Peet's Coffee and Tea

~Starbucks founder is on the board of directors
~Growing consistently and increasing revenue
~Strong balance sheet for a small-cap

Company

A Dutch immigrant, Alfred Peet, started Peet's Coffee and Tea. Peet arrived in San Francisco in the 1950's and opened the first Peet's in 1966. The store did very well; many people would line up just to get a fresh cup of coffee. A second Peet's opened in 1971. Inspired by Peet's, Jerry Baldwin went to Seattle and started Starbucks. Alfred Peet sold Peet's in 1979 to a coffee machine importer, Sal Bonavita. Two more stores were built in a span of four years after that, then surprise, surprise! Jerry Baldwin bought Peet's Coffee and Tea in 1984. Because of increasing duties at both Peet's and Starbucks, Baldwin sold Starbucks in 1987, and is still on Peet's board of directors today. Peet's only had four stores once Baldwin took over. Baldwin had resisted aggressive expansion at Starbucks, but he realized Peet's days as a small company should end. He let new blood come in to start expanding Peet's. Soon 5-6 Peet's were being built a year, and the wholesale business was picking up business as well. Peet's IPO was in 2001 when they wanted to really become a gourmet coffee supplier and reach new customers.

Business

Peet's Coffee and Tea is a marketer of fresh coffee beans and a specialty coffee roaster. Freshness is all Peet's. Peet's has strict freshness rules for their coffee and tea, something that giant Starbucks doesn't quite have (They have some less strict freshness standards as far as I know). Peet's offers fresh tea leaves, another thing that isn't too common in the U.S. these days. Peet's also offers fresh pastries in their retail shops.

Peet's also does the wholesale business, you will see their coffee and tea in many grocery stores. Peet's grocery accounts have gone from 130 to 3500 in the last three years!

Peet's has one roasting facility, but they are planning to build a new facility this year to meet their total demands. Now, you may be wondering, why are there so few Peet's retail shops? First, Baldwin was not very heavy on expansion. He opened one store per year, which is why he stepped aside as CEO and let a more aggressive team come in to expand the business. Second, Peet's has only recently boosted their wholesale business to a great number, now they are making much more revenue from that business. I think that management did a good job being patient, building up the cash, and now they are doing heavier expanding.

At year-end, Peet's had 92 retail shops, 20 built last year. For fiscal 2006, Peet's hopes to build 23-28 new shops and that roasting facility. Look at this graph to see Peet's sales, retail makes nearly twice as much as specialty sales (Grocery outlets is the main specialty).

Construction on the new roasting facility (It will be in Alameda, California) is scheduled to start this April and finish in December. Once it is finished, the estimated cost will be around $24 million.

                                   13 weeks   14 weeks   52 weeks    53 weeks
                                    January 1, January 2, January 1, January 2,
                                      2006       2005       2006       2005


      Retail stores                 $33,453     $30,381   $118,030   $100,444
      Specialty sales                17,180      14,689     57,168     45,239
    Net revenue                      50,633      45,070    175,198    145,683

Operating expenses:
      Cost of sales and related
       occupancy expenses            23,806      20,834     80,374     67,189
      Operating expenses             16,329      14,270     59,060     48,530
      Marketing and advertising
       expenses                       1,333       1,162      4,008      3,775
      Depreciation and amortization
       expenses                       1,934       1,628      7,299      5,794
      General and administrative
       expenses                       2,325       2,538      8,757      7,262

        Total operating costs and
         expenses                    45,727      40,432    159,498    132,550

    Income from operations            4,906       4,638     15,700     13,133

    Interest income, net                593         267      1,769        922

    Income before income taxes        5,499       4,905     17,469     14,055

    Income tax provision              2,059       1,713      6,782      5,270

    Net income                       $3,440      $3,192    $10,687     $8,785

    Net income per share:
      Basic                           $0.25       $0.24      $0.77      $0.66
      Diluted                         $0.24       $0.23      $0.74      $0.63

Financials

Peets currently has a market cap of 420.67 million. Peet's has a very nice $53.08M in cash with no debt, a current profit margin of 6.1% and operating margin of 8.96% (Trailing Twelve Months). These charts show the situation.

                                                     
                                                       January 1,  January 2,                                              
                                                            2006      2005

    ASSETS

    Current assets
      Cash and cash equivalents                           $16,996    $11,356
      Short-term marketable securities                     36,080         --
      Accounts receivable, net                              5,152      4,136
      Inventories                                          16,148     12,614
      Deferred income taxes                                 1,514      1,403
      Prepaid expenses and other                            3,372      2,280
        Total current assets                               79,262     31,789

    Long-term marketable securities                        16,890     52,057
    Property and equipment, net                            46,313     40,588
    Intangible and other assets, net                        5,434      3,455

    Total assets                                         $147,899   $127,889

LIABILITIES AND SHAREHOLDERS' EQUITY

    Current liabilities
      Accounts payable                                     $5,523     $5,710
      Accrued compensation and benefits                     5,563      4,266
      Deferred revenue                                      3,415      2,394
      Other accrued liabilities                             3,030      3,372
        Total current liabilities                          17,531     15,742

    Deferred income taxes                                   1,759        838
    Deferred lease credits and other long-term
     liabilities                                            2,537      2,182
    Total liabilities                                     21,827     18,762

    Shareholders' equity
      Common stock, no par value; authorized 50,000,000
       shares; issued and outstanding: 13,902,000 and
       13,500,000 shares                                   99,273     93,091
      Accumulated other comprehensive loss, net of tax        (76)      (152)
      Retained earnings                                    26,875     16,188

        Total shareholders' equity                        126,072    109,127

    Total liabilities and shareholders' equity           $147,899   $127,889

Peet's ended 2005 with cash and cash equivalents of $70M, compared to $64.3M at year-end 2004. What I really like here is this: Peet's is doing the heaviest expansion of its history. This is the most aggressive they have been ever! But they are still increasing revenues, improving sales, and they aren't racking up too much debt. I have never seen a small-cap company do this so well (Although I'm sure you have!), if they can continue to do what they have been doing, I believe this could be an opportunity at our feet.

Management

Patrick O'Dea, CEO, age 43

Patrick has served on Peet's board of directors since May, 2002, I have been impressed with his management of the company and I hope he will be CEO for many more years. Prior to working at Peet's, he was CEO of Archway/Mother's Cookies and Mother's Cake & Cookie Company for 4 years. He has had various other jobs at Stella Foods and Procter & Gamble.

Thomas Cawley, CFO, age 44

Thomas has been Peet's CFO since July, 2003. Prior to working at Peet's, he was CFO at Gap Brands, had various jobs at Yum! Brands, PepsiCo, Pizza Hut, The Quaker Oats Company, and General Foods.

James Grimes, Vice President of Operations, age 49

James has served at Peet's since July, 2002. Prior to this, James worked with Archway/Mother's Cookies, Mother's Cake and Cookie Company, Frito Lay, and Procter and Gamble. In 2001 he founded Supply Chain Consulting.

Peter Mehrberg, Vice President, age 46

Peter has been Vice President of Peet's since 1997. He has worked in some different roles with the company. Mehrberg served as Director of Real Estate from 1994 to 1997. Before joining Peet's, he worked in law and real estate.

Bruce Schroder, Vice President, age 45

Bruce has been VP since 2003, he is also the General Retail Manager and has worked with various parts of Peet's. Bruce was also CEO for HomeGain.com, worked at PepsiCo for 16 years, The North American Coffee Partnership, and SoBe.

To learn about Peet's roasters, take a look at this:

http://www.peets.com/who_we_are/people_leaders.asp

Expansion

Right now, Peet's has 92 stores in the U.S, but not all are in California. Peet's has one shop in Denver, 8 in Seattle, 5 in Portland, 6 in Boston, and 2 in Chicago. This leaves a total of 70 shops in California.

As far as expanding, Peet's is focused on the western part of the U.S. I estimate that they will focus on the west for 2-3 years, then they might start pushing east. But don't count on seeing a Peet's in the east (Aside from what they already have) for at least 2 years.

Insider Holding

Insiders only own 3.57% of all shares outstanding; institutions own 67.8%. So this isn't a very “Hidden” small-cap as you'd find in Hidden Gems. I really like the growth opportunity at hand, I would rather have that institutions number lower, but I think Peet's offers a great opportunity with or without heavy institutional ownership.

This is the one part that worries me with Peet's. In the last six months, insiders have sold more than 160,000 shares. Institutions have sold more than 200,000 shares! I don't really look at this with too much concern, why? Because insiders have stock portfolios also, they want to diversify their holdings. If any more heavy selling does happen, I will definitely be concerned and will look into the matter, but for now, insider selling won't affect me with opening a position.

Competition

I think anyone could write this paragraph! Of course, Starbucks is the first name that pops into people's head when thinking of Peet's competition. Let me tell you this: Peet's offers different products than Starbucks; people go to Peet's for a different experience than Starbucks. What I'm trying to say is that Peet's products are different from what Starbucks offers. Peet's has fresher products, tea, rare coffees etc. Peet's offers more exotic and rare products than Starbucks. It may be hard to imagine where Peet's will build their shops, since there are so many Starbucks around. Peet's was faced with this problem in years past and revenue keeps increasing, I feel that Peet's management will be able to find the right locations to succeed. Nevertheless, we have to keep a close look on Starbucks, just to see what their market strategy at this time is. I think Starbucks will build some more locations in the U.S. before focusing on China, that's my guess, but I'll be keeping a close look on events between Starbucks and Peet's.

Kraft Foods, Green Mountain Coffee, Procter and Gamble all have products that will be competing with Peet's in the grocery stores, but Peet's is increasing revenue in that area as well. Basically, as long as Peet's is increasing revenue and expanding, I feel comfortable with the competition. If sales take a sudden halt, I will be worried. I don't think competition will hurt Peet's, because Peet's has unique products with great quality that is, in many cases, hard to find in another product.

Risk

I see a couple risks involved with Starbucks. The first is if Peet's cannot find effective areas to build new shops and make a profit. Peet's will have to be careful with choosing new locations, they have done a great job so far and I think they will continue to do so. Second, if Starbucks chooses to stay in the U.S. and try to really compete with Peet's, that could hurt the company. I don't think Starbucks will do anything like this, but it is important to stay on top of Starbucks strategy's.

Peet's does not hold any patents for their roasting methods, so a company could try to duplicate Peet's roasting process. If this does happen, Peet's will still be a very unique company. I believe their sales would be just as strong. Competitors could also find a better roasting strategy than Peet's, which could hurt sales. I think it all comes down to believing in Peet's. I doubt any of this could be prepared for, at least to my knowledge, so it all comes down to what you believe Peet's will be able to do.

The specialty coffee market is a very competitive one, but Peet's product is unique enough to keep the company's sales in good shape. I just think that it's hard to match Peet's freshness, quality, and unique products with anything else.

Outlook

For fiscal 2006, Peet's hopes to open 23-28 new retail shops, targeting total net revenue growth or 20-23%. Revenue growth will be key with the new facility being built and the new retail shops. I am hoping that Peet's can have a good amount of cash with no debt, but with the heavy expanding this might be hard to do. Peet's also issued a slight warning with earnings:

Peet's is targeting earnings per diluted share of $0.80 to $0.83 for fiscal 2006, excluding the impact from the expensing of stock based- compensation; the impact of expensing stock based compensation in 2006 is expected to lower earnings per share by $0.18 to $0.20;

Their cash position should be fine if everything goes as planned:

Capital expenditures are expected to be in the range of $18 million in fiscal 2006, excluding the purchase of the new roasting facility.

Conclusion

I am going to be opening a position in PEET very soon; I think a great opportunity is at hand.

For additional research, I encourage you to look at these:

Web Site: http://www.peets.com/

Discussion Board:
http://boards.fool.com/Messages.asp?bid=114833

Coffee Menu:
http://www.peets.com/stores/espresso_menu.asp

Tea Menu:
http://www.peets.com/stores/tea_menu.asp

Complete Store List:
http://www.peets.com/stores/store_list.asp

Comments, questions, and other feedback is appreciated.

Foolishly,

pencils2