The Call of Caffeine

Pop quiz time.

You brew coffee and tea for a living. Your customers are unusually loyal, and your revenue growth shows it. In fact, you just reported sales were up 20% from last year while net income was 13% higher from the prior quarter. Who are you? Starbucks (Nasdaq: SBUX  ) ? Nope. How about Diedrich Coffee (Nasdaq: DDRX  ) ? Sorry. Better luck next time.

Those stellar numbers were put up by Peet's Coffee & Tea (Nasdaq: PEET  ) . The purveyor of all things caffeinated yesterday reported third-quarter sales of $34.5 million and net income of $2 million. Year-to-date sales passed the $100 million mark, with roughly 70% coming from its retail stores, most of which are in California. Per-share earnings were a steamy $0.14 per share, although the company said $0.02 could be attributed to lower than expected costs for settling a class action lawsuit.

But Peet's is no Starbucks. Don't get me wrong: I'm not knocking the company. The strategy for Peet's is different from that of its much bigger rival. Peet's talks about its products in the same way Robert Mondavi (Nasdaq: MOND  ) discusses its wines. And for good reason: Peet's CEO, Patrick O'Dea, told me in an interview that the idea is to get fresh-roasted beans in front of as many customers as possible. Peet's stores are bean depots that sell beverages.

The other 30% of its business is specialty sales, including filling orders over the Web and stocking grocery store shelves. That segment is growing at roughly 30%.

Yet there are problems with Peet's. For one, costs are rising. Third-quarter gross margins were lower when compared with the same period last year. Plus, the company is richly valued by all traditional measures. At $24 per stub the stock trades for roughly 40 times its trailing 12-month earnings. Even with guidance raised to an expected $.74 in per-share income that's still a P/E ratio of 32. Free cash flow appears to be improving, but its prior 12-month total was just $9 million. That doesn't compare well with its enterprise value of $298 million. Bear in mind, too, that stock options expensing could also have an impact on 2005 earnings.

The concept is intriguing, the product is good, and the candid statements from management are encouraging. But the risks brewed into Peet's valuation make the stock taste just a little too rich at this point.

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Fool contributor Tim Beyers actually prefers tea, but he loved Peet's when he and his wife were still living in the San Francisco Bay area. Tim owns no shares in any of the companies mentioned, you can view his Fool profile and other stock holdings here.


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