Specialty coffee makers had a great year in 2004. Starbucks (NASDAQ:SBUX) grew revenues by 23%, and Peet'sCoffee & Tea (NASDAQ:PEET) improved its top line by 22%. Even Allied Domecq's (NYSE:AED) Dunkin' Donuts, which admittedly provides a more humble cup, increased beverage sales by 13%.

Peet's, which bills its coffee as the real thing -- a rich, dark brew unlike the sweeter, milder "cocktail" versions -- is a small player with approximately 100 stores, most of them in California. Its cult following and great brand loyalty have helped Peet's begin making strides beyond the West Coast. Will it continue to provide the consistent growth that Fools love? Or has Peet's caffeine-fueled stock climbed too high at 36 times forward earnings?

Defining the word 'beanbag'
For a small regional outfit like Peet's, competing with the ubiquitous Starbucks poses obvious challenges. While Starbucks profits from its diverse array of beverages and the unique experience it provides customers, Peet's is all about the coffee. It sells its coffee in traditional retail shops by the cup or by the bag, but it also delivers whole-bean coffee directly to consumers at home or at the office. Peet's also sells its coffee at grocery outlets.

This is a product-focused company; it can't really compete with Starbucks for presentation. A Peet's customer will get the freshest and arguably the best coffee available, but that customer may not get the same "decaf grande nonfat no-whip no-foam extra-cocoa mocha" razzamatazz that Starbucks excels in providing. Those extra luxuries are Starbucks' moat, the justification for its higher prices. And danger awaits those foolhardy enough to try to cross it.

A sensible strategy
Peet's doesn't try to duplicate the Starbucks experience. In my opinion, that's a wise idea:

  • Starbucks created the "Starbucks experience" -- it did it first and best. A stickler for quality like Peet's doesn't have the cash to follow suit on a national level. Even if it did, the company would just be playing copycat.

  • Peet's has excellent product strength, and that should allow the company to charge premium prices for its whole-bean coffee.

  • Peet's aggressive distribution strategy broadens its audience and removes concerns about the location of its stores. Whether its coffee is purchased by a loyalist in one of its retail shops or a soccer mom at Safeway, the company still makes money. This approach hasn't lowered operating margins -- the company makes almost 10% operating profits on overall sales, with a mix of 16% at retail shops and 31% at grocery stores. That's commendably within striking distance of Starbucks, which made 10.6% overall last year. (Peet's numbers may not seem to add up because other segments of its business aren't currently profitable.)

The 31% margins on grocery-store sales grew from a modest 24% in 2002, with Peet's expanding within chains and supermarkets much faster than it opened its own smaller shops. With such a healthy and growing chunk of its profits stemming from specialty stores, it doesn't make sense for Peet's to focus exclusively on retail, as the following table indicates:

Operating Margins 2002 2003 2004
Retail 19.1% 19.2% 16.0%
Specialty 29.9% 28.4% 30.7%

Going forward, the company will continue selling more "beanbags" at grocery stores and specialty shops nationwide, helping Peet's to build brand loyalty. Management thinks that retail and grocery sales are complementary, and it doesn't believe that the two-pronged approach will prompt cannibalization.

Peet's doesn't feel the need to sell the concept of sexy lattes, even with a superior product. It lets the coffee do the talking and leaves the vanilla Frappuccinos to the other guy.

Eastward, ho!
A key question remains: Will Peet's get enough of a foothold to grow out of its niche market? While some observers might dismiss the company, with its 20 new stores in California, as merely a local player, others will glowingly point to the addition of 800 new grocery outlets to last year's 2,700. Specialty sales grew by 33%, while retail sales rose only 17%.

Starbucks' huge moat has ultimately benefited competitors like Peet's by expanding and redefining a commodity market. In its campaign to entice the average Joe with a more upmarket cup of joe, Starbucks has even managed to inspire a no-frills guy like myself to ask for a latte at Dunkin' Donuts. The increasing numbers of consumers who view coffee as something more than just a morning pick-me-up can only help Peet's.

At 3,500 grocery outlets and counting, Peet's still has a small share of the overall market, with considerable room to grow.

Should we buy at $32 per share?
That's a tough one. At $32, Peet's trades at a pricey 36 times its forward earnings of $0.89. It generates no free cash, since it currently spends all that it earns on expansion. The $68 million it has stashed away has also been earmarked for more growth. On the plus side, the company has no debt and is not likely to borrow for additional expansion.

To me, the company appears comfortable with its product strategy. It's wisely avoiding the temptation to be all things to all people. Peet's isn't just a good cup of coffee -- in my opinion, it's an attractive long-term investment.

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At the time of publication, Fool contributor BobbyShethia held no financial position in Peet's or any other companies mentioned in this article. He couldn't brew a good cup of coffee for a million bucks. The Fool has a disclosure policy.