Momentum stocks can be among the most rewarding types of stocks in the market, both to bulls and bears. It is all a matter of timing. Green Mountain Coffee Roasters (GMCR) was, up until September, a great stock to be long. But since David Einhorn called the stock out as a tempting short-sale candidate, it has plunged. On October 19, we profiled the company, outlining both the bullish and bearish cases for the company. Since our article, shares of Green Mountain have fallen by nearly 49%, compared to the S&P 500's 3.14% advance. It seems that the shorts have been proven right. But now that the stock has fallen, where does it go from here?
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There are three questions we must answer when it comes to Green Mountain going forward: Why has the stock plunged? Is David Einhorn correct? Where does the stock go from here? We will attempt to answer these questions below:
- Why has the stock plunged?
Initially, Green Mountain fell after Einhorn's short thesis was reported, but it held up relatively well in light of Einhorn's comments. That changed on Wednesday, however. Green Mountain reported its 4th quarter and fiscal 2011 earnings. The company posted Q4 EPS of 47 cents/share on sales of $711.9 million. This missed consensus EPS estimates by a penny and missed sales estimates by $49.5 million. The stock plunged after hours, a typical move for high-priced momentum stocks that miss expectations, since such stocks must report perfect quarters to justify their high valuations. While a high P/E ratio is not a sin, reporting a less than stellar quarter is. Green Mountain was guilty of that sin, and it paid the price. Though EPS rose by 135% over 2012, and sales advanced 91% over 2010, that was not enough. Sales missed even Green Mountain's own expectations. But was this a sign of misplaced expectations or a sign of trouble at the underlying business?
For that, we need to delve into the conference call. On the call, CEO Larry Blanford stated that,
our fourth quarter revenue was off our estimates. We believe this resulted from a number of factors, including changes in wholesale customer ordering patterns in our grocery and club channels. We saw strong increases in orders from certain customers and those channels during our fiscal third quarter followed by declines in their ordering patterns in our fiscal fourth quarter. However, IRI's point-of-sale data for grocery and customer provided point-of-sale data for clubs show a consistent level of year-over-year consumer portion pack demand growth over the same time period. For example, based on IRI data on sales through the grocery channel, each of the four week periods in our fiscal second half delivered between 135% and 161% year-over-year unit sales growth. The consistency shown by the consumer demand data leads us to believe that the variability in customer order patterns was not driven by consumer purchases.
According to management, the shortfall this quarter was not due to underlying problems with the company's products or changes in demand, and it seems that the data backs up that claim. However, the fact is that it is possible for executives to creatively mask the health of their businesses. David Einhorn called out the company on a number of issues, and although his short sale of the stock has no doubt yielded great profits, was it profitable for the reasons he outlined?
- Is David Einhorn correct?
In his short thesis, Einhorn outlined a myriad of potential issues with the company. He attacked its accounting practices, inventories, addressable market, patent expirations, and its capital expenditure plans. Einhorn has clearly profited from his bet, but is it for those reasons? It depends how you interpret the data. According to data in the company's earnings release, inventories increased by 365% over Q4 of 2010. On the surface, this seems extremely troubling. Whitney Tilson, who is also short Green Mountain, says that Green Mountain made this quarter by pulling demand forward, and is now paying the price for it. This would indicate signs of trouble at the company.
But is it? The picture here is mixed, with Wall Street seemingly split on the issue. Mark Astrachan of Stifel Nicolaus is bearish, suggesting that the market for K-cups has peaked, and the company shipped ahead of demand. That would validate a major point of Einhorn's short thesis, that the company has grossly overestimated the total market for its Keurig brewers. Yet, CFO Frances Rathke argues the company simply overestimated sales in the quarter, and that although demand may vary from quarter to quarter, demand is not slowing down. Furthermore, as CEO Larry Blanford stated, "on the specific suggestion of financial misconduct, there is no wrongdoing...the audit committee has looked at it, and we're confident there's nothing there, period."
Other analysts are also defending the company. Roth Capital Markets analyst Anton Brenner said that the shortfall this quarter was due to a price increase announced in Q3, causing some customers to build inventories before the raise. To him, this fact, if true, implies nothing about future demand and presents investors with an extremely attractive entry point into the stock. Janney analyst Mitchell Pinheiro argues that the drop in the stock far exceeds the magnitude and significance of the revenue miss. And Merrill Lynch analyst Bryan Spillane notes that end demand remains strong, and that margins have expanded. Per the earnings release, gross profit in 2011 was $904.6 million, or 34.1% of sales, compared with $425.8 million in 2010, which was 31.4% of sales.
Furthermore, analysts at Cannacrod Genuity pointed out an interesting correlation with Hansen's Natural (HANS). Analyst Scott Van Winkle noted that in May 2010, Hansen's sold off sharply after missing expectations. As With Green Mountain, the company instituted a price increase on its products, causing customers to build inventory. But Hansen's did not anticipate just how significant the channel load would be. Shares fell from $45 to $25. Yet investors who bought on the crash were able to almost triple their money. Third party data shows that Green Mountain's market is still growing swiftly. But Wall Street is mixed on the stock, and it is reasonable to say that the issues surrounding Green Mountain could be interpreted either way. While David Einhorn has clearly made money shorting Green Mountain, it is plausible that his short-thesis became a self-fulfilling prophecy, where investors sell Green Mountain blindly on a small earnings & revenue miss on fears Einhorn was correct, even if the miss was not caused by any underlying weakness at the company. Put simply, until the SEC actually files more charges against the company, of which there is no indication, we will not know if Einhorn is correct.
- Where does the stock go from here?
Green Mountain was one of the most expensive stocks in the market just a few short months ago. But now, the stock is priced at 27.4 times 2012 estimated earnings, and 17.8 times fiscal 2013 earnings. To Roth Capital markets, this appears to be a reasonable valuation. They note that both Starbucks (SBUX) and Peet's (PEET) trade at or above their growth rates. At these levels, Green Mountain's valuation seems perfectly reasonable, they argue. Merrill Lynch agrees. In placing a $90 target on the stock, they note that management has addressed several of the key issues surrounding the company. Green Mountain has outlined 2012 cap-ex, diffusing those concerns, and clarified the debate over the profitability of K-cups sold through partners. Management, on an operating profit level, is indifferent between sales of Green Mountain K-cups and partner-branded K-cups.
Anytime a stock drops as far as Green Mountain has, Wall Street immediately starts looking for possible acquirers. Starbucks, Nestle (OTC:NSRGY), and Coke (KO) have been described as potential acquirers. Yet Bloomberg says that such an acquisition is unlikely, at the moment. The landscape could change if the company meets its forecast revenue of $4.37 billion this fiscal year. At that level, it would be valued at merely 1.4x revenues, matching the median of the S&P 500. Despite this quarter, most analysts remain bullish on the stock. The average analyst price target is $96.56, which would represent upside of over 120%. The only major analyst who recommends selling the shares is Mark Astrachan of Stifel Nicolaus, who argues that the company is worth at most $32, due to weakening demand for its products.
Green Mountain Coffee Roasters has certainly gone through a tumultuous period. But this is a different company than it was two months ago. The valuation has gone down sharply, and expectations have been lowered. So is it a buy or is it a short? The answer depends wholly on your interpretation of the company's results, its balance sheet, and management's statements. There is something for both bulls and bears to love here. Bulls will argue that most of the uncertainty has been priced in at these levels, and the valuation is far more reasonable now than it was a few months ago. But lack of clarity on inventories, the SEC investigation, and concerns about competition and profitability should comfort the bears.
At this point in time, we recommend that investors assess their commitments to their positions. Shorting the stock at this price requires much more conviction than shorting it at over $100. And being long the stock at these levels means you must look past the issues and controversies surrounding the company. Investors who have this level of conviction should hold their positions and wait for the story to unfold.
As for initiating a new position in Green Mountain, that is something we would not recommend. We simply see too much uncertainty, both from the long and short side. We are content to remain long Starbucks, an investment that has done great for us, and should continue to do well for the foreseeable future. That company has none of the controversy of Green Mountain, a growing dividend & share buyback program, and an expanding brand, thanks to the acquisition of Evolution Fresh. Green Mountain has roasted a lot of coffee, and the stock has roasted both the longs and the shorts at various times. Who gets roasted from here on out depends on how you look at the company.