#-ad_banner-#Coffee chains like Starbucks (Nasdaq: SBUX) get the lion’s share of press when it comes to the $7 billion fresh coffee market. And up until now, the company has focused primarily on the chain’s retail side of the coffee business. What investors haven’t realized is that 86% of coffee drinkers consume coffee at home. That’s $2 billion worth of business that has largely gone ignored. Until now, that is.

Firms formerly focused on the retail side of the coffee business, are venturing into the all-important home coffee market. This includes Starbucks — the very company that brought coffee shops to the masses — which is combining forces with the market leader in the space. The combination represents a compelling investment opportunity.

The vast majority of the coffee market’s growth potential lies with in-home product offerings. For investors, the profit potential lies in single-cup serving home machines. Back in 2004 and 2005, the leading food players came out with single-serve coffee systems, whereby a single “pod” is placed in a coffee machine that combines the pod with hot water for a single-serving cup of coffee. Sara Lee’s (NYSE: SLE) Senseo machine came out in 2004 and was followed by the Nespresso machine from Nestle and the Tassimo device from Kraft (NYSE: KFT) in late 2005.

These single-serve systems have seen modest success since being introduced, but they have been eclipsed by the popularity of Green Mountain Coffee Roaster’s (Nasdaq: GMCR) Keurig brewing system. Green Mountain is currently the only pure-play firm in the space, and the stock’s incredible 458% gain in less than two years illustrates the fact that it now commands between 70% and 80% of the single-serve coffee market in the United States.

 

Green Mountain’s share price jumped more than 40% on March 10, 2011, the day it was announced that Keurig would be offering Starbucks pods. The stock now trades at a lofty forward price-to-earnings (P/E) ratio of 53. However, this is arguably justified, given that adding Starbucks to its system should keep growth going at a rapid clip. A sky-high valuation is also justified by historical growth, when sales expanded more than 32% annually during the past decade and earnings at greater than 29% each year during this period. Growth has only accelerated since then; during the past three years, annual sales growth has averaged 58%. Earnings have grown by an average of 71% annually. 

Starbucks anticipates its single-cup packages will bring in $1 billion in annual sales within a couple of years. This would boost sales by about 10% from current levels. However, given that profit margins of 30-35% for single-cup coffee are much higher than its store margins of about 20%, the positive profit impact is even higher. I estimate this can boost earnings to $2 per share, up from current projections of $1.50 per share.

Action to Take —> With a number of avenues for investors to profit in the space, I find buying the stocks of both Green Mountain and Starbucks to be a great combination for big shareholder gains.

With Starbucks anticipating $1 billion in sales from single-cup coffee, Green Mountain can capture at least half of this amount, which means a 30% or more jump in sales from current levels of $1.6 billion. A corresponding earnings boost of 30% would increase forward projections of $1.77 to $2.30 per share. At the current share price, this represents a forward earnings multiple of 28, which looks downright reasonable given earnings are growing at more than 50% annually.

As for Starbucks, single-serve coffee could further boost already-improving store growth trends and should breathe more life into the company’s domestic growth prospects. Starbucks remains firmly committed to store expansion overseas, and combined with the single-serve pod potential, this could allow earnings to grow at a 20% annual clip for the next few years. With the earnings projections I gave above, the forward P/E would be less than 17 — also quite reasonable, given the growth potential.

Overall, I see the potential for at least 50% gains in both Green Mountain and Starbucks shares within the next three years.