There are stocks with bull and bear arguments, and then there's Green Mountain Coffee Roasters (GMCR). A lot of shorts recently became interested in the stock when hedge-fund manager David Einhorn released a presentation detailing his bearish argument against the firm. The company's shares went into a large slide, losing over 50% of its value from that time. That was, until it reported a first quarter earnings beat, fueled by a divestiture of its "Filterfresh" brand and Green Mountain rallied back to $70 per share.
Oh, and then of course, Starbucks (SBUX) recently announced the creation of its own single-serve espresso machine, which is an adjacent product of the Keurig single-serve coffee machine, sending Green Mountain's shares tumbling back towards $50. Though this tug-of-war between the bulls and bears on Green Mountain may not end soon, we think shares of the firm could still have downside on the basis of our discounted cash-flow process. We are placing the company under review while we reevaluate our long-term assumptions.
Patent expiration could hurt earnings
We have no doubts that Keurig single-serve coffee machines are a hit. Though they aren't the most cost-effective solution, it's hard to argue against the success of this machine. For one, the company has sold well over 13 million Keurig brewers and several billion K-cups. However, these machines aren't directly profitable for Green Mountain. The firm operates a razor/razor-blade model where Keurig "gives" away the machine in turn for milking profits on the sale of K-cups (Green Mountain single serve packets). This sounds great as long as Green Mountain retains a patent monopoly on the business. But later this year the K-cup patents will expire (Green Mountain has had a monopoly on the business that Keurig invented since 1998), and we expect new entrants will produce cheaper packets that could lower prices for the entire market. In turn, this could hurt gross margins for Green Mountain and slow earnings expansion.
Inventories rising exponentially
Inventories are one of the most debated and nebulous areas for growth companies. In some cases, sales are growing so rapidly that companies should create as much product as possible to meet demand. However, there are no guarantees that the customer will keep coming, leaving the company with a bunch of products that customers don't want or need. Firms often deal with this issue through heavy discounting or by taking a charge, both directly impacting earnings in a negative fashion.
Inventories for Green Mountain rose by 125% year-over-year for the first fiscal quarter of 2012, to over $600 million. However, such growth isn't totally out-of-line with sales expansion, which was roughly 100% on a year-over-year basis. The big question is whether a large inventory build is appropriate, given that some of the inventory is the new Vue coffee maker and presumably a lot of the remaining inventory consists of K-cups.
Because the Vue is essentially a slightly better (and pricier) K-cup brewer, we question whether the Vue will fuel sales growth. Additionally, we aren't confident that Green Mountain will be able to hold off generic and lower-priced competition for single serve cups. Customers may have loyalty to Dunkin Donuts (DNKN) and Starbucks K-cups, but we don't see why someone would chose generic Green Mountain coffee over Folgers or any other low-end generic brand. Though Starbucks did announce that it will continue to produce Via coffee and Tazo tea for the newest generation brewer, we think this decision will be immaterial to consumer decisions at the margin.
In just the past few months, Starbucks has announced its Verismo single-serve latte machine, and Wal-Mart (WMT) has announced that it will enter the single serve arena with its own product. We'd like to clarify that Verismo is not a single-cup coffee maker, in our opinion, but that view doesn't mean some consumers won't switch over to a latte maker. However, it does suggest that the market's original reaction to the Starbucks' announcement was somewhat exaggerated. We don't expect people to start disposing of their Keurig machines any time soon.
On the other hand, we actually view a generic Wal-Mart machine as increased competition. People on the lower-end looking to purchase a single-serve machine may opt for the cheaper generic option, rather than shell out for the name brand. This could damage the K-cup business and thus could ruin the razor/razor-blade business model. Wal-Mart machines wouldn't require Green Mountain K-cups, and could cut the company entirely out of the process.
The razor blades aren't generating any cash
Since free cash flow is much more important, in our view, to the valuation of a company than earnings per share, we're very concerned about the company's lack of cash flow generation. For fiscal year 2011, Green Mountain generated less than a $1 million in operating cash-flow on $2.65 billion in sales (due to an enormous inventory build and large equity-based compensation). That's not exactly a very cash-rich business, as not even 1 cent per dollar of revenue is left after accounting for all operating items. And we haven't even gotten to capital expenditures.
Green Mountain spent nearly $300 million investing in adding capacity to its K-cup and Vue manufacturing. That seems like a lofty price to pay given the changing economics within the industry. To pay for this expansion, the company had to issue nearly $1 billion in new equity in May 2011 at $71 per share, diluting shareholders in the process. Raising such a large equity stake is a questionable move when the current business model isn't really profitable. However, the capital was raised within our previous fair value range.
We plan to update our fair value soon
Green Mountain is a prime example of where P/E ratios and discounted cash-flow analysis diverge. Though our fair value range seems rather conservative on an earnings multiple basis, our model accounts for the fact that the company won't be producing cash for shareholders for some time to come. The Keurig/K-Cup model seems to sell a lot of product, but that hasn't generated cash for shareholders in the past. We plan to update our valuation and report on the company soon.