An increasing number of large companies are jumping on the specialty coffee bandwagon, adding to Starbucks' (NASDAQ:SBUX) already numerous competitors. Dunkin' Brands Group (NASDAQ:DNKN), Green Mountain Coffee Roasters (NASDAQ:GMCR), and others compete with Starbucks for customers and coffee beans. But the competition may not be as fierce as it seems.
Not all coffee beans are the same
Before the advent of specialty coffee chains, most people simply chose between regular or decaf. Starbucks changed coffee drinkers' expectations so that ordering a grande half-caf soy latte at 120 degrees is just another order. Green Mountain offers a variety of options as well through its single-serve portion packs. Dunkin' Donuts offers the fewest options of the three. The one thing all of the companies have in common is that they use high-quality arabica beans.
Arabica beans are typically grown at high altitudes and vary in taste depending on the geography in which they are grown; beans from Latin America differ in taste from beans grown in Africa which differ from beans grown in Indonesia. Most of Starbucks' signature blends are made with beans from farms in Indonesia and the Pacific Islands, where the beans typically have stronger, more earthy flavors. Dunkin' Donuts sources its coffee from Latin America, where the beans are sweeter, and Green Mountain sources from all three regions in roughly equal proportion.
Premium price for premium coffee
The strong and bitter beans that Starbucks uses are considered to be of higher quality than the milder beans used by Dunkin' Donuts. However, both companies charge high prices for their beverages. Industry experts say that an 80% mark-up for high-end brews is commonplace. For instance, a $7 cup of Starbucks ultra-premium coffee is rumored to cost the company only $1.30 to produce. The margin on lower-priced coffee may be even higher -- experts believe a $2 cup of coffee from Dunkin' Donuts may cost the company only $0.10 to produce.
With gross margins over 50% , it is clear that coffee is an extremely profitable product. Just last summer, Dunkin' Donuts chief financial officer said, "[W]e are a beverage company." For a company with 'Donuts' in its name, this is a particularly telling statement about the profits to be made in the coffee market.
Starbucks, Dunkin' Donuts, and Green Mountain may compete in the same industry, but each targets a different segment of the coffee-drinking population. Starbucks' customer base is the most affluent of the three. The company roasts its high-quality Indonesian arabica beans into premium blends and offers a wide variety of modifications to its main menu; Starbucks boasts more than 87,000 drink combinations. It also offers an inviting atmosphere that encourages customers to linger; it offers a gourmet coffeehouse experience and therefore charges premium prices for its food and beverages.
Dunkin' Donuts, on the other hand, is more like the McDonald's of coffee. Its primary objective is to get customers in and out as quickly as possible. The coffee is milder than Starbucks' intense premium brews, and the atmosphere is an afterthought, but Dunkin' Donuts is positioned as the best option for undiscriminating coffee drinkers and hurried professionals who do not have time to wait for a gourmet brew to be made.
An analysis by social behavioral data firm TrueLens reveals that Starbucks' premium coffee has a more loyal following than Dunkin' Donuts' lower-priced coffee. It discovered that regular Starbucks drinkers mention Starbucks 88% of the time they talk about coffee, whereas Dunkin' Donuts drinkers mention Dunkin' only 14% of the time and mention Starbucks 59% of the time. This suggests that Dunkin' Donuts drinkers also frequent Starbucks -- perhaps only going to Dunkin' Donuts when in a hurry. In addition, market research conducted by Experian suggests that Starbucks' customers visit the coffee shop more frequently than Dunkin' Donuts' customers visit Dunkin' stores; at least one in five customers visit Starbucks more than six times per month, while fewer than one in six visit Dunkin' Donuts as frequently.
Meanwhile, Green Mountain avoids the brick-and-mortar battle and targets people who want fast-brewed gourmet coffee in their homes. The profit margin on single-serve portion packs is decidedly lower than coffee sold through retail chains. Green Mountain's fiscal 2013 gross margin was 37% compared to Starbucks' 57% gross margin.
Ease of entry is much higher in packaged and single-serve coffee than in the brick-and-mortar coffee-shop business, where a company must design and build hundreds of stores just to reach scale. Therefore, Green Mountain faces much more competition than Starbucks and Dunkin' Donuts, hence the lower margin.
Green Mountain's coffee does not differentiate it from Starbucks, but its Keurig brewers do. Green Mountain's at-home brewing systems hold the number one share of the U.S. market, with its leading Keurig Hot brewer penetrating 13% of U.S. households. Its top four brewers outsell Starbucks' Verismo, which has struggled to gain wide adoption due to a high price point and limited pod selection. However, Starbucks' more affluent customers may favor the Verismo, which gives it an important niche even if it cannot overtake Keurig.
Starbucks, Dunkin' Donuts, and Green Mountain all use arabica beans to make their coffee, but they serve different customer bases. Starbucks sources beans with more potent flavors and serves them in an inviting atmosphere, attracting affluent customers who want lots of options. Dunkin' Brands moves customers through the line much faster than Starbucks, so it attracts customers who want value-priced coffee served quickly. Green Mountain is the biggest player in a much more difficult part of the coffee industry, but has a market-leading position in the at-home brewing category. Each serves its target customers better than any other company, allowing each to earn high profits for the foreseeable future.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters and 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.