You should read the following discussion and analysis in conjunction with our consolidated financial statements and related notes included elsewhere in this report. Except for historical information, the discussion below contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934. The fiscal years ended December 28, 2008 (fiscal 2008), December 30, 2007 (fiscal 2007) and December 31, 2006 (fiscal 2006) all included 52 weeks.

Company Overview and Industry Outlook

Peet's is a specialty coffee roaster and marketer of fresh, deep-roasted whole bean coffee and tea 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, tea 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.

As we grow, we expect our operations to 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 use 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 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. We believe the growth in specialty coffee is particularly strong in grocery where specialty coffee dollars spent in the last year grew an estimated 12%.

We believe growth opportunities exist in all of our distribution channels. We believe that our specialty sales can expand to geographies where we do not have a retail presence. Our first priority has been to develop primarily in the western U.S. markets where we already have a presence and have higher customer awareness. In the long-term, we expect to continue to open new retail stores in strategic west coast locations that meet our demographic profile and partner with distributors and companies who share our passion for quality and freshness and are willing and able to execute accordingly in the foodservice and office environment. In grocery, we expect to continue to expand into new markets although the full extent of our penetration will depend upon the development of specialty coffee as a category in many markets.

Coffee commodity costs began to decline in July 2008 after over four years of increases above the prior three to four year range. We have fixed the price on 95% of our coffee costs in 2009 at a two to three percent increase over 2008. We expect the commodity market to continue to be volatile as worldwide demand, the strength of the dollar, and weather will continue to cause uncertainty in the market.

Our net revenues depend significantly on consumer confidence and spending, which have recently deteriorated due to the recession and may remain depressed for the foreseeable future. We believe that the current recession negatively impacted our net revenues in 2008. Despite revenue growth that was less than our plan, we were able to meet our targeted net earnings per share by leveraging our infrastructure investments and diligently managing our costs. In addition to achieving this target, we achieved the growth milestones as described below established at the beginning of year.

In 2008, the Company continued to pursue its strategy to expand its multiple distribution channels in the United States. The results of the efforts in 2008 include:

• opening 23 new retail locations, 22 of which were in California;

• expanding our grocery network by entering 2,400 new stores, primarily outside of our core western markets. This helped drive 23% revenue growth in our grocery business;

• expanding the availability of office coffee through a national partnership with Vistar, the largest office coffee distributor in the United States; and

• growing our foodservice business by establishing license kiosks in numerous locations including airports and grocery stores.

The current recession or a worsening of the United States and global economy could materially adversely affect our business as our revenues depend significantly on consumer confidence and spending. In 2009, while we will continue to grow our business, our primary focus will be on strengthening our core existing businesses with even more emphasis on operational efficiency. As a result, we will only open approximately 10 new stores in 2009, versus 23 in 2008, and expect to gain distribution in approximately 1,000 new grocery stores, versus the 2,400 we added in 2008. We believe this is the right strategic focus for us at this time, as we believe there are growth opportunities in these existing businesses and it will strengthen the Company long term. In 2008, we completed the implementation of a new inventory management system in our retail stores that enabled us to significantly reduce waste in the second half of the year and we will continue to focus on reducing waste and improving operations in 2009. In our specialty segment, we will also focus on leveraging the investments we have made in people and system infrastructure in 2009.

Business Segments

Our coffee and related items are sold through multiple channels of distribution that provide broad market exposure to potential purchasers of fresh roasted whole bean coffee. We are indifferent as to where consumers purchase our coffees and teas, and believe that our specialty and retail segments are synergistic. However, we also recognize that the economics of our retail stores and other distribution channels are different enough that we have chosen to report them as separate segments under SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information". Therefore, we currently have two reportable segments, consisting of:

• Our retail stores; and

• Specialty sales, which consist of sales to grocery stores, foodservice and office accounts, and sales to home delivery customers.

Business Categories

In addition to our reportable segments, we measure our business by monitoring the volume and revenue growth of two distinct business categories:

• Whole bean coffee and related products, consisting of products for home brewing, tea and packaged foods; and

• Beverages and pastries.

We believe these business categories are useful in understanding our results of operations for the periods presented because we operate our stores and record revenue through these two categories. Our stores are primarily designed to facilitate the sale of fresh whole bean coffee and hand-crafted coffee beverages. The format of our stores replicates that of a specialty grocer. Beans are freshly scooped from bins under the counter, weighed on counter top scales and hand packed into branded bags. In addition, our stores are also designed to encourage customer trial of our coffee through coffee beverages. Each store has a beverage bar that is dedicated to the sale of prepared beverages and artisan baked pastries.

Results of Operations

The following discussion on results of operations should be read in conjunction with "Item 6. Selected Consolidated Financial Data," the consolidated financial statements and accompanying notes and the other financial data included elsewhere in this report.

Our fiscal year is based on a 52 or 53 week year. The fiscal year ends on the Sunday closest to the last day of December. 2008, 2007 and 2006 were all 52 week years.

                                                              2008       2007       2006
Statement of income as a percent of net revenue:
Net revenue                                                   100.0 %    100.0 %    100.0 %
Cost of sales and related occupancy expenses                   46.9       47.5       47.0
Operating expenses                                             34.7       34.4       34.3
General and administrative expenses                             7.9        9.1        9.8
Depreciation and amortization expenses                          4.5        4.4        4.1

Income from operations                                          6.0        4.6        4.8
Interest income                                                 0.3        0.6        1.2

Income before income taxes                                      6.3        5.2        6.0
Income tax provision                                            2.3        1.9        2.2

Net income                                                      4.0 %      3.3 %      3.8 %

Percent of net revenue by business segment:
Retail stores                                                  65.9 %     67.5 %     67.2 %
Specialty sales                                                34.1       32.5       32.8
Percent of net revenue by business category:
Whole bean coffee and related products                         53.0 %     53.8 %     55.8 %
Beverages and pastries                                         47.0       46.2       44.2
Cost of sales and related occupancy expenses as a percent
of segment revenue:
Retail stores                                                  45.5 %     46.6 %     46.2 %
Specialty sales                                                49.6       49.4       48.6
Operating expenses as a percent of segment revenue:
Retail stores                                                  42.4 %     42.6 %     42.6 %
Specialty sales                                                19.8       17.4       17.5
Percent increase (decrease) from prior year:
Net revenue                                                    14.2 %     18.5 %     20.1 %
Retail stores                                                  11.5       19.1       19.8
Specialty sales                                                19.9       17.2       20.9
Cost of sales and related occupancy expenses                   12.8       19.7       22.4
Operating expenses                                             15.2       18.7       24.9
General and administrative expenses                            (0.7 )      9.9       54.7
Depreciation and amortization expenses                         18.4       26.8       18.0

Selected operating data:
Number of retail stores in operation:
Beginning of the year                                           166        136        111
Store openings                                                   23         30         25
Store closures                                                   (1 )       -          -

End of the year                                                 188        166        136

2008 (52 weeks) Compared with 2007 (52 weeks)

Net revenue

Net revenue for 2008 increased 14.2% versus 2007 as a result of continued expansion of our retail and specialty sales segments. Sales of whole bean and related products increased 12.7% to $151.1 million. Sales from beverages and pastries increased 16.0% to $133.8 million.

In the retail segment, net revenue increased 11.5% compared to 2007 as a result of increased sales from new stores and the sales they generated in their first 12 months. Stores operating for at least one year contributed only a nominal amount of sales growth for the Company. We opened 23 new stores in 2008 and 30 new stores in 2007. Sales of whole bean coffee and related products in the retail segment increased by 3.8% to $55.1 million, while sales of beverages and pastries increased by 15.0% to $132.6 million. The increase in beverage and pastry sales was primarily related to sales at the stores we opened in 2007 and 2008 and increased traffic in our existing stores. The slower growth in whole bean and related products was primarily due to continuing cannibalization of bean sales in retail stores as we increased the availability of Peet's coffee in grocery stores and our own retail stores.

In the specialty sales segment, net revenue increased 19.9% compared to 2007 as summarized by business channel below. The growth in net revenue in grocery was due to the 2,400 new stores we added during the year, bringing the number of grocery stores selling Peet's coffee to approximately 8,200, as well as growth in our existing accounts in the western United States. Foodservice and office net revenue increased 34.7% over the prior year primarily due to 38 new licensed partner locations opened during the year and 150 additional "We Proudly Brew" accounts that serve Peet's coffee in their own branded locations. Net revenue in the home delivery channel declined primarily due to cannibalization from our grocery business expanding in the eastern U.S. and lower gift sales during the 2008 holiday season.

          (dollars in thousands)     2008       2007       Increase/(Decrease)
          Grocery                  $ 51,490   $ 41,879   $      9,611       22.9 %
          Foodservice and office     27,516     20,430          7,087       34.7 %
          Home delivery              18,096     18,688           (592 )     -3.2 %

          Total specialty          $ 97,103   $ 80,997   $     16,106       19.9 %

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 decreased from 47.5% in 2007 to 46.9% in 2008. The decrease from last year was primarily due to procurement savings (-0.7%), leverage of costs related to the roasting facility that opened last year (-0.4%), and increased prices in retail and grocery (-0.3%), partially offset by higher green coffee costs (0.8%).

We expect cost of sales and related occupancy expenses as a percent of net revenue to continue to decrease in 2009 due to leverage of our new roasting facility, improved waste management in retail, and neutral commodity costs in aggregate.

Operating expenses

Operating expenses consist of both retail store and specialty operating costs, such as employee labor and benefits, repairs and maintenance, supplies, training, travel and banking and card processing fees. Operating expenses as a percent of net revenue for 2008 increased 0.3% to 34.7%. The increase was primarily due to higher costs associated with expanding the grocery business (0.7%), opening 53 new retail stores in the last two years (0.2%), partially offset by favorable workers' compensation insurance expense (-0.3%) and other cost savings. The favorable workers' compensation expense resulted primarily from a decrease in our self-insurance reserve for prior policy years due to favorable claims experience and settlement history.

General and administrative expenses

General and administrative expenses in 2008 were $22.5 million, or 7.9% of net revenue, compared to $22.7 million, or 9.1% in 2007. The decrease in expenses as a percent of net revenue is primarily due to higher net revenue (1.1%) and lower professional fees associated with our stock option review and related litigation (0.5%), partially offset by increases in headcount (0.2%) and various professional services. Professional fees associated with our stock option review and related litigation were $1.4 million in 2007 and $16,000 in 2008. The related lawsuits were dismissed in March 2008.

Depreciation and amortization expenses

Depreciation and amortization expenses increased in 2008 primarily due to the 53 stores we opened during 2008 and 2007.

Interest income

We currently invest in U.S. government, agency, municipal and guaranteed student loan obligations. Interest income includes interest income and gains or losses from the sale of these instruments. We earned $726,000 in interest income in 2008, compared to $1.4 million in 2007, due to our lower average cash and investment balances and lower interest rates. The Company does not have exposure in its investment portfolio for subprime mortgages or auction rate securities.

Income tax provision

The effective income tax rate for 2008 was 37.0% compared to 35.8% in 2007. Our effective rate increased 1.2% primarily due to a lower impact from the domestic production deduction and decreased tax-exempt interest income.

2007 (52 weeks) Compared with 2006 (52 weeks)

Net revenue

Net revenue for 2007 increased 18.5% versus 2006 as a result of continued expansion of our retail and specialty sales segments. Sales of whole bean and related products increased 14.0% to $134.1 million. Sales from beverages and pastries increased 24.1% to $115.3 million.

In the retail segment, net revenue increased 19.1% in 2007 compared to 2006 primarily as a result of increased sales from new stores we opened in 2006 and 2007 and growth in the existing stores. We opened 30 new stores in 2007 and 25 stores in 2006. Sales of whole bean coffee and related products in the retail segment increased by 8.1% to $53.1 million, while sales of beverages and pastries increased by 24.9% to $115.3 million. The increase in beverage and pastry sales was primarily related to sales at the stores we opened in 2006 and 2007 and increased traffic in our existing stores. The slower growth in whole bean and related products was primarily due to continuing cannibalization of bean sales in retail stores as we increased the availability of Peet's coffee in grocery stores and our own retail stores.

In the specialty sales segment, net revenue increased 17.2% in 2007 compared to 2006 as summarized by business channel below. Grocery had the highest growth rate in the segment with a 21.6% increase compared to 2006, primarily due to continued strong growth in our existing accounts and secondarily due to new accounts we added in 2007. We added 1,400 new stores during 2007, bringing the number of grocery stores selling Peet's coffee to approximately 5,800 at the end of 2007. Foodservice and office coffee net revenue increased 18.7% primarily due to our effort to expand distributorships and licensed partners. Net revenue in the home delivery channel grew 7.0% compared to 2006 due primarily to special offerings to our existing customers.

              (dollars in thousands)     2007       2006        Increase
              Grocery                  $ 41,879   $ 34,440   $  7,439   21.6 %
              Foodservice and office     20,430     17,211      3,219   18.7 %
              Home delivery              18,688     17,465      1,223    7.0 %

              Total specialty          $ 80,997   $ 69,116   $ 11,881   17.2 %

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 47.0% in 2006 to 47.5% in 2007. This increase was driven by an increase of occupancy as a percent of net revenue. Occupancy increased approximately 0.5% compared to 2006 due primarily to the impact of opening new stores, which had lower sales levels. Product cost was about equal in 2007 and 2006 as the retail price increase we took in November 2006 combined with procurement and waste savings offset inflation in milk and coffee and the cost of the new roasting plant in 2007.

Operating expenses

Operating expenses consist of both retail store and specialty operating costs, such as employee labor and benefits, repairs and maintenance, supplies, training, travel and banking and card processing fees. Operating expenses as a percent of net revenue for 2007 increased 0.1% to 34.4% from 2006. The increase was primarily due to a 1.2% increase from opening 55 new stores in the last two years, largely offset by the November 2006 retail price increase (0.5%) and leverage of retail overhead (0.6%).

General and administrative expenses

General and administrative expenses in 2007 were $22.7 million, or 9.1% of net revenue, compared to $20.6 million, or 9.8% for 2006. The decrease in expenses as a percent of net revenue is primarily due to higher net revenue (1.5%) and partially due to lower professional fees associated with our stock option review and related litigation (0.3%), partially offset by increases in headcount (0.9%). Professional fees associated with our stock option review and related litigation were $1.4 million in 2007 and $1.8 million in 2006.

Depreciation and amortization expenses

Depreciation and amortization expenses increased in 2007 primarily due to the 55 stores we opened during 2007 and 2006.

Interest income

We currently invest in U.S. government, agency, municipal and guaranteed student loan obligations. Interest income includes interest income and gains or losses from the sale of these instruments. We earned $1.4 million in interest income in 2007, compared to $2.5 million in 2006, due to our lower average cash and investment balances. The Company does not have exposure in its investment portfolio for subprime mortgages or auction rate securities.

Income tax provision

The effective income tax rate for 2007 was 35.8% versus 37.5% in the prior year. Our effective rate decreased 1.7% primarily due to increased benefits from the domestic production deduction and lower effective state income taxes from California enterprise zone tax credits and growth in states with lower rates.

Liquidity and Capital Resources

At December 28, 2008, we had $4.7 million in cash and cash equivalents and $8.6 million in short-term marketable securities for a total of $13.3 million. Working capital was $36.4 million as of December 28, 2008 compared to $38.4 million at December 30, 2007.

Net cash provided by operations was $25.4 million in 2008 compared to $20.1 million in 2007. Operating cash flows were positively impacted in 2008 by net income, net of depreciation expense, offset by other changes in working capital.

Net cash used in investing activities was $19.0 million in 2008. Investing activities primarily relate to purchases of property and equipment, and maturities and purchases of marketable securities. During 2008, maturities net of purchases totaled $6.9 million as we used funds to invest in property and equipment and the purchase of our common stock. Cash paid for property and equipment totaling $25.9 million included:

• $13.4 million to build-out new stores and remodel existing ones;

• $2.3 million used for foodservice kiosks, grocery displays and other equipment for specialty sales;

• $1.9 million used for additional machinery for the new roasting facility;

• $3.9 million used for conversion of our previous roasting facility into office space; and

• $4.4 million used for information technology support systems and other software and hardware to support our growing infrastructure.

Net cash used in financing activities was $17.0 million in 2008, primarily from the purchase of our common stock, offset by proceeds from stock option exercises.

Our 2009 capital expenditures are expected to be between $14.0 and $16.0 million. Approximately $8.5 million is expected to be used for the opening of 8 to 10 new retail stores and for remodeling and improvements to existing stores. Approximately $2.5 million is expected to be incurred for the design and development of a new enterprise resource planning system (ERP) that we plan to implement in 2009. Approximately $2.1 million is expected to be used for equipment and machinery to improve effectiveness and increase capacity at our roasting facility. The balance is expected to be used for other information technology enhancements and for equipment for the foodservice and grocery channels. We expect to finance these capital expenditures with our cash and marketable securities and with operating cash flows.

The following table summarizes the Company's contractual obligations and the timing and effect that such commitments are expected to have on the Company's liquidity and capital requirements in future periods as of December 28, 2008:

                                                                 Payments Due by Period
                                                                     (in thousands)
                                                         Less than                                   After 5
Contractual obligations                      Total        1 year        1-3 years      4-5 years      years
Equipment operating leases                 $     387    $       295    $        92    $        -     $     -
Retail store operating leases (1)            102,666         14,927         27,747         25,032      34,960
Fixed-price coffee purchase commitments       37,765         33,609          4,156             -           -
Not-yet-priced coffee commitments                384            305             79             -           -
Development commitments (2)                      437            437             -              -           -

Total contractual cash obligations         $ 141,639    $    49,573    $    32,074    $    25,032    $ 34,960

(1) Payments for maintenance, insurance, taxes and contingent rent for which we are obligated are excluded. In fiscal 2008 these charges totaled approximately $2.8 million.

(2) Contractual obligations for purchases of leasehold improvements for equipment and leasehold improvements for retail locations.

The Company has excluded from the table above uncertain tax liabilities as defined in FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes," ("FIN 48"), due to the uncertainty of the period of payment. As of December 28, 2008, the Company has a $0.1 million liability for uncertain tax positions (see Note 5 to the consolidated financial statements).

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 existing share purchase program and our contractual obligations as they come due. The Company also has $25 million available through a credit agreement entered into on November 26, 2008 with Wells Fargo Bank, National Association, the proceeds of which may be used in the general course of business, including to fund working capital, capital expenditures, share repurchases and other needs of the Company. The line of credit has a maturity date of December 1, 2009, with an option by the Company to extend the maturity . . .