Starbucks’ Earnings Preview: High Coffee Prices Coupled with Lower Input Costs to Widen Margins

Starbucks Corporation (NASDAQ: SBUX) is scheduled to release its Q3 earnings report on July 24. ^[1] The company reported strong second quarter results for the 2014 fiscal year, with global comparable sales growth of 6% and a revenue of $3.9 billion. The company recorded its 17th consecutive quarter with above 5% comparable sales growth despite the extremely harsh cold weather and increasing competition in the breakfast segment. The highlight of the second quarter was its noteworthy comparable sales growth in China and Asia-Pacific (7%), as well as in Europe and the Middle East (6%), primarily driven by increasing customer traffic. Operating margins expanded by 130 basis points to 16.6%, primarily due to favorable commodity costs. ((Starbucks Q2 earnings transcript, March 24, 2014))

Moreover, with the coffee prices skyrocketing over the past six months, the strategy of hedging coffee prices for longer duration has given the coffee giant an edge over its competitors. In addition to this, the company’s plan of venturing into new markets, investing in innovative drive-through formats and expanding its network will help boost its top line performance and pave the path for its growth in the future.

We have a $76 price estimate for Starbucks, which is 4% below the current market price.

See our full analysis for Starbucks Corportion

Starbucks expects the yearly revenue growth for fiscal 2014 to be above 10% and global comparable sales growth to be in mid single digits. With its China and Asia-Pacific (CAP) and Europe, Middle-east and Africa (EMEA) segment performing above expectation, the company expects its system-wide operating margins to improve 175-200 basis points over fiscal 2013. Consistent progress in the top line performance encouraged the company to set an EPS guidance of $0.64 to $0.66 for the third quarter and $2.62 to $2.68 for the whole fiscal year 2014.

Coffee Price Hike Despite Lower Input Costs to Drive Top line Growth

• High Coffee Menu Prices to Boost Comparable Store Sales

The beverage industry is witnessing a bullish surge in the prices of green coffee for over six months now. The price of Arabica coffee beans has surged almost 100% from a level of 106 cents per pound to around 220 cents in mid-April, due to tight supply as a result of prolonged drought in Brazil, followed by recent floods. ^[2] Prices could be driven higher by the end of this year due to increasing demand for premium coffee beans and speculation over early outbreak of El-Nino, the oceanic disturbances, that can further disrupt crops across Southern Brazil.

In the third quarter, Starbucks decided to raise the prices of its coffee menu, responding to soaring coffee bean prices. The company raised prices on some of its drinks by 5 to 20 cents, whereas it raised prices of its packaged coffee sold in supermarkets and other retail stores by $1 (8%) to $9.99 per bag. The price of grande and venti brewed coffee increased by 10 to 15 cents, whereas tall and venti lattes costed 10 to 20 cents more. ^[3] Initially, Starbucks’ officials announced that the company is not planning to raise coffee prices. However in June, companies such as Dunkin’ Brands (NASDAQ: DNKN), Peet’s Coffee and J.M. Smucker decided to raise their coffee prices. 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. And when Starbucks was sure that majority of the customers were aware of the reasons for the hike and the possibility of losing customer traffic to be minimal, the company did not hesitate to raise its coffee prices. ^[4]

However, this was late in the third quarter and this hike will hardly contribute to the revenue surge, but Starbucks has always been known for its above-average pricing. The company’s coffee prices are expensive as compared to its peers, but the company’s customer base has always been loyal to the brand. With all its competitors raising their coffee prices, it gives customers all the more reason to stay with the brand.

Since beverages accounted for 74% of Starbucks’ total retail sales in 2013, we can estimate the impact of high coffee prices in the third quarter result. This might further boost the beverage spend per customer visit. Moreover, a price rise in other food items might also contribute slightly to revenue growth.

• Hedged Coffee Prices to Widen Margins

In its latest Q2 earnings transcript, the company mentioned about its one year worth of protection on inventory and contracts. By the close of 2013, Starbucks had fixed-price coffee agreements valued at $588 million and variable-price commitments worth $294 million. To hedge against rising coffee prices, Starbucks virtually locked all of its coffee needs for 2014 and around 40% for fiscal 2015 at slightly favorable prices.

Coffee accounts for less than 20% of the company’s cost of goods as stated by Starbucks’ CEO in a recent interview with CNBC. ^[5] With low input costs and high coffee prices, the company expects the margins for this quarter to widen significantly.

Global Consumer Product Segment to Contribute To Revenue Growth

The consumer product segment includes whole bean and ground coffees, ready-to-drink beverages and other branded products sold worldwide through channels such as retail stores, grocery stores and U.S. food-service accounts. The revenues of this segment grew 10% in fiscal 2013, mainly due to increased sales of premium single serve products. The company continues to focus on the growth of its consumer product segment. Introduction of new products in this segment, such as the Evolution Fresh juices and Teavana tea, coupled with increasing popularity of single serve products have boosted this segment’s growth and might contribute significantly to revenue growth in this quarter.

With lower coffee costs and increased prices of packaged coffee in supermarkets, we can expect slight improvement in the segment margins.

The company’s direct distribution model has worked very well for this business and has enabled it to enhance its outreach, and position its products better in the market.

Expansion Plans on Track

Starbucks opened 335 outlets globally in Q2 of fiscal 2014, bringing the total count of stores to 20,519. The company is targeting to open 1,500 new outlets this fiscal year, with half of them in the emerging markets of CAP. The company has allocated a capital expenditure of $1.2 billion for this purpose. In Q3 of fiscal 2013, the company managed to open close to 340 stores and we can expect a similar new store count this quarter too.

Apart from planning to expand its Starbucks stores, the company is also expanding its Teavana Tea Bars. In the third quarter, the company opened its Teavana Tea Bars in New York, Chicago and Seattle. Tea, being the most consumed beverage in the world, it is a lucrative $90 billion market. If Starbucks succeeds in building Teavana similar to its coffee chain, the company can go on to dominate this segment in the near future.

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1.  FY14 Q3 Starbucks Earnings Conference call [↩]
2. Coffee futures, July contract, 2014 [↩]
3. Starbucks: price of venti latte rises [↩]
4. Why Starbucks has an edge over competitors despite rising coffee prices [↩]
5.  Starbucks’ CEO: CNBC Interview [↩]