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Reflections In A Cup: The Coffee Market, And A Retailer Of Interest

The coffee market and a retailer of interest


March 11, 2008
By Stuart Daw

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The coffee market, from Jan. 25, 2007, to Feb. 15, 2008, rose from 1.3145 to 1.5605 – nearly 25 cents per pound (US$ green). Since July 2006, when the average for that month was 1.1982, we have seen a whopping jump, 36.23 cents green, or over 43 cents per pound roasted. Prices for arabicas, along with robustas, are now at 10-year highs.

The coffee market, from Jan. 25, 2007, to Feb. 15, 2008, rose from 1.3145 to 1.5605 – nearly 25 cents per pound (US$ green). Since July 2006, when the average for that month was 1.1982, we have seen a whopping jump, 36.23 cents green, or over 43 cents per pound roasted. Prices for arabicas, along with robustas, are now at 10-year highs.

This is against a background of a low carryover in world stocks. According to an analysis done by the reliable German based firm F.O. Licht, world consumption will exceed production this coming year by roughly 1.8 million bags (production 123.4 million bags, consumption 125.2 million bags).

That’s roughly in equilibrium, so with a better upcoming crop than had been earlier predicted by Brazilian authorities, one would assume little need for panic. Thus roasters, cautious because of all the uncertainty, seem to have been caught flat-footed, as speculators have ridden the commodity bandwagon, driving prices higher at even the slightest rumour. 

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Consumption has been on the rise in many countries. That includes Russia and Eastern Europe, along with the emerging markets in Asia, and even within the producing countries such as Brazil, where sales have been rising along with their increased standard of living. One would normally expect that coffee growers, motivated by higher prices, would increase production by better field husbandry such as proper pruning, more fertilizer, pesticides, etc., even granted that coffee is not an annual crop that can respond as quickly to increased demand.

Coffee trading today is not what it used to be. Since Jan. 1, speculators have added 13,000 lots of net long contracts. That’s over 2,000,000 bags of coffee.

All “commodity softs” are strong, partly driven by the drive for ethanol production, and coffee is going along for the ride. But in addition to the normal conditions of supply and demand, speculators who are long-only index traders have bought into groups of commodities that include coffee but have no direct relation to it. Thus we have a classic battle between emotion (the specs with their gut feelings, reading their quasi-mystical charts), and reality (the roasters, having regard for world coffee production and consumption.

This makes buying for actual roasting a tricky exercise.

A Retailer Of Interest
Why would an investor about a year ago decide to go short on Starbucks’ stock?

The track record of rapid success and achievement of almost iconic status by that company should have bred confidence in even the most timid soul.

But around that time in a discussion with a respected associate, I recalled our professor at the University of Toronto many years ago asking the class, “When has a company become too big?”

The students came up with a few ideas, but in the end the professor summarized by borrowing the conclusion of economist Peter Drucker, who said simply, “When it becomes unmanageable.”

With the plunge of Starbucks stock and same store sales, and the obvious internal confusion causing the return of Howard Schultz to assume operational command, we might well inquire if that was the case. Schultz wants Starbucks to eschew the “commoditization” of the company, and to “recover its lost soul.”

Will He Succeed?
First, one must acknowledge the great, positive impact Starbucks has had on the coffee industry. And that’s not just in specialty coffee stores, but also in the industry at large, including the perception by the public, whose fascination with coffee has taken a happy turn for the better.

But what was the essence of their success? I submit it was not the coffee, which was quite ordinary, but the entertainment factor, the “experience” one had with the pleasant assault on the senses when entering the stores, including the sights and sounds of baristas doing their dog and pony show in the preparation of espresso-based drinks.
What about their current problems?

It’s always handy to blame management, which in the last analysis is usually a fair conclusion, barring some unexpected calamity from the outside such as governments banning coffee altogether. But there are a couple of things that might strike one as being responsible for management stress in this case.

The first is what Alan Greenspan might call irrational exuberance, reaching out beyond one’s grasp. And surely every
manager in any business anywhere must have marvelled at the daily opening of as many as six Starbucks stores. It’s enough just to contemplate the massive problem of staff training, especially at supervisory levels. But we are not talking here of just the home country’s language, but the fact that this thing is a worldwide phenomenon, spoken “in many tongues.”

The second big philosophical decision by management may have stemmed at least partly from the first, too-rapid growth. Management saw the legendary long lineups. Could the public be getting impatient with the waiting?  What non-coffee products might be reasonably handled, given space limitations? Will the aroma of fatty breakfast foods impact the ambience of that famed “Starbucks Experience?” What about ethnic and country differences in taste?

And what about the time taken and the high labour costs, along with the inconsistent quality of some of the complex beverages being prepared by hand? It must have seemed reasonable to management to automate that beverage preparation as much as possible by installing machines to do the work, and do it with more precision.

The risks in simplifying were high, but they forged ahead anyway. Now we see that Schultz has decreed that at 5:30 p.m. on Feb. 26, no less than 7,100 stores will close down for three hours for training baristas to make a perfect shot, how to steam milk, etc. And he may even decide to switch back to manual latte machines.

Starbucks has already decided to offer $1 coffee to combat the hot competition from McDonald’s.

In summary, the difficult problems in public companies trying to increase shareholder value forces some tough decisions on management.

Is cost cutting through automatic machines just cutting costs, or is it also cutting into the customer loyalty that “made Starbucks what it is today?” Starbucks now agonizes over these issues. Can McDonald’s, trying to elevate its own customers’ “experience” by emulating Starbucks, avoid similar problems?

Is it wise for them also, to try and become what they are not?