Coffee prices have been very volatile over the last 2 years, and as an investor, I want to know what effect this has historically had on Starbucks (SBUX) and what we can expect in the future. To answer those questions, I have taken a look on the cost structure of Starbucks, studied SEC-filings and earnings conferences, and looked at the relevant historical and forward commodity prices.
Prices of coffee beans and operating margin
To those who are not aware, there are two kinds of coffee beans:
- Arabica beans
- Robusta beans
Starbucks uses the former, as it creates a more flavorful brew. Robusta beans are slightly more bitter. Competitors like McDonald's and Dunkin Donuts use Arabica beans as well, so Starbucks can't differentiate itself in this way. Rather, I think Starbucks is winning customers by branding itself as a more "hip" coffee store.
Anyway, let's take a closer look at the prices of Arabica beans over the last 10 years. As can be seen in the below graph, one pound of Arabica beans sold for 27 cents in 2002 compared to 292 cents in February 2011. Since February, prices have fallen to around 172 cents each pound.
Prices of Arabica beans from 2002 - 2012
One may think that the increase in coffee prices in 2010/2011 would have a significant negative impact on profitability. However, the opposite seems to be true. As can be seen in the below graph, operating margin actually increased to 14.8% in 2011 from 5.8% in 2009.
As followers of Starbucks probably are aware of, Starbucks restructured its operation in 2008, as it had expanded too quickly and new stores cannibalized old stores. But despite the restructuring, it surprises me that the spike in coffee prices didn't have a significant effect on operating margins in 2011. It seems that Starbucks somehow minimizes the impact of the volatility of coffee prices.
How Starbucks minimizes the impact of coffee prices
I believe there are two explanations for the "irrelevance" of coffee prices.
- Purchase contracts
Starbucks buys most of its coffee from suppliers through fixed-price commitments. This means that it won't feel the effect of short-term fluctuations in coffee prices, as the price and quantity are fixed. I estimate that these commitments typically last around a year.
Another way Starbucks can minimize its commodity risk is through hedging. Typically, the company will make an arrangement to sell coffee on a specified future date (it buys a future). This means that it earns money when coffee prices increase, and hence this cancels out the input cost risk.
Does hedging neglect commodity risk completely?
While it may be possible in college textbooks to hedge perfectly, it is not always the case in the real world. Below I have quoted the treasurer of Starbucks, Richard Lautch, on the company's approach to commodity risk and hedging:
While the reader is probably thinking "coffee," it is actually the latte part of the cup that Lautch tinkered with first. "We have a big exposure to dairy-to milk," he says. "We didn't have any means of fixing price with our suppliers.
For suppliers to hedge with Starbucks would require them to have a fixed contract on one side with the company and a variable contract with the farmers on the other side. "They wouldn't want to have this mismatch, so we had to go directly to the farmers," Lautch says.
The mulling led to another innovation-hedging using Class III milk futures based on cheese, the product that most closely matches fluid milk, as a proxy hedge. "I'd love to find the perfect hedge and we're still looking, but for now we have something that works," Lautch says.
The essence of what Lautch said is that the volatility of Arabica coffee beans isn't very relevant, as Starbucks can minimize most of that risk through fixed-price commitments, but it can't do the same for milk, and it can only hedge the costs of milk imperfectly.
As an example of the effect of an imperfect hedge, let's assume that Starbucks has to pay its suppliers 4% more to buy milk. If it had hedged perfectly, the value of the future contract would increase by 4% as well. But since it can only hedge imperfectly, the future contract may increase by 2% or 6%, and therefore it can only partially offset the risk involved with the volatility of milk prices.
The effect of milk prices
As of FY 2011, Starbucks began publishing the effect the volatility of commodity prices had on operating margin. In FY 2011, increased commodity costs lowered operating margin by 2.3%, and for the first 3 quarters of 2012, commodity costs had a negative effect on margins of 2.1% In the below table, you can see that milk prices did indeed rise from 2010 to 2011, which could explain the increase in commodity costs in 2011. But here is the tricky part: Class III milk is used for hedging, which means that Starbucks benefits from the increased prices. The commodity costs of 2.3% are most likely calculated as the increase in the price the company pays its suppliers, and ignore the offset of hedging.
Source: Hoards.com, Dairybusiness.com
Prices of milk have decreased in 2012, which in theory should have benefited the reported commodity cost for FY 2012. However, commodity costs still increased in 2012, which most likely is explained by higher coffee costs.
But let's leave the past for now, and try to estimate the impact that prices of milk will have on future profitability. During the most recent earnings conference, CFO Troy Alstead told analysts that dairy costs were expected to increase. So when Starbucks needs to buy milk from its suppliers, it expects it will have to spend more than it did the prior year. But a percentage of that increase could be offset by an increase in MILK Class III. As investors, we do not know exactly how much Starbucks pays its suppliers, but we can get a pretty good understanding of how much Starbucks expects to benefit from the hedging. In the below graph, you can see how the MILK CLASS III future has performed since June. As you can see, it has increased over 10% since Troy Alstead spoke to investors in July, and I doubt that the actual price Starbucks pay to its suppliers has increased a similar rate. Therefore, this could be a situation where an imperfect hedge is beneficial to Starbucks, as the increase in the price of the commodity increases profit for Starbucks.
However, don't expect management to mention the effect MILK CLASS III will have on profit, as most companies prefer to attribute increased profit to improved performance of their main business rather than an imperfect hedge.
The effect of coffee prices
Unlike milk, coffee beans are purchased using fixed-price contracts. This means there is a delay before an increase in coffee prices impacts the bottom line. This effect can be seen in the latest quarterly report, where Starbucks attributes increased commodity costs to higher coffee prices, which increased during 2011 but declined in 2012.
When Starbucks renews the contracts, it will pay less for coffee than what it did in 2012, as the company will pay the current spot price. This means that prices of coffee beans will impact margins positively in 2013.
Think about the commodity costs and margins this way: despite increasing commodity costs in 2011 and 2012, Starbucks was capable of improving its margins. In 2013, commodity costs will most likely decline, so Starbucks doesn't even need improved operational performance to improve profitability.
Therefore, I think Starbucks has a lot of potential in the short run (especially if the imperfect hedge will benefit the bottom line), but I am also decently optimistic on the long-run prospects of Starbucks. I plan to follow this article up with other in-depth articles about Starbucks, which will elaborate on my long thesis.
Disclosure: I am long SBUX.