Green Mountain (GMCR) was a momentum darling in 2009. After a flat 2008, its shares took off in early 2009 and closed the year up an eye popping 216% at $81.47. It appears the stock has knocked back a few too many K-cups and is now close to peaking on the empty energy of a caffeine fueled run. GMCR looks like a classic case of what goes up must come down. Throw in K-cups' fad like nature and GMCR longs appear to be veering towards a nasty cliff.
Keurig brewers and the K-Cup are Green Mountain’s business and the growth of both has been explosive, but at best that growth will moderate if not evaporate.
Two Outstanding Bear Cases
TMFHumbleServant’s Giving GMCR the Thumbs Down is an excellent article. I encourage you to read the entire post, but here is his summary.
Here are the main points of my short thesis (the supporting data will follow):
K-Cup usage per day is declining
EBITDA/K-Cup is flat (maybe declining slightly)
The market is paying 3 times the EBITDA multiple over a 12-18 months ago for no relative improvement (I’ll discuss the absolute rise in EBITDA)
Despite over 4.2 billion (yes, with a “b”) K-Cups sold and counting, the company hardly generates any cash flow and has almost no cash on its balance sheet.
The dramatic rise in price comes at a time when short interest declined by about 50%.
And here’s the on-coming train that I could be stepping in front of, namely, the risks:
The growth rates for sales and profits are unbelievable as the company has done a fantastic job of transforming its business from a roaster to a “coffee standard.” Kudos to management!
Shorts could continue capitulate, which could drive prices higher.
Did I mention the growth rates are unbelievable? And that the market loves growth? If the growth period is longer than expected, the stock could move higher.
The market may not have gotten too carried away and discounted too much performance forward. Profits could simply fill in over time, causing the price to remain flat rather than drop.
Value Investors Club requires registration to view this GMCR bear case by heffer504. His key points included:
In the last 3 quarters, the company has sold 1.6m brewers on top of a base of 2.6m, but the number of pods they sell per quarter only increased 7%. In other words, the usage rate per incremental machine sold is .2/day, against an average rate of 1.3
The channel-fill game is over. Aside from a few supermarkets, there are no more doors to sell into after the Wal-Mart (WMT) contract last quarter.
Competition will get better, and the runway is limited. The reason the European guys have struggled in the US (while dominating in Europe, where single-serve coffee is widely penetrated) is that they focused on taste, not convenience. In addition, since Keurig’s patent s around the K-Cup expire in 2012, every coffee maker will be able to make the pod without paying GMCR a royalty.
Green Mountain’s patents for its K-cup technology expire in 2012. Heffer504 mentioned this and I believe most GMCR investors are aware of it, yet they dismiss it or downplay its importance. Even if Green Mountain continue to sell Keurigs, come 2012 they will not receive royalties from other K-cup sellers. In the unlikely event that K-cups still dominate the single cup market then watch out below as competitors steal market share, K-cup prices fall and Green Mountain’s royalty stream disappears. Margins and profitability will collapse.
Even if GMCR continues to increase earnings there is no room for price appreciation. Their coffee machines and K-cup sales can not continue to grow at the current pace for much longer. When sales slow, ratios will contract. This is the inevitable path that growth companies with finite growth potential always travel. With a current P/E of around 60 even if the company doubles their earnings over the next two years investors are likely to find their shares trading at around current prices as growth will surely have slowed by then.
What is more likely is that growth will slow sooner, ratios will contract and investors will get burnt. Another possible scenario and one investors who are desperate to buy into GMCR should look out for as an entry point, is that Green Mountain will stumble in an upcoming quarter and be taken out to the woodshed. No, I’m not saying a stumble and share price shellacking will make for a good investment, it’s simply that you’d then lose less.
Can investors profit from a long investment in GMCR? Yes, of course they can, as a new sucker enters the market every day who may well pay even more for the shares. Momentum stocks often go further and faster than I envision. Earnings could continue to grow at pace for a few more quarters and perhaps the already inflated ratios could expand further before popping.
Warnings signs to look out for
GMCR investors are unlikely to agree with me as most investors are unable to accept contrary arguments to their positions. So, let me at least give you some danger signs to look for.
Inventory and Accounts Receivables
Investors should track the inventory and receivables of their companies each month. This is most important for high growth companies which may be fads. No matter how fervent a GMCR investor you are, you at least must concede that K-cups could be a fad. Right?
Problems are likely to show up in both receivables and inventories a quarter or two before earnings fall. Each quarter you should calculate the YoY change in receivables, inventory and inventories composite parts. Here is a chart for the changes in those metrics for 2008 to 2009.
What you’re looking for are any changes that don’t mesh; inventories and/or receivables growing faster than sales. They’re your flags for further investigation. For example from above:
- Why have receivables grown faster than sales? Are they channel stuffing? Providing more generous terms to maintain their growth?
- Why has raw materials only grown at half the rate of finished goods? Perhaps they held off on raw materials purchases to ensure they meet estimates in the last quarter.
- Why have finished goods grown faster than sales?
In this instance the differences are small and may mean nothing, but investors should at least be able to answer why they exist. Be alert for larger than average accounts receivables and bloated inventories.
Investors need look no further than the fascinating story of Crocs Inc. (CROX) for a fine example of inventory bloating. Crocs' share price peaked prior to the Q3 2007 earnings release which showed massively bloated inventories. Inventory grew 297% compared to revenue growth of 130%. Accounts receivable growth of 165% also outpaced sales. This caused a large spike down in the share price, but even at that late stage investors paying attention to inventory bloating could have saved themselves a lot more pain, as CROX continued to tumble for a year.
Investors should have been alert to problems and looking to sell after the Q2 ‘07 earnings showed inventories jump 191% , out pacing the amazing sales growth of 162%. Do not under estimate how difficult it is to manage growth.
Consistent insider selling during a share price run up is an indication that management may believe the share price has little left in the tank. Have a look at Crocs for a fine example of this. Insiders were heavy sellers during its meteoric rise in 2007. GMCR insiders stopped buying in late 2008 and have been selling ever since.
Disclosure: No position in GMCR or CROX.