A reason to skip Starbucks

CEO Patrick O'Dea tells Fortune's Matt Boyle how tiny Peet's can challenge the giant of the specialty coffee industry.

By Matthew Boyle, Fortune writer

NEW YORK (Fortune) -- Despite the ubiquity of Starbucks (Charts, Fortune 500), only about one out of six Americans drink specialty coffee on a daily basis, according to the National Coffee Association. To Patrick O'Dea, that smells like opportunity. For the past five years, the former Pringles salesman has run Peet's Coffee & Tea (Charts), a brand revered by coffee snobs but unknown in large swaths of the country.

Peet's has 150 stores, mostly in California, and sells beans directly to nearly 5,000 grocery stores, like Safeway and Whole Foods (Charts, Fortune 500). Since 2002 O'Dea has more than doubled revenues to $210 million, but profits took a hit last year and the stock is well off its 52-week high of $31. O'Dea recently sat down with Fortune's Matthew Boyle to discuss his company's commitment to delivering a good cuppa joe.

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Peet's CEO Patrick O'Dea
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What attracted you to Peet's in 2002?

Three things: the people, the brand and the business opportunity. This business was founded in Berkeley, California [in 1966], so it's got a lot of culture and color to it and has passionate people like founder Alfred Peet. I'm a brand guy, having grown up inside Procter & Gamble, and Peet's is a powerful brand with an incredibly fanatical customer base. People go to extraordinary lengths to get this coffee.

How big is this business opportunity?

Today, specialty coffee is a $12 billion business, and $2.5 billion of that is whole-bean coffee people buy for their homes. The other part is sold primarily through specialty coffee shops. The market is growing at a rapid rate, and I think that Peet's can really carve out the high end of that category.

Why do you feel that way?

About 52 percent of U.S adults drink coffee daily, and that figure is stable. But only 16 percent of adults drink specialty coffee daily, and that number is rising. So there is a large group of people not drinking specialty coffee. In the Bay Area, about 65 percent of all coffee bought for at-home consumption is specialty coffee. But in the entire U.S., that figure is only 27 percent. So there is a whole country that has not come to it yet. That's a huge business opportunity, and it's at a tipping point now. Whether it's wine or dog food, people are trending towards premium products.

How much of Peet's sales come from its stores?

Sixty-seven percent of our sales come from our retail stores. The other 33 percent comes from sales of whole bean coffee and tea through grocery stores, home delivery and foodservice.

How do your stores compare with Starbucks?

We're fundamentally different from other coffee shops. Our average sales for stores open at least three years are $1.3 million, which compares to about $1 million for a Starbucks. Of that, $500,000 comes from sales of whole bean coffee and tea. When you walk into our stores, you will find a bean counter with 32 bins of fresh beans, and we scoop to order. You can also order a beverage, which accounts for the other $800,000. We sell a lot more straight-up coffee than Starbucks does. We do have a blended cold drink line called Freddos, but we sell very few beverages in our stores that don't contain coffee. Our prices are about 10 percent higher than Starbucks.

What do you make of Starbucks' founder Howard Schultz's recent memo warning against the "commoditization" of the Starbucks brand?

I think whenever you get that large, there is always pressure to continue to drive comp-store sales. But you have to be careful about how you go about doing that. We are indifferent to where you buy your coffee - in the grocery store, via home delivery or in our stores. As a result, we do not report comp-store sales because that would cause us to do unnatural things. Even though 68 percent of our business is from retail stores, we don't view ourselves as a retailer.

What's your expansion plan?

We own and operate 150 stores and about 130 of them are in California. There are about 1,700 freestanding Starbucks locations in that state alone. When I got to Peet's and saw that we had two stores in Tokyo, I said, 'My gosh, Tokyo? We need another store in Berkeley!' So we're really focused on that core. Of the 30 new stores this year, at least 20 will be in California, and the rest will be in the western United States.

What about grocery sales?

Five years ago we were in 130 specialty grocery stores, mainly in and around our roasting plant. Today we are in almost 5,000 grocery stores, and we just opened a new $29 million artisan roasting facility in Alameda, Calif. We have a direct-store-delivery system to all our channels, so our trucks are delivering fresh coffee overnight. A coffee bean is perishable when it comes out of a roaster. Air, light, and moisture are its enemies, so you have to get it from the roaster into the cup as quickly as possible.

How do you keep those beans fresh?

For grocery stores, we roast the beans and then put in them in a protective foil barrier. We flush the bag with nitrogen to take out the oxygen, and then we put a one-way valve in it so that the CO2 can escape but oxygen cannot get into the package. We would remove our products from a grocery shelf prior to most other companies' products arriving on the shelf.

What is your favorite roast right now?

My favorite single origin coffee is from New Guinea. It's got a very smooth and chocolaty flavor to it. But the one I come back to time and again is Major Dickason's, which is our No. 1 selling blend. Back in the 1960s, there was a customer in Berkeley named Key Dickason. He bought some beans from Alfred Peet and blended them and asked Peet to taste it. Alfred said, 'Let me work with you on that.' And the eventual product was Major Dickason. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer LIBOR Warning: Neither BBA Enterprises Limited, nor the BBA LIBOR Contributor Banks, nor Reuters, can be held liable for any irregularity or inaccuracy of BBA LIBOR. Disclaimer. Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.