Coffee Economics

Growth is merely keeping pace with population gains says Andrea Illy: “Quality has been able to conquer even the most reluctant consumers. So, let’s continue to improve quality, and we will have more consumption.”

By Dan Bolton

Andrea Illy is gifted with the ability to see over the coffee horizon. His vantage as chairman of illycaffé SpA is that of a strategist perched above the daily fray, peering far ahead.

What he sees globally is a coffee industry traversing a troubling course.

Following his presentation at the Re:Co Symposium in Seattle last April, Illy sat with STiR to discuss his views on coffee economics, consolidation, financial sustainability, and a way forward.

Illy’s old world gentility is neither colonial or pretentious. It is grounded in the company’s close ties to growers, initially in Brazil where illycaffé introduced rigorous science-based standards and began direct sourcing over 25 years ago. The Università del Caffè that Andrea established has graduated an entire generation of coffee entrepreneurs since its founding in Naples in 1999.

The main campus in Trieste oversees 25 branches in coffee producing and consuming countries and, since 2017, San Francisco. The program’s 400-hour master’s degree in coffee economics and science is highly rated and confers 60 university credits to qualified graduates in economics, agriculture, engineering, political science, mathematics, and the natural sciences.

Illy’s first job with the company in 1990 was supervisor of quality control, a mission that continues to guide his stewardship of the $539 million-grossing, family-owned venture. In his broad view Illy, 54, sees the economics of coffee as topsy-turvy. As consumption rises, generating wealth among the 150 consuming nations along the supply chain, the 50 emerging economies that produce coffee receive proportionately less and less, he explains. Less than 10% of the global industry value is retained in producing countries.

Illy explains that the number of coffee drinkers has more than doubled to 1.5 billion from 600 million 20 years ago. Yet, as quantities expand, market penetration remains flat. More people than ever drink coffee but individually, they drink less.

The dominance of consuming countries in the value chain is “troubling,” he observes. Annual sales (excluding retail) are an estimated $300 billion, yet 20 million of the world’s 25 million growers receive only $200 per year “which is much below the threshold of poverty established by the United Nations,” he said.

Farmgate prices barely cover the cost of production. Growers receive $20-25 billion—about 6-8% of total value. While those up the chain apply handsome mark-ups and enjoy high margins, coffee as an agricultural commodity is experiencing deflation.

Financial markets are another concern. Trading is highly volatile and there has been a “decoupling” of the physical stocks from prices. Prices remain low despite the fact that physical stocks shrunk from 55 million 60-kilo bags in 1990 to 21 million bags in 2016.

Coffee is sustainable

Consumers have increased their per capita spending on coffee by 30% in the past 10 years, says Illy.

Fortunately, per capita spending is growing at the same rate as consumption. 

“That means that quality drives consumption, not price. This is a very, very important message for the coffee community because it demonstrates that we have a strategy that is sustainable,” said Illy.

“The better the quality, the more sustainable the coffee, the more positive the coffee outlook as more people will drink it,” he said.

Cafés have been one of the main drivers, growing 6% and doubling the number of units, triggering an increase in consumption. This is most evident in emerging markets, he explains.

Expect that growth to accelerate, led by the Chinese economic boom. In every country coffee consumption increases proportionately to disposable income, he said.

Value is closely tied to specialty offerings. The market share of specialty is significant in North America but accounts for only 10% of market value in Europe, he notes. “Western Europe is now second to Asia—and Asia just started,” says Illy.

Korea, Indonesia, Japan, Vietnam, China, Australia, every country on the Pacific Rim is “adding value in an important way. Because they sell quality, they don’t sell cheap coffee.”

Consolidation from the ground up

Ten years ago Brazil and Vietnam accounted for 46% of coffee production. Their combined share has since grown to 53%.

The very soil on which coffee is grown is getting scarce. By 2050 a combination of heat and irregular rainfall will reduce the land suitable for arabica production by half. Africa is emerging as a major producer. China is already the seventh largest arabica-producing country in the world.

The entire industry is literally reshaping.

During the past five years there have been $43 billion in coffee mergers and acquisitions (m&a), says Illy.

“This is the first time in history that such a huge amount of capital has flooded the market in order to consolidate the industry,” he said. “This industry consolidation is probably led by disruptive technology tied to growth of the portionate [single-serve] systems,” he surmised.

When customers shift from roast and ground to single-serve it means traditional coffee brands are not growing any longer. This is why you have consolidation through m&a, putting brands together to gain market share, he explains.

This is being done by a big German group JAB Holding, which is now number one in volume, and number two in value in just five years,” he said.

Consolidation provokes a reaction by other competitors, changing the strategy from organic growth to external growth. “All the industry is in a kind of turmoil,” he said. “Either you feel that you are prey; that you are at risk of becoming prey, or that you should become a predator,” he observed.

Press accounts name illycaffé as an acquisition target for Nestlé or JAB Holdings. “I’m not too concerned because you have at the same time differentiation and fragmentation of the industry.”

Direct sourcing

The Illy family began sourcing direct in 1991 – long before Third Wave shops touted their relationships at origin. Virtually all the company’s coffee is purchased direct.

Vertical integration has been financially successful, he says.

“Direct sourcing is a core element of our strategy. We work hand-in-hand with coffee growers, transferring the knowledge needed to produce coffee specifically for us and applying quality standards above the official market standards, and, of course, paying them a premium,” he said. “This gives us better quality traceability, creates loyalty with the coffee growers, and gives us the ability to narrate the product story we sell to customers,” he said, adding, there are plenty of positive effects, one of the most important of which is that it encourages differentiation.

The way forward

The way forward was paved in Milan at Expo 2015 during a great celebration of coffee attended by 13 million visitors with 40 producing countries participating, Illy explains.

“Why do we drink coffee? It is for the wellbeing that it gives us. It’s about pleasure, and it’s also about health. It makes us live better and longer,” he says. The concept is described in the Milan Coffee Legacy, an official document filed with the United Nations.

“In it we acknowledge the existence of a virtuous cycle that connects the wellbeing that coffee delivers to consumers with the development of coffee growers,” he said. Integrating downwards creates more value and opportunity for growers who are closely tied to a whole ecosystem of roasters, he said.

The result is better quality coffee—and more consumption.

Coffee prospered the last two decades because of quality and greater differentiation which brings curiosity and engagement, says Illy. “Differentiation is one of the strategies to increase the value of the coffee industry that you see in beer and wine,” he observes. There are 300,000 different beers and only 30,000 coffee brands. “Wine has 1,000 varietals and one million brands,” he said.

“Coffee is a relatively young industry that has to learn from other industries how to really make itself sustainable and create value,” he said.