Green Mountain Coffee Roasters (NASDAQ:GMCR) announces earnings after the close on Wednesday, May 8, 2013. If history is any indication, the stock is likely to make a huge move, one way or the other. Over the last four quarters, the average price change after earnings was a whopping 26.1% (measured from the closing price on the day before the announcement until the closing price when the Weekly options expired on Friday).
Here is what has happened after the past four earnings announcements:
While GMCR has met or exceeded expectations for all four previous quarters, the market has clobbered the stock when it only met the earnings expectation (possibly fueled by claims that they had cooked the books to make those numbers). The average change over the past four quarters has been 26.1%, skewed by the huge 49.3% drop one year ago. Even discounting that quarter, the average change has been 18.4%.
It is no surprise that current option prices are predicting a move of 14.5%. This "low" expectation (by historical standards) is perhaps an indication that the company is settling down and a little more mature today than it has been in the recent past. Still, fireworks of some sort can be expected. A 14.5% change in a day or two is still a huge move in the general scheme of things.
There are two issues that need to be addressed - first, how will the company do compared to expectations (analysts say earnings will be $.72 while whisper numbers are $.78), and second, what is the stock likely to do after those earnings are announced? Historically, the two results have had very little relationship between them (in half the quarters, meeting or beating expectations resulted in a lower stock price, for example).
Three months ago, just prior to the earnings announcement, I foolishly published a Seeking Alpha article entitled, "Why Green Mountain Coffee Roasters Will Soar This Week." While the company met earnings, revenues, and margins, the stock traded down 7.7% because guidance was tepid (the company merely reiterated earlier guidance). Since then, the stock has rallied 30% while the S&P 500 has moved up only 6.3%. So my analysis was sound even if my timing was off. I'm glad I hung onto my stock.
What I learned is that earnings time seems to take on a life of its own that seems quite different from the fundamentals. The stock market has always been more emotional than rational (at least in my view), but around earnings announcements the divergence seems to accelerate.
So how do I think GMCR's results will be next week? That seems to be the easier question than guessing which way the stock will move. Quite simply, I think the company will beat expectations for three reasons:
1. The company is maturing under professional leadership. In December, 2012, GMCR hired rising star Brian Kelley from Coca-Cola (NYSE:KO) as its new CEO. He took over the reins from the company's iconic serial entrepreneur founder Bob Stiller who did not have experience running a large company. Under Stiller's leadership, the company's early success ran into serious setbacks when David Einhorn published his short thesis in October 2011 which was followed shortly by an SEC inquiry, shareholder suits, charges of inappropriate accounting methods, and the ultimate removal of Stiller as board chairman when he had a margin call on his stock and was forced to unload millions of shares at a time when insiders were prohibited from trading their stock.
Since taking over last December, Kelley has largely kept GMCR out of the headlines (I live in Vermont and carefully monitor the local news on the company - the biggest news of late was the laying off of a small number of production workers, probably as part of a publicized effort to improve margins).
For a comprehensive review of GMCR's roller-coaster history, read Martin Redfield's excellent article. Now that Kelley is in charge, it seems likely that the company will become a more predictable and less volatile company with fewer scandals and miss-steps, real or imagined.
2. Coffee prices have fallen steadily while single-cup prices hold steady. Check out the benchmark Arabica coffee prices for the past year:
This price downtrend is likely to continue. Just last week, Goldman Sachs Group Inc. lowered its price forecasts for Arabica coffee futures, citing an improving production outlook in leading grower Brazil. Prices will be at $1.45 a pound in three, six and 12 months, the bank said. This is $.10 a pound lower than its most recent estimates.
Unlike gasoline prices, retailers generally don't raise or lower coffee prices when green coffee prices fluctuate. This means that meaningful non-recurring profits might result from raw material prices falling.
Some coffee prices have come down, but apparently not for single-cup packages. Last week, Kraft (KFT) lowered prices for its premium brand Gevalia coffee by 6% in response to Starbucks' (NASDAQ:SBUX) lowering prices by 10%. However, KFT specifically reported that coffee in its Keurig cup offerings would remain at the same price levels. Speaking of KFT, last week the stock soared 6.3% after announcing higher-than- expected earnings. Could it be that part of their success was higher margins for its Maxwell and Jacob coffee products? It does seem to be a possibility.
3. Hedge funds are buying shares - Net institutional purchases in the current quarter were 14.7 million shares, which represents about 11.39% of the company's float of 129.03 million shares. When the big guys plough money into a company with a checkered history such as GMCR, you can bet that they have done their homework first. They have a much better idea of what's going on in the industry than any individual could ever hope to have, and when they start accumulating stock it's usually a good bet to follow their lead.
Okay, so I think that earnings reported Wednesday evening will exceed expectations. But the larger and more elusive question is how the market will react. As history tells us, there is often a big difference between how good earnings might be and what happens to the stock price.
I see one important indication that the stock will fall unless there are blow-out earnings such as we saw in Netflix (NASDAQ:NFLX) a couple of weeks ago. Expectations seem to be sky-high. Whisper numbers are 8.3% higher than analysts expect, and the stock has steadily climbed by 30% over the last quarter. When expectations are this high, any small disappointment - in earnings, revenue, margins, guidance - might well result in a lower stock price.
Last quarter, when the company exceeded on all these measures except guidance (which it left unchanged), the stock tanked, apparently (based on analyst questions in the conference call) because cash flow was not seen as sufficiently high enough to support both international growth and continuing the company's stock repurchase program. Sometimes you just can't win no matter how good the numbers are.
Offsetting the high-expectations concern is the fact that short interest remains high, raising the likelihood of a short squeeze:
In the last quarter while the stock has gained 30%, it is remarkable (at least to me) that the short interest number has hardly budged. Over the past 30 days, however, it has gone down about 1.8 million shares (to about 32.2 million), but this number represents about 39% of the float, a huge amount for most companies, and if earnings are indeed above expectations, there might be a lot of short covering.
Given these offsetting indicators, my best bet is that the company will exceed expectations but the stock will fall slightly. Most importantly, I feel confident that the stock will fall less than the 7.7% it fell last quarter after a favorable earnings report.
I feel good about the new CEO's performance to date, and expect him to be concerned about establishing his legacy. It looks like he is turning GMCR into a mature company that will be marked by moderate improvements rather than dramatic swings in both directions. The investment community will surely love that.
Option prices for GMRC are so high that you should be able to make money even if you are wrong with the direction the stock price takes. My best guess is that the stock will fall slightly after a good earnings announcement, with high expectations offsetting good results and short sale covering. But I realize that this is only a guess, and I feel much more comfortable with making a wager that will make a gain if the stock falls by less than 7.7%, stays flat, or goes up by any amount.
This is what I plan to do with the company trading at about $58:
- Buy To Open 10 GMCR June-13 52.5 calls (GMCR130622C52.5)
- Sell To Open 10 GMCR May2-13 57 calls (GMCR130510C57) for a debit of $3.70 (buying a diagonal)
The short 57 Weekly call is a dollar in the money which provides some downside protection while there is over $3.50 in time premium to collect. The risk profile graph for 10 spreads (assuming implied volatility for the June options will fall from its current 60 to 47 where it was after the last earnings announcement):
The graph shows that the stock can fall by 10% and a small loss would result, but at any higher price there would be a gain, possibly as much as 50% or so if it falls just a little. We should expect a fall in June option prices after the announcement, but the June 52.5 calls are so far in the money that most of the value comes from the intrinsic part of the option price rather than the time premium, so these calls should not experience the big drop that at-the-money options will take. The difference between the strike prices of the long and short sides is $4.50, well more than the $3.70 cost of the spread, and the June options will retain some time premium since they have 7 weeks of remaining life.
In the unlikely event (at least to me) that the stock falls 10%, weekly calls could be sold against the June 52.5 calls over the next 7 weeks to recoup any losses that might result. If the stock falls by 10% it would be right at the $52.50 price of the June calls. Checking back at what an at-the-money call with 7 weeks of remaining life would be worth after the last announcement, I calculated a price of about $3.70, or the same as the original cost of the spread. Bottom line, this spread should make a gain at any price other than a drop of more than 10% after the announcement.
This looks like one of the most intriguing and potentially profitable option plays that I have seen in a very long time. I plan to bet my (still unbuilt) guest house on the trade (although I must admit the last time I bet that house was a long bet on AAPL at just about the worst possible time, although I have recovered most of those losses with several earnings plays since then).
If you are a stock trader rather than an options trader, I would be ready to load up on shares if the stock does manage to fall after beating expectations like it did last quarter. Of course, waiting for that to happen might not work out because maybe this time around, the stock will move higher as it did in the prior two quarters when the company exceeded estimates.
As I noted earlier, the market seems to be especially irrational just before and after earnings are announced. We can probably count on that phenomenon continuing again this week.