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Coffee Still Has Kick

Posted: May 02, 2008 14:13 PM by Will Ashworth

Tickers in this Article: GMCR, PEET, SBUX, MCD

Three coffee retailers announced earnings this week and they were all disappointing. Starbucks (Nasdaq:SBUX), the highest profile of the group, said earnings dropped 28% to $108.7 million in the second quarter due to several factors, including higher dairy costs, increased store lease costs and expenses related to its ongoing transformation. At first glance, revenues seem decent, up 12% to $2.5 billion; however, dig deeper and you'll notice that same store sales were down 1%. Furthermore, the company missed analyst revenue expectations by $50 million. It seems their customers simply didn't have as much discretionary spending money available for grande lattes.

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Does this signal the end of the line for hyper-growth in the coffee business? For now, but there are still a few businesses that are doing just fine. Let's take a look at a couple of the companies that are still brewing up profits for investors.

Coffee Companies to Perk Up Portfolios
Green Mountain Coffee Roasters (Nasdaq:GMCR) is a Vermont-based company that got its start roasting coffee in a small shop in Waitsfield and now sells more than 100 varieties of coffee to wholesale clients across the Northeast. While it does well financially, the commitment it makes to environmental sustainability is what gets me revved up. For six years straight, it has been selected for the Sustainable Business 20 (SB20), a list of public companies that are changing the world for the better. It also gives 5% of its pretax income to socially responsible initiatives through coffee donations, etc. In 2007, this amounted to just under $1.1 million.(for more on ethical investing, see Go Green With Socially Responsible Investing.)

Coffee Karma
All of this commitment to the world-at-large means nothing without profits. Fortunately, the company's social responsibility seems to be good karma. In fiscal 2007, it grew revenues 51.6%, to $341.7 million, and pretax income increased by 34.4%. Its second quarter numbers, released May 1, were equally impressive: revenue and pretax income were up 46% to $120.9 million and 83.2% respectively. A good deal of the growth came from its Keurig Single-Cup Brewing system, which contributed $60.7 million in sales, up 89% year-over-year. Clearly, buying the remaining 65% of Keurig it didn't own for $104.3 million in June 2006 was a brilliant decision. In the second quarter, Keurig sales were half the overall total compared to 39% the previous year. The single-cup is just in its infancy with only 4-5% market penetration in the United States according to Canaccord Adams analyst Scott Van Winkle. This potential has the coffee company estimating its 2008 revenue growth at 42-47%. Scott Van Winkle also believes the single-cup market has more potential than any other small appliance out there and that the Keurig system could generate 25% growth annually for the next 10 years. That's some future!

Banishing the Dreary Drip
Alfred Peet, the father of modern specialty coffee, opened his first store in 1966. By the time he retired in 1983, an industry was born. No longer would Americans accept the dreary drip coffee sold in grocery stores. A trip to Peet's Coffee and Tea (Nasdaq:PEET) became a ritual for many. In fact, it inspired three college students so much that they opened a place called Starbucks in 1971. They went on to buy Peet's in 1984, selling Starbucks to Starbucks' current CEO Howard Schultz and investors in 1987. In 2001, Peet's went public at $8 a share. Two of the original Starbucks owners, Gerald Baldwin and Gordon Bowker, still own shares in Peet's.

Quality Brew
Peet's has always had a reputation for quality. That came from the hard work of Alfred Peet in the early days and it has stayed with the company ever since. Today, loyal customers are "Peetniks", because they'll drink nothing else. This loyalty translates into a nice business. In 2007, Peet's sales were $249.3 million with an operating profit of $11.6 million; in the first quarter of 2008, revenues grew 17% to $67.1 million and operating profits 62% to $2.99 million. In 1997, the company moved from only selling coffee in its stores to distributing the brand through multiple channels including grocery stores, offices and even through home delivery. By focusing on opening coffee houses on the west coast, it was able to keep a close eye on its retail operations while continuing to grow the specialty business nationwide. It's a formula I believe will continue to generate steady revenues. By 2010, Peet's expects to have distribution throughout the country. It's important to note that specialty sales generate 31.6% operating margins in comparison to 5.8% for the retail stores. However, without the retail stores growing brand awareness, specialty sales wouldn't get the market penetration they're experiencing and without the extra profits from the specialty sales, the company wouldn't have as much cash to build more stores. It's a symbiotic relationship.

Bottom Line
Has the coffee business become too crowded? I don't think so. Why else would McDonald's (NYSE:MCD) be adding specialty coffees to its everyday offerings? The simple truth is that coffee is currently undergoing a transformation in which people are demanding better coffee in more locations than just the traditional coffee shop. Whether it's the fast food joint you frequent, the fitness club where you work out, or the sports arena where you watch your favorite team, customers are becoming less and likely to settle for inferior brews. Once we're through this recession, I think we'll see growth pick up once again. (To read more on investing directly in coffee, check out The Sweet Life OF Soft Markets.)

By Will Ashworth

Will Ashworth lives and works in Toronto, Canada. He's worked in and around the financial services industry for much of his adult life. He loves investing and is passionate about helping others learn how to put their money to work.

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