As the Coffee Market Heats Up, Where Are The Winners?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Coffee retailers trade at wildly different price multiples. Are any of them potential buys in light of a weak Euro zone and cheap coffee beans? Are any stocks of these rival coffee companies trading at compelling valuations?

McDonald’s Heats Up Coffee Retail

Canadian McDonald’s (NYSE: MCD) McCafe drinkers will be able to take their favorite cup of coffee home and brew it on their own. The same might not be true in the U.S., where the fast-food chain will still brew the coffee only in their restaurants. This is a major step for McDonald’s, which will allow its coffee to retail at $7 for a 12-ounce bag.

However, this move to grocery stores represents the beginning of McDonald’s foray into coffee mass retail, like many other restaurants and coffee makers. Starbucks (NASDAQ: SBUX) is a prime example whose many stores sells its beans and ground coffee. The entrance of Starbucks stores also pulled away a large chunk of coffee drinkers from fast-food restaurants, which were once the haven for breakfast diners. In response, McDonald’s created the McCafe, which boosted sales for the fast food giant. Burger King (NYSE: BKW) also responded by offering coffee from Seattle’s Best, a branded coffee owned by Starbucks.

Dunkin’ Donuts of Dunkin’ Brands (NASDAQ: DNKN) also has a massive marketing program to campaign for its signature coffees, which have taken over sales and have become more popular than the brand’s lines of donuts.

Single Serve Coffee Market

Green Mountain Coffee Roasters’ (NASDAQ: GMCR) Keurig brewing system was once the only single-serve game in town, but now faces new challengers. The newest entrant in the coffee cup market is commercial beverage equipment maker Bunn. Bunn’s home coffee machine is called MyCafe and is a compatible system for Keurig’s single serve cups. Bunn joins other rivals like the Esio Beverage Company, which licensed Wal-Mart to sell their machine. The Esio system can make both cold and hot drinks. Starbucks also jumped in, selling a single-serve Verismo machine that can make espresso and coffee.

Despite many competitors, Green Mountain remains the leader in the market based on the quality of its products and customer loyalty. Green Mountain took over half the retail market in 2011. It was still the market leader, though its market share was smaller than in previous years.

Green Mountain Coffee Roasters is trading at price-to-earnings multiples below other coffee companies, while its growth trajectory is among the best of its peers. For this reason it is an attractive buy candidate. It is not as trendy as other brands or stocks, but its valuation is compelling.

South American Supply Glut

Unfortunately, cheaper beans can’t make up for the high valuations of coffee retailers, which face lower demand expectations from a depressed Euro zone. These bitter valuations and acrid fundamentals make most coffee stocks unpalatable for investors.

Next year’s coffee yield is likely to be bountiful, with Peru’s coffee yield for next year’s beans expected to rise by 20%. Eduardo Montauban of the Peru Coffee and Cocoa Chamber said, “Production may increase to 4.56 million bags from 3.8 million estimated for this year.” Lower prices could send income from coffee exports down to $950 million, down by as much as 40% from $1.57 billion. This supply glut is already being felt in the commodity futures market.

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, pay cuts, and tax hikes. Europeans are switching to cheaper, lower-quality coffees in response to these challenges. Gourmet Arabica coffee is preferred, but now Europeans are switching to Robusta, a bitter but less costly alternative. This trend has worldwide consequences, since Europe has the greatest coffee consumption per person. The market premium for Arabica beans has narrowed over the past year, reaching its low in July 2009. The spot price of Arabica beans has fallen about 30% because of the switch to Robusta. Downward revisions for Vietnam’s forecasted production of Robusta beans may continue to narrow the spread between these two beans.

Many Coffee Stocks Sell Luxury

We have learned from Europe’s distress how designer coffee is a luxury good, not a consumer staple. This makes many coffee stocks sensitive to economic downturns. These businesses market an affordable commodity to designer price points between $1.00 and $6.00 per cup, when a person can brew coffee for less than $1.00 per pot. In times of economic distress individuals who cut back on their indulgence in luxury coffee products; hence these stocks are highly cyclical.

Grinding Coffee Valuations

Valuation multiples for these coffee stocks vary considerably. Starbucks is too expensive, based on valuation at roughly $51 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 Starbucks has a much higher 2.87 ratio. Starbucks shares are trading at a pricey 28.47 price-to-earnings ratio, a value that is significantly greater than the 14.23 average of the S&P 500. The 7.46 price-to-book multiple of this stock is above the 2.07 price-to-book ratio of the S&P 500.

These valuations would be too high for a safe stock, and are indefensible for a cyclical one. Starbucks is an even worse investment proposition at these valuations because it also highly exposed 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 roughly as much international exposure as Starbucks, with about 30% of its locations outside of North America. Worse yet, Dunkin' Brands market prices of $30 per share imply unfathomable valuations. Its price-to-earnings ratio is an indefensibly high 76.64. Its 10.72 price-to-book multiple of this stock is also high relative to the stock market. Investors should demand lower valuations to take on the risk of cyclical stocks whose products are cut from budget-minded consumers.

The best investment among these candidates is Green Mountain Coffee Roasters 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 10.98 price-to-earnings ratio, and a 1.69 price-to-book multiple. Moreover, the stock is safer because 85% of its revenues come from the United States and 14.5% come from Canada. Thus, it is insulated from economic issues outside of North America. Therefore Green Mountain Coffee Roasters is the best stock pick among these coffee companies.

Burger King is too expensive, based on valuation, at a price of roughly $15. Investors can buy more sales per dollar from the S&P 500 since this stock has a much higher 2.5 ratio. Burger King shares are trading at a lofty 56.52 price-to-earnings ratio and a high 4.77 price-to-book multiple.

The current market prices for McDonald's are near $85 per share, which is above average. 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 McDonald's has a much higher 3.1 ratio. McDonald's shares are trading at a fair 15.96 price-to-earnings ratio, in line with the S&P 500 average. The 6.09 price-to-book multiple of this stock is higher than the 2.07 S&P 500 price-to-book ratio.

Conclusion

Green Mountain Coffee Roasters is the cheapest stock on this list based on its low price multiples. It is also insulated from global economic issues, making it the best stock pick among these coffee companies.

Eat Up, Investors

With Green Mountain as cheap as it's ever been, many investors are wondering whether this is the end of the former market darling, or the perfect entry point for an enormous rebound. You can find a recommendation for how to approach investing in the company in The Motley Fool’s new premium research report. In it you'll find everything you need to know about Green Mountain, including whether it's a buy at today's prices. Click here for instant access.


BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of McDonald's and 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 Burger King Worldwide, Green Mountain Coffee Roasters, McDonald's, 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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