Green Mountain Coffee Roasters (GMCR) reported a beat across the board when it reported Q1 2013 earnings results on February 6, 2013. The stock tumbled upon earnings release as investors likely shared in a healthy bout of profit taking that saw the stock climb almost 10% in as little as five trading sessions leading up to earnings. For the quarter, the company reported $.76 in earnings per share against Wall Street's expectations of $.65 a share. The company accomplished this outsized beat on earnings by achieving a 16% increase in net sales, an increase of 14% in brewer and accessory sales and an increase of 21% in single serve packs.
The big achievement from an investor's perspective came in the form of free cash flow as the company was able to produce $254 million in free cash flow during the quarter, driven mostly by increased revenues. Also of great importance, free cash flow generated in the quarter highlights lower brewer inventory in Q1 as is typically the case for the company.
Moving forward, the company offered investors an optimistic projection for Q2 2013 with net sales expected to climb in the range of 14-18% and earnings per share outlook of $.70-$.75 a share. For FY13 the company has broadened its outlook on earnings to $2.72-$2.84 a share. Additionally, the company has curtailed its capex guidance to $350 million to $400 million from the prior range of $380 million to $430 million. With the lowered capex spend on the year; the company now expects to come in at the higher end of the range with regards to forecasting $100-$150 million in free cash flow.
As we look at the entirety of the quarterly results and FY projections, our assessment of the company to proficiently build upon its recent successes should bear fruits for the balance of 2013. The biggest takeaway from the quarterly results had to be that the threat of competition for GMCR, while ever-increasing, is manageable for the company as the product category develops further. In the light of increased competition and category expansion the company has outlined the following initiatives to address this topic of concern for investors and the business:
- First, the company understands the benefits of becoming more operationally efficient and consistent as it works toward achieving greater capacity utilization proficiency.
- Second, the company can dramatically improve its in-store presence to reduce out of stocks, to have better price pack architecture, to significantly improve shelf and merchandising presence, to make it easier for consumers to shop the category and to have a clear look of success that profitably grows all of the system brands with retail partners.
- Third, the company will work to sharpen and increase marketing effort to further strengthen core brands, Keurig and Green Mountain Coffee. Brian Kelley says, "We need more firepower behind these brands in the marketplace to keep them fresh, relevant, and part of the daily conversation".
- The company will continue to drive the success of the Vue technology with new brewers, better features, new beverage products, and a strong marketing effort.
- Finally, the company has a significant opportunity to grow, in current channels like away from home, in new channels, in new categories, with new brewer technologies, and in new geographies.
With respect to each of these core initiatives, in order to successfully address the competition head-on, GMCR must prioritize them and execute with a high degree of proficiency.
As expected and outlined in the quarterly preview, gross margins continued to contract sequentially although they did expand YOY. Gross margins for the quarter came in at 31.3% vs. 29.1% in the same period a year ago. Unexpectedly, the company benefited from lower green coffee costs and lower warranty claims. Warranty claims, however, by our estimates should go up sequentially and impact the company's margins negatively in the subsequent quarters. This is also typical coming out of the gift giving season and largely baked into the company's guidance. Even though the company attributes the successful decline in warranty claims as a feat of increased brewer quality achievement, our reverse logistics data from retailers suggests the current warranty/return rate increased in accordance with sales, suggesting the decline in warranty rate is based off of a sales ratio and not necessarily an apples-to-apples performance figure that should be attributed to brewer quality. I respectfully disagree with management's assertion as little more than a point of perspective.
In addition to gross margin contraction, Capital Ladder Advisory Group recently noted that GMCR would see some price degradation in K-cups during the quarter as our channel checks indicated the average K-cup price has come down by an estimated $.03 per K-cup YOY. A continuation of this price degradation in the product category should be expected, but not to the degree that it would impact the company's earnings performance negatively as other provisional measures are taking place to offset the price/K-cup declines. In the GMCR Q3 2013 transcript, the company notes that it has planned for this price degradation and has positioned itself accordingly across the retail channels. During the Q1 2013 Conference Call with analysts, CFO Fran Rathke addresses K-cup price degradation head on by saying, "You know, I think we're just factoring in some of the price tiering that we've got in our business in the quarter, in Q2, in our estimates. I think overall, we feel our customers are in a good position in terms of weeks on hand on single pack inventories, as well as our own inventory is in really good shape at just about four weeks on hand. So I think we don't anticipate any slowdown in the portion pack growth. And we don't expect to see significant degradation in price, but we've got some of that factored in, as we saw about 1 percentage net price realization this quarter".
Clearly, price degradation is an issue and some of the analysts got this metric wrong when analyzing the totality of the Keurig system. Here is what I wrote in my quarterly preview: "However, the greater sized portion packs have reduced the average selling price per K-cup, excluding the Starbucks' (SBUX) premium priced K-cup products. With all the data at hand, including Starbucks K-cups, the price degradation/K-cup is about $.015 per K-cup and proves to be irrelevant presently. I would be more concerned about price degradation if the actual price degradation/K-cup was a full $.03 and Starbucks was NOT a licensed partner of GMCR. Green Mountain Coffee is managing its tiered pricing strategy well as new licensed partners come into the picture such as Costco (COST).
GMCR has proven that certain K-cup patents, which expired in 2012, were not the only barrier to entry in this product category, but its first mover advantage is a key part of the current success GMCR is seeing. Brian Kelley speaks more eloquently on the issue of patents and the little relevance he gives to the issue now. He acknowledges that patents give you a head start but the success is in much more than those patents today. "It's in the mass and scale which gives GMCR a better cost structure. It's in the ability to partner successfully with strong brand partners. It's in a broad distribution system that took years to build. It's in having a multimillion household installed base, and it is in the ability to mine customer insight and to target continued innovation with the unending goal of delivering new solutions to consumers, customers, and partners over time. I would also note that achieving the scale, cost, and quality advantages that we enjoy today is not easy for others to replicate."
Moreover, let us touch briefly on brewer sales and shipments and how they differ. The company noted that shipments of brewers will decline in Q2 2013. First and foremost this is to be expected and consistent with the YOY trend. Additionally, this does not mean brewer sales will decline as noted during the conference call with analysts. Here is where it is important to understand the difference between sell-in and sell-out as an investor. GMCR benefits directly in the quarter from what it sells-in to the channels. This is why Q1 is always so strong for GMCR as the company ships a great number of brewers during the quarter and for the holiday selling season. As the retailers build inventory for the holidays, there is traditionally some inventory overhang in inventory coming out of the holiday selling season for the retailers to work off. Subsequently, GMCR does not have to ship as many brewers in Q2. What is left for the retailers to sell after the sell-in from GMCR in Q1 is now known as sell-out product, sell out from the retailer to the consumer where GMCR does not benefit on the brewer side in the quarter. Having said that; the quicker the retailer turns that inventory hang the quicker GMCR will see additional brewer orders and subsequent K-cup sales.
As we look forward to what is in store for GMCR in the subsequent quarters, our next stop is at the International Home and Housewares show in Chicago, Illinois during the first week of March. GMCR will participate in the event and Capital Ladder Advisory Group will have the opportunity to speak directly with corporate officers with respect to business operations. We are looking forward to discussing plant improvements, international efforts, product and pipeline expansion initiatives as well as strategic partnerships with licensed partners.
On February 7, 2013, Stifel Nicolaus came out with additional notes to clients concerning the quarterly performance by GMCR in which it notes the following: "Interestingly, while competitive pressure has been less than anticipated following K-Cup patent expiration, price/mix declined 5% y/y in F1Q13, an acceleration from a 3% y/y decline in F4Q12. Maintains Sell rating on GMCR shares and estimate fair value in the low $30s".
Additionally, Canaccord came out in defense of the company stating the following: "New strategies coming into focus; maintain Buy and raise target to $54 from $45. Firm expects several years of strong revenue and earnings growth driven by rising penetration of Keurig single-cup coffee makers in North American households. GMCR reported strong upside to consensus EPS estimates on in-line sales and significant margin expansion. Brewer units and sales materially exceeded forecast in Q4, the outlook is right in line with forecast. With cash flow rising, the BS cleaner and margins expanding, firm believes a 15 PE is now the base valuation for a growing food/beverage stock".
It's pretty amazing how the same quarterly results can be viewed in sharply contrasting ways. Shares of GMCR reached the Capital Ladder Advisory Group price target during trading yesterday and we are presently re-evaluating our new price target at a higher level than our previous price target. We have seen some encouraging signs of stabilization in the business model during the recent quarters and more proficient demand forecasting than in the past which has led to better inventory reads for market researchers. GMCR typically does not offer the market research community insight into inventory data outside of the quarter, but rather points the community into the direction of the sales data provided by NPD or Nielsen's. However, these firms do not acquire sales data from some of the biggest retailers selling GMCR products such as Wal-Mart (WMT) and Bed Bath and Beyond (BBBY). NPD has broadened its scope of retailers now to include greater grocery channel sales data, but without the biggest retailers its sales data remains inconclusive. The big boys of retail such as BBBY and WMT are still in charge of Keurig products and as such we are delivering to the investment community three recent channel checks from the current quarter including the Vue brewer sales over the last 8 weeks. We will not be sharing channel check data outside of Capital Ladder Advisory Group clientele for the remainder of the quarter so we hope you enjoy. Good luck and look for our latest research and analysis on GMCR at capitalladders.com.