Green Mountain Coffee Roasters, Inc. (GMCR) continues to disappoint investors through the first three quarters of fiscal 2012 as the company lowered guidance in both Q2 and Q3. Since rising to almost $70 a share in February this year, the stock has been under intense pressure as short interest has also risen during this time. After releasing Q3 earnings that once again disappointed investors in many aspects, including gross margins which fell for a third straight quarter, the company announced a strong buyback plan that essentially helped to serve as a base for the stock price during the quarter. Once investors discovered the $500 million buyback within the quarterly release, the stock rebounded in the after hours trading session from $15.75 a share to nearly $22 a share.
The company lowered its fourth quarter guidance and made an attempt at level setting expectations for the foreseeable future. This was probably the smartest move by management in the last 3 reporting cycles. Looking toward Q4 2012, here are the company's expectations:
- Total net sales in the range of $889.9 million to $925.5 million or net growth of 25% to 30% from $711.9 million in the fourth quarter of fiscal 2011.
- Management now anticipates fourth quarter 2012 non-GAAP earnings per diluted share in the range of $0.45 to $0.50 per diluted share, excluding the non-GAAP items.
Here is a look at what the company achieved in Q4 2011:
- Total Net Sales: $711.9M
- K-Cup® portion pack net sales: $475.5M
- Keurig brewers & accessories net sales: $115.1M
- Earnings of $0.47 a share
- Approximately 83% of consolidated net sales from Keurig Brewing System (brewers + K-Cup ® portion packs)
- Q4'11 GAAP operating income increased by 156% over the prior year quarter
- Q4'11 non-GAAP operating income improved 128% over the prior year quarter
- $0.7 million in expenses associated with SEC inquiry and pending litigation
- $11.8 million in amortization of identifiable intangibles related to the Company's acquisitions
- Q4'11 non-GAAP operating margin of 16.7% of net sales compared to 14.0% in Q4'10
As I stated, the lowered guidance and level setting of expectations was a smart move by management. Furthermore, the company clearly detailed the reasons for lowering guidance for the general investing public, for which a greater sense of action on behalf of management was being displayed. Fran Rathke noted that prior forecasting methodology needed to change due to the dynamics of a maturing company. Let's look at the methodology and reasoning outlined by Fran Rathke on the conference call:
- The company's prior forecasting of demand was flawed to some degree given the rapid growth of distribution and channel distribution segments, which have recently slowed in growth and diverged.
- Once target channels reach a higher level of penetration, naturally growth slows and forecasting demand needs to be more closely monitored and methodology for forecasting demand needs to be adjusted as GMCR is in the process of doing.
- Temporary under utilization of labor and capacity, which primarily played out in the firm's fiscal second and third quarters and will also affect the fourth quarter, is another factor in the lower guidance issued. Naturally, utilization of labor and capacity are directly correlated to forecasting and the under utilization likely led to some unnecessary expenditure in the quarter, which should be remedied come Q1 2013 with a higher level of execution.
- Lastly, the company's new forecasting methodology takes into account seasonality and ordering cycles and patterns which can shift QoQ. Since growing its grocery retail base, specialty and department store retailers have curbed their inventory levels, which are also taken into account under the new forecasting methodology.
Fran also touched on increased orders from retailers, which influenced Q1 2012 results as trade inventory levels at retailers spiked due to fear over GMCR's capacity constraints. Now that these constraints are no longer an issue for GMCR and its retail partners, a more normalized ordering pattern can be tracked, thus offering greater ability for the company to guide shareholders.
Issues plaguing the company and its stock price continue to center on its core patents and competition. Let's put this to rest once and for all and accept the statement of the CEO as fact and a jumping point toward more pressing matters the company will be facing. Larry Blanford said that the K-Cup patents will be expiring in September of 2012 and the company will likely face increased competition. However, he also noted that GMCR has been and will be prepared for this greater threat. The company's strength comes from its brand recognition and abundance of choices in flavors and price point for brewer systems. Competitors will have to at the very least match this competitive edge going forward to greatly disrupt GMCR's business. The company believes in its strength as a market leader and points to its relationships with current licensees as proof that they can add value to a private label entrant's prospects in the space. GMCR will be adding to its brand partnership with Folgers and Starbucks (SBUX) when they introduce these brands to the Vue platform later this year. Most importantly, with regards to competition, the CEO has outlined the plan in place already to combat and even invite competition to some degree as the company feels they will gain more licensees and partnerships. Larry Blanford also states that the threat of competition is baked into its 2013 guidance.
Now let's take a closer look at some of the operational highlights that have recently been announced by GMCR. Larry Blanford knew what he was talking about in the way of licensing deals to come. The first licensing deal was announced on October 9th. The company reached an exclusive deal with Dr Pepper Snapple Group (DPS). Green Mountain Coffee Roasters and Dr Pepper Snapple Group announced the companies have reached an agreement to offer Snapple® premium iced teas in K-Cup® and Vue® packs for Keurig® single cup brewing systems. The new Snapple K-Cup® and Vue® packs will be filled with the finest teas to create a great-tasting iced tea experience with the ease and convenience of a Keurig® brewer. Snapple K-Cup® pack iced teas will be offered in a variety of at home and away from home channels for Keurig® brewer consumers in the United States and Canada in Spring 2013, with Vue® packs to follow. The new beverages will join the current Brew Over Ice collection, a line specially crafted to brew iced beverages with any Keurig® brewing system, making it easy and convenient to get a refreshing iced beverage at home or in the office.
The second agreement was reached between Costco Inc. (COST) and Green Mountain Coffee Roasters. GMCR announced it is the exclusive manufacturer of Costco Kirkland Signature brand K-Cup® packs for the Keurig ® single cup brewing system. The new offerings bring together the broad consumer appeal and value of Costco's premium store brand with the high quality and convenience of the Keurig ® single cup brewing system and its best-in-class Keurig Brewed® coffee and beverage brands.
When analyzing GMCR's current quarter and future quarters, investors should factor in both competition and new product launches. The only competitive edge the company will have going forward is its technology and further product innovations. Many will argue that the company's extensive distribution channels will be hard, if not impossible to match, but matching GMCR's distribution isn't necessary to achieve profitability in this market segment. In fact, many bear fund managers would point to the company's inability to scale profitability for such a business which is heavily levered to commodity and raw material costs that don't seem to be coming down in a sustainable way. GMCR is the clear leader in this business segment, but achieving greater net profitability for shareholders will fall upon operational success going forward and this falls within being able to forecast demand as noted earlier.
Competition is attacking GMCR from all angles and it seems to have hit a climactic point during the 4th quarter with product launches from a host of brewer manufacturers and grocery retailers. Supervalu (SVU) recently announced its entrance into the single-serve coffee market with coffee pods which will be compatible with popular brewer systems like the Keurig. Grover Square, a private-label brand of coffee from Sturm Foods, a division of private label powerhouse Treehouse Foods, also announced the company was getting into this hotly contested market. Geared for use in Green Mountain's Keurig coffee makers, Grover Square single-serve coffee is appearing side-by-side at Wal-Mart (WMT) with other Green Mountain brands. The importance of these two entrants into the single-serve market is simple; it's all about pricing. At Wal-Mart, Grove Square is priced 20% lower than Green Mountain. Unfortunately for Grover Square's, the company is already having issues with their K-cups showing breakage and grounds in the coffee. But if all this competition results in a price war, Green Mountain's margins could fall further than they already have. More recently a retail analyst, Howard Penny, laid claims to the notion that Kroger (KR) is selling its store brand product of coffee pods at $6 each, an entry point that could pressure Green Mountain Coffee Roasters, Supervalu, and Safeway (SWY) to trim prices on their single serve offerings.
Looking at GMCR's competition from another angle, we come to focus on other brewer systems which seem to be coming to market in rapid-fire during fiscal Q3 of 2012. A host of new brewers from independent companies have hit store shelves in recent months and just in time for the heavy holiday shopping season.
Bed Bath & Beyond (BBBY) is the biggest GMCR retail partner by sales volume. The home goods retailer is now featuring three of Braun's Tassimo brewers and flavored coffee pods on its e-commerce site and featuring the product in highly visible areas in the kitchen electronics department. Free shipping was offered until October 9, 2012 on all Tassimo products. Through channel checks we've conducted, orders for the Tassimo system have increased month-to-month at Bed Bath & Beyond by nearly 11% since June 2012, while orders for Keurig brewers have shown signs of slowing growth. For more information on channel check data, view our channel checks provided earlier this month, or take a look at past results.
Tassimo is not the only increased source of competition GMCR is facing. Nespresso has launched a whole new line of coffee and espresso makers that can be purchased at Sur La Table, Williams-Sonoma (WSM), Macy's (M) and Crate & Barrel, some of which don't offer Keurig products. With this anticipated increase in competition, it was only a matter of time before the Starbucks single-serve brewer system hits the marketplace. In September, the Verismo hit the market in a big way and sent shares of GMCR tumbling. Apparently, Starbucks' CEO Howard Schultz's reassurance to GMCR shareholders that the company still values and will support its relationship with Green Mountain fell on deaf ears. Apparently, what GMCR shareholders heard from Schultz was, "We are now offering our own brewers, and therefore, we will take market share from GMCR."
Lastly, there is also Green Mountain's My K-cup which is also witnessing the threat of competition. Wal-Mart has its very own version of the My K-cup in stores and at half the price of a $19.99 Green Mountain My K-cup . Bed Bath & Beyond is also selling a generic version of the My K-cup at a 10% cheaper cost to shoppers. In light of this new sku offering at BBBY, the retailer also reduced the price of Keurig's My K-cup to $17.99. The Café Cup is also trying to gain market share this holiday season.
Before moving on to additional highlights in the quarter, let's quickly discuss the Vue system. Capital Ladder Advisory group continues to monitor sales for the Vue machines and V-packs. There are a wide variety of opinions on the Vue, but the bottom line comes down to profitability with the newer system, and presently the system is not profitable for GMCR. Is the Vue a failure? In this low margin business, you are either accretive or not and the Vue is not. While GMCR paints a more forward looking profit position for the Vue, it is our belief that the consumer is painting a different picture as is indicated by consistent channel check data acquired by Capital Ladder and is further evidenced by dramatic rebate programs and price cuts on the Vue system during the quarter. But there are two ways to view a rebate program and we suggest investors take into consideration both viewpoints.
A rebate program on the surface can portray a weakness in demand or sales. It assumes that the wholesaler is having difficulty moving product and as such the wholesaler is forced to reduce the price of goods offered in order to recoup some product costs while achieving consumer adoption of the product. But in the case of GMCR, one could draw the conclusion that the rebates offered during the quarter were a result of write downs already booked in order to clear out inventory, which has or will be reflected on the firm's balance sheet. So is the rebate already baked into the books or not? We won't know until GMCR tells investors. Additionally, a rebate program serves to pull demand forward, much like the tax incentives offered to first time home buyers between 2009 and 2011. These tax incentives, or discounts if you will, served to stabilize and clear some housing inventory, and nearly 5 years after the housing bubble burst, we recently saw a 4 year high in Housing Starts data. It is clear that strategic and value added discounts or rebates can prove to be effective for a business model. Having offered two views on rebates and discounts Capital Ladder maintains that sales of the Vue system are not showing signs of near-term profitability.
Some additional highlights which occurred during the quarter related to greater analyst coverage and institutional buying. Lazard's new analyst coverage by Matthew DiFrisco sent shares soaring upon the announcement of a significant price target. Mr. DiFrisco began coverage of GMCR with a buy rating and a target price of $39 a share. Shares headed higher on this offering by Lazard and breached the $30 level for the first time since May, affording investors some hope that shares of GMCR would once again return to glory, or at the very least, achieve a more reasonable price to earnings multiple. So did the Lazard analyst do his homework? The current price action in shares of GMCR would suggest that he didn't, but the reality is that stocks can and do move based on more than just the fundamentals or real time data analysis.
A few days after this newly announced analyst coverage, Luigi Lavazza disclosed that it had increased its holdings in GMCR by roughly 36%, adding 2.8 million shares. With this increase, Lavazza now owns a 6.8% stake in GMCR. Shares of GMCR continued their march higher on this latest news headline and surpassed the $32 level. For many investors, this represented a strong exit point for which to take profits if you had been a buyer of GMCR shares in recent months. If you were such an investor, this act of profit taking would have proven wise, as shares have fallen precipitously over the last several weeks.
While the threat of competition is ever increasing, Green Mountain has continued to bring to market new product offerings. A host of new machines and K-cup flavored coffees, teas and even lemonades have helped the company achieve greater sales revenues during the quarter. However, the margin on these newer product offerings remains questionable to say the least. It has been suggested that the average K-cup price has declined more than $.09 over the last 6 months as the company has launched several value pack products with many retail partners. Consumers can now buy their K-cups in bulk, 48-60 K-cup packages if they so choose at a discount to the smaller package sizes offered in the past. This is where investors can see the biggest price decline in real time channel checks. However, what we don't know is whether or not the operational efficiency improvements that have produced this greater package offering are the result of the company's ability to offer the K-cups at a discounted price without impacting gross margins.
What is obvious to the average investor is the clear marketing and merchandising of new single-serve brewers at retailers. From Bed Bath & Beyond to Macy's, retailers are devoting more and more space to the product category. Green Mountain is now in an uphill battle to maintain its brand leadership and advance the product category further. This bifurcated battle comes at a high cost in a low margin business.
The company still has opportunities to grow internationally, but has yet to take noticeable steps in this direction outside of the recent appointment of Gerard Geoffrion. In his new role, Mr. Geoffrion will lead the exploration of business opportunities outside North America. Pursuant to the terms of the offer, Mr. Geoffrion will work for the company on a full-time basis and will receive an annual base salary of $390,000 and other benefits, including short-term (with an opportunity at target for Fiscal Year 2012 of 60% of base salary) and long-term incentive (with an opportunity at target for Fiscal Year 2012 of 120% of base salary) bonus compensation based upon the Company achieving certain operational and financial goals, as determined by the Company's board of directors in its sole discretion. The writing is on the wall for GMCR investors. This recent announcement points to a near-term ceiling in North American business for Green Mountain.
When considering international expansion for Green Mountain Coffee Roasters, the question is why hasn't the company committed to this development to date and after developing this strong category in the coffee industry. We answer this question in our full Q4 report which is available at capitalladders.com.
Capital Ladder Advisory Group's expectation for the quarter ended September 31, 2012 from GMCR has not changed QoQ as a slowing of sales growth continues to present itself in the data. While the company did recently report that input costs will come down in Q4 of 2012, it remains to be seen whether or not the company has made significant headway in production and capacity utilization as well as forecasting sales demand. We maintain that true clarity with regards to GMCR will not be realized until 2013 when a more defined trend can be ascertained by the average investor. 2012 has presented investors with a roller-coaster of earnings results and headlines packed with competitive threats and forward-looking licensing deals.