Leading analyst Jamie Rollo at Morgan Stanley takes an in-depth look at Costa and argues that competition for the chain in the UK is intensifying, there are questions over its overseas strategy, adding a second brand, that a demerger from parent company Whitbread is looking more unlikely and that it could face a renewed challenge by Starbucks.
Rollo said: “Costa is growing outlets at 15% and profits by 20-30% annually, and will likely stretch its F2016 target of 3,500 outlets to at least 4,000 by FY2018. Although we continue to think a demerger makes sense given the lack of synergy with hotels, we no longer see a conglomerate discount within Whitbread to support a separation (we estimate its share price values Costa at 26x FY13 P/E), and the timing is not ideal for two reasons; tougher competition and its international strategy may need to change.”
Under increasing competition, Rollo highlights the fact that Tesco recently bought a stake in coffee chain Harris & Hoole, and is likely to expand it into its stores, yet 15% of Costa’s equity stores are in a Tesco.
He said: “The market is seeing other new entrants (Greggs, Lavazza), expansion into breakfast by non-specialists such as pubs, and increasing growth of ‘artisan’ shops. Costa is seeing more local opposition to its opening in some small towns, and may suffer from the ‘McDonald's effect’.
“Costa has likely gained from Starbucks UK’s adverse publicity, but Starbucks is fighting back. Costa is ubiquitous in the UK: its 1,500 UK outlets make it bigger than McDonalds and nearly as large as branded catering outlet leader Greggs, but this rises to nearly 8,000 including wholesale outlets and machines. Starbucks’ US density suggests 2,000 outlets might be Costa’s natural UK limit.
“The UK already has nearly twice the density than the US of coffee shops, and our proprietary research shows that for 70% of Costa outlets there is another Costa, Starbucks or Caffe Nero within one mile.
“Costa today reminds us a bit of Starbucks 10 years ago, when its success in the US was so tremendous it neglected its overseas expansion, and with hindsight grew too quickly in the US. Starbucks today trades on a premium multiple, but it troughed at just 10x P/E post the downturn.”
He said that Costa’s success in the UK makes its international strategy look somewhat weak: "Most overseas markets are franchised so barely register in profits, and expansion targets for the China JVs suggest a maximum of £10-20m EBIT in 5-10 years, so worth perhaps 100-200p per share. Costa will continue to derive 90% of EBIT from the UK as this is where its highly profitable equity stores are.
“So we think the overseas strategy may need to change, and we think Costa could consider putting more equity and investment into developed markets such as France (where it has a trial store). This may mean the international strategy becomes higher risk, with start-up losses.”
Costa currently operates c.1,500 outlets, 35% of the UK’s branded coffee shops and nearly twice as many as its nearest competitor Starbucks. Costa both operates outlets and franchises them, and EBIT per outlet in the UK is £75k for an equity outlet and £25k for a franchise.
It also has c.2,000 Costa-branded vending machines, and another c.4,000 wholesale outlets. Costa also operates overseas, mainly via franchise, and it has two joint ventures with 250 outlets in China, which currently break even. EBIT per outlet for an international franchise is c.£15k and for the China JV £30k. It has a target to get to 1,900 outlets in the UK and 3,500 in total (including 500 in China) by FY2016.
Market leader and taking share
Costa is the largest and yet also the fastest-growing coffee shop chain in the UK. Rollo said: “Costa's UK outlets (equity and franchise) have been growing at an annual rate of 17% – much faster than the overall market at 9.6%, branded coffee shops at 8.4% and independents at +1.9%.
“Despite the fast growth of non-specialty coffee shops (e.g. Pret A Manger, Eat, McDonald’s, etc.) which are also included in the overall count of 15.7k UK coffee shops, Costa has increased its market share of the overall market from 7% in 2007 to 9.6% today. If we look at the branded coffee market in isolation Costa has increased its share from 20% five years ago to 29% now.
“It now has twice as many shops as Starbucks even though they were around the same size in 2006, and three times as much as Caffe Nero, which used to be larger. Costa has opened 1,000 outlets since 2006, which is bigger than the current Starbucks network alone.”
High returns, internally driven growth
Rollo said that the group’s clear targets for rollout will drive 25% incremental return on investment. He said: "We estimate its expansion plan will drive £15m annual EBIT growth, perhaps £13m after growth of central costs, which on £55m capex drives 25% incremental ROI. We expect the company to roll forward its expansion plans by two years to at least 4,000 outlets by F2018.”
Demerger potential
Rollo believes that Whitbread is likely to separate Costa at some point with the arguments in favour well rehearsed, but that the valuation argument is thinning. He said that the company’s management is under no pressure to go down the demerger route while performance remains strong.
UK expansion likely to get harder
The analyst said 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. The analyst also argues that the company could do more with its existing shops.
Underinvested internationally?
Rollo said that Whitbread has been a good owner of Costa, but there is room for improvement in its international strategy, with China unlikely to move the profit dial. He said that while higher risk, there could be a bigger profit pool in say France and Germany than in China for the brand.
