Tuesday, 15 December 2015

Part 2: The Bubble

The State of Speciality Coffee

Part 2: The Bubble

The growth in speciality coffee shops in the last decade has been astonishing. While different markets have grown at different rates , the patterns and trends of growth have been very similar.

Pioneers open a speciality coffee business in a city, serving something genuinely new and substantially better than the rest of the market. These coffee businesses are usually run by people with a burning passion for great coffee, who would be opening their business regardless of economic climate – in many cases cities saw a boom in the coffee cultures during the recessions brought on by the global financial crisis in 2008.

The success of these pioneers gives reassurrance to another tier of entrepreneurs, who also want to open a cafe, who have been hesitant, and who are encouraged by what looks like healthy customer demand for a better product.

In turn, this increase in growth in coffee shops spurs a new tier – those who think the coffee business is clearly the business to be in, and who decide to enter the market too. Typically there are more well funded businesses in this category (though they’re not absent from the first two). I’m not trying to cast aspersions at anyone here, and I’m not claiming that this is as clear cut as presented. In most cities all three types of entrepreneur are opening coffee businesses at the present.

Growth Vs Competition

Taking London as a case study does come with certain drawbacks: it is an unusually dense city, concentrating both people and money. As such it has been able to foster a rate of growth in coffee that would not be possible in most other places. However, I think that concentration simply speeds up a process that will be seen in many other cities around the world. It is, in a way, a canary in a coalmine.

The rate of openings in London and the UK only continues to increase. The last data I saw on speciality businesses in the UK showed that around half of the speciality coffee shops and coffee roasting companies in the UK are less than 2 years old. 1 That is incredible to me, to see growth like this at the moment. It is also extremely disconcerting.

I’ve often used Kevin Kelly’s idea of “1,000 true fans” to talk about the necessary audience for a successful business. What concerns me is that every time a new cafe opens it needs 1,000 customers (who won’t come every day, but will identify as being a regular) to be sustainably successful (certainly in London). This isn’t a perfect number, in other cities it could be smaller. However, it does illustrate what isn’t happening: Every time a new cafe opens 1,000 new customers don’t just magically appear. Yes, new speciality coffee customers are generated by every business that opens – but not enough.

As such we’re entering a pretty typical economic scenario: there is more supply than there is demand, and supply is increasing rapidly.

What we’re seeing now is every business have to fight a little harder for every customer. We’re seeing established businesses suffer, for the first time, a decrease in year on year sales (in terms of checks/customers processed).

The growth has not been in independent businesses alone. Let’s take London as an example. Here are two maps, showing the same rough area of central London. One is from the Telegraph’s interactive map of branded coffee shops in the UK, the other from 100 Cups – a blog detailing the best speciality coffee shops in London.

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You can dismiss chain coffee businesses if you like, but you should know that the typical UK chain coffee business process nearly 2.5x the number of customers per day as the typical UK independent coffee shop. That’s a staggering number, mostly because it shows that many UK independents are struggling to gain real traction when it comes to growing retained customers. Remember also that these chains have grown substantially in the last decade – it isn’t just independents that have boomed.

Access to finance

Post global financial crisis was a difficult time for businesses lookin to expand. Banks weren’t lending and as such single unit operators were slow to expand. That has changed recently, and crowdfunding (either through a bond or through selling equity) is becoming increasingly commonplace. In some ways I’m surprised at the willingness of people to invest but then the same Fear Of Missing Out could be said to be driving the absurd investments and valuations seen in the tech world. I believe now to be a golden time to raise this way (I’m not, however, saying people therefor should) because the are likely to be some pretty spectacular failures which may cause sufficient consumer outrage to provoke changes in regulation around it. I read all the financials I can from companies in a variety of fields including coffee and some projections simply appear so unlikely as to be impossible.

Even though it is far from ubiquitous I think it is having an impact – established businesses are attempting rapid growth and the money being raised is attac in more and more interest and attention in the sector.

Consumption data

With the growth of all these coffee shops you’d think that this would be mirrored in consumption data. That doesn’t seem to be the case. Using ICO figures for net green coffee imports (total imports, less re-exports), against accurate historical population, the per capita consumption hasn’t shifted much. In the UK in 2005 the per capita consumption was 2.56kg, and in 2013 it was 2.64kg (a 3.2% growth). This is somewhat mirrored in the USA also – consumption increasing only 10% in the last decade. The UK data is particularly surprising, and I think speaks to a shift in the type of coffee consumed. Instant coffee sales are on the decline, I believe an indicator of a slight move of the needle on base expectations of coffee quality. 

While the ICO figures seem so contrary to what we are seeing that I want to investigate them further, I don’t want them to detract from the key idea. We appear to have too many coffee shops for the market to be sustainable. This alone would be an issue but I believe that problem is being further compounded by other factors:

Staff Costs

Typically those who open coffee businesses because they see an apparent opportunity don’t already have an indepth knowledge of coffee. As such there has been a dramatic rise in the number of businesses trying to hire experienced baristas to guide them through opening and to manage coffee quality. Never before have there been so many opportunities in the coffee industry, but never before has demand for staff been higher. This does something that most would consider positive – it drives up wages and pay for baristas and for knowledgeable coffee people. Just watching the jobs go up on Coffee Jobs Board in London has shown the rate of growth and the shift in the type of staff that coffee businesses (especially new ones) are looking for. The advertised rates of pay have noticeably trended upwards in the last two years.

For a cafe this is difficult. Labour costs are often the biggest cost for a cafe, with the typical cafe in most markets now running a labour cost in the range of 30–40% of net revenue (not all are here, but a large number are). The exception to this would be in countries with strong tipping cultures, whose lower wages look better on paper. (One reason there will be strong resistance to change). However, they are by no means immune to change – notable increases in minimum wage in many US states being an example. The increased challenge in finding staff, coupled with the increased costs of hiring and training are applying huge pressure to existing coffee businesses. It is also feels much harder to use a price increase on food and drink to cover the additional cost in a market place with increasing competition – if anything that competition will push coffee business to decrease their margins, or offer better deals, to try to win more business.

Rent

If you look at the two maps from earlier a little closer you’ll see something interesting. You can pretty clearly see which streets in London cost more – they’re full of the chain coffee shops, and almost empty of independents. The Strand or St James’ are two good examples.

Rents in London, and in many cities around the world, have played something of a cruel joke on coffee businesses. Many coffee shops chose to open in up and coming neighbourhoods, gambling by taking a lower rent in an area that traditionally didn’t have the type of consumer base they’d need. However, as cities are changing rapidly at the moment we are seeing gentrification spread at a surprising rate. Many up and coming neighbourhoods have quickly become more expensive places to do businesses, and one of the business types considered essential to the gentrification of an area is a coffee shop. By helping make those neighbourhoods more attractive, many coffee shops are being repaid with higher rents. 

Rent is an increasing pressure, and as more and more businesses come to the rent reviews in their lease agreements I think more and more are likely to be shocked by the shortsightedness and greed of their landlords.

rent

This is, again, by no means unique to London – even if the particular set of circumstances driving London property market may be unique. New York, San Francisco, Seoul, Melbourne, Tokyo and many other cities are seeing a dramatic impact of rapidly increasing rents of the long term viability of a number of coffee businesses throughout those cities.

What Bursts The Bubble?

So, I’d argue we are in something of a bubble and I think I’ve laid out the main pressures in the market that could cause it to burst. I don’t think calling it a bubble is completely accurate because of what I think comes next. However, I have not discussed something of importance and potentially significant impact: the price and availability of high quality green coffee in the future.

The global supply of coffee, as a generic product, is obviously not considered threatened – as the low C-market price clearly shows. However, we’re discussing speciality coffee and the outlook there is worse. The amount of washed arabica coffee (as a percentage of total production) is in steady decline. There is also an increasing demand for high quality washed arabica, and I think that is showing the prices roasters are paying at the moment. I think if you asked roasters whether the prices they are paying now are similar to the prices they were paying the last time the C-market was in the same place (implying some level of relatively fixed quality-derived differential) then they would say “No, coffee has gotten more expensive”. I’m not saying this is a bad thing – but it is evident of a particular problem that belongs to our subset of the wider coffee industry.

Seeing a steady increase in price would only add further fragility to an already fragile supply chain on the consumer side. Roasteries would either have to up prices (and fear of losing out to cheaper competition will prevent them doing so), or they put the prices up and pass the pressure on up to the cafe. While coffee beans are not a large part of a cafes total outgoing, they are still significant.

I wanted to include the green coffee situation, but I don’t think it is entirely appropriate to explore it in depth in this series of three posts.

In the final part tomorrow I will explain what I think will happen in the next few years, and what the likely repercussions will be of the coffee industry becoming, in many ways, the victim of its own success.

  1. This is from Allegra’s “Future of Coffee” report.  ↩︎

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