Thursday, May 22, 2008

Peet's Coffee and Tea Shareholder Meeting, May 21, 2008

I enjoy going to Peet's shareholder meetings because they always give away goodies, and their food and coffee are great (the "Special Offering" coffee, probably the Anniversary Blend, was great--much better than the Pike's Place Starbucks blend). This year, shareholders who attended the meeting in Emeryville, CA received a very sturdy bag made with some kind of recyclable material with "Peetniks" inscribed on it. Inside the bag were a pound of Peet's Coffee, Anniversary Blend, and a 1/4 lb. tin of Peet's Anniversary Breakfast Blend tea (Special Offering, 2008).

Patrick O'Dea, Peet's CEO, provided a lot of information in this 2007 interview:

Interview with O'Dea

This part of the interview was interesting:

How much of Peet's sales come from its stores?

Sixty-seven percent of our sales come from our retail stores. The other 33 percent comes from sales of whole bean coffee and tea through grocery stores, home delivery and foodservice.

There seems to be some strategy shift. Peet's is now trying to move more into grocery stores and based on my understanding, trying to increase its share of coffee bean sales in grocery stores and by direct mail. Apparently, its beans are cheaper when bought in grocery stores vs. its retail stores, probably because Peet's stores offer fresher beans.

Peet's is still true to its roots, when it was just a small company with a few employees. As a result of having many long-time employees, it runs its meetings like a big family event. This year, Gordon Bowker was honored for his contributions. He was one of the founders of Starbucks. As some of you may know, Peet's was the original Starbucks, and back then, Starbucks bought its beans from Alfred Peet. (Peet's first store opened in Berkeley, CA, but Peet's is still incorporated in Washington State, a vestige of the original Starbucks connection.) When Howard Schultz came in and bought the first Starbucks company from the founders, those founders then went on to found Peet's, due to the differences in philosophy at the time about whether consumers would pay 3 dollars for a cup of coffee. Mr. Bowker was ribbed for being the creator of the original Starbucks logo (with the ubiquitous mermaid). He is a soft-spoken man and accepted the award, which was a coffee tryer (looks like a Civil War pistol--it's used to taste coffee when its freshly roasted) mounted on a plaque. He told a story about how Mr. Peet went out of his way to ensure customer satisfaction, even with testy customers.

Here are the meeting's highlights:

The meeting took about two hours. The CEO mentioned that "coffee comes out of roasting like popcorn," and Peet's wanted their customers to be able to smell the coffee (Schultz expressed the same sentiment this year in SBUX's Seattle's meeting). The CEO said that Peet's was a "retailer who happens to sell coffee." Then, he touted the growth of the company. In 2002, Peet's had 1450 employees; now, Peet's has 3750 employees, a sign of how much it has expanded. Peet's emphasized that was upgrading its technology to improve retailing operations. It has an "ERP" system that allows it to coordinate and track not just inventory, but financial information, orders, and other aspects of the retailing operation. CEO O'Dea, after the meeting, even showed me that he had instant access to the Peet's retail managers by pulling out his Blackberry and instantly looking up the particular store I had indicated was not receiving enough vegan chocolate chip cookies.

Peet's touted its stock performance and said it had about 20% annual growth in earnings per share (this was non-GAAP, however), and had done well, especially when compared with the S&P 600 restaurant index. Then, a video was shown about the history of Peet's, broken up into different time periods, from 1966-1983, 1984-1996, etc.

After Mr. Bowker was presented with his plaque, another gentleman, a tall, red-headed male, Doug Welsh, got up to talk about Peet's beans and its efforts to search for the best beans available. This gentleman appeared to be a consummate professional, even more so than the CEO, who is prone to making some off-the-cuff statements (like, "Everything comes to Cincinnati 5 years late," in response to a question about why Peet's wasn't expanding in the Midwest). Mr. Welsh appears to be a vital part of the management team and would be my pick for the next CEO. A video presentation about Peet's in different countries ensued. The presentation focused on activities in Rwanda, Tanzania, and Nicaragua, and how Peet's had helped the local citizens basically become entrepreneurs, and now had exclusive rights to their coffee.

The Q&A session was insightful, but the problem was that no one went around the room with microphones, so it was hard to hear the questions, and the CEO didn't always repeat them.

The first question was about stock options. Peet's is involved in litigation for its stock option grant practices, so this question seemed a bit of a plant. In case you are interested, here is the CEO's salary:

O'Dea Compensation Report

The CEO mentioned that the company was reducing the level of options that the management team would be entitled to, and the goal was not to exceed 2% of the outstanding shares in order to keep it under the 2.8% institutional investor ownership goal. (The CEO's response was confusing, because a quick Yahoo finance search shows that institutional investors own 93.1% of the stock, and insiders own 3.91%.) The CEO said that initially, when new management is hired, option grants are high to attract key talent, but the level of option grants eventually decreases.

There was a mention that the Alameda facility was a gold-certified LEEDs facility, which means that it has achieved the highest level of compliance with environmental best practices.

The CEO said that he was looking forward to the Tanzania Kilimanjaro coffee.

A shareholder asked a question about costs, especially rising fuel costs. The CEO said that fuel wasn't a major cost.

14% of the expenses are related to buying coffee and tea (futures were pricing coffee at 1.38 and tea at 1.70--he didn't elaborate--see Futures Pricing for more)

3% of costs are related to milk.

Peet's buys its coffee 9 to 12 months ahead of time, so it is well-positioned to handle cost increases.

Peet's plans on having a total of 190 stores by the end of 2008. A question was asked about how many they planned on having in 2009. The CEO said he didn't know, but they had 140 stores in California. This is what steered the conversation into Peet's growth strategy. The CEO said that Peet's was focusing on growing its home delivery, office sales, and grocery store business/food services. (For an example of what might be sold to an office, see

Peet's doesn't plan on television advertising at all. It wants to get the coffee in the consumers' hands and get business through word of mouth and quality. Its marketing campaign is basically a "grass roots" campaign (on the plus side, ad expenses will be low or non-existent). Basically, Peet's feels that its coffee speaks for itself.

I asked a question about whether Peet's planned on expanding internationally. I mentioned that Starbucks was closing some stores in the U.S. and opening stores abroad, and as a result, they might get a head start over Peet's in the huge international market in terms of brand-name recognition and consumer loyalty. Although I did not mention this, having international operations would also serve as a small hedge against inflation if the American dollar continued to plummet. The CEO said that Peet's had no plans to expand internationally.

The best response came from Mr. Doug Welsh about a question relating to Fair Trade coffee. Peet's said that Fair Trade wasn't as reliable anymore as an indicator of fair wages and sustainability. There were even competing certification firms for Fair Trade, implying that the name and Fair Trade "brand" were being diluted and would mean nothing in time. He said that it was better, such as the case of "Las Hermanas," Peet's experience and work in Nicaragua, to "tell the story directly." His response basically indicated that Fair Trade was a fad that would be declining. The real background is that Fair Trade doesn't always mean higher quality beans, and Peet's is interested in actual higher quality, not just a sticker or logo that indicates high quality.

All in all, the meeting was a very enjoyable experience. After the meeting, I spoke with a long time employee (14+ years). He ("Steve," one of the master roasters) was able to enlighten me about why Peet's wanted to go the direct sale route rather than the retail route. First, a new retail Peet's store costs 2 to 3 million dollars to build. A deal with Albertson's obviously doesn't cost Peet's anything. I mentioned that perhaps the profit margins were higher on sales made in the retail store, and he didn't know whether that was true, but he did say that coffee beans are cheaper in the grocery stores. Steve and I got to talking about Starbucks. He said that SBUX makes a profit of about 700K per store, while Peet's makes between 1.2 and 1.8 million dollars per store, twice as much. In addition, Peet's has much more room to grow because it only has about 166 stores, whereas Starbucks has thousands of stores. I mentioned that SBUX would probably become a media-type company focusing on music and other sales (chocolate, etc.) to boost revenue, while Peet's would remain more of a pure coffee operation. We both agreed that the institutional investors would eventually pressure Peet's to expand its retail stores. Because the current CEO, Mr. O'Dea, doesn't seem to favor this kind of quick expansion, there may be a conflict between some investors and the slow but steady growth Peet's currently has in mind. I remain neutral on the shares at the current price (P/E seems a bit high for the slow but steady growth Peet's is contemplating), but recommend that shareholders attend the annual meeting.

I reiterate that Peet's appears to be a great company, and one that is concerned about employee welfare. After my comments about Mr. Doug Welsh and whether he would be staying with Peet's, I received a phone call from Peet's indicating that they hoped Mr. Welsh would be around a long time, and, as he's wont to say, "I'm just getting started." Bravo.

Update on May 23, 2008: I spoke with a Peet's employee who told me that the reason Peet's isn't expanding quickly in terms of its retail stores is because they have only one roasting facility in the Alameda (the Emeryville building was converted into offices). Each roasting facility also requires a "master roaster" to supervise production and roasting of the beans, and currently, she knew of only one master roaster, "Steve," the employee I spoke with after the annual meeting. It is difficult to find and hire master roasters because they require at least 10 years of experience.

She reiterated Peet's main focus on quality, saying that Peet's doesn't want to make larger batches of beans because that would reduce quality (she mentioned Starbucks and how they may have started mixing beans to keep up their supply). That "small batch" strategy makes sense, because in order to preserve quality, you cannot ship more coffee beans cross-country without an extremely efficient shipping line and several major production facilities, and with only one roasting facility, Peet's doesn't have the infrastructure yet to preserve quality and ship beans to too many stores nationally. Therefore, its slow growth strategy seems to revolve around its commitment to quality, i.e. making sure the roasting facility is set up to produce just the amount of beans they currently need and not to increase production until another roasting facility is created. For now, because so many of Peet's stores exist in California (140 out of the planned 190), having one roasting facility is acceptable. If, however, Peet's wants to serve NY and other Eastern states, it will probably have to set up a roasting facility in Ohio, or another place where land is cheap, and use that facility to ship beans to the East Coast.

It is clear that Peet's must expand to the East Coast, because its stores are already present throughout California's high income cities, and in order not to cannibalize its own California sales, it needs to move to other areas where the average resident makes at least 65,000 dollars per year. Outside of California, such areas are present primarily on the East Coast. Thus, Peet's has to expand outside of California. That necessity of expanding to the East Coast makes its business strategy of focusing primarily on grocery store alliances and direct sales rather than more store openings curious. If Peet's wants to ship to grocery stores all over the U.S. and preserve quality, it needs to open another roasting facility near the East Coast anyway. Why not, then, pursue a strategy of opening more stores on the East Coast as well as targeting grocery stores? It seems that the two go hand-in-hand, especially if Peet's doesn't plan on any major advertising.

There is also another issue: because so many East Coast residents use public transportation, they tend to shop at corner markets rather than huge chain supermarkets. Peet's strategy may fail if it tries to target only major grocery stores on the East Coast. Perhaps Peet's has not focused on the East Coast because land is so scarce, and it would need to spend quite a bit of money to open a roasting facility. But such concerns could be alleviated by opening a facility near the East Coast, perhaps near Chicago (Northbrook, IL?), and/or Cleveland (cheaper land, high college student population, which has high disposable income). This is one reason the CEO's comment about Cincinnati seemed ill-advised--why aggravate a huge potential clientele base in the Midwest by casting a large city there in a less-than-complimentary light? In any case, it appears that Peet's may be slowing growth unnecessarily by not pursuing all of its options in terms of creating retail stores as well as alliances with local grocery chains. Peet's curious business strategy of not aggressively pursuing more store openings is why I am currently neutral on the stock, as well as the fact that many American consumers are heavily in debt and may have less disposable income in 2009 than they did in 2007 and 2008. But make no mistake--Peet's coffee is still the best because of its emphasis on quality.

FYI: Peet's Coffee Earnings Call Transcript

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