Starbucks Shielded from Further Downside Due to Rising Input Costs

Starbucks (NASDAQ:SBUX) is the world’s leading roaster and retailer of specialty coffee. Through its global network of owned and franchised coffee retail outlets, Starbucks offers a wide range of products from coffees and teas to sandwiches and brewing equipment. It competes with McDonald’s (NYSE:MCD), Caribou Coffee (NASDAQ:CBOU) and Peet’s Coffee (NASDAQ:PEET) in the broader market for specialty coffee.

We estimate that the Starbucks’ company-owned stores consititute around 46% of our $26.41 price estimate for Starbucks’ stock, while franchised stores generate an incremental 30%. Our price estimate stands roughly 18% below market price.

Here we examine the impact that rising commodity costs could have on Starbucks. We’ve previously discussed how these trends might impact large manufacturers like Kraft, noting that profit margins could come under pressure and market share could suffer as manufacturers try to offset the cost with price increases (See Rising Commodity Prices Could Limit Kraft Upside).

Coffee Prices Hitting Historic Highs

Coffee prices reached historic highs in 2010, and will likely continue their upward climb through 2011. The trend is largely due to a a supply-demand mismatch. On the demand side, there is an increasing preference for premium coffee from a rising demographic of affluent young professionals in emerging markets like Brazil, China and India. This has been supplemented by sustained demand from North America and Europe despite the prevailing economic recession. On the supply side, heavy rains across major coffee growing regions in Colombia and Central America have limited coffee production. ^[1]

Rising input costs have already prompted Starbucks to raise pricing over the past year. Starbucks is now also increasing prices on some of its products in China, which is expected to be the company’s largest growth market during the next two years. According to Euromonitor International, Starbucks sales in China grew by more than 3x between 2004 and 2009, with the company now controlling a 70% market share in the region. ^[2]

Consumer Spending Outlook

High unemployment levels in the US could be another cause for concern among premium coffee retailers. Though the U.S. unemployment rate improved marginally from November, reportedly reaching 9.4% in December, the recent data still indicates a slow hiring pace. ^[3]

However recent retail sales does indicate a sign of hope for consumer spending. Retail sales (ex-autos) rose to $584 billion for the period Nov 5 to Dec 24, according to MasterCard Advisors’ Spending Plus. This is a 5.5% increase from last year and the best performance over the past 5 years ^{[4] [5]}

Starbucks’ Customer Base the Key to Sustained Growth

While other coffee retailers might see rising input costs and their corresponding price increases pressure market share as consumers seek cheaper alternatives, we believe Starbucks remains relatively shielded from this outcome due to the nature of its customer base. Starbucks targets a more affluent demographic of coffee drinkers that typically exhibit strong brand loyalty, making demand for its coffee more inelastic with respect to price fluctuations. This effect was observed during the recent economic downturn.

Further, with expanding wealth and discretionary spending in many emerging markets, the growing demographic of young middle-class working professionals might exhibit a bit of brand loyalty as well, propping up the company’s revenues in these regions.

1. The Wall Street Journal: Tight Markets Seen for Coffee, Sugar and Cotton [↩]
2. Bloomberg: Starbucks to Raise Some Prices in China as Costs of Raw Materials Increase [↩]
3. The Wall Street Journal: Economy Adds Fewer Jobs Than Expected [↩]
4. NASDAQ: US Equities Week Ahead [↩]
5. Bloomberg: US Retailers’ Holiday Sales Jump 5.5% on Apparel [↩]