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Peet's Coffee & Tea, Inc. (PEET)

Q2 2009 Earnings Call

July 28, 2009 5:00 pm ET

Executives

Patrick J. O’Dea – President and Chief Executive Officer

Thomas P. Cawley - Chief Financial Officer

Analysts

Nicole Miller - Piper Jaffray

Colin Guheen - Cowen and Company

Michael Podhorzer - Sidoti & Company

David Tarantino - Robert W. Baird

Matthew DiFrisco - Oppenheimer & Co.

Steve West - Stifel Nicolaus & Company, Inc.

Operator

Thank you so much for holding everyone and welcome to the Peet's Coffee & Tea second quarter ’09 earnings results conference call. As a reminder this call is being recorded and we will be conducting a question and answer session after the presentation.

With us today from the company is President and Chief Executive Officer, Mr. Pat O’Dea and Chief Financial Officer, Mr. Tom Cawley. Mr. Cawley, please go ahead, sir.

Thomas P. Cawley

Thank you, Operator. As we begin, I need to inform you that the information being discussed in this conference call will include forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those projected in these forward-looking statements and Peet’s can give no assurance to the effect of these statements and we assume no obligation to update them.

For additional information concerning factors that could cause actual results to differ materially from those in our forward-looking statements, please refer to the section entitled Risk Factors in the most recent annual report on Form 10-K for the year ending December 28, 2008, filed with the SEC on March 13 of this year. It’s also available on Peet's website.

Now let me turn it over to Pat.

Patrick J. O’Dea

Thanks, Tom. We’re pleased with our results for this quarter in what has certainly been a challenging environment and encouraged by how we achieved them. We’re also excited about the national launch of a new line of Godiva brand coffees. This is an important strategic initiative for the company which will leverage the direct store delivery selling system we’ve built and enable us to compete in a large segment of the specialty coffee market beyond where the Peet's brand currently competes.

To start off, I’d first like to speak to our sales results in the context of our overall strategy this year then talk about the Godiva coffee launch and the context of a longer term vision we have for the company. Afterwards I’ll turn it back over to Tom to take you through the quarter.

Over the last six to nine months in our two largest business channels, retail and grocery, we’ve seen some pretty extraordinary activity. Retailers of premium priced brands have resorted to price discounting and free giveaways to try to bring customers back into their stores and rebuild their top lines.

In grocery stores we’ve seen premium priced brands in many categories discounting themselves at 30%, 40%, even 50% off their regular prices. As I said back when we reported our first quarter, we made a very conscious strategic decision to maintain our premium position and not over react to this near term price discounting environment in a way that would damage the brand longer term.

Instead, we redoubled our service efforts to our existing customers at our won stores and in the grocery channel we worked with our customers to get Peet’s every day price right and leveraged our direct store delivery sales force in the store.

As a result of this approach, we have not experienced the kind of negative existing store sales that other retailers of premium priced brands have experienced and in fact, our existing store sales have remained remarkably stable through the first half of this year.

In the grocery segment, our sales for the first six months of the year are up 10% and our share continues to grow, also up 10%. Peet's may very well be one of the few premium priced brands in the grocery store achieving strong sales and share growth despite the economic and competitive environment which is a real testament to the brand’s strength and to our direct store delivery sales system.

Nevertheless, we’d like to accelerate this growth rate and to that end, by the end of the second quarter, we completed implementation of our every day pricing strategy with customers and we’re encouraged by the sales trends we are now seeing.

Our food service and office business suffered a double timing whammy this quarter but should accelerate nicely in the second half. Last year in this quarter we grew plus 42% as we added 12 new license locations. Conversely, this year our license openings are back half loaded and we will add another 25 or so openings on top of the 4 we have done so far this year. In July alone, we’ve opened 6 locations.

To sum it up, the combination of this top line strategy and leveraging the strong infrastructure we built is enabling us to drive strong profit growth despite the environment. Second quarter earnings per share of $0.26 was up 24% versus a year ago, bringing our EPS for the first half of the fiscal year to $0.49, up 36% versus a year ago. As Tom will share in a moment, while commodity costs in aggregate have been modestly favorable, the bulk of the margin improvement we’re achieving is being driven by our people leveraging the infrastructure we’ve put in place.

Looking forward on our business in the second half of the year, operating improvements will continue to drive the middle of the P&L and are modestly more optimistic about the top line driven primarily by improvements in food service and grocery.

Longer term, as we’ve shared in the past, our vision is to be the gold standard specialty coffee and tea company. This vision reflects a passionate commitment to produce distinctive quality coffees and teas that are deeply rooted in our company’s culture. Over the last six years, building from strength in the western US, we’ve firmly established Peet’s as the quality leader at the high end of specialty coffee in grocery stores by staying true to the three core product tenets: selectivity, artisan roasting, and freshness that yield the distinctive deep roasted cup of coffee that is recognizably Peet’s.

The grocery specialty coffee category is nearly $1 billion and growing at about 7% to 10% a year. With the Peet's brand signature deep roast profile, we’re competing today in about a third of this category. The other two thirds of the category consists of lighter to medium roast profile coffees and flavored coffees and in our opinion there is no clear quality leader in this segment.

Today we announced that we have entered into a license agreement and will launch a line of Godiva brand specialty coffees nationally to compete in this two thirds of the category. Our intention is to make Godiva coffee the leading quality medium roast and flavored coffee brand in the United States.

In creating the line up, we brought our coffee buying expertise to the party and Godiva’s chocolatier chefs brought their flavor expertise. The result, we believe, is a superior quality distinctive tasting medium roast and flavored coffee line which will be the gold standard in this segment. The Godiva line will begin showing up in select stores starting in the fourth quarter of 2009. We do not expect the national launch to be complete until well into 2010 based on customers’ specific schedules.

Importantly, the Godiva coffee concept is rooted in an indulgent, every day flavor experience and will therefore be sold in the very accessible retail price range of between $7.99 and $8.99. Lower than Peet's and the market leading specialty coffee, but premium priced to other lighter roasted and flavored specialty coffee brands.

While we do not expect any material sales or profit impact from the Godiva launch this year as early Q4 sales progress is likely to be offset by startup expense, we do expect Godiva coffee to contribute significant incremental sales and profit to the company over the next several years based on the category, size, strong brand awareness, excellent product, and the strength of our DSD system. It’s just too early to tell how big this will be.

One final point I’d like to make and then I’ll leave the rest to Q&A. We will be selling and distributing the Godiva coffee line in the grocery, mass merchandiser, club, and related outlets where consumers typically shop for coffee consumed at home. It will not be available in Peet's stores or on Peet's websites.

Now let me turn it back over to Tom to take you through the quarter.

Thomas P. Cawley

Thanks Pat. For the second quarter, total operating profit improved 18% over last year’s strong Q2 while EPS was up 24%. Total operating profit margin improved 80 basis points, primarily as a result of improvements to our gross margin.

Gross margin was 55.2%, up 120 basis points from last year’s 54%. Since gross margin represented the largest benefit year-over-year, I will focus most of my attention here. First, let me talk about commodities in aggregate, specifically what we need to pay for coffee, milk, and gasoline. Net net, these costs ended up just slightly favorable on our P&L since higher coffee costs were more than offset by lower milk and gasoline prices.

Our coffee costs for the quarter were up about 4.4% above last year which resulted in a cost that was 60 basis points above last year. However, this was offset by lower milk prices. Our cost per gallon was down 15% versus last year, which improved margins by 30 basis points, and lower fuel costs that reduced shipping by about another 60 basis points. This was the first time in years that net commodities have actually helped us, albeit only by about 30 basis points.

Now let me move to what we do control and how that helped to drive the remainder of the 120 basis point improvement in gross margin which can really be captured in two areas. First, leveraging our roasting plant costs and continued shipping efficiencies versus last year improved margins by 60 basis points as we were running an efficient manufacturing operation.

Second, last year we selectively took pricing in our grocery and retail businesses and this combined to improve margins by about 50 basis points. There are a lot of other ins and outs that netted like favorable coffee waste being offset by some occupancy deleverage but each by itself is less than 20 basis points.

The rest of the P&L was rather uneventful so I won’t repeat what’s in the press release. Basically, improvements in retail operating expenses were offset by slightly higher G&A and depreciation deleverage due to the new stores and IT investments we have made in our stores and our DSD system. Net net total operating margins were up 80 basis points or 150 basis points on a year-to-date basis.

I also want to point out the results in our segment reporting because our results really reflect our strategy. First, retail operating margins improved from 7.1% to 9.5%. For the past two years or so, we’ve said that we will increase retail margins as a result of two dynamics. First, we now have a great team in place that has the tools to improve performance and we’re seeing that in every area, from coffee waste to supplies cost.

Second, we have said for years that investing in new stores was dragging down margins and if we slowed down the number of new store openings, you would see margins improve and they are.

In specialty, we’ve communicated that margins would go down due to our expansion in grocery in the eastern United States while our operating expenses are higher than in the west. That is played out also as specialty margins dropped slightly from 29.6% to 28.9%, still a very attractive margin.

Now I’d like to move below the operating profit line. Interest income was $48,000 for the quarter, down from last year’s $202,000 due to a much lower interest rate than last year. Our tax rate was 36.6% for the quarter which was a little below our 37% full year forecast. From a cash flow standpoint we continue to be a strong cash generator.

So far this year we have generated $16 million in cash from operations and invested only $8.8 million in Cap Ex. For the full year we’ll spend around $15 million in Cap Ex and we expect our cash flow to continue to be strong.

Overall, our profit performance in the quarter was strong and the operating efficiencies and cost improvements that drove it were broad based and largely sustainable. As a result we are narrowing our guidance to the higher end of our previous range to $0.79 to $1.00 target.

One other point I want to share is that as of today we’ve locked in prices for 55% of our coffee needs for next year. Overall the market for coffee has been favorable and we’ve been able to lock in prices that are below this year’s prices. We are targeting to reverse the inflation we saw in coffee from 2008 to 2009 and get back to or below 2008 levels.

That’s all our prepared comments, Operator. We can now open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Nicole Miller - Piper Jaffray.

Nicole Miller - Piper Jaffray

Tom, you talked about coffee inflation. What are you thinking, I know you use much less dairy, but what are you looking at for inflation there next year?

Thomas P. Cawley

In dairy?

Nicole Miller - Piper Jaffray

Yes.

Thomas P. Cawley

I really don’t have really good visibility to dairy for next year to be honest. We are the coffee experts, not necessarily the milk experts, and we rely on our partners for that, so I don’t even have an outlook that I could share with you.

Nicole Miller - Piper Jaffray

Okay, totally understandable. Just a big picture question for either one of you. How should we think about as you are going to be selling more SKUs for grocery, how do you want us to look at the comp? I use that term lately but I’m saying in my mind I’m looking at… you’re probably in a stable amount of doors, so right now the increase in grocery really does reflect what would be a comp selling more pounds of whole bean coffee, and as you have these license agreements, and I think you’re talking about going down the road of pushing other things through the DSD channel, how are we going to be able to parse out like comps and SKUs today versus more SKUs tomorrow and how will the price points compare too? So could you sell more units? I’m trying to think about if it will be a higher price or a lower price items so that maybe even units could outpace revenues?

Patrick J. O’Dea

Nicole, let me take an initial short shot, then Tom, if you have something you want to add here. The best way to gauge how well we’re doing and what will be our gauge and we’ll share it with you is share results. Obviously that comes from syndicated data, either IRI or Nielsen. We use IRI, which breakout by brand what’s happening in terms of your sales growth through the front register of grocery stores and you can also get from that percent ATV distribution, how much has changed, velocity per point of distribution, and all of those sort of metrics. But there’s not a “comp store” equivalent. That’s the metric that we use to gauge our performance.

Thomas P. Cawley

First off, we’re not done as far as expanding. We will have more grocery stores, just to correct that point, as we go forward over the next few years. The other point is we’re not just trying to spread the volume over more SKUs. Part of the reason going into Godiva is the incremental nature of that occasion. It’s a different occasion for customers. The customer profile tends to be very different, so we are looking at it as additive onto the business, not just spreading it over more SKUs.

Nicole Miller - Piper Jaffray

How many doors were you in at the end of --

Thomas P. Cawley

We’re at 8400. So we didn’t add any major accounts this quarter, which we weren’t planning on it. Any accounts we were adding this year are going to be near the back half of the year, which is what we said in the beginning of the year. Then at the end of Q3 we’ll give our guidance for what our expectations are for next year.

Nicole Miller - Piper Jaffray

Just a final question on the sources you did mention, Pat, NPD on the Starbucks call last week was brought up, that the coffee segment was contracting. Can you just share with us what you’re seeing in the industry in general and then what can you share with us about your share [seeing] results?

Patrick J. O’Dea

As I shared actually in the script here, for the first six months of the year our share has grown 10% on sales growth. About 13% is reported by IRI for the first six months of the year in the category is growing about 3. So that’s total coffee. So our total coffee share for the first six months of the year is up 10% and our sales are up about 10%.

In terms of category growth, for the specialty coffee category, if you were to take a quarter basically we saw 7% growth in the specialty coffee category in the second quarter which was the same as it was in the first quarter. So if you remember a year ago we were talking that the specialty coffee is growing at about 15% to 17% and that it dropped in the fourth quarter down to single digits and the last two quarters has been 7%.

[It’s an jar] sales have been growing 9% or 10% year-to-date. We’ve actually been gaining share in specialty coffee as well, so that’s kind of where the total business is right now.

Operator

Your next question comes from Colin Guheen - Cowen and Company.

Colin Guheen - Cowen and Company

Some of the commentary around sales trajectory hitting I guess out of the quarter. Pat, you mentioned something about every day pricing and that there had been some change in kind of the sales trajectory coming out of the quarter. Can you just kind of clarify that?

Patrick J. O’Dea

I think I shared this in our last call too. I referred to it again in this call. During the first six months of the year in this sort of recessionary environment we’ve seen a lot of short term deep discounting promoting going on in grocery. I spoke to it at the end of the first quarter. I gave my perspective which was this was sort of a hopeful effort on the part of grocery trade customers to try to stem the decline in traffic that was leaving their stores and going to more value oriented places like mass merchants and club stores, and that I thought over time that deep discounting would abate because eventually grocers would realize that they have to sort of bite the bullet and lower their every day prices to bring people back to their stores and be able to trust that they’re getting a good every day price.

That was a strategy that we sort of pushed with our customers and we resisted doing the deep discounting that some other folks did and we were successful in working with our customers to get our every day price which had gotten out of whack because they were taking too much margin back to a more reasonable level. For example, in the western United States, today when you go into a grocery store you can buy Peet's every day at an everyday shelf price of about $9.99. Three months ago in some stores that was as much as $11.49. Six months ago in most every store in the western United States in the $11 to $12 range.

So by the end of the second quarter virtually every major customer in the western United States had adopted this new every day more reasonable price strategy, not just on our brand, but on items across their entire store, and as a result of that activity, since we’ve seen that activity occur, we’re seeing significant increases in our non-promoted business which is what we wanted to see and we avoided sending the wrong signal to our customers by doing the deep discounting thing in the first half of the year.

So that’s what I was referring to. Obviously as I said first quarter, one month does not a trend make, but I’m encouraged by the change that’s occurred and I would expect to see improvement there.

Colin Guheen - Cowen and Company

Maybe for Tom, what is kind of the growth rate on the home and food service and licensing kind of component in the second half, if you just kind of parse that revenue stream out, how should we be looking at that?

Thomas P. Cawley

So food service and office have been flat for the quarter and as we’ve talked about, we have a lot more licensing coming on board. It’s not going to return to the 20s or anything like that that we had last year but as we start looking… We’re hoping to get that into the double digits type of numbers with all the license accounts that we have coming on board.

The home delivery segment has been negative and will continue to be negative. It continues to be cannibalized by our grocery business as well as it is impacted by the economy to the extent that gift giving is impacted and what people are willing to pay for shipping and things like that, so this quarter we are down 5% and I would expect that to continue with the exception of the 53rd week, we’ll get some benefit there.

Colin Guheen - Cowen and Company

There’s kind of been a hypothesis put out there that there’s been increased awareness around specialty coffee given some of the ad campaigns in the QSR space. Could you comment about that, maybe any trends that you saw in the retail store segment around that big push with advertising or whatever you --

Patrick J. O’Dea

We have not seen any impact from it so it would be all speculation. There’s no measurable difference for whether it’s helping, hurting, or doing anything.

Colin Guheen - Cowen and Company

Just lastly, Pat, you mentioned with the Godiva that it will be sold in mass market and some other places where you don’t currently sell Peet's. How are you going to attack that from a distribution strategy given your DSD is grocery store focused?

Patrick J. O’Dea

There will be some mass merchandising customers that we will sell Godiva direct to but the bulk of the business will go through our existing direct store delivery sales system.

Colin Guheen - Cowen and Company

In the third quarter are you going to kind of shed some light on the economics of the licensing agreement or how as we look into 2010 or how are we going to go about modeling I guess.

Patrick J. O’Dea

So first off we’ll have a better idea. Right now we’re not selling it anywhere yet so we’ll have a better idea next quarter. The economics of this, if you really think about what we’re doing, is we’ve spent years building a direct store delivery system. We’ve spent years building a sales force that goes and calls on these accounts and from a marginal standpoint getting more volume to leverage those is very profitable for us. Obviously on a gross margin basis with the license fees and so forth, Godiva will have a lower margin to begin with than Peet’s system but it’s the benefit that we have that we already have the resources in place, for better or worse we have a pipeline that we’re going to be pumping more through that pipeline and from a total margin standpoint will be beneficial.

Right now we’d be guessing probably a little too much of telling you how much of an impact it will have for next year but we do know this year will be negligible from a total profit standpoint, but in the third quarter hopefully we’ll have a little better visibility into how many stores it will be in the channels and so forth and how it all is playing out and we’ll give you some guidance then.

Operator

Your next question comes from Michael Podhorzer - Sidoti & Company.

Michael Podhorzer - Sidoti & Company

Pat, you just mentioned the licensing fee for Godiva. Can you tell us exactly what that fee is right now?

Patrick J. O’Dea

No, we’re not at liberty to discuss what that is.

Michael Podhorzer - Sidoti & Company

Do you have any early results that you can share with us from the introduction of the bottled iced teas earlier in the month?

Patrick J. O’Dea

Let me just speak briefly to it. The ready to drink bottles… I’ll put these into context. In our ready to drink bottled iced tea, multi channel market tests that we’re executing in Sacramento right now, the test as it stands today is selling a line of 6 different ready to drink bottled teas in a proprietary Peet's glass bottle through our direct store delivery system into grocery stores, we’re also selling it in some select Peet's stores and it’s available in some select Costco club outlets. We’re learning a lot about that operationally.

The teas are performing from a sales standpoint after a couple months here. Very strong relative to other specialty bottled teas, things like Tazo Tea and things like that in that statement. We have a lot to learn there since it’s a very new business. One of the problems we have right now frankly is it’s probably a little too much tonnage for the direct store delivery system that we have on coffee up there just as it stands today and the other thing we’d like to learn a little bit more about is working with some distributors to get some up and down the street cold bottle outlet business where our direct store delivery sales organization doesn’t currently stop.

So I think we’re learning a lot, we’re encouraged by the results we’re seeing. I wouldn’t look at that as something that we’re going to announce a national [won ton] in the next conference call or two. That one’s got a longer wick on it. I think the big new incremental sales and profit near term impact is the launch of the Godiva medium roast and flavored coffees which we expect will be significant.

Thomas P. Cawley

Michael Podhorzer - Sidoti & Company

I know you guys don’t give an exact retail same store sales figure, but can you share the range that you have?

Patrick J. O’Dea

I think we said publicly a few times we’ve been really for the past now six quarters between minus 1 and positive 1 and we’re still in that range. I’d say we were down fractionally from last quarter and by fractionally I mean less than a point but we’re still within that range.

Michael Podhorzer - Sidoti & Company

Also I noticed there were no shares repurchased in the quarter. Any reason for that, just didn’t find value in the shares at this point, something else?

Patrick J. O’Dea

We never talk about what our strategy is for why we’re buying or why we’re not buying.

Operator

Your next question comes from David Tarantino - Robert W. Baird.

David Tarantino - Robert W. Baird

Question on this Godiva relationship. Could you maybe elaborate on what some of the new activities Peet's will be doing with that brand? Who’s going to be doing the marketing and product development in particular and maybe how are you going to divide the responsibilities for the core business activities?

Thomas P. Cawley

So this is a licensing agreement where Godiva has essentially licensed us their brand name. Everything else we are doing. So we have developed the product. The product has already been developed. We’ve developed the packaging. We will be overseeing the roasting of the coffee to our specifications. We’re having a roaster skilled in flavored coffee and medium roasting roast the product for us. We’ll be selling it at the headquarter level and of course at the store level through our direct store delivery system and we’ll be distributing it.

Godiva has brought sort of their flavor expertise to us in assisting us develop the product with the right Godiva flavor notes to it and of course their brand name which has extraordinarily high awareness and trust in the United States. In fact basically tied for the highest awareness chocolate brand name in the United States and slightly less than Hershey. But everything about the initiative we’re doing. Godiva has really just licensed us the name. That includes if there is marketing, trade spending, we set the pricing and so forth for it also, so those will be out of our pocket also.

David Tarantino - Robert W. Baird

I guess a follow up. This seems like quite a bit of complexity that’s being layered into the current operations. I guess a bigger picture question is why does it make sense to do that at this stage rather than focus on growing the core Peet's brand and should this be viewed as a signal that maybe the runway of growth for Peet’s is maybe not as long as what we might have thought previously?

Patrick J. O’Dea

David I’d answer that emphatically no and in fact I think this initiative will accelerate Peet’s growth and also not very complex. Let me sort of paint this picture here. You step back as we’ve always said in the past when we’ve had sort of website and sort of laminated cards throughout the company for the past six years. Our vision is to be the gold standard specialty coffee and tea company.

As we look at the grocery segment, it’s $1 billion segment. Of that $1 billion, only a third of that $1 billion specialty coffee segment is in what we call premium priced unflavored deep roasted coffee where Peet’s competes. Over the last six years we’ve clearly established… we’ve built our own direct store delivery selling system. No one else has anything like it. Our guys are in there one to four times a week selling both trade customers and consumers on the Peet’s proposition.

We’ve established Peet's as a result as the clear quality leader with a leading share in many markets and our share continues to grow despite the fact that we’re in a recession and we’re a premium priced brand and our share continues to grow at that sort of 10% rate as I’ve said here today in that third of a segment. However, during this period of time we’ve built this incredible infrastructure of home office people in sales and marketing, 250 direct store delivery sales routes, and the only thing that we’re doing on it is 8 to 10 SKUs of Peet's deep roasted coffee that competes for a third of the segment.

So consistent with our vision, we’re expanding and leveraging this capability that we have to compete in the other two-thirds of the segment, and we’re doing it with a very well established, highly flavor credentialed brand name in Godiva and we’re going in with a very premium quality product because there is no segment leader there. There’s a lot of brands which I call operate in the sort of messy middle of flavored coffee, but nobody has established themselves as a premium quality flavored coffee.

So we’re leveraging the existing infrastructure that we have to do this and we’re also leveraging sort of the cultural commitment to quality, the coffee expertise, and the ethos of the company which is all about delivering the best quality coffee and tea possible. This will be the premium quality specialty flavored coffee on the marketplace with Godiva and we’ll be very successful with it. If anything, it’s a little less complicated if for no other reason that we’re not roasting it in our facility.

So quite literally all we have to do is ship the Godiva coffee SKUs along with our Peet's coffee SKUs to our existing route sales representatives and they’ll visit the same number of stores as they do today with the product.

What will happen as this occurs is the route system that we have out there, we will be adding volume to the route system, and the way the dynamic works is when you add volume to the route system, it enables you to take any particular route and lower the number of stores that they have to stop.

So today in the eastern United States where the brand might have lower volume than here in the west, a route may visit as many as 60 to 65 stores. When we add volume to that route with the Godiva launch, that route will be cut back so maybe they’ll only visit 40 to 45 stores. That will increase the frequency with which they visit every store which will increase the display and merchandising that we get in those stores and we’ll build our volume and strengthen the financial picture not just for the Godiva coffees we’re launching bur for Peet’s as well so the dynamic of adding this volume to the routes will actually help the whole system from a volume standpoint and financially.

I think if we had probably announced that we were expanding this and had gone through several quarters of declining grocery volume and share it would be a different story but the tarmac in terms of growth potential on Peet's is still very long and very significant and as we’ve said in the past we expect Peet's to be in the neighborhood of three to four times its size over the course of the next three to five years.

David Tarantino - Robert W. Baird

Tom, a last question related to your guidance. If I look at the earnings growth and margin expansion you’ve delivered in the first half, the guidance for the full year implies the second half would have very little of that margin expansion and a lot less earnings growth. Why would that be? Are you just trying to be conservative or is there some cost factor that you’re concerned about the second half relative to the first half?

Thomas P. Cawley

Right now I would say that since we still have more than 50% of our sales ahead of us and the fourth quarter tends to be our largest quarter for us, there’s just a lot of year left and we don’t know what’s necessarily going on in the economy and we’re not assuming that everything that’s gone right in the past will continue to go right. So there’s nothing structurally necessarily that is fundamentally different overall. I think we’re just saying there’s a lot of year left and we’re not ready to come off of something we said from the beginning of the year.

Operator

Your next question comes from Matthew DiFrisco - Oppenheimer & Co.

Matthew DiFrisco - Oppenheimer & Co.

Tom, can you give us what the market share might be existing right now for the Godiva coffee sold in the grocery channel?

Thomas P. Cawley

Zero.

Matthew DiFrisco - Oppenheimer & Co.

They only do it through their catalog? Campbell’s doesn’t distribute it in any grocery stores whatsoever?

Thomas P. Cawley

Campbell’s doesn’t own Godiva. Godiva is privately held. Campbell’s sold it, I’m not sure how long ago, but quite a while ago.

Matthew DiFrisco - Oppenheimer & Co.

I thought they were still distributing it through select grocery stores or is it just through their catalog store then?

Patrick J. O’Dea

No, they have a very, very small coffee business which is sort of through the catalog and the store and sort of the Godiva gift wrap which will eventually become the coffee that we create that’s their coffee business now.

Matthew DiFrisco - Oppenheimer & Co.

Do you know any sort of share of what coffee, I guess it’s flavored chocolate or associated with chocolate flavors?

Patrick J. O’Dea

Chocolate I can’t speak to. In terms of the market, a little over $900 million in specialty coffee, two-thirds is flavored and light roast, of that two-thirds of flavored and light roast, about a third is flavored. Godiva, while it’s the Godiva chocolatier brand, obviously is very schooled in flavored ganaches for their chocolates, so the flavor expertise they brought to the party was well beyond just chocolate.

Matthew DiFrisco - Oppenheimer & Co.

This is going to be obviously be in the coffee aisle and you’re not going to be doing anything else as far as like their cocoa or anything like that distributing into the store?

Patrick J. O’Dea

No. We’re licensing the brand name for coffee.

Matthew DiFrisco - Oppenheimer & Co.

Is there any representation of your name on there, Peet's?

Patrick J. O’Dea

No. It will be totally separate brands from the consumer. Godiva will be Godiva and the consumer will get a very flavor indulgent experience in a much more medium roast profile. Peet's will be Peet's, deep roasted and fresh.

Matthew DiFrisco - Oppenheimer & Co.

Is there a manufacturing or roasting hindrance from them from you being able to do this product in your plant?

Thomas P. Cawley

Let me just clarify –

Matthew DiFrisco - Oppenheimer & Co.

I guess my question is don’t you have capacity today to do… Would it be profitable to do in-house at your own facility instead of doing it --

Thomas P. Cawley

Obviously we’ve looked at all the variables and decided to have a partner roast this coffee for us. The partner is one of the very experienced at roasting flavored coffees. We developed the product first, the correct bean for the roast profile, worked with Godiva and flavor experts on the flavorings, and then with our roasting partner to bring it all together in a final product and I think it’s better to do in their facility than in ours for multiple reasons.

Matthew DiFrisco - Oppenheimer & Co.

If I was a salesperson or a sales representative of yours on either coast, do I make equal incentive and commission off of selling a bag of Godiva versus selling a bag of Peet's? What’s the differential or motivation for me to sell more Peet’s than Godiva or is it equal?

Patrick J. O’Dea

We’ve introduced the Godiva line to our route sales representatives across the country. We’re also actively selling to customers right now and the organization is ecstatic about the introduction so the route sales representatives, the reason why is because as you know they are highly commission based and they’re quite confident that the Godiva brand on their routes will significantly strengthen their overall personal business.

Matthew DiFrisco - Oppenheimer & Co.

Right, but is there… if it’s a lower margin product, apples to apples, you’d want the incremental sales to still be a Peet's bag of coffee rather than a Godiva if only one incremental bag could be sold. Is there a different payout structure as far as selling a Peet's product versus selling a Godiva product to the sales rep?

Patrick J. O’Dea

I wouldn’t think about it that way because I think that assumes that you have sort of a constrained capacity and resource. We only have 8 to 10 SKUs of Peet's today and a lot of growth tarmac ahead of us. We’ll add the Godiva line up to this and relative to other direct store delivery, sales reps in other categories, these guys will still be dealing with probably one-twentieth the SKUs and these are very complimentary brands meaning they’re going to be in complimentary segments so they’re going to be very accretive to each other. The Peet’s customer is a pure coffee lover, deep roasted full flavored fresh coffee. The Godiva coffee will be a lighter roast profile, flavored consumer that looks very, very different than the Peet’s consumer, so from a direct store delivery sales rep standpoint, this is all incremental volume and sort of the relative commission rate won’t affect behavior.

Thomas P. Cawley

Matt, one thing just to be clear. We are not putting this on any of our shelf space. We’re not giving up shelf space in order to introduce this product. As we sell it in it is a mandate across the system that it is incrementally sold and I know some other brands have done that where they’ve actually taken some of their product off and put someone else’s. We’re not doing that. Given our relative market share of the total coffee category, we’re about 3% of the total coffee, our plan is this is coming from other people, not from us.

Matthew DiFrisco - Oppenheimer & Co.

Then I guess just in the terms of your market share that you’ve been talking about 10%, if grocery grew at 9% and you grew market share at 10% and you’re also in more doors, is the category contracted or has there been a combination between category contracting and less price or is it the east coast per store volumes are just smaller?

Patrick J. O’Dea

East coast per store volumes are smaller. If you look at the last six months IRI data, the overall coffee category grew about 3%. We grew 13%. The difference in there is our share growth of about 10%. That’s what I’m referring to. They dynamic that you just articulated would be when we add an incremental door so to speak in the eastern United States, the velocity is not as strong as it is in the western United States so it will bring down the average.

Matthew DiFrisco - Oppenheimer & Co.

So you’re winning share and you’re coming from the higher volume markets into the smaller markets and sustaining or gaining more share?

Patrick J. O’Dea

Which is the reason why earlier in the call when somebody asked about how do we figure this out, it’s not a retail model, it’s a consumer packaged goods model, and you have to look at share, otherwise you can get caught up in the same store sales thing.

Matthew DiFrisco - Oppenheimer & Co.

My questioning on the Godiva, and I presume its others also, your name is very strong with coffee. Godiva is chocolate. Isn’t there a brand equity though in Peet's as far as going maybe vertical or even buying an existing brand because there are plenty out there that are not that expensive that are on the shelf now, have some brand equity or… I’m just thinking more coffee rather than chocolate and given your presence as a prominent coffee player today, did you do some consumer research that said there’s a risk of hurting the existing brand or you couldn’t do down vertically to that lower price point of the $8 and below flavored coffee products? I’m just wondering, what Starbucks did by buying Seattle’s Best. Could you have bought a Caribou or something of that nature?

Patrick J. O’Dea

The analogy that you just gave is a good one because when you look at our competitors in the grocery channel, most of them have a mainstream brand and then a second lighter roasted specialty flavored brand. I think Smuckers which doesn’t have a high end specialty coffee brand has Folgers and then it has a license arrangement with Dunkin Donuts. I believe Kraft has the mainstream brand of Maxwell House but then has a license agreement with Starbucks and Seattle’s Beset and the relationship between Starbucks and Seattle’s Best in some ways might be analogous to the relationship between Peet's and Godiva in that Seattle’s Best tends to be a more medium roast profile with flavors as does Dunkin.

So just stepping back, a couple things about our thinking, first thing as I shared my prepared comments today, Peet's coffee is a very distinctive thing and the power of the brand, and its ability to win at the high end and establish itself as the premium quality leader and continue to grow at a premium price in this kind of environment, really speaks to the power of that brand.

The power of that brand is rooted in its 43 year heritage but also its unyielding commitment to the selectivity of the highest quality beans, the way we artisan roast it by hand in small batches to a very signature deep roast profile, and its freshness. That’s what Peet's is. It’s a very distinctive thing and we never considered taking Peet's into a lighter roast or to a flavored coffee segment. The power of the brand is that it is a very specific thing.

Having said that, we’ve built this organization capacity and we have a vision for the company which is to be the gold standard specialty coffee and tea company and there’s two-thirds of the category in grocery stores and flavored and lighter roast coffees where we’re not competing. So we had to go search for how we wanted to compete in that segment. We looked at buying existing brands, some of which you’ve referred to some existing brands out there. However, most of those brands, they had some regional strongholds but they didn’t mean anything nationally.

The second thing that we wanted to do was we wanted to establish the premium quality flavored coffee, so we were looking for a brand name with high awareness and unparalleled premium quality flavor credentials and when you look at flavored coffee in the grocery segment today, there isn’t any brand coming at it from a flavored credentialed standpoint. Godiva is a brand name with extraordinarily strong awareness, more than any of the brands that you can think of out there with regional coffee strongholds, and unparalleled flavor credentials. The combination of those two things and the research of course that we did behind that and other alternatives led us down this path. So I’m very confident that we’ve made the right selection and I’m excited about what we’ve got coming.

Matthew DiFrisco - Oppenheimer & Co.

I might have missed it. What was the timetable on when we should hear more about the flow through of this and the economics of the deal and the expectations for this to contribute as a sales contributor?

Patrick J. O’Dea

[inaudible] I’m sitting here looking and I’m trying to anticipate some of your questions from time to time and one of the questions we thought might get asked is how big can Godiva be? So let me answer that question since it’s pretty similar to what you just asked. The answer is this can be very big but what we’re telling you is it’s just too early for us to peg it but if you look at some of the facts, this will help sort of dimensionalize it.

We’re going into two-thirds, we’re going to compete in two-thirds of specialty coffee which is currently about $600 million and the category is growing at 10% so we’re going to compete in a segment of the category that’s about twice as big as where Peet's is competing. Godiva has very strong national awareness, 89% of chocolate buyers which is just about everybody are aware of Godiva and second only to Hershey’s. There’s no clear premium quality leader in the flavored coffee segment nationally and we’ve got the existing pipeline of our direct store delivery and selling and distribution system, not to mention new distribution outlets like mass merchandisers and club stores.

So we have significant expectations for this and ultimately this should become as large as the Peet’s business is today. The question is how quickly will we be able to get it there. The economics obviously will not be as strong as Peet's because there is a license fee and the pricing is slightly less than Peet's although slightly premium to existing flavored coffees. However, the overall economics are more like our specialty economics and obviously they are a retail economics and then the other point which Tom will be able to give you a better perspective on down the road as we start to see it is there’s economic benefit to the entire system lead that to Peet’s by adding this significant new brand and volume opportunity to our direct store delivery selling system.

Matthew DiFrisco - Oppenheimer & Co.

Did you say the duration of it as well? Then I’ll hang up and let everyone else talk, sorry.

Patrick J. O’Dea

The duration of?

Matthew DiFrisco - Oppenheimer & Co.

The agreement with Godiva.

Patrick J. O’Dea

No, but obviously it’s intended to be a long term agreement moving forward but we’re not in a position to release the specifics of the agreement in terms of licensing fee and length of contract other than to say obviously this is a partnership intended to be a long term agreement and we intend to do that.

Operator

Your next question comes from Steve West - Stifel Nicolaus & Company, Inc.

Steve West - Stifel Nicolaus & Company, Inc.

I’m going to beat the dead horse here with the Godiva. If we look at the DSD system, there’s a lot of stores like in the Midwest where you guys aren’t located. Can I think about this Pat, you talk about accelerating your presence with Peet’s is really getting you in the doors now and then that helps you get Peet’s in the doors of these stores where you aren’t as you go forward?

Patrick J. O’Dea

Obviously with us now having two very premium quality, premium brand names that are sort of the gold standard in their respective segments, we’re in a position to penetrate more customers in more parts of the United States. I think Steve, coming out of the box, job one is introducing Godiva nationally through the existing direct store delivery selling system and accruing the benefits of that to the overall system because as we add the volume we’ll be able to cut down the route sizes. As we cut down the route sizes, our service levels improve. As our service levels improve, our volume on both brands improves. As both of those things improve, the economics of the route system improves. It’s just a very positive cycle. Then beyond that you’re correct, the Godiva brand name is well known nationally and the segment is large and there are markets that we would go to with it that we probably haven’t gone to with Peet's yet.

Steve West - Stifel Nicolaus & Company, Inc.

I appreciate that. When you say national, national relative to Peet’s because Peet’s isn’t really national yet, right?

Patrick J. O’Dea

When you think about Peet’s, while the brand is only available in I think about 44% of the ACV, we’re in markets that represent well over 60% of specialty coffee so there are some places in the United States where specialty coffee isn’t that well developed yet so when I start to think of numbers in the neighborhood of 65% to 70% of specialty coffee consumption, that’s getting pretty close.

Thomas P. Cawley

But to your point Steve I think you’re accurate in your assessment of saying there are places right now where they don’t sell enough deep roasted coffee even to our competitors that we have chosen not to go to because of our current route structure that now could be open to us as well as Godiva because people there may drink more light roasted coffee so we’ve stayed out of them, so it may allow us to expand geographies. I don’t think it will help us sell. We could have sold into those markets anyway, into the headquarters and so forth. It just now makes the economics more palatable for us.

Steve West - Stifel Nicolaus & Company, Inc.

So that’s not a priority then, to get Godiva in every store in America on a national basis then.

Patrick J. O’Dea

I think we’re going to sell to the constraints of the economics of direct store delivery system for us to some extent. It may have some other opportunities for us to do some things that we’re not doing today with Peet’s but we’ll be exploring those over time.

Steve West - Stifel Nicolaus & Company, Inc.

One last question. You talked about Godiva, the investments you’ll have to make in the back half with kind of ramping things up. Is that included in your guidance then too?

Patrick J. O’Dea

Yes.

Steve West - Stifel Nicolaus & Company, Inc.

So there is a drag then and that’s why we’re not seeing the guidance go up, because of the Godiva deal. Is that fair to say?

Thomas P. Cawley

I wouldn’t call it… It’s not a huge drag. Because we will have sales and things like that in the fourth quarter as we go into account so I think it just won’t be accretive, not that it’s necessarily a drag.

Operator

Ladies and gentlemen, that’s all the time we do have for your questions this afternoon. Mr. Cawley, I’ll turn it over to you for any closing comments.

Thomas P. Cawley

I’d just like to thank you all for joining us today and that will conclude our call for today.

Operator

Ladies and gentlemen, again that does conclude our conference. We thank you for joining us and wish you all a great afternoon.

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Source: Peet's Coffee & Tea, Inc. Q2 2009 Earnings Call Transcript
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