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I think PEET is one of the best positioned, small-cap growth names in the restaurants/coffee space.  Unfortunately, the surge in coffee prices is an overhang, but not a deal-breaker to the growth story.  We would use any commodity concern-induced dips as an entry point.  PEET is scheduled to report 4Q10 earnings after the close tomorrow.

PEET’s current FY11 EPS guidance range of $1.53 to $1.60 represents an effective doubling of the company’s EPS from 2008.  Guidance includes a price increase already implemented in the retail and home delivery businesses at the start of 4Q10 and an announced price increase to foodservice and office customers, most of which will occur at the start of 2011; they have not taken any pricing in the grocery channel at this point.

  1. The guidance also includes expectations that PEET has locked in 40% of their coffee needs for 2011 and the assumption that they will be buying significantly higher cost coffee over the balance of the year.  As of the company’s 3Q10 earnings call, PEET guided to a 15% increase in total 2011 coffee costs.
  2. Sales are targeted to grow in the 8% to 10% range, driven by a mid single-digit rate growth in retail and a higher growth rate in specialty.
  3. Gross margins are expected to decline by about 100 bps, due to higher coffee costs and an increase in mix of specialty sales as a percent of total sales.  For reference, the Specialty business yields lower gross margins than the retail business, but as a result of relatively lower operating expenses, it generates higher operating margins (estimated 27% operating margin for FY10 relative to 10% for the retail business).
  4. Operating margins are expected to improve about 50 to 100 bps driven by the mix shift towards the Specialty business, the continued optimization of the retail channel and leveraging of fixed costs.

The company is working to offset higher coffee costs and improve retail margins by continuing to focus on initiatives to reduce waste in coffee, milk and based goods.  Secondly, retail margins should continue to benefit from improved efficiencies in all areas of the store, including labor productivity, supplies and maintenance.

What does SBUX see in PEET?

PEET is firmly positioned at the high end of the specialty coffee category and the company’s continued growth within the grocery channel is key to its overall growth rate going forward.  As the specialty category becomes mainstream, there will continue to be new opportunities for the company to grow, geographically, through new channels, and to customers that would not have been possible a decade ago when specialty coffee was still in its infancy. 

Relative to new channels, in early 4Q10, PEET began shipping to 600 Wal-Mart stores using its DSD network.  Although the company only expected the new distribution to contribute modestly to business in 4Q10, it expects the contribution to be more meaningful in 2011.  We are looking forward to getting an update on the Wal-Mart trends on tomorrow’s 4Q10 earnings call.

  1. PEET has posted strong double-digit sales growth in its existing traditional grocery store business for the past eight years. Growth within the grocery channel had been driven by the selling, merchandising and person-to-person marketing approach inherent in a DSD system. PEET is a leader in the specialty coffee segment in its most established markets with 32% share in California (#1) and 20% share in the West (second only to SBUX), according to IRI.  SBUX has witnessed PEET’s success with direct delivery and now wants control of its own distribution system.  SBUX could easily leverage PEET’s DSD experience and infrastructure.
  2. As the specialty coffee category continues to become more mainstream, the Peet's brand would be ideally positioned within the Starbucks portfolio.  Although some would argue that Starbucks would not want to buy a premium brand that would compete with its own brand, it is important to note that the Peet’s brand would add another price point to SBUX’s coffee portfolio as it is priced about 15% higher than the Starbucks brand in the grocery channel, according to IRI.  Peet’s would give SBUX three price points within the grocery channel when you include Seattle’s Best, which is priced about 20% lower than the Starbucks brand.  With Peet’s, SBUX would dominate the growing specialty segment and have complete ownership of the grocery aisle.
  3. PEET’s operating margins have improved nearly 240 bps since 2008 (based on my FY10 estimate), as a result of the company’s decision to slow down retail unit growth and focus on in-store execution and from the growing sales contribution from the specialty segment, which as I highlighted earlier, is a significantly higher margin business.  For reference, the specialty segment accounted for 34% of PEET’s total sales in 2008 and about 39% in 2010.  Most of this growth has been driven by the grocery segment.  Based on my estimates, I expect the specialty segment’s sales mix to increase to about 43% in 2011, which will have a positive impact on margins.  I am sure the recent strength in PEET’s margins has not gone unnoticed by SBUX.
  4. PEET has “built an infrastructure that is delivering increasingly profitable growth without requiring significant new capital investment.”

Howard Penney

Managing Director