Peet’s Coffee & Tea, Inc. Q2 2008 Earnings Call Transcript

Aug. 1.08 | About: Peet's Coffee (PEET)

Peet’s Coffee & Tea, Inc. (NASDAQ:PEET)

Q2 2008 Earnings Call

July 31, 2008 5:00 pm ET

Executives

Thomas P. Cawley – Chief Financial Officer

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

Analysts

Lawrence Petrone - WR Hambrecht

Brian Moore - Wedbush Morgan Securities, Inc.

Colin Guheen - Cowen and Company

Nicole Miller - Piper Jaffray

Steve West - Stifel Nicolaus & Company, Inc.

David Tarantino - Robert W. Baird

Analyst for Matthew Difrisco - Oppenheimer

Operator

Welcome to the Peet’s Coffee & Tea second quarter 2008 earning results conference call. (Operator Instructions) With us today from the company is President and Chief Executive Officer, Pat O’Dea and Chief Financial Officer, Tom Cawley. For opening remarks, I will now turn the call over to Tom Cawley.

Thomas P. Cawley

As we begin, I need to inform you that the information being discussed in the 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. 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 section entitled “Risk Factors” in the most recent annual report on Form 10-K for the year ended December 30, 2007 filed with the SEC on March 14 of this year and our first quarter Form 10-Q filed May 8, 2008. They’re both also available on Peet’s website. Now, let’s turn it over to Pat.

Patrick J. O’Dea

Overall, we’re pleased with the progress we made this quarter. We continue to drive strong growth in our specialty businesses which in our multi-channeled coffee and tea-focused business model account for about a third of our sales but about two-thirds of our operating profit.

I’m also pleased with the margin improvement we achieved which was a result of excellent management to the business across the company including our retail stores. Tom will talk more about this later.

Here are the highlights. First, our sales growth was 17% led by strong growth in both grocery and foodservice which helped to offset softer retail growth which was comparable to our first quarter. Second, EPS was $0.21 per share versus $0.13 per share last year putting a solid lay on track to our $0.77-$0.80 guidance.

Third, our grocery business in existing markets continued to be strong and our expansion is on track. Year-to-date through the second quarter, we have added 1,400 new grocery outlets in the East and we are now serving almost 7,200 grocery stores, on track to achieving our goal of 8,000 by year-end.

Finally, we approved our operating margins by 240 basis points through a combination of procurement savings, waste reduction in our retail stores, overall good cost management and approved operating efficiencies across the board.

Now here are some specifics on our sales performance. Our specialty businesses grew a collective 24% in the quarter. Our largest specialty business, grocery, was up 27%. This growth came equally from our established base in the western U.S. where we continue to improve our market share and new markets in the eastern part of the country where distribution is ramping up quickly.

In the quarter we gained distribution at approximately 300 new grocery outlets, bringing the year-to-date total to 1,400. Consequently, most of the growth in our eastern U.S. business came from first quarter additions. We’re also gaining more shelf space in both western and eastern U.S. grocery customers based on our performance and the trades desire to drive the more profitable specialty coffee category where we are the clear premium brand.

We also have just enacted an average 6% price increase in the grocery segment effective next week. This was in response to rising commodity-related input costs which we believe will be sustained for some time. All of our competitors have already taken price increases in grocery earlier in the year.

The foodservice and office segment grew 42% this quarter which was driven by the addition of 12 new licensed Peet’s locations bringing our total licensed locations to 49 as well as strong growth in our “We Proudly Brew” program. We strategically use our licensing and “We Proudly Brew” programs as part of our multi-channel strategy to develop the Peet’s brand in key markets and as a means of accessing target markets in captive locations we cannot serve any other way. This business includes customer types such as airports, large office complexes, restaurants, colleges and universities and select higher-end grocery stores as part of an overall market development strategy.

The whole delivery business was down 2%. Home delivery was impacted by the expansion of our grocery business since we are making our product available in geographies historically we only served through home delivery.

Our retail business grew 13% in the quarter. This came from a combination of new stores opened during the past year and sales growth on our existing stores. Our existing store sales and traffic growth continues to be positive, driven by more positive beverage growth offset by mid single-digit bean declines associated with our multi-channel bean expansion. We did see a slight improvement in the existing store sales versus Q1. I would hesitate to call that a trend given the economic environment we’re in.

We opened four new stores in the quarter versus eight in the first quarter and we remain on track to open about 25 this year. Now, I’ll turn it over to Tom to talk through the financials for the quarter.

Thomas P. Cawley

Our EPS for the quarter was up 62% at $0.21 versus $0.13 per share last year. Gross margin was 54.0%, up 120 basis points from last year’s 52.8%. This increase was driven by procurement savings, very good waste management in our retail stores, leverage of our plant and occupancy infrastructure, and these improvements more than offset the commodity inflation and higher shipping costs incurred as we grow our East Coast grocery business. For the full year, we expect gross margin to be slightly better than last year, fairly comparable to our year-to-date trend.

Operating expenses were down 30 basis points versus last year at 35.2%. The improvement was driven by retail where we were able to leverage our existing above-store infrastructure and manage other in-store costs. Operating expenses were higher in specialty as expansion of the grocery business is more expensive that our existing West Coast business. For the year, we are expecting operating expenses to be about a half a point above last year due to continuing investments in growth which will accelerate yet in the third quarter after less investment for the second quarter.

General and administrative expenses were flat to last year at $5.4 million which resulted in G&A as a percent of sales declining from 8.9% to 7.8%. This is a particularly low quarter of spending for us as we had our lowest quarterly marketing spending of the year. We’ll have higher spending in the back half of the year but as a percentage of sales we will end the year with close to a half a point of leverage in this line item.

Depreciation in the quarter was up 20 basis points at 4.5% of sales. This line continues to grow with sales due to the cost of new stores. Net-net, our operating margin increased 240 basis points due to operating efficiencies and the leverage of our existing cost structure as well as below average new grocery accounts and new store openings.

While we approved our overall margin for the year, we can see about half of the margin improvements we experienced this quarter not continuing as we invest more marketing and incur operating expenses associated with more eastern U.S. grocery expansion in the second half. For the year, we expect to see our operating profit margin to be 50-100 basis points better than last year on a comparable basis.

Below the operating line, interest income was $202,000 for the quarter, down from last year’s $463,000 due to lower interest rates in last year. We ended the quarter with $18 million in cash versus $23 million last year.

During the quarter, we spent $8.3 million to purchase some of our own stock. The repurchased shares had no impact EPS in the quarter.

Year-to-date capital spending was $15 million. For the year, we expect to spend about $26 million which includes $12 million for new stores.

I would like to turn it back over to Pat to wrap it up.

Patrick J. O’Dea

On this quarter we made good progress and the story as we see it unfolding this year remains the same as we previously shared. Throughout the year, the broader economic environment will challenge our retail top-line growth and impact our commodity-related input costs. We will partially offset this with improved operating efficiencies in our stores, procurement savings and good middle of the P&L management across the company as we did here in the second quarter.

If we experience unusual cost increases, I would think we’ll be sustained as was the case in the grocery segment recently. We will consider pricing action accordingly. At the same time, we will continue rapidly growing our grocery business in both existing and eastern expansion markets and our foodservice-office segment will grow quite nicely, driven primarily by new licensed and “We Proudly Brew” locations. These areas will drive strong specialty segment growth which is where most of our profit comes from. In fact, sales from our specialty channel increased to 34% of our total business, up from 32% from the same quarter last year and contributed fully two-thirds of our profit.

Clearly in the broader macroeconomic environment, it is a challenging one which is unfortunate because as a company, I can see us hitting our stride. Over the remainder of the year, there are many puts and calls that can affect us positively and negatively, all related to what happens in the economy. As a result, we don’t assume any improvement in the economy in our outlook for the next six months. Despite this, we’re reasonably confident in our $0.77-$0.82 EPS guidance driven by improved operating margins for all the reasons previously cited and sales growth likely in the 16%-17% range.

That is all of our prepared comments. We can now open up the line for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We’ll take our first question from Lawrence Petrone - WR Hambrecht. Please go ahead.

Lawrence Petrone - WR Hambrecht

Could I just break down a little bit your discussion of operating margins? Tom, you talked overall in terms of the company, I was wondering just specifically in terms of your retail channel, you had good margins all the way around, but I’m just wondering, in terms of retail, you had great gross margins, operating margin was very good at 7%. What should we be thinking about going forward, commodity costs as you said are staying very high. Are you going to continue to drive forward some of those cost management and waste management initiatives you had which will maintain the gross margin and operating margins where they are or do you expect some other expenses to hit in this quarter, particularly marketing expenses?

Thomas P. Cawley

First of all, from the marketing expense that won’t affect retail to a degree. Most of the marketing that we’re having in the back half of the year is going towards the specialty businesses. There’s a little bit of increase. That’s not a factor in retail. In retail, I think we’ve talked about it over the past year that starting in this quarter; we were actually rolling out a waste management system into our stores that we had been piloting for over a year. We’re starting to see some of the results with that in our stores in waste, in coffee, in milk, in a lot of different areas. We also are in the process of, last year we were talking about procurement savings; this quarter was squarely in the middle of those savings on a year-over-year basis. A lot of them we enacted in the third quarter of last year and then we’ve continued to add some more. The second quarter is getting double-hit with very good year-over-year comparisons on procurement and that includes new contracts of shipping things to our stores as well as cups, lids, etc. That part will continue. It won’t have a year-over-year improvement probably going forward as much for the overall operating margin. In addition, we only opened a handful of stores this quarter versus last quarter we opened nine. This quarter, we were less than half of that. There are also a lot of start-up operating expense lines and so this quarter, we end up with a little better margin of that.

Lawrence Petrone - WR Hambrecht

So on a sequential basis, should we see a little bit of drop in Q3?

Thomas P. Cawley

You’ll see a drop in the improvement. I can’t tell, I don’t have it in front of me in terms of citement. Depending on the number of stores that we open, the fourth quarter is actually going to be a little heavier in stores than in the third. So Q3 should be without looking at it, there’s not a lot that’s going to change, probably quarter to quarter from Q2 to Q3. Other than Q3, we had a little bit lower seasonal volumes because it picks up the heat of the summer. So we might be sweating it worse.

Lawrence Petrone - WR Hambrecht

Pat, one quick question. You touched on the licensing agreements you have. I was wondering if you could give us an update on the Rally’s agreement that you have. I know, I think you had talked previously about rolling out your 100 stores under that licensing contract.

Patrick J. O’Dea

Yes, let me talk broadly about that. We used licensed stores and also our “We Proudly Brew” program as part of an overall strategic plan to develop a market and as a means of exposing the brand to the right target audience in captive locations. This year, we will have about doubled the number of licensed store locations from 32 at the end of ’07 to just about almost 70 at the end of this year. We’ll probably be expanding some of our “We Proudly Brew” locations as well.

Let me give you an example of how we use these programs strategically to develop a market and support the growth of our coffee business in what we believe to be truly channeling a different way. Sacramento is a market of about 2.2 million people, greater Sacramento. About two years ago, in the Spring of 2006, our share of the at-home grocery coffee market there was about 9% of the total coffee market and obviously higher as a percentage of the specialty coffee market. That was a distant second to the market-leading specialty coffee at the time who had a 19% share of the total coffee market. Over the last couple years, we built our company store base there up to about 12 stores and this past year, we launched a combination of licensed kiosks and “We Proudly Brew” locations, and about 30-40 grocery stores in this market so far year-to-date. We’re on our way to about 80 in the market and probably 100, some of them fall outside the market.

As a result of that multi-channeled trial and awareness building approach, we are now the market share leader in the grocery segment with a 15 share. Our top-line growth across all channels in the market far exceeds the company’s overall growth rate and the channel mix that we’ve created is much more capital efficient and profitable. So I think that’s a good example in Sacramento where we’ve used strategically brewing programs whether in licensed form or “We Proudly Brew” to support our overall goal which is to grow our specialty coffee business in the marketplace with consumers and the channel a different way. We’re doing that in various markets. It depends upon the market, the level and depth in which we use that.

Operator

We’ll move on to our next question from Mr. Brian Moore with Wedbush Morgan Securities, Inc..

Brian Moore - Wedbush Morgan Securities, Inc.

I have a question on the, I think on the last call you guys were on the lower end of the $0.77-$0.82 range. I guess where do we stand on that first, and then on the revenue guidance, the 1 point change today from the last call. Is that coming more from retail or specialty?

Thomas P. Cawley

It’s coming from retail. We have lowered our expectations for retail. We were hoping that it would actually pick up in the back half of the year. We now, assuming it’s not going to happen and that the trend run will continue. Specialty, we’re actually a little more bullish on. As far as our guidance, it was very purposeful that we did not stay at the lower end of the range which we had been saying that, saying that we were kind of squarely in the range. I think it was a backhanded rate in our guidance for the year.

Brian Moore - Wedbush Morgan Securities, Inc.

Then on the cadence of slope for Q3 and Q4, how might we spread that out?

Thomas P. Cawley

We had four in this quarter, I think we only have three or four in Q3, the rest are in the fourth quarter.

Brian Moore - Wedbush Morgan Securities, Inc.

Are we at the low end of the 25-30 range for the full year or is the 25 still the number?

Thomas P. Cawley

It’s 25.

Brian Moore - Wedbush Morgan Securities, Inc.

Can you comment on the operating income by segment for specialty? In terms of the change there for the balance of the year, should it become statistical from what we saw in Q2 or will it be greater in terms of a little bit of pressure you saw with 230 basis points?

Thomas P. Cawley

Now, Q2 is very good for us, partly because we did not go into many grocery stores. So we didn’t have a lot of the start-up in getting people up and going. We did most of that in Q1 for the grocery accounts. In Q3, that will pick up again. As we’re opening in Q4, we’re opening a lot of stores, so the cost will go into Q3. Our overall margin in each of the businesses has to come down in Q3. That’s why I mean we were 230 basis points better this quarter but for the year, I certainly want to be 50-100. So when you do that math, you’ll see that as we have more marketing spending and more investments in the growth, they’ll kind of normalize. This was a little bit of an alignment of the stars, with some lower marketing expense, lower opening augmented by some good cost control. The good cost controls will continue. The other structural things will kind of get back in line now.

Brian Moore - Wedbush Morgan Securities, Inc.

Final question for Pat, maybe. Could you share with us performance in new markets versus older markets, maybe you have some numbers you could share with us regarding the velocity sales and the pricing environment?

Patrick J. O’Dea

I assume you mean the grocery channel?

Brian Moore - Wedbush Morgan Securities, Inc.

Yes, in the grocery channel.

Patrick J. O’Dea

We kind of said in the past, in the western U.S., we’ve sort have been around now going on our 5th-6th year. We are seeing continued double-digit growth and top-line growth. That continues. I think in the most recent 12-week IRI reported data, our dollar sales growth in the western U.S. market, we’re in the sort of 15% range. We’re continuing to build our share in grocery. That’s kind of the way it looks there. Obviously our dollars sales growth in the eastern U.S. markets more than double a year ago because we’re expanding distribution there pretty rapidly now. We’re feeling pretty good about how it’s going in terms of distribution, we said 1,400 new grocery stores added year-to-date of which only 300 were in the second quarter, the remainder were in the first period we’ll add another 800-1,000 in the second half of the year. Timing on those is a little bit hard to pave to a quarter. I don’t know if that helps.

Brian Moore - Wedbush Morgan Securities, Inc.

Maybe just one final question. Can you speak to your experience in the Florida market, maybe compare and contrast that with when you went into Boston which was a year ago?

Thomas P. Cawley

It’s still pretty early for us in the Florida market. We have a great relationship with Publix and we just kicked in some marketing activity there recently which resulted in some nice left in the June period. I’m looking forward to winter in the Northeast when the Florida population doubles. I think there’s a real seasonality to the business in Florida as you might imagine. We’re satisfied with the progress that we’re making and its growing. I think it’s too early to compare it to New England since we’re only about 3-4 months in but we feel pretty good about the progress we’re making.

Operator

We’ll move on now to Colin Duking from Cohen & Co.

Colin Guheen - Cowen and Company

My first question is about talking on the Sacramento experience. What’s the re-opportunity of the “We Proudly Brew” program and the licensed store program on the East Coast? What’s kind of your outlook for that?

Thomas P. Cawley

I think there are opportunities for that. The thing that I would underscore about it is the people that we do those programs with are the kind of people who are making a commitment to make a statement to their customer about the quality of their coffee, and usually they’re trying to upgrade their overall image in the marketplace as well. That’s not everybody in the business. This is much a strategic as it is an economic decision for our partner that we do it. I do think there are opportunities in the East to use brilliant programs to help us build our consumer business and overall brand presence. I think we’ll see some of those in the future. That’s about all I can say about it now.

Colin Guheen - Cowen and Company

Is there any impediment on the East Coast versus the West Coast? Is there penetration of the competitor?

Thomas P. Cawley

Oh, yeah. There’s deeper love. We already had brilliant programs with other large specialty coffee customers that have contract terms to them that last for some period of time so there’s that. There are other things that affected as well. I think if there are people who are willing to make a distinctive statement with the brand they’re offering and the quality of what that brand infers to their own operation, that would be most interested in Peet’s and I think there are people like that but there are definitely an impetus to just taking that and not expanding it.

Colin Guheen - Cowen and Company

I guess the marketing spend was brought up a couple times. Is that going more to the specialty business or is that still the retail stores? Can you elaborate more of the timing and the exact destination of marketing expense?

Thomas P. Cawley

That is really for the specialty business and the grocery expansion. As we step up more grocery outlet expansion and made third and fourth quarters, we only did 300 stores in the second quarter. As we step that up in the third and fourth quarters, there’s marketing spending associated with introducing into new customers in the East, it usually has to do with direct mail and other targeted marketing to the consumer to introduce this to them.

Colin Guheen - Cowen and Company

Let’s let Tom off the hook here. The share repurchases are those going to be used? Is it fair to say in the future we’re going to try and offset a dilution from options, or the strategy of the repurchase program maybe? A little more color on that.

Thomas P. Cawley

Usually, we don’t talk about what our strategy is. I think that going at it more recently would be opportunistic. The dilution that we had had in some of the shares and where our stock price was. It seemed like a good time.

Colin Guheen - Cowen and Company

Any color on the unit opening pipeline for ’09? I know that you said that ’09 might be a year to be more cautious given where rents are and such. Maybe it will develop more on a 2010 period. Any comment on the pipe line for 2009 at retail stores?

Thomas P. Cawley

We’re going to hold off on our ’09 guidance until our third quarter call as we done every year. So we’re not prepared to talk about ’09 yet.

Colin Guheen - Cowen and Company

Are there any closures stated for retail stores, currently or being considered?

Patrick J. O’Dea

We closed one store in the Denver market. It was a bad real estate choice that actually closed last week which is the only store we closed in a couple of years. We have no other stated plans to close any stores.

Operator

We’ll now move on to Nicole Miller of Piper Jaffray.

Nicole Miller - Piper Jaffray

I just wanted to ask about bigger picture development, not any number or any one year. One of your larger peers out there is closing stores, what does that mean for you in opportunities or just given that that is partially done from an economic back drop, does that just give you kind of pause as well?

Thomas P. Cawley

Nicole, the way we think about it is, I know I said this before, but the big picture, we really do think about our company and what we’re trying to build as being a specialty coffee and tea company and it happens to have some of its own retail stores as opposed to being a retailer that happens to be in the specialty coffee and tea business. As a result of that thinking, our goal is to really go into any particular market and grow our coffee and eventually tea business with the consumer in a way that’s the most effective way for us to do that. We do like stores and we do like having brewing programs whether they’re in the form of a licensed store or kiosk or a brewing program, a “We Proudly Brew” program. It gives the consumer in the marketplace, a shortness of time, an awareness vehicle and in the case of a licensed kiosk or even better yet, a Peet’s store, we’ll full experience which is good brand building. It’s one of many tools that we’ll use when we go into a market to develop it.

Right now, we have sort of three different scenarios going on in market development. One is how you see in California, where we’re much more penetrated with our own retail stores in terms of Northern California in particular and then we’re in all of the other channels as well, grocery for the consumer being the biggest one. Now we have some situations where we have a smaller number of company-owned stores like a Sacramento or a Portland where we might only have 10-12 stores and we’ve augmented that with strategic license partners and maybe some brewing partners and built a real strong consumer business on the back of that.

Then we have some situations in the interim United States where we’re just a consumer business through grocery and we’re using targeted marketing and direct store deliveries, selling and merchandising to drive our business that way. So I think we can use a mixture of those and as a result of that we don’t really sort of sit back and say, we have to drive our sales growth and our vision for what we’re trying to accomplish with the company has to be driven by an increase in number of new Peet’s company-owned retail stores every year.

Having said all of that, what’s happening in other people’s retail store, café portfolio, I don’t think we look at that as either opportunistic, it’s not an opportunity for us to accelerate in any way our store growth nor do I see it as something that’s going to be a windfall because somebody’s closing a bunch of stores and they would happen to be around Peet’s and we would expect our traffic to go up. I think it’s probably a situation where the stores are in geographies that are not particularly relevant to Peet’s or anything we do.

Patrick J. O’Dea

Just a quick fact for you. They obviously sent a list of where the stores were and we looked at where they were near us. In almost every situation, a few people pulled up, we’re in this town also, maybe this will help us or something like that. They pulled it up and the competitor that they’re closing is a mile and a half away and there were two other ones closer than that one. So they tend to be pretty penetrated where we’re usually outflanked anywhere between 5-10:1, if one closes, it’s not a big deal for us.

Nicole Miller - Piper Jaffray

I saw on the at-hunt side, obviously there’s a huge opportunity for the grocery or mail, there’s a number of different distribution methods. Just in general, are you seeing more growth like in the single serve packaging or how is packaging holding up? What are the longer-term opportunities for you just in grocery or at home, I guess?

Patrick J. O’Dea

The café business continues to grow. In the last 52 weeks, according to IRI, the total specialty category in grocery stores is up 16.4%. That part of the business is the majority of it and it’s growing pretty quickly. In terms, are you asking about single-serve coffee?

Nicole Miller - Piper Jaffray

That’s just one piece of it. I am wondering if that’s going faster, if you guys know, and just how you can be a part of all of those different opportunities.

Patrick J. O’Dea

Our goal for the brand is we believe the specialty coffee category which is now in a 29% of the total category range nationally will become mainstream in the next three to five years. It’s our intent to establish Peet’s as being winning at the high end and being the premium, quality premium-priced brand in that merging segment, which in a $3 billion category today which is growing nicely is a very strong, profitable business for us. I think we’re in a good position to take advantage of that with our “only roast to order”, direct delivery, selling and merchandising system and the business.

The forms that consumers choose to use to brew coffee at home, right now obviously the predominant form is the one that we’re in, by a long shot. There’s a small single cup market developing at home and it’s primarily developing in the New England market but it’s still quite small. It’s not a major factor in the western United States. It will develop, we think, into a certain percentage of the category over the course of the next, say, five to six years. I’m not exactly sure what that will be but it’s still relatively small. If consumers decide that’s a form that they need, enmasse want to enjoy Peet’s and that would be a form that we would consider entering at some point. I think the alternatives for what that would look like over a five-year period or more, will grow.

Operator

We’ll move on to Steve West from Stifel Nicolaus & Company, Inc..

Steve West - Stifel Nicolaus & Company, Inc.

Tom, you guided something about a $26 million under operating costs but you broke up. I couldn’t quite hear you. Can you restate what you said before on that? I was toward the end of your talk there.

Thomas P. Cawley

It was in my speech?

Steve West - Stifel Nicolaus & Company, Inc.

Yeah, about $26 million.

Thomas P. Cawley

Yeah, that doesn’t sound familiar.

Steve West - Stifel Nicolaus & Company, Inc.

Can you talk about, just go back to specialty and what you’re seeing, you’re talking about you’re growing market share and you’re taking it from somebody, are you taking it more from the specialty side or kind of more the Folgers and that area, the mainstream brands, or maybe both?

Patrick J. O’Dea

Yes, the answer’s both. It’s actually three-fold. One, we’re growing the category. That’s for sure. That’s why a lot of grocers like to have Peet’s. Second, we are taking share from other major specialty coffee players out there, for sure. The specialty segment of which we’re a part continues to steal share from the more mainstream commodity coffee which is declining.

Steve West - Stifel Nicolaus & Company, Inc.

Speaking of commodities, I know you didn’t give anything in ’09 but how are you guys looking as far as coffee, assume the prices go back up again and then they’re down again and then they’re coming back up. How are you guys looking on coffee in your contracts right now?

Thomas P. Cawley

Last I checked we were about 39% purchased for next year. Our strategy remains the same which is we have a very patient view and trying to be forward-bought so as coffee goes up and down, we sit on the sidelines when it goes up and when it comes down and hits a trough, then we go in and we lock up some contracts. So I think we’re about where we were this time last year which worked very well for us.

Steve West - Stifel Nicolaus & Company, Inc.

One last question. You talked about the 6% price increase on the specialty channel which sounds like you have a lot of pricing power there. I assume there’s nothing at retail that you’re doing as far as pricing?

Thomas P. Cawley

We haven’t taken any retail pricing to date –

Patrick J. O’Dea

We did it in January. We did it in the quarter.

Thomas P. Cawley

We haven’t taken any in the quarter. We took a nickel on drinks in January, right at the beginning of the year, which you recall. The 6% is on the grocery business only, not the total specialty business. We haven’t announced any pricing anyplace else either.

Operator

We’ll move on now to David Tarantino from Robert W. Baird.

David Tarantino - Robert W. Baird

Tom, can you explain what the key drivers of the cost pressures are in the grocery business and if that 6% that you’re taking is enough to completely offset those pressures?

Thomas P. Cawley

The pricing we took in grocery was a 2-year coffee cost pressure that we were offsetting. We hadn’t taken pricing since October of ’05, I believe, in grocery, where we had taken a 10% price increase back then. All of our competitors, most of them have taken two or three price increases in that time. It is totally coffee-driven. The incremental cost for us to set up our selling and merchandising system on the East Coast is were looking at as our cost of doing business and we’re not passing that on so they’re not paying more on the east for it or anything like that. So it really was just a coffee cost offset.

David Tarantino - Robert W. Baird

It was sufficient to cover?

Thomas P. Cawley

As we did it, we did it in mind to, with two things in mind. One thing, to try and get our margins back where they should be from a gross margin standpoint and to look in to the future a little bit of where coffee costs are going. The other is to strategically look at where our grocery partners will price the product because there’s certain price ranges that we want to be competitive in by market so as we’re just telling you all this right now, we have been meeting with each of our grocery partners of the past month. We had given them plenty of warning, one in replacing strategies, took our analysis to what the particular price points would be, and the competitive nature of it. The cost increase was driven by the commodities going up but it was a very strategic look at it and how we address it by market especially since we’re just being introduced into a lot of markets.

David Tarantino - Robert W. Baird

You mentioned, just a follow-up to that, I think Pat mentioned that others have taken price increases. Are they in that 6% range? Are you keeping a spread versus the competition that you like or is that spread widening or narrowing?

Patrick J. O’Dea

I think you’d see, its multiple moving parts, right? It’s what we price to the grocer, and then the trade margin and what margin the grocer decides to take. Then it ends up with what the consumer sees. Generally speaking, obviously, our price through the grocer will be higher than our competitors and will typically result in anywhere from say a 8%-10% everyday shelf price premium to our largest specialty coffee competitor. That can vary in any particular store that you go in, however, depending on how the grocer, what margin the grocer decides to take at any particular time and then there’s promotions all the time too. Generally speaking, if they took the same margin on us as our competitors and it was an everyday shelf price and the product wasn’t on promotion, it would be in the range of 10% premium range.

David Tarantino - Robert W. Baird

One bigger picture question on grocery. What is the long-term opportunity there in the U.S. on terms of either number of doors or commodity volume, percentages and how long do you think it will take you to get to a complete penetration state?

Patrick J. O’Dea

I think we’ll talk more about the strategy here at the end of the third quarter this year when we talk about ’09, when we lay that out. Today, I think we’re in about a third of the ACV and about 35% of all commodity. Grocery stores represent 30% of all commodity volume which translates in our case to 7,200 stores today. There’s a lot more than 7,200 stores nationally depending upon who you talk to, anywhere from 25,000 to 30,000 but we’re in the bigger metro markets and the higher ACV stores, so it’s the larger volume stores. Alternately, Peet’s should be in 70% of the all-commodity volume in the United States. However, the pace at which we get there will follow the development of specialty coffee from being 29% of the category to being 60%-70% one day. So for example, there are markets right now that you wouldn’t want to go into, the specialty coffee market, there’s not nearly as developed as it needs to be, but in five years from now, it will be. I think that you would be in double the stores today but the pacing of how that occurs, it may not make sense to do that all next year because you’ll be ahead of the curve.

The other thing is that I think, especially in our model, what we like to do, we like to enter a market, get a foothold, then build some critical mass and start to get some leverage. You might bite off chunks and then build the chunks that you bite off and then head to further new ground as the category develops. So we’ll talk more about that at the end of our third quarter call as we set the plate for ’09 but ultimately, I think you could be in twice as many stores, twice the ACV and it’s just a matter of what’s the smart timing and strategy to do it.

David Tarantino - Robert W. Baird

One last question. Is there an opportunity that you see in signing up a major customer like a Target for example?

Patrick J. O’Dea

You mean like a non-grocery customer?

David Tarantino - Robert W. Baird

Correct.

Patrick J. O’Dea

My gut reaction I would say is no, but I wouldn’t want it to sound that definitive. The whole reason is because most of the specialty coffee market is really in grocery and specialty grocery stores. It’s not in mass merchandisers. They do have some coffee if you go in there but if you look at the numbers, the $3 billion is in grocery stores and the mass merchandisers specialty coffee business is tiny in comparison and they’re average movement per store is also smaller. We’re kind of fishing where the fish are for the most part.

Operator

We’ll move on to Matthew DeFrisco from Oppenheimer.

Analyst for Matthew Difrisco - Oppenheimer

This is Analyst for Matthew Difrisco in for Matt. I had a quick question about your experience in the Northeast. You been there for over a year. I’m wondering some of the earlier stores you entered, how your comping on those stores, has it kind of stabilized, was it a honeymoon in the beginning, if you can give that kind of trend, the older stores you’ve been in.

Patrick J. O’Dea

In grocery stores for example?

Analyst for Matthew Difrisco – Oppenheimer

Yes.

Patrick J. O’Dea

I think the way to think of it now, let’s look at July of ’08 that we would have entered into New England in say July of ’06 or August, about two years ago. We went live two years ago. So I think we’re still seeing very high growth rates.

Thomas P. Cawley

If you have IRI data in front of you, you’d look at Boston, and you’d see that business is up about 28% for what’s being scanned, for the past 12 weeks with Boston is an example. If you were to look at the last 52 weeks, we’re up 100%. It continues to grow pretty rapidly.

Analyst for Matthew Difrisco – Oppenheimer

Is that backing out the addition of new doors that you’re in?

Thomas P. Cawley

Often we haven’t added a door in that market in over a year. That would be, I hate to use the word, comp number.

Analyst for Matthew Difrisco – Oppenheimer

Yesterday, Starbucks talked about how Kraft was not selling their coffee through very quickly but it looks like you’re gaining share. Is there anything that Starbucks, your largest competitor is doing in the grocery channel differently? Are they kind of being less aggressive, are they stepping back, which allows you to kind of fill to more share?

Patrick J. O’Dea

There’s a fundamental difference here. That is because we’re a specialty coffee company and that’s the way we think about our business and we’ve gone to market in the grocery channel with our own people. We have our own sales people who call and they call on headquarters. We have our own direct store delivery selling and merchandising system which is in the store 3-5 times a week. This is our business. We are in this business directly. We’re building it, we have a whole consumer marketing department which drives it, etc. We strategically did not make the choice to take the grocery business and give it to our large CPG company and have them handle it for us. I think that was the right decision because we’re able to drive growth with the focus we have on it and we’re not a small piece of another large $45 billion where we’re not their top priority. So it’s just a strategic choice on our model to drive the consumer business in grocery stores ourselves and we have fundamentally different results when you do that.

Analyst for Matthew Difrisco – Oppenheimer

Switching gears to the retail business in California. It’s been asked a couple different ways but I know you’re adding more license to it, you’re moving more into grocery, you’re asking about where these sales are coming from, it does sound like they’re moving away from the retail store growth, I mean, is that fair to say that this isn’t just a blip and that we can assume that those other channels are filling some of the growth that you previously found in the retail side, just as we build our model, far and out?

Patrick J. O’Dea

I think there’s a broader strategic question that we’ll probably address as we give guidance for next year and so forth, but one of the things we have said in the past is, we are committed to invest where the returns are the best. For these two years that we’re in right now, we see a tipping point in grocery, and we’re putting our dollars behind the grocery business. We haven’t really given any longer term vision of where it’s going probably because we’ll figure it out as we look at where the economy is, what the environment is out there and so forth. We’ll probably, this will develop over time and I think, right now, the company remains focused on getting the grocery business established and focused is A1 on our list of priorities.

Analyst for Matthew Difrisco – Oppenheimer

Lastly, in terms of your 2008 plan for retail stores. It’s backend-loaded. I’m wondering what’s driving the more backend-loaded. I know years back, it could be more evenly weighted throughout the year. We’re just kind of wondering about that.

Thomas P. Cawley

We’ve opened 13 of our 25 halfway through the year so for the full year basis, we’re not backend-loaded. The back half is a little backend-loaded. It’s just circumstances of an individual basis, it’s kind of fallen into the, we ended up with a lot of new construction this year. Things kind of come out of our control. It’s nothing conscious. It just sort of happened.

Analyst for Matthew Difrisco – Oppenheimer

Are there more stores opening in Northern California than Southern or if it will reduce charge more if it was coming out of Southern California market?

Patrick J. O’Dea

I say over the last four years we have had more stores out there. Northern California has always represented more than 60% of the store openings and that’s continuing.

Operator

That concludes the question and answer session today. At this time, I would like to turn the call back over to our host, Mr. O’Dea and Mr. Cawley for any additional or closing remarks. Thank you.

Patrick J. O’Dea

Thank you all for calling and we look forward to talking to you after our third quarter when we’ll give some guidance for our 2009 expectations. Thank you.

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