Starbucks: Coffee Prices Don't Matter That Much

| About: Starbucks Corporation (SBUX)

Summary

Starbucks consumer buying habits stay about the same when prices go up.

Analysts only attribute 20% of Starbucks’ overall costs to coffee inputs.

Starbucks management has positioned the company to hedge against short-term price spikes.

Starbucks management has positioned the company to pass through long-term price increases.

When is the last time Starbucks (NASDAQ:SBUX) lowered beverage prices at its retail stores?

Never.

Starbucks might have the most inelastic demand curve in the quick service restaurant industry. In other words, Starbucks consumers' buying habits stay about the same when prices go up.

Earlier this month, I released a series of articles outlining my long thesis for Starbucks. I realize now that my articles were quite biased to the long side. I did a poor job writing about the potential threats that the company may face. As I published my series, fellow Seeking Alpha author Macro Investing published an article titled "Coffee Price Could Double In The Next 12 Months." In short, the article argued for a rapid increase in the price of the iPath Dow Jones-US Coffee ETN (NYSEARCA:JO). It also argued that rising coffee prices may have negative consequences on margins for companies like Starbucks. The iPath Dow Jones-US Coffee ETN tracks the price of Bloomberg Coffee Subindex Total Return, which tracks the price of coffee commodity prices. Since the start of the year, the index is up by about 3.33%:

Source: Bloomberg.com

However, over the last 5 years, the index is down by a whopping 67%:

Source: Bloomberg.com

In Macro Investing's article, a strong bull case is laid out. Rising coffee demand alongside a coffee supply shortage should lead to higher coffee prices. I completely agree that coffee prices will rise alongside global demand. And, I believe it is possible that coffee prices could rebound and even double this year.

But what would rising coffee prices actually mean for Starbucks? What would happen if coffee input prices rose by 100%?

Not much.

First off, analysts only attribute 20% of Starbucks' overall costs to coffee inputs. As of the most recent quarter, Starbucks had 60% gross margins including occupancy costs. So, if coffee prices doubled, gross margins including occupancy costs would decline to about 52%.

But the impact wouldn't be immediate. As of the most recent 10-K, the company reported:

Total green coffee purchase commitments as of September 27, 2015 were $1.1 billion, comprised of $819 million under fixed-price contracts and an estimated $266 million under price-to-be-fixed contracts. As of September 27, 2015, approximately $38 million of our price-to-be-fixed contracts were effectively fixed through the use of futures contracts. All price-to-be-fixed contracts as of September 27, 2015 were at the Company's option to fix the base "C" coffee commodity price component. Total purchase commitments, together with existing inventory, are expected to provide an adequate supply of green coffee through fiscal 2016.

A sharp and temporary increase in the price of coffee would have little immediate impact on the bottom line. However, a sharp, long-term increase in the price of coffee would have an impact on the bottom line.

That said, a long-term increase in the price of coffee inputs could be easily passed onto consumers. Almost every single year, Starbucks raises the price of its already very expensive coffee beverages. And if you are anything like me, you pay the increases with little debate. Over the last 5 years, the price of coffee inputs has plummeted yet the price of the company's beverages has increased dramatically.

Starbucks has built an incredibly loyal customer base. Starbucks has also pioneered the membership rewards concept in the quick service restaurant industry. As of the most recent quarter, the company added an additional 1 million new members. Starbucks has over 12 million active My Starbucks Rewards members in the U.S.

Starbucks customers have in the past, and will in the future, absorb any pass through pricing. Customer loyalty created the company's inelastic demand curve.

Rising coffee prices are a threat, but they do not dent the long-term thesis. Starbucks management has positioned the company to hedge against short-term price spikes. And, Starbucks management has positioned the company to pass through long-term price increases.

Disclosure: I am/we are long SBUX.

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.

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