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The Value Line Investment Survey recently began coverage of the Caribou Coffee Company (CBOU). Founded as a single coffeehouse in 1992 in Edina, Minnesota, it has grown to 410 units operating in 20 Midwestern and Eastern states. There are also 131 franchised stores, 75 of which are overseas. By domestic store count, Caribou places second – albeit a distant one – after Starbucks (SBUX), which operates around 6,700 U.S. stores.

The company figures it can drive average unit volume in the coming years through differentiation on a number of fronts. Caribou wants you to forget that it’s a chain by giving its coffeehouses more of a down-home feeling with a rustic, quirky décor. And it aims to compete in the premium coffee category, but prices offerings as if standard fare. Management says it can do this because of better sourcing and roasting technologies. Indeed, a recent consumer survey showed that Caribou coffee ranks well on taste against offerings from rivals Starbucks and Peet’s (PEET).

An expanding food menu has been driving up the average check. The company launched a line of breakfast sandwiches in about 50 units earlier last year. Additionally, the offerings appear to be increasing the perception of better value among customers. Due to the success, management has accelerated the rollout. By the end of the March quarter, roughly 60% of stores will probably be offering the new breakfast line. There appears to be lots of room to grow. Currently, about 18% of customers buying a coffee or other drink also purchase a food item. That’s significantly short of the 40% of Starbucks’ customers.

Store Growth

For the next few years, the focus as far as unit expansion goes will likely be on increasing the store density in its existing geographies. Although there are stores in 20 states, only a handful account for the majority of units, so there’s a lot of opportunity to expand. We are expecting a fairly modest number of new units, probably 10 or so, in 2011. That should rise to 20-25 units in 2012, with a ramp up to roughly 35-45 new units (or 8%-10%) annually in subsequent years for the foreseeable future. The company aims to manage this growth carefully, picking only the most favorable “neighborhood” type locations in an effort to protect the company’s carefully honed image.

Commercial Channels

Roughly a year ago, the company became more aggressive with its efforts to expand into new channels, including groceries, mass merchants, club stores, foodservice providers, corporate customers, hotel and entertainment venues, and online customers. These moves appear to be paying off. Caribou now has whole bean and ground coffee distribution in 40 states, nationwide including the K-Cup business – through a partnership with Green Mountain Coffee (GMCR). This business is showing potential; the commercial segment grew 52%, to $42 million, in 2010. We look for additional double-digit growth this year as the company pushes its distribution further. Moreover, this segment should become more profitable over the next few quarters as promotional (trade) spending declines. As its retail concentration increases, this ought to help drive business in commercial channels, which currently accounts for 15% of the top line. Caribou’s 4% share of this market ought to expand to 8%-10% in the coming years.

Franchising

Although the company has been in business for nearly two decades, it began franchising only a few years ago, and the number of locations has grown to 131, which generated $10 million in 2010. We view further expansion of this segment to be very strategic. It takes very little upfront capital from Caribou and the revenue stream carries a high margin, since the operating-cost and risk burdens are on the owner/operator.

Financial Health

With no debt, about $30 million in working capital, and good cash flow generation, Caribou appears well positioned to execute on its plans to develop its menu and expand its presence in various distribution channels and geographies in the coming years.

 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.