Keurig Green Mountain Is Brewing Up Dividend Growth Potential

Sep. 4.14 | About: Keurig Green (GMCR)

Summary

Keurig Green Mountain has a market cap of $22 billion and a dividend yield of 0.75%.

The company has one of the highest Dividend Coverage Ratios in the large capitalization space that I track.

The Keurig 2.0 represents a great opportunity for the company to gain access to the office market while also protecting the brand.

Pod purchasers may not open their wallets for more expensive k-cups. Investors must follow the roll-out of the Keurig 2.0 to understand the competitive position of Keurig Green Mountain.

The scope of this article will look at the financial health of Keurig Green Mountain (NASDAQ:GMCR), and the potential to increase the scant dividend.

While investors see the current yield of 0.75% as possibly unattractive, the extremely robust Dividend Coverage Ratio suggests that the company has the ability to more than double the dividend over the next two years. This company has one of the highest coverage ratios for the universe of large cap stocks that I track, and dividend growth investors should consider this stock on any pullback.

How Safe is the Dividend?

Cash flow summary ($ in millions)

39 weeks ended 6/28/14

39 weeks ended 6/29/13

Cash from operations

$824

$772

Capex

($222)

($190)

Free cash flow

$602

$582

Proceeds from Sale of Common Stock

$1,348

-

Repurchase of Common Stock

($881)

($997)

Dividends*

($78)

-

Click to enlarge

The cash and short-term investments at 6/28/14 was $1.2 billion.

* The company did not pay a dividend in the first quarter. To adjust for this, we add $40.7 million to the $78 million paid in the most recent 2 quarters for a 'pro-forma' 39-week dividend, or $118.7 million.

For the most recent 39 weeks, GMCR generated $602 million in free cash flow, or cash from operations minus capex. To calculate the dividend coverage ratio, we must use the free cash flow figure (numerator) and the pro-forma 39-week dividend of $118.7 million discussed above. The dividend coverage ratio is therefore 5.1x.

For more comparisons on other large-cap dividend coverage ratios, see this article on McDonald's (NYSE:MCD) or this article on Verizon (NYSE:VZ). Please note that I calculated that McDonald's had the financial capacity to raise the dividend by 10% in the upcoming months.

Cash Conversion Cycle

In a recent series of articles, I've looked at the financial health of various companies by analyzing the cash conversion cycle. Given the large amount of receivables and inventory necessary for operations, let's look at how GMCR is performing.

39 Weeks

Ended 6/28/14

FYE 9/28/13

FYE 9/29/12

Amounts in Millions of $

$3,512

$4,358

$3,859

Net sales

$382

$468

$364

A/R

30

39

34

(1) Days receivables {(Receivables/Sales)*365

days for full year or 273.75 for the 39 weeks}

39 Weeks

Ended 6/28/14

FYE 9/28/13

FYE 9/29/12

$2,146

$2,739

$2,590

Cost of sales

$639

$676

$768

Inventory

82

90

108

(2) Days inventory {(Inventory/Cost of Sales)*365

days for full year or 273.75 for the 39 weeks}

$2,146

$2,739

$2,590

Cost of sales

$370

$312

$280

Accounts payable

47

42

39

(3) Payable Days {(Payables/Cost of Sales)*365

days for full year or 273.75 for the 39 weeks}

64

88

103

Cash conversion cycle {1 + 2 - 3}

Click to enlarge

Source: Q3 10-Q for GMCR

The cash conversion cycle is the amount of time between a company spending cash and receiving cash per each sale. It is a measure of efficiency, and how long cash is tied up in working capital. The CCC is a great way to analyze the efficiency of the organization in managing cash to generate more sales.

In FY 2013, GMCR held inventory for 90 days plus 39 days to collect receivables or 129 days in total. GMCR pays accounts payable in 42 days, thus achieving a 88-day cash conversion cycle. For an explanation of how cash conversion can exemplify a business with a strong business moat, see this illuminating article on Amazon (NASDAQ:AMZN). Unfortunately, GMCR is not able to dictate terms to the extent that AMZN can, but this does not mean that the core business of GMCR is weak. In fact, the above chart shows the core business improving.

Please note that the intention of this article is not to compare AMZN and GMCR. The above is mentioned to illustrate the strength of a business model, and how suppliers can fund operations, much like a bank or an equity investor.

Keurig 2.0 - Will Consumers Upgrade to the New Machine?

Since its K-Cup patents expired in 2012, GMCR has seen cheaper, off-label pods take a 14% market share.

In August, GMCR rolled out version 2.0 of its brewing machine that uses bar code scanners to verify that pods are properly licensed. Now, consumers can enjoy single-cup brewing technology from Keurig machines, and also the newest innovation: a four-cup carafe to serve the at-home market in a big way. Consumers and office workers have often complained that "Keurig 1.0" could only brew a cup at a time, so if you wanted to make Irish coffee for a large crew of friends and family, the eighth cup was warm while the first cup was room temperature.

In August, President and CEO, Brian Kelley announced, "We're thrilled to have changed the game yet again by offering consumers the ability to brew a variety of sizes, from a single cup to a carafe, and choose from more than 290 varieties from more than 50 brands, all within one system, Keurig 2.0."

One question that analysts are tracking is whether this new closed loop coffee system will gain market share in corporate America and the office buildings that many Americans spend 8+ hours per day.

One key issue for owners is that interactive technology will prevent unlicensed portion packs from accessing the 2.0 platform, which should put a lid on unlicensed brand market share. However, consumers may feel that the new, 2.0 k-cups will be at a premium price.

Finally, investors must also realize that profit margins will be impacted as the 2.0 is marketed aggressively. Analysts from KeyBanc are looking for a long-term installed base of Keurig 2.0 machines of 25 to 33 million.

A Glimmer of Hope from Restaurant Installations

GMCR is now marketing to foodservice businesses, with Subway a recent notable customer addition. Keurig is now in more than 20,000 Subway locations. On one hand, Subway will benefit from cost efficiency, an increase in beverage freshness, and wider varieties, while on the other, Keurig will be able to tap more distribution points. Looking ahead, management expects more such food joints and restaurants to install its coffee solution.

Conclusion

I conclude that GMCR has the capacity to pay a $2 annual dividend sometime in 2015. I base this judgement on the strong cash flow, dividend coverage ratio and the liquid balance sheet.

GMCR trades at a large premium to the S&P 500. The trailing P/E ratio is about 36x compared to an S&P 500 index trading at about 18x. Also, note that GMCR has a below market dividend yield of 0.75% compared to an S&P 500 dividend yield of 1.7%. Due to the strength of the operating results and the capacity to raise the dividend, I would not be short this stock. Investors may be willing to pay a premium for stocks with capacity for dividend increases.

This article did not cover the significant risks that GMCR will face as they continue to expand into cold beverages and the 2.0 system. Both of these ventures may require substantial capex, and this could strain the dividend. Also, investors must recognize that with Coca-Cola (NYSE:KO) equity investment in GMCR, the cold beverage could become a major contributor to earnings. This cold beverage opportunity is not within the scope of this article.

The above article is an opinion, and not investment counsel.

Disclosure: The author is long MCD.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.