One should never base an investment on a single reporting metric, but when it comes to gross margins, this tends to tell a big picture story that can signal a longer term trend. In this article, we will compare the gross margins of two company's respective "razor/razor" blade business models to see which one settles out with the more sound investment thesis. As noted directly, although this one metric should not be the only focus for an investment thesis, for the purposes of this article, it will be the main focus. Our aim is to develop an understanding of gross margin contribution for Green Mountain Coffee Roasters (GMCR) and SodaStream International (SODA).
Both GMCR and SODA employ the same business model which is known as the razor/razor blade business model. The business model's concept is very simple and very effective. Essentially, the company sells a razor (coffee maker or soda maker) which necessitates a future purchase of a razor blade (K-cups or flavor syrups and CO2). Typically on the razor side of the business, the gross margins are less than that of the razor blade side of the business.
Now let's look at GMCR's gross margins separate from that of SODA. GMCR sells its Keurig line and Vue line of brewers, coffee and tea flavored drinks. GMCR represents a unique razor/razor blade business in that the company earns almost nothing on its brewer line of products. The high cost associated with manufacturing and production of most of their brewer systems in the United States makes it terribly difficult for the company to produce any profits on the brewer systems alone. Everything from regulatory burdens to tax rate as a percentage of sales is factored into the equation here.
Where GMCR shines and makes the bulk of its profits is through the millions of portion packs it sells annually. The portion packs are obviously the higher margin "razor blade" product which supports the totality of the business. With that said, GMCR has managed to produce gross margins in the mid 30% range over the last two years. Unfortunately, as competition, higher green coffee prices and tier pricing strategies have come into play over the last 12 months, GMCR has witnessed margins contract over the last 12 months, and margins currently rest in the low 30% range.
Critics of GMCR and its management team, both past and present, place blame on the outsized capital expenditure dedicated to increase manufacturing capabilities in the United States when other opportunities were on the table for consideration. While grants from the federal government did serve to mitigate some of the underlying costs of this build-out for manufacturing, it only serves to ensure the relatively low margin turn-out for the company in the years to come. Localized manufacturing has also created barriers for profitable export to other nations. If GMCR can only manage low to mid 30% gross profit margins for distribution within the North American region, how does it produce any profit for export? Ideally, outside manufacturing or outside partnerships will need to be explored in the likeness of GMCR's partnership with Luigi Lavazza.
Presently, GMCR does have a brighter gross margin picture to paint as the cost of green coffee prices have come down dramatically. Additionally, the company is presently operating in the part of the FY in which the product mix shift benefits gross margins as fewer brewer systems are produced in relation with portion pack sales. Lastly, operational improvements with regards to capacity utilization are said to be improving for the company quarter to quarter. All of these factors should serve to help improve gross margin output in the near term. Now let's take a look at GMCR's previous four reporting gross margin results.
As the chart clearly indicates, gross margins have declined sequentially in each of the previous four reported quarters. However, with improved operational efficiencies and lower commodity costs, GMCR may be turning a corner with respect to gross margins. At the very least, the company is working off of a relatively low performing gross margin base from last year's results. The main takeaway from the noted gross margin performance is that the company has very little room for error in the business model as a whole. Operating a business with relatively low margin of profitability and insignificant cash flow can sometimes prove to be cumbersome and volatile, also easily recognizable in the company's most recent performance.
Now let us turn our attention to another company which also employs a razor/razor blade business model, SodaStream International. SODA also has a unique razor/razor blade business. Unlike that of GMCR's razor/brewers, SODA's razor/soda maker actually has a gross margin in the low 30% range depending on the particular soda maker. So the company does turn a profit on its soda makers or hardware for you tech junkies. As far as SodaStream's razor blades are concerned, the company makes several razor blades such as bottles, flavor syrups and the all-important CO2 just to name a few. Gross margins for these products range from 50% to nearly 90%. The net result of the compilation of product offerings manufactured and produced by SODA bear mid 50% gross margins for the company, roughly 20% greater than that of GMCR. Now let's take a look at SODA's gross margin results over the previous four quarters.
One headwind that SODA is currently battling comes from the demand side of the equation. Essentially, the company had not planned for the outsized demand of its products which resulted in margin contraction during Q4 2012. The company received orders for its product line that outstripped its manufacturing capacity. Many are of the opinion that this is a good problem to have, even though it adversely affects gross margins in the near term.
As a result of this demand side issue, SODA has subcontracted for third party manufacturing of some of its products as a means to fulfill orders while it currently builds out its one million square foot new manufacturing facility within Israel Proper. In light of this development, SODA has guided gross margins to be flat YOY at around 54%. I guess in some cases, flat isn't such a bad situation when your margins are at these levels. With that said, it calls into question the future of gross margin performance for SODA. It has been detailed by SODA's CEO Daniel Birnbaum that upon completion of the new manufacturing facility in 2014, SODA will likely enjoy margin expansion due to the consolidation of manufacturing from some 7 facilities currently operating in and around Israel to one main facility in Israel Proper.
With the company currently operating 7 facilities and each facility having specialized operations, the transportation and management expenses to run these several facilities has weighed on gross margins over the past few years. As a byproduct of manufacturing consolidation, the company will be able to focus efforts on something more than just, "Has the truck gotten here yet". Right now, this phrase is at the tip of the tongue for most facility managers at SodaStream, as trucks are loaded with unfinished products and transported from one facility to the next to complete a single soda maker.
There is yet one more thing to consider when discussing these two reputable companies, and I briefly touched on it earlier, and that is competition and pricing. Pricing factors into gross margins as much as anything else does. While GMCR has been experiencing price degradation in its respective products, SODA has seen very little change in its pricing; if anything, the price of SODA maker units has actually been increasing YOY. This anomaly is in part due to the lack of competition SODA is experiencing in its product category. Barriers to entry in this product category are much higher than most understand. Sure, anyone can produce a soda maker, but the soda maker is not where the money is, as we outlined through our gross margin per product depiction. The money is in the syrups and CO2. Again, sure, anyone can produce syrups, and they currently do around the world, but this has not resulted in declining prices or syrup sales for SODA products over the last several years. This denotes or explains that the competition for soda syrups in the marketplace currently is healthy competition. Additionally, healthy additions or competition in such a young category as the at-home carbonation category will likely serve to increase consumer awareness of the product category for years to come.
Lastly, the biggest barrier to entry in SODA's product category is the CO2 distribution network. SODA has spent the last 5 years building out its CO2 distribution network. The intricacies in this network require strong expertise on the part of SODA and buy-in from retail partners. The CO2 exchange process is unlike most retail processes which ask the retailer to take something back from the consumer as a sale. It requires compiling data, storage, due diligence at the point of sale and reverse logistics expertise. For these reasons, 90% of all retailers around the world currently only operate one company's CO2 exchange, SodaStream's. For the minority of retailers which operate 2 exchanges, many times the process goes awry, and the retailer makes errors in completing the exchange process, resulting in additional costs for the retailer. With this knowledge at hand, some small appliance makers have decided that if you can't beat them, join them. When Hamilton Beach introduces their respective soda maker system later this year, they will be using SodaStream's CO2 and CO2 exchange. Naturally, SodaStream will enjoy the profits from this partnership.
When competition is healthy, gross margins can remain intact, but in such a fiercely embattled territory such as coffee and coffee flavored drinks, the major players are in a fight for every consumer dollar. GMCR is making the right moves to combat the pricing war currently waged in the product category, but we don't expect to see 40% gross margins any time soon. SODA is benefiting from the youth of its product category and high barriers to entry. With new manufacturing capabilities to come in 2014, we could see gross margins expand beyond 57% in the years to come, although this feat of strength remains to be seen, as inevitably, competition will come in some manner of significance.