How Starbucks minimizes the impact of coffee prices
I believe there are two explanations for the “irrelevance” of coffee prices.
1. Purchase contracts
Starbucks buys most of its coffee from suppliers through fixed-price commitments. This means that it won’t feel the effect of short-term fluctuations in coffee prices, as the price and quantity are fixed. I estimate that these commitments typically last around a year.
Another way Starbucks can minimize its commodity risk is through hedging. Typically, the company will make an arrangement to sell coffee on a specified future date (it buys a future). This means that it earns money when coffee prices increase, and hence this cancels out the input cost risk.
Think about the commodity costs and margins this way: despite increasing commodity costs in 2011 and 2012, Starbucks was capable of improving its margins. In 2013, commodity costs will most likely decline, so Starbucks doesn’t even need improved operational performance to improve profitability. Therefore, I think Starbucks has a lot of potential in the short run (especially if the imperfect hedge will benefit the bottom line), but I am also decently optimistic on the long-run prospects of Starbucks. I plan to follow this article up with other in-depth articles about Starbucks, which will elaborate on my long thesis.
Starbucks recently announced a revamped pricing structure. Prices for many of its popular (read: lower-end) products such as brewed coffees and lattes are headed downwards. A spokesperson claims that this is the first time in Starbucks’ history that prices have been reduced. According to an article written by Claire Cain Miller in the New York Times, the coffee purveyor is also redesigning its menu to feature lower priced brewed coffees, as well as offering promotions on iced drinks. This strategy makes sense: the struggling economy dictates discounts and McDonald’s brewed coffees and lattes are stealing price sensitive customers.
Paradoxically, Starbucks is also increasing the prices of its higher-end more complex drinks including Frappuccinos and caramel macchiatos, of which there is less competition from rivals. In some cases, prices are rising by 30 cents (8%). There is some justification for this price increase. In Starbucks recent quarterly earnings release (third quarter ending June 28), same store sales in the U.S. were down by 6%. Broken down, 4% of this decline was due to fewer transactions (customers defecting to McDonald’s, for instance) and the remaining 2% from a decrease in average value per transaction. Thus, for the most part, customers who continued to patronize Starbucks spent the same amount on each visit.
So why raise prices right now when demand is waning? Some speculate that Starbucks is trying to make the most profit from its devoted customers who are hooked on its products. In other words, its specialty drinks are in the cash cow phase of the Boston Consulting Group’s Growth Share Matrix. For products in this cash cow phase, the general recommendation is to reduce investments and simply harvest profits from current demand.
All successful products have their heyday of strong growth and then eventually reach a point where demand remains constant or decreases. After all, remember when CB radios and radar detectors were the rage? When a product reaches the cash cow stage of its lifecycle, the general strategy is to take the money and run. What are the chances that macchiatos will experience a growth surge in the future?
With rivals (including McDonald’s and Dunkin Donuts) stealing share from Starbucks’ lower-end products and concerns about the growth of its highly differentiated premium coffee drinks, what’s the growth driver that justifies Starbucks’ current price to earnings ratio of 59? This high p/e ratio indicates that investors feel the company has higher potential growth opportunities than the average company (in contrast, GE’s p/e ratio is 10.5 and Wal-Mart’s is 15).
A company’s pricing strategy can be a good indicator of its future growth potential.
A weak cost structure means Starbucks’s costs are high in comparison to their competitors