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Energy drink producer Monster Beverage (NASDAQ:MNST) reported lackluster first quarter results due to lower sales growth and a lack of cost containment. Revenue was well below consensus expectations, growing just 7% year-over-year to $484 million compared to the last several quarters of double-digit revenue growth. Earnings fell 10% year-over-year to $0.37 per share, which failed to come close to the consensus estimate.

According to Monster's management, the entire energy drink industry experienced weak sales growth during the first quarter relative to the powerful double digit growth rates the industry has become accustomed to. What's driving the weakness? It appears to be largely related to health issues. The FDA provides a report describing the negative effects of caffeine, but from what we can tell, a moderate amount (modestly pegged at 200mg/daily) seems relatively safe. After over a millennium of usage, caffeine isn't anything new, and it has been a regular part of the western diet for the past several centuries.

Still, caffeine is a drug, but its extraction from coffee and synthetic creation has also been going on since at least the end of the 19th century. From what we gather, caffeine is probably not as inherently dangerous as how it's consumed. Much was made about a 14 year old girl who died last year after drinking two 24 ounce Monsters. Though we feel for such a loss, Monster Beverage may not be entirely to blame (or receive any blame at all), as she had a heart condition and exceeded the manufacturer's suggestion for beverage consumption.

However, the healthfulness of caffeine and the energy drink category pales in comparison to the public perception. Complaints against these beverages, in particular 5 Hour Energy, have been fairly elevated over the past years, and cities like San Francisco are attacking Monster on the legal front over marketing practices allegedly geared towards children. Although there is no context for the complaints, and for all we know, some may have surfaced after a day's worth of unhealthy behavior, sentiment is certainly shifting against energy drinks in the US, and we wouldn't be surprised to see further opposition abroad.

Nevertheless, legislation against caffeine seems unlikely, in our view.

Not only would additional controls on caffeine hit energy drinks, but controls could also negatively impact the profit drivers of blue-chip companies like Coca-Cola (NYSE:KO), Pepsi (NYSE:PEP), and even Starbucks (NASDAQ:SBUX). Lest we not forget that several of Starbucks' drinks have caffeine counts that make smaller sized energy drinks look irrelevant. Thus, we see the threat of national regulation as slim, unless the FDA finds more evidence against highly-caffeinated products.

Even regional controls have failed to gain steam so far. Chicago recently proposed legislation requiring age controls or concentration bans, but little progress has been made. As we mentioned earlier, San Francisco is pursuing legal action against Monster for marketing practices, and we think cities like San Francisco could end up restricting sales or banning certain concentrations altogether. A recent study found evidence to suggest that l-carnitine (an addition to energy drinks) could pose health risks, but we think energy drink manufactures would simply remove the ingredient. Plus, l-carnitine is currently sold and often marketed to promote fat loss, and evidence linking the amino acid to artery issues is still limited.

Aside from broader market risk, Monster Beverage did a terrible job of control costs during the quarter. Gross margins fell 100 basis points year-over-year to 52.1%, which management blamed on the weaker yen. Management added that gross margins were up slightly in North America, but raw material costs still increased year-over-year.

However, input costs didn't weigh on operating profit as much as the lack of cost control elsewhere did. Selling expenses jumped 120 basis points year-over-year to 13.5%, distribution cost were up 30 basis points to 4.6%, while G&A soared 310 basis points year-over-year to 11.8%. Increased selling expenses makes some sense, especially since we believe the company anticipated significantly stronger sales growth.

However, we think the rise in G&A was disappointing. CEO Rodney Sacks provided an unsatisfactory excuse, saying:

"The increase in general and administrative expenses was primarily attributable to increased payroll expenses and, in particular, increased professional service costs for legal, accounting and other professional costs. These costs, net of insurance reimbursements, were $4.9 million higher than in the comparable quarter of 2012. Additionally, travel costs were substantially higher in the first quarter than in the comparable quarter last year. Many of the increases in SG&A spending were planned based on increased budgeted sales, which did not fully materialize."

Essentially, it sounds to us as though the company started investing in ways to protect itself against possible legislation and began lobbying politicians. Such large costs could put a cap on profitability for 2013.

Ultimately, we think the sentiment shift against the healthfulness of energy drinks could prove to be more dangerous to Monster's profitability than the legal ramifications.

From what we gathered on the conference call, management is prepared to defend the safety of its products and our independent research leads us to believe that the threat of national regulation is low. Like alcohol and other controlled substances, it appears much of the danger lies in how it is consumed, rather than in the product itself. Still, we think shares of the company look fairly valued, and the long-rumored Coke acquisition looks unlikely given the shaky state of demand growth going forward. We're not rushing to add shares to the Valuentum Best Ideas portfolio.

Source: Lack Of Cost Control And Demand Risk: The Story Of Monster Beverage