Coffee competitors vie to be cream of the crop

Benj Gallander and Ben Stadelmann
Friday, November 25, 2011

Soul, jazz and blues singer Lou Rawls achieved notoriety for his distinctly rich and bold vocal sound. On his first solo album, he included the old blues standard “I’d Rather Drink Muddy Water,” which refers to roiling emotions that go hand in hand with possible infidelities.

Picking up on a lighter theme, one can’t help thinking that the title is more of a call used by today’s coffee aficionado. As in, “How about a Black Eye?” followed by the response, “Are you serious? I’d rather drink muddy water.” Touchy, touchy. Be that is it may, coffee choices are spread across a spectrum of wants and needs that define the person and their preferred beverage.

The aim of the players in this sector is to profit from that passion. With the colder weather upon us, two notables have been kicking it up a notch. Tim Hortons (what percentage of their clients remember that he was a great hockey player anymore?) and McDonald’s are heavily promoting their specialty espresso coffee offerings.

At Tim’s, it’s via the use of the Nestlé Milano automated machine with its pretty glowing buttons. Perfect for the season. Tim’s is the top seller of so-called “on-the-go coffee” in Canada, with McD’s as second banana. So the bet is that their own customers will buy something pricier than they wouldn’t ordinarily try, and that those who frequent cafés will compromise for a lower price.

There are questions as to what exactly consumers are willing to give up. A café should offer, in a nutshell: ambience, a superior roasting process, and barista service technique for that premium price. Though we can see an initial boost to sales, it is more difficult to discern how much mileage this strategy can generate over the longer term.

There are a few publicly traded offerings in this industry if your portfolio is so inclined. Starbucks is, of course, the incumbent, and it has had a great rebound since late 2008. After a redesign of their logo, which eliminated the word “coffee,” they’ve just announced they will start a chain of juice bars. It seems they’ve outgrown the muggies.

At the other end of the spectrum is a newbie on the Venture exchange called SPoT Coffee. It’s a tiny company with frothy dreams and amaretto wishes. Recent results showed the consolidated net loss is getting smaller. They’re currently only operating seven stores, with third-quarter system-wide sales of $1.67 million.

To grow the number of stores and create a brand, future rounds of financing may be needed, as it is doubtful that operations will provide a sufficient boost. Their strategy is to be friendlier and create a “sense of gathering and of community.”

The irony is that they seem to be adopting the original idea behind Canada’s first large chain of café-style retail stores, Second Cup. At Contra the Heard, we look for potential turnaround stories, and this is the one that comes closest to qualifying. It’s been almost a year since Second Cup converted back to a corporation from an income trust and the CEO instituted a five-year blueprint for change. Apart from tweaks to store design, advertising, tea offerings and coffee certifications, the main part of the plan is to bulk up the number of stores.

Same-store sales are no longer dropping but flat. The stock pays a dividend with a yield of almost 10 percent, which typically signals the market’s lack of confidence in its sustainability. Some who continue to support Second Cup lament the fact the company has no plans to reinstate its once very popular and unique loyalty card.

Though the business of retailing coffee in Canada is quite mature, it hasn’t stopped anyone from entering the market or treading on toes. The fight for market share never seems to stop brewing. The players keep battling to try and outsmart each other by using the creative techniques of marketing, store design and product offerings to develop and maintain their brand.

At this point, it’s hard to see much opportunity for an investor in this space. We’re actually more partial to home-brewing, anyway, with the ambience inspired by the background music of Lou and his blues.