Green Mountain Coffee Roasters (NASDAQ:GMCR) blew earnings expectations out of the water after the bell on November 20th, reporting earnings on a non-GAAP basis of $0.89 per share against the average analysts' estimate of $0.75 per share. The firm also beat on the top line with revenues of $1.047 billion, easily beating expectations for less than $965 million. Capital Ladder Advisory Group had modeled for GMCR to beat on both the top and bottom line, but not to this extent. All-in-all, Green Mountain Coffee had another great quarter and finished FY13 with a bang. With that said, all eyes naturally turn to FY14 guidance to see where the company might be heading as revenue growth for the full year only grew by roughly 12% and is continuing to decelerate.
As it pertains to FY14 and Q1 2014 guidance, GMCR left much to be desired, but a lot of room for upside potential or surprise if you will. As the company continues to outperform expectations on the bottom line, it might be reasonable to expect a continuation of outperformance at least with regards to the first half of the year and with consideration being given to the newly enhanced and announced share repurchase program of $1 billion. With that being said, GMCR is anticipating non-GAAP earnings per diluted share of $3.75 to $3.85 in FY14. This is in line with the firm's previous guidance of earnings growth at the high-end of the mid-teens range when you exclude the tax benefit the firm saw in the fourth quarter of fiscal '13 which contributed $0.12 earnings per share. For the full year, the company expects revenue growth in the high single digits, with stronger growth in the second half of the fiscal year upon successfully adding currently unlicensed competition to the Keurig portfolio of licensed brand K-cups.
For the first quarter of fiscal year 2014, GMCR expects net sales growth in the low-to-mid single digits due to difficult brewer and portion pack sales comparisons, more significant impact from unlicensed packs on the firm's growth rate and a currency headwind in Canada. GMCR expects non-GAAP earnings per diluted share in a range of $0.85 to $0.90, an increase of 12% to 18% over the prior year period, but below the average analysts' estimate of $0.96 per diluted share. This earnings growth rate deceleration is to be expected as the firm transitions to a more normalized growth rate and aims to transition toward new brewer platforms. However, the risk to the current earnings model is higher than in the previous year as many operational headwinds develop through the course of fiscal 2014. I will go into this with greater details a little later.
Green Mountain expects free cash flow in the range of $200 million to $300 million and capital investments in the range of $400 million to $450 million including approximately $200 million primarily to fund new innovations as well as IT investments. Based on last year's cash generation of $603 million, this is a dramatic decrease in cash flow year-over-year, but likely necessary as noted by the firm's dedication to reinvest in the business to provide the market with new beverage platforms and enhance system technologies. GMCR expects to spend around $200 million on new product innovation in 2014 as the firm rolls out the Keurig 2.0 with RFID technology and develops a line of cold beverage brewer platforms.
Over the last 12 months, Green Mountain Coffee Roasters has successfully created a good deal of leverage in their business. This leverage is highlighted in the company's cash flow generation and gross profit margin expansion. During FY13, gross profit improved 430 basis points to 37.2% from 32.9%. Favorable Green Coffee costs contributed 290 basis points, and 240 basis points came from improvements in operational efficiencies. These improvements were partially offset by negative price realization of 100 basis points. During the most recently reported quarter, GMCR delivered a 240 basis point improvement to 36% of net sales versus 33.6% last year. Favorable Green Coffee costs contributed 380 points improvement in the quarter. Quality and productivity-related improvements contributed another 160 basis points. Embedded in the 160 basis points improvement was an adverse impact of 200 basis points from a $20 million write-down of brewer inventory taken as the firm began curtailing/discontinuing the manufacturing and distribution of Vue brewer systems in order to transition toward new beverage systems. Also of note, price realization and product mix adversely affected Q4's gross profit by 140 basis points and 120 basis points, respectively. It is important to take note of the company's continued cost structure related to Green Coffee costs through FY14 which are nearly 100 percent locked-in at this time.
Green Mountain's cash flow generation has been highly scrutinized over the course of FY13 by many balance sheet aficionados. With the company extending payment schedules (bill payment) beyond the typical 30, 60, 90 day paradigm assigned by most credit accounts, curtailing CAPEX spend on a quarterly basis and re-balancing inventory levels, Green Mountain has been able to consistently increase its cash flow generation. On the Q3 2013 Conference Call with investors, Fran Rathke denotes the path to greater free cash flow generation:
"Our strong fiscal year 2013 free cash flow of $603 million, which was 125% of GAAP net income, resulted from a healthy balance of net profit growth, lower inventory levels on the working capital side and lower capital investment."
Now, naturally the CFO left out the bill payment side of the cash flow equation, but it is safe to assume that all bills will be paid and are in keeping with fiscal year reporting standards even if these monies are relocated from one quarter to the next. Essentially, the money will show up somewhere which is another reason we would believe that cash flow generation won't be as robust in 2014 as it was in 2013 and as GMCR has forecasted for the investment community. If one believes in the "boom or bust product cycle," cash flow generation plays a key role in this theory or paradigm. Now consider this understanding and juxtapose it with recent developments regarding GMCR's recent product development cycle (Vue) and things don't look so bright for the company's future cash flow generation model.
Any way you slice this "operational pie," what you are forced to recognize is the leverage which GMCR has created in its business to adjust to the changing needs of the business. In 2012, the business was highly capital intensive as the firm deployed greater than $400 million in CAPEX to expand manufacturing capabilities alongside creating the necessary improvements to its capacity utilization needs and greater efficiencies in its production lines. Much of this capital deployment from 2012 has born fruits in 2013 as gross profits increased greatly and during a transition period where less capital deployment was deemed necessary by executives. But now the firm is once again embarking on a newly expected growth initiative in both distribution and innovation. The bottom line which should be considered by investors is that leverage is simply a creation of time through the generation of cash. With that understanding in mind, GMCR has afforded itself at least 12 months as it has planned to spend greater than $400 million to activate, and hopefully profit from, its new distribution expansion and innovation pipeline plans. So let's get highly critical here for a moment and discuss more broadly the likelihood that GMCR will successfully complete and profit from its planned initiatives.
Critical Business Analysis
I have admittedly been highly critical of GMCR's business on the whole. We maintained a $65 share price during the Spring through Fall in the face of an appreciating share price performance coupled with analysts' price targets being increased. When we analyzed the sum of the parts and with greater insight into the product line than most have accounted for we did see some disturbing trends taking place which we outlined for investors. The trend in unlicensed/private label K-cup competition, while not favorable to GMCR, was not of the most concern at the time due to the expanding market of single-serve coffee which benefits all market participants. Essentially there is plenty of market share to go around, given a company's ability to market its products effectively of course. What are more impactful to our investment thesis are consumption rates, overall market place competition, product placement and price erosion.
On many occasions, we noted when and where product placement was being curtailed YOY for Keurig products which resulted in same-store-sales declines for Keurig products at certain retailers. While this is not of great importance during an expansion phase and when the retail distribution market is less saturated, it is of great importance when much of the retail distribution market has been saturated in North America as the Keurig product has succumb to in 2013. As it pertains to product placement, the Keurig product has seen its product placement less highlighted at retailers in 2013 than in 2012, in-part, due to the launch of the SodaStream (NASDAQ:SODA) and Nutribullet product lines at many retailers. When we consider competition for Keurig products, we naturally have to consider other coffee maker and coffee brands as competition, but Keurig is also competing for general counter top space in the household. With this in mind, Keurig is not just competing against like products, but it is competing in the small appliance market as a whole and retail consumption dollars are hard to come by nowadays. Department store retailers witnessed a 5.1% decline YOY according to the latest Census Bureau statistics. This deceleration in consumer spending is also highlighted in quarterly results which show revenue underperformance from the likes of Kohl's (NYSE:KSS), Wal-Mart (NYSE:WMT) and Target Corp. (NYSE:TGT). All three retailers have been forced to slash full-year profit and revenue guidance in the face of a challenging consumer environment.
Now let's move on to the pricing challenge. The average price for a K-cup or coffee pod has continued to come under pressure through much of 2013 and will likely continue to come under pressure based on consumer spending trends and competitive trends noted above. This under-mentioned point of analysis may be overlooked at present by many given the current cost of green coffee, but shouldn't be given the enormous volume of K-cup or coffee pod sales and the eventual normalization of green coffee costs. Taking a penny or two out of the suggested retail price per K-cup/coffee pod could be highly disadvantageous to gross profits and this point of analysis should be considered more deeply by investors as the trend in price erosion seems ever-lasting. Having said all of that, for the interim, green coffee costs are offsetting price erosion.
Now we come to the most critical aspect of analyzing the Green Mountain Coffee Roasters' business, the product pipeline and innovation trends. We believe this to be the most crucial part of the business going forward given the high market penetration already achieved in North America and decelerating sales growth. On the surface, the product pipeline looks strong with several platforms in development and the Keurig 2.0 set to launch near the end of 2014. The Keurig 2.0 is being developed as a closed platform with the ability to only operate licensed K-cups in the system. According to Green Mountain Coffee's CEO Brian Kelley, retail customers are not adverse to the closed system and are awaiting full development.
What may be a deterrent is pricing for future brewer platforms. Brian Kelley has indicated that the Keurig 2.0 should be priced in-line with the existing brewer retail price structure, but that pricing is quite broad, ranging from $99 to $199 for a brewer of choice. If the Keurig 2.0 is priced above $149.99, this brewer system will likely face adoption headwinds according to current brewer/price sales rates in the system.
Moreover, additional cold beverage brewer platforms are being developed to add flexibility to the product line-up of Keurig brewers. The company is somewhat closed-mouthed about the cold beverage platforms other than what they initially discussed at the investor/analyst community on September 10th during the Investor Day presentation. Their presentation slide show did notate a launch of the cold beverage platform in Q1 of 2015 (fiscal 2014). However, on the Q4 2013 Conference Call Brian Kelley stated the following:
"And then obviously any new invention like a cold system, we're quite confident and we're making great progress on it and we've not announced an exact date of launch, but we're moving quite well and I can assure you we're watching with a very disciplined way the sequencing of this and then the quality and the execution".
The company did very clearly denote an expected launch date for the cold brewer platform, but the latest statements seem to be disconnected from prior statements and slide projections. But I digress, as that is not the point of this analytical exercise which focuses on innovation and product pipelines.
If we use Green Mountain's latest product innovation cycle as a measure of future results, investors will likely not have much confidence in the company's product initiatives. To review briefly and express more openly, the Vue product line was not thoughtfully developed or deployed in the market place and subsequently sales for the product line never met GMCR's expectations as I have mentioned in the past. The Vue failed to provide the company with meaningful profits and is now being phased out of production and distribution as we noted to clients and the investment community in prior months. The largest obstacle the Vue product line faced was that it was not backward compatible. The brewer did not permit the use of K-cups and it did not offer the variety of V-packs similar to that of a Keurig brewer system. While the Keurig 2.0 will offer backward compatibility, it will still be a closed system, just not to the Vue or Keurig brand product lines and users of these product lines. Investors might wish to think about this strategy which GMCR intends to use in the Keurig 2.0 brewer.
For the cold beverage platforms, as noted above, the company is not offering very much in the way of information. On the conference call, however, analysts did inquire about these product initiatives and how they are associated with the sizeable increase in forecasted CAPEX during 2014. Noted below is a discussion from the Q4 2013 Conference Call Transcript regarding the cold beverage platforms:
- Fran Rathke (NASDAQ:CFO) - Sure, Bill its Fran. So I think in terms of the -- as we just discussed, it's really driven by new platform and most notably the cold platform. So once again on the cold our appliance will be manufactured by a contract manufacturer in Asia. We typically have some CapEx where we fund the tooling, but that's pretty small compared to packaging lines. And then with the cold platform we do need to invest where we make our money in the portions in the beverage, so that's where we've got a data line if you will going in R&D line and then we'll have to scale up in a commercial way with appropriate number of lines based on what we estimate the demand stream lines is, and I think the other thing is to recall is packaging lines we need to buy them essentially year ahead to get them manufactured and then installed and qualified.
- Bill Chappell (SunTrust) - So just because the cold won't use K-Cups (indiscernible)?
- Brian Kelley (President and CEO) - Correct.
- Fran Rathke (CFO) - Correct, it's a different portion pack form, yeah.
The little insight we are able to extrapolate from management denotes that new portion lines will be added which will serve to fill a totally different portion pack form for the cold beverage platform machines. Not K-cups at all it seems. Keep in mind that SodaStream, which distributes syrups in SodaCap form, is presently before patent review and acceptance in many countries, including the United States. Hopefully we will find out more about the cold beverage brewer platforms at the International Home and Housewares show in March of 2014.
Regardless of how the cold beverage platforms deliver flavored, sparkling or still beverages, they will certainly be in a highly competitive and cost sensitive market. Furthermore, Green Mountain Coffee Roasters is entering the category somewhat late as other manufacturers are currently dominating the landscape of at-home cold beverage systems. The cold beverage category through a brewer system at-home, first and foremost, requires a cost benefit analysis. In other words, the system has to provide some economic benefit to the consumer.
Investing In GMCR = Cash Flow vs. Product Cycle
Capital Ladder Advisory Group is currently reviewing a future position to be initiated in shares of GMCR given the information and metric reporting at hand. One aspect of the business is being highlighted within this reporting period which seems of extraordinary importance and we believe that it is the product development cycle; this sentiment is being mirrored among other analysts disseminating analysis on GMCR. Green Mountain Coffee has witnessed peaks and valleys in its cash flow generation over the last three years which has landed the company at a go-forward revenue growth model of less than 10% for fiscal 2014. This does concern us as the trajectory in revenue growth over the last 3 years has been ominously negative and should GMCR not produce fruit from this latest product development cycle in the next 12-18 months, revenues could turn negative during this time frame when cash flow will be dedicated to product development; all else considered equal in the macroeconomic landscape.