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Green Mountain's K-Cups Thrive As Coffee Prices Surge

Posted 08/26/2011 05:33 PM ET

Paying too much for your coffee? Blame sunspots and soybeans.

For nearly a decade, through 2009, global coffee prices generally advanced at a gradual, steady rate. The world's top coffee exporter, Brazil, had amassed surplus stockpiles during the 1990s. In years when bad weather hurt the harvest, Brazil dipped into its warehouses to moderate prices.

But by the end of 2009, that buffer had dwindled. The rise of Starbucks (SBUX) and other coffee chains was whipping up global demand. In addition, many of Brazil's farmers had turned to more lucrative crops, like soybeans. The coffee harvest was falling behind.

The scenario set the stage for what Shawn Hackett, president of commodity specialist Hackett Advisors, saw as "a generational move" in coffee prices.

"I would continue to buy coffee in the most aggressive fashion that your risk tolerance will allow," he wrote in a May 2009 note.

Hackett also added another element to the picture. Sunspot activity was sweeping to the bottom of a three-year cycle. His research showed, over the past century, the bulk of Brazil's frosts in June and July — the coffee harvest months — took place during low points in sunspot activity.

At the very least, the 2009-10 season's weather would be temperamental. Global coffee demand was rising, particularly for Brazil's high-grade Arabica beans used by Starbucks and other top chains. With supplies already tight, any dent in the country's crop could be catastrophic.

Hackett saw coffee prices as a lit fuse.

Still, by October 2009, investor attention was riveted on a wildly rebounding U.S. stock market. Coffee prices were down for the year, and Brazil's government was forecasting a record crop. Hackett argued that, under the best of conditions, the year's coffee harvest would barely satisfy growing demand.

By April 2010, Brazil's producers were acknowledging a problem. Growers began to harvest a month early after heavy rains led to uneven ripening of the crop.

In May, the government tallied a record 47-million-bag harvest — in line with estimates. Later counts showed only a portion of the beans were ripe, significantly reducing the crop yield. In June, prices spiked 10% after a cold snap sparked a buying frenzy.

The coffee bull market was under way.

By December, prices were up 45% for the year. By April this year, coffee had climbed 82% and was forcing retailers like Starbucks, McDonald's (MCD) and Peet's Coffee & Tea (PEET) to raise prices.

Coffee's new price paradigm couldn't have been better timed for Green Mountain Coffee Roasters (GMCR). The coffee wholesaler had spent years expanding its distribution network and fine-tuning the supply chain for its efficient, coffee systems called Keurig.

The systems brew a single high-quality cup at a time. In a world of spiraling coffee prices, the Keurig offered a sensible alternative to the old pot-at-a-time coffee culture.

"Many people have had the experience of showing up to a coffee station at work and finding coffee burned in the bottom of a pot," said Scott McCreary, head of Green Mountain's specialty coffee business unit. "Or at the end of the day, they'll want a single cup, but don't want to make a whole pot and waste most of it. We saw an opportunity there."

Green Mountain has ridden Keurig's spectacular popularity to the top of IBD's Wholesale-Food industry group. The group has held a steady, top 20 ranking for the past six weeks among the 197 industry groups tracked by IBD.

1. Business

Coffee is not a young market. Evidence shows the bright red beans originated in Ethiopia and were brought to what is today Yemen. There, they were first cultivated in the 6th century to make coffee, according to the Coffee Research Institute.

Today, farmers of all sizes grow and harvest the beans in more than 50 different countries. They sell to roasters, who bake them to the familiar, dark brown color. The U.S. Department of Agriculture estimated world coffee production in 2010-11 to be 137 million (132-pound) bags. That production gets distributed through a diverse array of wholesale and retail channels.

IBD's Wholesale-Food group contains a variety of food retailers. The largest, by both sales and market capital is Sysco (SYY), a supplier of food and related products to restaurants, hospitals, hotels and schools. United Natural Foods (UNFI) distributes organic and natural foods to groceries, including the Whole Foods Market (WFM) chain.

Green Mountain and Coffee Holding (JVA) hold Composite Ratings of 99, the highest in the group. United Foods is next in line, with an 85.

Green Mountain's success has been fueled by rapid acceptance of its Keurig systems. Company sales jumped from $225 million in 2006 to $1.36 billion last year.

Coffee Holding is a distributor that has grown by acting as a go-between, buying raw beans from farmers and selling them to Green Mountain's roasters. Coffee Holding's sales were $57 million in 2007 and have risen 84% since then, to about $105 million.

Another player in the group, Farmer Brothers (FARM), distributes basic tea, spice and coffees to restaurants, hotels and hospitals. It has managed slow but steady growth — on track to post sales of $452 million this year, up from $450 million in 2010. But it hasn't posted an annual profit since 2007.

• Name of the game: Offer high quality and/or innovative products. Provide high service while cutting costs from the distribution network. Nail down a supply of high-quality coffee beans by working closely with farmers in top coffee-growing countries.

2. Market

Coffee drinkers consume an estimated 2.25 billion cups of coffee a day globally. And the National Coffee Association says more than 150 million Americans drink coffee daily.

The International Coffee Organization says even Britons, long known as tea drinkers, are switching to coffee.

It says a recent study found adults in the U.K. spend an average of about $750 a year each for coffee, more than the average home annual electricity bill. It cited the spread of coffee chains.

Companies like Farmers Brothers, Green Mountain and Switzerland-based Nestle (NSRGY) grind and sell coffee. Coffee houses like Peet's and Starbucks sell it by the cup and by the bag.

Other food companies sell coffee in supermarkets under various brand names like Folgers (owned by J.M. Smucker (SJM) and Hills Bros., MJB and Chock Full O' Nuts, all owned by privately held Italian coffee heavyweight Massimo Zanetti.

3. Climate

Rising prices for commodities such as soybeans and corn have lured many farmers away from the coffee trade. Farmers that have stuck with growing coffee are barely producing enough beans to meet rising demand, Hackett says.

"The coffee industry has to invest in coffee producers, plant new trees, fertilize better to get production growth up in order to satisfy what had been a 2.2% annual growth rate for decades," Hackett said.

Green Mountain's McCreary says his company is doing just that.

"For Green Mountain roasters, we take 5% of pretax profit and put it back into the communities we work with. It could be for quality enhancements like an improved drying patio, allowing them to get higher prices for their coffee.

"It may be in the form of improved health care and improved education facilities. Those factors keep people in the community and interested in growing," he said.

Meanwhile, the industry is consolidating. For example, in order to nail down a consistent supply of high-quality coffee, Green Mountain in recent years has been buying up the companies that roast its beans.

It has most of them under its umbrella now, McCreary says, and the pace of acquisition will likely slow now.

4. Technology

The coffee industry has evolved in the last 20 years, going from tins of ground coffee sold in stores, and low-quality coffee made in pots and served in restaurants, to a widening array of choices.

Larry Blanford, Green Mountain's president and CEO, in a recent earnings call discussed plans to expand into new markets.

Green Mountain will leverage its Keurig single-cup, home coffee brewing systems. It's already created single-cup servings of cocoa and tea.

"Our beverage development group is also hard at work on new beverages that could provide functional and/or wellness benefits. We believe there is a meaningful opportunity for beverages beyond hot coffee and tea," Blanford said.

Green Mountain in mid-February inked a deal with Dunkin' Brands (DNKN), parent of Dunkin' Donuts. The coffee and doughnuts chain started trading publicly last month and it's rolling out Dunkin' branded Keurig K-cup systems in its stores.

And on March 10, Green Mountain and Starbucks signed a deal for the coffee house chain's coffee and Tazo teas to run in Keurig single-cup brewers. Starbucks branded K-Cup packs will hit store shelves this fall.

5. Outlook

Green Mountain, Coffee Holding and others in the group are seeing some effect from ongoing economic weakness, but are to a degree sheltered by the still growing trend among consumers.

Coffee drinkers may trade down from a 16-ounce "grande" to a 12-ounce "tall" cup, but rarely will they quit drinking coffee.

"Because of our quality and because people have developed a love of coffee, they don't make changes in consumption based on a few cents difference in price," Green Mountain's McCreary said.

Hackett says in the short run — the rest of this year and next year — given overall economic concerns and price instability, it's not going to be a good environment for coffee companies.

"They will see high costs continue and be forced to raise prices. Volume will slow and profit margins will slow until the market gets back in balance," he said. "There's no easy way out of this."

• Upside: The industry is resistant to economic swings. Even when consumers are pinching pennies, they still reach for their caffeine boost. Brazil's coffee trees are headed into the high side of their two-year supply cycle, which could bring supply and demand back in balance and help stabilize coffee prices.

• Risks: In addition to the near-term risk of a new global recession, there is the ongoing threat of farmers converting to higher-profit crops. Coffee sellers and processors must invest in farm communities to ensure an ample supply of the high-quality beans they need to stay in business.


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