Ask any longtime shareholder of Starbucks (NYSE:SBUX) how profitable selling coffee can be. It's no wonder that Peet's Coffee & Tea (NASDAQ:PEET) opted to go public after seeing the success of its big brother. As the company's third-quarter update confirms, it's also achieving success while growing as fast as economically profitable.
But first, let's look at third-quarter results. Total revenues for the quarter were up to $50.9 million, or an increase of 18.7% from the third quarter of 2005. For the nine months of 2006, total revenues were up to $150.3 million, or an increase of 20.6%. According to the conference call, margins were compressed because of several factors, including the adoption of FASB 123R (stock options), which was 90 basis points; an increase in the cost of coffee, which added 100 basis points; and an increase in store openings, which attributed an additional 70 basis point of expenses. The resulting operating margin was 3.3%, a significant drop from 7.5%.
And don't expect operating margins to improve anytime soon. Peet's has several growth initiatives that will continue to put pressure on its profits. The company is building a new roasting facility in Alameda, Calif., to serve increasing demand. Peet's is also planning a material increase in store count by adding 10 to 12 stores in the fourth quarter and another 30 to 35 stores in fiscal 2007. Management also said it is increasing its grocery store exposure in New England through its presence in Shaw's, part of the SUPERVALU (NYSE:ABS) family. Peet's already has a presence in Safeway Stores (NYSE:SWY) and Whole Foods Market (NASDAQ:WFMI). All of these investments in growth will keep Peet's' operating profits under pressure for some time.
However, these operating profits are just enough to cover its cost of capital. Using a basic 12% cost of equity and a 16% cost of stock option financing, I estimate the weighted average cost of Peet's capital to be 12.2%. I also estimate that Peet's latest results show the company is managing just over 12.4% return on its invested capital (ROIC) sans stock option expensing. In other words, Peet's is managing to grow revenues at 20% or greater while maintaining a slim economic profit.
That kind of operating performance translates into some seriously caffeinated value, and creating value is the basis for any long-term business success. If you like to invest in growth stories, then Peet's Coffee & Tea should be on your research list.
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Fool contributor Matthew Crews welcomes your feedback -- really! He has no financial position in any of the stocks mentioned. The Motley Fool has an ironclad disclosure policy.
