Investors Beware: The Coffee Glut is Coming

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Next year’s coffee crop is promising to be bountiful, sending commodity future contracts lower. Unfortunately, cheaper beans can’t make up for the high valuations of these companies, and lower demand expectations from a depressed euro zone. These bitter valuations and acrid fundamentals make most coffee stocks unpalatable for investors.

South American Supply Glut

Peru’s coffee yield for next year’s beans is expected to rise by 20 percent. The head of Peru Coffee and Cocoa Chamber Eduardo Montauban said, “Production may increase to 4.56 million bags from 3.8 million estimated for this year.” Coffee export income could drop by about 40 percent from $1.578 billion to $950 million. The effects of this oversupply are already being felt in the commodity futures market. In the S&P GSCI spot index, the price of Arabica beans plummeted 29% largely due to the roaster switch to Robusta. Investors in coffee futures are likely to offload their contracts.

Cooling European Coffee Demand

Weak European demand will also probably contribute to lower coffee bean prices.

Though cafés are an important social venue in European cultures, tough times limit the amount of money that can be spared for coffee at a café. Cafés in Europe are struggling to turn a profit as the weak European economy has reduced the disposable incomes of many Europeans.

Many Europeans face unemployment, higher taxes, and pay cuts. In response to these problems, many Europeans will switch to cheaper, lower-quality coffees. Gourmet Arabica coffee was preferred in Europe prior to Europe’s fiscal crises. Now, Europeans are switching to Robusta, a bitter but less costly alternative. Trend has global consequences since Europe has the greatest coffee consumption per person. The past market premium for Arabica beans has narrowed over the past year, reaching its low set in July 2009. It is expected to narrow further as Vietnam’s production of robusta beans has been revised lower.

Many Coffee Stocks Sell Luxury

We have learned from Europe’s distress how fancy coffees are a luxury good, not a consumer staple. Thus, many publicly-traded coffee stocks are highly sensitive to economic downturns. These companies mark up an affordable commodity to designer price points between $1.00 and $6.00 per cup when a person can brew coffee from expensive beans at the cost of less than $1.00 per pot. Individuals who indulge in luxury coffee products will often cut back on them in times of economic distress. For this reason, these stocks should be regarded as highly cyclical.

Bad Press

Starbucks (NASDAQ: SBUX) faces criticism for its labor practices and treatment of workers in Chile. The Supreme Court of Chile has fined the coffee giant $50,000 for threatening layoffs, withdrawing benefits, and replacing workers while they were on strike. This strike at Starbucks happened last year in order to protest for increasing lunch stipends and pay hikes to keep up with inflation.

This is a setback for Starbucks which prides itself on how its U.S. worker relations are among the best in the restaurant business. The company has been able to pass through some of its growing sales to U.S. baristas and other staff, avoiding cause for unionization altogether. Different units inside the company and affiliates have different worker relations. In its defense, Starbucks spokesman Jim Olson remarked, “We have always recognized and respected our partners' right to affiliate with a union and to voice their opinions."  However, Olson also commented “While we disagree with this latest ruling we respect the court's decision.”

The labor practices of local Starbucks units spurred Chile’s Labor Department to ban the coffee company from placing a bid to supply to local offices of the government.

Dunkin’ Brands (NASDAQ: DNKN) faces bad press for domestic problems. Three owners of failed Dunkin’ Donuts branches sued Dunkin’ for racial discrimination. Two African Americans and an Indian-American claim that their business decisions were negatively influenced by the franchise. Amy and Reggie Pretto, two African Americans, maintain that Dunkin’ all but forced them to open stores away from the New York/New Jersey area. Instead they built their branches in an area in Maryland where there was less business. The plaintiffs claim that their businesses failed because of less desirable Maryland locations.

Euro zone stress and higher prices for robusta coffee beans may negatively impact coffee stocks with significant global footprints. These and other forces are percolating to create a bitter environment for many coffee companies. Investors should be very selective when picking between these stocks.

Grinding Coffee Valuations

Valuation multiples for these coffee stocks vary considerably:

Starbucks is too expensive at roughly $45 per share. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.32 while this stock has a much higher 2.65 ratio. Starbucks  shares are trading at a pricey 25.31 price-to-earnings ratio, a value which is significantly greater than the 14.23 average of the S&P 500. The 6.4 price-to-book multiple of this stock is higher than the 2.07 S&P 500 price-to-book ratio.  These valuations would be too high for a safe stock, let alone a cyclical one. Starbucks is an even worse investment proposition at these valuations because it's also highly exposed to the risk of a global recession. It derives 25% of its store revenues from outside the United States and 37% of its locations reside outside of the United States.

Dunkin’ Brands has almost as much international exposure, with roughly 30% of its locations located outside of North America. Worse yet, unfathomable valuations are implied by Dunkin' Brands market prices of $32 per share. Its price-to-earnings ratio is an indefensibly high 61.04. Its 5.08 price-to-book multiple of this stock is also high relative to the broader market. Investors should demand lower valuations to take on the risk of cyclical stocks whose products are cut from budget-minded consumers.

Frothier valuations are implied by Peet's Coffee & Tea (NASDAQ: PEET) market price of $74 a share. This stock has a much higher 2.53 price-to-sales ratio, an enormous 68.02 price-to-earnings ratio,and a 5.1 price-to-book ratio.  In a sense Peet's is safer than Starbucks because it will not be directly impacted by foreign economic headwinds since its operations are focused in the United States. Regardless, its valuation is too high.

The best investment among these candidates is Green Mountain Coffee Roasters (NASDAQ: GMCR) at $24 per share. After a 46% drop in price over the past year this mid cap stock trades at a price-to-sales ratio of 1.03, a 11.07 price-to-earnings ratio, and a 1.69 price-to-book multiple. In addition to these below-market price multiples, the stock is safer because 85% of its revenues come from United States and 14.5%, come from Canada. Thus, it is insulated from economic issues outside of North America. For these reasons, it is the best stock pick among these coffee companies.


Know What You Own

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BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Starbucks and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, and short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Green Mountain Coffee Roasters and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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