How Will Rising Prises Affect Coffee Companies?

All coffee lovers out there must know that arabica coffee reached a two-year high last week, as investors expect lower supply for the next season. It would be the first global coffee deficit in five years.

Brazil, the world's largest producer, had the driest summer since 1972. As a consequence, its coffee harvest is estimated to drop 10% to 47.7 million bags compared to the last estimation. For next year, the outlook is even worse, as the country's output may fall as low as 40 million bags.

This is not good news, as for this upcoming season global demand may outpace production by 6.5 million bags compared with a surplus of 4.3 million bags a year earlier. As you know, a supply deficit equals higher prices, and this is exactly what we have started to see.

In fact, futures for arabica beans have surged 83% this year, the most among the 24 raw materials covered by the iShares S&P GSCI Commodity-Indexed (NYSEMKT: GSG  )  ETF. This price explosion comes after a bad 2013 performance when coffee prices in New York dropped 23% -- the third straight decline and the longest slump since 1993.

How will this affect companies?
If you review the numbers of the No.1 premium packaged-coffee brand in America, Starbucks (NASDAQ: SBUX  ) , you'll notice that coffee beans make up a smaller share of the price in coffee shops. In fact, for this company it represents just 8% to 10% of cafe operating expenses. So, it is likely that Starbucks will absorb this price hike. However, as far as cans and bags of coffee go, chances are that retail prices will increase.

Nonetheless, at year-end 2013, Starbucks had $611 million worth of coffee in its warehouses and fixed-price deals for a further $519 million in beans. So, it will take some time for the company to face higher prices.

New venture
Brian Kelley, CEO of Green Mountain Coffee Roasters (NASDAQ: GMCR  ) , stated that K-Cups should not get more expensive as coffee commodity prices skyrocket. Why? Mainly because the company's trademark coffee pods have a price premium built in that should protect them from swings in coffee futures.

Green Mountain managed to grow the coffee category at an accelerated rate and brought a premium to the coffee and tea category. This strategy has been so successful that now the company aims to do the same in the cold-beverage category.

That's why the company signed a $1.2 billion, 10-year deal with Coca-Cola to collaborate on a new, upcoming Keurig Cold system that will be on store shelves in fiscal 2015. The new product will allow consumers to make cold beverages at home the same way current Keurig users make coffee and tea with prepackaged pods. The new product will leverage on 18 million homes that own a K-Cup coffee maker, a good base to build upon.

The case for J.M. Smucker (NYSE: SJM  ) is similar but with two major differences. The company's coffee-product prices are moderate, and increasing competition from Starbucks could limit Smucker's ability to charge a premium in high-end categories. Hence, margins could be damaged. Nonetheless, its coffee business typically posts an operating margin in the mid-to-upper 20's, above average in the packaged-food industry.

Smucker holds more than 30% market share for coffee in the U.S. And since coffee brand loyalty is more pervasive, the company should be able to maintain its competitive position. Losing margin and/or share in coffee would be no joke for Smucker, as it accounts for about 50% of the company's revenue.

Final thoughts
These types of supply issues are not easy to reverse, as new crops require a whole season to develop. The fact that Brazil accounts for 37% of global coffee output (including 46% of arabica) makes matters a bit more complicated.

However, the rise in prices should not affect the retail price of most coffee products, as big companies normally hedge their coffee purchases to reduce their exposure to market swings. So, even if they have to deal with higher costs, they might absorb most of them and not transfer those costs to retail prices. Prices for coffee products have good margins already. These could be eroded, affecting profitability in the mid-term.

For Green Mountain Coffee Roasters, the fact that the company is looking to expand its business into the cold-beverage category is encouraging, especially having a leading partner the size of Coca-Cola.

Starbucks has a pricing policy that is not highly correlated to coffee-bean prices. In fact, it increased the prices of many of its drinks mid-year last year, when bean prices were decreasing. Unfortunately, this company does not comment on future pricing plans or strategy, so you'll have to wait and see.

J.M. Smucker should maintain its position despite this coffee price disruption and the increasing competition in the premium and single-serve segments. After all, consumers do not change their coffee brand preferences often. And the company owns Folgers, the leading coffee brand in the U.S.

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