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Recent Developments

Shares of Monster Beverage (NASDAQ:MNST) are down nearly 50% after setting an all-time high of $83.96 per share earlier this year. The shares began their decline after The New York Times reported that the Food and Drug Administration has received five reports of deaths over the past eight years linked to Monster Energy Drink. However, the company denies that its drinks may have been responsible for these deaths. In a statement, the company said that it has sold 8 billion energy drinks around the world and does not believe that its beverages are the cause of these deaths.

Personally, I think this news is way overblown. Energy drinks typically carry warning labels advising that children, pregnant women, and those who are sensitive to caffeine should avoid consuming energy drinks. Furthermore, Anais Fournier, the 14-year-old who died after consuming two large Monster Energy Drinks, had a pre-existing heart condition. We also cannot be sure if any of the other deaths can be linked to a medical condition or to energy drinks being used in conjunction with alcohol or drugs.

I also don't think that energy drinks are going to face anything as severe as getting banned, but we might see some regulation regarding the marketing and labeling of energy drinks. The worst case scenario in a situation like this is Monster will be charged maybe $5 million, which is a drop in the bucket for a company like this.

Business Analysis

Profile:

From its humble beginnings as a fresh juice company in the 1930s in California, Monster Beverage Corporation, or formerly named Hansen Natural Corporation, has successfully emerged as the world's second-largest energy drink company behind privately held Red Bull. Energy drinks make up the majority of the company's business (92% of revenue), led by its Monster Energy Drink brand, which was launched in 2002.

Growth:

Revenue from the company's energy drink products exploded from just over $49 million in 2003 to close to $1.6 billion by 2011 as the company's marketing efforts have resonated with consumers across the country. The company wants to duplicate its success in its home market across the globe. Considering less than 18% of the company's net sales come from outside the U.S., I believe the company possesses massive growth potential.

I still see huge growth potential in the domestic market as well, even though the Monster brand has a leading 34% market share of the U.S. energy drinks market on a volume basis (Red Bull is a leader in terms of dollars and is a larger player globally). By my calculations, the average American consumes 10 servings of Monster Beverage products per year, compared with 410 servings per year of Coca-Cola (NYSE:KO) products. I believe that per capital consumption in the U.S. for energy drinks can grow at over 30% annually for the foreseeable future, as a result of shifting demographics and new flavors. In the U.S., energy drinks resonate with a rather young demographic (mostly males 18-34), but as the years go by, Monster's customer base will continue to grow as their existing clientele ages and new young consumers are drawn to the product.

I believe that Monster also has growth opportunities to introduce new beverages. Although some product introductions, such as Monster's Worx Energy Shot (which competes against 5-Hour Energy Drink), have failed to gain a foothold in the marketplace, other products such as Java Monster and the noncarbonated Monster Rehab (a ready-to-drink tea) have garnered shelf space and market share in the convenience store channel.

Profitability:

Monster Beverage is extremely profitable. The company has an asset-light business model, because it utilizes third-party manufacturers and distributors to bring its energy drink to market. This type of business model has allowed the company to earn high returns on invested capital, which have averaged above 60% over the past decade (excluding excess cash and including off-balance sheet operating leases).

Financial Health:

Another aspect about the company that I really like is its strong balance sheet. As of September 2012, the company had over $610 million in cash and investments with minimal debt (mostly operating leases). Additionally, considering that the company earns around $300 million in annual free cash flow, the company has little need to tap the capital markets for funds.

Risk Factors

While Monster Beverage is a fantastic business, there are some risks that investors need to consider before investing in the company:

  • The company faces stiff competition from Red Bull, 5-Hour Energy, and ROCKSTAR. Additionally, the company also faces competition from leading beverage companies such as PepsiCo (NYSE:PEP) and Coca-Cola who have their own caffeinated energy drinks that consumers may choose.
  • Approximately 30% of Monster's products are distributed via the Coca-Cola Company, and if this relationship falters, Monster's business would most likely suffer.
  • Consumer preference could change. Should people switch away from energy drinks to something else, Monster's volume could decline significantly.
  • Some of the flavors and artificial sweeteners that are in Monster's drinks are sourced from just one provider. Production issues at these suppliers could have a temporary negative ripple effect across Monster's supply chain.
  • One customer accounts for a large portion of the company's net sales. Coca-Cola Refreshments, a subsidiary of The Coca-Cola Company, accounted for 29% of net sales in 2011. If Monster is not able to maintain a good relationship with this customer it could have a material adverse effect on it business.
  • Governments might impose legislation or taxes that impact the company's business, which may slow down Monster's growth rate.

Management & Stewardship

Monster has delivered excellent returns to its shareholders during the last decade. Chairman and CEO Rodney C. Sacks has led Monster since 1990 and has helped turn it into one of the world's largest energy drink companies. Additionally, Sacks and CFO Hilton H. Schlosberg collectively own close to 30% of the company. I believe that their significant holding adequately encourages them to profitably grow the business.

While I do like what management has done with the company over the years, I am somewhat disappointed to find out that the company has some related-party transactions. According to the company's most recent proxy statement, some of these related-party transactions include a director who is a partner in a law firm that gets paid to provide legal counsel to the company, as well as two directors whose families sell promotional material to Monster. Expenses for these transactions totaled $5.2 million in 2011. I would also like to see the chairman and CEO roles separated between two individuals. Overall, I view the company's standard of corporate governance as average.

Valuation

I estimate that a conservative fair value for this stock is just under $50 per share. In my fair value I forecast revenue to increase at 18% on a ten-year CAGR basis and profit margin to average around 12% during the ten-year forecast period. The fair value estimate implies an 8 times forward P/FC multiple. Excess cash on the balance sheet is also taken into account, which adds about $3 per share to the fair value estimate. As of November 12, 2012, the shares were trading around $45 per share, which gives us a margin of safety of approximately 11%. Personally, I would require a much larger margin of safety before buying the shares.

Conclusion

I believe that Monster Beverage is a good company with huge growth potential. However, considering the risks involved, I would wait for a larger discount to my fair value estimate before buying the shares. I believe an attractive entry point would be in the $25 to $30 per share range. Even paying up to $35 per share is reasonable if you're a long-term oriented investor.

Summary of Analysis:

Recent PriceFair Value EstimateMargin of Safety
$45.00$50.0011%
Financial HealthProfitabilityGrowth
Grade: AGrade: AGrade: A
ManagementEconomic MoatBusiness Risk
Grade: BNarrowHigh
Source: Monster Beverage Corporation Has Huge Growth Potential