Coffee bars in a froth as rivals vie for supremacy

Caffé Nero is upbeat about demand for the designer bean, but other chains have put expansion plans on hold and investors remain unconvinced

The cut-throat world of the coffee shop market looked to have delivered its first victim in the form of the ubiquitous Starbucks. The US coffee company notorious for the deployment of predatory-style tactics to infiltrate high streets up and down Britain was widely reported to have halted its ambitious UK expansion plans. The knives were out.

Critics of the designer coffee shop fad, which has seen 1,500 branded coffee bars spring up in the past four years, hailed the reports as further proof that the British taste for speciality coffees was as fleeting as the froth on a cappuccino. Earlier this year, another coffee chain, Coffee Republic, halved its expansion goal from 40 to 20 coffee bars and even closed three.

But in fact the future for the designer bean still looks as perky as ever. Starbucks insisted yesterday that its aggressive rollout plans remain unchanged – 100 new stores are scheduled for this year – coupled with an upbeat assessment of the market yesterday from Caffé Nero, the smallest of the Big Four in coffee shops, suggest the future of the coffee bar is still strong.

Gerry Ford, chairman and chief executive of Caffé Nero, was optimistic about the Italian-styled chain's opportunities to take on the best of them. However, the company reported widening pre-tax losses of £2.75m, up from £1.37m last year. Turnover surged to £15.6m from £6.7m. Mr Ford bases his optimism on a strong economic model, which combines a highly cash generative business with high gross margins of 70 per cent and around 35,000 transactions per day.

David Stoddard, an independent analyst at Teather & Greenwood, sees substantial growth prospects for the sector, especially outside London. He expects the number of branded coffee bars to increase by 40 per cent to around 2,100 by 2004 – slightly less than the 2,400 bars forecast to mushroom by 2003 by Allegra Strategies, a research company. And far from reaching saturation point, with just one branded coffee bar per 65,000 people the UK is still playing catch up with the US, where the penetration levels are one per 27,000.

Where coffee bar operators need to adapt their style, argue critics, relates to the products they sell. While even a simple latte can cost something north of £3 in some stores, the take-away culture that dominates customers' attitudes towards buying a coffee means that it is difficult to increase average spends.

Mr Ford thinks he has the answer: "Food that travels throughout the day. We start with freshly baked muffins and pastries in the morning, switch to fresh pasta, paninis [toasted Italian sandwiches] and interesting salads at lunch and then later on bring in cakes and biscotti," he said. "Our food accommodates what consumers want at a given time." Which means that customers that might just pop in for an espresso elsewhere grab something more substantial, staying longer and spending more. Outside London, the take-away to eat-in ratio is typically 30:70, compared with 70:30 in the capital.

Unlike its rivals, Caffé Nero makes 35 per cent of its sales from food products. This compares with around 15 to 20 per cent at Starbucks and Coffee Republic. Although margins on food are lower than those on drinks, they boosted Caffé Nero's average spend per head to £3 last year, against £2.20 to £2.30 at its competitors stores. Teather & Greenwood's Mr Stoddard agrees that the business model is sound. "So long as transaction volumes are high enough the low average transaction values aren't a problem," he said. "The key is how much food you sell."

Investors are not so easily convinced. Shares in Caffé Nero edged 0.5p higher yesterday to 40.5p. The stock has lost 20 per cent since it floated in March. Shares in Coffee Republic, yet to make a profit, slipped 0.75p to 12p, off a year-high of 29.75p.

Mr Stoddard sees the problem as poor newsflow. Last month, McDonald's confirmed it was selling its 36-strong Aroma chain, the first of the UK's branded coffee bars. While the fast food giant will convert the best sites to Prêt-a-Manger outlets, in which it has a stake, the move gives a taste of the consolidation the City believes is inevitable. Costa, Starbucks, Coffee Republic and Caffé Nero – control 60 per cent of the coffee bar market.