Why Starbucks Has An Edge Over Competitors Despite Rising Coffee Prices

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After gradually declining in 2012 and staying at tepid levels for almost a year-and-a-half, coffee prices have been on a tremendous up-run for the last six months. The price of Arabica coffee beans has surged almost 100% from a level of 106 cents per pound to around 220 cents in mid April, due to tight supply as a result of prolonged drought in Brazil, followed by recent floods.(( Coffee futures, July contract, 2014 )) It could be driven higher by the end of this year due to increasing demand for premium coffee beans. Brazil is the world's largest supplier of Arabica coffee beans and accounts for more than one third of the global supply. The country is expected to produce just 49 million bags of Arabica coffee in  the 2014-2015 season, as compared to 53.3 million bags in 2013. Moreover, International Coffee Organization (ICO) forecasts a decline in coffee production to 5% in the first semester of 2014 and anticipated a global coffee deficit of at least 2 million bags in 2014-15. (( Global Coffee Supply on Track of Deficit , www.brecorder.com))

To add to the injury, federal forecasters have also predicted an early outbreak of El-Nino , the oceanic disturbance, that can intensify this harsh weather, disrupting crops across Southern Brazil.  And if it damages the crop growth, it may lead to further price hike for coffee. On the positive side, drier and hotter weather around the Amazon River Basin, Colombia, and Central America can somewhat negate the potential of coffee yields being damaged by frost. However, the extent of damage caused by El-Nino cannot be predicted, but looking at the major probability of its early onset this year, it would be one of the prime market mover in later half of the year.

As of now, the next two quarters of the calender year look to be a pretty tough period for companies like Starbucks ( SBUX ) and Keurig Green Mountain (NASDAQ : GMCR), that are majorly dependent on coffee for revenues.

Since beverages accounted for 74% of Starbucks' total retail sales in 2013, the strategy of hedging coffee prices for longer duration has given the giant coffee brewer an edge over its competitors. Coffee accounts for less than 20% of the company's cost of goods as stated by Starbucks' CEO in a recent interview with CNBC.

Starbucks posted excellent second quarter figures in terms of global comparable sales growth and total revenues. The highlight of the second quarter was its noteworthy comparable sales growth in China and Asia-Pacific (7%), as well as Europe and the Middle East (6%). Operating margins expanded by 50 basis points to 21.6%, primarily due to favorable commodity costs. (( Starbucks Q2 earnings transcript, March 24, 2014)). These operating margins are under a threat if coffee prices continue to climb the ladder.

We have a $73 price estimate for Starbucks, which is in-line with the market price.

See our full analysis for Starbucks Corportion

Advantage: Hedged Coffee Prices

On the periphery, it appears that the coffee price hike will affect the pricing of the company's coffee items, but the core situation is not that complex, especially for Starbucks. The last time Arabica coffee prices rose sharply was back in May 2011, hitting an all-time high of around $3 per pound. As a result, Starbucks incurred an additional costs of around $200 million for the fiscal year 2011 and slightly more in 2012, which was somewhat offset by cut down in expenses in other operations. Effectively, rising commodity costs led to 1,000 basis points decrease in operating margins year-over-year.((SBUX earnings call transcript, Q4, 2011)).

The situation is partially different this time, the company seems to have learnt its lesson. In its latest Q2 earnings transcript, the company mentioned about its one year worth of protection on inventory and contracts. By the close of 2013, Starbucks had fixed-price coffee agreements valued at $588 million and variable-price commitments worth $294 million. To hedge against rising coffee prices, Starbucks virtually locked all of its coffee needs for 2014 and around 40% for fiscal 2015 at slightly favorable prices.

Chance To Strengthen Consumer Base And Maintain Margins

As of now, if the situation in coffee producing nations doesn't worsen, Starbucks will be the last of its peers to be affected, due to the nature of its customer base. Starbucks targets a more affluent demographic of coffee drinkers that typically exhibit strong brand loyalty, making demand for its coffee more inelastic with respect to price fluctuations. This effect has been observed during the economic downturns in the past. Despite falling prices in 2012 and 2013, Starbucks raised price of its menu items but the number of customers per day in U.S stores remained almost unchanged. Also, with expanding wealth and discretionary spending in many international emerging markets, the growing demographic of young middle-class working professionals might exhibit a bit of brand loyalty as well, propping up the company's revenues in these regions.

According to Starbucks' CEO, Howard Schultz, the company is not planning to raise its coffee menu prices despite the sharp rise in commodity costs. However, it might raise its grocery prices, but that is a different issue. ((Howard Schultz, Fox Business interview)) Looking at the approaching threats on coffee prices, Starbucks has a significant advantage over its smaller competitors which have relatively lower duration of hedged commodity price for fiscal 2014. Effectively, the company has a great opportunity to steal some market share in terms of number of coffee consuming customers. Starbucks' customer satisfaction, quality control and add-on services like Wi-fi are some other factors that might lure and sustain new customers.

Trefis currently forecasts a 4.5% annual growth in the number of daily customers for the fiscal year 2014. If the above scenario happens, the annual growth might rise to around 5%, resulting in a 4% upside to Trefis' current price estimate.

Furthermore, Starbucks still expects coffee segment to be its major driving force. To strengthen its base, the company purchased its first coffee bean farm in Costa Rica along with the opening of its new seven "agronomy and farmer support" centers in Ethiopia. The coffee giant is also planning to revamp its coffee menu, as mentioned in its latest earnings call. This might also lead to potential increase in average revenue per store from beverages.

Currently in our financial model, we forecast an annual growth of 12.3% in beverage revenue, which might climb to 13% in that scenario, which would hardly give an extra boost to their margins, but it would help maintaining it at current forecasts.

However, if coffee prices continue to shoot up past $3 per pound, hedging would be ineffective and the company would have to increase the price of items. Not only are coffee prices rising, so are milk and sugar prices. The company believes that rising dairy prices is more of a concern than coffee. According  to USDA, March milk prices rose 2% month-over-month and 33% year over year as a result of rising imports. Meanwhile, sugar prices are up about 13% since the end of January.((Dairy Data, USDA report)) So the combined effects might handicap Starbucks and force them to pass on the rising prices to the customers. Looking at the current situation in the U.S, rising prices is not a good option for fast casual restaurants. In that case, its margins would suffer around 2 percentage points, resulting in a  2.7% downside to trefis' price estimates.

It would be interesting to watch how its competitors tackle the high commodity cost situation.

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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.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: SBUX , MCD , GMCR , DNKN

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