Coffee displays all the characteristics one associates with a true commodity: it is liquid, price transparent and fungible. However, U.S. consumers have developed a more discerning palate when it comes to higher value, specialty foods, and in keeping with this trend, upscale coffee has proliferated. As specialty coffee becomes a larger part of overall U.S. consumption, what impact will it have on the broader coffee industry?
U.S. Coffee Drinkers Perk Up Global Consumption
According to the International Coffee Organization, coffee consumption worldwide increased 1.4% in 2014. While this growth rate may appear insignificant on its face, it must be viewed in the context of a leveling off of consumption growth in developing markets that had been growing robustly over the past decade: the law of large numbers at work.
Since 1990, the compound annual growth rate in global coffee consumption has been roughly 2%, largely driven by increasing purchasing power and changing tastes in emerging middle-class economies.1 Against a backdrop of globalization, economic liberalization and the unfettered movement of international capital over the past 25 years, emerging market economies in Latin America, North Africa, Eastern Europe and non-Japan Asia have witnessed a burgeoning middle class. As millions in developing nations have emerged from poverty, they have begun to demand the previously unavailable trappings of a middle class lifestyle. Coffee has been one of these creature comforts.
In 2007, coffee demand from traditional consumer markets (primarily Europe and the U.S.) was roughly 5.1 million tons, vs. about 4.3 million tons from nontraditional consumer markets. By contrast, in 2011, demand from traditional markets was roughly 5.3 million tons, compared with approximately 5.0 million tons from nontraditional markets (coffee-producing countries, tea-drinking regions and so forth).2
While the emerging markets helped to foster a global recovery in the years immediately following the Great Recession, their more recent middling economic performance amid collapsing commodity prices and a strong U.S. dollar has taken its toll on demand for discretionary consumer food products – and coffee has been no exception. For example, in Brazil, the third-largest coffee consumer behind the EU and U.S., consumption fell 1.5% in 2013, the first year-over-year decrease since 2003 and only the second since 1990.3
Perhaps an even more worrisome trend exists in the EU, no stranger to recent economic woes, where coffee consumption dropped 2.2% year over year in 2013 and was relatively flat in 2014.
The recent malaise in the world’s No. 1 and No. 3 consumers puts the 2014 global demand increase in sharp relief and suggests that the bump in consumption owes to the ever-important U.S. consumer. U.S. coffee consumption increased 3.25% year over year in 2013 and another 2.1% in 2014.4 According to the National Coffee Association’s (NCA’s) 2015 “National Coffee Drinking Trends” study, 59% of U.S. adults drink coffee daily, which makes it the country’s favorite beverage, beating soda by 20 percentage points.
U.S. Consumers’ Specialty Coffee Habit
Much of the U.S. coffee consumption increase owes to consumers’ growing appetite for specialty coffee. According to the Specialty Coffee Association of America (SCAA), one of every two cups of coffee consumed in the U.S. is considered specialty, and according to the NCA, specialty coffee consumption rose threefold between 2000 and 2015; 34% of adult coffee drinkers reported drinking specialty coffee daily, up from 24% in 2010.
Those tortured few who follow the coffee markets have for some time busied themselves fretting over whether the growth in single-serve, in-home coffee brewing would eventually put a crimp in U.S. coffee consumption. For many years, analysts have theorized that the largest consumer of coffee has been the kitchen sink, as most consumers once brewed a pot of coffee only to drink a few cups. Single-serve coffee products such as Nestlé’s Nespresso and Keurig Green Mountain’s pods, it was thought, would result in less waste and thus decreased demand. Consumption patterns, at least in the U.S., do not seem to lend credence to this concern. Indeed, the single-serve revolution seems to have begun to bring premium coffee from retail coffee shops into the home.
Even as premium coffee comes into the home, retail specialty coffee shops continue to grow. According to the SCAA, the number of U.S. specialty coffee retailers increased more than tenfold in 20 years, from 2,850 in 1993 to 29,300 in 2013. Of this total, 45% were chains or franchises, while 55% were independent, defined as having three or fewer locations. National chains and franchises such as Starbucks and Dunkin’ Donuts, both of which buy high-quality coffee, need a consistent flavor profile across all locations. These larger players cannot use small lots of specialty coffee that differ in availability or flavor between locations. Instead, the proliferation of small coffee shops and their impact on consumption trends continue to drive demand for specialty coffee.
Defining Specialty Coffee
Specialty coffee comes in many different varieties, is sourced from myriad origins and has a broad spectrum of flavor profiles. It is also referred to by different names – such as gourmet, premium, artisan or third wave – that complicate data collection and analysis. Though none of these appellations lend themselves to a concrete definition, specialty coffee generally focuses on higher-quality Arabica beans, lighter roasts, nuanced flavor profiles and greater attention to source and supply chain traceability.
Specialty coffee is a differentiated product, less commodity-like and typically costs more to produce. Differentiation and value derive from a variety of factors, including origin country, region, estate/farm, agricultural variety or certifications from nongovernmental organizations such as the Rainforest Alliance and Fair Trade International. Specialty coffee typically has one or more of the following characteristics:
- Grown using fair labor practices: Given the vagaries of the futures market and influences on the price that may or may not be driven by supply and demand fundamentals in the short run, farmers may not generate enough cash to pay their labor and maintain their crops. In theory, some of the premium price of specialty coffee is intended to eventually trickle down to the farmers.
- Sourced with a focus on crop sustainability: If commodity crop prices plummet – as they did in the so-called “coffee crisis” of the early 2000s, when the nearby contract on the New York futures exchange traded at below 50 cents per pound – many farmers will choose to switch crops or abandon their farms altogether. Given the premium value, specialty growers can be somewhat insulated from price fluctuations.
- Produced with a focus on quality: When farmers receive higher prices for their crops, they are more likely to invest in husbandry and processing best practices, which helps yield and quality of the final product.
- Shipped with a transparent and traceable supply chain: Commodity coffee is typically blended in large batches from multiple producers, farms, regions and origins. Specialty coffee consumers increasingly want to have a tie to a specific country, region, varietal or even farm.
M&A Activity Brews in the Specialty Coffee Industry
It is clear that there is growing demand for higher-quality coffee and supply chain traceability and that there is a still opaque, but starting to crystallize, sense of what constitutes “specialty.” But what has been the dollar impact on the U.S. aggregate retail coffee market? Over the past several decades, specialty coffee has grown from a niche market into a multibillion dollar industry. According to a study by The Fletcher School of Law and Diplomacy at Tufts University, specialty coffee industry sales grew from $8 billion to $18 billion between 2001 and 2012. The SCAA pegs the number somewhat higher. It estimates that the retail value of the U.S. coffee market is $46 billion and that while specialty coffee represents 51% of the volume, it accounts for 55% of the dollar value.
According to IBISWorld, profit margins and trading multiples in coffee roasting and retailing are on an upswing worldwide, but especially so in the U.S. because of the shift in consumer tastes to higher-quality, more expensive coffee. Publicly listed beverage and retail snack companies currently trade for 31.5 times earnings,5 and this trend has not been lost on larger, acquisitive players in the coffee industry.
Joh. A. Benckiser GmbH (JAB) has been on a buying spree. The company purchased California-based Peet’s Coffee & Tea and Minnesota-based Caribou Coffee in 2012, D.E. Master Blenders 1753, which had been spun off from Sara Lee Corp., in 2013, and Danish retail coffee shop chain Baresso Coffee in a deal announced in July 2015. Mondelēz International combined its coffee business with D.E. Master Blenders to form a joint venture called Jacobs Douwe Egberts, which is a pure-play coffee company with €5 billion in annual sales.
Deal value peaked in 2013 at $8.55 billion, driven by JAB’s acquisition of 85% of Master Blenders. While the market has come off its peak, it remains frothy. According to Dealogic, since the beginning of 2015, there have been 50 coffee or coffee-related mergers and acquisitions worth an aggregate $3 billion worldwide. Strategic buyers have represented 97% of the dollar value of the deals in 2015, with a clear eye toward adding scale to the higher margins associated with specialty coffee.
Specialty coffee roasters and retailers such as Stumptown Coffee Roasters, Intelligentsia Coffee, Blue Bottle Coffee, La Colombe Torrefaction and Toby’s Estate Coffee may serve as a clue to the next wave of consolidation in the coffee industry.
JAB-owned Peet’s reached an agreement to buy Stumptown in October 2015, though the purchase price has not yet been made public. Stumptown was founded in 1999 with a single location in Portland, Oregon, and grew to roughly a dozen retail locations in Portland, Seattle, New York and Los Angeles under its previous owner, private equity shop TSG Consumer Partners. More recently, Intelligentsia was sold to Peet’s. All of these trends reflect a shift away from commodity coffee toward a specialized consumer product where consumers are willing to pay a premium for differentiation – not unlike the wine market or craft beer. Is coffee in the process of being de-commoditized?
The Future of Coffee Futures
Most sales and purchases of Arabica coffee are made or hedged using the coffee futures (C) contract on the Intercontinental Exchange as a benchmark. While it’s too early to predict any eventual outcome, specialty coffee producers, importers and roasters/retailers are beginning to look for and find alternative price discovery and hedging tools to manage their businesses. Increased volatility in the benchmark and a divergence in price between commodity coffee and specialty coffee have combined to diminish the utility of the C contract as a pricing and risk management tool.
When asked what the stock market would do, J.P. Morgan famously quipped, “It will fluctuate.” Nowhere is this truism more apt than in commodity markets – and especially so in coffee of late. Over the past three years, coffee has been the second most volatile commodity on the Bloomberg Commodity Index behind natural gas.6 Volatility in the coffee futures market is driven by multiple factors, but two stand out: the weather in and financial condition of Brazil, which produces roughly 40% of the world’s coffee.
When concerns surfaced last year that a drought in Brazil would crimp supply, the C price displayed tremendous volatility. The near-month futures contract began 2014 at $1.11 per pound, peaked at $2.22 per pound in October and fell back to $1.67 per pound by year-end. The effect on the relative value of the U.S. dollar (USD) to the Brazilian real (BRL) is perhaps an even more stark and quantifiable comparison. The nearby chart displays the relationship between the nearby C contract and the USD/BRL exchange rate. Indeed, a regression of the C price against the value of one USD to BRL finds that over the past five years, the USD to BRL exchange rate displays a strong, positive correlation of nearly 65%.
Faced with volatility that is driven by exogenous factors, many specialty coffee industry players are further chagrined by a debate as to whether prices for premium coffees are diverging from and increasingly uncorrelated to prices for commercial grade coffees.
A recent Emory University study found a significant positive correlation between the futures price and the price of specialty coffee. The research compiled data from 361 contracts between 2010 and 2014 covering coffee from 15 countries and 32 cooperative growers associations and found that every $1.00 increase in the C price corresponded to a $1.09 rise in the specialty price. However, 87% of the sales contracts examined used the C price as a pricing benchmark, which makes the statistical logic seem circular.
Admittedly, as discussed, determining qualifiers for the designation “specialty” is far from an exact science, and data is difficult to obtain. Nevertheless, several data points and comparisons are illustrative and could lend credence to an apparent divergence in price. The SCAA began publishing the Specialty Coffee Retail Price Index last year, and this new benchmark increased 12.5% year over year in the second quarter of 2015, compared with a 24% drop in the most actively traded C contract for the comparable period.
When examining data collected from several different origins that focus on some combination of the attributes that designate a specialty coffee, there seems to be a clear divergence in price and lack of correlation. The following chart shows the weighted average free on board7 (FOB) sales price per pound of several different African specialty coffees. While there are only a few data points in this new index, a regression of the price of the specialty grade against the C price finds a correlation of 36%; a correlation of less than 50% essentially means that the prices move independently of one another.
An examination of the relationship between the C price and the premium to that price that several Latin American origins command finds an even weaker correlation. The following chart depicts the C price since 2007 and the weighted average premium differential to the C price from three Latin American specialty coffee varieties, both shown in cents per pound. A regression of the premium differentials against the C price finds a correlation of 1.4%.
Faced with a volatile and less relevant benchmark – and changing consumer demands and tastes – physical players in the specialty coffee market are seeking alternatives to the traditional pricing and hedging model. While this has not yet decreased the volume of contracts traded on the coffee futures exchange, it is not beyond the realm of possibility, nor is it unprecedented. Starting in the mid-1980s, U.S. consumers began to shift their orange juice consumption from frozen concentrated brands to premium freshly squeezed brands, a trend which continues to drive down participation in the frozen concentrated orange juice futures (FCOJ) market. We may be witnessing the beginning of a de-commoditization process in which coffee is shifting from a commodity product where price reigns supreme to a luxury consumer product where quality, brand and story matter first, with price a distant second.
As baby boomers’ consumption and purchasing power wanes and as millennials’ demand and disposable income grows, specialty coffee’s consumption will likely continue in both nominal and percentage terms, as the former’s tastes favor commercial grades while the latter’s run toward specialty. While it is premature to suggest that coffee prices per se will decouple from the futures price, it is clear that some of the higher value, specialty grades are increasingly less commodity-like, uncorrelated to the futures market and price inelastic. Though these grades remain a small percentage of the overall coffee market, their volumes are on a steeply upward sloping trend. If this continues, pricing and hedging will continue to vex the supply chain for some time to come.
For more recent BBH insights on the specialty coffee space, read the following articles:
- From the Ground Up: Building Brooklyn Roasting Company
- In Pursuit of the Sustainable Supply Chain: How Coffee Is Doing It
Brown Brothers Harriman is a leading U.S.-based bank to the coffee industry and finances a significant amount of the coffee imported into the U.S. annually. We have supported the green coffee trade for more than a century and will continue to monitor and adapt with our clients as it continues to change.
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1 Source: International Coffee Organization (ICO).
2 Source: ICO.
3 Source: ICO.
4 Source: ICO.
5 Source: Bloomberg and BBH analysis.
6 Source: Financial Times, August 2015.
7 Free on board (FOB) sales price: the price a buyer pays at the port of embarkation.