The Wall Street Journal-20080206-Peet-s- a Strong Coffee Play-

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Peet's: a Strong Coffee Play?

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While executive turmoil and slowing in-store sales roil its rivals, Peet's Coffee & Tea Inc. is moving ahead with plans to expand.

The specialty-coffee company, based outside San Francisco, is enlarging its profitable wholesale-grocery business with an eye on new East Coast markets. Peet's also plans to open more retail stores known for reasonably short lines and hand-ground coffee drinks -- even though selling more coffee beans in grocery stores is the main goal.

As a result, Peet's may be the best play for investors who want a position in specialty coffee, but without the uncertainties facing Starbucks Corp., Caribou Coffee Co. and Tully's Coffee Corp., which have all suffered shake-ups in their chief-executive ranks recently. And with Peet's shares trading around $22, the stock is viewed as a good bet.

"Peet's has done a nice job staying focused on the core equity of their brand," said David Tarantino, an analyst with R.W. Baird & Co., which rates the stock "outperform," with a $31 price target.

Unlike Caribou and Tully's, Peet's has shown consistent revenue and earnings growth, with third-quarter revenue up 19% from a year ago, and diluted earnings up 30%. Mr. Tarantino forecasts a fourth-quarter increase of 4%, compared with a decline in that figure reported by Starbucks for its latest quarter.

An uncertain economic outlook has helped put specialty-coffee company executives through the grinder in the past two months.

Caribou Coffee's CEO resigned Nov. 12, followed by its chief financial officer Jan. 11. Starbucks Chairman Howard Schultz resumed the CEO position Jan. 7, pledging a return to the company's core coffee culture. Tully's, which has delayed its public offering, saw its CEO and finance chief resign Jan. 15.

Mr. Schultz need look no further than Peet's, opened by Albert Peet in Berkeley, Calif., in 1966, for Starbucks's roots. Mr. Peet advised Starbucks's founders when they opened a gourmet coffee store in Seattle in 1971. In 1984, the original Starbucks partners bought the Peet's chain. In 1987, two of three partners sold Starbucks to Mr. Schultz and kept Peet's, taking the company public in 2001.

While Starbucks went on to became a global presence with more than 15,000 stores and plans for 25,000 more, Peet's has 168 stores, with plans to open 28 more by year's end, most of them in major East Coast markets.

Peet's followed a different, and more secure, path for a niche player focused on coffee quality, said Paul Argenti, a professor at Dartmouth College's Tuck School of Business.

"They are offering the coffee, whereas Starbucks is offering the experience and the store," Mr. Argenti said.

And that's where Peet's has an advantage over its store-crazy rival. Starbucks is suffering from weaker U.S. business and higher costs for essential things like milk, forcing it to curb its U.S. store growth.

Instead of rapid retail expansion, Peet's continues to hand-roast its beans as it expands its wholesale business, said Patrick O'Dea, who has been Peet's CEO for the past five years. "We think we will be able to thrive, because our whole goal is to stay true to the tenets of selectivity in the beans we buy and artisan roasting in small batches," Mr. O'Dea said in an interview.

Last year, Peet's built a $30 million roasting plant, positioning it to triple bean production, yet maintain its custom-order strategy, Mr. O'Dea said.

Peet's sells coffee beans in about 5,600 grocery stores nationwide. It also has mail-order and food-service accounts. Peet's emphasizes wholesale, because it is the most profitable. While two-thirds of the company's sales come from its own retail stores, that represents 20% of the company's profits. The other third of the business represents about 80% of profits, Mr. O'Dea said.

Mr. O'Dea, whose previous wholesale experience at Procter & Gamble Co. helped develop Peet's strategy, declined to say what wholesale margins are. But R.W. Baird's Mr. Tarantino calculates they are about six times higher than the retail business.

Peet's also distributes coffee using its own fleet of vans, instead of through a third party, as Starbucks has done with Kraft Foods Inc., said Steve West, an analyst with Stifel Nicolaus & Co., who rates the stock a "hold."

This ensures Peet's beans are no more than 10 days old when they hit the shelves in grocery stores and coffee shops, said Brian Moore, an analyst with Wedbush Morgan Securities Inc. "Investors have come to respect their plan and their long-term vision," said Mr. Moore, who rates the stock "hold," with a $26 price target.

All specialty-coffee companies will face heightened competition as economic pressures cause some consumers to shift coffee-drinking habits, analysts say. McDonald's Corp.'s plan to open coffee bars inside its nearly 14,000 U.S. stores in 2008 is also pressuring the sector.

But in the long term, the specialty-coffee category is expected to grow at a fast clip. In grocery stores, specialty coffee has penetrated only 20% of the $3 billion market, Mr. O'Dea said.

"In three to five years, what we think of today as mainstream coffee, not specialty coffee, will be gone in large part; it will just be coffee," Mr. O'Dea said.

Peet's stock hasn't escaped the hammering its peers have seen lately. The stock is down 26% from its year 52-week high of $30.37 on Dec. 26.

But Stifel Nicolaus's Mr. West said that if investors view Peet's as a coffee company that happens to have coffee shops, rather than as a coffee-shop company that happens to sell beans, they will have a better understanding of the Peet's strategy.

"Short term, they have a challenge, and that's reflected in the stock price, but longer term, these guys are set pretty nicely," Mr. West said.

Messrs. Tarantino's and West's companies expect to receive or intend to seek banking business from Peet's in the next three months.