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Summary

  • Starbucks raised coffee prices in response to worries of global coffee supply.
  • Starbucks concept as a third place has worked well.
  • Korean chain Caffe Bene plans to be Starbucks’ largest competitor by 2020.

Starbucks (NYSE:SBUX) is ubiquitous in the United States and abroad. Last year, the premium coffee roasting and retail chain "had more than 3 billion customer visits to [its] more than 19,000 stores in 62 countries," according to its 2013 annual report. "The Americas, [its] largest segment, produced revenue growth of 11 percent, led by the strength of the U.S., where comparable store sales have grown 7 percent or higher for 15 consecutive quarters, which is particularly noteworthy given the size of the market."

Coffee is big business and, in many ways, Starbucks' push to become a "third place" between home and work was successful. Today, people regularly meet at coffee shops, be it a starting place for a day out with friends, a low-commitment way to have a first date, or an all-ages alternative to frozen yogurt shops and fast food places - and disproportionately more of these people are millennials.

This is important because millennials have a lot of brand loyalty. Over 70% of millennials claim that they will never leave a brand they love and there are roughly 82 million millennials in America, outnumbering the baby-boomer generation.

The numbers are certainly encouraging, so much so that Starbucks is planning on opening 1,500 new stores in fiscal 2014. That's a lot of coffee!

COFFEE PRICES

Now, keep in mind that coffee is a commodity. Its prices fluctuate just as much on the basis of investor activity as world weather conditions.

The coffee that people trade is typically referred to as "C" class. While the differences are detailed more in Starbucks's annual report, suffice to say that the company uses a higher quality arabica coffee and this class of beans is typically traded at a premium to "C" coffee commodity prices.

Brazil which is "the world's top grower and exporter of coffee experienced its worst drought in decades earlier this year, and expectations of reduced supplies sent futures prices to more than two-year highs above $2 a pound," writes Barron's. "Arabica-coffee futures surged as much as 94% at the market's pinnacle in late April."

RISING PRICES

In response to rising coffee prices, Starbucks recently announced that it would be raising prices "for certain packaged coffee and other products, following other big java makers in responding to a jump in raw coffee costs earlier this year that is now making its way to consumer wallets," explains the Wall Street Journal. "Some beverages in Starbucks U.S. company-operated stores will increase by between five cents and 20 cents. A 20-ounce, venti-sized cup of brewed coffee, for example, will cost $2.35, an increase of either 10 cents or 15 cents, depending on the market."

And Starbucks is only the latest company to do so. J.M. Smucker (NYSE:SJM) lifted prices by roughly 9% on packaged coffee by Folgers and Dunkin' Donuts while Kraft Foods (NASDAQ:KRFT) recently boosted the price tags on its Maxwell House and Yuban coffees.

The fear had been that droughts in Brazil would cause a coffee shortage, but the market has been recovering since April. Prices for arabica coffee have fallen around 20% since then. While coffee prices are still a major factor for Starbucks - the company buys over half a billion pounds of coffee beans a year - coffee commodity costs only account for around 10% of store expenses.

Further, Starbucks currently has enough coffee, between contracts and inventory, to handle demand through fiscal 2014 (this figure is according to its 2013 annual report; the Wall Street Journal article said the company has locked in 40% of its coffee needs for 2015 as well), but there could be an entirely different issue the company will have to weather - new competition.

NEW COMPETITION

Starbucks has been so successful in pioneering the third place concept that the risk is no longer that people will stop frequenting coffee shops, but rather that they will leave Starbucks.

Korean coffee chain Caffe Bene could give Starbucks a run for the money. The company has already swelled to 900 locations in Korea since opening in 2008 (Starbucks in comparison has only 600 outlets in Korea), and they are planning on going global. According to Forbes, Caffe Bene CEO and founder Kim Sun-kwon is planning 10,000 locations worldwide by 2020 - that is more than half the number of Starbucks currently in existence.

As explained in Forbes:

"We believe we have a better mousetrap than what's currently out there," said John Barry, U.S. Director of Franchising for Caffe Bene, emphasizing the coffee shop's desire to create an environment that feels more like entering someone's living room rather than another grab-and-go retail in the middle of a hectic metropolitan city.

For example, rather than simple breakfast sandwiches, Caffe Bene has Belgian waffles. Instead of only frozen drinks, Caffe Bene also offers Italian gelato. Moreover, instead of offering pre-made sandwiches, Caffe Bene's are made fresh - and they franchise.

Caffe Bene will surely win some people over by offering a broader menu selection while maintaining a lingering atmosphere. The biggest challenge will be in establishing a brand identity that can inspire the same sort of loyalty seen in Starbucks customers.

TAKEAWAY

Starbucks is a solid company. The company is currently trading at $79.45 on a 52-week range of $66.30 to $82.50. Its revenues are growing, rising over 9% compared to an industry average of 6%. Starbucks has also enjoyed rising earnings per share, increasing the bottom line by 9.8% compared to the most recent quarter last year and, with such a strong foundation, the company could show a strong improvement in earnings this year.

Coffee prices will always have an effect on the bottom line of a business like Starbucks, but the rise of a viable competitor is a far bigger issue. If Caffe Bene makes good on its plan to have 10,000 stores by 2020, Starbucks will have a very real rival. Starbucks has evolved many times over since opening its doors so many years ago.

Starbucks well may be able to keep pace against such an aggressive competitor, but reinventions and battles can be costly - costs which are sure to be reflected on Starbucks' bottom line going forward. Investors in the stock have reasons to be encouraged in the short term but they should keep an eye on the competitive environment when considering a longer position.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Can Starbucks Weather The Coffee Drought? Probably. The Competition? Maybe.