Morgan Stanley – Costa Coffee has competitive advantages in the UK: Leisure analysts at Morgan Stanley have issued a note stressing that Costa Coffee enjoys competitive advantages in the UK. The note was issued after a call with a leading coffee sector consultant. The Morgan Stanley noted stated: “Costa has been a concern to investors given its slowing like-for-like sales, increasing competition, cost pressures, and historical underinvestment. The consultant believes Costa enjoys competitive advantages in the UK from its superior scale and product, that it will succeed in expanding its product portfolio and investment plans, and that there are some savings it can make in international markets. Costa Coffee put through an average 10p price increase yesterday. While the consultant noted a low level of price elasticity in the sector, we doubt Costa would take a price increase if trading was tough. Indeed, its Quarter Three like-for-like sales of 4.3% were better than expected, and the calendar adjustment the company made to 2.9% underlying implied a strong start to the festive period. We think Costa has many internal levers to drive growth: expanding its food offer (currently circa 30% of revenue) including a move away from sweet treats at breakfast / tea to fresher / healthier food at lunch; new drink products (specialty blends, ice cold drinks, nitro cold brew); more rapid delivery (new ovens, new tills, Drive Thru, Pronto format); more refurbishments (with the emphasis on increasing throughput rather than a formulaic refit); and the upside from digital (moving from a loyalty card to an app, rolling out Costa Collect bearing in mind Starbucks Mobile Order & Pay is now over 10% of its US transactions at peak periods). If Costa can turn the corner, then given UK hotel data remains solid (with the last 4 weeks running +5%, after a strong Nov/Dec), we think Whitbread could be facing some modest upgrades, but potentially a more material rerating. Costa appears to be holding its own: Costa reported 11.4% sales growth for the 9 months to December, in-line with the 12% Allegra forecasts for the branded coffee shop market to 2020, and the 10% reported for the market for 2015. He sees the market as being driven by increasing frequency of consumption, with consumers already in the market drinking more regularly, and noted the market grew through the 2009 slowdown, seeing both these factors as evidence of the habit-forming nature of caffeine consumption. Competitive advantages: He believes coffee consumers make spontaneous visits, unlike visits to say restaurants, meaning location and scale are paramount. Costa’s size (over 2x larger than Starbucks or Nero in the UK) and ability to work with different formats (e.g. motorway service stations, franchising, Drive Thru, Express machines) make it the natural choice for these consumers. In addition, surveys suggest Costa has the best quality coffee, and draws a lot of attention to its handmade (not machine-made) coffee, roastery, and heritage. Artisanal players do not appear to be scalable: value players may find price isn’t enough. He agreed the artisan market appears to be an enormous threat, but only at the local level as they tend to be run by individual entrepreneurs with a love of coffee who cannot scale the business, the product quality is quite inconsistent, and the stores tend to be smaller and in more secondary locations. Meanwhile, value players like Greggs or Pret are more food-led, and find the market is not very price sensitive on coffee, and that the quality of the coffee and convenience are more important factors. High street market tough, but Costa dealing with it: Around 45% of Costa stores are on the high street or in shopping malls, so at risk from the channel shift online. Costa is reportedly closing half as many stores each year than it is opening. However, there is plenty of upside from portfolio managing on the high street, for example swapping locations where its stores are “capped” (30% of them), and generating scale economies and / or lower rents as a result. Costa needs to be careful widening its food offer but can probably succeed: He noted that while Costa offers lots of bread-based and potted products, it is weak on salads and healthy food. It has tried to grow in this area in the past but it has increased wastage and hit margins. There is thus a trade-off between innovation and margin, and the company has been juggling this for a long time. He believes that Starbucks is more innovative, but probably has a less efficient model so can take the cost increase. In addition, if you innovate too quickly it is hard to track what is working, and coffee shops don’t want to stretch too much to the point they are predominantly food. He sees Costa as smart operators, and has never known the team not deliver what they said they would. He believes they can afford to innovate and still have the core high street engine room doing well. International cost base looks high: The consultant estimates that outlet profitability is c. £40m in Costa International, and with the business at break even there must be significant overhead (our model suggests outlet profits and central costs are c. £30m, but not far off). China is clearly struggled with overexpansion into cities with a handful of stores and high overhead, and exiting perhaps 15-20% of the stores was suggested, something Costa has already been doing. Coupled with strong growth in the franchise operation (which makes around half the profit), and further unit growth, we estimate International can generate £20m in less than five years, ahead of the company’s target. Express was seen as “the new international”, with rapid roll-out, scalability, and a low cost way to get brand recognition (though you do need a lot of them to move the dial).”