Growth In Caffeine Still Potent, But Potential For Buzz Kills Looms

This article was orignially published by Motif Investing.

A few years ago, something and a quarter would get you a decent cup of coffee. These days? Something and about 225 quarters will get you a share of Starbucks Corporation SBUX or Dunkin Brands Group Inc DNKN. Even after throwing in another 20 quarters for a coffee, it’s still a pretty good deal.

Long a breakfast afterthought, coffee has emerged as one of the strongest segments of the restaurant and dining industry over the last generation. It’s a $48 billion business in the U.S. alone, with more than half of that dedicated to specialty coffee. And there’s plenty of room for growth – about 500 million cups of coffee are served daily around the planet, meaning almost 7 billion people are grumpier than normal today.

There are a number of factors driving coffee’s moment. People are developing a serious coffee habit at an earlier age; among 18- to 24-year-olds, daily consumption has risen to 36 percent, nearly triple the 13 percent who drank coffee in 2008. Millennials also spend about $80 per month on coffee, well above the U.S. average of $67. More than other sectors of the restaurant industry, coffee shops have been in the forefront of innovation, harnessing mobile apps to drive customer traffic. One in every 5 Starbucks customers pays with a mobile phone, and the company is taking 5 million mobile orders every month. And while the U.S. slowly shakes off the last effects of the 2008 economic collapse, coffee has been found to be fairly resistant to hard times, losing surprisingly little ground during the Great Recession. According to the International Coffee Organization, people shifted consumption patterns, drinking about the same amount of coffee, but brewing it at home and using less expensive brands to save money.

Concentrated Industry

Imagine the typical coffee outlet. It probably involves a barista with a man-bun and liberal arts graduate degree running high-end coffee bean through an Aviatore Veloce TurboJet 100 Coffee Maker, an intimidating piece of equipment that more resembles a jet engine than a Mr. Coffee, while folk music plays softly in the background of the indie coffee shop. But that’s your imagination; the reality is that coffee is a highly concentrated sector, with more than 60 percent of the U.S. retail market controlled by Starbucks or Dunkin’ Brands.

The Seattle-based Starbucks is the undisputed leader in the business, with almost 15,000 stores in its Americas division, plus another 5,500 in China, Asia and the Pacific. The coffee boom has pushed its net revenues to $13.3 billion during the most recent year, a 21 percent increase since 2013. Its stock, which traded in the low $20s as little as five years ago, has been selling in the mid- to high $50s over the past year.

On the other side of the country, Canton, Mass.-based Dunkin’ Brands has seen its revenues from coffee jump nearly 8 percent to $614 million over the past year. The company has 8,431 U.S. outlets – almost all franchises, and nearly double the 4,815 that it reported a decade ago. Like Starbucks, Dunkin’ stock has risen from the low $20s five years ago to the mid-$50s, although with considerably more volatility.

If there’s a wild card in the coffee business at the moment, it’s the J M Smucker Co SJM, an Orrville, Ohio-based corporation better known for jellies and jams than coffee. In the depths of the economic collapse, however, the company bought Folgers coffee from Procter & Gamble Co PG for $2.95 billion. The acquisition has paid off with net sales of coffee increasing 8 percent last year, largely on the strength of single-serving pods sold under a Dunkin’ Donuts brand. Smucker also has taken aim at the growing Hispanic market, acquiring the 80-year-old Café Bustelo brand, as well as Café Pilon, both mainstays of south Florida’s Puerto Rican and Cuban coffee cultures.

Investors may also want to be aware of a third player in the North American restaurant business – Restaurant Brands International, the Oakville, Ontario-based owner of Tim Hortons and Burger King that takes credit for selling 8 of every 10 cups of coffee poured in Canada. While the Canadian market may not be the world’s largest for coffee, Hortons has reached iconic status. Coffee is the most popular beverage in Canada, and the country leads the rest of the world in per-capita donut consumption; Hortons sells both.

Strong Demand, Tight Supply

Global demand for coffee is strong, no doubt; it’s the second most-traded commodity, trailing only oil. Investors need to be reminded that coffee is an agricultural commodity and that agricultural commodities are subject to extreme fluctuations in price.

One of the most common maladies of coffee plants is a fungal disease known as coffee rust, which was first reported in East Africa in 1861. The disease initially causes defoliation, as well as death or yield reductions in subsequent years. A severe outbreak in Central America during the 2012-13 growing season dropped the harvest by 37 percent in El Salvador and 20 percent in Nicaragua. The outbreak cost growers more than $300 million.

Another growing issue involves labor. Coffee is grown in a narrow belt between the Tropic of Cancer and Tropic of Capricorn, with about two-thirds of the harvest coming from four countries – Brazil, Vietnam, Colombia and Indonesia. A lack of workplace standards in many countries has led to poor housing conditions, low wages and child labor, even in places like Hawaii. Outrage over the poor working conditions has fueled the fair trade movement. While the movement has encouraged patronage from Millennials who frequently like making social statements with consumption patterns, the higher labor prices can cut into profits for coffee businesses.

The biggest problem for coffee, however, may be unsolvable. Wild Arabica beans, which make up about 60 percent of coffee, could be extinct by 2080 because of climate change, according to a 2012 study released by the Royal Botanical Gardens, Kew. The amount of land that’s suitable for coffee could be cut by one-half as early as 2050, according to another study.

This isn’t to say that coffee is a bad long-term investment; it’s a much sought-after product in a growing market. But investors should take a long view and be aware that coffee will always be a commodity that’s subject not just to the whims of the market, but also to the whims of nature.