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Sunday, February 20, 2005 - Page updated at 12:00 AM

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Tully's Coffee: A brand that belies its size

Seattle Times retail reporter

Every Christmas Eve, the store managers heard from Santa by voicemail.

He'd give each a bundle of company shares, only to call back later that shift. Mrs. Claus had given him grog, he'd say. Their gift was then doubled.

Tom Tully O'Keefe — the founder, chairman and namesake of Tully's Coffee — was Santa, and the shares he doled were his own.

"I wanted to make sure they felt a sense of ownership," said O'Keefe, whose middle name honors his mother's Greek heritage. "The best way to do this is to make them owners."

To some employees, O'Keefe's generosity is legendary. To some investors, however, that generosity is viewed as misguided, at best.

Tully's eventually had to account for O'Keefe's gifts of stock as a company expense. (Federal accounting rules had viewed it as disguised compensation.)

Investors see this as one more example of the company's inability to live within its means. "There are a lot of people losing faith," said one longtime investor. "Tully's is not even a competitor anymore."

Since opening its first cafe in 1992, Tully's has developed into a strong, regional specialty-coffee retailer — one with a brand that belies its size. But if Tully's name casts a vast shadow over competitors, its sales are spread over a base an inch thick.

In its 12 years in business, Tully's has not made a net profit. While the company generated $1.3 million in cash flow from operations in fiscal 2004, it doesn't expect to turn a net profit for another year.

To understand Tully's past and its future, however, one can't compare it to its specialty-coffee peers. Tully's has traveled another path — one best viewed through the prism of the dot-com boom.

Kinder, gentler alternative

O'Keefe was a real-estate developer when he opened the first Tully's in 1992. He had leased several storefronts to Starbucks in neighborhood shopping centers.

"Tom thought he could do it better," said Rich Padden, his longtime friend and attorney.

By the mid-1990s, Tully's became one of a handful of regional specialty-coffee retailers to set a plan for aggressive growth.

The Specialty Coffee Association of America projected in early 1996 that the U.S. and Canada would be home to 10,000 coffee shops by 1999. Of those, 5,500 would be coffee bars and cafes, the group projected. The rest would be carts.

It seemed a racy prediction.

Starbucks dwarfed the competition by then, with nearly 1,000 stores and a goal to double by 2000. Tully's, meantime, sought to distinguish itself in other ways.

Tully's presented a milder roast and used overstuffed chairs and fireplaces to create an aura of comfort and warmth in its stores. But even if it wanted to be viewed as a kinder, gentler alternative to Starbucks, it wasn't afraid to capitalize on its competitors' growth.

Tully's began opening stores adjacent to Starbucks, much as Burger King positioned its fast-food restaurants near McDonalds two decades before.

In 1996, O'Keefe said Tully's didn't want to "beat itself over the head" trying to educate new communities on the finer points of gourmet coffee.

"We'd rather let Starbucks do that and drag off of them," he said.

Venti-sized plans

For those who know O'Keefe, this type of boldness didn't surprise them. He was senior class president at Issaquah High School when he invited someone to speak about legal alternatives to the Vietnam draft.

O'Keefe's brother fought in Vietnam, and his father was a decorated World War II veteran. While he invited military recruiters, he wanted to present students with all their options.

"He took a lot of heat for it, but he felt that it was a role that he needed to play," said his sister, Maureen Atherton. "That's a very typical Tom move. The heat doesn't bother him."

Investment bankers, meantime, placed a fire under Tully's growth. Like its dot-com counterparts, the company's charge was to build the brand and store count as quickly as possible to prime it for the public markets.

In June 1995, Tully's had 10 stores and 80 employees. Four years later, it had 59 stores and 545 employees.

This get-big-fast approach — reminiscent of the boom — was most evident in its splashy marketing deals. In 1999, Tully's beat out longtime Mariners' sponsor Starbucks for exclusive rights to serve coffee and espresso drinks at Safeco Field — a privilege for which it paid more than a $1 million.

Tully's signed another baseball marketing agreement a year later, this time with the San Francisco Giants' Pacific Bell Park. For $1.8 million, it got its logo on the left centerfield wall.

By then, in 2000, the company had swelled to 851 employees, with 75 company-operated stores in the U.S., 35 licensed stores abroad, and 37 locations in the works.

The ultimate symbol of its budding influence, however, came atop a building visible from Interstate 5. Tully's moved its headquarters to the old Rainier Brewery building south of downtown Seattle. It replaced the neon red "R" — a local landmark — with the green "T."

Rainier was part of Seattle's history; Tully's, it seemed, was its future.

Who needs sleep

O'Keefe was born April 1, 1954, to John and Sophie O'Keefe — the fourth of five children. O'Keefe's father was Irish and his mother was "100 percent Greek," family members say.

"It wasn't quiet, let's put it that way," Tim O'Keefe said of growing up in the family. "It was fairly lively."

John O'Keefe served in the U.S. Marine Corp, where he fought in Guadalcanal, the first U.S. offensive campaign in the Pacific during World War II. He was a physicist and was recruited by Boeing to work on its supersonic transport program to help address the issue of the sonic boom.

"I can only remember my dad working all the time," Tom O'Keefe said. "He was a nocturnal guy. He had his last pot of coffee at 10 p.m."

O'Keefe and his four brothers and sisters learned never to be idle, which may have translated into what each sibling refers to as the "O'Keefe Curse." One sibling can e-mail another at 2 a.m. and, more often than not, get a response.

"I think we're antsy," Atherton said. "We think the day should start."

If O'Keefe's father was a model of hard work, his mother was the one who sent all five kids to college without allowing any of them to feel deprived. O'Keefe learned the extent of his mother's painstaking ingenuity 15 years ago.

He had sent his mother, an avid baseball fan, to spring training in Phoenix. While she was away, O'Keefe's father came over and handed him mail that was sent to the house.

One envelope contained a bill from the Boeing Credit Union. The balance was $1,500, with a monthly payment of $47. After a little digging, O'Keefe realized that his mother had borrowed $8,000 in his name for tuition in the early 1970s.

Nearly two decades had passed, and Sophie O'Keefe was still dutifully paying down the loan. O'Keefe covered the balance and never brought it up.

When the bottom falls out

Tully's path paralleled the boom, but its business carried an important distinction. Retail businesses require repeated injections of money to cover the cost of inventory, rent and new stores.

Its goal was to debut on the stock market in 2000 or 2001, raising enough money to fuel its expansion. But the dot-com market collapsed, and with it went Tully's ability to raise the money it needed to expand.

Like its dot-com counterparts, Tully's went from the promise of a cash-fueled IPO to life-support in what seemed like an instant. "We were building to fit into that metric, and it went away," O'Keefe said.

Tully's shares are not publicly traded, but the company still must file reports with the Securities and Exchange Commission because it has more than 500 investors.

Tully's had worked to build stores that rivaled Starbucks in staffing and décor, but the costs began to catch up with them.

During its early stages, Tully's cost structure could support only two employees a shift, but it used three, viewing the third worker as a marketing expense. The company wanted to help build its image as a larger, more sophisticated operation.

Tully's also overstocked the food cases by 10 to 12 percent. O'Keefe's reasoning: If a customer walked into Starbucks and saw a decimated pastry case at 11 a.m., they would reason that it had a good morning. If the same occurred at Tully's, the customer would think the opposite.

"If you buy enough pastries for 11 customers, you'll never get that 12th one," O'Keefe said. "In the early years, we used an overstaffing and overstocking mentality to build the brand."

The company's largest point of differentiation, a milder alternative to Starbucks' dark roast, also cost more to produce than its largest competitor.

Because Tully's roasted in small batches, and spent more time roasting each batch, it meant more "shrinkage." Every batch of coffee was reduced by up to 15 percent.

Still standing

O'Keefe said the company could have continued to grow the business by bringing in more money, but it chose not to because the dilution to existing shareholders was "far in excess of what we felt was palatable," he said.

After the IPO market collapsed, the company applied the brakes, but some say it was too little, too late. Tully's closed its store design and construction division because it didn't have the money to open more stores. The management team, meantime, took a 10 percent deferral in income "until further notice."

But the company was slow to let employees go — inaction some attribute to O'Keefe's penchant for generosity.

Tully's, meantime, had problems holding onto chief executives. Tony Gioia, a former president at Baskin-Robbins, left last July after two years. He had taken over from interim CEO Marc Evanger, who guided the company for 10 months after his predecessor, Jamie Colbourne, quit five months into the job.

Tully's in October named former Seattle Sonics executive John Dresel as its president, but it no longer has a CEO. "Having a lot of titles doesn't make the business any better," O'Keefe said at the time of Dresel's appointment.

Larry Benaroya, principal of Benaroya Companies, said O'Keefe was slower to "do those types of things than others might have done," such as letting employees go.

His take, however, is this: Most of the companies during the dot-com frenzy aren't around anymore, and Tully's is. "It's pretty impressive actually," Benaroya said.

While Tully's annual sales have been flat for the past three years at roughly $50 million, it has worked hard to shrink its costs.

In fiscal 2002, its cost of goods sold — the value of a product before it's sold — accounted for 50.3 percent of overall sales. Last year, it declined to 43.6 percent.

Overhead has fallen, too — although some would say that it hasn't fallen enough. In fiscal 2002, the company spent 21.7 percent of its sales on overhead, down to 14.2 percent in 2004.

Starbucks last fiscal year spent 5.7 percent of its sales on overhead. Peet's Coffee, a comparably sized Tully's competitor, spent 3.5 percent on overhead for the same period.

For all of 2004, Tully's posted a $2.7 million net loss on sales of $50.8 million.

Tully's, O'Keefe said, made a conscious decision not to "cut to the bone." "The good news is that the overhead we have today doesn't have to get any bigger to scale up substantially," he said.

Waiting, impatiently

Some shareholders have grown tired of waiting.

At its 2004 annual shareholders meeting in December, O'Keefe was one of seven members elected to its board of directors. On average, the six others board members each received 224,000 ballots cast against their re-election. O'Keefe had 613,648.

In a December 2002 Harvard Business Review article, "Why Entrepreneurs Don't Scale," John Hamm identified four traits that mark successful entrepreneurs and that hinder business growth:

• Loyalty to comrades — failing to see and respond to a team member's weaknesses.

• Excessive attention to detail — executing brilliantly with demanding short-term assignments, but confusing tasks with goals.

• Single-mindedness — vision becomes tunnel vision when CEOs fail to listen to employees with a distinct view.

• Working in isolation.

Michael Preston, a Columbia University business-school professor, said the strengths that enable someone to get to one level often have the seeds of shortcomings when attempting to reach the next level.

"If you have a company that has been business for 12 years — and hasn't made a profit — I'd be very interested to see whether the founder has been willing to delegate," he said.

Eyeing the No. 2 spot

If Tully's ever had a chance to transcend its past, it's now.

The company is talking with investors, both institutional and private, to raise more than $10 million. Much of it will be used to open company-operated stores on the West Coast.

Tully's ended the 2004 fiscal year with 305 stores to Starbucks' 9,000.

Still, specialty-coffee retail experts say that while Starbucks is far and away No. 1, there's still room for a No. 2 brand.

For those who know O'Keefe best, they believe Tully's has a shot.

"I would never bet against Tom — never, ever, ever," Atherton said. "I have seen him pull a rabbit out of his hat too many times."

Monica Soto Ouchi: 206-515-5632 or msoto@seattletimes.com

Copyright © 2005 The Seattle Times Company

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