Peets Coffee & Tea (PEET) 10-Q 2007 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended July 2, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934

Commission file number 0-32233

PEET’S COFFEE & TEA, INC.

(Exact Name of Registrant as Specified in Its Charter)

Washington	91-0863396
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)

1400 Park Avenue

Emeryville, California 94608-3520

(Address of Principal Executive Offices)(Zip Code)

(510) 594-2100

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, no par value

Securities registered pursuant to Section 12(g) of the Act:

None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o .

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer (as defined in Exchange Act Rule 12b-2).

Large Accelerated Filer o Accelerated Filer x Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2). Yes o No x

As of August 7, 2006, 13,838,833 shares of registrant’s Common Stock were outstanding.

	INDEX
		Page
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements	1
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3.	Quantitative and Qualitative Disclosure About Market Risk	15
Item 4.	Controls and Procedures	16
PART II	OTHER INFORMATION
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	16
Item 4.	Submission of Matters to a Vote of Security Holders	17
Item 6.	Exhibits	17
	Signatures	17

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PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

PEET’S COFFEE & TEA, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited, in thousands, except share amounts)

	July 2,			January 1,
	2006			2006
ASSETS
Current assets
Cash and cash equivalents	$	13,798		$	20,623
Short-term marketable securities		34,853			32,453
Accounts receivable, net		5,205			5,152
Inventories		19,724			16,148
Deferred income taxes		1,514			1,514
Prepaid expenses and other		5,282			3,372
Total current assets		80,376			79,262
Long-term marketable securities		9,863			16,890
Property and equipment, net		52,779			46,313
Intangible and other assets, net		7,537			5,434
Total assets	$	150,555		$	147,899
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable and other accrued liabilities	$	7,903		$	8,553
Accrued compensation and benefits		5,793			5,563
Deferred revenue		2,855			3,415
Total current liabilities		16,551			17,531
Deferred income taxes		1,759			1,759
Deferred lease credits and other long-term liabilities		2,814			2,537
Total liabilities		21,124			21,827
Shareholders' equity
Common stock, no par value; authorized 50,000,000 shares;
issued and outstanding:13,834,000 and 13,902,000 shares		98,555			99,273
Accumulated other comprehensive loss, net of tax		(88	)		(76	)
Retained earnings		30,964			26,875
Total shareholders' equity		129,431			126,072
Total liabilities and shareholders' equity	$	150,555		$	147,899
See notes to consolidated financial statements.

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PEET’S COFFEE & TEA, INC.

CONSOLIDATED STATEMENTS OF INCOME

(Unaudited, in thousands, except per share amounts)

	Thirteen weeks ended				Twenty-six weeks ended
	July 2,		July 3,		July 2,		July 3,
	2006		2005		2006		2005
Retail stores	$	33,581	$	28,575	$	66,981	$	55,858
Specialty sales		16,108		13,148		32,415		25,853
Net revenue		49,689		41,723		99,396		81,711
Cost of sales and related occupancy expenses		23,083		18,826		45,576		36,897
Operating expenses		17,913		14,362		35,326		27,863
Marketing and advertising expenses		1,097		741		2,187		1,572
Depreciation and amortization expenses		2,096		1,821		4,079		3,501
General and administrative expenses		3,399		2,116		7,036		4,310
Total costs and expenses from operations		47,588		37,866		94,204		74,143
Income from operations		2,101		3,857		5,192		7,568
Interest income		702		427		1,379		755
Income before income taxes		2,803		4,284		6,571		8,323
Income tax provision		1,040		1,681		2,482		3,292
Net income	$	1,763	$	2,603	$	4,089	$	5,031
Net income per share:
Basic	$	0.13	$	0.19	$	0.29	$	0.37
Diluted	$	0.12	$	0.18	$	0.28	$	0.35
Shares used in calculation of net income per share:
Basic		13,840		13,748		13,866		13,656
Diluted		14,549		14,424		14,579		14,297

See notes to consolidated financial statements.

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PEET’S COFFEE & TEA, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited, in thousands)

	Twenty-six weeks ended
	July 2,			July 3,
	2006			2005
Cash flows from operating activities:
Net income	$	4,089		$	5,031
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization		4,912			4,141
Amortization of interest purchased		243			100
Stock-based compensation		2,216			8
Excess tax benefit from exercise of stock options		(50	)		—
Tax benefit from exercise of stock options		606			2,302
Loss on disposition of assets and asset impairment		42			100
Deferred income taxes		—			(17	)
Changes in other assets and liabilities:
Accounts receivable, net		(53	)		354
Inventories		(3,576	)		(5,789	)
Prepaid expenses and other current assets		(1,910	)		(2,241	)
Other assets		(181	)		(18	)
Accounts payable and accrued liabilities		(1,443	)		(3,672	)
Deferred lease credits and other long-term liabilities		277			147
Net cash provided by operating activities		5,172			446
Cash flows from investing activities:
Purchases of property and equipment		(10,905	)		(6,484	)
Proceeds from sales of property and equipment		16			29
Changes in restricted investments		(1,969	)		(250	)
Proceeds from sales and maturities of marketable securities		24,480			19,500
Purchases of marketable securities		(20,129	)		(19,864	)
Net cash used in investing activities		(8,507	)		(7,069	)
Cash flows from financing activities:
Net proceeds from issuance of common stock		2,908			5,064
Purchase of common stock		(6,448	)		—
Excess tax benefit from exercise of stock options		50			—
Bank overdrafts		—			(96	)
Net cash provided by (used in) financing activities		(3,490	)		4,968
Decrease in cash and cash equivalents		(6,825	)		(1,655	)
Cash and cash equivalents, beginning of year		20,623			11,356
Cash and cash equivalents, end of year	$	13,798		$	9,701

See notes to consolidated financial statements.

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PEET’S COFFEE & TEA, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

UNAUDITED

1. Basis of Presentation

The accompanying consolidated financial statements of Peet’s Coffee & Tea, Inc. and its subsidiaries (collectively, the “Company” or “Peet’s”) as of July 2, 2006 and for the thirteen and twenty-six weeks ended July 2, 2006 and July 3, 2005 are unaudited and, in the opinion of management, contain all adjustments (consisting only of normal recurring items) necessary to present fairly the financial position and results of operations for such periods.  The financial information as of January 1, 2006, is derived from the Company’s audited consolidated financial statements and notes for the fiscal year ended January 1, 2006 included in the Annual Report on Form 10-K. The information included in this Form 10-Q should be read in conjunction with management’s discussion and analysis and notes to the financial statements in the Form 10-K.

The results of operations for the thirteen and twenty-six weeks ended July 2, 2006 are not necessarily indicative of the results expected for the full year.

2. Summary of Significant Accounting Policies

Stock-Based Compensation

Effective January 2, 2006, the beginning of the Company’s first fiscal quarter of 2006, the Company adopted Financial Accounting Standards Board (“FASB”) Statement No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), using the modified-prospective transition method. Compensation expense recognized included the estimated expense for stock options granted on and subsequent to January 2, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R), and the estimated compensation expense for the portion vesting in the period for options granted prior to, but not vested as of January 2, 2006, based on the grant date fair value estimated in accordance with the original disclosure provisions of SFAS 123. Results for prior periods have not been restated as provided for under the modified-prospective method.

Total stock-based compensation expense recognized in the consolidated statement of income for the thirteen weeks ended July 2, 2006 was $1,187,000 and consisted of stock option and ESPP expense of $1,110,000 and $77,000 respectively. Total stock-based compensation expense recognized in the consolidated statement of income for the twenty-six weeks ended July 2, 2006 was $2,216,000 and consisted of stock option and ESPP expense of $2,069,000 and $147,000, respectively. The related total tax benefit was $440,000 and $838,000 for the thirteen and twenty-six weeks ended July 2, 2006, respectively. Stock-based compensation expense was recognized as follows in the statement of income (in thousands):

	Thirteen weeks ended		Twenty-six weeks ended
	July 2, 2006		July 2, 2006
Cost of sales and related occupancy expenses	$	160	$	297
Operating expenses		370		717
General and administrative expenses		657		1,202
Total	$	1,187	$	2,216

The net effect of the adoption of SFAS 123(R) on net income was $1,382,000, $0.10 per basic share and $0.10 per diluted share for the twenty-six weeks ended July 2, 2006. The adoption of SFAS 123(R) resulted in a decrease of cash flows from operations and an increase in cash flows from financing activities of $50,000 for the twenty-six week period.

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The following table shows the effect on net earnings and earnings per share had compensation cost been recognized based upon the estimated fair value on the grant date of stock options and ESPP awards for the thirteen and twenty-six weeks ended July 3, 2005 (in thousands, except earnings per share):

	Thirteen weeks ended			Twenty-six weeks ended
	July 3, 2005			July 3, 2005
Net income - as reported	$	2,603		$	5,031
Stock-based employee compensation included in
reported net income, net of tax		4			4
Stock-based compensation expense determined
under fair value based method, net of tax		(1,728	)		(2,490	)
Net income - pro forma	$	879		$	2,545
Basic net income per share - as reported	$	0.19		$	0.37
Basic net income per share - pro forma	$	0.06		$	0.19
Diluted net income per share - as reported	$	0.18		$	0.35
Diluted net income per share - pro forma	$	0.06		$	0.18

The fair value of each option grant and ESPP award is estimated on the date of grant using the Black-Scholes-Merton (“Black-Scholes”) option-pricing model with the following assumptions for the twenty-six week periods ended July 2, 2006 and July 3, 2005:

	Stock Options						ESPP
Twenty-six Weeks Ended	July 2, 2006			July 3, 2005 (Pro forma)			July 2, 2006			July 3, 2005 (Pro forma)
Expected term (in years)		5.3			5.1			0.5			0.5
Expected stock price volatility		34.1	%		42.0	%		26.8	%		27.3	%
Risk-free interest rate		5.0	%		3.8	%		4.7	%		3.3	%
Expected dividend yield		0.0	%		0.0	%		0.0	%		0.0	%
Estimated fair value per option granted	$	11.96		$	8.76		$	6.97		$	7.89

The expected term of the options represents the estimated period of time from date of option grant until exercise and is based on historical experience of similar awards, giving consideration to the contractual terms, vesting schedules and expectations of future employee behavior. For grants prior to April 3, 2006, expected stock price volatility was estimated using only the historical volatility of the Company’s stock. Beginning with the period ended July 2, 2006, expected stock price volatility is based on a combination of historical volatility and the implied volatility of the Company’s traded options. The risk-free interest rate is based on the implied yield available on U.S. Treasury zero-coupon issues with an equivalent term. The Company has not paid dividends in the past and does not plan to pay dividends in the near future.

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Comprehensive Income

For the thirteen weeks ended July 2, 2006 and July 3, 2005, comprehensive income was $1,738,000 and $2,663,000, respectively. For the twenty-six weeks ended July 2, 2006 and July 3, 2005, comprehensive income was $4,077,000 and $5,053,000, respectively. Comprehensive income consists of net income and net unrealized gains and losses on investments.

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. Anti-dilutive shares of 560,023 and 0 have been excluded from diluted weighted average shares outstanding for the thirteen week periods ended July 2, 2006 and July 3, 2005, respectively, and 433,585 and 2,280 for the twenty-six week periods, respectively.

The number of incremental shares from the assumed exercise of stock options was calculated by applying the treasury stock method. 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):

	Thirteen weeks ended				Twenty-six weeks ended
	July 2, 2006		July 3, 2005		July 2, 2006		July 3, 2005
Basic weighted average shares outstanding		13,840		13,748		13,866		13,656
Incremental shares from assumed exercise
of stock options		709		676		713		641
Diluted weighted average shares outstanding		14,549		14,424		14,579		14,297

Recently Issued Accounting Standards

In July 2006, the FASB issued Financial Interpretation (“FIN”) No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, which clarifies the accounting for uncertainty in tax positions. FIN 48 requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The Company is required to adopt FIN 48 beginning January 1, 2007and does not believe it will have a material impact on its financial statements.

3. Inventories

The Company’s inventories consist of the following (in thousands):

	July 2,		January 1,
	2006		2006
Green coffee	$	13,140	$	10,263
Other inventory		6,584		5,885
Total	$	19,724	$	16,148

4. Marketable Securities

The Company’s short and long-term marketable securities balances include U.S. government, agency, municipal and guaranteed student loan obligations, and are classified as available-for-sale. Gross unrealized holding losses at July 2, 2006 are due to fluctuations in interest rates and are considered temporary impairments as management has the intent and ability to hold the securities to recovery.

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5. Stock Purchase Program

In February 2004, the Board of Directors approved the purchase of up to one million shares of the Company’s common stock, with no deadline for completion. During the thirteen and twenty-six weeks ended July 2, 2006, the Company purchased and retired 94,867 and 219,667 shares of common stock, respectively, at an average price of $29.02 and $29.31, respectively, in accordance with the share purchase program. As of July 2, 2006, 369,837 shares remained available for purchase under the program.

6. Stock Option and Employee Stock Purchase Plans

Stock Option Plans

The Company maintains several equity incentive plans under which it may currently grant non-qualified stock options to employees and non-employee directors.

Prior to the January 2, 2006 adoption of SFAS 123(R), the Company accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, because the stock option grant price equaled the market price on the date of grant, and any purchase discounts under the Company’s stock purchase plans were within statutory limits, no compensation expense was recognized by the Company for stock-based compensation. 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 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.

The aggregate intrinsic value in the table below is before applicable income taxes, based on the Company’s closing stock price of $30.19 as of the last business day of the period ended July 2, 2006, which would have been received by the optionees had all options been exercised on that date. As of July 2, 2006, total unrecognized stock-based compensation expense related to nonvested stock options was approximately $6.2 million, which is expected to be recognized over a weighted average period of approximately 32 months. During the twenty-six weeks ended July 2, 2006, the total intrinsic value of stock options exercised was $1.6 million.

As of July 2, 2006, there were 577,425 shares available for grant under the 2000 Equity Incentive Plan and 197,036 shares available for grant under the 2000 Non-Employee Director stock option plan. Changes in stock options were as follows:

				Weighted		Weighted Average		Aggregate
				Average		Remaining		Intrinsic
	Options			Exercise Price		Contractual		Value
	Outstanding			Per Share		Life (Years)		(in thousands)
Outstanding, January 1, 2006		2,551,306		$	18.68
Granted		392,964			30.04
Exercised		(130,218	)		18.18
Cancelled or expired		(48,550	)		25.00
Outstanding, July 2, 2006		2,765,502		$	20.22		7.38	$	27,772
Exercisable, July 2, 2006		1,878,803		$	17.06		6.60	$	24,669

The following table summarizes stock option information at July 2, 2006:

	Options Outstanding						Options Exercisable
			Weighted Average
			Remaining		Weighted				Weighted
Range of	Number of		Contractual		Average		Number of		Average
Exercise Prices	Options		Life (Years)		Exercise Price		Options		Exercise Price
$6.00 to $13.47		369,852		5.54	$	10.64		357,730	$	10.56
$15.49 to $15.49		661,206		5.91		15.49		661,206		15.49
$16.00 to $22.84		813,179		7.25		19.43		656,906		19.37
$23.26 to $28.91		565,712		9.06		26.55		198,079		26.04
$29.20 to $35.87		355,553		9.65		30.70		4,882		31.39
$6.00 to $35.87		2,765,502		7.38	$	20.22		1,878,803	$	17.06

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Employee Stock Purchase Plan

The Company has an Employee Stock Purchase Plan where eligible employees can choose to have up to 15% of their annual 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 ESPP, 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 increase the ESPP reserve by a smaller number of shares of common stock on that date. During the period ended July 2, 2006, employees purchased 21,190 shares of the Company’s common stock under the ESPP. At July 2, 2006 819,552 shares remain available for future issuance under the ESPP.

7. 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 grocery, home delivery, food service 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 operating 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 intangible and other assets.

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	Retail					Specialty					Unallocated			Total
			Percent of					Percent of								Percent of
	Amount		Net Revenue			Amount		Net Revenue						Amount		Net Revenue
Thirteen weeks ended July 2, 2006:
Net revenue	$	33,581		100.0	%	$	16,108		100.0	%				$	49,689		100.0	%
Cost of sales and occupancy		15,724		46.8	%		7,358		45.7	%					23,082		46.5	%
Operating expenses		14,729		43.9	%		3,184		19.8	%					17,913		35.1	%
Depreciation and amortization		1,512		4.5	%		355		2.2	%	$	229			2,096		4.2	%
Segment operating income (loss)		1,616		4.8	%		5,211		32.4	%		(4,726	)		2,101		4.2	%
Interest income												702			702
Income before income taxes															2,803
Total assets		37,815					10,736					102,004			150,555
Capital expenditures		3,833					199					2,662			6,694
Thirteen weeks ended July 3, 2005:
Net revenue	$	28,575		100.0	%	$	13,148		100.0	%				$	41,723		100.0	%
Cost of sales and occupancy		12,656		44.3	%		6,170		46.9	%					18,826		45.1	%
Operating expenses		11,831		41.4	%		2,531		19.3	%					14,362		34.4	%
Depreciation and amortization		1,276		4.5	%		383		2.9	%	$	162			1,821		4.4	%
Segment operating income (loss)		2,812		9.8	%		4,064		30.9	%		(3,019	)		3,857		9.2	%
Interest income												427			427
Income before income taxes															4,284
Total assets		29,930					9,750					97,028			136,708
Capital expenditures		1,583					362					322			2,267
Twenty-six weeks ended July 2, 2006:
Net revenue	$	66,981		100.0	%	$	32,415		100.0	%				$	99,396		100.0	%
Cost of sales and occupancy		30,548		45.6	%		15,028		46.4	%					45,576		45.9	%
Operating expenses		28,991		43.3	%		6,335		19.5	%					35,326		35.5	%
Depreciation and amortization		2,947		4.4	%		707		2.2	%	$	425			4,079		4.1	%
Segment operating income (loss)		4,495		6.7	%		10,345		31.9	%		(9,648	)		5,192		5.2	%
Interest income												1,379			1,379
Income before income taxes															6,571
Total assets		37,815					10,736					102,004			150,555
Capital expenditures		7,139					311					3,455			10,905
Twenty-six weeks ended July 3, 2005:
Net revenue	$	55,858		100.0	%	$	25,853		100.0	%				$	81,711		100.0	%
Cost of sales and occupancy		24,643		44.1	%		12,254		47.4	%					36,897		45.2	%
Operating expenses		22,726		40.7	%		5,137		19.9	%					27,863		34.1	%
Depreciation and amortization		2,439		4.4	%		744		2.9	%	$	318			3,501		4.3	%
Segment operating income (loss)		6,050		10.8	%		7,718		29.9	%		(6,200	)		7,568		9.3	%
Interest income												755			755
Income before income taxes															8,323
Total assets		29,930					9,750					97,028			136,708
Capital expenditures		4,858					841					785			6,484

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Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations

You should read the following discussion and analysis in conjunction with our financial statements and related notes included elsewhere in this report. Except for historical information, the discussion in this report contains certain forward-looking statements that involve risks and uncertainties. We have based these forward-looking statements on our current expectations and assumptions about future events. In some cases, you can identify forward-looking statements by terminology, such as “may,” “should,” “could,” “predict,” “potential,” “continue,” “expect,” “anticipate,” “future,” “intend,” “plan,” “believe,” “estimate,” “forecast” and similar expressions (or the negative of such expressions.) Forward-looking statements include statements concerning projected new store openings, 2006 revenue growth rates and capital expenditures. Forward-looking statements are based on our beliefs as well as assumptions based on information currently available to us, including financial and operational information, the volatility of our stock price, and current competitive conditions. As a result, these statements are subject to various risks and uncertainties. For a discussion of material risks and uncertainties that the Company faces, see the discussion in the Annual Report on Form 10-K titled “Risk Factors” for the year ended January 1, 2006. Important factors that could cause actual results to differ materially include, but are not limited to, the following:

· Increases in the cost and decreases in availability of high quality arabica coffee beans: Although we do not purchase coffee on the commodity markets, price movements in the commodity trading of coffee impact the prices we pay. 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; the ability of coffee-producing countries to agree to export quotas; and general economic conditions that make commodities more or less attractive investment options. Over the past eighteen months, the commodity prices for coffee have risen above their historical range for the prior three to four years. If we are unable to pass along increased coffee costs, our margin will decrease and our profitability will decrease accordingly. In addition, if we are not able to purchase sufficient quantities of high quality arabica beans due to any of the above factors, we may not be able to fulfill the demand for our coffee, our revenue may decrease and our ability to expand our business may be negatively impacted.

· A significant interruption in the operation of our one roasting facility: A significant interruption in the operation of our Emeryville, California roasting and distribution facility, whether as a result of a natural disaster or other causes, could significantly impair our ability to operate our business. Since we only roast our coffee to order, we do not carry inventory of roasted coffee in our roasting plant. Therefore, a disruption in the service of our roasting facility would impact our sales in our retail and specialty channels almost immediately. Moreover, our roasting and distribution facility and most of our stores are located near several major earthquake fault lines. 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 after a significant deductible and co-insurance limit is met. However, in the event of a catastrophic earthquake, our coverage is limited and we would incur additional expenses.

Company Overview and Industry Outlook

Peet’s is a specialty coffee roaster and marketer of fresh, deep-roasted whole bean coffee sold through multiple channels of distribution for home and away-from-home enjoyment.  Founded in Berkeley, California in 1966, Peet’s has established a loyal customer base with strong brand awareness in California.  Our growth strategy is based on the sale of whole bean coffee and high-quality beverages in multiple channels of distribution including our own retail stores, grocery, home delivery, and office and restaurant accounts throughout the United States.  Our current expansion strategy is focused in the western United States, where we have strong customer awareness, loyalty and brand affinity.

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.  We believe that by offering high-quality products to consumers throughout the country, we will attract the same loyal customer base that we have attracted in California.

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As we grow, our operations will continue to be vertically integrated, allowing us to control the quality of our product at all stages.  We purchase high quality arabica coffee beans from countries around the world, and we utilize our artisan-roasting technique to bring out the distinctive flavor of our coffees. Because roasted coffee is perishable, we are committed to delivering our coffee under the strictest freshness standards. As a result, we do not stock or inventory roasted coffee. We roast to order and ship fresh coffee daily to our stores and customers.  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.

We are forecasting net revenue growth for 2006 in the 20% to 23%range over 2005 revenues. We expect to increase our revenues in 2006 through the continued growth in our specialty businesses, both in existing accounts and new accounts, and through growing our retail business by opening 23 to 28 new stores and continuing to expand sales in existing stores. In addition, we expect to make investments in 2006 to improve our capability to sustain this growth over the foreseeable future, including capital expenditures for the remodeling of existing stores, equipment for the grocery channel, information technology enhancements and roasting plant equipment. We also plan to spend approximately $26.0 to $27.0 million on a new roasting facility and related improvements and equipment beginning in late 2006 and in the first quarter of 2007. We expect to open the roasting facility in the second quarter of 2007.

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Results of Operations

The following discussion on results of operations should be read in conjunction with the consolidated financial statements and accompanying notes and the other financial data included elsewhere in this report.

	Thirteen weeks ended						Twenty-six weeks ended
	July 2,			July 3,			July 2,			July 3,
	2006			2005			2006			2005
Statement of operations data as a percent of net revenue:
Net revenue		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales and related occupancy expenses		46.5			45.1			45.9			45.2
Operating expenses		36.1			34.4			35.5			34.1
Marketing and advertising expenses		2.2			1.8			2.2			1.9
Depreciation and amortization expenses		4.2			4.4			4.1			4.2
General and administrative expenses		6.8			5.1			7.1			5.3
Income from operations		4.2			9.2			5.2			9.3
Interest income		1.4			1.0			1.4			0.9
Income before income taxes		5.6			10.2			6.6			10.2
Income tax provision		(2.1	)		(4.0	)		(2.5	)		(4.0	)
Net income		3.5	%		6.2	%		4.1	%		6.2	%
Percent of net revenue by business segment:
Retail stores		67.6	%		68.5	%		67.4	%		68.4	%
Specialty sales		32.4			31.5			32.6			31.6
Percent of net revenue by business category:
Whole bean coffee and related products		54.7	%		56.1	%		55.3	%		56.8	%
Beverages and pastries		45.3			43.9			44.7			43.2
Cost of sales and related occupancy expenses as a percent of segment revenue:
Retail stores		46.8	%		44.3	%		45.6	%		44.1	%
Specialty sales		45.7			46.9			46.4			47.4
Operating expenses as a percent of segment revenue:
Retail stores		43.9	%		41.4	%		43.3	%		40.7	%
Specialty sales		19.8			19.3			19.5			19.9
Percent increase (decrease) from prior year:
Net revenue		19.1	%		24.4	%		21.6	%		23.5	%
Retail stores		17.5			21.9			19.9			21.0
Specialty sales		22.5			30.2			25.4			29.3
Cost of sales and related occupancy expenses		22.6			22.6			23.5			22.1
Operating expenses		24.7			26.5			26.8			24.6
Marketing and advertising expenses		48.0			(24.0	)		39.1			(15.1	)
General and administrative expenses		60.6			18.5			63.2			23.0
Depreciation and amortization expenses		15.1			33.9			16.5			30.7
Selected operating data:
Number of retail stores in operation:
Beginning of the period		113			96			111			92
Store openings		7			4			9			8
Store closures		—			—			—			—
End of the period		120			100			120			100

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Thirteen Weeks Ended July 2, 2006 Compared to Thirteen Weeks Ended July 3, 2005

Net revenue

Net revenue for the thirteen weeks ended July 2, 2006 increased 19.1% versus the same period in 2005 as a result of continued expansion of our retail and specialty sales segments. Sales of whole bean and related products increased 16.2% to $27.2 million. Sales from beverages and pastries increased 22.8% to $22.5 million.

In the retail segment, net revenue increased 17.5% compared to 2005 primarily as a result of increased sales from the 21 new stores we opened in the last 12 months and growth in the existing stores. During the second quarter of 2006, we opened seven new stores compared to four in 2005. However, most of the stores were opened toward the end of the quarter, resulting in a 17% increase in the number of weeks stores were in operation. Sales of whole bean coffee and related products in the retail segment increased by 7.6% to $11.3 million, while sales of beverages and pastries increased by 23.3% to $22.3 million. The increase in beverage and pastry sales was primarily related to sales at the stores we opened in 2005 and 2006 and increased traffic in our existing stores. The slower growth in whole bean and related products was due to continuing cannibalization of bean sales in retail stores as we increased the availability of Peet’s coffee in grocery stores and the lower mix of whole bean sales in our new stores.

In the specialty sales segment, net revenue increased 22.5% compared to the thirteen weeks ended July 3, 2005. The $3.0 million increase consisted of a $2.1 million increase in grocery sales, a $0.5 million increase in home delivery sales, and a $0.3 million increase in sales to food service and office accounts. The increase in grocery was primarily due to continued strong growth in our existing accounts, new accounts we added in the last 12 months, and a price increase in October 2005. We added approximately 400 new stores over the past 12 months, bringing the number of grocery stores selling Peet’s coffee to approximately 4,000. And, in order to offset rising coffee and other operating costs, we increased our price to our grocery accounts by approximately 8% to 10% during October 2005. Net revenue to the home delivery channel grew 15.4% compared to the same period in 2005 primarily due to increased gifting around Mother’s Day and Father’s Day and sales of commemorative merchandise celebrating our 40^th Anniversary. In addition, food service and office coffee sales increased 8.0% primarily due to efforts in expanding our office distributorships, offset by the loss of the Omni Hotel business in the fourth quarter of last year.

Cost of sales and related occupancy expenses

Cost of sales and related occupancy expenses consist of product costs, including manufacturing costs, rent and other occupancy costs. As a percent of net revenue, cost of sales increased from 45.1% in 2005 to 46.5% in 2006 due to higher green coffee costs, an increased number of new stores, which have higher occupancy expenses on a lower sales base, and the impact of expensing stock-based compensation, partially offset by the price increase taken in our grocery channel. Higher coffee cost resulted in a 1.3% increase in cost of sales as a percentage of net revenue. We expect our coffee cost, which lags the commodity market price due to future commitments, to continue to increase for the remainder of 2006. The impact from a greater new store base resulted in a 0.5% increase in costs as a percentage of net revenue. In addition, stock-based compensation increased costs as a percentage of net revenue by 0.3%.

Operating expenses

Operating expenses as a percent of net revenue for the current quarter increased compared to 2005 due to the opening of new stores, higher costs in existing stores and the impact of expensing stock options, partially offset by pricing and leverage gained in the specialty segment.

In the retail segment, operating expenses as a percent of net revenue increased by 2.5% to 43.9%. The increase was due to a 0.7% increase from opening new stores in the last two years, 0.8% impact from stock-based compensation, and higher costs to support existing stores, primarily labor costs in the stores to support our 40^th Anniversary Celebration and the introduction of a new and improved Freddo^TM frozen blended drinks.

As a percent of net revenue, specialty operating expenses increased 0.5% to 19.8%. The increase was due to a 0.7% increase from the impact of stock-based compensation expense. The remaining 0.2% offsetting decrease resulted from the price increase in grocery, partially offset by higher operating expenses in foodservice and office channel.

Marketing and advertising expenses

For 2006, marketing and advertising expenses increased $0.4 million compared to the same prior year period. The increase was driven primarily by costs to support the Company’s 40th Anniversary Celebration in all channels.

General and administrative expenses

General and administrative expenses in the current quarter were $3.4 million, or 6.8% of revenue, compared to $2.1 million, or 5.1% for the same period last year. The increase was primarily due to the 1.3%, or $0.7 million impact of stock-based compensation. The remaining increase as a percent of sales was due to increases in headcount and audit and accounting related professional services.

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Depreciation and amortization expenses

Depreciation and amortization expenses increased in 2006 from $1.8 million to $2.1 million primarily due to the 29 stores we opened in 2005 and 2006.

Investment income, net

We currently invest in U.S. government, agency, municipal and guaranteed student loan obligations. Investment income includes interest income and gains or losses from the sale of these instruments. We earned $0.7 million in interest income in the second quarter of 2006, compared to $0.4 million last year, primarily due to higher interest rates on our investments.

Income tax provision

The effective income tax rate for the period is 37.1% compared to 39.2% during the second quarter 2005. The lower effective tax rate is due primarily to increased interest income from tax-exempt marketable securities during 2006.

Twenty-six Weeks Ended July 2, 2006 Compared to Twenty-six Weeks Ended July 3, 2005

Net revenue

Net revenue for the twenty-six weeks ended July 2, 2006 increased 21.6% versus the same period in 2005 as a result of continued expansion of our retail and specialty sales segments. Sales of whole bean and related products increased 18.4% to $55.0 million. Sales from beverages and pastries increased 25.9% to $44.4 million.

In the retail segment, net revenue increased 19.9% compared to 2005 primarily as a result of increased sales from the 21 new stores we opened in the last 12 months and growth in the existing stores. During the first half of 2006, we opened nine new stores compared to eight in 2005. Sales of whole bean coffee and related products in the retail segment increased by 9.2% to $23.1 million, while sales of beverages and pastries increased by 26.4% to $43.9 million. The increase in beverage and pastry sales was primarily related to sales at the stores we opened in 2005 and 2006 and increased traffic in our existing stores. The slower growth in whole bean and related products was due to continuing cannibalization of bean sales in retail stores as we increased the availability of Peet’s coffee in grocery stores and the lower mix of whole bean sales in our new stores.

In the specialty sales segment, net revenue increased 25.4% compared to the same period last year. The $6.6 million increase consisted of a $4.9 million increase in grocery sales, a $1.0 million increase in home delivery sales, and a $0.7 million increase in sales to food service and office accounts. Grocery continued to have the highest growth rate in the segment with a 42.3% increase compared to last year, primarily due to continued strong growth in our existing accounts. Home delivery sales increased by 14.2% and food service and office sales increased by 9.6%.

Cost of sales and related occupancy expenses

Cost of sales and related occupancy expenses consist of product costs, including manufacturing costs, rent and other occupancy costs. As a percent of net revenue, cost of sales increased from 45.2% in 2005 to 45.9% in 2006 due to higher green coffee costs, an increased number of new stores, which have higher occupancy expenses on a lower sales base, and the impact of expensing stock-based compensation, partially offset by the price increase taken in our grocery channel. Higher coffee cost resulted in a 1.0% increase in cost of sales as a percentage of net revenue. We expect our coffee cost, which lags the commodity market price due to future commitments, to continue to increase for the remainder of 2006. The impact from a greater new store base and from stock-based compensation each increased costs as a percentage of net revenue by 0.3%. The increase was partially offset by the 0.7% price increase we took in our grocery channel.

Operating expenses

Operating expenses as a percent of net revenue for the twenty-six weeks increased compared to 2005 primarily due to the opening of new stores and the impact of expensing stock options, partially offset by pricing and leverage gained in the specialty segment.

In the retail segment, operating expenses as a percent of net revenue increased by 2.6% to 43.3%. The increase was due to a 1.0% increase from opening new stores in the last two years and a 0.8% impact from stock-based compensation. The remaining increase was due to higher costs to support existing stores, both in the stores and above store management.

As a percent of net revenue, specialty operating expenses decreased 0.4% to 19.5%. The decrease was primarily due to the price increase taken in October 2005 in our grocery channel, which decreased expenses as a percent of net revenue by 0.9%. The remaining decrease was due to leveraging the relatively fixed operating structure in the grocery channel. This was partially offset by a 0.6% impact from stock-based compensation.

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Marketing and advertising expenses

For 2006, marketing and advertising expenses increased $0.6 million compared to the same prior year period. The increase was driven primarily by costs to support the Company’s 40th Anniversary Celebration in all channels.

General and administrative expenses

General and administrative expenses in the current quarter were $7.0 million, or 7.1% of revenue, compared to $4.3 million, or 5.3% for the same period last year. The increase was primarily due to the 1.2%, or $1.2 million impact of stock-based compensation. The remaining increase as a percent of sales was due to increases in headcount as well as recruiting, audit and accounting related professional services.

Depreciation and amortization expenses

Depreciation and amortization expenses increased in 2006 from $3.5 million to $4.1 million primarily due to the 29 stores we opened in 2005 and 2006.

Investment income, net

We currently invest in U.S. government, agency, municipal and guaranteed student loan obligations. Investment income includes interest income and gains or losses from the sale of these instruments. We earned $1.4 million in interest income for the twenty-six week period ended July 2, 2006, compared to $0.8 million last year, primarily due to higher interest rates on our investments.

Income tax provision

The effective income tax rate for the twenty-six week period and as projected for the full-year is 37.8% compared to 39.6% for the twenty-six weeks ended July 3, 2005. The lower effective tax rate is due primarily to increased interest income from tax-exempt marketable securities during 2006. The rate was also higher during the first half 2005 than the full-year rate of 38.8% due to discrete true-up items during the period.

Liquidity and Capital Resources

At July 2, 2006, we had $13.8 million in cash and cash equivalents and $44.7 million in short-term and long-term marketable securities for a total of $58.5 million. Working capital was $63.8 million as of July 2, 2006.

Net cash provided by operations was $5.2 million for the twenty-six weeks ended July 2, 2006 compared to $0.4 million for the same prior year period. Operating cash flows were higher than the prior year period primarily due to timing differences in working capital.

Net cash used in investing activities was $8.5 million for the twenty-six weeks ended July 2, 2006. Investing activities primarily relate to purchases of property and equipment, an escrow deposit for our new roasting facility, and maturities and purchases of marketable securities. During the twenty-six week period ended July 2, 2006, we purchased land totaling $2.3 million adjacent to the new roasting facility under development in addition to our planned new store and other capital acquisitions.

Net cash used in financing activities was $3.5 million for the twenty-six weeks ended July 2, 2006. Financing activities consisted primarily of $6.4 million for the Company’s purchase of its common stock, offset partially by the exercise of stock options by employees.

Our remaining 2006 capital expenditures are expected to be between $9.5 and $10.5 million, excluding investments that we may incur late in the year to purchase the new roasting facility. Approximately $8.0 to $9.0 million is expected to be used for the opening of the remaining new retail stores out of the total 23 to 28 scheduled for 2006 and expenditures for new stores in progress for 2007. The remaining is expected to be used for the remodeling of existing stores, equipment for the grocery channel, information technology enhancements and roasting plant equipment. In addition, we plan to spend approximately $26.0 to $27.0 million on the new roasting facility and related improvements and equipment late in the year and in the first quarter of 2007.  

For the next twelve months, we expect our cash flows from operations and cash and marketable securities to be sufficient for our operating and capital requirements, our share purchase program and our contractual obligations as they come due.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

We invest excess cash in interest-bearing, U.S. government, agency, municipal and guaranteed student loan obligations. These financial instruments are all subject to fluctuations of daily interest rates. Therefore our investment portfolio is exposed to market risk from these changes.

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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.

We currently use fixed-price purchase commitments, but in the past have used and may potentially in the future use coffee futures and coffee futures options to manage coffee supply and price risk.

Fixed-Price and Not-Yet-Priced 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. We also enter into “not-yet-priced” commitments based on a fixed premium over the New York “C” market with the option to fix the price at any time. As of July 2, 2006, we had approximately $21.0 million in open fixed-priced purchase commitments and approximately $1.9 million in not-yet-priced commitments for a total of approximately $22.9 million with delivery dates ranging from July 2006 through July 2009. We believe, based on relationships established with our suppliers, that the risk of non-delivery on such purchase commitments is low.

Coffee Futures and Futures Options

As of July 2, 2006, we held no coffee futures or futures options. We had no outstanding positions at July 2, 2006 or July 3, 2005. We do not hold or issue derivative instruments for trading purposes.

Please refer to our Annual Report on Form 10-K for the year ended January 1, 2006 for a further summary of risks.

Item 4. 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 Officer, as appropriate, to allow timely decisions regarding required disclosure.

As of July 2, 2006, 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 II - OTHER INFORMATION

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

The following table sets forth all purchases made by us or any “affiliated purchaser” as defined in Rule 10b-18(a)(3) of the Exchange Act of the Company’s common stock during thirteen week period ended July 2, 2006.

					(c)Total Number of Shares Purchased as		(d) Maximum of Shares
Period	(a) Total Number of Shares Purchased (1)		(b) Average Price Paid per Share (1)		Part of Publicly Announced Plans or Programs (1)		that May Yet Be Purchased Under the Plans or Programs (1)
April 3, 2006 - May 7, 2006		25,200	$	29.00		560,496		439,504
May 8, 2006 - June 4, 2006		—		—		560,496		439,504
June 5, 2006 - July 2, 2006		69,667		29.02		630,163		369,837
Total		94,867	$	29.02		630,163		369,837

⁽¹⁾ Represents purchases made by the Company pursuant to its stock purchase program. On February 11, 2004, the Company’s Board of Directors authorized the Company to purchase up to 1.0 million shares of Peet’s common stock, with no deadline for completion, and the Company announced its plan on February 12, 2004 on Form 8-K. As of August 7, 2006, 633,585 shares have been purchased. The Company expects to make purchases from time to time on the open market at prevailing market prices or in negotiated transactions off the market.

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Item 4. Submission of Matters to a Vote of Security Holders

The 2006 Annual Meeting of Stockholders of the Company was held on May 16, 2006. The two persons named below were elected as proposed in the proxy statement pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, to serve as directors until the Company's Annual Meeting in 2009 and until their successors are elected and qualified. There were 13,301,815 votes cast in the election of directors. The voting regarding each nominee was as follows:

	For		Withheld		Non-votes
Gerald Baldwin		13,086,777		215,038		537,694
Hilary Billings		12,966,878		334,937		537,694

The following directors' term of office as a director continued after the meeting: Gordon Bowker, H. William Jesse, Michael Linton, Patrick O'Dea, and Jean-Michel Valette.

Further, the selection of Deloitte & Touche LLP as independent auditors for the fiscal year was ratified. The matter was approved with 13,101,960 votes for, 193,890 votes withheld, and 5,965 votes abstained. Of the total shares outstanding on the date of record, 537,694 shares were not voted.

Item 6. Exhibits

Exhibit Description

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.

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.

	PEET’S COFFEE & TEA, INC.
Date: August 10, 2006	By:	/s/ Thomas P. Cawley
		Thomas P. Cawley
		Vice President, Chief Financial Officer and Secretary
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