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The Next Cup of Your Favorite Coffee May Cost You More
Posted by: abirk (IP Logged)
Date: April 21, 2014 10:19AM

Coffee prices have seen a parabolic run-up in recent weeks as unprecedented hot and dry weather in Brazil has sucked the life out of what was expected to have been a record crop. The biggest Arabica coffee rally in two decades is beginning to force smaller-brand roasters to quietly raise wholesale prices.

Starbucks (SBUX) and Dunkin' Brands Group (DNKN) buy, roast and brew huge mountains of coffee each year, and sharp spikes in coffee prices can negatively impact their bottom lines. Starbucks alone purchases about 500 million pounds of coffee each year, representing about 3% of world supply.

For now, retail prices for coffee are stable. Roasters typically have enough supplies to cover themselves for a few months. But if the price of the arabica beans continues to rise, consumers could start seeing the cost of their morning coffee creep up later this year.

An Insight Into the Reasons

January was the hottest month on record for parts of Brazil, and the drought was said to be the worst in 50 years. One estimate said 30% of the coffee crop may have been lost. Brazil produces 40% of the world’s coffee grounds. In 2012 (most recent data), the South American country produced a whopping 3,037,534 tonnes of beans – more than double Vietnam, its closest competitor.

In fact, Brazil has been the biggest coffee producer for 50 of the 51 years data have collected by the Food and Agriculture Organization.

While major coffee makers typically use long-term hedging strategies that help protect them from sudden price swings, smaller private-label brands are often more exposed, having locked in prices too late or in insufficient volume. If the market remains at these levels for several months, their only options are to raise prices or tweak their blends with cheaper beans, said one coffee analyst.

But even some larger firms are feeling the pinch. Mondelez International Inc. (MDLZ) maker of Jacobs and Kenco coffees in Europe, said that coffee prices will likely be a headwind in the first half of 2014 compared with 2013.

"Obviously, the recent spike in coffee prices, if sustained, could change our full year outlook," Mondelez Chief Financial Officer Dave Brearton said on Feb. 12, when the futures market was around $1.40 per pound. "If it stays there, we would obviously adjust our prices upwards to reflect that because coffee is a pass-through category."

It has been fueled by a rush of speculative buying after an unexpected drought hit top grower Brazil's main arabica region, damaging beans at a critical stage of their development and threatening to cut output by 11 percent, from estimates in January.

Cut Crops and Increased Costs

But bigger isn't always better. The coffee-producing capital of the world experienced its second-driest January in 80 years, and farmers are worried that yields are going to take a tumble.

Arabica coffee futures rose to a two-year high to $2.08 per pound this Tuesday, as analysts took a second look at estimates. Brazil is the top producer of arabica, and bean costs have soared around 85% so far this year amid fears of a trimmed 2014 to 2015 crop, with ripple effects extending through 2016.

Not only do droughts directly affect coffee yields, but they can also skyrocket electricity costs. Brazil depends on hydropower for 80% of all its generation, and low reservoir levels means less power pumping from hydroelectric dams.

Impact on the Companies

Brian Kelley, CEO of Green Mountain Coffee Roasters (GMCR) stated that K-Cups should not get more expensive as coffee commodity prices skyrocket mainly because the company's trademark coffee pods have a price premium built in that should protect them from swings in coffee futures.

Green Mountain managed to grow the coffee category at an accelerated rate and brought a premium to the coffee and tea category. This strategy has been so successful that now the company aims to do the same in the cold-beverage category.

The case for J.M. Smucker (SJM) is similar but with two major differences. The company's coffee-product prices are moderate, and increasing competition from Starbucks could limit Smucker's ability to charge a premium in high-end categories. Hence, margins could be damaged. Nonetheless, its coffee business typically posts an operating margin in the mid-to-upper 20's, above average in the packaged-food industry.

Smucker holds more than 30% market share for coffee in the U.S. And since coffee brand loyalty is more pervasive, the company should be able to maintain its competitive position. Losing margin and/or share in coffee would be no joke for Smucker, as it accounts for about 50% of the company's revenue.

Starbucks has a pricing policy that is not highly correlated to coffee-bean prices. In fact, it increased the prices of many of its drinks mid-year last year, when bean prices were decreasing. Unfortunately, this company does not comment on future pricing plans or strategy, so you'll have to wait and see.

To End

Big coffee companies — Starbucks, Green Mountain Coffee Roasters and J.M. Smucker — are going to be just fine. They have plenty of beans in warehouses and plenty more locked in at cheap rates via hedging contracts. At the end of 2013, Starbucks had $611 million worth of coffee in its warehouses and fixed-price deals for a further $519 million in beans.

Still, coffee companies probably won’t be shy about raising prices; they haven’t had a decent excuse for hikes in years. Last spring coffee retailers en masse cut prices on bags and tins of grocery store coffee.

Meanwhile, they’ve lost money on hedging in the years-long swoon in prices. In the second half of last year, Starbucks recorded a $15.6 million loss on coffee contracts — akin to about 1.5 percent of its profit in that time. In fiscal 2013, Green Mountain recorded a $1.5 million loss on coffee hedging.

It’s possible that the futures market has gotten a little hysterical. Some analysts are estimating that as much as 10 percent of Brazil’s crop will be lost this year. Those who play the arabica markets have watched prices fall for a long time. Those who believe beans were fairly priced in early 2011 are eager to bet they will return to that level.

For now, retail prices for coffee are stable. Roasters typically have enough supplies to cover themselves for a few months. But if the price of the arabica beans continues to rise, consumers could start seeing the cost of their morning coffee creep up later this year.

Stocks Discussed: SBUX, DNKN, MDLZ, GMCR, SJM,
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