2 Speed Bumps Along Starbucks' Road to Growth

Starbucks is a fast-growing business with a wonderful future ahead of it. In all likelihood, it will be a much bigger and more profitable enterprise 10 years from now. However, there are a few stumbling blocks that could make its growth choppier than investors would prefer.

Supply shortages
Starbucks charges a premium to its customers because it sells premium coffee. To make premium coffee, Starbucks purchases high-quality arabica, which costs more than the commodity traded on the financial exchanges. Unfortunately, coffee farmers can produce only so much high-quality arabica before they can no longer grow enough to satisfy the caffeine cravings of morning commuters in industrialized nations. Therefore, the price of arabica must rise.

The first signs of trouble appeared in 2011, when coffee prices spiked due to fears of a supply shortage. Starbucks privately negotiates its purchases with farmers, but the price is based on the price of commodity coffee. Therefore, a spike in the price of the commodity had a large adverse effect on Starbucks' coffee price.

Source: Starbucks.

Unfortunately, such spikes in the price of coffee will be the norm in the years ahead because there are too many coffee drinkers and too few coffee growers. Slightly more than 11 million pounds of arabica coffee was produced in the 2011-2012 growing season. Starbucks alone purchased 545 million pounds of coffee in 2012 -- 5% of the world production of arabica. The supply of high-quality arabica is even lower, meaning Starbucks actually accounts for a higher percentage of total purchases of its principal input.

Moreover, the expected 2013-2014 arabica production is only 39% higher than it was in 1979-1980, whereas Starbucks purchased 27% more coffee in 2012 than in 2011. Clearly, coffee prices must rise.

Although a limited supply of high-quality arabica could hinder Starbucks' growth in the years ahead, it could end up serving as a competitive advantage. Starbucks is already the largest coffee chain in the world and therefore has access to a greater supply of coffee than any other company. If the supply of high-quality arabica were unlimited, nothing would prohibit others from providing the same high-quality coffee. However, since new entrants will have a hard time getting their hands on as much coffee as Starbucks, large-scale competition with Starbucks on quality will be a difficult task.

Panera Bread wants to be the Starbucks of food
As restaurants go, Starbucks has a wide moat. It has nearly 20,000 locations in 62 countries and worldwide brand recognition. However, the realities of the restaurant business still apply: Low barriers to entry and low switching costs require a constant devotion to courting customers.

Unfortunately for Starbucks, Panera Bread has proven adept at courting customers. Panera has become something like a Starbucks of food. Its bakery-cafes serve handcrafted fresh-baked artisan bread and all-natural ingredients in a cozy atmosphere. It prides itself on the "Panera experience," which features "Panera Quality" and "Panera Warmth" -- not unlike the high-quality beverages and inviting atmosphere that create the Starbucks experience.

It turns out that people want high-quality food in an inviting atmosphere as much as they want Starbucks coffee; Panera's revenue is six times higher than it was just 10 years ago. It now has 1,736 U.S. locations and is on track to open 34 more locations in the fourth quarter. What's more, Panera serves high-quality coffee to go with its food. The company even offers single-serve cups that customers can buy in-store and at select retailers.

Starbucks has countered Panera's advances in two main ways. First, Starbucks extended a distribution agreement with Green Mountain Coffee Roasters earlier this year in a move that signals a defeat for Starbucks' single-serve brewer, Verismo. The single-serve channel, which accounts for more than one-quarter of grocery sales of coffee, is a crucial brand extension for coffee companies. In addition to Starbucks, Green Mountain has distribution deals in place with Dunkin' Brands, J.M. Smucker, and ConAgra. Panera's entry into the market is just another indication of the low barriers to entry in the space.

Starbucks is also entering Panera's key competence: high-quality lunch food. In fact, food is becoming an increasingly important part of Starbucks' business. It recently purchased a San Francisco Bay area bakery, La Boulange, that will supply company-owned U.S. locations with baked goods, sandwiches, and similar items by mid-2014. Starbucks, it seems, is creating its own Panera Bread within its stores. As such, expect food sales to spike sharply higher in the years ahead.

Source: Starbucks.

Starbucks shall prevail
Starbucks' earnings will likely be much higher 10 years from today, but the progression will not be linear. Supply shortages and fierce competition are just two of the many obstacles that lie between 2013 and 2023. However, if Starbucks' moat remains intact, long-term shareholders will be rewarded for riding out the bumps in the interim.

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The article 2 Speed Bumps Along Starbucks' Road to Growth originally appeared on Fool.com.

Fool contributor Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters, Panera Bread, and Starbucks. The Motley Fool owns shares of Panera Bread and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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