Is coffee the new cigarettes? SBUX's bottom line indicates yes

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Bobby Raines 04/28/2014

Stocks are off to a bumpy start so far in 2014, but of things almost had to cool off a bit after the run they had in 2013.

However, some assets have been on a tear so far this year, including a number of agricultural commodities. It seems that while many measures of inflation show prices being relatively stable, a number of factors have contributed to higher costs for a number of agricultural commodities.

The Federal Reserve's most recent Beige Book of economic activity reported that prices for pork and beef had risen in a number of areas of the country after  "a pig virus adversely affected hog farming" in a number of areas. The Fed is underselling things quite a bit, as millions of pigs have been killed by the virus, driving up prices for all kinds of pork derivatives. That's right, prices for futures contracts for pork bellies and actual bacon prices are rising because of this.

It's not just pig viruses though, various weather events had contributed to increases in a variety of commodities. One commodity that's made a big jump this year is coffee. A drought in Brazil, where more than 30% of the world's coffee is produced, has hurt this year's crop, sending futures prices skyrocketing.

That jump in coffee prices could have spelled trouble for companies like Starbucks ( SBUX ). Higher input costs can lead to lower margins even if sales increase, because profits can get eaten up by higher costs. For example, look at Chipotle's ( CMG ) recent quarter, where revenue topped expectations but earnings missed estimates because the cost of food was higher.

Starbucks recent quarter showed no such problems. The company's earnings were in line with estimates, and margins actually expanded despite the rise in coffee prices. Operating margins expanded to 16.6%, compared to 15.3% in the same quarter a year earlier. Same-store sales grew by 6%, evenly split between a 3% increase in transaction volume and a 3% increase in the size of orders.

Granted, some of the blow of higher coffee prices hasn't been felt yet as the company used futures contracts to try hedge against big swings in price, but the company also has considerable pricing power. Starbucks sees itself as a luxury brand, and as such doesn't have a problem raising prices. The company has continued to grow despite a long history of price hikes.

Tobacco has traditionally been the go-to example for the concept of inelastic demand, as the addictive nature of the product means the companies selling cigarettes can raise prices almost at will without seeing much change in customer habits. As the tobacco industry withers and slowly dies, I wouldn't be at all surprised to see Starbucks become the leading example of inelastic demand.


Chart courtesy of stockcharts.com

Looking longer term, Starbucks has a lot going for it. It plans to start selling alcohol in some stores, hopefully increasing sales late in the day when there is typically less demand for coffee. Also, the price of coffee beans is unlikely to stay high forever, Starbuck's pricing history includes a lot of price hikes due to short-term increases in the price of coffee, but the company isn't in the habit if dropping prices when the price of coffee falls. A bumper crop in Brazil next year is it all it would take to sent the company's margins through the roof. This trade will return a full profit so long as the stock is above $65 at June expiration, giving it about 9% downside protection.

Investors who share my optimistic opinion on Starbucks could consider a June 62.50/65 bull-put credit spread. This position yields a 25-cent credit, which is an 11.1% return, or 76.5% on an annualized basis (for comparison purposes only.




The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Originally published on InvestorsObserver.com


This article appears in: Investing , Options

Referenced Stocks: SBUX , CMG

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