Is Green Mountain An Attractive Takeover Target?

| About: Keurig Green (GMCR)

There has been a lot of consolidation in the coffee and tea business lately. Recently, Caribou Coffee (NASDAQ:CBOU) became the latest acquisition to be announced. The acquirer of Caribou already has made strides into this space, purchasing Peet's Coffee and Tea last summer. About a month ago, coffee giant Starbucks (NASDAQ:SBUX) announced it would be acquiring Teavana (TEA) as well. Those are three acquisitions in the space in a short period of time, and investors are wondering which will be the next candidate to go.

That brings me to Green Mountain Coffee Roasters (NASDAQ:GMCR). Green Mountain has been one of the biggest debate stocks over the past year, with longs and shorts fighting extensively. Green Mountain shares traded over $115 late in 2011, but just a few months ago, were trading for barely above $15 after their third quarter earnings report. Green Mountain announced a huge stock buyback at that report, which sent shares soaring higher, more than doubling at one point. Recently, shares jumped even higher after the company's Q4 beat. While those who purchased this stock at $60, $80, or even $100 are still in a world of hurt with shares now around $42, those who bought over the last few months have been greatly rewarded. Investors may wonder if the latest results prove Green Mountain is back, and at depressed prices, could a buyer come in? Today, I'll look at the potential and risks this company has in terms of a possible acquisition.

Why Acquire Green Mountain?

Green Mountain's K-cups are one of the most recognizable brands in the United States today. You can find them almost everywhere, and those who use them love them. The ability to brew a single cup of coffee at home or at the office is a great idea and very convenient. Plus, the wide variety of flavors can appeal to a variety of tastes. In fiscal 2012, which ended in September, sales of single-serve packs were up 59% to more than $2.7 billion for the company. Dollar sales of those packs were up more than $1 billion over the prior year period.

The second reason is that while growth has slowed down tremendously in recent years, the next stage of growth hasn't even occurred yet. The second stage will occur when Green Mountain decides to expand internationally, outside of just the US and Canada where it operates currently. Think of the market possibilities outside of North America for Green Mountain. There is plenty of growth ahead, and someone willing to purchase the company now would be getting ahead of that growth. As I mentioned in the article above, the company has assigned Gerard Geoffrion, former President of GMCR Canada Holding, Inc. and President, Canada Business Unit, to serve as the company's President of International Business Developmen.

International expansion will not only help when it comes to revenues and potentially earnings, but it could also help improve bottom line margins. One thing that is really hurting the bottom line for Green Mountain is taxes. The effective tax rate for the recently ended fiscal year was nearly 37%. If Green Mountain can start producing profits in lower taxes areas, they can get some relief on the effective tax rate. Think about it this way. In that fiscal year I just mentioned, the pre-tax margins for Green Mountain were 14.93%. The company, with its 36.91% effective tax rate, had a net profit margin of 9.42%. Had the company's effective tax rate been say 30%, the profit margin would have been 10.45%. Now that 1.03% doesn't seem like a huge difference, but you're talking about a profit margin that would have been nearly 11% higher. That's quite a lot.

Green Mountain is also working to improve its gross margins, which declined 123 basis points for the fiscal year. The company admitted that they had some manufacturing issues that hurt gross margins, and they've worked to fix them. If Green Mountain can start boosting its gross margins, and also have a lower effective tax rate, you are looking at a company that could boost net margins above 10% next year. The following table shows how the full year margins have fared over the past four fiscal years. When it comes to the bottom line, Green Mountain is a lot more profitable than it used to be.

A prominent brand could lead to explosive international growth, if and when Green Mountain decides to go down that road. Green Mountain is looking to improve gross margins going forward. Coffee prices have fallen about 38% the past year, but Green Mountain has also worked to correct manufacturing issues. A company with growing sales and increasing profits is surely to be a possible takeover target.

Potential downside and risks:

When a stock is at $42 and it was over $115 just over a year prior, something must have been wrong. There are some red flags with Green Mountain that might scare off potential acquirers, a few of which I mentioned when examining this name as a short candidate.

The first issue is in regards to the firm's accounting. Green Mountain has always been under a microscope when it comes to its accounting, which is one of the main points hedge fund titan David Einhorn brought up when he shorted the name in 2011. The company has undergone multiple investigations by the SEC in regards to the recording of sales, and Green Mountain did restate a ton of financial statements a few years back. There are also some who are wondering if Green Mountain's latest beat was due to a change in the company's inventory obsolesence. If a company is under SEC investigation, investors tend to bail, thanks to past blowups like Enron. The last thing an acquirer wants is for their acquisition to blow up, kind of like what just happened with Hewlett Packard's (NYSE:HPQ) recent acquisition of Autonomy.

The second thing that would worry potential buyers, ignoring the potential for international expansion for a moment, is the slowdown in revenue growth. Two fiscal years ago, Green Mountain's revenues grew by 95.38%. In the fiscal year that just ended, revenues rose by 45.58%, and that included an extra week in the period. For the current fiscal year, Green Mountain has guided to a sales growth range of 15% to 20%. Some have questioned the long-term viability of Green Mountain's K-cups after some patents expired earlier this year. While the company has not seen any meaningful business leave, the patent expiration does open up the possibility that private labels could manufacture their own Keurig compatible cups. We've also seen some supermarkets, like Kroger (NYSE:KR), start their own plans to introduce single serve cups. The competition aspect is two fold. First, it could steal away business. Second, extra competition could start a price war that could force Green Mountain to lower prices and thus margins would suffer.

A third thing that a potential buyer might not like is the fact that Green Mountain has slashed capital expenditures in an effort to free cash for a stock buyback. I detailed the company's capex figures in my short candidate article. Here's the quick summary. When Green Mountain started their previous fiscal year, they said yearly capex would be somewhere between $700 and $780 million. Going into the fourth quarter, they guided to just $525 to $575 million. For the year, they ended up around $450 million, $75 million below the low end of the guidance range. On the flip side, they bought back $76.5 million worth of stock in Q4. The company guided to just $380 to $430 million of capex in their next fiscal year. I think a potential buyer would be more interested if Green Mountain was investing in the business, rather than buying back stock.

Who would buy them?

When it comes to who would buy them, there is always one obvious possibility, and that is Starbucks. The Starbucks rumors have been out there for quite a while, and these companies do have a partnership together. Some may question that relationship now that Starbucks has its own brewer, the Verismo out, but for now, both companies state that they are working together. As the above article states, "Acquiring Green Mountain here might allow Starbucks to expand its Verismo lineup, perhaps branding Green Mountain's Keurig brewers under the Verismo nameplate." The additional benefit is that Starbucks is growing tremendously outside of the United States. They would have the means necessary and the setup required to expand Green Mountain's presence to outside of North America.

The second possibility is that you would get a major food type, like a Nestle or Kraft, now known as Mondelez (NASDAQ:MDLZ). One of these large international food producers would have the capabilities and financial resources to make this a very viable transaction. Of course, there is always the possibility of the company going private, but you'd probably need a group of investors, given a potential $8 billion plus enterprise value, assuming a 20% premium to the enterprise value as of Wednesday.

Final Thoughts:

Green Mountain has a lot of positives and negatives associated with it. This is a company that hasn't even touched the surface when it comes to international expansion. The company could have a ton of growth ahead of it, which is one solid reason why the company could be an attractive takeover target. However, there are definitely red flags such as accounting issues and competitive fears that might scare off potential buyers.

In this article, my goal was to examine some of the prospects in regard to Green Mountain being a takeover target. By no means was this a complete list, and knowing the passionate base of both long and short investors in this name, I'm sure the debate on this issue has just begun. The point of this article was to start that debate, with the issues presented above being the starting points. In my opinion, Green Mountain could be an attractive takeover target, but it would be an expensive one. The one solace for buyers is that even with a 25% premium currently, you'd only be paying about $52 a share. A little over a year ago, a 25% premium could have meant a takeover price over $135.

Green Mountain has rebounded strongly after a solid fourth quarter. The company is now in its busiest quarter, their fiscal first, thanks to the holiday season. If the company can produce another solid quarter, this stock will continue its recent rally, especially with roughly one third of all shares short (short squeezes are definitely possible on good news). But if added competition or other factors cause sales and earnings to miss expectations, this stock will be hammered like it has been in recent quarters. I'm classifying this article as a long idea because of the possibility of a takeover, but that doesn't mean I am formally recommending investors buy it. When it comes to buying any stock, you should always buy a solid business with strong fundamentals. Trying to speculate on companies being bought out usually is a losing strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.