Costa needs to wake up and smell the coffee in China

UK giant won’t have things all its own way in Chinese market

WRITING a column like this each week forces you to think how business can quickly transform itself and how a bit of imagination can produce great new global industries in the blink of an eye.

For instance, I’m partial to a relaxing cup of Java’s finest, but I’d never have believed, 30 years ago, that global chains of coffee shops would be vying with each other for dominance in a multi-billion dollar businesses stretching from the heart of China to sub-Saharan Africa.

The company we are looking at here, Costa Coffee, is part of what was once the traditional British Whitbread brewing chain, which dumped its beer-making arm and converted itself into what it is today, a largely coffee-focused chain with a budget hotel operation and multiple restaurant brands.

Today Whitbread has an impressive freehold portfolio, good brands and is valued by the market at £7.4bn (€8.3bn). Its revenues last year at £3.3bn (€3.7bn) were almost double those of 2012, its earnings per share climbed 60pc in the same period and profit before tax is £550m.

Whitbread bought Costa from Sergio and Bruno Costa for £20m two decades ago. At the time it had 40 outlets and revenues of £55m.

Today it has 4,000 outlets and operating profits more than three times the Costa brothers’ revenues.

It is the market leader in the UK, estimated to be worth £9bn. Costa also developed a lucrative coffee vending machine market (8,000 in total) selling real coffee in factories, hospitals, train stations and universities.

In spite of a satisfactory performance in the past few years, Whitbread has its challenges.

The UK hotel business is facing increased competition and it wants to spread this business in Europe.

It has also opted to spin off the coffee side, under pressure from corporate raiders who have put the group under unwelcome attention.

Having agreed to the demerger the company would like to take its time about it, not surprisingly given that coffee has been such an engine of growth.

However, the active investors disagree, claiming six months is adequate. The management’s foot-dragging could be a desire to reach Costa’s goal of £2.5bn in revenues, with more than a third coming from overseas, within the next two years. This could help the spin-off.

There is a view by some investors that the group may have missed the boat when JAB, a Luxembourg investment vehicle owned by the wealthy Reimann family, bought for £1.5bn (€1.67bn) the UK company Pret A Manger, a coffee and sandwich-to-go chain. They feel JAB could have been persuaded to acquire the larger Costa rather than the smaller Pret.

A market leadership in the UK is not the height of Costa’s ambition.

It has hopes of expanding its operations into the Chinese market, but this may pose more problems than it would first appear.

The big coffee shop name in China, as elsewhere in the world, is Starbucks – which is reckoned to have 80pc of the Chinese market and has an ambitious plan to triple its Chinese revenues and grow the number of outlets to over 6,000. It is not getting its own way there, however.

Some local venture capitalists in China have recently raised $200m (€170m) to throw behind a new Chinese operation called Luckin Coffee, whose Plan

A is to take the Starbucks challenge head-on and importantly compete on price. It sells its lattes some 30pc cheaper than Starbucks.

Locals say Luckin Coffee has the potential to make life a lot harder for Starbucks and presumably for any other outsiders like Costa who want to change the refreshment habits of the vast Chinese population. Luckin is said to have opened 500 shops in just five months.

The Costa ambition is to triple its 400 Chinese stores over a four-year period, which sounds a modest enough target when you see what else is happening there.

Whitbread’s shares trade at around £40 each, with a price earnings multiple of 17, and while I like the share, I will hold off until the timing of Costa’s spin-off is settled.

Luckin Coffee can make life harder for Starbucks

Nothing in this section should be taken as a recommendation, either explicit or implicit to buy any of the shares mentioned.