Leading analyst Jamie Rollo at Morgan Stanley said that he believed that there were a number of upcoming risks to Costa’s impressive pace of expansion in the UK, including Tesco, local opposition and Starbucks.
He said: “Last year, Tesco bought a stake (reported as 49%) in a small coffee chain called Harris + Hoole. Tesco’s CEO was recently quoted in The Guardian (5 February) as saying that Tesco will put them into some of its stores, and is currently trialing one in a London store. Costa has 130 equity stores in a Tesco, which is around 15% of its UK equity stores. Whitbread says that the stores are around half the normal size of its other equity stores, implying perhaps £5m profit might be at risk.
“In addition to Tesco, the segment is seeing new entrants in the form of Greggs (the largest UK branded caterer is rolling out its Moment coffee shop format), and Lavazza (targeting 400 stores over 10 years). There is also increased competition from non-specialists, for example Wetherspoon (which sells 25m cups of coffee) and McDonald’s (the UK’s largest breakfast provider), and from existing coffee shop operators (Starbucks plans 300 new outlets, Caffe Nero another 200).
“High quality ‘artisan’ independent coffee shops are growing strongly, and driving the mass market chains to increase focus on authentic interiors, barista technique and to introduce a wider range of crafted coffees.”
Costa is already seeing more local opposition to its opening in some small UK towns, for example Totnes, Burnham, Southwold, Bishops Waltham and Bingham.
“It took the unprecedented step of agreeing last year that the retail scene in Totnes would be damaged by its arrival,” said Rollo. “It has since taken a firmer stance in other towns, but the Totnes decision seems to have encouraged local opponents in other towns.
“This is a bit like the Wetherspoon situation a decade ago, where it was rolling out 100 pubs a year and being opposed by many small towns. Wetherspoon never reversed a decision, but did reduce its pace of roll-out significantly. McDonalds UK suffered similar image issues. Costa management is very focused on avoiding the image of a pervasive brand that does not care about the local community.”
“Starbucks not going away. The adverse publicity recently experienced by Starbucks over its UK tax affairs has probably benefitted its competitors. The UK is Starbucks’ second largest market by store numbers outside North America, and it is determined to make a profit here. Starbucks recently began a television advertising campaign to promote a cut-price latte deal on Mondays, concurrently with additional Rewards scheme benefits. It still plans to add 300 more outlets in the UK.”
The analyst said that Costa was already at a high density in some towns and that analysis showed that in London 75% of Costa shops are within 0.25 miles of either another Costa, a Starbucks or a Caffe Nero.
He said: “Outside of London, there is a 70% overlap within one mile. There are only 17 urban centres (definition as per the UK & Ireland census) with no Costa shops, although some of those cities are surprisingly large and have no Starbucks or Caffe Nero either. Across the UK as a whole, for 72% of Costa outlets there is another Costa, Starbucks or Caffe Nero within one mile.
“The UK has a higher density than the US. There are around 10,000 coffee shops in the UK (excluding non-specialist operators such as McDonald’s, source Allegra), which is around 6,200 people per outlet. The US has around 29,000 gourmet coffee/tea outlets (excluding bakery chains and non-specialist operators, source NPD CREST), which is around 10,800 people per outlet. On this definition, the UK has nearly twice the density of the US. If we widen the categories to include non-specialist operators, the UK has 15,700 outlets and the US 45,000, so the density drops to 4,000 for the UK and 7,000 for the US, meaning the UK still has greater density.”
Rollo said that he believes 2,000 outlets might be Costa’s natural limit.
He said: “Costa has more UK outlets than McDonalds, and nearly as many outlets as the second coffee retailer Starbucks. It is not far from UK leading branded catering retailer Greggs, and is bigger than Subway. There is a natural limit to any brand, and a couple of indicators suggest this might be around 2,000 for Costa. Starbucks USA, its densest market, has 11,100 stores, which is one outlet per 28,000 people. This compares to Costa UK at one outlet per 41,000 people. On Starbucks USA’s penetration, Costa UK could get to around 2,200 outlets.
“Another guide might be Subway’s UK target of 2,000 outlets, which is very close to Costa’s 2016 UK target of 1,900 stores. Our current forecast for Costa is 2,100 by 2017. In addition, the number of Costas is arguably already much larger than 1,500, given it has 2,000 machines and 4,000 wholesale outlets.”
The analyst also argues that the company could do more with its existing shops.
He said: “Costa is looking at ways to do more with existing stores, including selling more food, adding new products, looking at ways to innovate and expand its range. We think it could consider unit sales as a new target, rather than outlets alone.
“One way of avoiding the pervasive brand issue and increasing penetration in towns where it already has high density could be to create a second brand, perhaps under a softer, more local name. However, this could risk tacit admission that the Costa brand has reached critical mass, or even saturation, and that it might be cannibalized by the new brand.”
