These companies are pouring billions into piping hot coffee market

Demand for the morning pick-me-up is on the rise and beverage companies are gearing up to exploit the trend.

Vikram Barhat 3 October, 2018 | 5:00PM

As winter approaches, things are heating up in the hot beverages industry. It's getting particularly frothy in the coffee market where rivalries are brewing and capital is pouring in.

Sensing a colossal opportunity, leading brands are aggressively sinking billions in acquisitions and tie ups in a bid to corner the piping hot market for the world's fastest-growing drink categories.

Soda maker Coca-Cola recently stormed into the fiercely competitive coffee market with the purchase of British coffee chain Costa Coffee for a whopping US$5.1 billion, its biggest acquisition ever. The deal comes close on the heels of Swiss food giant Nestlé upping its coffee stakes by infusing US$7 billion in a deal with Starbucks for the rights to sell the U.S. coffee chain's products globally.

While health conscious consumers around the world are distancing themselves from sugary sodas, coffee continues to enjoy a favourable treatment as a comfort beverage. Millions of habitual drinkers around the world consume coffee to jumpstart their morning, for a postprandial java jolt, or as a casual social activity. Globally, and particularly in the United States, the demand for the morning pick-me-up is on the rise and beverage companies are gearing up to exploit the trend.

The following players are upping the stakes in the coffee market, have a growing line-up of products tied to the brew, and have the resources to expand, innovate, compete and remain profitable.

Starbucks Corp.
Ticker: SBUX
Current yield: 2.22%
Forward P/E: 21.7
Price: US$55.70
Fair value: US$64
Value: 14.9% discount
Data as of Oct. 1, 2018

Java juggernaut  Starbucks (SBUX) sells coffee, espresso, teas, cold blended beverages, food and accessories from 28,700 stores around the world. The company also sells packaged and single-serve coffee, tea, juice and pastries through its own stores and grocery chains.

Despite tepid U.S. sales and growing competition in China, Starbucks remains "a compelling consumer growth story, poised for top-line growth and margin expansion through menu innovations, and sustainable cost advantages," says a Morningstar equity report.

Starbucks is much more than a U.S. retail story. "It's just starting to scratch the surface of its long-term channel and geographic growth potential," says Morningstar sector strategist, R.J. Hottovy, adding that "many of Starbucks' competitive advantages also apply to international markets, which we view as a critical growth engine over the next several decades."

The coffee retailer recently announced plans to dramatically grow its presence in mainland China with the goal of building 600 new stores annually over the next five years, doubling the store count to 6,000 by 2022. Another key Asian market, India, is also ripe for expansion with a potential for 1,000 stores over the next decade. "With a widely recognized brand, Starbucks is among the few retail concepts to be successfully replicated across the globe," says Hottovy, who appraises the stock to be worth US$64, prompted by promising long-term growth and margin expansion story. "The firm will eventually exceed its domestic store count overseas."

The coffee giant's sustainable competitive advantage, or wide moat, stems from brand intangible asset that commands premium pricing and meaningful scale advantages, he adds.

McDonald's Corp.
Ticker: MCD
Current yield: 2.41%
Forward P/E: 20.4
Price: US$167.54
Fair value: US$190
Value: 13.4% discount
Data as of Oct. 1, 2018

Burger behemoth  McDonald's (MCD) generates revenue through company-owned restaurants, franchise royalties and licensing pacts. Restaurants serve value-priced menu through more than 37,400 locations in 120 countries. McDonald's is among the few restaurant chains to enjoy success globally.

The coffee-driven breakfast menu accounts for about a quarter of the chain's sales and is its most profitable daypart. The company is making an aggressive thrust into the coffee market by revamping its US$4 billion McCafé brand. The company has been rolling out compact-sized McCafés in high-density urban locations to increase its footprint and consolidate its reputation as a leading coffee brand in a bid to take on morning heavyweights such as Starbucks and Dunkin' in the U.S., Tim Hortons in Canada and regional rivals in other geographies.

CEO Steve Easterbrook's major turnaround efforts, which include the elimination of an assortment of expenses worth US$500 million, have started to bear fruit. "Early results of the initiatives have been promising, with a return to positive global comparables in 2016 and 2017," says a Morningstar report. "Additionally, the rapid rollout of all-day breakfast in the United States and other markets implies McDonald's is overcoming its supply chain and execution issues, and it portends a more seamless rollout for new products and technologies."

Menu innovation has historically played an important role in enhancing wide-moat McDonald's competitive advantage. As the company tries to rebuild and retain its customer base, it has intensified its focus on coffee and snacking through a $1 beverage menu and stand-alone McCafe kiosks, says Hottovy, whose US$190 fair value for the stock implies a price-to-2019-earnings of 23 times and 3% to 4% free cash flow yield.

Coca-Cola Co.
Ticker: KO
Current yield: 3.33%
Forward P/E: 20.7
Price: US$46.20
Fair value: US$49
Value: 6.1% discount
Data as of Oct. 1, 2018

The largest non-alcoholic beverage company in the world,  Coca-Cola (KO) generates more than US$30 billion in annual revenue from carbonated and noncarbonated drinks including Coca-Cola, Diet Coke, Fanta, Sprite, Minute Maid, Powerade and Dasani. With trademark Coca-Cola contributing 45% of unit case volumes worldwide, Coca-Cola generates the majority of its revenue outside of the United States.

Coke recently took a deep dive into coffee with the US$5.1 billion buyout of UK coffee giant Costa Coffee, which will "bolster Coca-Cola's presence in the fast-growing coffee category, particularly in the UK, where Costa holds more than one third share of coffee houses," says a Morningstar equity report. Coca-Cola already produces, distributes and markets iced coffee beverages for Dunkin' and McDonald's.

The Costa acquisition should further sweeten its coffee portfolio and up its coffee play. "We find merit in the strategy underlying the deal, given the robust growth prospects in the global coffee and tea space," says Morningstar equity analyst Sonia Vora, noting that Coca-Cola currently controls a 15% share of the ready-to-drink tea and coffee category (which represents around 15% of the overall coffee and tea market), and that coffee and tea account for around 7% of the firm's retail value mix.

Coca-Cola's wide moat, or sustainable competitive advantage, flows from its brand intangible assets and cost advantages created by its strong relationships with retailers and economies of scale. "Coca-Cola's unparalleled brand strength and global distribution network have allowed it to generate excess returns on invested capital despite a decade of volume declines in the carbonated soft drink market," says Vora, who puts the stock's value at US$49, noting the company will continue to dominate the global non-alcoholic beverage market.

Dunkin' Brands Group Inc.
Ticker: DNKN
Current yield: 1.85%
Forward P/E: 24.4
Price: US$72.85
Fair value: US$68
Value: 6.7% premium
Data as of Oct. 1, 2018

Coffee chain  Dunkin' Brands (DNKN) sells hot and cold coffee, baked goods and ice cream through Dunkin' Donuts (82% of revenue) and Baskin-Robbins (18%). The company rang up an impressive US$11.2 billion in system-wide sales in 2017 and is the second-largest global beverage and snack chain behind Starbucks.

The firm, which rebranded itself recently by dropping the "Donuts" from its name, announced a US$100-million investment plan to make it easier for consumers to grab a coffee on the go. The firm is pursuing a beverage-led growth strategy with a focus on speed and convenience that has seen revenue jump nearly 5% in the second quarter this year.

"Dunkin' offers investors an intriguing long-term cash flow growth story backed by a strong brand intangible asset and franchisee system," says a Morningstar equity report. "Dunkin' can extend its brand reach beyond core markets, supported by solid franchise location returns, and more technological-leveraged and drive-thru focused restaurant formats."

Although the coffee market will become more competitive as leading players expand, Dunkin' has many growth catalysts to keep its U.S. comps growing. They include "a solid beverage and breakfast sandwich pipeline, a streamlined menu, targeted value offerings, new store formats and digital marketing," says Hottovy, who recently raised the stock's fair value from US$64 to US$68, implying a 2019 price-to-adjusted-earnings multiple of 22 times and around 4% free cash flow yield.

Hottovy projects steady margin expansion and improved return on invested capital, and asserts the coffee heavyweight still remains a compelling shareholder-return investment story given its US$650-million share repurchase plan. "Dunkin's strong cash flow generation and lack of near-term debt maturities should lead to dividend increases and share repurchases, boosting shareholder returns," he adds.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Coca-Cola Co53.49 USD-0.04
Dunkin' Brands Group Inc76.77 USD-0.17
McDonald's Corp208.30 USD0.52
Starbucks Corp86.71 USD0.30

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.