By David Sterman
When it comes to shorting a stock, one of two outcomes emerge: You were correct, and shares plunge as anticipated. Or you were wrong, and shares rally higher, causing considerable pain.
But for short sellers in Green Mountain Coffee Roasters (GMCR), there's another outcome: They've been badly burned as shares have surged, but they insist they've been right all along, and it's only a matter of time before the stock crashes and burns.
When I first laid out the thesis in place by short seller David Einhorn roughly two years ago, I concluded: "Einhorn scores some strong points, most notably that the company has failed to generate real cash out of this business and may fail to do so once the key patents expire in 11 months. Even assuming that Einhorn is too bearish, this stock still looks expensive."
The stock quickly fell out of bed, as I noted a month later and by the summer of 2012, shares were universally loathed. Yet in the past 12 months, shares of Green Mountain Coffee Roasters have mounted a stunning comeback.
Short sellers must have assumed this stock was dead in the water, but after this sharp recent rebound, they're back at it: The short interest rose to a 12-month high of 32 million shares at the end of August, representing 26% of the stock's float and the equivalent of six days of trading volume.
The Real Numbers?
On the face of it, you'd think short sellers are focusing on Green Mountain's rapid deceleration in sales growth. Revenue rose at least 39% every year from fiscal years 2006 through 2012, but the top line is expected to rise just 10% in fiscal 2013 and 2014. (A big spike in profit margins will enable net income to grow at a much faster pace.)
Shares trade for less than 25 times projected 2014 profits, which isn't especially alarming either, considering the brand's seemingly strong resonance with customers.
But some short sellers think the company's numbers are a work of fiction. They claim that management is erroneously identifying products shipped to distributors as end-user sales. The New York Times raised these concerns earlier this month.
I have some qualms about the Times' analysis. My main concern: Green Mountain has a lot to lose -- and little to gain -- by artificially inflating sales figures, other than to cause pain to short sellers. And that seems like an unlikely motivation. Why would the company risk its reputation on such moves, especially after it endured a costly investigation from the Securities and Exchange Commission (SEC) less than two years ago?
Dubious Plans For Growth
During a meeting with analysts Sept. 10, management ran through a series of new niches the company may pursue. One such rumored move: Products that mimic SodaStream's (SODA) carbonated beverage dispensers.
This is a management team has shown a deft touch in terms of cultivating the single-serve Keurig K-cup phenomenon. So when management hints at new growth initiatives, you have to assume they'll meet with a degree of success.
My concerns instead stem from the brutal nature of food packaging and retailing. Private-label K-cup suppliers are gaining traction, forcing Green Mountain to lower its prices for these "razor blades" in the process.
Regardless of the success of other initiatives, the main driver of this business will still be the K-cups. And management's moves to protect that business are underwhelming. As an example, Merrill Lynch analysts say the (soon-to-be-launched) Keurig 2.0 platform "is intended to provide an enhanced (and proprietary) brewing process, which, if successful, will discourage additional development of unlicensed production."
Really? The response to growing private label competition is to make sure that new machines won't work with private-label K-cups? That seems absurd.
Consumers will migrate to other machines that work with the growing proliferation of K-cup options, all of which are cheaper than Green Mountain's offerings. The effort to design an "enhanced brewing process" also seems curious. Few consumers seem to feel that current K-cup offerings are disappointing. It's akin to Starbucks (SBUX) saying, "Our coffee used to be good, but we're making it better." That's not what a Starbucks customer is looking to hear.
Green Mountain aims to aggressively roll out new products over the next 12 months, which explains why some investors have been pushing this stock back up. Yet as Merrill's analysts conclude, "Most of this will come down to how consumers respond."
Short sellers expect these new growth initiatives will be underwhelming -- and not robust enough to mask a slowdown in the core K-cup business.
Risks to Consider: As an upside risk, Green Mountain's international penetration is fairly low, and entry into new large markets could invigorate K-cup growth.
It's unwise to ignore the accounting allegations raised by The New York Times. But that shouldn't be the sole pillar of your investment thesis. Instead, it's the likelihood that this company is not the growth company it once was. Merrill Lynch, for example, sees free cash flow rising from $425 million in fiscal 2013 to just $453 million two years from now. That doesn't seem to justify the company's $13 billion valuation.