Green Mountain Coffee (GMCR) shares have lost about 63% since the September highs. Many investors are confused and not sure how to react to the current allegations surrounding the company. The sharp sell-off started with allegations from David Einhorn who accused the company of committing fraud during inventory, shipping, and other supplier practices. Numerous articles and even a class action lawsuit have since hit the company.
I would like to give my perspective on these allegations as well as my thoughts. Now keep in mind, many of the concerns brought up are nothing more than allegations at this point and have not been confirmed by the company.
Here are some concerns being brought up regarding Green Mountain's business:
- The market opportunity is much smaller than what the company is telling us. Green Mountain estimates about 90 million households own a coffee maker. The company currently has about 10 million Keurig devices installed in households. David Einhorn estimates that the real market for the company are households that drink more than 2 cups of coffee a day. This would bring the market down to 64 million households. Einhorn then believes that the true addressable market is 21 million households. Einhorn believes that Green Mountain currently has 50% of the addressable market.
I believe that if you want to talk about total available market, you have to count every household that owns a coffee maker. After all, those are the people that currently own the product that Green Mountain is trying to sell to. Now, does that mean that all those customers will buy Keurig? Of course, not but the 90 million households should be used to account for potential market.
I also don't agree with Einhorn's belief that Green Mountain's true market are customers that drink more than 2 cups of coffee a day. Just by looking at the current numbers, there are about 30 million households that drink only one cup of coffee a day but still own a coffee maker. Keurig is just like any other coffee maker, just more convenient.
Regarding Green Mountain's true addressable market, I always take analyst projections with a grain of salt, especially when they are trying to quantify a market. I again have to disagree here and feel that you have to use the full 90 million households as the potential market. After all, it's these type of projection models that created the financial crisis in the first place, not to mention the recent blowup of MF Global.
- The Starbucks (SBUX) and Smuckers deal will cannibalize higher margin K-cup sales.
Green Mountain coffee has declined to comment on specifics regarding K-cup margins. This makes it extremely difficult to find out if overall profitability will be impacted. I believe it is safe to assume that margins may be less than sales of Green Mountain brands.
I expect to see a lift in sales here with the Starbucks deal. One of the key parts of the deal is that Starbucks will sell K-cups in stores next year. I also expect that Starbucks will sell Keurig coffee makers as well to complement the K-cups. I believe this will bring awareness to the brand as well as increase overall sales of K-cups.
Consumers want choices and I feel that if Green Mountain were to limit the variety of its brands, consumers may get bored with the brand and leave. I have to agree with Green Mountain here and believe that by introducing a variety of brands like Dunkin Donuts (DNKN) and Starbucks, the company will keep existing customers and acquire new customers looking for more convenient ways to enjoy drinks from their favorite brand.
- K-cup patents will expire in 2012, this will bring competition that will hurt Keurig's Razor/Razor Blade model.
It will be very difficult for a competitor to enter this market for several reasons. The first thing a competitor will do is size up the potential opportunity. The competitor will then compare that to the possible risk involved to see if it makes sense.
When sizing up the risks, the capital required alone would be in the hundreds of millions. The competitor would also be faced with not having full control of its business but rely on Keurig. Green Mountain already plans to make changes on its next generation of coffee makers that will change the compatibility with its original K-cups. This will leave the competitor with the ability to only sell to Green Mountain's existing customer base without any growth opportunity. Keurig also has an accessory that allows consumers to create their own coffee. This allows consumers that don't want to pay higher prices the ability to make coffee cheaper. This limits the potential market of competitors looking to profit off consumers looking for better pricing.
There are very few brands left that may want to compete. Green Mountain has done a great job shutting down potential competitors by signing manufacturing deals with them. Why would Starbucks or Dunkin Donuts want to compete with Green Mountain when it already has distribution? I don't expect to see any competitor that will pose an immediate threat to Green Mountain.
Sturm was tagged as a possible competitor in the private label space. The company produces filter-less K-cups and could modify lines to compete with Green Mountain by offering private label brands. I believe Green Mountain has a big advantage here. Green Mountain already has relationships with many of the markets and could easily start offering private label brands with similar contract manufacturing arrangements like Starbucks.
- Capital expenditures are growing much faster than the business. The capital investment should be getting more efficient as the company achieves scale.
The company has been making large investments in expanding its production as well as expanding its product lines. The company recently expanded its production with higher output K-cup portion pack lines. Green Mountain also built new lines for its Brewed Over Ice Beverages. The company expanded its supply chain as well to accommodate growth of Cafe Escapes and Green Mountain Apple Cider.
Green Mountain plans to invest between $630 million and $700 million on capital expenditures in 2012. The company expects to spend about 80% of that budget on new capacity. Green Mountain projects it must increase capacity to meet the growth of its installed base of brewers.
Green Mountain is trying to stay ahead of its demand curve to ensure that the company can meet its customers needs. The required investment in building lines for other varieties of drinks are also much more different than the lines used for coffee. This is why you are not seeing the scaling benefits yet in its capital expenditures. I expect capital expenditures to continue to increase as the company looks to develop a new line of espresso drinks and brewers.
- Green Mountain was investigated by the SEC in September 2010 for revenue recognition practices as well as the company's relationship with one of its vendors. David Einhorn believes that there may still be material issues.
Green Mountain has since made an accounting restatement as well as complied fully with the SEC. The issue was Green Mountain did not file contract documentation with MBlock. Einhorn believes that Green Mountain is using MBlock as a tool to create fraudulent inventory and sales reports.
Green Mountain has responded to the SEC and stated that the company is exempted from filing due to the type of relationship that Green Mountain has with MBlock. I have to side with Green Mountain here, the company is trying not to disclose confidential information right before the loss of its patents. This type of information could be damaging if competitors were to decide to compete.
The allegations brought by David Einhorn at this point are nothing more than that. I have to invest on facts as well as the track record of the company. In this case Green Mountain has performed well despite a tough economy. The latest earnings report [see transcript] showed Green Mountain delivered 95% revenue growth, a 148% non-GAAP operating income improvement and 135% non-GAAP net income growth.
The sell-off has to do with fear more than fact. I expect Green Mountain to continue with its growth and expect big things from its future launch of espresso drinks. I believe investors have overreacted to these allegations and are presenting long term investors with an opportunity to invest in a strong growing company. I expect more upside from Green Mountain and view pullbacks as opportunities to buy.
I plan to accumulate a small position in the $30 to $40 range using the strategy I outlined in S&P 500 Strategy: Outsmart The Next Sell-off. Ideally I would like to get an average price around $32. This position is a part of my speculative investments so be careful and do your research.