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Why Starbucks' Pricing Challenges Are About to Get Worse

Justin Rohrlich March 23, 2010 2:10 PM|

       The coffee chain is offering cheaper cups, USA Today, and free pastries. But rising bean prices could cause its new initiatives to backfire.

Perhaps taking a cue from the Dollar Menus at McDonald's (MCD) and Burger King (BKC), the Super Value Menu at Wendy's (WEN), and a Happy “Hour” at DineEquity Inc.'s (DIN) Applebee's Neighborhood Grill & Bar that actually extends from 11:00 a.m. to 7:00 p.m., then kicks in again from 10:00 p.m. to closing time, Starbucks (SBUX) is making a rather obvious effort to lure back lost customers with a raft of new initiatives.

There’s the recently-introduced “Pike Place Brew” -- a cup of regular coffee for $1.50.

There’s the “guns allowed” policy, which means no sales lost to those packing heat.

Today, customers were treated to a free pastry with the purchase of any “handcrafted or brewed beverage” at participating stores.

And now, in a thinly veiled admission that not everyone across the United States of America reads the New York Times, Starbucks will be offering USA Today to its customers after 10 years of the Times, the Times, and nothing but the Times.

"Consumer news is part of the coffeehouse experience," said Chris Bruzzo, VP for brand content and online at Starbucks Coffee. "We're delighted to be able to provide our customers with more selection in how they choose to source their news content and customize their Starbucks experience."

It’s certainly nice of Starbucks to give patrons “more selection in how they choose to source their news content and customize their Starbucks experience,” and that customers won’t have to remove their weapons from their holsters while purchasing a now-reasonably-priced cup of coffee while thumbing through the Reader’s Digest of newspapers. But what effect will it have on the stock?

Analyst John Staszak of Argus Research tells Minyanville that he's “confident Starbucks can boost traffic” as a result of its new initiatives. He has a Buy rating on Starbucks, as he sees same-store sales improving and costs remaining low.

Greg Schroeder, founder and managing director of Wisco Research, has a slightly different take.

“Starbucks is introducing a lot of new initiatives, and while each one, individually, probably is not a huge driver of traffic, they’ve each done a pretty good job of adding incremental sources of revenue,” he says.

Schroeder recently downgraded Starbucks to Hold, which was a function of price, not fundamentals, as he thought the valuation was “a little extended” after realizing a “good gain” and suggested that investors start taking profits in the $24 to $25 range.

USA Today and sub-$2 cups of coffee aside, how will the world coffee market affect Starbucks’ fortunes moving forward?

Money manager Ryan Krueger of Houston’s Krueger & Catalano says “supplies are very tight” and warns that risk exists for the company in that regard.

Shawn Hackett, president of Hackett Financial Advisors, who has a particularly keen focus on the coffee trade, agrees.

“Starbucks uses primarily Arabica beans, and current supplies of Arabica are the tightest they’ve been in a while,” he explains. “Starbucks does benefit by buying six to nine months out, but at some point, they’ll be forced to pay higher prices.”

Hackett says that, while Arabica supply isn’t a problem today, it could become one come fall, winter, and spring 2011.

“That’s when we could see coffee prices really skyrocket, raising input prices for Starbucks -- and with a limited ability to raise retail prices, they’ll get squeezed and the stock might suffer,” he says.

Some say this year’s expected bumper crop in Brazil will be enough to offset lower yields in other parts of the world.

But due to Brazil’s “oscillating crop seasons,” there’s good reason to doubt that.

“Here’s how it works,” Hackett says. “One year, Brazil has a large coffee crop, the next year, they have a small one. The trees spend those 12 months resting until the following season, when they explode again. This year is supposed to be their 'on' year, with a 50 to 55 million bag harvest expected -- one of the biggest crops ever.”

However, there’s a twist in the equation. Hackett points out:

Brazil consumes 19 million bags of coffee domestically and they export 32 million bags. That means they need to produce 51 million bags to meet domestic and international demand, while also producing, hopefully, a few million extra bags to build reserves for next year’s crop, which, because of the oscillating seasons, will be small. This will give the market a few months of breathing room through the summer, but won’t change the tightness in supply expected to come into play at the end of the end of the year.


But now, there’s yet another twist to factor in.

Hackett is concerned about the above-average rainfall Brazil experienced this year, which he describes as a “question mark” going into harvest time.

“Excessive rainfall causes irregular flowering, which generally does not lead to a high-end crop,” he says. “When Brazil harvests its beans, we may see the crop yields come in at less than 50 million bags -- only no one will know until the beans are picked.”

If that happens, the supply squeeze will come sooner than Hackett predicts.

For which even off-the-charts sales of USA Today won’t be able to make up.

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