Caribou Coffee CBOU
November 06, 2008 - 2:47pm EST by
2008 2009
Price: 1.76 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 34 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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One might run away from a company that generated top-line CAGR of ~19% from 2002-2007 but concurrently witnessed EBITDA declining at over 20% CAGR for the same period.  However, currently trading well-below its tangible book value of ~$51M (although likely to decline some today when results are released), an investment in Caribou Coffee provides substantial upside potential with limited near-term downside risk.  Although I maintain a significant amount of concern regarding consumer discretionary businesses, I embrace CBOU as an attractive risk/reward long primarily based on the Company’s brand equity, owner-oriented management and Board (note $560K of insiders bought stock since August 11th with ~75% of such purchased by newly-hired CEO), and the likelihood that I ascribe to operating performance improving based on an effective turnaround implemented by recently hired management. 


As a micro-cap, Caribou Coffee (“CBOU” or “the Company”) is an orphaned stock.  A review of Q2’08 ownership evidences an absence of any notable institutional public ownership.  However, and more importantly, there is owner-oriented alignment at the Board and management level.  Arcapita Investment Management, which owns over 60% of CBOU’s stock, is tired of the Company’s recent underperformance and has engaged in several recent management changes that strongly position the Company to execute a successful turnaround.  Arcapita is a Bahrain-based investment firm (U.S. headquarters located in Atlanta) that was founded by former executives from the investment firm Investcorp.  Arcapita bought the Company for ~$80M at the end of 2000.


The attractiveness of CBOU as a long is premised on a successful operational turnaround.  The turnaround is focused on four key areas:

  • Improving the unit profitability of the coffeehouses
  • Rationalizing organizational cost structure
  • Aligning the current real estate portfolio
  • Profitably growing the commercial and franchise business channels


In regards to framing a potential turnaround, it’s worth noting that it wasn’t long ago (in both 2005 and 2006) that CBOU generated EBITDA that exceeded $15M, but in 2007 the Company generated less than $5M of EBITDA.  This year is a transition year but Q2 results did evidence recent improvements to operating performance that could be an inflection point of turnaround momentum (note that Q2’08 EBITDA grew by over 20% from prior period; when store closure expense is excluded, the growth yoy was ~65%). 


Based on the Company’s current enterprise value of ~$30M, I am attracted to the high probability I assign to management being able to generate EBITDA of at least $10M, a figure the Company exceeded in 2002-2006 as noted below, and also the likely probability that management is able to drive EBITDA back above $15M.  Assuming 6x EBITDA (~20% discount to SBUX’s current multiple), if EBITDA were at $15M, CBOU would trade at over $4.75 per share (more than 150% the current price and excluding NOL value at ~$.50 per share) but gaining comfort with again achieving $15M of EBITDA needs to be more than a leap-of-faith.      


Historical EBITDA Summary

                                                            ’02       ’03       ’04       ’05       ’06       ’07       1H’08

CBOU Revenue                                   $108    $123    $160    $198    $236    $257    $125

CBOU Adjusted EBITDA ($M)           $11.8   $11.6   $14.4   $15.9   $15.0   $3.8     $3.5                                         EBITDA Margin           10.9%  9.4%    9.0%    8.0%    6.4%    1.5%    2.8%


A key observation from the above is that CBOU’s margin has been on a steady decline.  Furthermore, for context, Peet’s Coffee & Tea--the most comparable publicly-traded peer with almost 200 retail units (primarily in CA)—generated an LTM EBITDA margin at over 11% (note SBUX’s is over 13%). The average EBITDA margin at Peet’s over the past five years is 10.9% compared to 6.9% at Caribou.  The main culprit for Caribou’s recent challenges has been the Company’s focus on top-line growth at the expense of optimizing the profitability of such growth and then only very recently reaping the benefits of a growing and profitable commercial segment.  Based on CBOU achieving 8-11% EBITDA margin in the past on a lower revenue base, the strong profitable growth at CBOU’s commercial segment, and CBOU’s store unit profitability focus resulting in prudent store closures, I don’t think it’s a leap-of-faith for management to improve the Company’s recent dismal results.  Before going into more detail about the potential turnaround, I should provide a summary about Caribou Coffee.


Summary Description

While Starbucks owns about 50% of the QSR beverage category market, this remains a highly fragmented segment in the restaurant industry, with over 40% of the category sales generated from chains with less than 50 locations.  Caribou Coffee is the closest domestic coffeehouse competitor (in units) to Starbucks but you might not be familiar with Caribou Coffee despite it being the second largest company-owned specialty coffee retailer in the U.S.  A brief summary follows:

  • Founded in 1992
  • Second largest company-owned coffeehouse operator
    • 80% of retail sales are beverages
    • As of June 29, 2008, CBOU had 490 coffeehouses (almost half of all U.S. locations in Minnesota and almost all U.S. locations in Midwest), including 75 franchised locations
    • As of September, 2008, almost 10% of CBOU’s units were located outside the United States (all non-U.S. locations are franchised; in Middle East, a master agreement exists to open as many as 250 coffeehouses by 2012)
      • Middle East (40 locations):  Kuwait (19), UAE/Dubai (15), UAE/Sharjah (3), Jordan (2), Bahrain (1)
      • South Korea (6)

Retail                Commercial                  Franchise                     

            Sales                $240.3             $12.4                           $4.1                            

            EBIT                ($11.3) (a)       $2.3                             $0.7

            D&A                $32.1               ---                                ---

            EBITDA          $20.8 (a)          $2.3                             $0.7


            (a)  Includes over $7M of store closing expense (i.e., “non-recurring”)   

                Note:  The financial summary does not include unallocated corporate expense which totaled $22.1M in 2007


  • Commercial business (up 67% in Q2 although small base)
    • Despite growth in specialty coffee retail industry, consumers brew seven of every ten cups of coffee at home (and in this economy, this figure isn’t likely to decline); CBOU has been gradually building its commercial/wholesale business as evidenced by twelve-ounce packages of Caribou coffee being sold at almost 5,000 retail locations nationwide including 1,200 Target stores, Costco, Shaw’s, Safeway, Dominick’s, Jewel-Osco, Supervalu, Kroger and Bed Bath & Beyond ; also sold through office coffee and food providers
    • Strategic partners/product licensing
      • Ice cream with Kemp’s (launched March 2006)
      • Granola bars with General Mills (launched July 2006)
      • K-cups (over 1M pounds) with Keurig (owned by Green Mountain; launched Spring 2007)
      • Ready-to-drink coffee with Coca-Cola (national distribution began in 2008)


Unit level economics are key area of focus for potential improvement

Caribou’s unit level returns are well-below (at half) Peet’s Coffee and Starbucks.  The primary issue for Caribou has been annual sales of only $600K per unit, on average, versus approximately or more than $1M at Starbucks and Peet’s.  As CBOU continues to prune its underperforming units and focus on its most profitable clusters (e.g., market share leadership in Minnesota), I believe margins will substantially improve.  In 2007, the Company incurred over $7M for closing expense and disposal of 28 coffeehouses.  These closing expenses are weighing on recent profitability and I have not excluded as non-recurring given my expectation that closing expenses are on-going in the near-term but one can argue for add-back since such expense will ultimately decline or be eliminated. 


As with any operational restructuring, the numbers in the near-term won’t provide a clear trend.  This idea is premised on changes in mix, likelihood for top-line reductions, but at improved profitability that more than makes up for reduction of unprofitable revenue.  On a more specific basis, unit level improvements are being sought by focusing on product throughput, store prototype, labor deployment, growth capacity optimization, and equipment utilization.  I anticipate that today’s call might provide more color on the benefit of these and other actions.


Recent changes to executive leadership team provide confidence regarding likelihood for successful turnaround

The concepts that are professed to improve operational performance seem plausible but ultimately it’s all about the execution.  I think it’s often difficult for a company of CBOU’s size to attract high-quality executive personnel but these key management hires evidence appropriate experiences that improve the likelihood for a successful turnaround:


  • CEO Michael Tattersfield joined CBOU in August 2008
    • Most recently Tattersfield was COO of lululemon athletica and was VP of Store Operations for Limited Brands but perhaps more relevant is his thirteen year career with YUM! Brands included extensive branding and franchise leadership experience including positions of CEO and Managing Director of Puerto Rico for KFC, Taco Bell and Pizza Hut; CFO of YUM! Brands Mexico business, and President of A&W All American Food Restaurants
    • It’s worth noting that Tattersfield has purchased over $427K of stock in the open market since joining in August; his cost basis is $2.88 (~60% above the current price) and he has purchased shares at $2.51-3.22
  • CFO Timothy Hennessy joined CBOU in September 2008
    • Most recently Hennessy was CFO of the third largest global franchise chain (based on $24B in sales) Carlson Wagonlit Travel; Hennessy was also involved in acquisitions and strategic planning for Carlson Wagonlit parent Carlson, a conglomerate whose other holdings include T.G.I. Friday’s and Pick Up Stix restaurant brands
  • SVP of Supply Chain, Product Management & Real Estate Development is Daniel Hurdle who joined in October 2008
    • Five years with Starbucks in executive leadership roles in both their retail food business and retail store construction and operations; Hurdle previously worked for McKinsey
  • SVP of Marketing is Alfredo Martel who joined in October 2008
    • Eight years with Yum! Brands including Brand Director role; Martel previously worked for advertising agencies BBDO and Grey Advertising



Valuation Summary


CBOU’s valuation at various stock prices is shown below:


                                    $1.50   $2.00   $2.50   $3.00   $3.50   $4.00   $4.50   $5.00

Equity Value (a)            $29M   $39M   $49M   $58M   $68M   $78M   $87M   $97M

Enterprise Value (b)      $26M   $36M   $46M   $56M   $65M   $75M   $85M   $94M

Adjusted Ent Val (c )    $17M   $26M   $36M   $46M   $56M   $65M   $75M   $85M



Valuation Multiples (d)

$5M of EBITDA          3.4x     5.2x     7.2x     9.2x     11.2x   13.0x   15.0x   17.0x

$10M of EBITDA        1.7x     2.6x     3.6x     4.6x     5.6x     6.5x     7.5x     8.5x

$15M of EBITDA        1.1x     1.7x     2.4x     3.1x     3.7x     4.3x     5.0x     5.7x


LTM Revenue              0.1x     0.1x     0.1x     0.2x     0.2x     0.3x     0.3x     0.3x


(a) Based on 19.4M outstanding shares

(b) Based on Q2’08:  $6.7M cash, $4.0M debt

(c ) Based on $29M of NOLs valued by rule-of-thumb at 33%; NOLs begin to expire in 2011

(d) Based on adjusted enterprise value at various amounts of EBITDA and LTM Revenue ($255.8M)


LTM Revenue and EBITDA Multiples among “Peer” Group

                        Ent                               EBITDA                      Rev                  EBITDA         

                        Val       Rev                  ($, margin)                    Mult                 Mult

Starbucks         $10.0B $10.3B             $1.4B; 13.2%              1.0x                 7.4x

Tim Hortons     $4.9B   $1.6B               $0.4B; 24.9%              3.0x                 12.1x

Green Mtn        $0.8B   $0.5B               $57M; 12.4%              1.7x                 13.6x

Peet’s               $0.3B   $0.3B               $31M; 11.1%              1.1x                 9.6x

Farmer Bros     $0.2B   $0.3B               NA                              0.7x                 NA



One approach to put CBOU’s current enterprise value in perspective is highlighting that Green Mountain Coffee (“GMCR”), which trades at 1.7x LTM Revenue and 13.6x LTM EBITDA, announced in September the acquisition of Tully’s coffee brand and wholesale business for ~$40M.  Based on the $30.4M of LTM wholesale sales through June 30th at Tully’s, GMCR’s acquisition amounts to 1.3x LTM Revenue.  Caribou’s LTM wholesale (or “commercial” as characterized by CBOU) sales over the same period amounted to ~$15M.  During the first half of 2008, CBOU’s commercial/wholesale sales grew by 55% versus the first half of 2007 (more than twice the rate of Tully’s wholesale business); over the same period, EBIT grew by more than 150% to $2.1M for the first half of 2008. 


Assuming GMCR or another suitor would buy the commercial/wholesale business, I assume 1.5x LTM Revenue for these purposes.  I use a higher multiple than the recent GMCR acquisition based on higher growth being generated at CBOU’s commercial/wholesale segment and more importantly the run-rate segment EBIT of $4.3M.  Based on such, I estimate the value for CBOU’s commercial/wholesale at $22.5M (implies just 5.2x EBIT; this is an extremely low valuation but I recognize that the segment EBIT might be somewhat inflated since there is likely some unallocated corporate overhead at CBOU that would burden the commercial/wholesale business if indeed separated).  The purpose of disaggregating the commercial/wholesale business is to frame one of the Company’s key areas providing downside protection at the current valuation. 


If CBOU was forced to raise cash proceeds or sought to elevate the visibility of how undervalued the public market is pricing its stock, I am confident the Company could separate this segment to monetize it accordingly based on the strength of its brand coupled with existing and growing presence in numerous traditional and non-traditional distribution channels.  Assuming such a hypothetical transaction, the remaining retail and franchise business is being valued at ~$10M (note I don’t include value for NOLs as I assume such would offset taxable gains associated with a sale of commercial/wholesale).  Given the potential for improvements in the retail operations and ultimately franchise-based growth, this approach that frames the current valuation for the non-commercial business offers substantial downside and upside potential.


Selected Concerns

There are many issues beyond the fact that I am very bearish about consumer discretionary businesses (i.e., largest composition of my short book) and there is no disputing that visiting a Caribou retail unit is a discretionary purchase decision.  The alternatives to making the visit to one’s neighborhood Caribou are numerous and, in addition to consuming home-brew (although CBOU might benefit via its commercial segment), include many competitors beyond Starbucks, such as lower-cost alternatives at venues like McDonald’s, Dunkin Donuts, and 7-Eleven.  Caribou does operate within a large market (i.e., the specialty coffee market is substantial and growing) but there’s no disputing that current economic and competitive issues are and will continue to be challenging. 


In August 2006, the Company formalized plans to shift to a franchise, rather than company-driven, development strategy.  A move to franchising (now 15-20% of CBOU’s total unit mix) provides opportunities for CBOU to improve its business profile, returns on capital, and free cash flow generation.  However, in this financing environment where we know even McDonald’s franchisees are troubled to access funding for their coffee expansion, I don’t ascribe any weight to franchising as a catalyst in the near-term relative to the well-documented financing challenges.  That being said, it would only be upside versus no expectations.  Another concern is that the Company has a poor track record of meeting or exceeding the Street’s expectations and the Company has already sought to improve performance (i.e., engage some turnaround measures) with two other CEOs in just the past 18 months.  I am not oblivious to these issues but I think the current stock price discounts all the past issues and assigns virtually no probability to the potential that the current management team (one I deem to be much more qualified than prior) can achieve objectives sought—improve unit profitability, rationalize cost structure, optimize real estate, drive franchising (as noted, I don’t ascribe upside to franchising in the near-term but presumably no one else does and so anything is upside to expectations). 


Arcapita and the Shari’ah principle is additional concern.  The firm that owns over 60% of CBOU shares manages Caribou Coffee’s capital structure in accordance with Islamic principles, which means that the Company must follow certain business practices when it comes to employing debt (specifically constraining the use of debt) or hedging commodity needs.  However, given the current credit crisis, one cannot disagree that the absence of substantial leverage is obviously a good thing and especially so given the bumps in the road that CBOU hit along the way pursuing its growth.  Finally, the lack of liquidity in the stock is also a concern but that is primarily a portfolio sizing consideration.  Despite these and other concerns I and you might have, I own CBOU and advocate the idea as a long-dated option providing substantial upside potential versus downside risk and therefore an extremely attractive risk/reward for the reasons I described above.   




Selected Catalysts

Earnings release today evidences some turnaround momentum towards better margin structure
More disclosure regarding closures of underperforming store units and building blocks towards margin improvement (e.g., overhead reductions)
Continued trajectory of growth in commercial segment
Additional insider buying that elevates stock to potential incremental buyers
Non-deal roadshow that engages handful of institutional investors to buy into turnaround upside potential
Potential monetization of commercial/wholesale segment or whole company if stock price doesn’t soon reflect its underlying value
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