It's been a very intriguing back half of 2012 for shareholders of Monster Beverage Corp. (MNST). Headlines surrounding the ingredients within Monster Energy drinks have come under severe scrutiny in the last two quarters. If investors strip out these headline risks which have taken the stock from "high-flyer" status to "crash-and-burn" status during fiscal Q3 2012, shareholders are left with a few glaring problems facing Monster Beverage Corporation. Sales are slowing in several key markets while cost of goods sold is increasing in other key markets. These two important factors are imposing pressure on gross margins which have notably been on the decline in recent quarters and have proven to impact earnings in a negative way.
The company missed earnings expectations for Q3 2012. Here are the notated reasons for the earnings miss as outlined by Monster Beverage Corp. CEO Rodney Sacks:
- Less robust growth for the energy category as a whole in the US
- Less robust growth for Monster Energy in our US market, particularly in the latter half of the quarter.
- Lower sales in Canada in the quarter largely due to a realignment by Coca Cola Canada of their inventory levels.
- The strength of the US dollar against certain currencies in our international markets.
- Lower sales of Monster Energy Extra Strength Nitrous Technology Energy drinks.
- Net sales for the company's warehouse segment decreased 7% to $25.7 million for the three months ended September 30, 2012.
- We have experienced a substantial drop-off in sales of Worx Energy shots.
- Gross profit margins achieved in the third quarter of 2012 were 50.5% versus 52.7% in the comparable quarter in 2011.
While the eight bullet points above represent the majority of headwinds the company faced in the quarter, one could definitively add a few more after reading through the company's Q3 2012 Earnings Transcript
Moving forward, investors will have to consider the direction and velocity of international expansion which Monster Beverage has embarked upon. It is very clear to see that Monster Energy, Tea and Coffee Flavored beverages are selling nicely in markets around the world. This fact is beyond contention as is represented in the data presented by Monster Beverage Corp., NPD Group and Capital Ladder Advisory Group. While sales in mature markets are showing signs of slowing growth, in newer markets sales are just beginning to take-off. However and most importantly as it relates to overall profitability, sales are not the problem, cost of goods sold is the clear problem the company is facing. So has the company "bitten off more than it can chew"? It might be time to separate the company from the stock, MNST.
While the company continues to grow and expand its distribution reach, input costs are impacting profitability. In regions such as Australia, Japan, Brazil, Central and Eastern Europe, the company continues to sell goods that result in operating losses. These operating losses thus weaken margins and overall profitability. Monster can't simply remove itself from non-performing regions that it has dedicated so much time, money and brand to. The company is moving forward with efforts to increase operating proficiencies through careful reconstruction of its operations, brand marketing and distribution deals in these non-performing regions. Again, it is important to separate sales from profits as not all sales are created equally.
During the most recent quarter, Canadian sales were affected due to a realignment of inventories from Coca Cola Canada. The realignment came due to lower sales of Monster Energy Extra Strength Nitrous Technology line which was repositioned from 12 ounce cap cans to 12 ounce Sleek flat top cans. I hope you read carefully the words "flat top cans". Capital Ladder Advisory Group's Junior Market Research Analyst Clara Donaldson spoke with a representative of Coca Cola Canada LTD. whom indicated that the distributor had requested alternative packaging for the Extra Strength Nitrous Technology line due to transportation, damage and merchandising costs as a portion of sales. While the reasons for the realignment of inventories by Coca Cola Canada LTD was not outlined in the quarterly conference call by Monster Beverage, it is apparent that the company is incurring repackaging and labeling costs in Canada which are decreasing sales and overall profitability in the region. Considering the aforementioned detailed information, it might be safe to say that the Canada sales issues may be a one-off event which may not impact subsequent quarterly results.
If we now move forward to Central and Eastern Europe, Monster Beverage is continuing to see high costs of selling goods. The cost of product sampling teams and trade development personnel are included as part of the company's selling expenses. These costs were substantially higher in Europe in the most recent quarter as compared to the U.S. and last year. As distribution improves and the European markets mature, Monster Beverage should see a reduction in these costs, particularly as a percentage of sales. The problem with this assumption is that while it works out great for the company as part of its overall expansion plans, it may not feed through to profitability in the near to midterm. As the company continues to enter new markets in Asia and South America, it intends to fund similar trade development programs to establish the Monster brand in those countries. In other words, increased profits in some regions will serve to grow new markets and may not materially impact earnings any time soon. This is where separating the stock from the company may prove accurate.
It is keenly important, as I have outlined before, that in Central and Eastern Europe, Red Bull is the dominating headwind Monster Beverage is competing against. The second headwind is private label energy drinks along with the move to at-home carbonation in the region which is being spearheaded by SodaStream International (SODA). SodaStream sells soda machines, CO2 to carbonate water inside the soda machine, 1 liter and half liter reusable bottles and flavored syrups to be used in carbonated water. SodaStream has licensing deals with Kraft Foods (KRFT) to offer consumers Country Time Lemonade and Crystal Light Brand syrups. The company sells Crystal Light Wild Strawberry Energy syrups alongside several other SodaStream energy flavored syrups. In Central and Eastern Europe, SodaStream has achieved strong household penetration due to the economical benefits offered via its eco-system of products. The average cost of a SodaStream brand energy drink per/liter is roughly 75% less than a Red Bull or Monster Beverage energy drink. It is no wonder, with this competition in the Central and Eastern European regions; the company continues to struggle with profitability. In light of these headwinds, the company has stated that it should see some profitability benefits in these regions in the future by way of strategic changes. Unfortunately, the company has yet to give specifics on these strategic changes. I would expect management to renegotiate existing trade agreements with its distribution partners in the region alongside repositioning sampling and marketing efforts.
Brazil is another issue which has eroded YOY profits for the company. In Q1 of 2012 the company eluded to a disruption in its business in Brazil due to issues plaguing its distribution partner in the region. It appears that the issues have become insolvent for the two parties and Monster Beverage has been working toward a new strategy and may name a distribution partner for its business in the Brazilian market in the very near term. On the company's Q3 Conference Call with analysts, the company stated that they are in the midst of reevaluating the business in Brazil as results have not been satisfactory there this year and management has reached an advanced stage of negotiations with an alternative distributor. In an article I authored back in August titled "A Monster Catches Our Attention", I detailed Monster's need to handle the distributor issues in Brazil sooner rather than later and before it eats into profitability.
As stated earlier, Monster is very likely going to continue with its global expansion efforts. The company launched Monster Energy in the Philippines and Turkey in the third quarter of 2012 and in conjunction with a new distributor, participated in an expanded launch in the Ukraine. Additionally the company plans to launch Monster in Chile, Peru and Singapore in the next few months and in Argentina and Taiwan in 2013. Monster Beverage is not giving up on Central and Eastern Europe as it is also planning to launch Monster in additional countries in these regions in 2013. Lastly, and now that the company has finally overcome labeling and ingredient issues in Korea, Monster Beverage anticipates commencing sales there within the next few months. Unfortunately, we have heard this before with regards to the Korean expansion efforts.
The Asia Pacific region is proving to be a major headache for the company and shareholders as it continues to manifest itself in gross margin contraction YOY. Damages for products shipped to the region continue to pile up. Ultimately, the goal for the company will be to find a local producer in the region which can facilitate production of Monster cans that are suitable for the Japanese and Korean marketplace. The upfront investment in finding a local producer requires much capital expense and until recently, sales didn't warrant such expenditure. Now that sales velocities have shown steady improvement in the region, the company is actively seeking a production partner in the region. This measure would prove impacting to gross margins and overall profitability. Look to hear more about this in future quarterly updates.
During Q3 2012, Monster launched Monster Ultra Zero and Cuba Lima in 16 ounce cans and began the process of launching two new DUB products called Baller's Blend and Mad Dog in 16 ounce cans. While sales for Q3 showed slowing growth, October sales seemed quite robust YOY. So what was behind the ramp up in demand during October? We are of the opinion that October represented a large ordering cycle which not a good initial gauge of end demand. Additionally, the company benefited from the launch of Monster Ultra Zero which was adopted across the whole network. Unfortunately, in the early going Cuba Lima is not seeing the same network and mass market orders. It is important to recognize that these orders hitting mass market channels will need to see end user demand.
In November, Goldman Sachs (GS) moved to upgrade Monster Beverage citing strong EU sales during November. Goldman says, "For Monster, data has total Europe sports/energy drink sales up 4.1 percent with a 1.1 percent rise in volume and 2.9 percent gain in price/mix. Goldman notes that Monster continues to be the leader in this category.
However, in a more recent research note from Suntrust analyst Robinson Humphrey he explains a decline in sales for Monster beverage based on Neilsen data. Humphrey says, "Monster's energy drink sales rose 17.1 percent for the four-weeks ended November 24th. While the growth is solid, it's down from 23.4 percent in October."
It is very clear that Monster continues to grow its sales. The strength of sales growth, however, might be in question. Either way sales are no longer the determining factor behind investing in Monster Beverage Corp., profitability is the key. If management can't achieve its outlined goals in mature and newer markets, margins could begin to turn a corner and accelerate higher. If we simply look at the balance sheet and operating income statements we see a relatively strong company. But the trend in 2012 shows weakening results and this weakening trend has fed through to weakness in share price in the last 6 months. For traders, the volatility in share price has created great opportunity while long term shareholders have seen some share depreciation
So here is one of the biggest concern investors will be facing going forward and it is one that will probably carry with it some more volatility in shares come 2013, more litigation. Our market research team had several distinct conversations with 13 different hedge funds and institutional investors whom were gearing up to file suits against Monster Beverage alleging wrongdoing on the company's behalf which the plaintiffs attest to a breach of corporate fiduciary duties. Here is what I reported on to clients in September and included in my November article which was published on Seeking Alpha:
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 topic in the near future. Below is the latest class action lawsuit filed by Iron Workers Pension Plan which is noted in Monster Beverage's latest 10-Q filing.
- On September 13, 2012, two derivative complaints were filed in California Superior Courts, purportedly on behalf of the Company, by shareholders of the Company who made no prior demand on the Company's Board of Directors. One action, in the Superior Court for the County of Riverside, is styled Iron Workers District Council of Tennessee Valley & Vicinity Pension Plan v. Sacks, et al. The other action, in the Superior Court for the County of Los Angeles, is styled Rumbaugh v. Sacks, et al.
- The Iron Workers complaint names as defendants certain officers, directors, and employees of the Company, including Sacks, Schlosberg, Harold C. Taber, Jr., Benjamin M. Polk, Norman C. Epstein, Mark S. Vidergauz, Sydney Selati, and Thomas J. Kelly. The Rumbaugh complaint names each of the same individuals as defendants, with the exception of Thomas J. Kelly. The Company is named as a nominal defendant in each action. The factual allegations of the two complaints are substantially similar. Each alleges, among other things, that the Individual Defendants breached their fiduciary duties to the Company by causing the Company to market, advertise, and promote its Monster Energy® brand of energy drinks in a way that has exposed, and will continue to expose, the Company to costly investigations into its compliance with federal and state laws and regulations pertaining to food and beverage advertising. The complaints further allege that, beginning in February 2012, the Individual Defendants further breached their fiduciary duties by making statements in press releases and public filings about the Company's earnings and financial condition and by failing to disclose that the Company was improperly advertising, marketing, and promoting its Monster Energy® brand of energy drinks. The Iron Workers complaint further alleges that while the Company's shares were purportedly artificially inflated because of those improper statements, certain defendants sold Company stock while in possession of material non-public information regarding the Company's "true" business health. The Iron Workers complaint asserts causes of action for breach of fiduciary duty and unjust enrichment. In addition to those causes of action, the Rumbaugh complaint also asserts causes of action for abuse of control, gross mismanagement and waste of corporate assets. The plaintiffs seek an unspecified amount of damages to be paid to the Company, adoption of corporate governance reforms, and equitable and injunctive relief.
In addition to this latest lawsuit filed against the company, in April of 2013, a longstanding class action lawsuit which alleges that Monster Beverage Corp. has engaged in channel stuffing will finally be heard and adjudicated. Here is what I will say openly about the allegations of channel stuffing. For those of you who may suggest that Monster contracts lower tier distributor partners in many cases outside of the U.S. as a form of lowering costs, I would suggest it be considered that the company may also engage in partnerships with these distributorships as a way to impose its might where the company would otherwise not be able to do so. In other words, "Here, take this extra pallet of Monster Energy Drink and warehouse it Mr. Dirstributor". A link has been provided to the company's 10-Q filing above and as part of an investors due diligence it may prove beneficial to dedicate some time toward reading through the filing carefully.
Disclosure: I am long SODA.