COMMENT
Trouble Brewing In Coffee Shops

Marks & Spencer (LSE: MKS) is about to give the already-crowded café market a good stir by adding takeaway coffee to its menu. It has launched three sites in London that have been equipped with, what the company describes as, state-of-art Italian coffee machines. What's more, it plans to add patisserie-style cafés in other stores too. Just think what an extra 400 coffee shops may do to a saturated café market.

According to market research company Euromonitor, the boom in the UK coffee shop market is well and truly over. So is it a case of being better latte than never for M&S?

Currently, there are over 8,000 coffee shops in the UK, with branded coffee chains accounting for around one in three café. It is little wonder that almost every high street up and down the country now has a Starbucks (Nasdaq: SBUX), Costa Coffee, which is owned by Whitbread (LSE: WTB) and Caffe Nero (LSE: CFN). In fact Caffe Nero reckons there is room for at least 400 of its outlets, which will represent a doubling in size of its existing chain.

Without doubt, explosive growth has been the main feature of the coffee shop market since it emerged in the 1990s. And despite intense competition, expansion generally at the expense of profit has been a key strategy for the main operators. However, expansion has also seen some weaker players ground down by better capitalised companies. For instance, Coffee Republic (LSE: CFE), which was once the third-largest café owner with 107 outlets, has withdrawn from the branded coffee shop arena altogether.

Interestingly, with some semblance of order in the café market, margins have improved considerably. What's more, operations that were once loss-making are now firmly in the black. In September, Caffe Nero said annual profits doubled to £5.6m on sales of £70m. Margins improved too, up from 6% to 9%. But at 250p, Caffe Nero shares are valued at 36 times earnings. Plainly, investors are expecting the company to grow very significantly.

But it may pay to tread in the sector. The entry of M&S, plus the expansion of franchise operations such as Puccino's, may cause margins to contract again. In my view, there are still lots of unanswered questions. For instance, how will branded coffee shops evolve to survive, and will serving food to cost-conscious British consumers provide the answer? More importantly, can a sector that has quadrupled in size in five years carry on growing? It may do, but when I hear that Costa is taking its brand to China, then it almost certainly means that growth at home is slowing.

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