BusinessWeek ran an article in the most recent issue on Green Mountain Coffee Roasters (GMCR) speculating about a takeover, albeit a very pricey one. These types of things are always thrilling "journalism" but tend to indicate an investor should move in the opposite direction. There are grander examples of BusinessWeek doing it with their "Death Of Equities" cover in 1979, but this focuses on a specific stock, so I decided to write my thoughts.
A brief overview of the company/market consensus: Just think razors and blades. GMCR has patented technology called the k-cup. You buy a moderately priced machine that you insert single serve coffee packets that are high margin. It's quick and convenient. All you have to do is put water in the machine. Mr. Market has decided to value this company at a phenomenal valuation. After all, "razors and blades" is what that dude from Omaha invested in and made a bundle, right?! Coffee has caffeine. GMCR is selling a better product than Gilette because coffee is more addictive and habit forming and people use more of the coffee pods/"blades" so it must be worth as much if not more. The company has had explosive growth and trades 4x sales and 80x earnings, although management claims earnings will double this year. They definitely have made a great product with a great value proposition both in convenience and cost, but history should tell us that the odds are they won't be the ones to profit the most off of their idea.
Interestingly enough, Alice Schroeder talks about another idea of Buffett's that is worth noting in this video I harp about all the time on the blog. She discusses the competitive position of IBM (IBM) and how Buffett knew how hard it was to enter a business that IBM was involved in, such was their size and operational prowess. You can observe this idea throughout Buffett's investments and any business with a competitive advantage. Microsoft (MSFT) was not much of an innovator, but it has been damned good at staving off the competition until recently. Walmart (WMT) was not the first big box discount retailer.
Is GMCR in the position of these giants? After all, it does have about 80% of the market for its k-cup coffee pods. Will it vaunt itself to the heights of corporate America and dominate its market? This type of advantage is call the first-mover advantage. It can be a decisive factor, although not always. Did Henry Ford invent the car? Did Microsoft invent anything? No and no. They perfected it and they crushed the competition. Google (GOOG) was not the first search engine. People don't try to compete with it anymore, they try to make companies they can sell to them.
Does this type of industry dynamic confront GMCR? Yes. Getting Dunkin Donuts on board with k-cups is definitely a huge victory, because that brand is huge. While many PE deals have been adventures in financial engineering and cutting costs to the bone, the Dunkin Donuts takeover has been a wild success from a consumer standpoint. The stores are cleaner and the coffee has a strong following. This is definitely in favor of GMCR.
The problem with GMCR is that it isn't the IBM, Microsoft, Google, or Ford (F). It faces competition from real serious companies. Nestle (OTC:NSRGY) and Starbucks (SBUX) are savvy. They know whats up. Nestle has been growing its Nespresso brand organically. They have a huge stable of billion dollar brands they've built up over the years. They bought Kraft's (KFT) frozen pizza segment for a shade over 10x pretax, not a crazy multiple. The combination of disciplined management and savvy operations means they: a) aren't going to buy GMCR, and b) they are going to grow their Nespresso organically and take it to GMCR. They won't become poor capital allocators overnight. The historical success of Nestle is a strong indicator that they are going to have the mettle to bring the heat through their scale and pricing power.
The elephant in the room seems to be Starbucks, which the tea leaf readers have all sorts of predictions about. Like Nestle, they have savvy management that doesn't seem very acquisitive. Even more similarly, they have a history of growing strong brands. The Via extension has been a wonderful success on every front. It also indicates management is competent enough and determined to roll out new products that extend the brand. It's always 50/50 when a founder-CEO returns, but Howard Schultz has proven a lot more Steve Jobs than Michael Dell. When it comes to coffee, Starbucks knows what its doing. One might argue that the target demographic of GMCR/Dunkin Donuts is different than Starbucks, but one can't dispute the power of the brand and marketing an affordable luxury. You can pull up taste tests and whatever proof about the taste of Dunkin Donuts vs. Starbucks vs. McDonalds (MCD), but the profitability, growth, and traffic that Starbucks generates is undeniable. Their size and scale make them formidable competitors as well.
Coca-Cola (KO) is an interesting wildcard. People seem to believe they will attempt to acquire GMCR. Looking at history, this isn't too far fetched. The Glaceau deal was done to acquire a fast growing new segment. Coffee, with its caffeine component, makes it the kind of business Coke would love to get into. PepsiCo (PEP) has historical ties to Starbucks as distributor of some of their ready-serve cold beverages. This leaves Coca-Cola open to a possible move in the sector. While the Glaceau valuation was aggressive, VitaminWater did and still does face a lot less competition in its direct segment. GMCR doesn't appear to possess the same long term competitive dynamics.
Economics 101 is that high profit margins attract competition. Where it gets more complicated is when companies are capable of defending their markets from competition. The unfortunate factor to consider about GMCR is that it is heading full speed ahead to the train wreck that is known as trying to compete with Starbucks, Nestle, and potentially other brands. This tends to be a losing proposition. It's valuation seems too dear to attract any sane buyers to save it from this impending doom. Of course there in lies the risk. While I have no position in the stock, it is interesting to think about what business history can show us about today's growth stocks.
The 1940 edition of "Security Analysis" by Ben Graham has this Horace quote at the beginning that always leaps to the front of my mind in cases like this:
"Many shall be restored that now are fallen and many shall fall that now are in honor."