Will a Limited Coffee Supply Lead to Higher Prices at Starbucks?

Coffee futures have risen dramatically since the start of the year, and companies like Starbucks and Dunkin’ Donuts could pass along higher coffee prices to their customers.

May 7, 2014 at 5:01PM

It's been a rough first quarter for coffee growers amid uncertainty that this year's coffee harvest could produce a lower yield. As the price of coffee beans has skyrocketed, Starbucks (NASDAQ:SBUX) has held off on new coffee purchases over the past few weeks. The rising price of arabica-coffee futures has made investing in these contracts, used to manage and stabilize the market price of coffee, an expensive proposition. Arabica-coffee futures hover around $2.15 a pound after prices rose almost 90% this year, the highest level in the past two years.

Crop loss out of Brazil is at the root of the increase in price. Brazil, the largest producer and source of one-third of the world's annual coffee output, has been battling a severe drought that could impact this year's crop. The current harvest is in its early stages, so it's too soon to tell what the crop loss will be. Early estimates by Brazil's National Coffee Council predict the harvest will be 10% smaller than last year's.

Craig Russell, the head of coffee at Starbucks, told The Wall Street Journal that the company has been able to lock all of its coffee prices for this year and 40% of the following fiscal year. Starbucks typically buys coffee futures two years in advance and sets the price at a later point in time. Starbucks is not anticipating higher prices at its 20,000-plus cafes or for its bagged coffee products. The company also has the option of buying from Colombia, the second highest producer of arabica beans.

Starbucks' outlook for 2014 and diversification strategy
The company raised its earnings-per-share outlook for 2014, predicting a range of between $2.62 and $2.68. Revenue growth is expected to be 10% or higher. This is the second time Starbucks boosted its earnings outlook since its January earnings report on fiscal 2013, where it estimated EPS of $2.59 to $2.67 a share and revenue growth of at least 10%.

The latest results show that Starbucks' strategy of diversification into products outside of its coffee line is aimed at maintaining brisk growth. Last year, the company was busy acquiring tea retailer Teavana and San Francisco bakery La Boulange; it also joined forces with Danone to sell Greek yogurt parfaits and other food items. There are also plans to offer Fizzio carbonated drinks in 40% of its U.S. stores this year. Other growth opportunities and sources of revenue the company is considering include the licensing of the technology of its mobile- payment systems and opening more cafes in Latin America and China.

Dunkin' expanding into the Western region of the U.S.
McDonald's (NYSE:MCD) and Dunkin Brands' (NASDAQ:DNKN) Dunkin' Donuts compete with Starbucks for the breakfast crowd, so higher coffee prices will have an impact on these food retailers as well. Starbucks' switch to offer non-coffee-related offerings makes it better able to compete with rival Dunkin' Donuts. Dunkin' already offered a wider variety of food items before it switched its focus to coffee and coffee drinks, considered a higher-margin product for the brand. Dunkin's coffee has developed a loyal following, and many consider it a more reasonably priced product when compared to Starbucks coffee.

With nearly 11,000 Dunkin' Donuts locations and most of these located in the Eastern part of the country, the company is looking at the Western region of the U.S. for expansion. Dunkin' has plans in place to open its first restaurant in California by year-end 2014. One of the company's long-term goals is to open 15,000 Dunkin' Donuts locations in the U.S. The company is hoping to use technology improvements to also drive sales, which includes the launch of a national rewards program and online ordering of cakes for its Baskin-Robbins ice cream chain.

McDonald's waging war on breakfast?
While Starbucks and Dunkin' Donuts naturally cater to the breakfast crowd, McDonald's is focused on expanding its food selections in this area. Its McCafe product line, which includes regular coffee, iced coffee, and other breakfast food items, debuted in 2009. In fact, breakfast accounts for 20% of McDonald's U.S. sales and is a clear area of growth for the company.

In March, McDonald's offered free coffee for a limited time to bring in customers and encourage the purchase of other breakfast items. In the company's 2013 annual report, it stresses the importance of growing the McCafe brand not just in the U.S. but in Europe and Asia. Whether its food selections can attract customers away from the competition remains to be seen .

My Foolish conclusion
If these companies need to replenish their coffee supplies in the short term, it's possible customers may see higher coffee prices in their restaurants, which could hurt sales -- especially as they promote coffee drinks, like iced coffee, that already carry a higher price and have been selling well.

And bad weather isn't just affecting the current coffee harvest; in the first quarter of 2014, consumer spending and economic growth slowed when compared to the fourth quarter of 2013 due to severe winter conditions. While the May 2 jobs report showed improving conditions on the unemployment front, wage growth is still under the 3% average annual growth reported before the recession. Still, improving job conditions are a good sign that consumers may be ready for higher prices of consumer staples like coffee. 

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Eileen Rojas 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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