Coffee Investors, Here Comes the Caffeine Crash

by: Ian Bezek

Recently, coffee stocks have had a tremendous run, with companies such as Green Mountain Coffee Roasters (NASDAQ:GMCR), Caribou Coffee (NASDAQ:CBOU), Coffee Holding (NASDAQ:JVA) and even the market leader Starbucks (NASDAQ:SBUX) giving investors utterly breathtaking results. As you can see, coffee stocks have given shrewd investors incredible results since the end of the financial panic of 2008.

Company Ticker Low High Current Gain from Low
to current price
Coffee Holding JVA 0.56 30.98 23.08 4,021%
Green Mountain
Coffee Roasters
GMCR 5.11 96.91 90.53 1,672%
Peet's Coffee and Tea PEET 17.79 62.86 60.35 239%
Starbucks SBUX 7.06 41.11 39.58 459%
Caribou CBOU 1.10 15.09 13.35 1,114%
Jammin Java JAMN 0.10 6.35 1.05 950%

But when coffee stocks lose their buzz, a crash is likely to follow. Already, we've seen alarming signs. Coffee Holding has seen its shares dive from a peak of more than $30 earlier this week to $23 today, a more than 20% loss of value in two trading sessions. Caribou Coffee is also down more than 10% from its peak earlier this week. Also, another coffee play, Farmers Brothers (NASDAQ:FARM), saw its shares rise 20% Monday, but it since given back all those gains and more.

The whole coffee industry is highly vulnerable to an acute correction. The sector's "cheapest" stock is Starbucks, and even it trades at a 28 P/E ratio (Caribou has an 8 P/E ratio due to a one-time tax gain, but excluding that, its P/E would be in the 30s).

The valuations would make sense if these were revolutionary companies that could maintain growth for many years. But that simply isn't the case. Americans are only going to drink so much coffee in a given year. The coffee shop culture has already become fashionable - it's hard to see the coffee industry's total size getting much bigger. Investors must ask themselves: For how long can coffee remain a growth industry? In the future, growth for companies such as Green Mountain is likely to come at Caribou's or Starbuck's expense.

And how many more retail locations can be opened? Starbucks already has more than 17,000 stores. The North American coffee market has just about reached the saturation point. And while margins are still fairly high, one has to expect compression on that front as well. With competitors at lower price points in the coffee space such as McDonald's (NYSE:MCD) and Dunkin' Donuts (which is preparing its IPO) aggressively fighting for market share, it's hard to see coffee margins going anywhere but down.

Rising competition in a saturated market is a sufficient reason to avoid a sector. Add in the fact that all of the industry's main players seem quite overvalued fundamentally after their huge runups in the past couple years, and the whole sector looks like a good short. And there's yet another cause for concern: Coffee prices.

Click to enlarge

Over the past couple of years, the commodity cost of coffee has nearly tripled. Someone must pay for this price increase, be it the distributors such as Coffee Holdings or the retailers such as Starbucks, or the end customers. Starbucks has been repeatedly raising prices, so far with some success, to try to pass through the cost to end consumers. But how long will customers be willing to put up with rising coffee prices, either at Starbucks or the grocery store? There's little to stop people who want premium beverages to switch from their $5 Starbucks drink to something from Jamba Juice (NASDAQ:JMBA) or numerous other non-coffee competitors.

At this point, I think the whole coffee sector is overpriced, and many of its companies appear to be solid short sale candidates. Coffee Holding looks like a particularly compelling opportunity for bears, as it has surged the most with its chart starting to look like a classic pump and dump. Much of Coffee Holding's recent increased profitability was due to successful hedging of coffee prices rather than improved profitability in its core business, and the company relies on Green Mountain Coffee Roasters for roughly half its revenues. With coffee prices rising and heavily reliant on just one customer, it would be easy for Coffee Holding to end up seeing its margins get heavily compressed. And Coffee Holdings' margins are already razor-thin once you exclude the unusual hedging gains.

For those who still like the sector (or want a bullish name for a pair trade), the best long in the sector is probably Starbucks. While I have trouble justifying its high P/E ratio given the headwinds coffee companies are facing, at least Starbucks has a dominant brand that gives it better ability to pass along cost increases to consumers rather than absorbing it themselves. Starbucks also pays a decent dividend, which is unique among the coffee stocks. At this point, though, coffee stocks looked like they are headed for a period of rapid declines, and I'd urge investors to lock in profits and consider shorting the most overvalued of the companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.