In a recent article, I started to analyze the Green Mountain Coffee Roasters stock (GMCR) and which developments investors might expect in the medium term. My initial article was more of an informative piece about the characteristics of momentum stocks and the stages of price development they go through. In this article, I would like to delve more into what investors should expect in the near future for GMCR stock. To do that, I will explore the similarities to another sector, Solar (TAN), which has gone through both the advance and crash stages of price development.
My main approach to momentum stocks is that, they go through such a euphoric phase at their peak that their valuation multiples become unattainable. This holds true even after the company completes its rapid growth. The multiples at the peak are so high that even after accomplishing astounding rates of growth for three years, the company still can't grow into the valuation at its peak. As a result, momentum stocks never go back to their glory days once they are broken (the price trend is broken to the downside and momentum traders leave in droves). Some investors wonder whether GMCR is going to take back its highs. The answer to that question is a relatively certain "no," in my opinion.
This does not mean there isn't money to be made in GMCR stock, however. Momentum stocks remain very attractive trading opportunities even after they crash.
Some momentum stocks like Salesforce.com (CRM), RedHat (RHT) or NetSuite (N) trade at levels completely detached from a rational valuation multiple. Therefore they lack the downside protection that arises from solid fundamentals. GMCR is different in that sense that the company does have a great product and the valuation is not as extreme as the aforementioned stocks. In my opinion, it is a shame that this company became a darling of momentum investors and it had to go through the boom and bust stages in an aggressive fashion. The underlying company has a similar revenue and profitability growth to investor darling Apple (AAPL) and could have very well become the Apple of the coffee sector.
To predict what might be in store for GMCR stock, I find it helpful to analyze the similarities to the solar sector. Solar stocks had similar dynamics and growth rates to GMCR, and what they have gone through as a momentum stock might give a good approximation to what is in store for GMCR. Below you will find a list of events that I expect will happen to GMCR based on what solar stocks have gone through after they lost their momentum stock status.
Rise in raw material commodity costs. While there will be a lot questions about GMCR's profitability after its patents expire, the underlying sector will still be growing at an astounding rate. This will fuel an increase in the underlying commodity price, in this case coffee. There will probably be a lot of reports about, how the home-brewed coffee is the next big thing, how the demand is exploding and how the coffee producers are scrambling to cope with demand. This increase in raw material coffee costs will pressure the profitability prospects of GMCR even more and pressure the stock price.
The GMCR patents will expire and a slurry of low cost competitors will flood the market. Our financial system rewards revenue growth more than profitability. Whether this is good or not is debatable. However, that is the case whether investors like it or not. As a result, when there is a product group that is highly growing, a herd of companies get into that sector and try to grab market share even though they lose a ton of money. The underlying logic is that although the profitability is low, finance guys will reward them for becoming part of a growing sector.
As of this writing this did not happen yet, because the K-cup product is protected by a set of patents owned by GMCR. However, those patents are set to expire later in 2012. Once those patents expire the market will be flooded by a large group of competitors that are hungry for growth, even at the expense of losing money. This will erode almost all of GMCR's profitability. This stage will be similar to the Chinese companies like Trina Solar (TSL) and Yingli Green Energy (YGE) entering the solar market in droves.
It is important to note that at this stage the overall K-cup business will still be growing exceptionally and this will seemingly justify the investments being made by all those low cost competitors. The revenue growth will be there for most producers including GMCR, but profitability will erode away due to competition.
Raw coffee oversupply will crash the coffee prices, benefiting the K-cup producers. While the consumer side of the market is being flooded with entrants, there will have been enormous investments made by the coffee producers to cope with demand. As expected, these investments will prove to be not well planned and unnecessary, and lead to oversupply. The underlying commodity prices for the K-Cup business will crash. This will support the argument that GMCR and all its competitors are actually good investments. At this stage stock prices will stabilize somewhat and the some oversold stocks will even bounce quite strongly.
This stage will be similar to what happened to the polysilicon prices in late 2010 and early 2011 and the strong bounce in more speculative solar stocks such as Energy Conversion Services (ENER)
Price war and complete disarray in the sector. After the stabilization stage, it will turn out that the consumer demand for the home-brewed coffee sector was overestimated, much like the supply side. This will lead to a price war among the competitors. The consumer will be very price sensitive and in order to keep market share, producers will slash K-Cup prices very fast. This will start to raise questions about the viability of this product category. The product will also have lost its fashionable status by then too which will make matters worse.
This stage is exemplified by what happened to solar stocks in 2011.
Exits from the sector and value investors coming in. Competitors will start to exit from the market as losses will really start to strain their finances. This stage will be similar to the Solyndra bankruptcy in the solar sector. Because of the price crash in the above stage, the valuations on the remaining competitors will have come back way below book value. The P/E multiples will also be extremely attractive. Value investors will start to come in. The stocks will continue to be very volatile but the underlying business will start to stabilize and there will be good trading opportunities.
I would like to end this article by noting a difference between the home-brewed coffee sector and solar. The main difference is poly-silicon solar panels are more of a commodity, while GMCR K-Cups have a brand value embedded in them. This will somehow mitigate the price declines in K-Cups from commoditization. It is safe to say that GMCR is to the home brewed coffee sector, what First Solar (FSLR) or LDK Solar (LDK) is to the solar sector. After the boom and bust stages of price development and the K-Cups are a stable business, there will still be a lot of value in GMCR stock and it will probably be at a very favorable valuation. However until then the stock will just be a trading vehicle pushed around by momentum investors. It will also be in a mainly downward trend.