By Howard Penney, Hedgeye

Devotees of Peet’s Coffee and Tea may cringe to hear this, but Starbucks should take a good look at the chain’s potential as an acquisition. The surge in coffee prices is an overhang, but not a deal-breaker to Peet’s growth story. Any commodity concern-induced dips in the share price should be viewed as an entry point.

For some background on Peet’s, its current fiscal year 2011 earnings per share guidance of $1.53 to $1.60 represents an effective doubling of the company’s EPS from 2008. This estimate takes into effect the price increases already implemented in the retail and home delivery businesses at the start of the fourth quarter of 2010, in the foodservice business in January and in the grocery segment in early February. As of the company’s third-quarter 2010 earnings call, management had decided not to take pricing in the grocery channel, but significantly higher coffee costs pushed the company to implement an 8-10% price increase.

Peet’s expects total coffee costs will be up nearly 30% year-over-year. Sales are targeted to grow in the 8% to 10% range, driven by a mid single-digit rate growth in retail and a higher growth rate in specialty.

The company is working to offset higher coffee costs and improve retail margins by continuing to focus on initiatives to reduce waste in coffee, milk and baked goods. Secondly, retail margins should continue to benefit from improved efficiencies in all areas of the store, including labor productivity, supplies and maintenance.

What should Starbucks (SBUX) see in Peet’s (PEET)? The small, Emeryville, Ca.-based chain is firmly positioned at the high end of the specialty coffee category and the company’s continued growth within the grocery channel is key to its overall growth rate going forward. As the specialty category becomes mainstream, there will continue to be new opportunities for the company to grow, geographically, through new channels, and to customers that would not have been possible a decade ago when specialty coffee was still in its infancy.

In the last quarter of 2010, Peet’s began shipping to 600 Wal-Mart (WMT) stores using its direct store delivery (DSD) network. Although the new Wal-Mart distribution business only contributed modestly to business in the quarter, the company expects the contribution to be more meaningful in 2011 as it looks to add another 300 to 500 net new stores, primarily toward the second half of the year.

Management commented on its last earnings call that it’s doing well in Wal-Mart and is in the process of finding the right mix of stores to target. It acknowledged there are a number of Wal-Mart stores that they should be in that they are not yet currently in, but at the same time, they are in some stores already that they would be better off exiting.

Here are the key points to consider regarding Starbucks and Peet’s:

1. Peet’s has posted strong double-digit sales growth in its existing traditional grocery store business for the past eight years. Growth within the grocery channel had been driven by the selling, merchandising and person-to-person marketing approach inherent in a DSD system. Peet’s is a leader in the specialty coffee segment in its most established markets with 32% share in California (#1) and 20% share in the West (second only to Starbucks), according to IRI. Starbucks has witnessed Peet’s success with direct delivery and now wants control of its own distribution system. It could easily leverage Peet’s DSD experience and infrastructure.
2. As the specialty coffee category continues to become more mainstream, the Peet’s brand would be ideally positioned within the Starbucks portfolio. Although some might argue that Starbucks would not want to buy a premium brand that would compete with its own brand, it is important to note that the Peet’s brand would add another price point to Starbucks’ coffee portfolio as it is priced about 15% higher than the Starbucks brand in the grocery channel, according to IRI. Peet’s would give Starbucks three price points within the grocery channel when you include Seattle’s Best, which is priced about 20% lower than the Starbucks brand. With Peet’s, Starbucks would dominate the growing specialty segment and have complete ownership of the grocery aisle.
3. Peet’s operating margins have improved about 250 basis points since 2008, as a result of the company’s decision to slow down retail unit growth and focus on in-store execution and the growing sales contribution from the specialty segment, which is a significantly higher margin business compared to the retail business. For reference, the specialty segment accounted for 34% of Peet’s total sales in 2008 and about 39% in 2010 – the grocery segment drove most of this growth. I expect the specialty segment’s sales mix to increase to about 43% in 2011, which will have a positive impact on margins. I am sure the recent strength in Peet’s margins has not gone unnoticed by Starbucks.