How Will Coffee Prices Affect Kraft’s Beverages Business?

The beverages business is important for Kraft Foods Group (NASDAQ:KRFT) as it contributes to approximately 11.6% of the value of the entire company, according to our estimate. Kraft’s beverages business consists mostly of coffee sales, therefore, coffee prices play an important part in determining the costs for this division. In this article, we analyze the current trends in coffee prices and its implications on Kraft’s beverages business.

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Supply Driven Trend In Coffee Price

Before trying to understand the impact of coffee prices on Kraft, let us first analyze the historical trends in coffee prices. Coffee prices remained by and large flat from September 2013 until January 2014 on the basis of a good harvest, especially in the South and Central American countries that produce most of the coffee sourced by Kraft. However, recent supply reductions have caused coffee prices to soar and nearly double, as shown in the graph below. ^[1]

This reduction in coffee supply has been mostly on account of drought and plant diseases. Central American countries that produce 10% of the world’s coffee, have been hit simultaneously with drought and a fungus that has destroyed crops. Countries from this region that have seen a double-digit drop in their Arabica coffee beans export include Guatemala, El Salvador, Nicaragua and Mexico. Meanwhile, coffee production in the South American country of Brazil is expected to be down by 5-10% this year due to a drought. Brazil is the largest coffee grower in the world, contributing to one-third of the world’s coffee supply. Brokerages suggest that the possibility of reduced harvest this year and the next, could raise coffee prices by close to 10% within a few weeks. ^[2]

Impact Of Rise In Coffee Prices On Kraft

The rise in price of coffee can affect Kraft adversely in one or more of the following ways

• Rising prices of coffee can lead Kraft to hike prices of its products, which may affect its market share as it competes mostly in the moderately price sensitive mid-premium category. ^[3]. Currently we expect Kraft’s market share in beverages to remain 4% in 2021. If there is a one percentage point reduction in this parameter to 3% in the same period, it can reduce our estimate of value of the stock by 3.4%.

• Kraft may choose not to increase the prices of its coffee products in response to an increase in the price of coffee. This may preserve market share, but can affect its profitability negatively. Our forecast for Kraft’s beverages profit margin for 2021 is currently at 17.7%. If this drops to 15% in the same period, our estimate of the value of the stock goes down by 5%.

• A rise in coffee price can lead all companies selling coffee-based beverages to raise the price of their products. This may result in reduced consumption of these products due to decreased demand from price-sensitive consumers. This set back to coffee-based beverages will also negatively affect the overall beverages market. Currently our estimate for the market size of the beverages market in the U.S. and Canada is $71 billion. If this reduces to $60 billion in the same period, our estimate for the value of Kraft’s share price reduces by 6.5%.

A Lose-Lose Situation For Kraft

To sum up, the rise in coffee prices to the extent discussed in this article may prove too costly for the beverage manufacturers to absorb. To maintain sales in the face of rising prices, Kraft may have to continue with its significant promotional expenditures that it had planned to scale back on. On the other hand, if some part of the rising cost is absorbed by the company, its profits for the division will be negatively affected. Overall, the coffee price conundrum poses a lose-lose situation for Kraft. This may lead the management to fall short on their commitment to maintain pricing power in the face of increasing competition. ^[4]

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1. Coffee Historical Price [↩]
2. Coffee Weather Woes Spread To Central America [↩]
3. What Does Kraft Foods Split Mean For Its Coffee Business [↩]
4. Kraft Q2 Earnings Call Transcript [↩]