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This article is part of a five-article series looking at investing in soft drink companies. Each article will investigate price targets, analyze the company's current and future prospects, and compare it with other companies in the industry. This is the second of five articles. To view our first article featuring Coca-Cola (NYSE:KO), please click here. To view our feature on PepsiCo (NYSE:PEP), click here.

Monster Beverage (NASDAQ:MNST) is sitting in an interesting place right now with some current headwinds that are creating potential value for a company that has a lot of growth potential. For those looking at investing in Monster Beverage, you must understand the risks with the company, which include potential FDA regulations in the future. Yet, MNST is a company with vibrant potential that will be outlined in this article.

The first topic to discuss when looking at MNST is the situation with the FDA. In late October, the FDA released statements noting that five deaths had been linked to the company's drinks, sending shares soaring down around 30%. Shares have since recovered back to the mid-$50 levels. Despite the recovery, investors should understand that the situation occurring with energy drinks is not over. There are several potential risks to consider here. Energy drinks could go the way of cigarettes/alcohol in a most extreme situation, where it would be required to print larger warnings, limit marketing practices, and even have age requirements.

Shares largely recovered, though, because the FDA does not appear to be moving down that path right now. In late November, the FDA said that no immediate action would be taken against energy drinks companies, but the organization was considering labeling warnings. The FDA believes that Americans have had a long history of drinking caffeine levels at safe rates. Yet, energy drinks are not regulated in the same way soft drinks are since energy drinks are a dietary supplement. Soda cans cannot have more than 71mg of caffeine in them, while energy drinks do not have those limitations. A potential caffeine limitation may also be something to look out for in the future.

The truth of the matter, though, is that this issue has been grossly blown out of proportion. Energy drinks, as a whole, have less caffeine than coffee drinks. The beverages do have a large amount of vitamins and other nutrients that some are suspicious of, but in all, energy drinks lag coffee drinks in caffeine amounts. Looking specifically at MNST, the company has anywhere from 10-13mg of caffeine per ounce in its drinks. A Starbucks (NASDAQ:SBUX) Grande Coffee has nearly 21mg of caffeine per ounce and Dunkin Donuts (NASDAQ:DNKN) coffee has over 13mg per ounce. The safety issues come from the appeal of these drinks to youth vs. the taste of coffee, which is a bit of the concern. At the same time, the long-term effects of these issues do not seem too strong. We reduced our price target overall though as we do see some negative impacts on growth potential because different parties will limit consumption or ban it.

Overall, though, the FDA debacle created an opportunity for a company with outstanding growth potential. In the past five years, MNST has grown its revenue 120%, but the company is nowhere near done. The company has tons of potential for international expansion as well as domestic expansion. MNST controls 37% of the energy drink market share right now, only trailing Red Bull, which has 42%. As we can see, the energy drink market is mostly a two-horse race, and the two lead horses are moving into international markets as well as increasing domestic sales. According to Nielsen ratings, Monster saw a 19.5% increase in sales from mid-July to mid-October, which was the largest increase of any energy drink company. 20% growth of sales is very strong for the beverage industry and strongly outpaces other public beverage companies.

What's even more exciting is the international potential for this company. The company is expanding into many new markets and is seeing very strong results in there new ventures. Here are some statistics from the company's latest quarterly transcripts. The company saw sales in Mexico grow 46% year over year in Q3. Gross sales to all customers out of the U.S. grew by 19%, and net sales to Europe, Middle East, and Africa grew by 43%. The company has tons of potential to see larger growth in these areas as it has just entered many of the markets in the last couple years, and MNST is still entering new ones right now. The company is expanding into Chile, Peru, and Singapore in Q4 2012 as well as Argentina and Taiwan in 2013. The expansion into these international markets is going to provide the company a lot of potential growth for the coming years, as we have configured into our price target below.

The final parts of the situation at Monster Beverage are its strong financial makeup, acquisition potential, and economic moat. The company is a very promising acquisition candidate. Coca-Cola and PepsiCo have both struggled to enter and make headway in the energy drink market, and it is a growing market that continues to expand. At some point, we believe that MNST will become a buyout candidate for KO and PEP. Will it happen in the next month or two? No. Will it happen in the next five years? It could. We believe that gives the company an added premium to shares that will not go away, and any time those rumors are dangled, it creates a lot of potential upside for the company. Any suitor will wait for the FDA hangover to leave and clear up before any buyouts will occur, so we are at least six to 12 months away from any buyouts taking place.

The final aspect of MNST's business that we like is its strong financial health. The company has a great balance sheet. It has $600 million in cash as of the latest quarter compared to zero long-term and short-term debt. That type of ample cash on hand has allowed the company to do things like its recent $250 million stock buyback, which helps increase equity value. The company has 14% FCF/sales, which is an even greater sign of Monster's dominant financial position.

Price Target

Ticker

New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range

MNST

$82

$86

Buy

Hold

$68/$95

The price target was configured through a five-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis (all figures in millions):

Step 1

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income

572

620

688

700

727

Taxes

217

236

261

266

276

Depreciation

20

21

23

25

28

Capital Expendit.

-37

-48

-51

-55

-57

Working Capital

100

100

100

100

100

Available Cash Flow

238

257

299

304

322

Step 2

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for MNST: 6.00%.

2012

2013

2014

2015

2016

PV Factor of WACC

0.9434

0.8899

0.8396

0.7921

*

PV of Available Cash Flow

224

229

251

241

*

*For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out residual growth rate. Residual growth rate is typically between 2% and 6%. Four percent is average growth for industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher P/E ratios. We will give you cap rate.

Cap Rate for MNST: 2.0%.

2016

Available Cash Flow

321

Divided by Cap Rate

2.00%

Residual Value

16087

Multiply by 2016 PV Factor

0.7921

PV of Residual Value

12742

Step 4

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

945

PV of Residual Value

12742

Cash/Cash Equivalents

283

Interest Bearing Debt

0

Equity Value

13970

We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5

Divide equity value by shares outstanding:

Equity Value

13970

Shares Outstanding

171.37

Price Target

$82

In the end, we have found that MNST is worth around $82, which we believe accurately reflects the company's five-year projections.

Profitability

Q1-Q3 2012

Q1-Q3 2011

Operating Margin

27.5%

27.3%

Gross Margin

51.7%

52.6%

Return on Equity

30.6%

22.6%

The company has very strong profitability for the beverage industry, which is due to the fact that it operates through third-party manufacturers and distributors, which allows MNST to spend less money. The company saw a strong increase on its return on equity (ROE) from 23% to 31% in the past year as well as an increase in its operating margin. How does this compare to Monster's competition?

PEP has an operating margin at 15%, gross margin at 52%, and ROE at 21%. KO is performing with a 24% operating margin, 61% gross margin, and 22% ROE. Dr. Pepper Snapple (NYSE:DPS) has operating margins at 18%, gross margins at 58%, and ROE at 24. Cott (NYSE:COT), finally, offers 5% operating margin, 13% gross margin, 8% ROE. As we can see, MNST outpaces all competition with profitability.

Value

Current

Industry Average

P/E

28.6

21.5

Future P/E

22.3

N/A

The company has strong valuations with a 29 P/E and 22 future P/E, but we believe that the value is appropriate due to its high levels of growth and potential to be acquired. The company's future P/E at 22 is definitely above our sub-15 threshold for value, but MNST is a growth stock. It is growing at five to eight times the competition, so there higher valuation makes sense. Its competition all have cheaper valuations, but lower expected growth rates. PEP is at a 19 P/E and 16 future P/E. KO sits with a 20 P/E and 17 future P/E. DPS has a 15 P/E and 14 future P/E, and COT has a 24 P/E and 12 future P/E. MNST outpaces all of its competition here, but this valuation is much lower than it has been in the past and presents a great buying opportunity.

Source: Monster Beverage Headed To $80, Better Growth Potential Than Coca-Cola And PepsiCo