Is it time to wake up to the coffee opportunity?

It is fuelled by one of the world's most popular drugs, it is highly addictive, and its rapid expansion offers a multi-billion investment opportunity. Coffee is big business.

Just how big? According to Nestlé (CH:NESN), which depends on Nescafe, the world's largest coffee brand, for over a quarter of its £83.3bn revenue, coffee is the most consumed drink globally – bar water. Yet, despite its immense popularity, the growing global middle class means there are still markets that are relatively underserved. That nut (or rather, bean) is one Nestlé, Starbucks (US:SBUX) and countless other companies are spending billions trying to crack.

Doing so will not be easy. Despite, or perhaps because of, its long existence, coffee remains a fragmented market, one that is somewhat resistant to the big listed equity brands even in the countries that already love a cup. Added to this are big and growing threats to production, including the climate crisis, farmer exploitation and an unstable global order.

It's therefore uncertain whether the growth of coffee will pay dividends for the listed companies throwing money at this hot commodity, or whether they might end up with a bitter taste in their mouths.

From seed to Starbucks 

Coffee is a global phenomenon comprising two related but distinct markets: at-home and takeaway. Nestlé is the biggest player in the former and Starbucks in the latter, but several other listed companies are also heavily involved. No single company has a monopoly over either market, suggesting there is still room for innovation and consolidation.

This process of expansion and contraction has already been playing out for centuries. Various sources attribute the discovery of coffee not to a place or culture but to one man: a 9th century Ethiopian goat herder named Kaldi. It was not until almost a millennium later that the first coffee shop opened in London in 1652 at the still-operating Jamaica Wine House, just down the road from the Bank of England.

UK growth potential

As coffee surged in popularity in much of the Western world, Britons stuck rigidly to their tea-drinking habits at first. 

Then came instant coffee such as Nestlé's Nescafe, a staple of many UK homes for decades. From the early 1990s, Starbucks and the influence of US culture convinced Britons that takeaway coffee from specific regions was worth spending extra money on. The industry calls this trend, seen in many countries across the world, the 'third wave' of coffee, and one of the men who has ridden it is James Hoffmann, the founder of coffee chains including Square Mile Coffee Roasters.

“This movement of speciality originated in the US and blossomed there first as an approach to sourcing and selling. From a financial perspective, it aimed to decommodify coffee into a speciality product,” says Hoffmann.

“Speciality coffee wants to tell you exactly where your coffee comes from. It’s the wine model. For a long time, people were buying coffee as if they were buying a bottle of wine that just said ‘France’ on the front.”

The first UK Starbucks opened in 1995, and the growth of speciality coffee since has been breakneck. In just three decades, the UK has gone from barely understanding coffee to, in Hoffmann’s words, “probably having enough” coffee shops.

On the one hand, this presents a problem for Starbucks, Greggs (GRG), and their peers, whose offering at least partly depends on selling more coffee to more people. On the other hand, there remains an opportunity for the chains owing to the fragmentation of the UK coffeeshop market. 

In other words, while quality takeaway coffee is easy to find in many places, reliable chains are not. This is a problem that Clive Black, director at analyst Shore Capital, says Greggs has tapped into better than Starbucks. Despite Starbucks having a first-mover advantage in the UK coffee market, he says it has not been as aggressive as Greggs with its expansion.

Where Starbucks likes to take large spaces where customers can sit, plug in laptops, and enjoy talking for hours in exchange for a higher-priced cup of coffee, Greggs is in what Black describes as the "coffee and bacon roll" market. It muscles into as many train stations, airports and transport hubs as possible with small units. It then sells cheap "100 per cent Fairtrade" coffee alongside its cheap breakfasts.

Over the past two decades, Greggs has opened up more UK shops than Starbucks and extended its lead, but Starbucks has been no slouch. While its transition from outright ownership to franchising slowed growth to a near halt between 2017 and 2020, it has picked up since then.

According to analysts Edison, Greggs is number three in the UK take-out coffee market behind Costa Coffee and McDonald's (US:MCD), whose success has been attaching coffee to its already large UK presence. Meanwhile, Black says Costa, once owned by Whitbread (WTB) but now controlled by Coca-Cola (US:KO), has “knowledge of property” on its side. Indeed, the world over, success in takeaway coffee is as much about growing a real estate portfolio as it is about beans.

SSP Group (SSPG) is another UK company attempting to tap into a similar market to Greggs, offering reliable coffee chains at transport hubs. While no one brand under SSP is as big as Greggs, the business has roared back to life post-Covid, with revenue surging over a third last year. Bakery and coffee are a big part of that, accounting for 25 per cent of the £3bn figure.

The coffee on-the-go trend has benefited from commuting habits, with office workers grabbing coffee en route to work, but Black argues that Greggs' continued growth shows there is more to it than that. Whether the future means more working from home or a continued return to the office, Greggs, SSP and others will continue to benefit from the population's growing desire for convenience and a wish to seek out known coffee brands for their takeaway fix, especially in transport locations.

Coffee is also expanding into other realms of British life. As younger people drink less alcohol, the humble pub is reinventing itself to appeal to their less boozy tastes. More low and non-alcoholic beers and spirits alongside more food options are part of the equation, but so is coffee. Pub chain JD Wetherspoon (JDW) told the IC that around 2.5 per cent of its revenue comes from coffee and said that this £50mn figure is growing both in absolute terms and as a proportion of sales.

One company looking to benefit from the desire for reliable high-street coffee chains and the rise of less alcoholic pub environments is Loungers (LGRS). The Aim-traded stock, which depends on coffee sales for 10 per cent of its revenue, has had a difficult few years since listing amid a pandemic-induced ravaging of the casual dining market. However, chief executive Nick Collins is bullish about the future and insists the company is onto something larger with its 'lounge' concept. The company markets itself as a coffee shop, restaurant and bar/pub all in one, having been inspired by coffee shop culture in places such as Australia.

The overseas experience

While Greggs, Loungers and Starbucks might be in growth mode in the UK, North America is a more mature market. However, as with the UK, there remains the possibility for consolidation and taking market share from smaller players. Starbucks is one of the best-placed companies to do that, growing its North American portfolio of shops by 3 per cent in 2023. The pace of growth is much slower than the 9.5 per cent annual increase seen in the UK, but the company is still chugging along as befits its consumer-staple status.

Some listed businesses are trying to offer something new in North America. Dutch Bros (US:BROS) is a small but growing US coffee brand targeting the 'drive-thru' coffee market. The McDonald's drive-through takeaway coffee chain CosMc's launched late last year.

However, the coffee giants know the biggest expansion prospects lie in the less mature markets. Progress has been challenging. China and India, which account for over a third of the global population, have historically been tea-drinking nations. There is potential in both countries, but geopolitical tensions have made expansion in China an even tougher prospect than it once was. Chinese consumers have historically boycotted US brands, including Starbucks. Copycats have also previously sold knock-off coffee en-masse using Starbucks' mermaid branding. However, some of those issues now look like a thing of the past. As of its latest results, China was Starbucks' fastest-growing market, with its portfolio expanding 13 per cent annually.

The company first tapped the Chinese market via a joint venture, and uses this structure in India, too, in keeping with foreign direct investment rules at the time of its arrival there: it has been in a 50:50 joint venture with local giant Tata since 2012. Its success is hard to judge as Starbucks does not break out its Tata Starbucks earnings separately, although the fact that Tata has other coffee brands in the country arguably makes expansion more complicated. 

Starbucks has ambitious plans for China in the years ahead: it plans to increase its store count to 9,000 by 2025, up from 6,800 at the end of last year. Demand from the world's largest country is also on the rise: Citigroup analysts say China's coffee import figures in January and February this year were a "real surprise", three times as high as in 2023 and potentially indicating that "the country may be on the cusp of a coffee culture boom".

Yet perhaps the biggest obstacle for takeaway coffee businesses is not expansion in the countries that do not already love coffee, but their ability to gain ground in countries that do. Analysts say that much of Latin America and Europe have historically resisted large takeaway coffee chains precisely because they already have their own fully developed coffee culture. 

Indeed, it was not until last year that Starbucks finally opened a cafe in Rome, where good coffee on the move is already ubiquitous and cheap. When Starbucks opened its first Italian store in Milan five years earlier, protesters set fire to the palm trees it had planted in the nearby piazza. The company now has several outlets in and around Rome, well over a dozen in and around Milan, but none in another major metropole, Naples, with the nearest being a shop outside the small city of Caiazzo.

In the at-home market, coffee is more fragmented than meets the eye. Nestlé's Nescafe conquered the world of instant coffee, but the single-serve coffee market is more competitive, where Nestlé's Nespresso offering competes with Keurig Dr Pepper's (US:KDP) Keurig machines. Both companies make billions from the machines themselves as well as the coffee to go with them. Other major players include Smuckers' (US: SJM), which owns US at-home favourite Folgers and sells the at-home version of Dunkin Donuts coffee, and JDE Peets (NL:JDEP), which owns Douwe Egberts and several other coffee brands. Israeli brand Strauss (IL:STRS) also has a chunky market share (see chart).

The back-and-forth competition between these players underlines that, while coffee is a product that benefits from economies of scale, it still has not been consolidated by a singular company. The big six at-home companies account for less than half of the global market share, and Nestlé, the largest, accounts for under a quarter. Compare that with JPMorgan's analysis of the beer market in 2016, where the biggest six brands controlled 58 per cent of the market, and AB InBev, the biggest, controlled 27.3 per cent. 

Further consolidation is possible, but so is further disruption from young up-and-comers. Coffee may be over 1,000 years old, but from a global perspective, it is just getting started.

Supply chain pain

Before coffee can conquer the rest of the world, it must reckon with some of the seedier parts of its history. The global middle classes love to drink it, but it is produced by the global poor. As European nations expanded their empires from the 16th century onwards, coffee became a way of extracting wealth from colonies, with devastating impacts.

Despite centuries of pledges and progress, a fundamental power imbalance still exists.

A significant number of the coffee giants have been accused of using unfair labour practices or worse in their supply chains in recent years. As recently as January, Starbucks came under particular scrutiny because of alleged labour rights violations despite its "100 per cent ethical" supply chain claims, raising questions about how consumers and investors should treat large coffee companies' assurances about their production lines.

The company said it "continues to aggressively defend against claims that Starbucks has misrepresented our ethical sourcing commitments to customers". It added: "We take allegations like these extremely seriously and are actively engaged with farms to ensure they adhere to our standards. Starbucks remains committed to working with our business partners to meet the expectations detailed in our global human rights statement."

Then there is the climate crisis. Warmer and more erratic weather will make growing coffee harder, placing additional pressure on farmers and farming. This story is playing out already – coffee prices have risen sharply since the start of the year owing to drought in major production regions such as south-east Asia. Analysts suggest demand has also risen because coffee roasters have been building reserves ahead of a new EU law, due to come into force at the end of 2024, that will ban coffee beans grown on deforested land. 

The changing climate also means some kinds of coffee will become harder to produce. The robusta bean, typically considered less tasty than the higher-end arabica, may grow in popularity because it is easier to harvest. As production becomes more challenging, companies will need to negotiate more carefully, and perhaps more fairly, with producers – all while selling the product at an appropriate price. They may also need to market new kinds of coffee beans to consumers as arabica becomes hard to source.

Squaring that circle may sound challenging, but many analysts and experts are relatively relaxed about what this will mean for coffee companies' bottom lines. If coffee production becomes more complicated and expensive, all will need to raise their prices. Faced with the choice between not drinking the addictive substance they love and paying more, the analyst consensus is that almost all consumers will pay more. Even if production becomes more challenging, coffee companies might not need to raise prices by much, either. The costs involved in selling coffee mostly comprise shipping, packaging, marketing and selling to the end user rather than the raw material cost. 

In theory, then, the simple way to produce sustainable, ethically sourced coffee is to raise prices. Deciding how fair coffee should be is increasingly a decision made by the consumer. Fairtrade coffee and coffee claiming to be even 'fairer' still trade alongside the cheaper options where the pay for farmers may be more exploitative. If customers are willing to pay more, coffee companies can raise standards without hurting their margins.

The reality is unlikely to be that simple. Even a compelling long-term trend cannot exist free from near-term economic concerns, and there are signs that mature and even some developing markets are in the middle of a slowdown. Recent figures from both Keuring Dr Pepper and Nestlé suggest an under-pressure consumer. At KDP, the category leader in the US, US coffee organic growth of -10 per cent in the fourth quarter of 2023 was twice as bad as had been forecast by analysts, though in the first quarter of 2024 revenue growth improved to -2 per cent. At Nestlé, real internal growth for its Nespresso segment (no longer as 'premium' as it once was) was negative in the first quarter – again missing expectations – with Europe a particular weak spot. Starbucks, meanwhile, saw same-store sales globally fall 4 per cent in the quarter to March, with China sales down by 11 per cent.

Yet even with its production issues, a climate crisis, and near-term pressures in mature markets, coffee's investment case remains solid. Structural demand is still growing, and the barriers to entry showcase the benefits of scale. If there are some reasons to be bearish on the giant coffee businesses in this high-growth market, that only presents an opportunity for other players. Plenty of investment perks are still percolating for those picking the right shares.