ITEM 1. BUSINESS
Peet's is a specialty coffee roaster and marketer of branded fresh roasted whole bean coffee. We sell our fresh roasted coffee under strict freshness standards through multiple channels of distribution including grocery stores, online and mail order, office, restaurant and food service accounts and 76 company-operated stores in seven states.
We believe that roasted coffee is a perishable product and we pursue distribution channels that are consistent with our strict freshness standards. For instance, our distribution to grocery stores emphasizes the use of an existing network of distributors who deliver fresh goods to our targeted accounts. Our online and mail order customers are shipped coffee directly from our facility and we roast to order. Our goal is to ensure that customers receive coffee within days of roasting.
Over the past seven years, we have expanded from a regional retailer that operates its own outlets into a national coffee brand available through multiple channels of distribution. We extended our retail presence to Southern California in 1997, Chicago and Portland in 1998, Boston in 1999, and Seattle, Denver, and Austin in 2003. We signed our first office coffee distribution agreement in 1997 and have since added a number of restaurants, food service accounts, and office coffee distributors in select markets. We added online ordering capability to our website in 1997 to complement our existing mail order business and have since invested in marketing programs designed to support our online and mail order channel. In 1998, we initiated a strategic expansion into specialty grocery and gourmet food stores. During the last two years, this expansion was further developed to include distribution to mainstream grocers; as we expanded our grocery accounts from 130 to over 2,700 stores. We believe our expansion strategy emphasizes disciplined growth and enhancement of our brand's image and quality reputation. See Note 13, "Segment Information" to the "Notes to Consolidated Financial Statements", included elsewhere in this report.
Our website is located at www.peets.com. Our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, as well as any amendments or exhibits to those reports, are available free of charge through our website at http://investor.peets.com/edgar.cfm as soon as reasonably practicable after we file them with, or furnish them to, the SEC. Peet's was organized as a Washington corporation in 1971.
COMPANY RETAIL STORES
We operate 76 retail stores in seven states through which we sell whole bean coffee, beverages and pastries, tea, and other related items. Our stores are designed to facilitate the sale of fresh whole bean coffee and to encourage customer trial of our coffee through coffee beverages. Each store has a dedicated staff person at the bean counter to take orders and assist customers with questions and issues. Upon order, beans are scooped and ground to the customer's specific requirement. To ensure that the freshest beans are sold to customers, we implemented a policy to not sell beans beyond ten days from roasting and we train our store managers to order and replenish coffee. Our beverage counter features coffee based beverages that promote the sale of whole bean coffee with a standard rotation of coffee brewed from each category of coffees we sell. It is our policy to brew a new batch of coffee every 30 minutes and not re-heat milk in espresso based drinks to ensure freshness. See "Item 2.
ITEM 2. PROPERTIES
Peet's headquarters are located in Emeryville, California, where the Company leases approximately 60,000 square feet of office and production space, including roasting and direct delivery fulfillment facilities. Within these facilities, we have 15,000 square feet devoted to general corporate and retail overhead and a call center for the direct delivery business. Our lease expires in 2005 and we have an option to extend the lease for an additional ten years.
We operate 76 retail stores in seven states. Our retail locations are all company operated in leased facilities. Our store size averages approximately 1,800 square feet. Our stores are typically located in urban neighborhoods, suburban shopping centers (usually consisting of grocery, specialty and service stores) and high-traffic streets.
The following table lists the number of retail stores we have in each location as of February 27, 2004:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On February 25, 2003 and March 7, 2003, two lawsuits were filed against the Company entitled Brian Taraz, et al. vs. Peet's Coffee & Tea, Inc., and Tracy Coffee, et al. vs. Peet's Coffee & Tea, Inc. Each was filed in Superior Court of the State of California, County of Orange, and sought class action certification. These suits were filed by one former and one current store manager alleging misclassification of employment position and sought damages, restitution, reclassification and attorneys' fees and costs. On March 4, 2004, the Superior Court granted preliminary approval of a settlement of the suits and conditional certification of the class for settlement purposes. The Company recorded a charge of $2.7 million during the third quarter for the estimated payment of claims to
eligible class members, attorneys' fees and costs, costs to a third-party claims administrator, as well as applicable employer payroll taxes. This charge is included in "General and administrative expenses" in the Company's consolidated statement of income for 2003. The settlement is subject to the court's final approval, the Company's right to terminate if more than 10% of the settlement class opts out of the settlement, and the plaintiffs' right to terminate if claims by class members in the aggregate exceed more than 10% of the number of work weeks specified in the settlement agreement.
In addition to the lawsuits described above, we may from time to time become involved in certain legal proceedings in the ordinary course of business. Currently, the Company is not party to any other legal proceedings that management believes would have a material adverse effect on the financial position or results of operations of the Company.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our security holders during the quarter ended December 28, 2003.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET FOR THE REGISTRANT'S STOCK
The Company's common stock is traded on the Nasdaq National Market System under the symbol ''PEET''. The following table sets forth, for the periods indicated, the high and low closing prices for our common stock as reported on the Nasdaq National Market for each quarter during the last two fiscal years.
As of February 27, 2004, there were approximately 295 registered holders of record of the Company's common stock. On February 27, 2004, the last sale price reported on the Nasdaq National Market System for the common stock was $20.48 per share.
DIVIDEND POLICY
We have not declared or paid any dividends on our capital stock since 1990. We expect to retain any future earnings to fund the development and expansion of our business. Therefore, we do not anticipate paying cash dividends on our common stock in the foreseeable future. Our current credit facility restricts our ability to pay dividends. See ''Management's Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources.''
USE OF PROCEEDS FROM SALES OF REGISTERED SECURITIES
We completed our initial public offering of our common stock in January and February 2001 pursuant to a Registration Statement on Form S-1 initially filed on October 13, 2000, as subsequently amended (the ''Registration Statement'') (File No. 333-47597). As of February 27, 2004, $17.4 million of the net proceeds from the offering had been used for debt reduction, and the remainder of the net proceeds was invested in short-term, interest-bearing, investment grade securities.
We completed our secondary public offering of our common stock in April 2002 pursuant to a Registration Statement on Form S-3 initially filed on March 27, 2002, as subsequently amended (the "Registration Statement" (File No. 333-85085). The aggregate proceeds to us from the offering were $43.9 million. We paid expenses of approximately $2.9 million, of which approximately $2.4 million represented expenses related to underwriters' fees. Net proceeds from the offering were $41.0 million. As of February 27, 2004, all of the net proceeds were invested in short-term and long-term, United States Government and Agency securities. We expect that our use of proceeds from the offering will conform to the intended use of proceeds as described in our prospectus dated April 19, 2002, except that the proceeds have been invested in short-term and long-term, interest-bearing United States Government and Agency securities until required for working capital purposes.
SHARE REPURCHASE
On February 11, 2004, the Company's Board of Directors authorized the company to repurchase up to 1.0 million shares of Peet's common stock. The repurchases will be made from time to time on the open market at prevailing market prices or in negotiated transactions off the market. The repurchases are expected to continue through the end of 2004 unless extended or shortened by the Board of Directors.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The table below shows selected consolidated financial data for our last five fiscal years. Our fiscal year is based on a 52 or 53 week year and ends on the Sunday closest to the last day in December.
The following selected consolidated financial data should be read in conjunction with our consolidated financial statements and related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
You should read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Except for historical information, the discussion below contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934.
COMPANY OVERVIEW AND INDUSTRY OUTLOOK
Peet's is a specialty coffee roaster and marketer of branded fresh roasted whole bean coffee sold through multiple channels of distribution. Since the founding of our business in 1966, we have established a strong customer base and brand recognition in California. Our national expansion strategy is based on the sale of whole bean coffee in multiple channels of distribution. Currently, our expansion strategy is focused in the western United States, where we have more physical presence and higher customer awareness.
We expect the specialty coffee industry to continue to grow. We believe that this growth will be fueled by continued consumer interest in high quality coffee and related products.
Our operations are vertically integrated. We purchase Arabica coffee beans from countries around the world, apply our artisan-roasting techniques and ship fresh coffee daily to our stores and customers within 24 hours of roasting. Control of purchasing, roasting, packaging and distribution of our coffee allows us to maintain our commitment to freshness is cost effective and enhances our margins and profit potential.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to the financial statements.
We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. These accounting policies and estimates are periodically reevaluated, and adjustments are made when facts and circumstances dictate a change. Historically, we have found our application of accounting policies to be appropriate, and actual results have not differed materially from those determined using necessary estimates.
Our accounting policies are more fully described in Note 2 "Summary of Significant Accounting Policies" in the "Notes to the Consolidated Financial Statements," included elsewhere in this report. We have identified the following critical accounting policies:
- -Inventory. Raw materials consist primarily of green bean coffee. Finished goods include roasted coffee, tea, accessory products, spices, and packaged foods. All products are valued at the lower of cost or market using the first-in, first-out method, except green bean and roasted coffee, which is valued at the average cost. We continually evaluate the composition of our coffee related merchandise and mark down such inventory as needed. Our historical inventory write-offs have been immaterial.
- -Intangibles and other assets. During 2002, we entered into a contractual agreement with Safeway Inc., a national grocery chain, to sell Peet's coffee through its grocery stores. We began shipping during the third quarter of 2002. The agreement included an upfront payment to Safeway Inc. that we recorded in intangibles and other assets and is being amortized as a reduction of revenue based upon estimated sales during the contract period.
- -Long-lived assets. In evaluating the fair value and future benefits of long-lived assets, we perform an analysis of the anticipated undiscounted future net cash flows of the related long-lived asset and reduce their carrying value by the excess, if any, of the result of such calculation. We believe at this time that the long-lived assets' carrying values and useful lives continue to be appropriate.
- -Accrued workers' compensation. In March 2002, we modified our workers' compensation insurance policy to a high deductible insurance program with an overall program ceiling to minimize exposure. We began recording an estimated liability for the self-insured portion of the workers' compensation claims. The liability of $1.1 million recorded as of December 28, 2003 is determined based on information received from our insurance carrier including claims paid, filed and reserved for, as well as using historical experience. Should a greater amount of claims occur compared to what is estimated or the settlement costs increase beyond what was anticipated, the recorded liability may not be sufficient.
- -Accrued litigation. During 2003, two lawsuits were filed against us alleging misclassification of employment position. The lawsuits sought class action status in addition to damages, restitution, reclassification, and attorneys' fees and costs. The Superior Court of the State of California, County of Orange, granted preliminary approval of the proposed settlement of the lawsuits that, subject to the Court's final approval, would fully resolve all claims brought by the plaintiffs. A charge of $2.7 million was recorded in the third quarter of 2003 for the estimated payment of claims to eligible class members, attorneys' fees, costs to a third-party claims administrator, and applicable employer payroll taxes. The liability recorded as of December 28, 2003 of $2.3 million is an estimate and should a greater amount of claims occur or if the court does not certify the settlement, the recorded liability may not be sufficient.
- -Income taxes. In establishing deferred income tax assets and liabilities, we make judgments and interpretations based on enacted tax laws and published tax guidance applicable to its operations. We record deferred tax assets and liabilities and evaluate the need for valuation allowances to reduce deferred tax assets to realizable amounts. Changes in our valuation of the deferred tax assets or changes in the income tax provision may affect its annual effective income tax rate.
- -Hedge accounting. We have in the past used coffee futures and options to hedge price increases in price-to-be-fixed coffee purchase commitments and anticipated coffee purchases. These derivative instruments qualify for hedge accounting. If these derivative instruments did not qualify for hedge accounting, we would have to record the changes in the fair value of the derivative instruments directly to earnings. See "Item 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We invest excess cash in money market accounts, short-term investments and long-term U.S. Government and Agency securities. These financial instruments are all subject to fluctuations of daily interest rates. Therefore our investment portfolio is exposed to market risk from these changes.
The supply and price of coffee are subject to significant volatility and can be affected by multiple factors in the producing countries, including weather, political and economic conditions. In addition, green coffee bean prices have been affected in the past, and may be affected in the future, by the actions of certain organizations and associations that have historically attempted to influence commodity prices of green coffee beans through agreements establishing export quotas or restricting coffee supplies worldwide.
Our coffee hedging strategy is intended to limit the cost exposure of the main commodity used in our business, green coffee beans. We use fixed-price purchase commitments, coffee futures, and coffee futures options to manage coffee supply and price risk.
Fixed-Price Purchase Commitments
We enter into fixed-price purchase commitments in order to secure an adequate supply of quality green coffee beans and fix our cost of green coffee beans. These commitments are made with established coffee brokers and are denominated in U.S. dollars. As of December 28, 2003, we had approximately $16.2 million in open fixed-priced purchase commitments with delivery dates ranging from January 2004 through November 2006. We believe, based on relationships established with our suppliers in the past that the risk of non-delivery on such purchase commitments is low.
Coffee Futures and Futures Options
We use coffee futures and futures options to reduce the price risk of our coffee purchase requirements that we cannot make or have not made on a contractual basis. These instruments are traded on the New York Coffee, Sugar & Cocoa Exchange. We use these futures and options solely for financial hedging purposes and never take actual delivery of the coffee traded on the exchange. The extent of our coffee futures and coffee futures options positions at any given time depends on the amount of coffee we have contracted to purchase, the amount of coffee
qualified for hedge accounting, and general market conditions and trends. Our hedging positions are only placed by the Chief Financial Officer through one brokerage firm that we believe to be reputable. As of December 28, 2003, we held no coffee futures or futures options.
The following table reflects the outstanding coffee futures hedging positions as of December 29, 2002. We had no outstanding positions at December 28, 2003.
These derivative instruments qualify for hedge accounting. The effective portion of the gains and losses are accounted for as inventory costs and are recorded as expense or income when the related coffee is sold. The ineffective portion is recorded as an expense or income immediately. We do not hold or issue derivative instruments for trading purposes.
RECENT ACCOUNTING PRONOUNCEMENTS
During April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. The adoption of SFAS No. 149 did not have a significant impact on our operating results or financial position.
During May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of those financial instruments were classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a significant impact on our operating results or financial position.
In January 2003 the FASB issued FASB Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities and was subsequently revised in December 2003. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, explains how to identify variable interest entities, and how an enterprise should assess its interest in an entity to decide whether to consolidate such entity. Further, FIN 46 requires existing unconsolidated entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. The revision of FIN 46 further defines and narrows the scope of the variable interest entity as well as defers the effective date of the guidance to the first quarter of 2004. The adoption of FIN 46 is not expected to have an impact on our results of operations or financial position.
RISK FACTORS
WE MAY NOT BE SUCCESSFUL IN THE IMPLEMENTATION OF OUR BUSINESS STRATEGY OR OUR BUSINESS STRATEGY MAY NOT BE SUCCESSFUL, EITHER OF WHICH WILL IMPEDE OUR GROWTH AND OPERATING RESULTS.
Our business strategy emphasizes expansion through multiple channels of distribution. Currently, our retail stores, which generated nearly 72% of our 2003 net revenue, continue to be an important element of our business. We do not know whether we will be able to successfully implement our business strategy or whether our business strategy will be successful. Our ability to implement this business strategy is dependent on our ability to:
- - Market our products on a national or international scale and over the internet; - - Enter into distribution and other strategic arrangements with third party retailers and other potential distributors of our coffee; - - Increase our brand recognition on a national and international scale; - - Identify and lease strategic locations suitable for new stores; and - - Manage growth in administrative overhead and distribution costs likely to result from the planned expansion of our retail and non-retail distribution channels.
Our revenue may be adversely affected if we fail to implement our business strategy or if we divert resources to a business strategy that ultimately proves unsuccessful.
BECAUSE OUR BUSINESS IS HIGHLY DEPENDENT ON A SINGLE PRODUCT, SPECIALTY COFFEE, IF THE DEMAND FOR SPECIALTY COFFEE DECREASES, OUR BUSINESS COULD SUFFER.
Sales of specialty coffee constituted nearly 84% of our 2003 net revenue. Demand for specialty coffee is affected by many factors, including:
- - Consumer tastes and preferences; - - National, regional and local economic conditions; and - - Demographic trends.
Because we are highly dependent on consumer demand for specialty coffee, a shift in consumer preferences away from specialty coffee would harm our business more than if we had more diversified product offerings. If customer demand for specialty coffee decreases, our sales would decrease accordingly.
IF WE FAIL TO CONTINUE TO DEVELOP AND MAINTAIN OUR BRAND, OUR BUSINESS COULD SUFFER.
We believe that maintaining and developing our brand is critical to our success and that the importance of brand recognition may increase as a result of competitors offering products similar to ours. Because the majority of our retail stores are located on the West Coast, primarily in California, our brand recognition remains largely regional. Our brand building initiative involves increasing the availability of our products and opening new stores to increase awareness of our brand and create and maintain brand loyalty. If our brand building initiative is unsuccessful, we may never recover the expenses incurred in connection with these efforts and we may be unable to increase our future revenue or implement our business strategy.
Our success in promoting and enhancing the Peet's brand will also depend on our ability to provide customers with high quality products and customer service. Although we take measures to ensure that we sell only fresh roasted whole bean coffee and that our retail employees properly prepare our coffee beverages, we have no control over our whole bean coffee products once purchased by customers. Accordingly, customers may prepare coffee from our whole bean coffee inconsistent with our standards, store our whole bean coffee for long periods of time or resell our whole bean coffee without our consent, which in each case, potentially affects the quality of the coffee prepared from our products. If customers do not perceive our products and service to be of high quality, then the value of our brand may be diminished and, consequently, our ability to implement our business strategy may be adversely affected.
BECAUSE OUR BUSINESS IS BASED PRIMARILY IN CALIFORNIA, A WORSENING OF ECONOMIC CONDITIONS, A DECREASE IN CONSUMER SPENDING OR A CHANGE IN THE COMPETITIVE CONDITIONS IN THIS MARKET MAY SUBSTANTIALLY DECREASE OUR REVENUE AND MAY ADVERSELY IMPACT OUR ABILITY TO IMPLEMENT OUR BUSINESS STRATEGY.
Our California retail stores generated 63% of our 2003 net revenue and a substantial portion of the revenue from our other distribution channels is generated in California. We expect that our California operations will continue to generate a substantial portion of our revenue. In addition, our California retail stores provide us with means for increasing brand awareness, building customer loyalty and creating a premium specialty coffee brand. As a result, an economic downturn or other decrease in consumer spending in California may not only lead to a substantial decrease in revenue, but may also adversely impact our ability to market our brand, build customer loyalty, or otherwise implement our business strategy.
THE GROCERY WORKERS STRIKE IN SOUTHERN CALIFORNIA HAS ENDED, HOWEVER, A SIMILAR STRIKE IN OTHER REGIONS COULD NEGATIVELY IMPACT OUR GROCERY BUSINESS.
The Southern California grocery workers strike impacted Safeway, Albertson's, and Ralph's. We sell coffee to each of these supermarkets in the area as well as in other regions in the Western United States. If a similar strike were to occur in other regions such as Northern California and the Pacific Northwest, where we have the majority of our distribution, our grocery revenue could be negatively impacted.
IF WE ARE UNABLE TO CONTINUE LEASING OUR RETAIL LOCATIONS OR OBTAIN LEASES FOR NEW STORES, OUR EXISTING OPERATIONS AND OUR ABILITY TO EXPAND MAY BE ADVERSELY AFFECTED.
All of our 76 retail locations are on leased premises. If we are unable to renew these leases, our revenue and profits could suffer. In addition, we intend to lease other premises in connection with the planned expansion of our retail operations. Because we compete with other retailers and restaurants for store sites and some landlords may grant exclusive locations to our competitors, we may not be able to obtain new leases or renew existing leases on acceptable terms. This could adversely impact our revenue growth and brand building initiatives.
BECAUSE WE RELY HEAVILY ON COMMON CARRIERS TO SHIP OUR COFFEE ON A DAILY BASIS, ANY DISRUPTION IN THEIR SERVICES OR INCREASE IN SHIPPING COSTS COULD ADVERSELY AFFECT OUR BUSINESS.
We rely on a number of common carriers to deliver coffee to our customers and retail stores. We consider roasted coffee a perishable product and we rely on these common carriers to deliver fresh roasted coffee on a daily basis. We have no control over these common carriers and the services provided by them may be interrupted as a result of labor shortages, contract disputes or other factors. If we experience an interruption in these services, we may be unable to ship our coffee in a timely manner. A delay in shipping could:
- - Have an adverse impact on the quality of the coffee shipped, and thereby adversely affect our brand and reputation; - - Result in the disposal of an amount of coffee that could not be shipped in a timely manner; and - - Require us to contract with alternative, and possibly more expensive, common carriers.
Any significant increase in shipping costs could lower our profit margins or force us to raise prices, which could cause our revenue and profits to suffer.
WE DEPEND ON THE EXPERTISE OF KEY PERSONNEL. IF THESE INDIVIDUALS LEAVE OR CHANGE THEIR ROLE WITHIN OUR COMPANY WITHOUT EFFECTIVE REPLACEMENTS, OUR OPERATIONS MAY SUFFER.
The success of our business is dependent to a large degree on our management and our coffee roasters and purchasers. If members of our management leave without effective replacements, our ability to implement our business strategy could be impaired. If we lost the services of our coffee roasters and purchasers, our ability to source and purchase a sufficient supply of high quality coffee beans and roast coffee beans consistent with our quality standards could suffer. In either case, our business and operations could be adversely affected.
WE MAY NOT BE ABLE TO HIRE OR RETAIN ADDITIONAL MANAGEMENT AND OTHER PERSONNEL AND OUR RECRUITING AND TRAINING COSTS MAY INCREASE AS A RESULT OF TURNOVER, BOTH OF WHICH MAY INCREASE OUR COSTS AND REDUCE OUR PROFITS AND MAY ADVERSELY IMPACT OUR ABILITY TO IMPLEMENT OUR BUSINESS STRATEGY.
The success of our business depends upon our ability to attract and retain highly motivated, well-qualified management and other personnel, including technical personnel and retail employees. We face significant competition in the recruitment of qualified employees. Our ability to execute our business strategy may suffer if:
- - We are unable to recruit or retain a sufficient number of qualified employees; - - The costs of employee compensation or benefits increase substantially; or - - The costs of outsourcing certain tasks to third party providers increase substantially.
We expend significant resources in training our retail managers and employees. During the past few years, retail employee turnover has increased to approximately 75% per year. If turnover continues to increase, we may incur additional recruiting and training costs.
BECAUSE WE HAVE ONLY ONE ROASTING FACILITY, A SIGNIFICANT INTERRUPTION IN THE OPERATION OF THIS FACILITY COULD POTENTIALLY DISRUPT OUR OPERATIONS.
We have only one coffee roasting and distribution facility. A significant interruption in the operation of this facility, whether as a result of a natural disaster or other causes, could significantly impair our ability to operate our business. Moreover, our roasting and distribution facility and most of our stores are located near several major earthquake faults. The impact of a major earthquake on our facilities, infrastructure and overall operations is difficult to predict and an earthquake could seriously disrupt our entire business.
Our earthquake insurance covers net income, continuing normal operating expenses and extra expenses incurred during the period of restoration. However, in the event of a catastrophic earthquake, our coverage is limited and we would incur additional expenses.
WE HAVE A HIGH DEDUCTIBLE WORKERS' COMPENSATION INSURANCE PROGRAM AND MORE CLAIMS AND HIGHER COSTS FROM THESE CLAIMS MAY ADVERSELY AFFECT OUR PROFIT.
Our current workers' compensation insurance program is a modified self-insured program with a high deductible with an overall program ceiling to limit exposure. The California workers' compensation environment has been unpredictable with continually increasing costs in the past five years. The majority of our business is in California, therefore, we are exposed to the same increased costs. Additionally, we have had to estimate our liability for existing claims whose outcome is uncertain. While we believe our reserve methodology on these claims is appropriate today, unfavorable development in this area will also affect any open claims that were filed beginning March 2002, the date we transitioned to a high deductible program. Should a greater amount of claims occur or the settlement costs increase beyond what was anticipated, our expenses could increase and our profitability may decrease.
INCREASES IN THE COST AND DECREASES IN AVAILABILITY OF HIGH QUALITY ARABICA COFFEE BEANS COULD IMPACT OUR PROFITABILITY AND GROWTH OF OUR BUSINESS.
Coffee prices are currently near historical lows and we believe they are likely to increase in the future. Coffee is a trade commodity and, in general, its price can fluctuate depending on:
- - Weather patterns in coffee-producing countries; - - Economic and political conditions affecting coffee-producing countries; - - Foreign currency fluctuations; and - - The ability of coffee-producing countries to agree to export quotas.
If the cost of our green coffee beans increases due to any of these or other factors impacting us negatively, we many not be able to pass along those costs to our customers because of the competitive nature of the specialty coffee industry. If we are unable to pass along increased coffee costs, our margin will decrease and our profitability will suffer accordingly. If we are not able to purchase sufficient quantities of high quality Arabica beans due to any
of the above factors, we many not be able to fulfill the demand for our coffee, our revenue may decrease and our ability to expand our business may also suffer.
OUR ROASTING METHODS ARE NOT PROPRIETARY, SO COMPETITORS MAY BE ABLE TO DUPLICATE THEM, WHICH COULD HARM OUR COMPETITIVE POSITION.
We consider our roasting methods essential to the flavor and richness of our roasted whole bean coffee and, therefore, essential to our brand. Because we do not hold any patents for our roasting methods, it may be difficult for us to prevent competitors from copying our roasting methods. If our competitors copy our roasting methods, the value of our brand may be diminished, and we may lose customers to our competitors. In addition, competitors may be able to develop roasting methods that are more advanced than our roasting methods, which may also harm our competitive position.
COMPETITION IN THE SPECIALTY COFFEE MARKET IS INTENSE AND COULD AFFECT OUR PROFITABILITY.
Competition in the specialty coffee market is becoming increasingly intense as relatively low barriers to entry encourage new competitors to enter the specialty coffee market. Our whole bean specialty coffee competes with several major national brands, such as Gevalia (Kraft Foods), Green Mountain Coffee, Illy Caffe , Millstone (Procter & Gamble), Seattle's Best (Starbucks) and Starbucks, as well as numerous smaller, regional brands. In addition, we compete indirectly against all other coffee brands on the market. A number of nationwide coffee marketers, such as Kraft Foods, Procter & Gamble and Nestle, are distributing premium coffee brands in supermarkets. These premium coffee brands may serve as substitutes for our whole bean coffee. In addition to competing with other distributors of whole bean coffee, we compete with retailers of prepared beverages, including coffee house chains, particularly Starbucks, numerous convenience stores, restaurants, coffee shops and street vendors. If we do not succeed in effectively differentiating ourselves from our competitors or our competitors adopt our strategies, then our competitive position will be weakened.
Despite competing in a fragmented product category, whole bean specialty coffee brands are being established across multiple distribution channels. Several competitors have been aggressive in obtaining distribution in specialty grocery and gourmet food stores, through online and mail order and in office, restaurant and food service locations. We have only recently begun to penetrate these channels. Other competitors may have an advantage over us based on their earlier entry into these distribution channels.
Many of these new market entrants may have substantially greater financial, marketing and operating resources than us. In addition, many of our existing competitors have substantially greater financial, marketing and operating resources than us.
LAWSUITS AND OTHER CLAIMS AGAINST THE COMPANY MAY ADVERSELY AFFECT OUR PROFITABILITY.
We may from time to time become involved in certain legal proceedings in the ordinary course of business, such as the two lawsuits filed in 2003 against us entitled Brian Taraz, et al. vs. Peet's Coffee & Tea, Inc., and Tracy Coffee, et al. vs. Peet's Coffee & Tea, Inc. In investigating any claims against the Company or defending any allegations, we may incur legal fees, settlement fees, damages or remediation expenses that may harm our business, reducing our sales and adversely affecting our profitability. Further, while the Superior Court has granted preliminary approval to the settlement of the lawsuits brought by Taraz et al., the settlement remains subject to the court's final approval, our right to terminate if more than 10% of the settlement class opts out of the settlement, and the plaintiffs' right to terminate if claims by class members in the aggregate exceed more than 10% of the number of work weeks specified in the settlement agreement, and may therefore never be consummated.
ADVERSE PUBLIC OR MEDICAL OPINION ABOUT CAFFEINE MAY HARM OUR BUSINESS.
Our specialty coffee contains significant amounts of caffeine and other active compounds, the health effects of some of which are not fully understood. A number of research studies conclude or suggest that excessive consumption of caffeine may lead to increased heart rate, nausea and vomiting, restlessness and anxiety, depression, headaches, tremors, sleeplessness and other adverse health effects. An unfavorable report on the health effects of caffeine or other compounds present in coffee could significantly reduce the demand for coffee, which could harm our business and reduce our sales and profits.
ADVERSE PUBLICITY REGARDING CUSTOMER COMPLAINTS MAY HARM OUR BUSINESS.
We may be the subject of complaints or litigation from customers alleging beverage and food-related illnesses, injuries suffered on the premises or other quality, health or operational concerns. Adverse publicity resulting from such allegations may materially adversely affect us, regardless of whether such allegations are true or whether we are ultimately held liable.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
All information required by this item is included on pages to in Item 15 of this Form 10-K Report and is incorporated in this item by reference.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officers, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of December 28, 2003, the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable-assurance level.
There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information respecting continuing directors and nominees of the Company is set forth under the caption "Election of Directors" in the Company's Proxy Statement relating to its 2004 Annual Meeting of Stockholders and is incorporated by reference into this Form 10-K Report. The Proxy Statement will be filed with the Securities and Exchange Commission in accordance with Rule 14a-6(c) promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange Act."). With the exception of the foregoing information and other information specifically incorporated by reference into this Form 10-K Report, the Proxy Statement is not being filed as a part hereof. Information respecting executive officers of the Company is set forth at Part I of this Report.
Information respecting compliance with Section 16(a) of the Exchange Act is set forth under the caption "Section 16(a) Beneficial Ownership Reporting Compliance" in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information concerning executive compensation required by Item 11 is set forth under the captions "Executive Compensation," "Stock Option Grants and Exercises," "Employment Agreements" and "Compensation Committee Interlocks" in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information concerning security ownership of certain beneficial owners and management required by Item 12 is set forth under the caption "Security Ownership of Certain Beneficial Owners and Management" and "Our Equity Incentive Plans" in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information concerning certain relationships and related transactions required by Item 13 is set forth under the captions "Employment Agreements" and "Certain Transactions" in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information concerning principal accounting fees and services required by Item 14 is set forth under the caption "Proposal 2 - Ratification of Selection of Independent Auditors" in the Proxy Statement and is incorporated by reference into this Form 10-K Report.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
The following documents are filed as part of this Form 10-K.
(a)(1) Index to Consolidated Financial Statements.
The following Consolidated Financial Statements of Peet's Coffee &Tea, Inc. and its subsidiaries are filed as part of this Form 10-K:
(a)(2) Index to Financial Statement Schedule.
Schedules are omitted because they are not applicable, not required or because the required information is included in the Consolidated Financial Statements or Notes thereto.
(a)(3) Listing of Exhibits
EXHIBIT DESCRIPTION - ------- ----------- 3.1 Amended and Restated Articles of Incorporation.* 3.2 Amended and Restated Bylaws.* 4.1 Form of common stock certificate.* 10.1 Credit Agreement, dated as of September 1, 2000, among Peet's Coffee and Tea, Inc., Peet's Companies, Inc., Peet's Trademark Company and General Electric Capital Corporation.* 10.2 Letter Agreement dated October 11, 2000 among Peet's Coffee and Tea, Inc., Peet's Companies, Inc., Peet's Trademark Company and General Electric Capital Corporation.* 10.3 First Amendment to Credit Agreement dated as of January 19, 2001 among Peet's Operating Company, Inc. (formerly Peet's Coffee and Tea, Inc.), Peet's Coffee & Tea, Inc. (formerly Peet's Companies, Inc.), Peet's Trademark Company and General Electric Capital Corporation.* 10.4 Loan Agreement, dated as of December 1, 1995, by and between California Statewide Communities Development Authority and Peet's Coffee and Tea, Inc.* 10.5 Amended and Restated 1993 Stock Option Plan. (1)* 10.6 1994 California Stock Option Plan. (1)* 10.7 1997 Equity Incentive Plan and form of Stock Option Agreement. (1)* 10.8 Peet's Operating Company, Inc. Savings and Retirement Plan. (1)* 10.9 2000 Equity Incentive Plan and form of Stock Option Agreement. (1)* 10.10 2000 Non-Employee Director Plan and form of Stock Option Agreement.(1)* 10.11 2000 Employee Stock Purchase Plan and form of Offering. (1)* 10.12 Peet's Operating Company, Inc. Key Employee Severance Benefit Plan.(2)* 10.13 Change of Control Option Acceleration Plan. (1)* 10.14 Advisory Engagement Letter dated December 9, 1996, between Peet's Operating Company, Inc. and Jesse.Hansen&Co.* 10.15 Peet's Operating Company, Inc. Key Employment Agreement for Vice President, Real Estate dated as of January 4, 1999. (2) 10.16 Peet's Operating Company, Inc. Key Employment Agreement for Vice President of Operations dated as of June 24, 2002. (2) 10.17 Peet's Operating Company, Inc. Key Employment Agreement for Vice President, Coffee dated as of June 6, 2000. (2)* 10.18 Peet's Operating Company, Inc. Key Employment Agreement for Vice President of Information Systems dated as of January 20, 2000. (2)
10.19 Peet's Operating Company, Inc. Key Employment Agreement for Vice President, Marketing dated as of January 4, 1999. (2)* 10.20 Form of Indemnity Agreement between the registrant and each of its directors and officers. (2) 10.21 Second Amendment to Credit Agreement, dated as of June 29, 2001, among Peet's Operating Company, Inc., Peet's Trademark Company, Peet's Coffee & Tea, Inc. and General Electric Capital Corporation. Incorporated by reference to Exhibit 10.23 to the Company's quarterly report on Form 10-Q for the quarter ended July 1, 2001. 10.22 Third Amendment to Credit Agreement, dated as of March 1, 2002, among Peet's Operating Company, Inc., Peet's Trademark Company, Peet's Coffee & Tea, Inc. and General Electric Capital Corporation. Incorporated by reference to Exhibit 10.24 to the Company's annual filing on Form 10-K for the year ended December 30, 2001. 10.23 Fourth Amendment to Credit Agreement dated as of April 23, 2002 among Peet's Operating Company, Inc., Peet's Trademark Company, Peet's Coffee & Tea, Inc. and General Electric Capital Corporation. Incorporated by reference to Exhibit 10.24 to the Company's quarterly report on Form 10-Q for the quarter ended March 31, 2002. 10.24 Peet's Coffee & Tea, Inc. Key Employment Agreement for Chief Executive Officer dated as of May 6, 2002. Incorporated by reference to Exhibit 10.17 to the Company's quarterly report on Form 10-Q for the quarter ended June 30, 2002. (2) 10.25 Peet's Coffee & Tea, Inc. Amended and Restated 2000 Non-Employee Director Stock Option Plan and Form of Stock Option Agreement. Incorporated by reference to Exhibit 10.10 to the Company's quarterly report on Form 10-Q for the quarter ended September 29, 2002. (1) 10.26 Fifth Amendment to Credit Agreement dated as of December 31, 2002 among Peet's Operating Company, Inc., Peet's Trademark Company, Peet's Coffee & Tea, Inc. and General Electric Capital Corporation. 10.27 Sixth Amendment to Credit Agreement dated as of February 21, 2003 among Peet's Operating Company, Inc., Peet's Trademark Company, Peet's Coffee & Tea, Inc. and General Electric Capital Corporation. 10.28 Peet's Coffee & Tea, Inc. Key Employment Agreement for Vice President, Specialty dated as of June 9, 2003. Incorporated by reference to Exhibit 10.17 to the Company's quarterly report on Form 10-Q for the quarter ended June 29, 2003. (2) 10.29 Peet's Coffee & Tea, Inc. Key Employment Agreement for Chief Financial Officer dated as of June 25, 2003. Incorporated by reference to Exhibit 10.17 to the Company's quarterly report on Form 10-Q for the quarter ended September 28, 2003. (2) 21.1 Subsidiaries of the registrant.*
23.1 Consent of Deloitte & Touche LLP. 31.1 Certification of the Company's Chief Executive Officer, Patrick O'Dea, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended. 31.2 Certification of the Company's Chief Financial Officer, Thomas Cawley, pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as amended 32.1 Certification of the Company's Chief Executive Officer, Patrick O'Dea, pursuant to Section 906 of Sarbanes-Oxley Act of 2002 32.2 Certification of the Company's Chief Financial Officer, Thomas Cawley, pursuant to Section 906 of Sarbanes-Oxley Act of 2002.
______________ * Incorporated by reference to Exhibit 10.18 to the Registrant's Information Statement on Form S-1 (File No. 333-47957) filed on October 13, 2000, as subsequently amended. (1) Compensatory plan or arrangement. (2) Management contract.
(b) Reports on Form 8-K
Current Report on Form 8-K filed on October 27, 2003 to furnish under Item 12 a press release guidance dated October 27, 2003
Current Report on Form 8-K filed on October 29, 2003 to furnish under Item 12 a press release dated October 29, 2003
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: March 12, 2004 PEET'S COFFEE & TEA, INC. By: /s/ Patrick J. O'Dea ----------------------- Patrick J. O'Dea President and Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Patrick J. O'Dea and Thomas P. Cawley and each of them, as his true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him and in his name, place, and stead, in any and all capacities, to sign any and all amendments to this report and to file the same, with all granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in connection therewith, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE --------- ----- ----
/s/ PATRICK J. O'DEA President, Chief Executive Officer March 12, 2004 - ----------------------- and Director (Principal Executive Patrick J. O'Dea Officer)
/s/ THOMAS P. CAWLEY Vice President, Chief Financial March 12, 2004 - --------------------- Officer, and Secretary (Principal Thomas P. Cawley Financial and Accounting Officer)
/s/ JEAN-MICHEL VALETTE Chairman March 12, 2004 - ------------------------- Jean-Michel Valette
/s/ GERALD BALDWIN Director March 12, 2004 - -------------------- Gerald Baldwin
/s/ HILARY BILLINGS Director March 12, 2004 - --------------------- Hilary Billings
/s/ GORDON A. BOWKER Director March 12, 2004 - ----------------------- Gordon A. Bowker
/s/ H. WILLIAM JESSE, JR. Director March 12, 2004 - ---------------------------- H. William Jesse, Jr.
/s/ CHRISTOPHER P. MOTTERN Director March 12, 2004 - ---------------------------- Christopher P. Mottern
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INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Shareholders Peet's Coffee & Tea, Inc.
We have audited the accompanying consolidated balance sheets of Peet's Coffee & Tea, Inc. and subsidiaries as of December 29, 2002 and December 28, 2003, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 28, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Peet's Coffee & Tea, Inc. and subsidiaries as of December 29, 2002 and December 28, 2003 and the results of their operations and their cash flows for each of the three years in the period ended December 28, 2003, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 12 to the financial statements, effective January 1, 2001, the Company changed its method of accounting for derivative financial instruments to conform to Statement of Financial Accounting Standards No. 133.
/s/ DELOITTE & TOUCHE LLP
San Francisco, California March 11, 2004
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See notes to consolidated financial statements.
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See notes to consolidated financial statements.
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See notes to consolidated financial statements.
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See notes to consolidated financial statements.
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PEET'S COFFEE & TEA, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. HISTORY AND ORGANIZATION Peet's Coffee & Tea, Inc., (the ''Company'') sells fresh roasted coffee, hand selected tea and related items in several distribution channels, including specialty grocery and gourmet food stores, online and mail order, office and restaurant accounts and company-operated retail stores. At December 29, 2002 and December 28, 2003, the Company operated 65 and 75 retail stores, respectively, in California, Colorado, Illinois, Oregon, Massachusetts, Texas and Washington.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany transactions have been eliminated in consolidation.
USE OF ESTIMATES - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECLASSIFICATIONS - Certain reclassifications have been made to prior years' financial statements in order to conform with the current year's presentation.
YEAR END - The Company's year end is the Sunday closest to December 31. The years 2003, 2002, and 2001 included 52 weeks.
CASH AND CASH EQUIVALENTS - The Company considers all liquid investments with original maturities of three months or less to be cash equivalents.
INVENTORIES - Raw materials consist primarily of green bean coffee. Finished goods include roasted coffee, tea, accessory products, spices, and packaged foods. All products are valued at the lower of cost or market using the first-in, first-out method, except green bean and roasted coffee, which is valued at the average cost.
PROPERTY AND EQUIPMENT are stated at cost. Depreciation and amortization are recorded on the straight-line method over the estimated useful lives of the property and equipment, which range from 3 to 10 years. Leasehold improvements are amortized using the straight-line method over the lesser of the estimated useful life or the term of the related lease, which range from 3 to 10 years.
INTANGIBLES AND OTHER ASSETS include lease rights, contract acquisition costs, deposits, and restricted cash. Lease rights represent payments made to lessors and others to secure retail locations and are amortized on the straight-line method over the life of the related lease from 5 to 15 years. Intangibles, primarily lease rights, net of amortization, were $1,040,000 and $809,000 at December 29, 2002 and December 28, 2003, respectively. The related accumulated amortization was $1,882,000 and $1,944,000 at December 29, 2002 and December 28, 2003, respectively. Amortization expense for 2001, 2002, and 2003 was $238,000, $246,000 and $203,000, respectively. Future amortization expense for 2004 through 2008 is estimated at $155,000, $134,000, $118,000, $112,000, and $112,000, respectively. Contract acquisition costs represents a payment made to a retailer to obtain distribution for a specified period of time and is being amortized as a reduction of revenue over the contract period.
INVESTMENT POLICY - Investments are classified as available for sale and are recorded at fair market value. Any unrealized gains and losses are recorded in other comprehensive income (loss).
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IMPAIRMENT OF LONG-LIVED ASSETS - The Company evaluates the recoverability of its long-lived assets whenever events or changes in circumstances have indicated that the carrying amount of its assets might not be recoverable. If the fair value is less than the carrying amount of the asset, a loss is recognized for the difference. No impairment charges were recorded during 2001, 2002, or 2003.
ACCRUED COMPENSATION AND BENEFITS - Beginning in March 2002, the Company modified its workers' compensation insurance policy to a high deductible program with an overall program ceiling to minimize exposure. We began recording an estimated liability for the self-insured portion of the workers' compensation claims. The liability is determined based on information received from the Company's insurance adjuster including claims paid, filed and reserved for, as well as using historical experience. As of December 29, 2002 and December 28, 2003, we had $703,000 and $1,136,000 accrued for workers' compensation.
A summary of the accrual activity is as follows (in thousands):
STORE CLOSURE - The Company continually reviews the operating performance of individual stores. An estimate for the costs associated with closing under-performing stores in the period in which the store is closed. The plan includes the method of disposition and the expected date of completion. Costs, which are considered to have no future economic benefit, include direct costs to terminate a lease or sublease a property and the difference between the book value and estimated recovery of fixed assets. Significant changes to the plan are unlikely. The operating costs, including depreciation, of stores or other facilities to be sold or closed are expensed during the period they remain in use.
No expense was recorded in 2001, 2002, or 2003. As of December 30, 2001, the Company had an accrual of $59,000, which was paid during 2002.
In August 2001, the Company assigned, with the consent of the landlord, the existing lease for a store to another entity. The Company remains liable for rent and other charges under the lease, which expires December 31, 2008. However, the assignee's parent company has guaranteed the payment by the assignee of rent and other charges under the lease assignment up to $313,000 (equivalent to approximately four years of rent due under the lease). The Company expects that the assignee will make all future rent payments required under the lease. See Note 11.
REVENUE RECOGNITION - Net revenue is recorded upon purchases by customers at retail locations or when merchandise is received by customers in the specialty sales channel. Sales returns are insignificant. The Company establishes an allowance for estimated doubtful accounts based on historical experience and current trends, which management believes are appropriate.
The Company records shipping revenue in net revenue. The Company recorded shipping revenue of $1,522,000, $1,617,000, and $1,726,000 related to online and mail order and specialty sales in 2001, 2002, and 2003, respectively.
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A summary of the allowance for doubtful accounts is as follows (in thousands):
COST OF SALES AND RELATED OCCUPANCY EXPENSES consist primarily of coffee and other product costs. It also includes plant manufacturing (including depreciation), freight and distribution costs. Occupancy expenses include rent and related expenses such as utilities.
PREOPENING COSTS or costs associated with the opening or remodeling of stores, such as payroll and rent, are expensed as incurred.
HEDGING ACTIVITIES - The Company uses coffee futures and options to hedge price increases in price-to-be- fixed coffee purchase commitments and anticipated coffee purchases. These derivative instruments qualify for hedge accounting under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. See Note 12. The Company does not hold or issue derivative instruments for trading purposes.
FAIR VALUE OF FINANCIAL INSTRUMENTS - The carrying value of cash and equivalents, receivables and accounts payable approximates fair value. Investments are recorded at fair value. The carrying value of debt approximates the estimated fair value due to floating interest rates on the debt. The fair value of futures contracts is the amount at which they could be settled, based on estimates obtained from dealers. At December 29, 2002 the net unrealized gain/(loss) on such contracts was $31,000. At December 28, 2003 there were no open futures contracts. See Note 12.
ADVERTISING COSTS are expensed as incurred. Advertising expense was $2,773,000, $2,775,000 and $3,136,000 in 2001, 2002, and 2003, respectively.
DEFERRED LEASE CREDITS - Certain of the Company's lease agreements provide for scheduled rent increases during the term of the lease. Rent is expensed on a straight-line basis over the term of the lease.
INCOME TAXES -Income taxes are accounted for using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statements and tax bases of assets and liabilities using enacted tax rates currently in effect.
STOCK-BASED COMPENSATION - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principle Board, (APB), No. 25, Accounting for Stock Issued to Employees. Accordingly, no compensation cost has been recognized for the stock option awards granted at fair market value. Through 2001, the Company granted options at 85% of fair value and recorded compensation expense equal to the intrinsic value over the vesting period. The Company has recorded compensation expense of $305,000 in 2001, $290,000 in 2002, and $191,000 in 2003. Statement of Financial Accounting Standards, (SFAS), No. 123, Accounting for Stock-Based Compensation, requires the disclosure of pro forma net income and earning per share as if the Company had adopted the fair value method. Had compensation cost for the Company's stock option plans and employee stock purchase plan been determined based on the fair value at the grant date consistent with the provisions of SFAS No. 123, the Company's net income would have been reduced to the pro forma amounts indicated below (in thousands):
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The Company uses the Black-Scholes option-pricing model for determining the fair value of options, which requires the input of certain estimates that may affect what is deemed fair value. The existing model may not necessarily provide a reliable single measure of the value of its stock options. Management will continue to evaluate alternative methodologies that may more appropriately reflect pro forma compensation expense.
Additional disclosure requirements of SFAS No. 123, Accounting for Stock-Based Compensation, are set forth in Note 10.
The fair value of each option grant and ESPP award is estimated on the date of grant using the Black-Scholes option-pricing model with the following assumptions:
NET INCOME PER SHARE - Basic net income per share is computed as net income divided by the weighted average number of common shares outstanding for the period. Diluted net income per share reflects the potential dilution that could occur from common shares issued through stock options, warrants and the conversion of preferred stock. Anti-dilutive shares of 110,750, 630,621 and 142,747 have been excluded from diluted weighted average shares outstanding in 2001, 2002 and 2003, respectively.
The following table summarizes the differences between basic weighted average shares outstanding and diluted weighted average shares outstanding used to compute diluted net income per share (in thousands):
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The number of incremental shares from the assumed exercise of stock options and warrants was calculated applying the treasury stock method.
RECENTLY ISSUED ACCOUNTING STANDARDS - During April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The guidance should be applied prospectively. The adoption of SFAS No. 149 did not have a significant impact on our operating results or financial position.
During May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. SFAS No. 150 clarifies the accounting for certain financial instruments with characteristics of both liabilities and equity and requires that those instruments be classified as liabilities in statements of financial position. Previously, many of those financial instruments were classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003 and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a significant impact on our operating results or financial position.
In January 2003 the FASB issued FASB Interpretation No. 46 ("FIN 46"), Consolidation of Variable Interest Entities and was subsequently revised in December 2003. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, explains how to identify variable interest entities, and how an enterprise should assess its interest in an entity to decide whether to consolidate such entity. Further, FIN 46 requires existing unconsolidated entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. The revision of FIN 46 further defines and narrows the scope of the variable interest entity as well as defers the effective date of the guidance to the first quarter of 2004. The adoption of FIN 46 is not expected to have an impact on our results of operations or financial position.
3. INVENTORIES The Company's inventories consist of the following at year end 2002 and 2003 (in thousands):
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4. PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment consists of the following at year end 2002 and 2003 (in thousands):
Depreciation expense was $5,455,000 in 2001, $5,005,000 in 2002 and $5,564,000 in 2003, respectively. Construction in progress includes manufacturing plant equipment, new store fixtures and other capital projects not yet placed in service.
5. INVESTMENTS At December 29, 2002 and December 28, 2003, the Company maintained long term investments classified as available for sale of $28,102,000 and $16,572,000. The long term investments are comprised of United States Treasury Notes and Bonds, and Federal Agency notes and bonds, maturing within five years. Gross unrealized holding gains were $360,000 and $29,000 and gross unrealized holding losses were $0 and $4,000 for the period ended December 29, 2002, and December 28, 2003, respectively. Gross unrealized holding losses at December 28, 2003 are due to fluctuations in interest rates and are only considered as temporary impairments. There are no securities with unrealized losses aged greater than twelve months.
During 2002 and 2003, the company sold securities for net proceeds from investments of $229,383,000 and $97,915,000, and realized gains of $27,000 and $294,000, respectively. Realized gains and losses are determined on the specific identification method. For the periods ended December 29, 2002 and December 28, 2003, the Company had net unrealized gains of $227,000 (net of $133,000 tax) and $16,000 (net of $10,000 tax) respectively, included in accumulated other comprehensive income (loss).
6. BORROWINGS The Company maintains a credit facility with General Electric Capital Corporation. The facility expires in September 2005 and provides for a revolving line of credit up to $15,000,000 and the issuance of up to $3,000,000 in letters of credit. Total availability under the revolving line of credit is determined by subtracting our funded debt from our trailing twelve month earnings before interest, taxes, depreciation and amortization, or (EBITDA), multiplied by 3.75 for the period before September 1, 2001, 3.5 for the period after September 1, 2001 and before September 1, 2002, and 2.5 thereafter. As of December 28, 2003, there was no outstanding balance and $14,942,000 was available under the Company's line of credit.
Borrowings under the credit facility are secured by a lien on substantially all of the Company's assets. The credit facility contains covenants restricting the Company's ability to make capital expenditures, incur additional indebtedness and lease obligations, open retail stores, make restricted payments, merge into or with other companies and sell all or substantially all of its assets and requiring the Company to meet certain financial tests.
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Long term borrowings consist of the following at year end 2002 and 2003 (in thousands):
7. INCOME TAXES The income tax provision (benefit) consists of the following (in thousands):
The difference between the effective income tax rate and the United States federal income tax rate is summarized as follows:
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Deferred tax assets (liabilities) consist of the following at year end 2002 and 2003 (in thousands):
The Company has state net operating loss carryforwards of $1,867,000, which expire between 2006 and 2007.
The utilization of our net operating loss and credit carryforwards may be subject to a substantial annual limitation due to any future "changes in ownership," as defined by provisions of the Internal Revenue Code of 1986, as amended, and similar state provisions. Should we be subject to this annual limitation, this may result in the expiration of net operating loss and credit carryforwards before utilization.
A valuation allowance is provided when it is more likely than not that some portion or all of the deferred tax assets will not be realized.
8. EMPLOYEE BENEFIT PLAN The Company's 401(k) plan covers substantially all employees. Employees may contribute up to 60% of their annual salary up to a maximum of $12,000. The Company matches 50% of amounts contributed by its employees. The Company contribution was $413,000, $438,000, and $261,000 in 2001, 2002, and 2003 respectively. The plan does not offer investments in Company stock.
9. SHAREHOLDERS' EQUITY In April 2002, the Company issued 3,137,500 shares of common stock at $14.00 per share of its common stock in a public offering and received net proceeds of $41,030,000.
During 2001, the Company issued 2,682,623 shares of stock at $8.00 per share in an initial public offering of its common stock and received net proceeds of $17,790,000. Upon the closing of the initial public offering, each of the outstanding shares of preferred stock converted into shares of common stock at a conversion rate of one to two.
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10. STOCK OPTION AND EMPLOYEE PURCHASE PLANS In 1997, the Company adopted a successor equity incentive plan to the Company's existing stock option plans, which provides a means by which selected employees, directors, and consultants of the Company may benefit from increased stock value through the granting of incentive and nonstatutory stock options. The Company has reserved 1,280,000 shares of common stock for issuance pursuant to the plan. The purchase price of the common stock issuable under this plan is determined by the Board of Directors, however may not be less than 85% of the fair market value of common stock at the grant date. The term of a granted stock option is 10 years from the grant date. Stock options generally vest over three to four years.
Effective in 2001, the Company adopted a new stock option plan for which the Company has reserved 1,500,000 shares of common stock for issuance pursuant to the plan. As of each annual meeting of the Company's shareholders, beginning in 2002, and continuing through and including the annual meeting of the Company's shareholders in 2010, the number of shares of common stock reserved for issuance under the 2000 plan will be increased automatically by the lesser of (i) five percent (5%) of the total number of shares of common stock outstanding on such date, (ii) five hundred thousand (500,000) shares, or (iii) a number of shares determined by the Board prior to such date, which number shall be less than (i) and (ii) above. The purchase price of the common stock issuable under this plan is determined by the Board of Directors, however may not be less than 85% of the fair market value of common stock at the grant date. The term of a granted stock option is 10 years from the grant date. Stock options vest according to a pre-determined vest schedule set at grant date.
Also effective in 2001, the Company also adopted a 2000 Non-Employee Director Plan that provides for the automatic grant of nonstatutory stock options to purchase shares of common stock to non-employee directors which is administered by the Board of Directors. The aggregate number of shares of common stock that may be issued pursuant under the plan is 330,000. As of each annual meeting of the Company's shareholders, beginning in 2002, and continuing through and including the annual meeting of the Company's shareholders in 2020, the number of shares of common stock reserved for issuance under the 2000 plan will be increased automatically by the lesser of (i) three quarters of one percent (0.75%) of the total number of shares of common stock outstanding on such date, (ii) sixty thousand (60,000) shares, or (iii) a number of shares determined by the Board prior to such date, which number shall be less than (i) and (ii) above. The exercise price of options granted will be equal to the fair market value of the common stock on the date of grant and have a term no more than ten years from the date granted. Option grants vest over a period of three years from the date of grant. In 2001, 2002, and 2003, the Company granted non-employee director options to purchase an aggregate of 120,000, 110,000 and 60,000 shares of common stock, respectively.
As of December 28, 2003, there were no shares available for grant under 1997 stock option plan, 139,738 shares available for grant under the 2000 stock option plan, and 160,000 shares available for grant under the 2000 Non-Employee Director stock option plan. Changes in stock options were as follows:
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At December 30, 2001, December 29, 2002, and December 28, 2003, 1,392,087, 1,428,323, and 1,240,306 options, respectively, were exercisable with a weighted-average exercise price of $5.93, $7.05, and $10.12, respectively.
The following table summarizes stock option information at year end 2003:
During 2001, the Company adopted a 2000 Employee Stock Purchase Plan ("ESPP"), where eligible employees can choose to have up to 15% of their annual base earnings withheld to purchase the Company's common stock. The purchase price of stock is 85% of the lower of the beginning of the offering period or end of the offering period market price. The Company authorized 200,000 shares of common stock available for issuance under the plan, which will be increased as of each annual meeting of the Company's shareholders, beginning 2002 until 2020, by the lesser of 200,000 shares or 1.5% of the number of shares of common stock outstanding on that date. However, the Board of Directors has the authority to designate a smaller number of shares by which the authorized number of shares of common stock will be increased on that date. During 2001, 2002 and 2003, employees purchased 36,789, 82,865 and 81,821 shares, respectively, of the Company's common stock under the plan at a weighted-average per share price of $6.80, $6.86 and $8.89, respectively. At December 28, 2003, 364,722 shares remain available for future issuance.
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The weighted average fair value of the stock options granted during 2001, 2002 and 2003 was $6.56, $9.42, and $6.85, respectively. The weighted average fair value of each 2001, 2002 and 2003 ESPP award was $3.91, $3.84, and $4.33, respectively, per share.
See Note 2 for the pro forma effect of accounting for stock options using the fair value method.
11. COMMITMENTS AND CONTINGENCIES LEASES - The Company leases its Emeryville, California coffee roasting plant, distribution center, administrative offices, and warehouse, its retail stores and certain equipment under operating leases that expire from 2004 through 2012. Certain leases contain renewal options for an additional five to fifteen years, and also provide for contingent rents to be paid equal to a stipulated percentage of sales. The lease agreements also provide for periodic adjustments to the minimum lease payments based on changes in cost of living indices or other scheduled increases.
Future minimum lease payments required under non-cancelable operating leases subsequent to December 28, 2003 are as follows (amounts in thousands):
Rent expense was $4,738,000, $5,077,000, and $5,979,000 for 2001, 2002, and 2003 respectively, including contingent rents of $146,000, $139,000, and $149,000.
As of December 28, 2003, the Company is a guarantor on a lease assigned to a third party that has $458,000 of remaining lease payments. The Company has a security deposit of $6,000 and a guarantee from the sublessee's parent for a maximum amount of $313,000. See Note 2.
PURCHASE COMMITMENTS - As of December 28, 2003, the Company had approximately $16,152,000 of outstanding coffee purchase commitments from 2004 to 2006 with fixed prices.
EMPLOYMENT AGREEMENTS - The Company has agreements with certain officers to provide severance benefits in the event their employment is terminated under certain defined circumstances.
LEGAL PROCEEDINGS - On February 25, 2003 and March 7, 2003, two lawsuits were filed against the Company entitled Brian Taraz, et al vs. Peet's Coffee & Tea, Inc., and Tracy Coffee, et al. vs. Peet's Coffee & Tea, Inc. Each was filed in Superior Court of the State of California, County of Orange, and sought class action certification. These suits were filed by one former and one current store manager alleging misclassification of employment position and sought damages, restitution, reclassification and attorneys' fees and costs. On March 4, 2003, the Superior Court granted preliminary approval of a settlement of the suits and conditional certification of the class for settlement purposes. During 2003, the Company recorded a charge of $2.7 million for the estimated payment of claims to eligible class members, attorneys' fees and costs, costs to a third-party claims administrator, as well as applicable employer payroll taxes, which is included in "General and administrative expenses" on the
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accompanying consolidated statements of operations. The settlement is subject to the court's final approval, the Company's right to terminate if more than 10% of the settlement class opts out of the settlement and the plaintiffs' right to terminate if claims by class members in the aggregate exceed more than 10% of the number of work weeks specified in the settlement agreement.
In addition to the lawsuits described above, we may from time to time become involved in certain legal proceedings in the ordinary course of business. Currently, the Company is not party to any other legal proceedings that management believes would have a material adverse effect on the financial position or results of operations of the Company.
12. HEDGING ACTIVITIES The Company is exposed to price risk related to price-to-be-fixed coffee purchase commitments and anticipated coffee purchases. The Company uses coffee futures and options to manage price increases and designates these derivative instruments as cash-flow hedges of its price-to-be-fixed coffee purchase commitments and anticipated coffee purchases. The Company does not hold or issue derivative instruments for trading purposes.
On January 1, 2001, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133, as amended, establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated in a fair-value hedge, the changes in the fair value of the derivative and the hedged item will be recognized in earnings. If the derivative is designated in a cash-flow hedge, the effective portions of changes in the fair value of the derivative will be recorded in other comprehensive income and will be recognized in earnings when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash-flow hedges are recognized immediately in earnings.
The adoption of SFAS No. 133 on January 1, 2001 resulted in a liability of $1,304,000 representing the fair value of the open futures at January 1, 2001, a deferred tax asset of $519,000 and accumulated other comprehensive loss of $785,000 net of tax.
During 2001, 2002 and 2003, the effective portion of the cash-flow hedges amounted to a loss of $295,000 (net of $195,000 tax), a gain of $66,000 (net of $38,000 of tax) and a loss of $20,000 (net of $12,000 of tax), respectively, and was recorded in other comprehensive income (loss). The ineffective portion of the hedges of $27,000 and $15,000 was recorded as cost of sales during 2002 and 2003, respectively. Accumulated other comprehensive income (loss) related to hedging activities, net of tax, was $38,000 and ($3,000) as of December 29, 2002 and December 28, 2003, respectively, all of which is expected to be reclassified into cost of sales over the next twelve months as the related inventory is sold. For the years ended December 29, 2002 and December 28, 2003, $379,000 and ($21,000) of coffee futures gains/(losses) included in other comprehensive loss were reclassified into cost of goods sold. As of December 28, 2003 there were no open futures contracts. The fair value of the open futures contracts as of December 29, 2002 was a net asset $31,000.
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13. SEGMENT INFORMATION
The Company operates in two reportable segments: retail and specialty sales. Retail store operations consist of sales of whole bean coffee, beverages, tea and related products through Company-operated retail stores. Specialty sales consist of whole bean coffee sales through online, mail order, grocery, wholesale and office coffee accounts. Management evaluates segment performance primarily based on revenue and segment operating income. The following table presents certain financial information for each segment. Segment income before taxes excludes unallocated marketing expenses and general and administrative expenses. Unallocated assets include cash, coffee inventory in the warehouse, corporate headquarter assets and intangibles and other assets.
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Net revenue from external customers for the two major product lines are as follows:
14. RELATED PARTY TRANSACTIONS A member of the Board of Directors is the former Chairman and a current shareholder of Jesse.Hansen&Co, a strategic and financial advisor to the Company pursuant to an engagement letter dated as of December 9, 1996 between Jesse.Hansen&Co and the Company. The Company paid Jesse.Hansen&Co $60,000 and $30,000 in 2001 and 2002, respectively for advisory services. This advisory relationship was terminated in June 2002.
15. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
* The third quarter includes the effect of a pre-tax charge for litigation settlement and severance of $3.4 million or $0.16 per share.
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