The Fuqua School of Business at Duke UniversityFUQ-02-2006

Cecocafen: Providing Hope In AnUnstable Market

Prepared by Dan Grundman, Richard Hooper, Amber Kuchar, Kristopher Nordstrom under the supervision

of Campbell R. Harvey. Copyright © 2006. All Rights Reserved.

Cecocafen: Providing Hope in an Unstable Market

Case Synopsis

This case explores the viability of an inexperienced coffee cooperative buying a dryprocessing mill in Nicaragua. The Center of Northern Coffee Cooperatives (Cecocafen)is only two years old and believes that it is vital to their social mission and businessstrategy that they control the entire production chain to improve quality and ensureconsistency of its product. The cooperative faces substantial challenges in completing the transaction, including executing a successful business model in the face of extremelyvolatile market conditions and uncertain political and economic stability. Furthermore,there is no precedent to follow, as no cooperative has ever attempted to purchase a mill. Only a thorough examination of the numerous risks and uncertainties facing Cecocafenwill determine whether or not the transaction is feasible.

Objectives of the Case

By working through this case, students should develop an understanding of thepolitical, economic, and social context around a strategic investment decision in anemerging market. Specifically, the case requires an analytical look at the variousfinancing options available for enterprises that promote social welfare, the impact of non-financial returns in determining whether or not to accept or reject an investment, and theimportance of evaluating real options in building a longer-term view of a particularscenario. In addition, the case asks students to evaluate both the explicit and implicitrisks associated with a project or investment, explore alternative investment/projectvaluation methodologies in light of ambiguous or incomplete information, andunderstand the role of the cost of capital and cost of debt in analyzing financial returns. To a lesser extent, the student should also consider the strategic implications of verticalintegration.

Primary objectives of this case include: • Risk assessment of the coffee industry• Risk assessment of the political, economic, and social environment in Nicaragua• Analysis of Cecocafen’s investment decision• Analysis of a foreign bank’s investment decision with respect to both financial

and economic rate of return• Identification and evaluation of real options• Evaluation of supply chain control in an industry which provides the economic

foundation of an emerging market• Qualitative analysis of the social impact of the cooperative system and specialty

coffee

2

02-2006

Why Coffee?

Cecocafen: Providing Hope in an Unstable Market

Coffee is the second largest commodity traded on the world market, second only to

oil, and has a huge impact on the lives of millions of small farmers across the world. Coffee is also interesting because of the complicated relationship between the variousstakeholders, geopolitical relationships, and price volatility. The principal consumers ofcoffee are in the developed markets while coffee production only occurs in emergingmarkets, and a very small percentage of the final price is derived from the cost of thebeans. This presents a formidable challenge for those attempting to improve the livelihood of coffee producers by helping them to capture more of the value of theirproduct and to be less vulnerable to the instability of the world coffee markets.

Why Fair Trade and Cooperatives?

Fair trade coffee bypasses the traditional export middlemen and provided additional

support to the farmers, which give the producer higher profits and protects them from market risk. Fair Trade products are marketed as a socially responsible product thatprovides a living wage to the farmers. Western businesses and other organizationspartner with small businesses, cooperatives, and associations in emerging markets toimprove the livelihood of small farmers by increase their access to credit and establish higher prices for their products. The profits from the Fair Trade are often reinvested incommunity projects such as health clinics, childcare, education, and literacy training.

Risk Identification and Mitigation

There are several risks facing Cecocafen’s decision to purchase Solcafe. These risks

can be divided into four generalized categories: 1. Production risks – those risk factors that directly impact the production of coffee2. Market risks – those factors impacting the coffee market as a whole3. Transaction risks – risks directly related to the purchase of the dry processing mill4. Sovereign risks – risks facing any business operation in Nicaragua

Below is an in depth analysis of these risk factors, their potential impact to the

cooperative’s business model, as well as potential mitigating factors:

3

Cecocafen: Providing Hope in an Unstable Market

Production Risks

General Risks Specific RisksMitigating Factors

W

e

at

h

er

The yield of the Nicaraguan

market is

There is little that can be done todependent upon largely unpredictablemitigate this factor, but Cecocafen’s factor of weather. Worldwide prices shade tree farms are slightly moreare determined in large part by weatherprotected from the dangers of erosion orconditions in competitor countries.sustained winds.

N

at

ur

al

The coffee-

growing area

of Nicaragua

There is little that

Cecocafen can do

to

Disaster

is subject to earthquakes and volcanoes. protect against natural disaster. Such occurrences can damage not onlycoffee production, but destroy the roadsneeded to transport the product.

L

a

b

or

u

nr

es

t

Failing

Coffee growing is

a labor-intensivepractice, and its production could behampered by strikes and workstoppages.

Nicaragua’s

poor road

system is a

Cecocafen’s cooperative

set-up ensuresthat small growers have a politicalvoice in determiningCecocafen’sstrategy. Also, Cecocafen’s move towards vertical integration will help inguaranteeing growers a

better price for their beans than they could achieve on their own. Finally, Cecocafen’smanager Pedro Haslam has the trust ofmany of the farmers as a result of hisyears in the Sandanista military.

Cecocafen has contacts within

the NGOinfrastructure

4

major impediment to agricultural community and can advocate forproduction. The country also lacks infrastructure projects, but overall willadequate ports, requiring exportation to have little ability to influence thego through Honduras or Costa Rica. quality of infrastructure. They haveGiven the country’s high level of used some of the proceeds from Fairindebtedness and the conditionality of Trade to build roads to their producers’International Monetary Fund debt, it is houses. unclear whether the government will beable to allocate resources maintain or improve the infrastructure.

z

02-2006 Cecocafen: Providing Hope in an Unstable Market

Market Risks

General RisksSpecific Risks Mitigating Factors

Price Volatility The coffee

market is among the most

The cooperative set-up allows

a certainvolatile commodity markets in the amount of hedging to take place via theworld. As a general trend, falling

futures market. While prices have been

coffee prices have been squeezing falling, Cecocafen’s business strategymargins for coffee producers, as inputprices remain unchanged.

focusing on high-quality specialtycoffees ensures that its growers willreceive a premium price over its competitors. Fair Trade coffee price floor creates some protection from theprice volatility. In 2001, when worldprices dropped below the break-evenpoint, Fair Trade was vital to thesurvival of producers.

Market World consumption of coffee has Demand for specialty

coffees has beenDemand

increased by an average of only 1.2%since the 1980s, unable to match thegrowth in supply.

growing at a much greater rate. Goingforward, analysts predict that demandgrowth will fall slightly, but still remainwell above the trend for coffee overall at 4%.

New

marketentrants

The World Bank is promoting coffee Cecocafen’s

strategy of creating high-production as a means of development quality specialty coffees will set their in many Southeast Asian and African beans apart from new entrants who arenations. mostly

focused on high yield, low

quality beans.

Asymmetry ofinformation

General Risks

Lack ofAvailableCredit

Importers are unable to determinequality of the beans they are purchasing

Transaction Risks

Specific Risks

Cecocafen cannot fund the purchasethrough equity alone. National banksare reluctant to lend to cooperatives,and the project is too small to garnerinterest from the major internationalNGOs

Importers would be more assured ofconsistency in quality if Cecocafenmaintained control of its beans throughthe processing stage.

Mitigating Factors

Management has identified threeanthroposophical banks willing to lend to finance projects with a social impactin developing nations.

5