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The Price of Coffee is on the Rise: Who's Really Going To Profit?

By , Money Morning •

By Jason Simpkins
Staff Writer

First it was the cost of a tank-full of gas for your Mercedes SUV. Then it was interest rate on your home-refi loan. But when they messed with your morning ritual – and boosted the price of your morning latte, well, that was taking things just too damned far.

Coffee-king Starbucks Corp. (Nasdaq: SBUX) recently boosted its prices by nine cents a beverage. It was the second price increase in 10 months and has boosted the price tag of an already pricey Starbucks morning brew by about 14 cents. The prior price hike – tacked on last October – adjusted for higher labor and energy costs, while the most recent addition to prices was attributed to the big spike in the price of milk, a key component of such Starbucks' mainstays as lattes.

Milk prices have soared in response to – of all seemingly unrelated factors – a big uptick in the production of ethanol, a gasoline substitute that counts corn as one of its key ingredients. Well, since corn is also a key ingredient in the production of milk – it’s what dairy cows like to eat – that means there’s been a big spike in demand for that one crop. And as everyone knows, when you boost demand but keep supply relatively steady, the result is a big upswing in price.

Though rankled a bit, most Starbucks regulars are undeterred in their admiration for the Seattle-based company, which helped transform coffee from breakfast-table beverage into an any-time-of-day treat. Indeed, some consumers can probably recite their never-wavering daily drink order – grande sugar-free vanilla skim latte—faster than they can list all the names of their kids.

One Starbucks regular – a Baltimore-area financial advisor who stops in several mornings a week – buys herself gift cards en masse so that she won’t succumb to her organized nature and start keeping a ledger of how much money she’s spending on Starbucks drinks each month.

“I keep getting these $25 gift cards, and even they go pretty fast,” said the financial advisor, who somewhat sheepishly requested anonymity. “But those lattes sure are good.”

Coffee prices have hovered between $1.00 and $1.20 per pound for the past two years, making the coffee bean one of the few commodities that hasn’t picked up steam in the current commodity boom.

But that may be about to change.

And in an odd irony, the Starbucks price increase may well have forced us to reassess that company as an investment opportunity. At yesterday’s closing price of $27.48, Starbucks’ shares are down $12.53 each, or a whopping 31%, from their 52-week high of $40.01. That price decline alone – coupled with the company’s tremendous track record for consistent, long-term growth – is essentially enough to make Starbucks an interesting investment opportunity.

But let’s mix in one more ingredient, and really make this a potent portfolio pick-me-up.

And that ingredient is China.

Viewed through that lens, Starbucks stands as an example of an investment with a wicked one-two punch: Its business in the developed markets will continue to grow at a predictable rate, making this a stock with an attractive upside and an acceptable level of risk. But its foray into China could serve as a bit of jet fuel, enabling the company’s profit growth to rocket ahead of what analysts expect, providing you with the higher returns that typically accompany a China-focused stock, but again with the moderate risk afforded by companies whose headquarters remain in the United States.

Contributing Editor Keith Fitz-Gerald likes to refer to this very sound strategy as “investing in companies that will profit from China,” as opposed to investing in China directly. It’s worked well for him, now we’ll show you how it can work for you.

The ‘Three Cs:’ Coffee, China and Capital Gains

Okay, so that’s three Cs and a G.  But it’s still an intriguing picture, isn’t it?

The demand for coffee has been picking up in recent years thanks to a worldwide surge in demand by every commodity’s new best friend, China. It’s been estimated that China's coffee consumption was approximately 45,000 tons in 2006. But that number could jump five-fold or even six-fold to reach 300,000 tons annually by 2020.

China, traditionally a tea-drinking nation, looks to be following a pattern similar to that seen in Japan a few years ago. After a steady climb, Japan is now the world’s third-largest coffee importer. According to the International Coffee Organization, China’s current import volume is less than a tenth of Japan’s, but coffee consumption is growing at an unparalleled rate of 10% to 15% each year. And with a population of 1.3 billion, it won’t be long before China leapfrogs Japan and Germany, and becomes the No. 2 coffee consumer in the world.

So, which countries are going to see the most profit from this surge in demand? Well, Brazil is a given. Even though its exporters saw their profits plummet this year as the Brazilian real rose 15% against the U.S. dollar this year, Brazil remains the world’s largest producer of coffee beans.

Brazil, no doubt, will experience a profit increase. But over time, it looks like Africa, too, will eventually present some spirited stiff transatlantic competition.

The Coffee Reigns Down in Africa

While Brazil produces more coffee beans, East African countries have a much-steeper tradition and a higher quality product.

“Africa is becoming strategic: Buyers know they get quality and there's a growing fashion for sustainable, organic coffees, over the mass production you get out of Brazil and Vietnam,” Henry Ngabirano, managing director of the Uganda Coffee Development Authority, said in an interview with Reuters.

Uganda is one of a many African countries whose high altitude and small-scale coffee bean farms produce a higher quality coffee. That’s important, as high-quality coffee and specialty blends have become favorites in many coffee-drinking nations.

Uganda has become one of the world’s leading producers of high quality Robusta coffee, which requires a very particular climate to cultivate. Uganda reported a 65% growth in earnings over last year, reaching $17.91 million in May, the latest figures available. In June, Uganda's coffee earnings rose 60% compared to a year earlier, reaching $24.32 million. There was also a 31% rise in the number of 60-kilogram bags sold, according to data from the nation’s coffee board. Also, according to the board, Uganda's coffee production is expected to increase by about 14%, to at least 2.5 million bags, by the end of 2007.

Ethiopia is currently Africa’s largest coffee producer. Approximately 25% of its population owes its livelihood to the coffee industry. Coffee is the nation’s most profitable agricultural export, accounting for 65% to 75% of its foreign-exchange earnings, and approximately 10% of the country’s GDP.

Earlier this year, the government of Ethiopia and Starbucks reached an agreement that will allow the country to trademark several of its beans. The purpose of the licensing agreement is to provide the country of Ethiopia with name-brand recognition by associating it with select specialty coffees. The hope is that if a particular specialty coffee proves popular, the nation that produces the crucial coffee bean will be able to command a premium price in the market.

Kenya will produce approximately 54,000 tons of coffee in the 2007-to-2008-crop season, according to a report by the Coffee Research Foundation. And Kenya, too, is seeking to trademark its specialty coffee beans. The Coffee Board of Kenya thinks the new trade brands could be on the market within a year.

Starbucks Sniffs Around Africa

After reaching its licensing deal with deal with Ethiopia, Starbucks launched a plan to assist small-scale coffee producers by setting up a farmer support center to improve bean quality. It is also providing $1 million in seed money to fund business-development “micro-loans.” And that outlay is in addition to the $4.2 million that Starbucks has already supplied for social-development projects in the region.

However, the U.S. hot-beverage giant clearly has more than philanthropic intentions for Africa. A few months ago, Dub Hay, Starbucks Senior Vice President of Coffee Procurement, announced the company would double its purchases of coffee from Africa by 2009. It’s estimated that Starbucks buys 294 million pounds of coffee a year, with only 6% coming from Africa. Starbucks wants to double Africa’s contribution to 12% during the next two years.

Starbucks isn’t content to just buy coffee beans from Africa, however. In an interview with Reuters, Philip Gitao the Director of the East African Fine Coffees Association said, “Starbucks wants to come into Africa and get involved in production. One thing that has pushed this trend is the specialty movement – coffees grown in unique areas.”

By assisting in the production of African coffee beans – and gaining favor with African governments and populations – Starbucks is laying a solid foundation for future trade relations. That’s not to say the coffee-producing nations of East Africa don’t have a lot to gain, however.

Which Brings Us Back to China

Even though East African nations are among the world’s biggest coffee exporters, China’s accelerating market has proved elusive to African growers. Uganda is the only African coffee grower currently distributing its product in China. That’s because the market in China is notoriously competitive and some African countries lack the resources to establish a legitimate presence there.

Ethiopia’s coffee exports to China were only worth a $198,000 in 2005, a minor part of the nation’s $350 million worth of exports. That number was an improvement of more than a 100% over the two previous years, but the country has a long way to go. It needs help, and that help may be on the way.

While African countries are struggling to gain leverage in China’s fast-growing market, Starbucks has already made headway. For eight years, it has been at the forefront of China’s developing java market, which it one day will be the biggest market outside of the United States. The franchise currently manages over 400 shops in mainland China, where coffee drinking continues to grow in popularity.

It is Starbucks that plans to increase its purchase of African coffee beans, offer micro-financing loans to farmers, and provide social development programs. And, in addition, it will now be distributing brands of coffee licensed by African nations to its 400 coffee shops in mainland China.

Over the next few years, East African nations will continue to push for their own avenues of global distribution. They will also continue in their efforts to boost the price of their unique coffee beans in any way they can. In the meantime, Starbucks has become a very powerful agent for African coffee production, particularly in China, the world’s fastest growing coffee market.

 

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