Coffee Depression Stokes Starbucks' Expansion

| About: Starbucks Corporation (SBUX)

After months of decline, global coffee prices have risen in July as demand for cheaper coffee, Robusta, touched an 11 month high. Prices of Arabica however, remain low. Exports for the first nine months of the coffee year 2011/12 have gone back up to corresponding 2011 levels with Vietnam witnessing the highest YoY growth of 21.6%. Total exports in June increased by 5.1% sequentially and decreased by 6.1% year-on-year to 9.6 million bags.

Robusta is both cheaper and easier to grow than Arabica. Arabica comprises the Colombian milds, Brazilian naturals and other mild grades. It is lower in caffeine than Robusta and smoother in flavor. Robusta is primarily used in espresso grinds like Café Bustelo and instant coffees from Nestle (OTCPK:NSRGY). Robusta production has been growing at an average of 3.6% over the last ten years whereas Arabica by just 1.2%. Each year, Robusta's exports manage to reach record levels while taking market share away from Arabica. With an almost one-third share in 2002/03, Arabica touched 39% of all coffee produced in 2011/12.

For September, Vietnam, the world's leading Robusta producer, expects the exports to fall from 120,000 tons to 60,000 - 90,000 tons or 1 million - 1.5 million bags. For the next month, which will be the first for FY 2012/13, the country is expecting its production to fall by 20% in Daklak, the primary coffee producing province. Due to an earlier than expected harvest, exports could be available as early as October. Traders have predicted the demand to remain low following the holiday season. However, it will not have any negative impact on the supply due to availability of ample stocks with farmers and exporters.

On the other hand, Colombia, the second largest producer of Arabica after Brazil, expects its production to rise by as much as 8.8% by the end of the year. The increase in shipments was due to dry weather which will help Colombia increase its exports level after the massive drop last year. In 2011, the total production in the country fell to a 35 year low due to unusually large spell of rainfall. Through early September, the year's output rose to 9.5 million bags, thanks to a 21% increase in production in August which translated into an impressive 56% rise in exports to 0.6 million bags. Despite rising production, the country does not expect to touch the 11.5 million ton mark reached in 2008 before the harvest was hit by disease and rain.

The coffee giant Starbucks Corp (NASDAQ:SBUX) uses Arabica beans exclusively, and according to CNNMoney dominates the prepared coffee market with a 33% share. Starbucks' primary competitors McDonald's (NYSE:MCD) and Dunkin Brands (NASDAQ:DNKN) use both Arabica and Robusta to control costs. Coffee prices have been extremely volatile in the past decade with global demand constantly rising, especially as more people around the world are demanding the smoother flavor of Arabica. Between 2001 and 2009 retail prices per pound across the U.S. and Europe rose by an average CAGR of 5.48%. Despite the rising prices in since 2010, it has been able to consistently increase its net income from $315 million in 2008 to more than $1.2 billion last year.

In Starbucks' case, it appears that its operating margins are not affected much by coffee price volatility because of their excellent management of the futures market. In its Q3 report, it reported a lower than anticipated increase in revenues by 13% over last year at $3.3 billion and a profit of $333 million or $0.36 per share against analysts' estimate of $0.45 per share. The main disappointment in the report came from the EMEA (Europe, Middle East, Russia and Africa) segment where its profits fell by 47% from $4.9 million in 2011 to $2.6 million in 2012. For the fourth quarter, Starbucks expects its non-GAAP earnings to increase by 19%-22% YoY while 2013's EPS will increase by 15-20%.

The management has reiterated in a conference call that despite setbacks in EMEA, it is expecting significant turnarounds in that sector in 2013, particularly in Europe as it plans to open around 100 new stores in the continent. The question everyone is asking now is has Europe bottomed? Has all of the bad news been revealed and priced in? Some investors are beginning to make noise about buying up real estate and stocks in places like Spain and Italy. Investing in Europe now is a strong move if one is expecting growth to return to the periphery in the next 18-24 months. Costs of a start-up should be low due to the alchemy of cheap land, labor and the Euro. Overall, it has planned to open 1,200 new stores, half of them in the Americas, while it is aiming for 1,500 total stores in China by 2015 where it currently has 600 stores.

China, which now contributes 13% to profits, up from 9% in 2010, is where revenues increased the most at an impressive 31% rate in Q3 YoY. Furthermore, Starbucks is now entering India this year, a market almost the size of China but where tea is preferred over coffee. India has very low coffee consumption rates; 100g per person in a year compared to 4.5kg in U.S. However, consumption has seen a CAGR of 5.1% since 2008.

The great growth opportunity for increased coffee consumption is in the emerging markets that are also producers. The countries with the highest consumption growth rates are also some of the biggest producers: Vietnam (CAGR 18.2%), Philippines (CAGR 15.6%). The only emerging market that is not a producer with high CAGR is Australia (7.7%). So, this is a great growth opportunity for everyone with a presence there, not just Starbucks but McDonald's as well.



% Yield


















As a pure play against the coffee market Starbucks at this point represents both greater value and greater opportunity than Dunkin Brands. Both are trading like growth stocks but one is generating far better return on assets deployed. Dunkin's balance sheet is made up of mostly Goodwill and Intangibles (74% of total assets) versus 5.4% for Starbucks. McDonald's has been improving its top to bottom presence in China, but are still struggling to establish themselves like YUM Brands (NYSE:YUM) has with KFC. That said the stock is very attractive at these prices in the face of rising food costs, as people continue rotating to QSRs for meals out.

With depressed coffee prices for the time being and demand flat in the established coffee markets Starbucks and Dunkin will only find growth in high growth emerging markets. Their moves into Vietnam, India and China may justify their high valuations, with Starbucks' upscale brand image providing margin cushion in the tier 1 cities where their locations are concentrated.

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