Arabica coffee prices have skyrocketed once again after an 18-month hiatus. Prices have shot up since last November from $1.06 per pound to around $2.15 per pound currently. This unfortunate trend has been brought about by a prolonged drought that has hit Brazil, the world's largest supplier of Arabica coffee, as the nation accounts for more than one third of global supply. Expectations call for Brazil to produce just 49 million bags of Arabica coffee in the 2014-2015 season, versus 53.3 million bags last year. This will lead to a shortfall of 7.1 million bags below global demand, the largest deficit since the 2009-2010 season.
On the surface, it appears as if coffee brewers such as Starbucks (NASDAQ:SBUX) and Keurig Green Mountain (UNKNOWN:GMCR.DL) will be left with little choice than to hike the prices of their lattes and cappuccinos because of this. However, the situation is a bit more complex than that.
The effects of high Arabica prices
The price of coffee, like any other market commodity, changes with the fluctuating forces of demand and supply. The last time Arabica coffee prices rose sharply was back in May 2011, when they hit an all-time high of $3.089 per pound.
As a result of the meteoric rise, Starbucks incurred about $200 million in additional costs that year, and a similar amount in 2012. Starbucks was quite lucky in that it was able to offset these costs by trimming its costs elsewhere. Keurig Green Mountain was, however, not as fortunate, and the rising prices bit off about 150 basis points from its gross margin even after the company hiked the price of its coffee.
The reason why Starbucks tends to weather rising coffee prices better than many of its competitors, including Keurig Green Mountain, is because the giant coffee brewer tends to hedge coffee prices over longer durations of time than its peers do. Starbucks chief executive Howard Schultz told Fox Business recently revealed that the company has locked-in coffee prices for about a year through its physical inventory, as well as coffee bean contracts. By the close of 2013, Starbucks had fixed-price coffee agreements valued at $588 million, and variable-price commitments worth $294 million.
The story is quite different at Keurig Green Mountain. The company had locked-in $269 million in coffee purchase commitments by the end of December 2013. That translates to only about three months of coffee supply for the company.
Different dynamics at GMC
Keurig Green Mountain is more sensitive to huge changes in coffee prices than coffee brewers such as Starbucks and Dunkin' Brands are because coffee constitutes a lower proportion of overall costs for coffee houses or restaurant chains, primarily because the latter sell their coffee at higher prices. The price of a K-Cup is considerably lower than the price of a coffee cup at a cafe.
For instance, coffee costs account for 8%-10% of overall costs at Starbucks. The Wall Street Journal estimates that brewing a Starbucks grande latte in the U.S. costs around $0.64, including the cost of the espresso, milk, sweeteners, cup, sleeve, and lid. A grand latte sells for around $4.30 in New York, and much more in places like Stockholm and Oslo where it goes for $7.40 and $9.83, respectively. Thus, commodity costs for Starbucks average about 15% of the company's coffee revenue, when you calculate them using the New York figure.
In contrast, commodity costs for Keurig Green Mountain were about 62% of its overall revenues in fiscal 2013, more than four times the percentage at Starbucks. GMC's gross margin shot up 400 basis points last year as a result of lower coffee costs. However, if coffee prices keep rising, as many fear, then the company is very likely to see significant margin erosion in the current fiscal year.
Rising commodity prices might force Starbucks to hike prices, too
Starbucks is usually among the last companies to hike its coffee prices whenever the price of the commodity goes through the roof.
The current situation is, however, quite dire. Not only are coffee prices rising, so are milk and sugar prices. Although the United States Department of Agriculture has not yet made its March data available, February dairy prices rose 5.1% month-over-month and 27% year-over-year as a result of rising imports. Milk accounts for almost half of the cost of brewing a grande latte, more than twice the cost of coffee. Meanwhile, sugar prices are up about 13% since the end of January.
While these increases are nothing like the huge spike in coffee prices, the combined effects might push Starbucks to the brink of its ability to absorb the rising costs before it has to pass on some of the costs to its customers.
Foolish bottom line
Starbucks' channel development segment sells packaged coffees and teas as well as K-Cups and brewers. The segment is growing at a brisk pace and currently accounts for about 10% of the company's overall sales. Although Starbucks might be forced to hike its coffee prices late this year or early next year if coffee prices don't let up, the effect on its share price might not be as marked as it might be on Keurig Green Mountain's shares.
In the meantime, investors can take some comfort in the fact that coffee prices are nowhere near the level they reached in 2011, nor are they likely to go that high.