Here's the Reason Starbucks Is Raising Prices (and Why It's the Right Move)

Starbucks is increasing prices simply because it can. Customers know Starbucks is high-priced, which is how it's successfully passed on price increases before.

Jun 24, 2014 at 9:00AM

Specialty coffee retailer Starbucks (NASDAQ:SBUX) is about to raise prices in response to soaring agricultural commodity prices over the past several months. In fact, the price of arabica beans is up more than 50% year to date. Because of this, Starbucks made the decision to pass on the rising input costs to its customers. While management may have had some reservation in doing so, it's the right move.

Starbucks is a premium brand that has always been known for its above-average prices. And it raised prices just a year ago, so another modest increase shouldn't really be a surprise to anyone. Plus, Starbucks will be able to protect its high margins. It's not the only one reacting to high commodity prices. Lower-end coffee retailers, such as Dunkin' Brands (NASDAQ:DNKN), are following suit.

Starbucks is still registering impressive growth, even after raising prices last year. And rather than erode margins and compress profitability by absorbing increasing costs, it's making the right decision by passing on price increases to its customers.

Why is Starbucks raising prices? Because it can
Starting Tuesday, June 24, Starbucks plans to raise prices on some of its in-store beverages by $0.05-$0.20, according to The Wall Street Journal. The retail price of packaged Starbucks coffee bags sold in grocery stores will go up by about $1. The increase won't affect K-Cup single-serve packs, Seattle's Best coffee, or packaged coffee sold in Starbucks stores.

This move shouldn't result in sticker-shock. Starbucks is universally known as a premium brand. High prices have never dissuaded customers before. In fact, establishing itself as a high-end name allows Starbucks to maintain high prices and fat margins.

You may recall that Starbucks last summer raised prices in its cafes by a similar percentage. Starbucks upped its prices by about 1% last June, and that certainly didn't have a negative effect on the company's financial performance. There's enough precedent for management to know that customers won't be too upset.

High prices didn't stop the company from racking up 12% sales growth last year. Comparable sales, which measure sales at locations open at least one year, rose 7%, thanks to a 5% increase in traffic.

This year, Starbucks is doing equally well. Global comparable sales grew 6% last quarter. Its operating margin expanded by 130 basis points and reached a company record.

The simple reason why Starbucks is ratcheting up its prices is because it knows it can. It's obviously confident enough that its customers will still flock to its stores. Starbucks enthusiasts can afford its already lofty prices, so it stands to reason they can afford to fork over a few more dimes per cup. To illustrate, Starbucks states its average ticket will rise by less than 1% as a result of the price increase.

In fact, it's the lower-end retailers that may have more trouble passing on price increases. This is why Dunkin' Brands would only go as far as to say it would "modestly" increase its prices in response to soaring commodity prices. One of the major reasons customers go to Dunkin' in the first place is its lower prices. Dunkin' runs a much higher risk of upsetting its customer base than Starbucks does its customers, who presumably don't pay too much attention to prices.

A few final Foolish thoughts
Starbucks is about to raise prices slightly on many of its packaged and in-store products. It shouldn't come as a surprise, though, given that there are many good reasons for this decision. It makes financial sense since agricultural prices have skyrocketed in just the past few months. This has significantly increased input costs, which Starbucks should pass on to customers to protect its margins.

From a strategic perspective, it's unlikely anyone will even notice the price bump. Starbucks has always been and will always be known as a premium retailer. Its customers are well-accustomed to paying above-average prices. Starbucks did the same thing a year ago, and it's still racking up impressive profit growth, thanks in large part to expanding margins. When you take it all into consideration, it's clear that Starbucks is making the right move by raising prices.

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Bob Ciura has no position in any stocks mentioned. The Motley Fool recommends Starbucks. The Motley Fool owns shares of 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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