from the opening of 1,224 new licensed retail stores in the last 12 months.

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Foodservice and other revenues increased 13% to $193 million for the 26 weeks ended April 1, 2007, from $171 million for the corresponding period of fiscal 2006. The increase was primarily attributable to growth in new and existing accounts in the U.S. foodservice business.
Cost of sales including occupancy costs increased to 41.8% of total net revenues for the 26 weeks ended April 1, 2007, compared to 40.3% for the corresponding period of fiscal 2006. The increase was primarily due to a shift in sales to higher cost products, increased distribution costs due to the Company’s expanding store base and food programs, and higher rent expense attributed to growth in higher priced real estate markets.
Store operating expenses as a percentage of Company-operated retail revenues decreased to 39.5% for the 26 weeks ended April 1, 2007, from 39.9% for the corresponding period of fiscal 2006. The decrease was primarily due to higher provisions for incentive compensation in the prior year due to exceptionally strong performance.
Other operating expenses, expenses associated with the Company’s specialty operations, increased to 21.7% of total specialty revenues for the 26 weeks ended April 1, 2007, compared to 20.7% in the corresponding period of fiscal 2006. The increase was primarily due to increased payroll-related expenditures to support the growth in the International licensed stores operations as well as higher marketing costs related to expansion of ready-to-drink coffee beverages in the Asia-Pacific region.
Depreciation and amortization expenses increased to $224 million for the 26 weeks ended April 1, 2007, compared to $186 million for the corresponding period of fiscal 2006. The increase was primarily due to the opening of 1,279 new Company-operated retail stores in the last 12 months. As a percentage of total net revenues, depreciation and amortization expenses decreased to 4.8% for the 26 weeks ended April 1, 2007, from 4.9% for the corresponding period of fiscal 2006.
General and administrative expenses decreased to $241 million for the 26 weeks ended April 1, 2007, compared to $243 million for the corresponding period of fiscal 2006. This decrease was primarily due to lower provisions for incentive compensation compared to exceptional performance in the prior year and unusually high charitable contributions in the prior year. These were partially offset by increased payroll-related expenditures and higher professional fees in support of continued global growth and systems infrastructure development in the current year. As a percentage of total net revenues, general and administrative expenses decreased to 5.2% for the 26 weeks ended April 1, 2007, from 6.4% for the corresponding period of fiscal 2006.
Income from equity investees increased 13% to $45 million for the 26 weeks ended April 1, 2007, compared to $40 million for the corresponding period of fiscal 2006. The increase was primarily due to higher equity income from international investees, and higher income from the North American Coffee Partnership, which produces ready-to-drink beverages, including Starbucks bottled Frappuccino® coffee drinks and Starbucks DoubleShot® espresso drinks.
Operating income increased 16% to $561 million for the 26 weeks ended April 1, 2007, compared to $482 million for the corresponding period of fiscal 2006. Operating margin decreased to 12.2% of total net revenues for the 26 weeks ended April 1, 2007, compared to 12.6% for the corresponding period of fiscal 2006, primarily due to higher cost of sales including occupancy costs, partially offset by lower general and administrative expenses.
Net interest and other income increased to $5.8 million for the 26 weeks ended April 1, 2007, compared to $3.4 million in the corresponding period of fiscal 2006, primarily due to foreign exchange gains in the current year compared to foreign exchange losses in the prior year and higher income recognized from unredeemed stored value cards. These were partially offset by increased interest expense due to higher borrowings and higher interest rates on the Company’s revolving credit facility.
Income taxes for the 26 weeks ended April 1, 2007, resulted in an effective tax rate of 37.2%, compared to 37.9% for the corresponding period of fiscal 2006. The Company currently estimates that its effective tax rate for fiscal year 2007 will approximate 37%, with quarterly variations.
Net earnings for the 26 weeks ended April 1, 2007, increased 18% to $356 million from $301 million for the same period of fiscal 2006. Diluted earnings per share increased by 21% to $0.46 for the 26 weeks ended April 1, 2007, compared to $0.38 per share for the comparable period in fiscal 2006.

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SEGMENT RESULTS
Segment information is prepared on the 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 (in thousands):
United States

26 Weeks Ended 26 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of U.S. total net
revenues
Net revenues:

Company-operated retail
$ 3,255,652 $ 2,722,250 19.6 % 89.2 % 89.1 %
Specialty:

Licensing
218,099 177,734 22.7 6.0 5.8
Foodservice and other
175,578 156,955 11.9 4.8 5.1

Total specialty
393,677 334,689 17.6 10.8 10.9

Total net revenues
3,649,329 3,056,939 19.4 100.0 100.0


Cost of sales including occupancy costs
1,439,078 1,156,710 39.4 37.8
Store operating expenses (1)
1,302,168 1,096,863 35.7 35.9
Other operating expenses (2)
104,145 92,216 2.9 3.0
Depreciation and amortization expenses
165,792 137,218 4.5 4.5
General and administrative expenses
45,410 45,120 1.3 1.5

Subtotal operating expenses
3,056,593 2,528,127 20.9 83.8 82.7


Income from equity investees
— 151 0.0 0.0

Operating income
$ 592,736 $ 528,963 12.1 % 16.2 % 17.3 %



(1) As a percentage of related Company-operated retail revenues, store operating expenses were 40.0% for the 26 weeks ended April 1, 2007, and 40.3% for the 26 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 26.5% for the 26 weeks ended April 1, 2007, and 27.6% for the 26 weeks ended April 2, 2006.
United States total net revenues increased 19% to $3.6 billion for the 26 weeks ended April 1, 2007, compared to $3.1 billion for the corresponding period of fiscal 2006.
United States Company-operated retail revenues increased 20% to $3.3 billion for the 26 weeks ended April 1, 2007, compared to $2.7 billion for the corresponding period of fiscal 2006, primarily due to the opening of 1,042 new Company-operated retail stores in the last 12 months and comparable store sales growth of 4% for the 26 weeks ended April 1, 2007. The increase in comparable store sales was due to a 3% increase in the average value per transaction and a 1% increase in the number of customer transactions.
Total United States specialty revenues increased 18% to $394 million for the 26 weeks ended April 1, 2007, compared to $335 million in the corresponding period of fiscal 2006. United States licensing revenues increased 23% to $218 million, compared to $178 million for the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues as a result of opening 768 new licensed retail stores in the last 12 months. United States foodservice and other revenues increased 12% to $176 million, from $157 million in fiscal 2006, primarily due to growth in new and existing foodservice accounts.
United States operating income increased by 12% to $593 million for the 26 weeks ended April 1, 2007, compared to $529 million for the same period in fiscal 2006. Operating margin decreased to 16.2% of related revenues from 17.3% in the corresponding period of fiscal 2006, primarily due to higher cost of sales including occupancy costs. Cost of sales including occupancy costs increased primarily due to a shift in sales to higher cost products such as food and merchandise, increased distribution costs due to the expansion of the Company’s store base and food programs, and higher rent expense. Partially offsetting this was lower store operating expenses and lower general and administrative expenses as a percentage of total net revenues, primarily resulting from higher provisions for incentive compensation in the prior year due to exceptionally strong performance.

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International

26 Weeks Ended 26 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of International total
net revenues
Net revenues:

Company-operated retail
$ 673,864 $ 505,577 33.3 % 85.0 % 83.7 %
Specialty:

Licensing
101,069 85,034 18.9 12.8 14.1
Foodservice and other
17,494 13,628 28.4 2.2 2.2

Total specialty
118,563 98,662 20.2 15.0 16.3

Total net revenues
792,427 604,239 31.1 100.0 100.0


Cost of sales including occupancy costs
389,295 290,244 49.1 48.0
Store operating expenses (1)
250,784 190,576 31.7 31.6
Other operating expenses (2)
30,918 21,816 3.9 3.6
Depreciation and amortization expenses
41,114 31,295 5.2 5.2
General and administrative expenses
47,053 34,371 5.9 5.7

Subtotal operating expenses
759,164 568,302 33.6 95.8 94.1


Income from equity investees
20,940 16,903 2.6 2.8

Operating income
$ 54,203 $ 52,840 2.6 % 6.8 % 8.7 %



(1) As a percentage of related Company-operated retail revenues, store operating expenses were 37.2% for the 26 weeks ended April 1, 2007, and 37.7% for the 26 weeks ended April 2, 2006.

(2) As a percentage of related total specialty revenues, other operating expenses were 26.1% for the 26 weeks ended April 1, 2007, and 22.1% for the 26 weeks ended April 2, 2006.
International total net revenues increased 31% to $792 million for the 26 weeks ended April 1, 2007, compared to $604 million for the corresponding period of fiscal 2006.
International Company-operated retail revenues increased 33% to $674 million for the 26 weeks ended April 1, 2007, compared to $506 million for the corresponding period of fiscal 2006. The increase was primarily due to the opening of 237 new Company-operated retail stores in the last 12 months, comparable store sales growth of 8% for the 26 weeks ended April 1, 2007 and favorable foreign currency exchange for the British pound sterling. The increase in comparable store sales resulted from a 6% increase in the number of customer transactions coupled with a 2% increase in the average value per transaction.
Total International specialty revenues increased 20% to $119 million for the 26 weeks ended April 1, 2007, compared to $99 million in the corresponding period of fiscal 2006. The increase was primarily due to higher product sales and royalty revenues from opening 456 new licensed retail stores in the last 12 months and growth in new and existing foodservice accounts.
International operating income increased 3% to $54 million for the 26 weeks ended April 1, 2007, compared to $53 million in the corresponding period of fiscal 2006. Operating margin decreased to 6.8% of related revenues from 8.7% in the corresponding period of fiscal 2006, primarily due to higher cost of sales including occupancy costs, higher other operating expenses and higher general and administrative expenses. The increase in cost of sales including occupancy costs was primarily due to accounting corrections totaling $3.4 million in the first fiscal quarter, and to increased distribution costs due to the Company’s expanding store base and food programs. Higher other operating expenses and general and administrative expenses as a percentage of total net revenues resulted from increased payroll-related expenditures to support continued rapid international store growth.

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Global Consumer Products Group

26 Weeks Ended 26 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of CPG total net
revenues
Net revenues:

Specialty:

Licensing
$ 169,561 $ 158,736 6.8 % 100.0 % 100.0 %

Total specialty
169,561 158,736 6.8 100.0 100.0

Total net revenues
169,561 158,736 6.8 100.0 100.0


Cost of sales
101,196 91,957 59.7 57.9
Other operating expenses
13,136 8,764 7.8 5.6
Depreciation and amortization expenses
43 61 0.0 0.0

Subtotal operating expenses
114,375 100,782 13.5 67.5 63.5


Income from equity investees
24,074 22,651 14.2 14.3

Operating income
$ 79,260 $ 80,605 (1.7 %) 46.7 % 50.8 %

CPG total net revenues increased 7% to $170 million for the 26 weeks ended April 1, 2007, compared to $159 million for the corresponding period of fiscal 2006. The increase was primarily due to increased product sales and royalties in the International ready-to-drink business as well as an increase in product sales in the International packaged coffee and tea business through grocery and warehouse club channels.
CPG operating income decreased slightly to $79 million for the 26 weeks ended April 1, 2007, compared to $81 million for the corresponding period of fiscal 2006. Operating margin decreased to 46.7% of related revenues, from 50.8% in fiscal 2006, primarily due to higher other operating expenses and higher cost of sales. Other operating expenses increased primarily due to higher marketing expenditures to support continued international expansion of ready-to-drink beverages. Cost of sales increased primarily due to a shift in sales to higher cost products.
Unallocated Corporate

26 Weeks Ended 26 Weeks Ended
April 1, April 2, % April 1, April 2,
2007 2006 Change 2007 2006
As a % of total net
revenues
Depreciation and amortization expenses
$ 16,632 $ 17,222 0.4 % 0.4 %
General and administrative expenses
148,869 163,445 3.2 4.3

Operating loss
$ (165,501 ) $ (180,667 ) 8.4 % (3.6 %) (4.7 %)

Unallocated corporate expenses decreased to $166 million for the 26 weeks ended April 1, 2007, compared to $181 million in the corresponding period of fiscal 2006. The decrease was primarily due to higher provisions for incentive compensation in the prior year due to exceptional performance and unusually high charitable contributions in the prior year. These were partially offset by increased payroll-related expenditures and higher professional fees in support of continued global growth and systems infrastructure development. Total unallocated corporate expenses as a percentage of total net revenues decreased to 3.6% for the 26 weeks ended April 1, 2007, from 4.7% for the corresponding period of fiscal 2006.

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Liquidity and Capital Resources
The following table represents components of the Company’s most liquid assets (in thousands):

April 1, October 1,
2007 2006
Cash and cash equivalents
$ 200,179 $ 312,606
Short-term investments – available-for-sale securities
77,872 87,542
Short-term investments – trading securities
65,780 53,496
Long-term investments – available-for-sale securities
20,994 5,811



Total cash, cash equivalents and liquid investments
$ 364,825 $ 459,455


The Company manages its cash and cash equivalents, and liquid investments in order to internally fund operating needs and make scheduled payments on short-term borrowings.
The Company intends to use its cash and liquid investments, including any borrowings under its $1 billion commercial paper program, which is backstopped by the existing 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. Management believes that strong cash flow generated from operations, existing cash and liquid investments, as well as borrowing capacity under the commercial paper program should be sufficient to finance capital requirements for its core businesses for the foreseeable future. Depending on available liquidity and market conditions, Starbucks may repurchase shares of its common stock under its authorized share repurchase program. A portion of share repurchases in the past have been funded using the Company’s $1 billion credit facility. Outstanding borrowings under the facility were $847 million and letters of credit given were $13 million as of April 1, 2007, leaving $140 million of capacity under the facility. Accordingly, significant additional share repurchases in excess of cash flow will be limited in the absence of additional borrowing authorizations. Significant new joint ventures, acquisitions, and/or other new business opportunities may also require additional outside funding.
Other than for 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.
Cash provided by operating activities totaled $738 million for the 26 weeks ended April 1, 2007. Net earnings provided $356 million and the effect of noncash depreciation and amortization expenses further increased cash provided by operating activities by $235 million. In addition, growth in Starbucks Card balances provided $69 million in deferred revenue.
Cash used by investing activities for the 26 weeks ended April 1, 2007 totaled $591 million. Net capital additions to property, plant and equipment used $507 million, primarily from opening 671 new Company-operated retail stores and remodeling certain existing stores during the first half of fiscal 2007. This amount includes the effect of the net change in non-cash capital accruals totaling $54 million. During the 26 weeks ended April 1, 2007, the Company used $47 million, net of cash acquired, to purchase 90% equity ownership in the Company’s previously licensed operations in Beijing and Tianjin, China.
Cash used by financing activities for the 26 weeks ended April 1, 2007 totaled $262 million. Cash used to repurchase shares of the Company’s common stock totaled $563 million. This amount, and the effect of the net change in unsettled trades totaling $31 million from October 1, 2006, together represent the total accrual-based cost of the share repurchase program for the first half of fiscal 2007. 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. On May 1, 2007, the Starbucks Board of Directors authorized the repurchase of up to 25 million additional shares of the Company’s common stock. As of May 1, 2007, a total of up to 26.1 million shares remained available for repurchase, under the current and previous authorizations.
Partially offsetting cash used for share repurchases, were net borrowings under the Company’s revolving credit facility of $147 million during the 26 weeks ended April 1, 2007, which consisted of additional gross borrowings of $576 million offset by gross principal repayments of $429 million. In addition, there were proceeds of $108 million

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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.
Store Data
The following table summarizes the Company’s retail store information:

Net stores opened during the period
13-week period 26-week period Stores open as of
April 1, April 2, April 1, April 2, April 1, April 2,
2007 2006 2007 2006 2007 2006
United States:

Company-operated stores (1)
271 157 553 321 6,281 5,239
Licensed stores
142 132 365 330 3,533 2,765



413 289 918 651 9,814 8,004




International:

Company-operated stores (1)
42 54 118 114 1,553 1,316
Licensed stores (1)
105 81 252 219 2,361 1,905



147 135 370 333 3,914 3,221




Total
560 424 1,288 984 13,728 11,225




(1) International store data has been adjusted for the acquisition of the Beijing 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 plans to open approximately 2,400 new stores on a global basis in fiscal 2007. In the United States, Starbucks plans to open approximately 1,000 Company-operated locations and 700 licensed locations. In International markets, Starbucks plans to open approximately 300 Company-operated stores and 400 licensed stores.
Contractual Obligations
There have been no material changes during the period covered by this report, outside of the ordinary course of the Company’s business, to the contractual obligations specified in the table of contractual obligations included in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in the 10-K.
Off-Balance Sheet Arrangement
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 Japan. The guarantees continue until the loans, including accrued interest and fees, have been paid in full, with the final loan amount 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 April 1, 2007, the maximum amount of the guarantees was approximately $5.4 million. Since there has been no modification of these loan guarantees subsequent to the Company’s adoption of 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.
Commodity Prices, Availability and General Risk Conditions
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.

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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 the 10-K.
Seasonality and Quarterly Results
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.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), which seeks to reduce the diversity in practice associated with the accounting 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 is currently evaluating 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 generally accepted accounting principles 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 annual financial statements for fiscal years ending after November 15, 2006. The adoption of SAB 108 is not expected to have a significant impact on the Company’s consolidated financial statements.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits companies to choose to measure many financial instruments and certain other items at fair value. SFAS 159 is effective for financial statements issued for fiscal years beginning after November 15, 2007, or Starbucks first fiscal quarter of 2009. Early adoption is permitted. Starbucks has not yet determined if it will elect to apply any of the provisions of SFAS 159 and what the effect of adoption of the statement would have, if any, on its consolidated financial statements.

Fiserv, management's discussion

From Fiserv's 10-Q, dated May 3 2007:

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

We provide integrated information management systems and services, including transaction processing, business process outsourcing, document distribution services, and software and systems solutions. Our operations are primarily in the United States and consist of three business segments: Financial Institution Services (“Financial”); Insurance Services (“Insurance”); and Investment Support Services (“Investment”). The Financial segment provides account and transaction processing systems and services to financial institutions and other financial intermediaries. The Insurance segment provides a wide range of services to insurance carriers, agents, distributors, third-party administrators, and self-insured employers. The Investment segment provides administrative, custodial and processing services to individual investors, retirement plan and pension administrators, financial planners and investment advisors.

Management’s discussion and analysis of financial condition and results of operations is provided as a supplement to the accompanying unaudited condensed consolidated financial statements and accompanying notes to help provide an understanding of our results of operations, our financial condition and the changes in our financial condition. Our discussion is organized as follows:


•

Recent accounting pronouncements. This section provides a discussion of recent accounting pronouncements that may impact our results of operations and financial condition in the future.


•

Non-GAAP financial measures. This section provides a discussion of non-GAAP financial measures which we use in this report.


•

Results of operations. In this section, we provide an analysis of the results of operations presented in the accompanying unaudited condensed consolidated statements of income by comparing the results for the three-month period ended March 31, 2007 to the results for the three-month period ended March 31, 2006.


•

Liquidity and capital resources. In this section, we provide an analysis of our cash flows and outstanding debt as of March 31, 2007.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Both SFAS 157 and SFAS 159 are effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact that the adoption of SFAS 157 and SFAS 159 will have on our financial statements.



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Non-GAAP Financial Measures

In this report, we use two non-GAAP financial measures, internal revenue growth percentage and free cash flow. We use these measures to monitor and evaluate our performance, and they are presented in this report because we believe that they are useful to investors in evaluating our financial results. Non-GAAP financial measures should not be considered to be a substitute for the reported results prepared in accordance with GAAP. The methods that we use to calculate non-GAAP financial measures are not necessarily comparable to similarly titled measures presented by other companies.

We measure internal revenue growth percentage as the increase or decrease in total revenue for the current period less “acquired revenue from acquisitions” divided by total revenues from the prior period plus “acquired revenue from acquisitions.” “Acquired revenue from acquisitions” represents pre-acquisition revenue of acquired companies for the prior period. “Acquired revenue from acquisitions” was $37.0 million ($18.7 million in the Financial segment and $18.4 million in the Insurance segment) in the first quarter of 2007. Internal revenue growth percentage is a non-GAAP financial measure that we believe is useful to investors because it allows them to see the portion of our revenue growth that is attributed to acquired companies as compared to internal revenue growth.

We measure free cash flow as net income plus share-based compensation, depreciation and amortization, less capital expenditures, plus or minus changes in net working capital. Free cash flow is a non-GAAP financial measure that we believe is useful to investors because it shows our available cash flow after we have satisfied the capital requirements of our operations.

Results of Operations

The following table presents, for the periods indicated, certain amounts included in our condensed consolidated statements of income, the relative percentage that those amounts represent to revenues, and the change in those amounts from year to year. This information should be read along with the condensed consolidated financial statements and notes thereto.



Percentage
of Revenue Increase

Three months ended March 31,

(Dollars in millions)
2007 2006 2007 2006 $ %

Revenues:


Processing and services
$ 779.2 $ 761.0 63.9 % 69.4 % $ 18.1 2 %

Product
440.3 335.6 36.1 % 30.6 % 104.6 31 %


Total revenues
1,219.4 1,096.7 100 % 100 % 122.8 11 %


Expenses:


Cost of processing and services(1)
498.8 486.0 64.0 % 63.9 % 12.8 3 %

Cost of product(1)
369.8 272.1 84.0 % 81.1 % 97.7 36 %


Sub-total(2)
868.6 758.1 71.2 % 69.1 % 110.6 15 %


Selling, general and administrative(2)
157.4 145.7 12.9 % 13.3 % 11.8 8 %


Total expenses(2)
1,026.1 903.7 84.1 % 82.4 % 122.3 14 %


Operating income(2)
$ 193.4 $ 193.0 15.9 % 17.6 % $ 0.4 0 %

(1) Each percentage of revenue equals the relevant expense amount divided by the related component of total revenues.
(2) Each percentage of revenue equals the relevant expense or operating income amount divided by total revenues.



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Total Revenues

Total revenues increased $122.8 million, or 11%, in the first quarter of 2007 compared to the first quarter of 2006. The internal revenue growth rate was 8% in the first quarter of 2007 with the remaining growth resulting from acquisitions. Overall internal revenue growth was primarily derived from sales to new clients, cross-sales to existing clients and increases in transaction volumes from existing clients partially offset by a $29.7 million decrease in flood claims processing revenues.

Processing and services revenues increased 2% in the first quarter of 2007 compared to the first quarter of 2006. This increase was primarily driven by sales to new clients, cross-sales to existing clients, increases in transaction volumes from existing clients and incremental revenue attributable to several acquisitions, offset by a decrease in flood claims processing revenues. Product revenues increased 31% in the first quarter of 2007 compared to the first quarter of 2006. This increase was primarily due to new clients in the pharmacy management and workers' compensation businesses. The revenue growth in the pharmacy management and workers' compensation businesses was impacted significantly by the inclusion of prescription product costs in both revenues and expenses of $220 million and $154 million in the first quarters of 2007 and 2006, respectively.

Total Expenses

Total expenses increased $122.3 million, or 14%, in the first quarter of 2007 compared to the first quarter of 2006. Cost of processing and services as a percentage of processing and services revenue remained relatively consistent in the first quarter of 2007 compared to the first quarter of 2006. Cost of product increased as a percentage of product revenue from 81.1% in the first quarter of 2006 to 84.0% in the first quarter of 2007, primarily due to the significant increase in prescription product costs as discussed above. Selling, general and administrative expenses as a percentage of total revenues were relatively consistent as a percentage of total revenues in the first quarters of 2007 and 2006.

Operating Income and Operating Margin

Operating income increased $0.4 million in the first quarter of 2007 compared to the first quarter of 2006, and operating margins decreased 1.7 percentage points from 17.6% in the first quarter of 2006 to 15.9% in the first quarter of 2007. Operating income and margins in the first quarter of 2007 were negatively impacted by a $29.7 million decrease in higher-margin flood claim processing revenues and a significant increase in revenues in the pharmacy management and workers' compensation businesses, which generate operating margins in the low- to mid-single digits. The inclusion of prescription product costs in both revenues and expenses reduced operating margins by approximately 3 percentage points in the first quarters of 2007 and 2006. Partially offsetting these factors were increases in higher-margin revenues and improvements in operating efficiencies within our bank core processing and payments businesses and an increase in contract termination fees. The Financial segment businesses generally enter into three to five year contracts with clients that contain early contract termination fees. These fees are generated when a contract is terminated or when an existing client is acquired by another financial institution and can vary significantly from period to period based on the number and size of clients that pay these fees and on how early in the contract term the fee is payable. Contract termination fees totaled $9.0 million and $3.9 million in the first quarter of 2007 and 2006, respectively.



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Table of Contents

Segment Results

The following table presents, for the periods indicated, revenues, operating income and operating margin for our business segments.




Three months ended March 31,

(Dollars in millions)
Financial Insurance Investment Total

Total revenues:


2007
$ 767.3 $ 417.7 $ 34.4 $ 1,219.4

2006
699.9 362.5 34.3 1,096.7


Operating income:


2007
$ 159.9 $ 27.9 $ 5.5 $ 193.4

2006
130.2 56.7 6.0 193.0


Operating margin:


2007
20.8 % 6.7 % 16.0 % 15.9 %

2006
18.6 % 15.7 % 17.6 % 17.6 %


Revenue growth
10 % 15 % 0 % 11 %

Operating income growth (decline)
23 % (51 %) (8 %) 0 %

Operating margin growth (decline) (1)
2.2 % (9.0 %) (1.6 %) (1.7 %)
(1) Represents the percentage point improvement or decline in operating margin.

Financial

Revenues in the Financial segment increased by $67.4 million, or 10%, in the first quarter of 2007 compared to the first quarter of 2006. The internal revenue growth rate in the Financial segment was 7% in the first quarter of 2007 with the remaining growth resulting from acquisitions. Internal revenue growth in the Financial segment was primarily driven by increased volumes, new clients and cross-sales to existing clients in the bank core processing, payments and output solutions businesses.

Operating income in the Financial segment increased $29.8 million from $130.2 million in the first quarter of 2006 to $159.9 million in the first quarter of 2007. Operating margins improved 2.2 percentage points from 18.6% in the first quarter of 2006 to 20.8% in the first quarter of 2007. The increases in operating income and operating margins within the Financial segment resulted primarily from increased higher-margin revenues and operating efficiencies in our depository institution core processing and payments businesses and an increase in contract termination fees.

Insurance

Revenues in the Insurance segment increased by $55.3 million, or 15%, in the first quarter of 2007 compared to the first quarter of 2006. The internal revenue growth rate in this segment for the first quarter of 2007 was 10% with the remaining growth resulting from acquisitions. The internal revenue growth was primarily driven by new clients in the pharmacy management and workers' compensation businesses partially offset by a $29.7 million decrease in flood claims processing revenues from $30.3 million in the first quarter of 2006 to $0.6 million in the first quarter of 2007.

Operating income in the Insurance segment decreased $28.8 million from $56.7 million in the first quarter of 2006 to $27.9 million in the first quarter of 2007. Operating margins declined 9.0 percentage points from 15.7% in the first quarter of 2006 to 6.7% in the first quarter of 2007. The decreases in operating income and operating margins within the Insurance segment resulted primarily from a decrease in higher-margin flood claims processing revenues. Additionally, operating margins were negatively impacted by the significant increase in revenues in the pharmacy management and workers' compensation businesses, which generate operating margins in the low- to mid-single digits, and expenses in the health division associated with our consumer directed and business process outsourcing initiatives. The inclusion of prescription product costs in both revenues and expenses negatively impacted operating margins in the Insurance segment by approximately 7 percentage points in the first quarter of 2007 and approximately 12 percentage points in the first quarter of 2006.



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Investment

Total revenues in the Investment segment remained relatively consistent in the first quarter of 2007 as compared to the first quarter of 2006. Operating margins in the Investment segment were 16.0% in the first quarter of 2007 and 17.6% in the first quarter of 2006.

Interest Expense, Net

Interest expense increased $2.3 million in the first quarter of 2007 as compared to the first quarter of 2006 due primarily to rising interest rates and increased average borrowings outstanding.

Income Tax Provision

The effective income tax rate was 38.6% in the first quarter of 2007 and 37.8% in the first quarter of 2006. The effective income tax rate in the first quarter of 2006 was favorably impacted by the finalization of various tax returns. We expect that the effective income tax rate for the remainder of 2007 will be 38.5%.

Diluted Net Income Per Share

Diluted net income per share was $0.66 in the first quarter of 2007 compared to $0.64 in the first quarter of 2006. Diluted net income per share in the first quarter of 2007 compared to 2006 was positively impacted by strong operating income growth in the Financial segment and negatively impacted by a decline in operating income in the Insurance segment, primarily due to a significant decrease in higher-margin flood claims processing revenues.

Liquidity and Capital Resources

The following table summarizes our free cash flow:




Three months ended March 31,

(In millions)
2007 2006

Net income
$ 113.6 $ 116.2

Share-based compensation
11.0 13.8

Depreciation and amortization
50.3 47.4

Capital expenditures
(48.9 ) (47.2 )


Free cash flow before changes in working capital
125.9 130.2

Changes in working capital, net
(4.4 ) 13.1


Free cash flow
$ 121.5 $ 143.3


Free cash flow of $121.5 million in the first quarter of 2007 decreased $21.8 million compared to the first quarter of 2006 primarily due to the negative impact of net working capital items of $4.4 million in 2007 compared to a positive impact of $13.1 million in 2006.

In the first quarter of 2007, we used our free cash flow and borrowings under our revolving credit facility and commercial paper program primarily to repurchase 2.7 million shares of our common stock for $141.8 million and to fund acquisition related payments of $43.4 million. On January 31, 2007, our board of directors authorized the repurchase of up to 10 million additional shares of our common stock. Share repurchases under the authorizations are expected to be made through open market transactions as market conditions warrant. Shares repurchased have historically been held for issuance in connection with acquisitions and equity plans. Our current policy is to use our free cash flow to support future business opportunities and to repurchase shares of our common stock, rather than to pay dividends.

At March 31, 2007, we had $821.9 million of long-term debt of which $522.4 million was outstanding under our revolving credit and commercial paper facilities. We maintain a $500 million unsecured commercial paper program, which is exempt from registration under the Securities Act of 1933. Under this program, we may issue commercial paper with maturities of up to 397 days from the date of issuance. We also maintain a $900 million unsecured revolving credit facility with a syndicate of banks. We may increase the availability under this facility up to $1.25 billion at our discretion, subject to a number of conditions, including the absence of any default under the credit agreement. The revolving credit facility supports 100% of our outstanding commercial paper. As a result, borrowings under the commercial paper program reduce the amount of credit available under the revolving credit facility. The revolving credit facility contains various restrictions and covenants. Among other requirements, our consolidated indebtedness is limited to no more than three and one-half times consolidated net earnings before interest, taxes, depreciation and amortization. The facility expires on March 24, 2011. We were in compliance with all debt covenants throughout the first quarter of 2007.



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We believe that our cash flow from operations together with other available sources of funds will be adequate to meet our operating requirements, required operating lease payments, required repayments of long-term debt, and expected capital spending needs in 2007. At March 31, 2007, we had approximately $370 million available for borrowing under our credit and commercial paper facilities and $201 million of cash and cash equivalents. In the event that we make significant future acquisitions, we may raise funds through additional borrowings or the issuance of common shares.

Historically, our growth has been accomplished, to a significant degree, through the acquisition of businesses that are complementary to our operations. We expect to continue to pursue acquisition candidates that we believe would enhance our competitive position.

L-3 Communications Holdings, management discussion

From the 10-Q, dated May 7th:

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS

Financial Section Roadmap

The financial section includes management’s discussion and analysis (MD&A), our unaudited condensed consolidated financial statements and notes to those financial statements. The MD&A can be found on pages 25 to 34, the unaudited condensed financial statements and related notes can be found on pages 1 to 24. The following table is designed to assist in your review of MD&A.


Topic Location
Overview and Outlook
L-3’s Business Page 25
Key Performance Measures Page 26
Business Acquisitions Page 27
Results of Operations, including business segments Page 27 - 31
Liquidity and Capital Resources:
Anticipated Sources of Cash Flow Page 31
Balance Sheet Page 31 - 32
Statement of Cash Flows Page 33 - 34
Legal Proceedings and Contingencies Page 34

Overview and Outlook

L-3’s Business

L-3 is a prime system contractor in aircraft modernization and maintenance, Command, Control, Communications, Intelligence, Surveillance and Reconnaissance (C3ISR) systems and government services. L-3 is also a leading provider of high technology products, subsystems and systems. Our customers include the U.S. Department of Defense (DoD) and its prime contractors, the U.S. Department of Homeland Security (DHS), U.S. Government intelligence agencies, major aerospace and defense contractors, allied foreign government ministries of defense, commercial customers and certain other U.S. federal, state and local government agencies. Our sales to the DoD represented approximately 73% of our total sales in 2006. Our remaining sales in 2006 were composed of approximately 7% to non-DoD U.S. Government customers, including federal, state and local agencies, approximately 7% to allied foreign governments, and approximately 13% to commercial customers, both domestic and foreign.

We have the following four reportable segments: (1) C3ISR, (2) Government Services, (3) Aircraft Modernization and Maintenance (AM&M), and (4) Specialized Products. Financial information for our reportable segments is included in Note 15 to our unaudited condensed consolidated financial statements.

The C3ISR reportable segment provides products and services for the global ISR market and secure networked communication systems and equipment. We believe that these products and services are critical elements for a substantial number of major command, control, communication, intelligence gathering and space systems. These products and services are used to connect a variety of airborne, space, ground and sea-based communication systems and are used in the transmission, processing, recording, monitoring and dissemination functions of these communication systems. The Government Services reportable segment provides communications systems support and engineering services, information technology services, teaching and training services, leadership development, logistics support, intelligence support and analysis and other technical services. The AM&M reportable segment provides specialized aircraft modernization, upgrades and sustainment, maintenance and logistics support services. The Specialized Products reportable segment provides a broad range of products, including power and control systems, microwave components, simulation and training, electro-optic/infrared (EO/IR) products, precision engagement, aviation and display products, telemetry products, security and detection systems, combat propulsion systems and undersea warfare products.

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Key Performance Measures

The key financial performance measures that L-3 uses to manage its businesses and monitor results of operations are sales growth and operating margin. We define organic sales growth as the increase or decrease in sales for the current period compared to the prior period, excluding sales in the current period from business acquisitions that have been included in L-3’s actual results of operations for less than twelve months. Combined, these financial performance measures are the primary drivers of L-3’s operating income, earnings and net cash from operating activities. We define operating margin as operating income as a percentage of sales. L-3’s business strategy continues to be focused on increasing sales from organic growth and select business acquisitions that add new products, technologies, programs or customers in areas that complement L-3’s existing businesses. The larger portion of our historical sales growth has been from business acquisitions. We made our largest acquisition on July 29, 2005, when we acquired The Titan Corporation (Titan) for a purchase price of approximately $2.8 billion. We expect that our sales growth from business acquisitions will decline from our historical levels for the foreseeable future. The aggregate size of our most recent business acquisitions are not as large as Titan, and we do not expect to acquire businesses as large as Titan in the foreseeable future.

Sales Growth. For the five years ended December 31, 2006, our compounded annual growth rate for our consolidated sales was 32.8% and our average annual organic sales growth was approximately 11%. Sales growth for the three months ended March 31, 2007 (2007 First Quarter) was 13.6%, including organic sales growth of 9.1%, and sales growth from business acquisitions of 4.5%.

Our World Wide Linguist Support Services contract (Linguist Contract) with the U.S. Army generated sales of $174 million for the 2007 First Quarter. In March 2007, the U.S. Army amended the Linguist Contract. The amendment provides for three contract options, each with a three-month period of performance. The first option was exercised extending the contract to June 9, 2007. As previously disclosed, the U.S. Army did not select our proposal for the Translation and Interpretation Management Services (TIMS) contract, and, on December 22, 2006, we filed a protest with the U.S. Government Accountability Office (GAO). On March 29, 2007, our protest challenging the evaluation and selection decision for the TIMS contract was sustained by the GAO. The U.S. Army has 60 days to respond to the GAO’s recommendation. The U.S. Army has asked the GAO to reconsider its decision. The TIMS contract is the successor contract to the Linguist Contract to provide translators and linguists in support of the U.S. military operations in Iraq. We can provide no assurances about the outcome of our protest of the TIMS contract and whether the Linguist Contract will be extended beyond June 9, 2007.

We, as most U.S. defense contractors, have benefited from the upward trend in overall DoD spending over recent years. The Bush Administration’s fiscal year 2008 DoD budget request, including a fiscal year 2008 Global War on Terror (GWOT) supplemental request and the President’s five-year Defense Plan, indicates a slower rate of growth is unlikely until after 2008. We believe that our businesses should be able to continue to generate organic sales growth after 2008 as we anticipate the defense budget will continue its focus on areas that match certain of the core competencies of L-3: C3ISR, precision-guided weapons, network-centric communications, special operations forces (SOF), government services and training and simulation. Additionally, the increased DoD spending during recent years has included supplemental appropriations for military operations in Iraq, Afghanistan and the GWOT.

Operating Margin. Our operating margin was 9.9% for the 2007 First Quarter and the three months ended March 31, 2006 (2006 First Quarter). As described more fully in Reportable Segment Results of Operations, operating margins improved in three of the company’s business segments resulting from improved contract performance, higher sales volume and lower indirect costs. The improvements were primarily offset by lower margins in the C3ISR segment primarily due to lower secure terminal equipment (STE) sales and higher development costs for new products. Over the next year, we expect to generate modest improvements in operating margin as we expect to continue to increase sales volume, reduce indirect costs and improve our overall contract performance. However, future business acquisitions and future new business, including the Linguist Contract if extended, could reduce our future operating margins, if they have margins lower than L-3’s existing operating margin. One of our business objectives is to sustainably grow operating income, earnings and cash flow, and improving operating margins is a primary consideration for achieving this growth, but it is not the only consideration.

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Business Acquisitions

Our Annual Report on Form 10-K for the fiscal year ended December 31, 2006 summarizes the business acquisitions that we completed through the end of last year. Also see Note 3 to our unaudited condensed consolidated financial statements contained in this quarterly report. During the 2007 First Quarter, we used $22.0 million of cash in the aggregate to acquire a business and pay the remaining contractual purchase price for our TRL Electronics plc (TRL) acquisition.

All of our business acquisitions are included in our consolidated results of operations from their dates of acquisition. We regularly evaluate potential business acquisitions. On May 4, 2007, we acquired Global Communication Solutions, Inc. (GCS) with cash on hand. GCS has annual sales of approximately $90 million.

Results of Operations

The following information should be read in conjunction with our unaudited condensed consolidated financial statements contained in this quarterly report. Our results of operations for the periods presented can be affected significantly by our business acquisitions. See Note 4 to our audited consolidated financial statements for the year ended December 31, 2006, included in our Annual Report on Form 10-K, for a discussion of our 2006 business acquisitions and Note 3 to our unaudited condensed consolidated financial statements for the 2007 First Quarter, included in this report for a discussion of our business acquisitions during the 2007 First Quarter.

Three Months Ended March 31, 2007 Compared with Three Months Ended March 31, 2006

Consolidated Results of Operations

The table below provides selected financial data for L-3 for the 2007 First Quarter and 2006 First Quarter.


Three Months Ended
March 31,
2007 2006
($ in millions, except per
share data)
Net sales $ 3,299.7 $ 2,903.8
Operating income $ 326.1 $ 288.4
Operating margin 9.9 % 9.9 %
Interest and other income, net $ 5.1 $ 5.9
Interest expense $ 73.0 $ 71.9
Effective income tax rate 36.6 % 36.9 %
Net income $ 162.1 $ 138.9
Diluted shares 126.0 123.3
Diluted earnings per share $ 1.29 $ 1.13

Net sales: For the 2007 First Quarter, consolidated net sales increased by $395.9 million, or 13.6%, to $3,299.7 million, compared to consolidated net sales of $2,903.8 million for the 2006 First Quarter. Consolidated organic sales growth of 9.1%, or $265.4 million, was driven primarily by strong demand for government services, aircraft modernization, base support operations, intelligence, surveillance and reconnaissance (ISR) systems, secure networked communications products and several specialized products, including power and control systems, propulsion systems, EO/IR and precision engagement products. The increase in consolidated net sales from acquired businesses was $130.5 million, or 4.5%. Sales from services increased by $137.2 million to $1,704.8 million for the 2007 First Quarter, compared to $1,567.6 million. The increase in service sales was primarily due to organic sales growth in the Government Services reportable segment. Sales from products increased by $258.7 million to $1,594.9 million for the 2007 First Quarter, compared to $1,336.2 million. The increase in product sales was primarily due to organic sales growth in several product areas in the Specialized Products and C3ISR reportable segments. See the reportable segment discussions below for a quantitative analysis of our organic sales growth.

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Operating income and operating margin: Consolidated operating income increased by $37.7 million, or 13.1%, to $326.1 million for the 2007 First Quarter, compared to $288.4 million for the 2006 First Quarter. Operating margin remained at 9.9%. Operating margins improved in three of our business segments resulting from improved contract performance, higher sales volume and lower indirect costs. The improvements were primarily offset by lower margins in the C3ISR segment primarily due to lower secure terminal equipment (STE) sales and higher development costs for new products. The changes in operating margin are further explained in our reportable segment results discussed below.

Interest and other income, net: Interest and other income was $5.1 million for the 2007 First Quarter, compared to $5.9 million for the 2006 First Quarter. The 2006 First Quarter included $4 million of interest income on the settlement of a claim.

Interest expense: Interest expense for the 2007 First Quarter increased by $1.1 million, or 1.5%, to $73.0 million, compared to $71.9 million for the 2006 First Quarter.

Effective income tax rate: The effective income tax rate for the 2007 First Quarter decreased to 36.6% from 36.9% for the 2006 First Quarter primarily due to the retroactive enactment of the U.S. Federal income tax credits for research and experimentation activities in the fourth quarter of 2006.

Diluted Shares Outstanding: Diluted shares outstanding for the 2007 First Quarter increased by 2.7 million shares to 126.0 million shares from 123.3 million shares for the 2006 First Quarter. The increase was primarily due to more shares of common stock outstanding because of shares issued in connection with our various employee stock based compensation programs and contributions to employee savings plans made in common stock. These increases were partially offset by purchases of common stock in connection with our share repurchase program that was authorized by L-3’s Board of Directors in December 2006.

Diluted earnings per share and net income: Diluted EPS increased by $0.16, or 14.2%, to $1.29 per share for the 2007 First Quarter, compared to $1.13 per share for the 2006 First Quarter. Net income for the 2007 First Quarter increased by $23.2 million, or 16.7%, to $162.1 million, compared to $138.9 million for the 2006 First Quarter.

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Reportable Segment Results of Operations

The table below presents selected data by reportable segment reconciled to consolidated totals. See Note 15 to our unaudited condensed consolidated financial statements contained in this quarterly report for our reportable segment data.


Three Months Ended
March 31,
2007 2006
(dollars in millions)
Net sales:(1)
C3ISR $ 553.8 $ 466.7
Government Services 1,028.0 898.8
AM&M 636.9 561.8
Specialized Products 1,081.0 976.5
Consolidated net sales $ 3,299.7 $ 2,903.8
Operating income:
C3ISR $ 49.7 $ 53.5
Government Services 92.1 76.8
AM&M 62.2 51.4
Specialized Products 122.1 106.7
Consolidated operating income $ 326.1 $ 288.4
Operating margin:
C3ISR 9.0 % 11.5 %
Government Services 9.0 % 8.5 %
AM&M 9.8 % 9.1 %
Specialized Products 11.3 % 10.9 %
Consolidated operating margin 9.9 % 9.9 %

(1) Net sales are after intersegment eliminations.

C3ISR


Three Months Ended
March 31, Increase /
(decrease)
2007 2006
Net sales $ 553.8 $ 466.7 $ 87.1
Operating income 49.7 53.5 (3.8 )
Operating margin 9.0 % 11.5 % (2.5 )ppts

C3ISR net sales for the 2007 First Quarter increased by 18.7% compared to the 2006 First Quarter. Organic sales growth was $58.8 million, or 12.6%, reflecting an increase in sales of $64.7 million, primarily related to strong demand from the DoD for secure networked communications products and ISR systems. This increase was partially offset by lower sales volume of $5.9 million for STE, a product with declining demand as it continues to approach full deployment in the marketplace. The increase in net sales from acquired businesses was 6.1%, primarily due to the acquisition of TRL on July 12, 2006.

C3ISR operating income for the 2007 First Quarter decreased by 7.1% compared to the 2006 First Quarter, primarily due to lower operating margin, which was partially offset by higher sales volume. Operating margin for the 2007 First Quarter decreased by 2.8 percentage points, primarily due to a decrease in higher margin STE sales, increased sales volume on contracts with greater material content and complex work scope which generated lower margin, and higher development costs for new secure communications products. These decreases were partially offset by the TRL acquired business, which increased operating margin by 0.3 percentage points.

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Government Services


Three Months Ended
March 31, Increase /
(decrease)
2007 2006
Net Sales $ 1,028.0 $ 898.8 $ 129.2
Operating income 92.1 76.8 15.3
Operating margin 9.0 % 8.5 % 0.5 ppts

Government Services net sales for the 2007 First Quarter increased by 14.4% compared to the 2006 First Quarter. Organic sales growth was $129.0 million, or 14.4%, primarily due to (1) increased sales volume of $82.1 million on existing contracts and recent new business awards for linguist, intelligence, training, and law enforcement services to support the U.S. military operations in Iraq and Afghanistan as well as the broader global war on terrorism and (2) $46.9 million of higher sales for communication software support, systems engineering, and other technical services to support U.S. Army communications and surveillance activities, and enterprise information technology support services for the U.S. Special Operation Forces Command because of growth on existing contracts and a recent new contract award.

Government Services operating income for the 2007 First Quarter increased by 19.9% compared to the 2006 First Quarter. The increase in operating income was primarily due to higher sales volume and higher operating margin. Operating margin increased by 0.5 percentage points due to improved contract performance and lower indirect costs.

Aircraft, Modernization and Maintenance (AM&M)


Three Months Ended
March 31, Increase /
(decrease)
2007 2006
Net sales $ 636.9 $ 561.8 $ 75.1
Operating income 62.2 51.4 10.8
Operating margin 9.8 % 9.1 % 0.7 ppts

AM&M net sales for the 2007 First Quarter increased by 13.4% compared to the 2006 First Quarter. Organic sales growth was $42.8 million, or 7.6%, driven primarily by increased volume of $61.3 million for base support operations related to continued support of U.S. military operations in Iraq and Afghanistan, growth in the Canadian Maritime Helicopter Program, and recent new business awards to maintain U.S. Navy E-6B aircraft and to modify C-130 aircraft for certain foreign government customers. These increases were partially offset by a decline of $18.5 million in aircraft support services sales, primarily due to a competitive loss of a contract in June 2006 to provide maintenance and support services for U.S. Navy fixed-wing training aircraft. The increase in net sales from acquired businesses was 5.8%, primarily due to the acquisition of Crestview Aerospace Corporation on June 29, 2006.

AM&M operating income for the 2007 First Quarter increased by 21.0% compared to the 2006 First Quarter. The increase in operating income was due to higher sales and higher operating margin. Operating margin increased by 0.9 percentage points, primarily due to improved performance on certain aircraft modernization contracts, partially offset by severance costs of $2 million related to certain administrative consolidation activities that began in the fourth quarter of 2006. The increase in margin was partially offset by acquired businesses, which reduced operating margin by 0.2 percentage points.

Specialized Products


Three Months Ended
March 31, Increase /
(decrease)
2007 2006
Net sales $ 1,081.0 $ 976.5 $ 104.5
Operating income 122.1 106.7 15.4
Operating margin 11.3 % 10.9 % 0.4 ppts

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Specialized Products net sales for the 2007 First Quarter increased by 10.7% compared to the 2006 First Quarter. The increase in net sales from acquired businesses was 7.1%, mainly due to the acquisitions of SAM Electronics GmbH (SAM) on January 31, 2006, and SSG Precision Optronics, Inc. and Nautronix Defence Group on June 1, 2006. Organic sales growth was $34.8 million, or 3.6%, primarily due to higher sales volume of (1) $31.3 million for power and control systems products due to recent new business awards from the U.S. Navy for power conversion and switching products and higher volume from commercial ship builders, (2) $22.1 million for combat vehicle propulsion systems for U.S. military reset and replacement of equipment consumed in the U.S. military operations in Iraq, (3) $12.7 million for airport security products due to procurement of explosive detection systems by the U.S. Transportation Security Administration, (4) $16.6 million for EO/IR and precision engagement products primarily related to new business wins in 2006 and (5) $5.1 million primarily for undersea warfare products. These increases were partially offset by a decline in sales volume of $53.0 million primarily for simulation devices and microwave products due to timing of certain deliveries, which are expected to occur after March 31, 2007.

Specialized Products operating income for the 2007 First Quarter increased by 14.4% compared to the 2006 First Quarter. The increase in operating income was due to higher sales volume and higher operating margin. Operating margin for the 2007 First Quarter increased by 1.2 percentage points, primarily because of improved contract performance and lower indirect costs for several business areas, including Displays, EO/IR and aviation products. These increases were partially offset by acquired businesses, which reduced operating margin by 0.8 percentage points.

Liquidity and Capital Resources

Anticipated Sources of Cash Flow

Our primary source of liquidity is cash flow generated from operations. We also have funds available to use under our revolving credit facility, subject to certain conditions. We believe that our cash from operating activities, together with available borrowings under the revolving credit facility, will be adequate to meet our anticipated requirements for working capital, capital expenditures, defined benefit plan contributions, commitments, contingencies, research and development expenditures, contingent purchase price payments on previous business acquisitions, program and other discretionary investments, interest payments, L-3 Holdings’ dividends and share repurchase plan for the foreseeable future. There can be no assurance, however, that our business will continue to generate cash flow at current levels, or that currently anticipated improvements will be achieved. If we are unable to generate sufficient cash flow from operations to service our debt, we may be required to sell assets, reduce capital expenditures, refinance all or a portion of our existing debt or obtain additional financing. Our ability to make scheduled principal payments or to pay interest on or to refinance our indebtedness depends on our future performance and financial results, which, to a certain extent, are subject to general conditions in or affecting the defense industry and to general economic, political, financial, competitive, legislative and regulatory factors beyond our control. There can be no assurance that sufficient funds will be available to enable us to service our indebtedness, to pay dividends, to repurchase shares of L-3 Holdings common stock, to make necessary capital expenditures and to make discretionary investments.

Balance Sheet

Contracts in process increased by $104.0 million to $3,374.1 million at March 31, 2007 from $3,270.1 million at December 31, 2006. The increase included (1) $73.5 million to support the Company’s recent and near-term anticipated organic sales growth as discussed below, including organic sales growth of $265.4 million for the 2007 First Quarter, (2) $24.7 million primarily to reclassify certain non-current assets to receivables on a contract based on the anticipated invoicing dates at March 31, 2007 and (3) $5.8 million of acquired receivables and inventory balances from business acquisitions.

Unbilled contract receivables increased by $62.6 million due to sales exceeding billings for combat vehicle propulsion systems, the Linguist Contract, aircraft modernization and power and control systems sold to commercial shipbuilders, partially offset by collections of progress payments on microwave

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products for contract performance milestones that have not been delivered. Billed receivables decreased by $20.9 million primarily due to collections for combat vehicle propulsion systems, aircraft support services and secure communications products. These decreases were partially offset by billings for government services. Inventoried contract costs increased by $15.0 million, primarily for aircraft support services and secure networked communications. These increases were partially offset by deliveries of ISR systems and combat vehicle propulsion systems. Inventories at lower of cost or market increased by $16.8 million primarily due to timing of deliveries for microwave products expected to occur during the year.

L-3’s receivables days sales outstanding (DSO) was 72 at March 31, 2007, compared with 72 at December 31, 2006 and 77 at March 31, 2006. We calculate our DSO by dividing (1) our aggregate end of period billed receivables and net unbilled contract receivables, by (2) our trailing 12 month sales adjusted, on a pro forma basis, to include sales from business acquisitions that we completed as of the end of the period multiplied by 365. Our trailing 12 month pro forma sales were $12,945 million at March 31, 2007, $12,657 million at December 31, 2006 and $11,568 million at March 31, 2006.

The increase in other current assets was primarily due to annual insurance premiums paid during the 2007 First Quarter. The decrease in property, plant and equipment (PP&E) during the 2007 First Quarter was principally due to depreciation expense in excess of capital expenditures during the 2007 First Quarter. The percentage of depreciation expense to average gross PP&E remained at 2.8% for the 2007 First Quarter compared to the 2006 First Quarter. We did not change any of the depreciation methods or assets estimated useful lives that L-3 uses to calculate its depreciation expense.

Goodwill increased by $27.6 million to $7,897.9 million at March 31, 2007 from $7,870.3 million at December 31, 2006. The increase related to business acquisitions is comprised of an increase of $14.6 million for a business acquisition completed during the 2007 First Quarter, partially offset by a decrease of $10.8 million relating to completion of final estimates of the fair value for assets acquired, and liabilities assumed, in connection with certain businesses acquired prior to January 1, 2007 and for final purchase price determinations. Additionally, goodwill increased by $7.0 million due to foreign currency translation and by $16.8 million due to the adoption of FASB Interpretation No. 48 ‘‘Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement 109’’ during the 2007 First Quarter. See Note 10 to our unaudited condensed consolidated financial statements for the 2007 First Quarter.

The decrease in other assets was primarily due to balance sheet classification adjustments to contracts in process as discussed above.

The increase in accounts payable was primarily due to the timing of payments for purchases from third-party vendors and subcontractors. The decrease in accrued employment costs was due to the timing of payroll dates for salaries and wages, and the payment to employees of 2006 management incentive bonuses. The increase in accrued expenses was primarily due to the timing of invoices received for subcontractor services. The decrease in advance payments and billings in excess of costs was primarily due to revenue recognized on contracts with foreign customers for aircraft modernization and the U.S. Transportation Security Agency (TSA) for airport security products.

The decrease in pension and postretirement benefit plan liabilities was primarily due to a $57.2 million reduction of liabilities in connection with the adoption of the measurement date provisions of SFAS 158, which requires us to use December 31 as the measurement date for all of our benefit plans. We previously used November 30 as the measurement date. The decrease was partially offset by pension expenses in excess of cash contributions during the 2007 First Quarter. See Note 13 to our unaudited condensed consolidated financial statements for the three months ended March 31, 2007, included in this report for a discussion of the impact of SFAS 158 on retained earnings.

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Statement of Cash Flows

Three Months Ended March 31, 2007 Compared with Three Months Ended March 31, 2006

We had cash and cash equivalents of $387.1 at March 31, 2007 and $348.2 million at December 31, 2006. The table below provides a summary of our cash flows for the periods indicated.


Three Months Ended
March 31,
2007 2006
(dollars in million)
Net cash from operating activities $ 223.9 $ 187.5
Net cash used in investing activities (49.2 ) (437.2 )
Net cash (used in) from financing activities (135.8 ) 28.4
Net increase (decrease) in cash $ 38.9 $ (221.3 )

Operating Activities

We generated $223.9 million of cash from operating activities during the 2007 First Quarter, an increase of $36.4 million compared with $187.5 million generated during the 2006 First Quarter due to (1) an increase in net income of $23.2 million and (2) an increase of $24.4 million because of less cash used for changes in operating assets and liabilities. These increases were partially offset by lower non-cash expenses of $11.2 million comprised of lower deferred income tax expense of $19.3 million, partially offset by $8.1 million primarily for higher depreciation expense. The cash generated from changes in operating assets and liabilities is discussed above under ‘‘Liquidity and Capital Resources — Balance Sheet.’’

Investing Activities

During the 2007 First Quarter, we used $22.0 million of cash in the aggregate to acquire a business and pay the remaining contractual price for the TRL acquisition.

Financing Activities

Debt

Senior Credit Facility. Our senior credit facility provides for a term loan facility and a $1.0 billion revolving credit facility.

At March 31, 2007, borrowings under the term loan facility were $650.0 million, and available borrowings under our revolving credit facility were $923.3 million, after reduction for outstanding letters of credit of $76.7 million. There were no outstanding revolving credit borrowings under our senior credit facility at March 31, 2007. Total debt outstanding was $4,535.3 at March 31, 2007, compared to $4,535.0 million at December 31, 2006. On April 3, 2007, we issued a standby letter of credit in the amount of $138.8 million, which reduced the available borrowings under our revolving credit facility by the same amount, as security in connection with a filing of a Notice of Appeal related to an adverse jury verdict previously rendered against the Company. See Note 12 to our unaudited condensed consolidated financial statements contained in this quarterly report.

Debt Covenants and Other Provisions. The senior credit facility and senior subordinated notes agreements contain financial covenants and other restrictive covenants. See Note 9 to our audited consolidated financial statements for the year ended December 31, 2006, included in our Annual Report on Form 10-K for a description of our debt and related financial covenants, including dividend payment restrictions and cross default provisions, under our senior credit facility. As of March 31, 2007, we were in compliance with our financial and other restrictive covenants.

The borrowings under the senior credit facility are guaranteed by L-3 Holdings and by substantially all of the material wholly-owned domestic subsidiaries of L-3 Communications on a senior basis. The

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payment of principal and premium, if any, and interest on the senior subordinated notes are unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally, by substantially all of L-3 Communications’ wholly-owned domestic subsidiaries. The guarantees of the senior subordinated notes rank pari passu with one another and are junior to the guarantees of the senior credit facility. The payment of principal and premium, if any, and interest on the CODES are fully and unconditionally guaranteed, on an unsecured senior subordinated basis, jointly and severally by certain of L-3 Holdings’ wholly-owned domestic subsidiaries. The guarantees of the CODES rank pari passu with all of the guarantees of the senior subordinated notes and are junior to the guarantees of the senior credit facility.

Equity

During December 2006, the Company’s Board of Directors authorized a program to repurchase up to $500 million of its outstanding shares of common stock through December 31, 2008. Under this program, repurchases may be made from time to time in the open market, pursuant to pre-set trading plans meeting the requirements of Rule 10b5-1 under the Securities Exchange Act of 1934, in private transactions or otherwise. The timing and actual number of shares to be repurchased in the future will depend on a variety of factors, including corporate and contractual requirements, price and other market conditions. During the 2007 First Quarter, we repurchased 1,840,523 shares of L-3 Holdings common stock for an aggregate amount of $150.8 million. At March 31, 2007, the dollar value of the remaining authorized L-3 share repurchase program was $323.6 million. Since April 1, 2007 through May 7, 2007, we repurchased an additional 366,900 shares of L-3 Holdings common stock for an aggregate amount of $32.7 million.

On February 6, 2007, L-3 Holdings announced that its Board of Directors had increased L-3 Holdings’ regular quarterly cash dividend by 33% to $0.25 per share. On March 15, 2007, we paid cash dividends of $31.3 million to shareholders of record at the close of business on February 21, 2007.

On April 24, 2007, our Board of Directors declared a regular quarterly cash dividend of $0.25 per share, payable June 15, 2007 to shareholders of record at the close of business on May 16, 2007.

Legal Proceedings and Contingencies

For a discussion of legal proceedings and contingencies that could impact our results of operations, financial condition, or cash flows, see Note 12 to our unaudited condensed consolidated financial statements.

Recently Issued Accounting Standards

For a discussion of recently issued accounting standards, see Note 16 to our unaudited condensed consolidated financial statements.

Forward-Looking Statements

Certain of the matters discussed concerning our operations, cash flows, financial position, economic performance and financial condition, including in particular, the likelihood of our success in developing and expanding our business and the realization of sales from backlog, include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act.

Statements that are predictive in nature, that depend upon or refer to events or conditions or that include words such as ‘‘expects,’’ ‘‘anticipates,’’ ‘‘intends,’’ ‘‘plans,’’ ‘‘believes,’’ ‘‘estimates’’ and similar expressions are forward-looking statements. Although we believe that these statements are based upon reasonable assumptions, including projections of total sales growth, sales growth from business acquisitions, organic sales growth, consolidated operating margin, total segment operating margin, interest expense, earnings, cash flow, research and development costs, working capital, capital expenditures and other projections, they are subject to several risks and uncertainties, and therefore, we can give no assurance that these statements will be achieved. Such statements will also be influenced by factors which include, among other things:

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• our dependence on the defense industry and the business risks peculiar to that industry, including changing priorities or reductions in the U.S. Government defense budget;

• our reliance on contracts with a limited number of agencies of, or contractors to, the U.S. Government and the possibility of termination of government contracts by unilateral government action or for failure to perform;

• the extensive legal and regulatory requirements surrounding our contracts with the U.S. or foreign governments and the results of any investigation of our contracts undertaken by the U.S. or foreign governments;

• our ability to retain our existing business and related contracts (revenue arrangements);

• our ability to successfully compete for and win new business and related contracts (revenue arrangements) and to win re-competitions of our existing contracts;

• our ability to identify and acquire additional businesses in the future with terms, including the purchase price, that are attractive to L-3 and to integrate acquired business operations;

• our ability to maintain and improve our consolidated operating margin and total segment operating margin in future periods;

• our ability to obtain future government contracts (revenue arrangements) on a timely basis;

• the availability of government funding or cost-cutting initiatives and changes in customer requirements for our products and services;

• our significant amount of debt and the restrictions contained in our debt agreements;

• our ability to continue to retain and train our existing employees and to recruit and hire new qualified and skilled employees, as well as our ability to retain and hire employees with U.S. Government security clearances that are a prerequisite to compete for and to perform work on classified contracts for the U.S. Government;

• actual future interest rates, volatility and other assumptions used in the determination of pension, benefits and stock options amounts;

• our collective bargaining agreements, our ability to successfully negotiate contracts with labor unions and our ability to favorably resolve labor disputes should they arise;

• the business and economic conditions in the markets in which we operate, including those for the commercial aviation and communications markets;

• our ability to perform contracts on schedule;

• economic conditions, competitive environment and political conditions (including acts of terrorism) and timing of international awards and contracts;

• our international operations, including sales to foreign customers;

• our extensive use of fixed-price type contracts as compared to cost-reimbursable type and time-and-material type contracts;

• the rapid change of technology and high level of competition in the defense industry and the commercial industries in which our businesses participate;

• our introduction of new products into commercial markets or our investments in civil and commercial products or companies;

• the outcome of litigation matters or government investigations material to us to which we currently are, or to which we may become in the future, a party;

• the outcome of current or future litigation matters and governmental investigation(s) of our businesses, including acquired businesses;

• costs or difficulties related to the integration of our acquired businesses, including Titan, may be greater than expected;

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• anticipated cost savings from business acquisitions may not be fully realized or realized within the expected time frame;

• Titan’s compliance with its plea agreement and consent to entry of judgment with the U.S. Government relating to the Foreign Corrupt Practices Act, including Titan’s ability to maintain its export licenses;

• ultimate resolution of contingent matters, claims and investigations relating to acquired businesses, including Titan, and the impact on the final purchase price allocations;

• competitive pressure among companies in our industry may increase significantly;

• pension, environmental or legal matters or proceedings and various other market, competition and industry factors, many of which are beyond our control; and

• the fair values of our assets, including identifiable intangible assets and the estimated fair value of the goodwill balances for our reporting units, which can be impaired or reduced by other factors, some of which are discussed above.

In addition, for a discussion of other risks and uncertainties that could impair our results of operations or financial condition, see ‘‘Part I — Item 1A — Risk Factors’’ and Note 16 to our audited consolidated financial statements, in each case included in our Annual Report on Form 10-K for the year ended December 31, 2006.

Readers of this document are cautioned that our forward-looking statements are not guarantees of future performance and the actual results or developments may differ materially from the expectations expressed in the forward-looking statements.

As for the forward-looking statements that relate to future financial results and other projections, actual results will be different due to the inherent uncertainties of estimates, forecasts and projections and may be better or worse than projected and such differences could be material. Given these uncertainties, you should not place any reliance on these forward-looking statements. These forward-looking statements also represent our estimates and assumptions only as of the date that they were made. We expressly disclaim a duty to provide updates to these forward-looking statements, and the estimates and assumptions associated with them, after the date of this filing to reflect events or changes or circumstances or changes in expectations or the occurrence of anticipated events.

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