Green Mountain Coffee Roasters (GMCR) is set to release Q3 2013 results August 7th after the closing bell. Shares of GMCR are on a tear this year up nearly 80%. With the stock trading at a forward looking P/E of roughly 25 times FY13 earnings, analysts are now wondering if a pullback in share price is warranted. So let's take a look at what analysts are expecting from the upcoming quarterly release.
Now let's take a look at the company's official guidance for the quarter ended June 31, 2013: The company anticipates a total net sales increase in the range of 11% to 15% from the year ago period driven by continued single serve pack growth. GMCR expects 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, GMCR expects 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 the fourth quarter, net sales guidance equates to a range of 14% to 17% growth for the year.
It is highly relevant to understand that GMCR's initial guidance for full year revenue was a growth rate between 15% and 20%. The lowering of revenue expectations is in part due to weakness in brewer shipments exhibited in Q2 2013 when brewer shipments fell by 9%. To be clear and fare with respect to the sales data for brewers, while shipments of brewers did fall by 9% during the quarter, point of sale data showed a 13% sell-through rate of brewers. The reason for the disparity between the sell-in and sell-through data was likely, in part, due to conservative ordering on behalf of the retailers ahead of the adoption of the newer Vue 500 brewer. With regards to brewer shipments, GMCR reaffirmed full year guidance of brewer shipment growth to be in the mid-single digits.
Having suffered through much of 2012 with gross margins of less than 38%, Green Mountain has seemingly turned a corner through greater operational efficiencies which effectively served to increase gross margins so far this year. In Q2 2013, the company expanded gross margins dramatically through lower green coffee cost, lower obsolescence expense, a product mix shift towards single serve packs and continued lower warranty expense due to improved brewer quality. Green Mountain achieved a 590 basis point improvement to 41.3% of net sales versus 35.4% in the prior year period.
On a more grand scale, Green Mountain is successfully streamlining and improving operations which is consistent with its ability to lower Capex spending YOY and sequentially. In its latest Capex guidance offered to investors, the company has effectively taken some $75 million in Capex spending out of the equation through operational improvements. So exactly what is the company doing to improve operations and lower overall costs, thus improving gross margins? Since Brian Kelly took the helm at GMCR, the company has embarked on improving the flow of coffee between roasting and grinding which effectively minimizes downtime on packing lines. The company is improving the way plants plan and respond to downtime. The company is balancing labor across plants to maximize efficiency, improving the scheduling at plants and delivering better customer service. Additionally, the company is examining every facet of the logistics footprint to make it more efficient.
Addressing The Away-From Home Market
With Green Mountain dominating the single-serve, at-home coffee category the company has now set its focus upon tackling the highly sought after away from home coffee category. 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%. Today Green Mountain estimates they are only in 10% of U.S. workplaces less than 5% of travel, leisure and hospitality locations and in less than 1% of the largest away-from home businesses which is the food service sub-segment.
Within this commercial category, the Keurig system of brewers has several advantages and/or keys for success over existing competitive brewer systems currently in the marketplace. First and foremost, Green Mountain can reduce coffee waste since today, the service industry brews coffee a gallon at a time in many cases. Green Mountain can also improve the speed of preparation, the variety of brands and the freshness and consistency that they can offer to their customers. GMCR is currently pursuing a number of opportunities in food service and the company is confident that this represents a significant growth opportunity for GMCR beginning in 2014.
The latest Keurig product development which will specifically address the away-from home marketplace is aptly named the Keurig® BOLT™ Carafe Brewing System. The commercial grade Keurig® BOLT™ system offers users the ability to brew a 64-ounce pot of coffee in approximately two minutes, bringing the innovation, speed, convenience and quality that Keurig® single cup brewing systems are known for to higher volume brewing.
"Keurig BOLT is a step in Green Mountain's journey of bringing Keurig simplicity, quality and convenience to new away-from-home applications," said Brian P. Kelley, President and CEO of GMCR. "While driving Keurig single serve adoption both in- and away-from-home remains a significant opportunity and priority, we recognize there are away-from-home consumption occasions where brewing in volume is preferred.
While this new effort from Green Mountain may prove to add incremental revenues in the mid-term, investors should not expect to see meaningful, if any, earnings contribution from the commercial market until later in 2014 as the product line is more broadly adopted and costs of acquisition begin to stabilize. The sheer magnitude of sales and marketing expenditures associated with tackling the away-from home market in the early going will need to be taken into consideration by investors. Having said that, Green Mountain is taking the necessary steps toward expanding its user base beyond the at-home market.
Private Label Competition
Private label competition continues to grab headlines in the single-serve coffee category. Since Green Mountain's K-cup patents expired in September of 2012, the threat presented to the company from new entrants has done little to stop the consumption of Keurig brand K-cups and licensed K-cups sold by GMCR. What has occurred, however, is the slow and steady price erosion of K-cups across the system. On average, the price per K-cup continues to see declines quarter-to-quarter and year-over-year as the competition for the consumer dollar heats up.
Capital Ladder Advisory Group (CLAG) has been tracking pricing and sales of K-cups over the last 3 years and over the last 18 months, the price/K-cup has born accelerated price erosion with the biggest price declines occurring in the current fiscal year. By our latest statistical data, the average price/K-cup has declined by $.0337 in 2013. We anticipate future pricing pressure to persist as more competition comes on-line.
Recent reports indicate that some 26 new entrants in the K-cup category have come into the category since September of 2012. When it comes to unlicensed competition in the category, Green Mountain has indicated the company believes that unlicensed compatible products will have only about 5% of the K-Cup universe this year, and perhaps 15% in two or three years.
During Q2 2013, we have reported on two separate, coffee related taste tests from independent research firms. The first set of findings is summarized in the following excerpt from PR Newswire:
March 26, 2013 /PRNewswire via COMTEX/ -- Independent Third Party Confirms Gevalia House Blend Earns More Taste Preference in National Taste Test. Today, Gevalia is asking coffee lovers to raise their mugs to celebrate an exciting announcement: More coffee drinkers prefer the taste of Gevalia House Blend bag coffee over the taste of Starbucks House Blend bag coffee. The results of a national taste test(i) conducted by an independent third party show that nearly 60 percent (59.7 percent) of coffee drinkers preferred the taste of Gevalia House Blend over the taste of Starbucks House Blend. Only 34 percent of participants preferred the taste of Starbucks House Blend while 6.3 percent showed no taste preference ...
The second set of findings was delivered from the most reputable of consumer brand research agencies and publications, Consumer Reports. In June of 2013, the firm conducted a study of single-serve coffee machines and concluded that the best machine on the market right now was the Delonghi Dolce Gusto Genio brewer. It rated higher than Keurig, Starbucks, Bunn and Mr.Coffee brewers. The one draw-back to the machine was that it only used Nescafe brand pods which only distribute 16 flavors currently. In concluding their respective research and taste test survey, Consumer Reports notes that none of the single-serve brewers produces a strong cup of coffee according to professional taste-testers.
Product Placement/Market Share
The near term problem, which is nothing new to Green Mountain, is shelf space and orders. At Office Depot, the Keurig line of products is definitively losing its prime shelf space as the Martinson line is now a featured product line housed in a prime real estate location known as the end-cap, where Keurig was featured previously. As noted in the past, Keurig is losing its prime product placement to other beverage providers inside and outside of the product category. Some notable displacement of Keurig products has been a result of Dr. Pepper Snapple Groups (DPS) dedicated advertising for its Dr. Pepper 10 and other "10" related products which were featured at Target (TGT) through much of GMCR's 3rd quarter. Additionally, SodaStream (SODA) has managed to take end-cap space away from Keurig products at retailers like Office Depot (ODP), Kroger (KR), Best Buy (BBY) and more.
Barron's latest article, with advanced research from Nielsen Holdings, sheds some light on the numbers offered by Green Mountain executives regarding their thoughts on competition from unlicensed products. Nielsen Holdings indicate that unlicensed products are gaining share in the K-Cup market at a faster rate than Green Mountain predicted. Todd Hale of Nielsen's suggests that new brands have garnered 16% of the segment's dollar sales this year alone. Below is a chart from Nielsen indicating market share. The most identifiable point of analysis regarding the chart is that while single-serve products climbed from 23% to 33% of ground coffee sales in Nielsen's measures for the 14 months through June 8, 2013, Green Mountain's share shrank from 52% to 43%, while unlicensed brands rose from 2% to 10%.
While it is noted in Barron's article, How Long Can Green Mountain Stay Hot?, that Nielsen's data does not include several large retailers, what is not mentioned is the away-from home category such as the office workplace which comprises a good portion of the coffee category. So what we have to do as investors is put this data into greater perspective.
First and foremost, we are not dismissing Nielsen's findings as CLAG has witnessed much of the same with respect to the competitive landscape in the single-serve category and disseminated similar research and data points to clients over the last several quarters. There are significant reasons for slowing sales growth that has been occurring at GMCR for several quarters as the company continues to come closer to achieving market saturation. The following list serves to outline points of consideration regarding slowing sales growth:
- Consumer spending waning YOY
- K-cup pricing at a premium to other formats
- More product offerings in the category
- My K-cup and other private label products allow users to use less costly grounds
- Convenience vs. Cost debate ever-increasing
- K-cup vs. grounds taste
- Shelf space allocation at retailers
- Addressable market size not fully recognized or addressed
Green Mountain has long since saturated the mass market retail space and in each of the 6 regions of the United States it currently has greater than 93% grocery market penetration with some regions having achieved greater than 97% market penetration. Naturally, as the remaining addressable market continues to contract, sales growth will do so in kind. This logical and measurable point of analysis can also be viewed in each of GMCR's quarterly supplemental slide presentations which show a direct correlation of sales growth to addressable market size remaining. Once again, while we tend to agree with Barron's suggestive commentary on the prospective pinch in earnings that GMCR could experience in the near term, we also would ask that investors consider the away-from home market undertaking the company has expressed for all practical measures of future investing in shares of GMCR. Lastly, what is also being overlooked with respect to earnings power and the current share price and share price appreciation of GMCR is the company's standing share repurchase program which has only exhausted some $200+ million of a stated $500 million program. In light of the variables noted throughout this earnings preview, we would be inclined to take advantage of any near term depreciation in share price which currently sits at some 25 times forward looking earnings and is inconsistent with the previous 18 month multiple.
What Green Mountain Must Accomplish
With sales growth slowing YOY, Green Mountain has to effectively penetrate additional sales channels moving forward. The North American at-home market will reach its peak in the coming quarters. Green Mountain is aiming to more broadly penetrate the away-from home market in the back half of 2013 and as we move into 2014. In-spite of this new development, the company will still need to address future curtailment of sales in the at-home market which continues to be a headwind in light of greater market share acquisition by private label competitors. Since Q3 of 2012, some 26 new private label offerings have entered the K-cup category. In less than a 12 month period of time, GMCR portion pack growth has deteriorated from 31% growth in Q3 2012 to 21% growth at the end of Q2 2013. Investors will need to play close attention to portion pack growth moving forward in order to identify any potential market share erosion GMCR could incur.
Green Mountain's latest partnership expansion with Starbucks (SBUX) will not conclude for a period of 5 years. When announced on the Q2 2013 conference call, this served to solidify investor sentiment regarding the two companies and their future cooperation. While details surrounding the expanded partnership could prove to find Keurig brewers being sold alongside more K-cups at Starbucks in the near term, Capital Ladder would not necessarily view this as anything more than a short term bump in orders .
Green Mountain has insinuated that its partnership with Starbucks could prove to help GMCR grow outside of the U.S. where it has little presence beyond small boutique retailers in the Asia-Pacific region. Nespresso, Strauss, Krups, Cuisinart, and Breville dominate the landscape for coffee and coffee-flavored drink brewers outside of North America. Starbucks currently operates thousands of shops outside of the United States, but investors should recognize that Starbucks has only incremental brand recognition in regions outside of the United States and in some regions Starbucks has yet to achieve profitability. Investors will need to see more from this partnership going forward to better understand the profit drivers one could expect from this expanded partnership.
Rumors Surrounding The Karbon
Recently, Green Mountain took a step related to the at-home CSD market which granted the company a trademark for the name Karbon. The trademark dates back to an initial patent filing in 2010. In an article related to the trademark and patent news, Capital Ladder Advisory Group outlined the issues related to this headline. Noted below is an excerpt from the patent filing associated with the trademark.
Aspects of the invention relate to carbonating a precursor liquid, such as water, to form a beverage. In some embodiments, a carbon dioxide source can be provided in a cartridge which is used to generate carbon dioxide gas that is dissolved into the precursor liquid. A beverage medium, such as a powdered drink mix or liquid syrup, may be provided in the same, or a separate cartridge as the carbon dioxide source and mixed with the precursor liquid (either before or after carbonation) to form a beverage.
So what is the problem we see in the very first paragraph of this patent filing and is easily identifiable by anybody who knows anything about the soda business? It's really quite simple if you have ever used a soda maker. If you have you would know why the syrup is delivered to the carbonated water outside of the mechanism and poured directly into the bottle. That's right, overflow or fizzing up if you will. Every paragraph, every sentence, every word and every design dimension associated with this patent assumes that the carbonation and syrup mixing occurs within the device. This is not coffee folks, this is a carbonated beverage. You are dealing with a combustible element. Should GMCR choose to enter the at-home CSD market, they will need to amend and/or update this patent for form, fit and function which they may or may not have already done.
There remains one more aspect of this development of a soda maker that is being widely overlooked. The aspect we are referring to is the company's stated reduction in Capex for the remainder of the year. It is unlikely that a future product development in this category would cost any less than $75-$100 million, yet that is the amount in reduced Capex the company has guided to for 2013. So, based on that further analysis, we conclude that the likely event of Green Mountain introducing a soda maker unit without the benefit of a partner such as SodaStream is unlikely, although stranger things have happened throughout the course of GMCR's public history.
In closing, GMCR's share price appreciation has been rewarding for investors thus far in 2013 and as long as the company is able to show a turnaround in brewer shipment numbers alongside K-cup growth which can support the current revenue guidance, investors will likely be rewarded further over the long run.