When Green Mountain Coffee Roasters (Nasdaq: GMCR) started selling its single-cup coffee brewing systems (known as the Keurig) five years ago, few expected the company to single-handedly revolutionize the coffee industry.

These days, former rivals are looking to partner with the company to help get a piece of the fast-growing “K-Cup” market. And because Green Mountain Coffee licenses its technology and rolls out its own expanded level of brewing options, sales and profits continue to grow at a breakneck pace. After rising at least 40% in each of the past five years, sales are expected to double to $2.7 billion in the fiscal year that ends in September. That’s impressive.

#-ad_banner-#What’s less impressive is Green Mountain Coffee’s $15 billion market value, which puts the stock’s value at more than 50 times projected fiscal 2011 profits. You have to question the wisdom of owning such a richly-priced stock in these sobering times. It would also be foolish to short the stock, simply because the company is unlikely to see sales slow in coming quarters.

But it’s easy to spot a pair of stocks to short in this hot sector, simply because these companies are sporting lofty multiples even though they aren’t really high-growth stocks. I’m talking about Caribou Coffee (Nasdaq: CBOU) and Peet’s Coffee (Nasdaq: PEET). These coffee chains, which have long toiled in the shadow of Starbucks (Nasdaq: SBUX), are embarking on store expansions intended to deliver decent growth in the near-term, yet look to be very modest growers in the long haul. There’s simply no good reason why shares of each company deserve a price-to-earnings (P/E) multiple (on projected 2011 profits) approaching 40. Let me explain…

 

Caribou Coffee
This chain has its roots in the Midwest, with more than half of its almost 500 stores in Minnesota, Illinois and Ohio. With a handful of stores in 13 other states, Caribou has always lacked the critical mass in those markets to help cover advertising and distribution costs. This lack of scale kept Caribou from generating any profit from 2003 through 2008. But in the past two years, the coffee chain has moved modestly into the black as a result of its expansion in several markets, which finally pushed the company over the hump.  

Caribou is also benefiting from a push into supermarket distribution, which helped sales rise 16.5% in the second quarter to $80 million. A big chunk of this comes from supermarket sales, and because stores already carry a huge selection of brands, it may be hard for new products to gain traction. So it’s unclear whether management will be able to double the base of supermarket sales in the next few years, as some analysts forecast.

For this matter, it’s not clear that we even need more coffeehouses. Starbucks did a fine job of blanketing the nation with a coffeehouse in virtually every key retail location. Caribou will most likely have to settle for second-tier locations as it rolls out more stores.The company expects to open 10 new locations in the 2011 fiscal year, and plans to add 8-10% to its store base by the 2013 fiscal year. 

But the stock’s real problem lies in Caribou’s expense structure. Coffee prices are surging, pushing Caribou’s gross margins down nearly 3 percentage points in the most recent quarter, compared with the year-ago period. Therefore, unless coffee prices fall back, Caribou’s year-over-year profit growth rates are set to slow. Profits in the first half of 2011 doubled to $7.4 million, but second-half profits are expected to rise only 10%. Caribou is on track for respectable growth again in fiscal 2012, with profits expected to rise roughly 20% as the company opens more stores and has the benefit of a full year’s worth of distribution with grocer Publix. In addition, Caribou plans to ramp up its K-Cup offering, a venture that’s new to the company and still generates minimal revenue.

Caribou is still likely to be a distant third in the coffeehouse space and is surely displeased to see a revamped Starbucks back on the growth path. In this light, you have to question why shares have doubled in the past six months, and how investors can justify the P/E multiple of 31 times projected 2011 profits.

Peet’s Coffee
This West Coast chain has a better track record than Caribou. Sales have been rising at a moderate pace throughout the past decade and the company has been consistently profitable.  The financial performance is all the more impressive when you consider Peet’s operates only 193 stores, a number that would usually be considered too low to gain critical mass in terms of advertising and distribution.

Just like Caribou, Peet’s is pushing to expand into supermarket distribution as a way to boost sales. The company’s coffee varieties have a great reputation among coffee connoisseurs, which has helped Peet’s garner premium pricing (its coffee can fetch upwards $10 a pound, while many supermarket brands sell for half as much). Trouble is, Peet’s has only really proven itself in California, Oregon and Washington, an area known for coffee fanatics. As the company looks to build its brand, it’s going to find saturated markets and more price-sensitive customers.

And pricing is crucial in this business because these companies must find a way to offset ever-rising coffee prices. Peet’s coffee costs (per pound) rose 37% in the second quarter. As a result, profits are likely to dip in the third and fourth quarter compared with year-ago results. Despite profit pressures, investors have been pouring into this stock, hoping to catch the next Green Mountain-like winner. The stock has been up about 33% in the past six months, but with shares trading for more than 30 times next year’s profits, a clear disconnect has emerged.

As a final concern, Dunkin Brands (Nasdaq: DNKN), which went public on July 27 and operates about 9,800 stores, is looking to sharply expand its base of Dunkin Donuts coffee shops in the Western region of the country. This chain has much more financial firepower and the resources to spend heavily on advertising.  That’s a Goliath that Peet’s and Caribou are unlikely to topple.

Action to Take –>  When investors start to realize growth prospects will dim beyond 2012, they’re going to start to question these high P/E coffee retailers. Coffee stocks have been on a tear this year, but investors should soon realize that Starbucks and Dunkin Brands have already saturated this space. Peet’s and Caribou Coffee appear overvalued by at least 25% to 30% — if not more. If you own either of these stocks, you should consider getting out before short-sellers catch on.

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