Green Mountain Coffee Roasters (GMCR) recently reported Q2 2013 earnings results which saw short interest take a severe beating. The company beat expectations handily on the bottom line although the top line seemingly missed analysts' expectations. But investors weren't focused on revenues/sales, which continue to show strong signs of slowing growth. Investors and analysts alike were more focused on the bottom line beat and an announcement that further cemented Green Mountain's partnership with Starbucks (SBUX).
On the Conference Call, Green Mountain's CEO Brian Kelley fielded questions from analysts related to the newly signed deal between the two companies. As the CEO of GMCR remained conservative with regard to detailing the new partnership, he did point to this venture as opening up new doors internationally for GMCR. Additionally, he noted the partnership would further advance Green Mountain's North American dominance through greater distribution in the region as well as greater product development for the region. We will likely see Keurig products offered at Starbucks' locations in the near future based on this new partnership agreement. Under the new agreement, Starbucks will add brands and varietals to the already robust Starbucks K-Cup and Vue pack portfolio of offerings for Keurig single cup brewers, ultimately tripling the number of Starbucks products and adding brands offered on the Keurig platform. New brands will include Seattle's Best Coffee, Torrefazione Italia coffee, Teavana Teas, and Starbucks Cocoa.
So while investors have resided to focus attention on bottom line results, at least in the interim, we will need to begin considering more broadly some of the trends that have been in place for GMCR over the recent years if not several quarters. Let's take a look at those margins to see how they performed in the most recent period ended against the underlying trend. The chart below identifies GMCR's gross margin performance dating back to Q2 2012:
Gross margins took a notable turn for the worse through 2012, but have recently turned in a more favorable direction due to lower green coffee costs, improved operational efficiencies, lower warranty claims and a shift in sales mix from brewers to single portion packs. While we congratulate GMCR for managing coffee costs and introducing brewers which show more stickiness than in the past (warranty claims), the sales mix shift may serve to define an underlying problem with regards to the general strength of sales and longevity for which gross margins can plausibly expand.
First and foremost, the benefits to gross margins accomplished in the most recent quarter are simply cycling from a larger base of brewer sales in the product mix last year, with some attributed to the Vue brewing system launch. Based on this analysis, which is supported by Fran Rathke's comments on the Q2 conference call with analysts, the benefit is likely transitory and will fade throughout the coming quarters. The following commentary is offered from the Q2 2013 conference call in an exchange between GMCR's CFO Fran Rathke and a GMCR analyst:
"Q1 of last year had per-sales returns had a pretty significant rate and then some comp that last quarter if I take a rate of the expense the sales return provision divided into the brewer and accessory sales it dropped much more precipitously in a positive way from Q1 of last year to Q1 of this year and then we did have some improvement but not anything significant."
For reiteration, we don't believe the 80 points of margin expansion which the company benefited from through warranty claims will be long-lasting.
Another perspective on warranty claims as a function of brewer sales YOY would be to understand that the company sold fewer brewers in Q2 2013 than the previous year's same period. GMCR sold 9% fewer brewers YOY in the most recently reported quarter which is another problem. According to GMCR's internal estimates which include NPD data and retail customer reported information, consumer purchases or POS accrued brewer through the second quarter increased by 13% over the prior year period. For the year, the company also reaffirmed guidance that they expect the brewer unit shipment and POS growth to be in the mid single-digits. Not sure if we understand this, but why is the company taking down POS growth estimates after a seemingly better end-demand performance in the quarter? We would have to assume it is related to fewer brewer sales during the upcoming warmer climate months, but that should be more than offset during fiscal Q4 if the company's growth trajectory is accurate. One thing we do understand is brewer shipments and as I noted in previous articles, orders from retailers have been and continue to come in light of growth estimates. The bottom line for GMCR is that this is not a GMCR-specific issue. Consumer demand and consumer spending on a seasonally adjusted basis are weakening, forcing retailers to carry fewer inventories. Many retailers are employing the strategy known as "one for show and one to go". This basically means that there is one product per sku shelf allocation and one in the back room to replenish the shelf. Not much inventory on hand.
What is a GMCR-specific issue is that SodaStream (SODA) has been taking purchase orders and selling space from GMCR. Best Buy reduced their orders dramatically for Keurig brewers in favor of allocating the same shelf space to SODA products. Our latest data from Target (TGT) now also supports the same thesis and investors can see this evidenced in stores as SodaStream products have recently taken the place of the Keurig display in the small appliance department of Target stores around the country. GMCR and SODA share some shelf space at Staples, but here is where we see greater order declines in the recent data: Office Depot (ODP) orders for Keurig products are down nearly sharply YOY since SodaStream recently signed a deal with Office Depot to distribute its product line in some 500 Office Depot locations. Office Depot is experimenting with a new merchandising strategy geared toward the office beverage center demand category. Lastly, every consumer goods company is getting hit by the lack of YOY orders from J.C. Penny (JCP) which all but halted home goods orders since the beginning of 2013.
It's all about demand and based on the newly updated net sales guidance offered by GMCR, demand continues to slow and the order flow is being impacted. GMCR updated net sales guidance for FY13 to grow in the range of 11%-14%. To put this net sales guidance into perspective, prior guidance was for net sales growth of 15% to 20%. The updated guidance represents a significant, further decline in net sales for the company. Unfortunately, this trend has been in place for two years now as the company grew net sales by 95% in 2011, 46% in 2012 and now expects to grow net sales in the teens for 2013. It is obvious why the company needs to find a footing in international markets as well as other channels such as food service where the company has indicated it plans to head over the next 12 month period.
With consumer demand slowing and GMCR having saturated most of North American grocery, mass market and specialty retail channels, it is ready to advance its platform for more commercial use. Brian Kelley offered investors some insight into the away from home category in the United States on the latest conference call:
"The U.S. away from home business for hot beverages is a $10 billion wholesale opportunity that consists of food service which is 74% of that total, workplace which is 20% and travel, leisure and hospitality which is 6%."
As part of the company's steps toward entering the food service channel in the U.S., the company recently completed its NSF food service certification.
What we have now is game of timing. Can GMCR penetrate this highly competitive food service and hospitality channel before its core business segment actually results in a further slowing of growth in net sales? International growth would also be ideal. However, we don't think Amero-centric investors fully appreciate the competitive landscape for coffee and tea flavored drinks in Europe and Asia. We noted before that GMCR would have to grow internationally and by way of partnerships and thus you have that partnership announcement. Whether or not international growth and North American channel development growth will be meaningful remains to be seen. However, it certainly proposes to offer investors interesting developments over the next several quarters.
So let's refocus for a minute and take a look once again at the bottom line. Green Mountain came in at $0.93, which crushed analyst forecasts for $0.73 a share in earnings. The bottom line beat was significant, beating earnings by $.20 a share, notably with a lower share count advantage since the company has instituted a share repurchase program worth $500 million. GMCR purchased roughly 608,000 shares of common stock at an average price of $44.65 per share for approximately $27 million during Q2 2013. These purchases bring the total shares repurchase since the fourth quarter of fiscal 2012 to roughly 8 million shares at an average price of $25.32 per share for a total of $202 million. What matter are earnings and sometimes it doesn't matter how you get them, it just matters that you get them. It's not fair to say that GMCR saw significant earnings improvement through its share repurchase program efforts when a greater portion of S&P 500 companies are doing the very same thing. This is the trend and right now for GMCR and the overall market, the trend is certainly your friend.
With that out of the way we can now move on to earnings guidance for the current quarter and the FY, also offered in the latest earnings report:
"We expect non-GAAP earnings per diluted share in a range of $0.71 to $0.78 excluding the non-GAAP items as noted in today's press release. This represents a growth rate of 37% to 50% over last year's $0.52 per share. For the full fiscal year, we expect total net sales growth in the range of 11% to 14% over fiscal 2012. On a comparable basis, when excluding the 53rd week of fiscal year 2012 which contributed $90 million in net sales in our fourth quarter, our net sales guidance equates to a range of 14% to 17% growth for the year. For FY13, we increased non-GAAP EPS estimate to a range of $3.05 to $3.15 per share representing growth of 27% to 31% over the prior year period."
Additionally, the company is lowering estimated capital investments to a range of $275 million to $325 million from a prior range of $350 million to $400 million. The company noted that the continued capex spending decrease is a result of greater utilization efficiencies and production line advancement that is now bearing fruit over the entire production line capabilities.
GMCR has outlined its business strategies for investors recently and they are as follows: First, earn sustained growth through continuous innovation and passionate advocacy of owned brands. Second, achieve operational excellence to delight consumers and customers. And third, develop talent and culture to achieve the GMCR mission. As part of these core business strategies the company will continue to drive innovation through multiple channels of product development and multiple channels of distribution. Brian Kelley noted that the company will roll out a new brewing system by the end of 2014 which will have the capability to use both K-cups packs and V-packs. There is no definitive pricing strategy for these brewers yet other than to say they will be in a range of price points that are comparable to today's Keurig and Vue brewers.
In conclusion, earnings look great, gross margins significantly improved, but net sales are showing rapid deceleration of growth. There doesn't appear to be much in the way of stemming the sales slowdown tide over the near term, but the long term looks healthy. Traders may look upon this recent reporting cycle from GMCR as an opportunity to either take some money off the table and look to re-establish a new position later, while short speculation may initiate new positions in the near term based on sales trends for GMCR.
Investment Thesis: GMCR has experienced rapid growth in recent years and is the leading single-serve coffee producer in North America. As the company nears market saturation, it has begun to rely more heavily on its existing user base to support sustained revenue and earnings growth. Capital expenditures committed in previous years are bearing fruit as greater efficiencies are felt through production and capacity utilization. Forecasting demand remains crucial for the company as the North American economy remains stagnant in the face off high unemployment and an increasing tendency toward consumer savings rather than consumer spending. Pricing for K-cup remains pressured and has declined in each of the last 4 quarters as competition and product mix evolve.
There is the distinct possibility that pricing could stabilize in the back half of 2013 as the company begins to anniversary Dunkin Donuts (DNKN) and some other licensed deals, however, in the interim, this will still hurt some of the dollar growth for GMCR. Retail distribution partners have more variety than ever to choose from in the single-serve coffee market as well as the beverage category as a whole. GMCR expects the existing user base to continue to grow well into 2016 in the consumer channel while it expands its away from home market share. At this time, we would not be inclined to dedicate new capital to shares of GMCR. Risk/reward is currently not favorable given sales trends and the macro-economic environment as proven by retail orders, general retail sales data and against the current P/E multiple for shares of GMCR. We currently rate shares of GMCR with a Hold rating.