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Why Starbucks Corp. (NasdaqGS: SBUX) Is Heating up the Coffee Wars

By Chad Fraser on March 13, 2012

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What does Starbucks Corp. (NasdaqGS: SBUX) have in common with the teachings of ancient Chinese military strategist Sun Tzu?

According to Investing Daily editor Jim Fink, quite a lot. On March 14, 2011, right after finishing Sun Tzu’s classic The Art of War, Fink put the company on his list of “Sun Tzu Stocks.” These were the companies that most closely followed the general’s teachings.

Fink wrote: “By isolating public companies that exhibit these characteristic management behaviors, I think you can compile a pretty nice investment portfolio of future stock market winners.”

The numbers back him up: since Fink’s list was published, Starbucks Corp. shares have jumped from $37.87 to around $51. That’s a 35% gain in just one year. (Click here to see Fink’s complete list of “Sun Tzu Stocks.”)

Starbucks Corp. made Fink’s list because it did a good job of sharing its success with its employees (or what Sun Tzu would call rewarding its army). On Thursday night, however, it took another page from The Art of War, employing another of the storied strategist’s tactics: deception.

Starbucks Corp. Caught the Competition Flat-Footed With Its New Coffee Machine

The coffee giant announced that it has developed a new single-cup coffee system called the Verismo with Germany’s Kruger GmbH & Co. The device, which can also make more sophisticated drinks like espresso, will be available online and through certain Starbucks stores in time for the 2012 holiday season.

The announcement came almost exactly a year after Starbucks Corp. had announced an agreement with Green Mountain Coffee Roasters Inc. (NasdaqGS: GMCR) to supply coffee pods (or K-Cups) for Green Mountain’s Keurig single-cup coffee system, which now dominates this market. Notably, Verismo coffee pods will not work with the Keurig.

Starbucks Corp. CEO Howard Schultz clearly recognized the importance of this new market:

“The premium single-cup segment is the fastest-growing business within the global coffee industry. We have long believed that the biggest prize within the segment is a high-pressure system that would give us the opportunity to deliver Starbucks-quality espresso beverages … for customers who desire the Starbucks espresso experience outside of our stores.”

Schultz went out of his way to state that the Verismo wouldn’t directly compete with the Keurig. But the market clearly wasn’t buying it. Starbucks Corp. shares rose 3% on the news, but Green Mountain stock took a big hit, plummeting 15%.

Starbucks Corp. Always Plays to Win

For its part, Green Mountain quickly responded with a press release pointing out that the Keurig uses “low pressure to extract maximum flavor and taste from ground and filtered specialty Arabica coffee,” where espresso-based machines like the Verismo “generally use high pressure and high temperature to produce a more intense taste profile, frequently used for mixing with milk in North America.”

That’s all well and good, wrote Brett Callwood of Benzinga.com, but it’s based on a pretty flimsy assumption: “… particularly in this economic climate, how many consumers will really be looking to buy two separate coffee brewing machines, one high and one low pressure? It seems unrealistic.”

Others, like Joshua Brown of investment advisory firm Fusion Analytics, saw the move into single-serve machines as inevitable. Quoted in a Reuters.com article, he said:

“There was no way that Starbucks and Dunkin’ Donuts were going to see this niche coffee market take off and not want a bigger share of it. A lot of people thought Starbucks was going to play nice and just sell K-cups through the Keurig. But Starbucks doesn’t do anything where they are going to be the No. 2 or the No. 3 player.”

New Coffee Machine Not the Day’s Only Surprise

An interesting aside to all of this involved some big shifts in options trading activity in the run-up to Starbucks’ big announcement, particularly in Green Mountain shares.

In an article on InvestorPlace.com entitled “Options Traders Were Ready for Starbucks,” writer Beth Gaston Moon pointed out that options trading in both stocks rose prior to Thursday’s announcement, but the biggest jump came in Green Mountain shares, where 80,000 puts and 55,000 calls were traded. The total of 135,000 was three times the stock’s average option volume of 42,000.

Some, however, thought this was more than just a lucky prediction. Quoted in an article on Reuters.com, Alan Thompson, options market maker at Timber Hill, said, “The level of aggressiveness that traders early on Thursday came for Green Mountain March downside puts was very suspicious. It raised our eyebrows.”

The most popular options were March put contracts which expire at the end of this week, with a strike price of $60. On Thursday, they were selling at an average premium of $1.60. (Green Mountain shares were trading at around $62.50 at this time.) That premium jumped to $7 during Friday’s session—for a 337% gain.

The Securities and Exchange Commission hasn’t said whether it will look into the matter.

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