There have been some easy predictions in the past, but this one investors should have seen coming a mile away. The trend was clearly presented in our Capital Ladder Advisory Group, LLC. Q3 Preview issued a week before Monster Beverage Corp. (NASDAQ:MNST) released its Q3 earnings results and that same trend persisted through Q3 as we all saw once those earnings results were released to investors.
Monster reported earnings and revenues that missed by a wide margin and shares fell sharply during the after hours session on November 7th only to rally during the day on November 8th to finish slightly down. This rebound in the share price leads many investors to believe that MNST has seen its worst days in the near term. Only time will tell, but the trend is clearly working against Monster Beverage Corporation and on many operational fronts.
Monster noted that higher effective tax rates, lower sales in the U.S., lower sales to Coca Cola refreshments Canada Ltd., lower sales in its warehouse segment, lower sales for Worx and changes in foreign currency exchange rates had an unfavorable impact on net sales during Q3 2012. Additionally, while the company achieved profitability in South Africa, Central and Eastern Europe are still incurring operational losses. Note that these European regions are highly penetrated by Red Bull and private label energy drink producers.
Sales of Peace Tea, ready-to-drink iced teas continue to exceed management's expectations. In the third quarter of 2012, gross sales of Peace Tea increased 44.1% over the same period in 2011. The company is continuing with their plan to introduce additional packages and container sizes for the Peace Tea brand during the first quarter of 2013. Additionally, Monster is continuing to sell in market Worx Energy shots, although there has been a substantial drop-off in sales.
Monster has continued to expand its global distribution by adding Turkey and the Philippines to its international portfolio of markets during Q3 2012. Management outlined that the company would look to expand further in the upcoming months by adding the nations of Chile, Peru and Singapore.
Unfortunately, the company continued to delay its market entrance for Korea as management persists with efforts to overcome product approval and label issues in Korea. November marks one full year since the company initiated its expansion efforts into Korea. The expenses related to these efforts are not parsed out for investors to fully see the impact they have had on the bottom line, but we suspect they are much more than the company desires. We tread very lightly with the topic of Korea as we outlined before to investors that Monster has already issued false and misleading statements regarding expansion and product approval efforts in Korea in the past. Noted below are management's statements from the Q3 2011 earnings conference call:
Getting products improved, even in Korea, has been a challenge, because until now, they have not really permitted any energy drinks containing caffeine in Korea and South Korea. So we've had some relaxation on how to get products approved in Korea that still have efficacy, which we've done now and -- but there have been some hiccups. Red Bull just recently launched in Korea, got some shipments in, then had shipments placed on hold and had empty shelves and then had to have debates with the authorities about formulations and reformulations. And we have had an approval for our products, and we're now in the course of planning the actual launch.
There is a pretty large discrepancy here between the statements made during Q3 2011 and what has actually transpired. We would suggest that investors don't overlook these statements as a matter of misspoken words; 13 individual hedge funds surely have not and we may hear more related to this developing top in the near future.
We outlined a series of headwinds the company would face in Q3 and it appears as though many have come to fruition. One of those very headwinds was related to distribution in Japan and profitability in the newly entered market. Just like in Q2 2012, Monster continued to struggle with shipments and incurred damages in the Asia Pacific region. The company incurred damages of product losses in relation to the production and shipping of products for Korea and Japan which negatively affected gross margins during the quarter.
Below is the direct statement we made on our Monster Beverage Corp. Q3 Earnings Preview:
Getting into the nitty gritty of Japan and Korea is proving difficult for analysts and stock strategists as Japan is quite new and carries high input costs. Monster has already stated this will be a strong market for the company in quarters to come, but initial input costs could continue to be a drag on the region and the bottom line as the region matures and operation missteps are ironed out. Korea poses additional need for consideration.
Issues related to advanced distribution and expansion remain a core profitability and margin issue for Monster. Sales in several regions are becoming more of a concern due to issues related to distribution partners. Brazil has been a key concern for Capital Ladder over the last few quarters as we noted to clients and readers of Seeking Alpha. Below is a detailed statement from our initial coverage on MNST:
As is often the case in situations where a distributor can no longer execute to the terms of the agreement, a wholesaler can step in and fund ongoing operations until additional lines of capital are acquired by the distributor. A second method of rectifying the situation can be an acquisition by the wholesaler of the rights of distribution to the region being serviced by the distributor (this is the most common approach used and the most profitable as margins can be greatly increased from direct sales). The third method of remedying the problem is an outright acquisition of the distributorship which in the case of the Brazilian distributor could position Monster Beverage perfectly in the South American market as it expands into countries like Peru, Chile and Argentina in the future.
The point we are trying to make here is that although this was not a focus event on the recent earnings conference call, it very well should have been as these distributor issues are ones that can cause big hiccups for future results that would-be and current investors had not anticipated. Distributors drive your business and if they don't, your business falters. We have seen instances in the past, and with other companies, where both bottom and top line results were greatly missed do to a company not addressing a distributor issue in a timely manner. Unfortunately, investors didn't see the miss coming as the company and the analyst community did not focus enough attention on the issue until it was too late.
Now let's take a look at what Monster Beverage Corp. said about Brazil on its Q3 Earnings conference call. It looks like management has reached its end game with the current distribution partner in the region and needs to make a decision in the near term to recapture lost sales and possibly lost market share in the region.
We are in the midst of reevaluating our strategy in Brazil as we have not been satisfied with Monster's results achieved there this year and have reached an advanced stage of negotiations with an alternative distributor.
The confluence of all these operational headwinds combined with lower sales in some product sectors resulted in lower than expected gross margins in Q3 2012. Analysts had projected margins of 53% while they came in at only 50.5%, down from 52.7% in Q3 2011. The company states that the decrease in gross profit as a percentage of net sales was largely attributable to geographic mix, production variances and product damages primarily in Europe and Asia, including production cost increases forced onto the company by partners in the United Kingdom, an increased promotional and other allowances as a percentage of net sales. You can very easily classify all of these issues as "operational headwinds".
So is the worst behind the behemoth energy drink producer? Probably not. As you can clearly see, these operational issues and sales trend issues don't simply turn around in a few short months, they tend to take a good 6 months to a year in some cases depending upon the operational issue. With regards to Asia, expect to see more pressure on gross margins moving forward or at least until the company can find a local producer in the region. Management outlined that the company was currently looking for an appropriate producer in the region, but until they can accomplish this feat, profitability will remain slow-coming.
Investors have to read between the lines sometimes and in the latest Q&A session we see another operational headwind that will possibly impact the company in Q4. We call these "between the liner gems". They show up in every conference call - you just have to pay close attention. Take a look at this one below from the Q3 conference call. The statement is from Rodney Sacks, Monster's CEO:
We also just had some price increases in the U.K. from our packer and we had some price variances and some damages there again. We had some losses. There were a number of changes that took place in some countries for regulatory reasons and we ended up with some inventory excesses which we are obviously trying to work through to sell elsewhere. But we think we will be able to work through that as it will normalize more going forward as we continue to establish the brand and the company internationally.
It is very obvious that many European nations are increasing the regulations surrounding energy drink products as well as other sugar-sweetened, carbonated beverages. This increase in regulatory changes usually means higher related costs to the producer of such products. We would expect to hear more or see more related to this topic going forward as the company struggles to achieve and/or maintain profitability in Europe.
It is a littered landscape the company is hoping to overcome as they recently exhausted the company's buyback plan. On November 13, 2012 the company instituted a new share repurchase program which helped boost shares of MNST in the early trading session. But the company needs to do much more than this to return shareholder value going forward. Management needs to overcome the operational issues which are plaguing profitability in several regions. It has been over a year since the company entered regions in Central and Eastern Europe and yet, by and large, they remain unprofitable as the company addresses distributor, regulatory and promotional issues. Competition continues to redefine the energy drink landscape and curtail the long term growth for individual companies participating in the sector.
We look forward to an improvement for Monster Beverage Corp in the quarters to come, but would suggest that investors pay close attention to the sales and gross margin trend that persists.