Third Wave Roaster Cafes: Am I competing with my supplier?

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Dec 12, 2007

A tour of Seattle cafes reveals that some prominent wholesale roasters are both coffee suppliers and cafe operators. This is especially true in the emerging Third Wave segment. Notably, Stumptown, Caffe Vita, and Zoka roast coffee as well as operate their own cafes. 

The dual role of these companies raises a question: Should someone who plans to open a cafe view the cafe operations of a potential coffee supplier as a competitive threat?

The answer to this question might seem obvious. Afterall, a roaster has a huge advantage in terms of their coffee price. The highest quality green coffee can be had easily for $3-4 per pound even in small quantities. And with the economies of scale that go with roasting commercially, each additional pound of coffee that is roasted diminishes unit costs.  Fixed overhead costs remain constant and at higher volumes, green coffee generally gets cheaper the more you buy.  Meanwhile buying higher quality pre-roasted coffee can cost $10-14 per pound.  This seems like a wide spread. However, there is more to this than meets the eye.

For one thing, the cost of coffee is a relatively small percentage of the total cost of operating a cafe. For a higher volume retailer, one with annual sales of around $500,000 per year or greater, purchasing pre-roasted coffee is generally 8-10% of their total operating expense. The SCAA (Specialty Coffee Association of America) estimates the cost of coffee to be as low as 5%, but this is based on a much lower green coffee price that does not account for the extremely high cost of direct origin-sourcing undertaken by Third Wave roasters. It also assumes a higher level of food and brewed coffee sales compared to espresso-based beverage sales.  For the typical operator offering a complete menu of specialty coffee beverages, the cost of milk and dairy is double that of coffee. And, labor and overhead represent 70-80% of the total cost of store operations. Look at it this way: for a typical, $4 cappuccino, approximately $0.07 is for the coffee, while around $3.00 is for the labor to make the beverage and pay the rent on the cafe. Even Starbucks makes only $0.11 profit on this drink. 

The message is this–the roaster-operated cafe gains relatively little operating advantage from their coffee roasting competency over their customer who buys coffee from them, because the cost of coffee is only a small fraction of the cost of overall store operations. For roasters, sales to existing cafe operators and directly to customers who brew it at home is extremely good business, because it avoids an enormous amount of costly overhead associated with opening and operating retail stores.  I would even venture to say that it almost seems like madness for a successful roaster to open even a single cafe. So, why do roasters open cafes? What do they gain? 

Before going there, one additional point should be made for clarification. A cafe, especially an outstanding, Third Wave one, is typically a local, neighborhood business. A profitable cafe is one that is well-placed to serve customers from a particular area, not customers from all over town. In Seattle, a store in Fremont does not compete with a store on Capitol Hill. Even two stores within the same general area of town are not necessarily competitors. 

This is an important distinction, because unless a roaster opens a cafe across the street from another shop, they may not really be reducing the traffic of the original store. Again, the cafe, especially the urban cafe, is a neighborhood-localized business. Understanding the importance of this fact can help you focus on identifying the killer location for your store. And with the right coffee, operational practices, and staff it can virtually guarantee your success.  It also means that a store opening nearby yours is not necessarily going to hurt business.  In fact over time, it may actually increase the volume of both locations.

It is useful to note here that understanding the significance of real estate with profound clarity and a sense of mono-maniacal purpose is one of the reasons Starbucks stores have proliferated. Starbucks recognizes that to dominate the market, essentially capture the entire specialty coffee segment, they must be accessible at this neighborhood level. They must literally offer the “Starbucks Choice” at every crossroads, where a critical mass of customers could be reasonably expected to make the decision to purchase coffee. Real estate matters enormously in this game. It matters where your cafe is located relative to your customers and to other cafes. If your roaster opens a cafe next to yours, that could be a problem. If they purchase an existing store, or open one somewhere else, it very likely should have no negative impact on your business. 

So back to the question of independent roasters and their cafes. Why do they open them? Are they trying to compete with their customers? Is there a secret or unstated strategy to one-up their existing wholesale accounts, and emerge with a dominant network of stores? First, these roasters are not siting their stores near their customers’ existing locations–they are opening up brand new territory, generally in areas of town that are expanding or undergoing gentrification. Furthermore, the conversations I have had confirm that roasters like Stumptown or Caffe Vita do not seek to dominate the retail segment with their own stores anyway. Most of these smaller roasters are privately held companies, not publicly traded, and not really well-funded enough to undertake a rapid store expansion that would allow them to disregard their wholesale accounts. Most importantly these roasters make far better margins from maintaining strong relationships with their wholesale and independent cafe customers–and expanding this base–than pursuing a retail strategy. For them, roasting is simply a better opportunity than opening stores. They know they serve their customers best by remaining specialized and highly focused on coffee. Their core competency is coffee sourcing at origin, roasting in micro batches, and supplying training on the techniques and tools required to prepare their coffee to perfection. They are great at coffee because they are focused on coffee–and what it takes to make it right. 

Because they do not supply a large number of company-owned stores, Third Wave roasters are able to offer very distinctive coffees, found at origin in extremely limited quantities. These coffees are very difficult to source other than directly from the farmer or coop. These particular coffees would under other circumstances be blended with lesser coffees to raise the overall standard for a larger batch of regionally identified coffee, but the distinctive qualities of a particular farm, cultivar, or mountainside would be all but lost. 

Highlighting this difference is one way that Third Wave cafes, whether company owned or independent, compete successfully against retail giants. The coffee product they serve, whether for use at home, or prepared in store is distinctive and undiluted. And it is carefully prepared by hand. This level of quality can not be faked. Furthermore, economies of scale actually undermine product quality in almost every sense from sourcing and roasting to the training required to prepare the coffee just right. So in this case, industry giants don’t gain an advantage from their sheer size alone.

In my experience, roaster-operated stores are often showplaces for presenting distinctive coffees like this of unmatched quality. They are also active learning labs for coffee preparation and technique, as interpreted by the roaster for their particular coffee. Roasters operate their cafes almost like fully-functional demonstration centers, and sometimes actually as training venues for their customers, while serving the neighborhoods they’re in. When I go to Stumptown, for example, I know I am experiencing this coffee to its best advantage. This in-store experience becomes a selling point for the coffee, especially for someone considering opening a cafe. But it can also be a litmus test to measure the success or failure of coffee preparation in independent cafes using this coffee. Which sort of brings us back to training–roaster-operated stores serve as a reference point for the product and a reminder of the importance of staying close to the highly-valuable wholesale client with knowledge, training, and support. Again, company-owned stores help them fulfill this. 

Finally, as Third Wave roasters continue to source more selectively, there is a chance that some of the rare coffees they are finding can not be sold in sufficient quantity through an existing network of independent cafes that serve their coffee–especially if they are new to a market. In this case, roaster owned stores, and even mail order, can serve as a safety valve, a way to find additional buyers, ensuring these extremely high end coffees continue to be sourced, roasted and sold–while ensuring none goes to waste. This is great news if you love this style of coffee.

All this being said—let’s talk again when Caffe Vita opens it hundredth store, as I wipe the egg from my face :-). In all seriousness, though, if you are considering opening a cafe, find the best independent Third Wave roaster you can, and if they happen to have a store or two, take advantage of this fact for assessing the coffee and for training later on.

Eric Perkunder