Will Rising Coffee Prices Bite Into Coffee Brewers' Profits?

Will rising coffee prices have a big impact on the profitability of coffee brewers such as Starbucks and Dunkin' Brands? Whether you're a panicked shareholder or simply an aficionado of these brewers' delectable java, it's important to get your head around this critical issue. Either way your wallet may thank you for it.

Feb 23, 2014 at 11:25AM

There has been a lot of talk lately concerning the soaring prices of Arabica coffee and the weak Brazilian coffee in 2013, and how these will impact coffee brewers' such as Starbucks' (NASDAQ:SBUX) and Dunkin' Brands Group's (NASDAQ:DNKN) profits. These two companies buy, roast, and brew huge mountains of coffee each year, and sharp spikes in coffee prices can negatively impact their bottom lines. Starbucks alone purchases about 500 million pounds of coffee each year, representing about 3% of world supply.

Starbuck sports a significantly lower operating margin than peers Dunkin' Brands Group, Krispy Kreme DoughnutsMcDonald's (NYSE:MCD), and Tim Horton's (NYSE:THI), implying that it's more vulnerable to sharp increases in operating expenses.

Getting a better perspective
First off, coffee accounts for a relatively small percentage of Starbucks' operating expenses -- somewhere in the 8%-10% range. It would therefore take a really sharp rise in coffee prices for it to have a tangible impact on Starbucks' bottom line. The company also has a huge inventory of green (unroasted) beans as well as roasted beans. Starbucks currently holds about $493.0 million worth of green coffee, and a further $235.4 million worth of roasted beans. This is enough to last the company many months.

Although it's true Arabica coffee prices have surged of late, the rise is relatively small, and current coffee prices are nowhere near where they stood in 2011.

Even better news is that Starbucks and other large coffee brewers have borrowed a play from airlines and their modus operandi. Large airlines are adept at hedging in times of rapidly rising global fuel prices. This means an airline could be paying for the fuel it's currently consuming at the prices that prevailed two years ago or so.

Likewise, Starbucks protects itself from swings in international coffee prices and irregular supply by negotiating coffee prices with its more than 300,000 growers, thus locking in prices well ahead of time. By the close of 2013, the brewer had fixed-price agreements valued at $588 million and unfixed price commitments worth $294 million. Although buying from more than 300,000 growers certainly presents a huge logistical challenge for Starbucks, it ensures that no single grower can arm-twist the company or get significant price leverage.

Peers in comparison
Dunkin' Brands Group may be smaller than Starbucks, with only half as many stores as its main rival, but it's busy undertaking an aggressive expansion plan in the U.S., its home turf. Dunkin' stores are concentrated within New England and the tri-state area. Starbucks' prefers high-traffic areas. The company has room to expand in the south and the west. Dunkin' Brands is looking to leverage the strong brand power it enjoys in its core New England region.

Dunkin' expects to record another 5% net unit development year in 2014. The company has begun issuing franchise agreements in California, and it chartered 100 restaurants there in the last 12 months.

Tim Horton's and its franchises make up the largest coffeehouse in Canada, with 4,350 restaurants. Although the company lacks the brand recognition of Starbucks or Dunkin' Brands, it has ample room to expand since it's mainly confined to the Western hemisphere.

Tim Horton's grew its top and bottom lines during the last quarter, at 3% and 8%, respectively. Although the company's revenue in its Canadian home market grew a mere 0.5%, growth in the U.S. market came in at a roaring 20%. The company's shares yield 1.9%, with 40% of its free cash flow returned to investors in the form of dividends each year.

McDonald's seems to be living up (down?) to its reputation as a built-out franchise with limited room for growth. Its growth has -- of late -- been lagging that of its peers.

Although its shares are quite cheap compared to those of its peers, its lower-growth prospects make it less attractive as a long-term investment vehicle.

Conclusion
All that talk about how sharply rising coffee prices will negatively impact coffee brewers' bottom-lines is exaggerated. Coffee costs account for a small percentage of the firms' operating expenses. These firms also hedge their coffee prices well in advance to provide them with better expense management and cost predictability. Coffee brewers remain as good of investments as ever before.

Just like Starbucks, the best companies find ways to ultimately defeat any potential headwinds in their path. These are the types of stocks that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it’s that type of stock. You can find out which one it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends McDonald's and Starbucks. The Motley Fool owns shares of McDonald's and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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