By Teresa Rivas

Grinding coffee beans is my three-year-old's favorite activity to do at his daycare. Coffee sellers should take heart, as at least one analyst argues younger consumers -- while not quite that young -- will be a major contributor to the category's growth in the coming years.

Though the business model of selling a legally addictive substance is appealing, investors have been concerned about coffee chains recently.

Lat week, the price of Arabica coffee soared to its highest level since 1977, while Robusta beans hit a record price in September, as widespread droughts in key coffee-producing regions have raised supply worries. The U.S. Foreign Agricultural Service post in Brasília lowered its 2024/2025 estimates for Brazil's production, expecting the nation will end with stocks of just 1.24 million bags.

As 22V Research's Colin Fenton notes, that ending stock level would mark a 26.4% decrease year over year. "It is an exceptionally low level" that keeps him long on Arabica.

Global giant Starbucks has seen its shares underperform the broader market this year. Keurig Dr Pepper stock has lagged; the company also will have to pay a $1.5 million after the Securities and Exchange Commission said it misled consumers about the recyclability of its single-use K-cup pods. In September, Keurig agreed to a cease-and-desist order without admitting or denying the findings.

American depositary receipts of China's Luckin Coffee have never retaken their 2020 highs. Only Dutch Bros.has outpaced the S&P 500 year to date.

However, TD Cowen analyst Andrew Charles says investors have gotten too pessimistic about coffee. In fact, he predicts it will be the second-fastest growing restaurant category in the U.S. over the next decade, with a compound annual growth rate of 6.7%, behind only chicken.

Although the category might seem oversaturated -- the satirical news website The Onion joked that a new Starbucks opened in the restroom of an existing Starbucks way back in 1998 -- Charles argues that coffee chains can still win by differentiating themselves.

To wit, he expects two kinds of brewers will likely deliver better-than-expected same-store sales over the medium term: those with a large variety of iced beverages on their menu and shops with the bulk of their sales coming via digital channels and apps. That's because iced drinks make up about 60% of sales, while online loyalty programs are driving engagement with Gen Z.

Gen Z -- typically considered those born between 1997 and 2012 -- will make up more than a quarter of the population by 2033 and tend to prefer to buy iced beverages than make hot coffee at home. The ritualistic nature of coffee -- and the need to order in a hurry in the morning -- make those habits long lasting.

"Given the stickiness of coffee habits, we expect digital and iced coffee to be the greatest contributors to growth in the away from home coffee market over the next 10 years," Charles notes.

However it isn't just younger consumers that Charles sees pushing sales higher.

"We are skeptical about whether at-home coffee will capitalize on the aging population like it has in the past," he writes. "Machine manufacturers have struggled to develop a compelling at-home cold coffee device that replicates the coffee shop experience, and the packaged coffee leaders have struggled to keep pace with changing consumer preferences."

Indeed, despite inflation-weary consumers' near-constant hunt for value, at-home coffee trends turned negative in 2024, with year-to-date sales down 1.7%. That shows the allure of buying coffee regardless of price -- especially cold and specialty drinks that aren't easy to replicate at home.

Combined, these trends leave Charles more confident on Starbucks, whose stock price target he upped to $115 from $100, and on Dutch Bros., now with a $65 price target from $53. The analyst has a Buy rating on both stocks.

"Overall, we expect Starbucks U.S. to continue to dominate the U.S. coffee shop market for the next 10 years, with market share increasing from approximately 42% in 2024 to about 43% by the end of 2033," Charles writes. The chain's market share gains will come at the expense of McDonald's and convenience stores, which focus less on the highly popular iced beverages, he adds.

By contrast, he thinks companies that focus on at-home coffee consumption, like Keurig Dr Pepper and J.M. Smucker, will cede market share amid these broader trends.

Overall, no matter where people brew it, demographics are on coffee's side. The years to come will see "younger consumers entering the workforce and parenthood, with coffee adoption rate that sticks through the age 60+ level," Charles says.

Tired working parents of all ages would likely drink to that.

Write to Teresa Rivas at teresa.rivas@barrons.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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December 04, 2024 14:27 ET (19:27 GMT)

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