As a follow up to my previous article, I will make an attempt to evaluate the risks associated with the stock price of Monster Beverage (NASDAQ:MNST) moving forward. This article is divided into three sections that will highlight the risk that exists in its business model, growth risk in the stock price, valuation using the DCF model, and an analysis of how the options market is pricing this risk. This should help investors in completing their analysis of company before they initiate any positions.
Business Model Risk
As mentioned in my last article, the energy drinks and shot market is expected to grow to $21.7 billion globally, which presents Monster Beverage with huge growth opportunity. As it starts to pursue this growth, company will face multiple challenges. The key ones among them are listed below.
1. Brand Awareness
Over the past 10 years, Monster Beverage has created a strong brand presence in the United States, which it should use as leverage for international expansion. Additionally, the strong marketing expertise it has developed in the U.S. will enable it to develop strategies to resonate with international consumers. Execution of such strategies outside the U.S. poses a risk to growth Monster Beverage plans to pursue.
2. Retail Distribution
Even though Monster Beverage has partnered with companies such as Coca-Cola (NYSE:KO), Anheuser-Busch InBev (OTCQB:AHBIF) for distribution in the United States, it still needs to develop an international distribution network. It has to compete with privately held Red Bull, which already has a very strong international distribution network. As the company reinvests more to expand its distribution, I see downside risk with operating margins before it starts to realize any profit on international sales.
3. Product Safety
Last year, the FDA announced that it will investigate adverse event reports, or AERs, related to energy drinks, which has heightened the focus on energy drinks. Even though the company stands by the safety of its products and has presented the flaws in a Drug Abuse Warning Network report, this has led to high uncertainty toward its core products. This has already led to increasing professional service costs, which will continue to depress the margins until this uncertainty clears out.
Quantification of Growth Risk
1. Existing Assets and Growth Assets
Discounting the present cash flows (operating income or net income) at the cost of capital will yield current assets in place for the business, and subtracting this value from the current stock price yields the price of growth assets.
Price for Growth
As of close on Dec. 24, 2013, existing assets are valued at $25.43 and growth assets are valued at $38.62. Current trailing 12 month EPS is $1.90, existing assets account for 13.4 ($25.43/$1.90), and growth assets account for 20.3 ($38.62/$1.90) in trailing 12 months P/E, presenting 57% risk related to growth in the stock price.
2. Growth Risk
We all recognize the fact that growth in the future can be risky, and any deviation from projected growth presents significant risk to the stock price. Revenue and operating income growth impact stock price returns, and understanding this relationship will put in context the stock price volatility that can be expected due to variation in growth drivers. Table 1 below highlights the impact on stock returns with 1 % variation in revenue growth and operating income growth.
Impact on Stock Price With 1 % Variation in Growth Variable
± 1 % Variation
Impact on Price
Operating Income Growth
For Monster Beverage, the market is currently implying revenue growth of 21.0% CAGR for the next five years.
3. Macro Risk
In order to estimate macro risk associated with Monster Beverage, I looked up the relative volatility of the company vs. the S&P 500 during calendar year 2008. The chart below highlights the price performance of Monster and SPY (used as a proxy for the S&P 500). Monster Beverage was approximately 25% more volatile in returns during that period. It seems reasonable to incorporate 25% more risk premium in our discount rate calculation
((T Bond Rate (3.00%) + 1.25 * Equity Risk Premium (5.32%)) resulting in a discount rate of 9.65%.
Click to enlarge images.
Relative Performance of MNST Vs. SPY During 2008
Source: Stock Charts.
Using the DCF model, a discount rate of 9.65%, 15% revenue growth over the next five years, and allowing the company to let its operating margins drop to 22.5% from existing levels of 25.36% for gaining market share in the next five years, my fair value estimate for Monster Beverage is $52.00 per share.
DCF Model -- Projected Next 10 Years
DCF Model Terminal Value
As a growth investor, it is critical to determine the fair price of the growth and the price we are paying for growth at the current market price. Breaking it down by price paid for existing and growth asset components will help investors determine if growth is expensive or fairly priced. At our fair value estimate for Monster, price of growth is close to the value added by it.
Price for Growth
Value added by Growth
Options Market Perceived Risk
Analyzing implied volatility levels in options six and 12 months out presents the risk currently priced by options markets. IV180 - 32.8% implies a risk of 23% (close to the risk we estimated based on relative volatility of Monster Beverage and the S&P 500).
The question investors need to ask is if the macro market and options market risk premium is 25%, why should someone buy a stock at a price that has 57% risk through growth in the future.
Macro Market Risk Premium
Growth Premium ( in current stock price)
Options Market Reflected Risk