Two things suddenly occurred to me about Green Mountain Coffee Roasters (GMCR):
1. It seems to have a durable competitive advantage in the home coffee market, marked by its partnerships with major coffee maker manufacturers and coffee suppliers and its shelf space in stores.
2. It has exhibited characteristics of a reflexive boom and bust.
Last year, it reported earnings growth of 151%, indicating a strong underlying trend. However, the free cash flow has been chronically negative. GMCR has been financing its capital expenditures by selling its shares for high valuations and using generous terms from its creditors. Even more troubling, recently the company has run into working capital decreases because of high inventory and high accounts receivable, and it has been funding these with further share issuance.
The shares had followed a typical reflexive pattern before October 2011. The earnings growth was partially fueled by share issuance, which generated large amounts of capital because of the high stock price. The perceptions rose impossibly high, and as the market bias diverged from the actual course of events, analysts predicted revenues that were much higher than what the company actually delivered.
The price turning point began in the August-September time period, when the general market began selling off. This was probably enough to spook some momentum traders out of the stock. Then there was a "twilight period."
A second turning point occurred in October, when David Einhorn recommended the stock as a short based on "accounting issues." The issues he cites are similar to what I have stated above - poor working capital management and ballooning capital expenditures that are both being financed by increasingly complex methods. This short recommendation turned the market's perception negative, and reinforced the negative price movements that had been occurring.
When the company reported a 91% growth in revenues, it missed analysts' estimates. The underlying trend seemed to be weakening, further reinforcing the effects of Einhorn's comments and the negative price momentum. The perception turned drastically negative, and the stock fell to below 40.
By now, it has been sufficiently long that the self-fuelling downtrend in price and perception has largely played out, and the stock price has remained relatively flat for the past month. The price momentum is actually positive again, and the RSI is above 50. Without sufficient reinforcement from a negative underlying trend (i.e. another revenue miss), the downward price movement is not likely to continue.
As far as the perception of analysts on the street, they are fairly bullish on the stock. The median target of 90 is much higher than the current target, and even the low target of 52 is a small upside to the current price. In fact, many analysts never turned negative on the stock.
The key question at this point relates to the strength of the underlying trend: Is it still intact? That is, are people going to continue to adopt Keurig coffee brewers and use Green Mountain Coffee K-cups?
To gain some insight into consumer trends, let's investigate Google (GOOG) web searches.
Google Trends show improving search volume indexes for "GMCR," "Green Mountain Coffee," and "Keurig." The Keurig searches are especially relevant, as these indicate interest in the machines themselves, which could lead to years of K-cup use. The searches spike each holiday season, and the 2011 season set a higher spike than previous years. These data seem to indicate that the product is increasingly being explored on the web, which may translate into increasing sales.
[Interesting side-note: The term "Coffee" was mostly flat for 2006-early 2011, but has been on a consistent uptrend in America for the last part of 2011, increasing over 50% over the last 6 months. Are Americans drinking more coffee this year?]
Financial statements also provide clues into the strength of the underlying trend.
The margins last year improved over the previous two years, indicating better pricing, and the selling, general, and administrative expenses decreased as a percentage of revenues, indicating leveraging of fixed costs. However, the 2011 10-K also revealed high inventories and high accounts receivable, which may point to a slow down in the growth trend, or over-expansion.
Finally, what will the effect of current share prices be on the underlying trend?
For the current quarter, the share price is about 50-60% lower than it was the prior quarter. The company now has to sell twice as many shares as it did pre-October 2011 to generate the same cash flow, which is creating significant downward pressure on the stock. This sustained lower stock price will limit how much cash flow is available for capital expenditures, and thus, limit growth. So, the lower price itself may cause GMCR to miss revenue targets.
There are three fundamental forces at play, and all are variable right now.
1) The perception: The expectation of analysts may still be too positive.
2) The price: If the price stays low, it will become reinforcing, as the company will sell more shares to buffer its free cash flow. If the price increases, the company can shore up its cash flow against its rising inventory and accounts receivable.
3) The underlying trend: If the inventory and accounts receivable do not come down, AND if the share price does not rise, then the company's growth will be in trouble. However, Google trends provide some evidence that revenue growth may have remained strong this quarter.
I believe there are four possible outcomes after the earnings announcement on February 1st:
- The lower share price has limited the growth capacity of GMCR. GMCR misses the estimates by a wide amount. The market bias turns negative. The stock falls sharply and sets new lows.
- GMCR grows revenues and earnings, but barely misses estimates. The market bias turns mildly negative. The stock falls, and tests the lows of November 2011.
- Sales growth has remained strong in spite of low share prices, however inventory levels are not handled. Market bias turns less positive, but still remains net positive. Stock continues modest rise, settles in mid-50s until next earnings report.
- Sales growth has remained strong, and inventory levels are reduced. Accounts receivable are reduced. Free cash flow remains negative, but stock sales can sufficiently cover this. Stock price rises. Stock sales generate more cash flow. Reflexive process is resumed. Market bias becomes increasingly positive. Prices continue to rise.
Any price rise in GMCR following earnings is bound to occur more slowly than a price decrease would. If #4 were to occur, it might set off a process that results in a long period of sustained earnings growth, in which case, it might present an excellent long opportunity. If #1 or #2 were to occur, I cannot predict with any accuracy how low the stock might go. I currently think that #3 is the most likely scenario.