In case you missed it, Monday was ''National Coffee Day.'' Social media feeds were chock full of coffee pictures, Vine videos and hashtags to celebrate the nation's infatuation with a legal drug that often now sells at premium prices at Starbucks, Dunkin' Donuts, and Whole Foods.
I still don't understand the underperformance of Dunkin' Brands (DNKN), Starbucks (SBUX), and McDonald's (MCD) shares this year relative to the Dow Jones Industrial Average and S&P 500. In fact, these three stocks are down for the year. Isn't the coffee space historically a sexy place to park a few dollars as a result of the crazy number of new locations that open globally every day, as well as oodles of fresh products being designed to lure people back into the restaurants in the evening?
The answer is yes, but there are headwinds preventing the usually sure-bet coffee companies from expanding their stock multiples and value in the public market. Here is a yummy list to chew on this morning.
- Free coffee giveaway days. Dunkin' gave a coffee away for free yesterday, for example. The intense discounting to drive traffic, and hopefully loyalty, is eating into profit margins.
- Free coffee and other items are being given away as part of new rewards programs and mobile payment platforms. Starbucks and Dunkin have gone down this path, and it's coming right out of profits.
- New restaurants are opening up on top of older locations, notably Dunkin' Donuts. By doing this, it cannibalizes sales and causes permanent competitive pressures in the marketplace. Bye-bye pricing power.
- Investments in digital platforms are causing profit margin pressures.
- The companies themselves may be getting too damn big to manage effectively. For instance, Dunkin' has operating problems in Japan that hampered performance in the second quarter. Only recently had Starbucks turned things around in the U.K., by closing stores and moving to a franchise model.
- Investors simply expect too much, specifically that every customer walking into a Dunkin', Starbucks, or McDonald's will want a sandwich to go along with a $0.99 small coffee. It just doesn't work like that in real life.
I would ultimately approach the entire sector cautiously (I have not liked McDonald's this year at all), with the least apprehension reserved for Starbucks. The land of the green mermaid seems to be the share gainer in the sector, while Dunkin', McDonald's, and Tim Hortons (THI) battle for a lower-quality customer through discounting. Here are a few sector-specific factors to be on the lookout for, should you decide to invest:
- A good sign would be stable to accelerating same-store sales growth rates globally over the past three quarters as industry discounting has picked up.
- Conversely, same-store sales should not be coming at the expense of operating margin expansion. If a Starbucks reports a 7% increase in U.S. same-store sales in a given quarter, I would like to see the segment's operating margin expand nicely year over year. By nicely, I mean more than five basis points.
- Membership numbers for mobile payment and rewards platforms must be surging each quarter. No exceptions.
- There has to be a constant stream of product innovation guided to by management. Dunkin will unveil new steak options in the fall, while Starbucks continues to introduce new food items for evening consumption.