Caribou Coffee Buyers Beware: Stock Is Not Cheap

| About: Caribou Coffee (CBOU)
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Caribou Coffee (NASDAQ:CBOU) is the second largest coffeehouse chain in the United States, with market capitalization of $250 million and 596 retail locations (408 company-owned and 188 franchised coffeehouses). The company's common stock provides investors with exposure to specialty and retail coffee sector. As opposed to the much-larger Starbucks (NASDAQ:SBUX), Caribou Coffee focused its expansion strategy primarily in the Midwest and outsourced international expansion to the franchise licensees.

Although I do not question the fundamental viability of the business model, I am certainly concerned about the current valuation at $12.68/share (Aug. 15th close) and enterprise value of $257 million. The company's forward P/E ratio is above 27, which is too high for Caribou Coffee's common stock.

Caribou Coffee generates revenues through the following three segments: company-owned coffeehouse sales, commercial sales of packaged coffee goods, including the K-Cup single serve line of business, and franchise royalties from licensed operators. The aggregate top line growth has been fairly modest over the last few years (2.54% CAGR since 2008 and 11.52% CAGR since 2010) with most of the growth coming from the rapidly expanding K-Cup single serve business (source: CBOU 10K). However, the recently reported sharp decline in K-Cup sales leaves no obvious catalysts for the revenue growth reacceleration.

The retail coffeehouse sales segment comprises 74.2% of Caribou's aggregate sales. It is the largest, most mature, and least dynamic part of Caribou Coffee. The segment's sales depend on two factors: net number of stores opened during the period and delta in comparable store sales. Since 2009, the retail segment revenues have increased at the meager 3.27%. The number of retail locations actually decreased from 414 in January 2010 to 408 in July 2012, which signifies current restructuring headwinds, closure of unprofitable coffeehouses, and operational challenges impacting further expansion. At the same time, comparable store sales increased at 4.7% and 4.5% in 2011 and 2010 respectively. Although the 4-5% comparable sales growth seems decent, it is still more in-line with or slightly above that for the value restaurant stocks, such as McDonald's (NYSE:MCD) and Yum Brands (NYSE:YUM).

On the most recent 2012 Q2 conference call, the management indicated their expectations for the 2-4% comparable store sales growth going forward. The updated guidance called for building 15 new company-owned coffeehouse locations in 2012, which would sum up to 3.7% of the 408 currently operated coffeehouses. Assuming that the company closes a handful of stores during the year, the net number of retail coffeehouses is expected to grow by approximately 2%. Therefore, the retail coffeehouse sales growth rate is unlikely to exceed low single digits. In order to justify the current forward P/E valuation, Caribou Coffee must be on track to expand revenues significantly faster than at blended 3-4% per year.

The commercial sales segment, contributing 21.9% to total sales in 2011, remained the single bright spot within Caribou Coffee until very recently. The segment consists of the following two separate distribution channels: sales of packaged whole-bean and ground coffee to retail stores and sales of blended coffee to Green Mountain (NASDAQ:GMCR) for sale and use in K-Cup single serve products. The K-Cup channel provided the greater part of the 60% quarterly growth in commercial sales over the last three years.

In Q2 2012, there was a significant reduction in Green Mountain's ordering of Caribou's blended coffee. Apparently, Green Mountain repositioned Caribou Coffee products within the K-Cup lineup, which led to the loss of retail space at Sam's Club and Costco. It was not completely clear about what exactly happened between Caribou and Green Mountain; nonetheless, Caribou Coffee's management attempted to portray the seemingly fundamental reduction in K-Cup sales as a short-term headwind.

Caribou's lesser visibility within the Green Mountain's product lineup, as well as Green Mountain's unsystematic challenges related to K-Cup patent expiration and entry of new single-serve platforms, further exacerbates prognosis for the Caribou Coffee's single serve products. In the highly unlikely case that the management's optimistic guidance is accurate, the commercial segment's long-term revenue growth in the 15-20% range still does not justify the premium valuation for the aggregate business of Caribou Coffee.

The franchise royalties channel contributed about $12.7 million to Caribou Coffee's top line in 2011, which adds up to 3.9% of the company's aggregate sales. Although the franchise segment has developed quite rapidly since 2006, it is still too small, on the absolute basis, to serve as a credible catalyst to reaccelerate Caribou Coffee's top line.

Furthermore, the quality of the bottom line profitability at Caribou Coffee is less than adequate. In the period between 2010 and 2012, operating income increased primarily due to lower depreciation expenses within the company-owned coffeehouse segment, as a result of drastically reduced retail expansion. Should the company proceed with opening additional coffeehouses, its mainly straight-line depreciation expense will erase or significantly reduce the bottom line profit margin.

Some of the main bullish arguments for the stock include Caribou Coffee's US-based presence with no direct European exposure, higher per-retail-store revenue potential through introduction of food items, and likelihood for the company to become an acquisition target. These are reasonable arguments; however, investors should stay focused on stock's objective fundamentals.

Since Caribou Coffee does not have company-owned retail presence outside the US, the company certainly has less exposure to global headwinds compared to its larger coffeehouse and restaurant chain peers. For instance, McDonald's (MCD) generates more than 40% of its revenues in Europe (source: MCD 10K) and Starbucks has more than 3,000, out of the 17,600 total, stores open in China/Asia Pacific (source: SBUX 10Q). On the other hand, Caribou Coffee does not enjoy the rapid growth upside potential associated with opportunities in the emerging markets.

Continuing introduction of food items and innovative beverages is certainly beneficial to the retail coffeehouse segment of Caribou. Although new products will probably increase monthly comparable store sales, that process tends to be evolutionary and the expected food inflation may erode margins. Therefore, it is fairly speculative to expect significant incremental benefits from the changing menu mix.

Caribou Coffee possesses the appropriate size and scale to be considered for either a vertical or horizontal acquisition. We have recently witnessed the acquisition offer for Peet's Coffee & Tea (NASDAQ:PEET) by Joh A. Benckiser, a German holding company, at a 29% premium to Peet's already high valuation. It is hard to speculate about who and when could make an acquisition offer for Caribou; nonetheless, I doubt that there is any rush to buy the company at current levels.

Considering all of the above, along with global macroeconomic headwinds and stock's poor liquidity, Caribou Coffee is significantly overpriced at $12.68/share.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.