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Coffee restaurants and processors have been through a lot lately. There was the stock surge of Starbucks (SBUX), which rose steadily and consistently from below $9.50 in early 2009 to around $60, fittingly, by April Fool's Day. Then there was the market "over"-correction of Green Mountain Coffee Roasters (GMCR) following the announcement of the Greenlight Capital (GLRE) short thesis, which sent shares plummeting from $49.52 to $25.87 in just one day there. Then there was the IPO of Dunkin Brands (DNKN), which has since appreciated by 26.1%. With GMCR trading at 8.7x past earnings versus 31x and 68.3x for market-saturated Starbucks and speculative Dunkin, a reasonable market correction over multiples is necessary. I recommend going long GMCR to benefit from cooling interest in Starbucks and Dunkin.

Green Mountain Coffee Roasters

At its peak of around $108 in 2011, GMCR was grossly overvalued at 211x 2010 earnings. However, speculation is always understandable in the marketplace, and many investors felt optimistic that it would be the next Starbucks. The problem is that the old, real Starbucks is, in my view, overvalued right now. But the current GMCR is cheap. 1Q12 results, largely lambasted, were still around 37% higher than last year's 1Q results while profit margins grew around 50 basis points to 10.5%.

There is also great price stratification with the K-cup market and thus meaningful "wiggle" room for GMCR to assert dominancy. Investors nevertheless remain singularly focused on the first quarter. Management is also committed to improving the efficiency of plant operations to reduce dependency on capital expenditures. IP protection issues have been overblown given general consumer interest.

Much of the reason why GMCR is currently undervalued has to do with how hype has inverted on itself and become doubt. Expectations, of course, should be somewhere between pure optimism and pure pessimism. Competition is not as intense as the market makes out, since consumers tend to focus more on quality in the coffee market. Starbucks has been able to sell its products at a premium to peers given its brand value--why can't GMCR do the same? Reports that Kroger (KR) will enter the market are not threatening at the current 8.7x past earnings.

Starbucks

The optimism surrounding Starbucks is equally interesting as the negativity surrounding GMCR. While the S&P 500 is currently valued at 15.4x past earnings, Starbucks is valued at a respective 30.6x and 23.1x past and forward earnings. Billionaire Chairman & CEO Howard Schultz was able to build up a great brand through saturating the market--that "infamous" strategy of locating a store on seemingly every street corner. What's more, the company is currently rated a "buy" on the Street with a $64.50 price target.

My problem with Starbucks going forward is that the market is treating it like it is a biotech company that can explode revenues out of nowhere. How much more can there be penetrate after you have saturated nearly all of the market? By definition, not much. And if competition applies to GMCR then surely it applies to Starbucks. Yet, the Street currently projects 19.2% annual EPS over the next 5 years as opposed to 17.1% over the past 5.

Assuming Starbucks can even beat the Street's expectations and annually grow EPS by, say, 25% off of the $2.29 2013 EPS consensus, 2016 EPS will be $4.47. At a 15x multiple, the company's future stock value would be $67.09. At a 10% discount rate, the present value of the stock should be $41.66. Thus, even (1) expectations that are more aggressive than the Street's and (2) are discounted generously at 10% for such uncertainty would lead to considerable depreciation.

Dunkin Brands

Dunkin recently IPOd and currently trades at 24.4x forward earnings. Analysts expect EPS to grow by 16.1% annually over the next 5 years for 2016 EPS of around $2.27. At a 15x multiple, the company's future stock value should be $34.05 and, at a 10% discount rate, it should be presently worth $21.14.

Even though Dunkin recently IPOd, do not be misled into thinking that it lacks an operating history. By contrast, Dunkin' Donuts and Baskin-Robbins were founded around half a century plus one decade ago. Cash flow generation has also been spotty with only $75M in 2008, $229M in 2010, and back down to $162.7M in 2011. Net income has also been inconsistent for a company that is priced for more than 16.1% annual EPS growth over the next 5 years at just a 10% discount rate.

Overall, I recommend investors hold out from both a long position and a short position in Dunkin and Starbucks. Both stocks are likely to be very volatile and thus are risky to bet on from either the bull or the bear side. Instead, investors are encouraged to go long the one company that appears to be unreasonably priced for the worst: GMCR.

Source: Buy Green Mountain And Forget About Starbucks, Dunkin'