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Will Rising Coffee Prices Destroy the Momentum at Starbucks?

Source:  Starbucks

Coffee giant Starbucks' (NASDAQ: SBUX  ) business has been as hot as its macchiatos lately. This was evidenced by strong comparable-store sales growth in its latest financial update, a performance that has defied a slowdown at competitors, like McDonald's (NYSE: MCD  ) . The company has also been getting mileage from its forays into the tea and baked goods areas through its Teavana and La Boulange brands, respectively.

However, with coffee prices on the rise, partially due to a fungus that is ravaging arabica coffee crops in Latin America, there may be storm clouds on the horizon for the king of the coffee house. So, is Starbucks a good bet at recent prices?

What's the value?
Starbucks has built the preeminent franchise in the premium coffee segment, thanks to a fiercely loyal customer base that seems more than willing to pay up for their favorite cup of java, evidenced by the approximately 7 million members of its loyalty-card program. The company's highly profitable business model has allowed it to grow at a fast clip, currently operating more than 20,000 stores around the world. 

Starbucks' strong cash flow has also provided the capital to buy market share in product areas where it is weak. Hence, the rationale behind its purchase of bakery La Boulange, a move that is allowing Starbucks to significantly upgrade its food offerings.

In FY 2014, Starbucks has continued to operate like a well-oiled machine, highlighted by a 10.5% top-line gain that was a function of both solid comparable- store sales growth and a continued expansion of its footprint, concentrated in the Americas and Asia-Pacific regions. More importantly, the company was able to generate an uptick in operating profitability during the period due to greater productivity in its domestic store operation as well as from greater sales in its high-margin wholesale channel. The net result for Starbucks has been an ability to consistently grow despite the general economy's ups and downs, with management expecting to add another 1,500 stores to its overall network in the current fiscal year.

Going after the Golden Arches
Of course, Mr. Market is expecting some heady future growth from Starbucks, evidenced by an above-market P/E multiple, and is likely hoping that the company can drive future growth by capturing more of its customers' breakfast spending.  Indeed, Starbucks has telegraphed that it wants to be a major player in the breakfast daypart, recently launching four new breakfast options, including Ham & Cheddar and Vegetable & Fontiago sandwiches.

Unfortunately, that strategic mind-set has Starbucks going up against a hyper competitive group of entrenched players, including McDonald's, which generates an estimated 30% of its total sales from the breakfast daypart. While McDonald's has posted pretty weak financial metrics lately, highlighted by flat comparable-store sales growth in its latest fiscal year, the company is also a highly profitable operation that has an unrivaled supply chain as well as a global store base that is almost twice as large as Starbucks' base of stores.

Also potentially thwarting Starbucks' ambitions in the breakfast daypart is the rise of new competitors to the space, including Yum! Brands' (NYSE: YUM  ) Taco Bell unit, which recently made a well-publicized move into the area with coffee and a number of food offerings, not to mention an advertising campaign that was directly targeted at the Golden Arches. 

Like McDonald's, Yum! Brands has had difficulty finding top-line growth lately, highlighted by a flat comparable-store sales performance in its U.S. geography during its latest fiscal year. However, the company is another highly profitable competitor that has the financial fortitude to compete in the breakfast space over the long run, making life difficult for Starbucks.

The bottom line
With almost three-fourths of its total sales coming from coffee beverages, Starbucks' profit statement is heavily tied to raw coffee prices, a situation that management is trying to alleviate through investments in the baked goods and prepared-food categories. That being said, the company anecdotally seems to have a strong ability to pass along raw coffee price increases to its customer base, and its momentum seems likely to remain on an upward trajectory for some time to come.

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  • Report this Comment On May 26, 2014, at 1:03 PM, DoctorLewis4 wrote:

    March 19, 20014. From CNBC: "I think the market, unfortunately, has completely overreacted and misread the coffee situation," Schultz said, noting the coffee company has already purchased nearly 18 months' worth of coffee. He added that coffee accounts for less than 20 percent of its cost of goods, and over the last 40 years, his company has encountered higher prices many times before.

    "The truth of the matter is that dairy is probably a bigger issue for us going forward than coffee, but we will be able to maintain our guidance, our EPS and absolutely manage through and negotiate through any rise in coffee costs," Schultz said. "So I think the market should realize that is a nonevent."

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