Friday, October 5, 2007

Portfolio Caffeine

The effects of caffeine on the central nervous system were first discovered in the 6th century in the Ethiopian highlands by a sheepherder called Kaldi. After his sheep ate red berries from a coffee tree, they seemed a bit jumpy and had difficulty sleeping.

The berries next made their way to a local monastery where the Abbott made a drink by mixing the beans with water into a concoction that kept him alert through the long hours of evening prayer.

Coffee most likely made its way to Asia in the latter half of the 17th century when a Dutch trader brought a seedling from Yemen to Java where the soil proved hospitable leading to a thriving and profitable industry to this day. Vietnam is now the worlds second largest coffee producer while India and Indonesia are in the top ten.

Despite substantial coffee production in Asia, much of the growth in the popularity of coffee in this predominantly tea drinking region can be attributed to instant coffee and the marketing efforts of Nestle. It rolled out the first commercially viable instant coffee in 1938 and it spread to Asia becoming a prestigious alternative to tea.

As incomes rose in Japan, coffee consumption grew as well making it the third largest consumer in the world. This is a trend that could continue in countries with rising disposable incomes such as China.

Coffee is now big business and as a world commodity is second to only oil. This size and growth potential for a habit forming product like coffee sure sounds like an investment opportunity to me. But how should you play the rise of coffee in Asia.

Since it takes about 4-5 years for a coffee tree to bear cherries, investing on the production side is not for the faint of heart due to hard to predict coffee price fluctuations. As one of the largest coffee plantation companies in Asia, Tata Coffee Ltd. of India, is worth a good look especially since it is an integrated coffee company with roasting, exporting and retail operations.

Nestle is also a possibility since it is the leader in instant coffee in China and many parts of Asia. A drawback is that the coffee business represents only roughly 10% of the sales of this diversified food powerhouse.

The most attractive option is to invest in the retail coffee market which is highly fragmented. Starbucks (SBUX) is the global leader with 10,500 retail outlets of which 3,500 are outside North America. Starbucks began in Asia with its first store in Japan in 1996 and now has 165 stores in mainland China, 221 in Hong Kong, Taiwan and Macau, 595 in Japan, 64 in Australia and 34 in Singapore.

Starbucks is a classic growth story. It added over 1,000 stores last year and plans 1,800 more in the fiscal year ending September 2006. 35 million people visit a Starbucks store each week and it has operations in 37 countries.

Its global goal is to reach 30,000 outlets with half of them located overseas. China could perhaps become its second largest market after America.

The core of Starbucks is its premium branded coffee but it offers much more. It has become a second gathering place outside of work and home. Starbucks Entertainment produces CDs and is considering providing music download facilities in its stores.

I am one of the millions around the globe that use Starbucks as a second office. During my last visit, I got behind a gentleman who added several pricey pastries, and a CD to his coffee for a whopping bill of $27.

One caveat for investors is that sales growth expectations are high and any significant disappointment would likely hit the stock rather hard. Another is that its China expansion may run into some difficulties though I have been impressed with its incremental strategy since its first store in Beijing opened in 1999.

With its financial strength, knowledge of markets and attention to detail, Starbucks seems to have the recipe for success in the fragmented retail coffee business. Since it is opening 4-5 stores a week, competitors will need to scale up rather quickly to pose a threat to its growth. Copycats are a problem though. Starbucks recently gained a key judicial victory when it won a court case against a Chinese company that infringed on its copyright.

Meanwhile, back in Ethiopia, another Starbucks knock-off called Kaldis does a brisk business. While Starbucks is not amused, it cannot help but be flattered by the imitation in the very birthplace of coffee.

Carl Delfeld is head of the global advisory firm Chartwell Partners and editor of the the "Chartwell Advisor" newsletter. He served on the executive board of the Asian Development Bank and is the author of "The New Global Investor." For more information go to or call 877-221-1496.