Peet’s Coffee & Tea, Inc.

/ (PEET-OTC)

$22.0

Overview

Peet’s Coffee and Tea, Inc. is a specialty coffee roaster and marketer of fresh, whole-bean coffee. It operates 72 company-owned stores in 4 western states. In addition, PEET is pursuing new channels of distribution, principally grocery stores.

Key Negative Factors / Key Positive Factors
Recent retail sales growth has moderated with most of the top-line expansion from the grocery store channel. / Overall sales growth is back on track after a sluggish period in 2003. PEET hit its full-year target of 15% growth in 2003 and analysts expect 18% at the top-line in 2004.
The specialty coffee business is competitive, highly fragmented, and has relatively low barriers to entry. PEET needs to build the brand beyond its retail outlets. / PEET is making progress in pursuing a multi-channel distribution strategy. Specialty sales, principally through grocery stores, rose 25% in the second quarter of 2004. The company’s beans are now in over 3,000 grocery stores. Accounts include Albertson’s, Safeway, Omni Hotels, Whole Foods, and Cost Plus.
Near-term, analysts have lowered EPS expectations for FY 2004 based on the cost of infrastructure investments and additions to management capacity. New stores are unprofitable during the first year of operation. / PEET has indicated plans to accelerate its investment in new retail units and its distribution infrastructure. Long-term, most analysts expect this to lead to higher sales and earnings growth.
The company has limited geographic diversification, with operations focused on the West Coast. / Over the long-run, analysts expect PEET’s vertical integration to lead to higher operating margins.

Peet’s Coffee and Tea (PEET) is a niche player in the growing specialty coffee market. Research analysts like PEET's positioning as a premium brand sold through a network of 82 retail stores. Long-term analysts believe the company’s success will depend on pursuing a multi-channel distribution strategy, including grocery stores, on-line and mail order, office, restaurant, and foodservice. Near-term, PEET has indicated that it plans to ramp-up investments in top-line growth at the expense of FY 2004 earnings. Investment success will probably depend on your evaluation of PEET’s strategy to accelerate new store openings.

Of the six analysts that cover PEET, 3 have positive ratings and 3 have neutral ratings.

Sales

The first quarter of 2004 was slightly above analyst expectations. Total sales increased 19%, driven by the specialty channel. Grocery accounts were up 102% with more than 3,000 points of sale now in place. Implementation of a new direct store delivery system has also enhanced sales at exiting locations.

Top-line results in the second quarter were up 15.4%. Retail store revenue increased 11.4% while the specialty channel was up 25.9%. The grocery business remains the main driver, increasing 61.4%. During the quarter, PEET opened six new stores, five in June. Analysts expect 15-20 new units for the full year and 20-30 new stores in 2005. This will require additional investments in distribution infrastructure and managerial talent. Long-term, the majority of analysts think the expansion will pay benefits for other distribution channels as the Peet’s brand becomes better recognized. Management is guiding toward 15%-17% top-line expansion in 2004, followed by 20% growth in 2005. Our consensus puts 2004 revenues at $141.2 million, up 17.9%.

Profit Margins

PEET’s profit margins are feeling the pinch due to accelerated new store openings. In the second quarter, gross margins narrowed 14bps while operating expenses jumped by 101 bps. Operating margins were still modestly higher than a year ago, but only due to lower marketing and advertising expenditures.

Investments in a new direct store delivery system and new store openings will continue to crimp earnings improvement as 2004 progresses. New stores take time to build a customer base for whole beans, and operate at a loss during the first year. For the full year, accelerated expansion will hold operating margins about flat.

Earnings Per Share

PEET’s second quarter EPS came in at $0.13, just ahead of the $0.12 reported a year ago,up 17.7%. The increase was limited somewhat by a higher tax rate, and more shares outstanding. For the full year, PEET is steering analysts toward earnings of about $0.60 share.

PEET’s board has authorized a share buyback of up to 1 million shares.

Target Price/Valuation

Research analysts with positive ratings have set 12-month price targets of $25 - $30 a share. Analysts have lowered expectations based on reduced earnings projections for 2004. Nonetheless, analysts at the high end are still using about 40 times 2005 EPS – well above PEET’s 20% long-term estimated growth rate.

Long-Term Growth

PEET estimates that the specialty coffee market expanded at a 35% annual rate during the 1993 – 2001 period. Analysts think PEET can expand earnings 20% - 25% annually, based partly on that trend line. In addition, PEET has invested in a significant support structure. Analysts expect operating margins eventually expand to 11%-12%, from 6.6% in 2002.

The company expects to open 15-20 new retail stores in 2004 and 20-30 units in 2005. Analysts, though, expect the grocery store sector to remain a significant sales driver. Current key accounts include Albertson’s, Safeway, Cost Plus, and Whole Foods Markets. Expansion will be focused on accounts west of Denver, Colorado.

Individual Analyst Opinions

POSITIVE RATINGS

Roth Capital – The stock is rated Buy with a targeted price of $27. The analyst expects an increased store presence to bolster sales in other channels, especially grocery. PEET is positioned to benefit from a qualitatively superior product, an attractive store-door delivery capability, and a multi-channel distribution strategy.

Sterne, Agee & Leach – The stock is rated Buy with a price objective of $30. Long-term, the analyst believes PEET’s investments in expanding the top-line will pay dividends. Its compelling investment prospects are marked by national expansion potential, multiple channels of distribution, and long-term profit margin potential. The analyst believes the company is considering raising prices.

NEUTRAL RATINGS

Adams Harkness – The stock is rated Market Perform with a target price of $16.50. The analyst doesn’t think a valuation significantly above the EPS growth rate is sustainable.

Harris Nesbitt – The stock is rated Neutral with a price target of $25. The analyst thinks margins have limited upside due to growth of the retail segment and ongoing cannibalization of bean sales at the grocery stores. In addition, Kraft is now selling Starbuck’s brands at the grocery store level.

Thomas Weisel – The stock is rated Peer Perform. The analyst views 2004 as a transitional year due to investments in unit development and strengthening of the specialty business.

WR Hambrecht – The stock is rated Hold. The analyst now thinks the aggressive store roll-out strategy is on track. The shares, however, trade at too much of a premium to the company’s long-term growth rate.

NEGATIVE RATINGS

There are no negative ratings on PEET.

Analyst Earnings Models

The attached spreadsheet includes recent analyst earnings models.