Coffee & newspapers go hand in hand, and lately there’s been a bunch of coffee in the news. Coffee prices are rising. There are Coffee Wars between Starbucks and McDonald's, with McDonald's expanding into Starbucks’ arena of coffee bars and baristas, and Starbucks possibly retaliating by market testing smaller, refillable coffees for a buck. And of course, there is the perennial Starbucks conundrum: “How many coffee shops are too many?”

Coffee Shops

Starbucks is scheduled to report its first quarter earnings Wednesday, and with its stock price down 22 percent on the quarter and 42 percent in the last year, investors are looking to see what kind of turnaround plan management has in mind.

Starbucks took a simple commodity, coffee, and turned it into an experience. The genius of Starbucks was convincing the masses (myself included) that coffee beans, water and possibly a little steamed milk was worth four bucks, when they could make a similar drink in their own homes for pennies. The secret was the environment.

Come, hang out, drink the coffee, read the paper, poach a little WiFi. They sold the experience. But despite appearances on street corners in suburban America, that experience is less of the draw nowadays. Traffic in the stores has decreased for the first time in years. Competition means that there is a coffee place on every corner in the city – and sometimes more than just one. Higher commodity prices have caused higher drink prices. This pressures margins and curbs demand.

Coffee

Coffee is a “soft” commodity. Like other agricultural commodities, there is a cyclical aspect to its pricing. But it is also subject to supply and demand pressures, just like all other commodities. Starbucks is just as much a victim of changes in supply as an oil refinery is to the price of oil. We tend not to think of Starbucks that way, because they fit into the consumer discretionary sector of the S&P 500, but make no mistake, they’re in the commodities business in a big way.

Here are some random cocktail-party data:

• Coffee is the second-most-traded commodity in the world after oil.
• 400 billion cups of coffee are drunk each year.
• One coffee tree produces about 1 kilo (2.2 pounds) of beans each year and has a lifetime of 10 to 20 years.
• An acre of trees produces 900 kilos, or almost a short ton of beans.
• Black coffee has zero calories.
• In 1685, Lloyds of London began life as a café.

The Coffee Belt extends around the globe running roughly from the Tropic of Cancer to the Tropic of Capricorn: anywhere there is rich soil, moderate sunshine and rain, and temperatures around 70 degrees.

Commercial coffees come in two main types - Robusta & Arabica. Robustas are hardy, a bit harsh and used mainly for instant coffees. Arabicas are milder and used for “tastier” coffees. The majority of beans are harvested by hand, due to the steep hilly terrain the trees thrive in and also because it is normal to have berries in various stages of development all on one tree (flower, green berry and ripe red berry).

In southern Brazil, however, the terrain is gentler and automation has come to coffee bean harvesting.

Brazil is the largest producer of coffee, responsible for about a third, or 33.7 million bags, of the 2007 crop year harvest. Vietnam’s rapid production growth over the last 20 years has moved it into the No. 2 spot with 15.9 million bags, and Colombia rounds out the top three with 12.4 million bags. Because Brazil is the gorilla in the market, what happens there influences the rest of the market. Brazil’s crop year extends from April to March, and its coffee production experiences a predictable cycle of on and off years. 2006 was an “on” year with 42.5 billion bags of coffee produced. 2007 was an “off” year with only 33.7 billion bags produced.

In the past two weeks, coffee prices have risen as the dollar has weakened, and things don’t look to get better. Coffee consumption in China was estimated at around 45,000 tons of coffee in 2006 and growing at a rate of 10% to 15% per year. Ahh, China, the driver of demand, be it in coffee or copper. No wonder companies such as Dunkin Donuts and Starbucks have plans to expand into China with growth rates like that. All in all, it means that coffee supply is expected to just keep up with demand for the next few years.

Of course, history shows us how this game plays out, in any agricultural commodity: Prices dropped in the late 1990s through late 2001 due to large crops overwhelming demand. The low prices discouraged farmers from planting new crops and even maintaining existing crops. When a period of drought at the end of 2004 hit Brazil and continued in Vietnam at the same time, and an increase in demand was seen, prices started to rise again.

So Where Does This Leave SBUX?

It’s important to note where Starbucks does and doesn’t fit in to this global equation. Let’s look at the chart:



Hard to make sense of, no? Statistically, SBUX stock price is inversely correlated with the price of coffee, at about -.12 (monthly closes, since SBUX went public). In a vacuum, this makes sense and ties to the premise that higher coffee prices would translate into lower margins and lower demand. But implying causality here would be difficult. Starbucks buys most of its coffee on contract, not in the open market, and while I can’t say for sure, I’m guessing they take precious little physical delivery on ICE “C” contracts.

But here’s the bottom line: Starbucks, while in the coffee business, is really in the restaurant business, and the restaurant business is and always has been about real estate. Starbucks’ golden years – as a stock – were based far less on the margins of the incremental cup of coffee and far more on their smarts in expanding their franchise and top of mind. Investors who are fixated on the cost of coffee should be much more concerned with management (all hail the new CEO) and how they migrate their real estate strategy in the face of an uncertain economy, increased competition, and international demand.

P.S.: About That Latte …

At first glance, you wouldn’t think that higher ethanol use would contribute to a higher price on your cup of coffee in the morning, but coffee is just one of the commodities coffee companies like Starbucks have to worry about. It’s the familiar story: The push for ethanol and resulting higher corn prices mean higher prices in the feed lot. Dairy cows eat a lot of corn. In order to keep feeding their cows and selling milk, farmers have had to pass on those higher prices to milk purchasers – and not just the folks at home, but restaurants and coffee shops are feeling the pain. Hence the price of lattes increases.

Coffee Rallies on Drop in Dollar, Speculation Demand Will Gain Bloomberg, Jan 28, 2008
How Ethanol Hurts Starbucks Forbes.com May 18, 2007 4:10ET
The Coffee Wars WSJ Jan 7, 2008 3:02pm
Coffee shops ponder the saturation point Business Week Jan 28, 2008
Coffee Fundamentals offer Steady Market for Option Sellers weary of Equities Yahoo Finance, Optionetics.com Commodity Roundup: Coffee Jan 24, 2008 2:00pm ET
USDA December Tropical report
International Coffee Organization
http://www.ico.org/documents/cmr0807e.pdf report from August 2007 world consumption numbers
Coffee National Geographic