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Green Mountain Coffee Roasters (GMCR) caught a break from its relentless decline rising more than 30% at one point after reporting second-quarter earnings on August 2. With a short ratio hovering around 20% the rise in the stock price was as much short covering as it was due to the good, but not great quarter. Green Mountain seems determined to punish the shorts by announcing a $500 million buyback concurrent with the earnings announcement. With a market cap of $3.4 billion, a $500 million buyback represents a significant proportion of shares. However, GMCR only has about $150 million of cash on its balance sheet and that cash may be better spent elsewhere.

A Closer Look at the Quarter

The quarter itself was good, but not great. Total Net Sales increased by 21% to $869.2 million. Single serve pack, most commonly known as K-Cups for the Keurig Brewer, sales were $638 million or an increase of 31% from 2011. Encouragingly, brewer sales increased 32% to $139.1 million. Continuing to sell more brewers is essential to ensure continued growth of K-Cups. Inventory is a big concern with Green Mountain and it stood at $667 million at the end of the quarter. Interestingly, GMCR chose to put the September 24, 2011, balance sheet in the press release as a comparable. In that quarter they carried $672 million of inventory. Though sales are growing it is hardly comparable to look at the period immediately before the busy Holiday season and compare it with the second quarter. In the actual comparable quarter (Q2 2011) GMCR carried inventory of $418 million. So the year-over-year inventory build was over 50%. Despite management excuses the inventory problem is far from under control.

The Elephant in the Room

Much like Pfizer (PFE) losing patent protection on Lipitor or Bristol-Myers (BMY) losing protection on Plavix, K-Cups are about to go generic. On September 16, 2012, two of the approximately 37 patents protecting K-Cups will expire. Analysts expect the expiration of these two main patents will open the door to generic competition from anyone who wants to make a generic version to work in Keurig Brewers. GMCR has recognized this and has attempted to partner with the likes of Dunkin' Brands (DNKN) and the Folgers brand from Smucker (SJM) to get their branded K-Cups on the market prior to patent expiration. There may be some exclusivity period involved in these deals, but eventually Smucker will be free to make its own K-Cup equivalent as well. Starbucks (SBUX) has also announced that it is planning to launch a competing brewer that is intended to take away brewer sales as well as single serve cup sales, further compounding the challenges for GMCR.

Green Mountain's Next Move

Green Mountain can sit by and watch its cash flow evaporate as margins on branded K-Cups contract and sales fall or it can proactively do something about it. The best course for GMCR is to do everything it can to build a premium brand around the single serve market and the best way to accomplish this is through an acquisition. With a market cap of $240 million, $40 million of cash, and $0 debt Caribou Coffee (CBOU) makes the most sense. Caribou is trading around $11.50 a share about $7 below its 52-week and all-time highs set in March, just before GMCR's difficulties started weighing on the shares. A target acquisition price would be $20/share or just under $500 million. Since GMCR is apparently comfortable buying back $500 million of stock, a $500 million acquisition should be seen as easily doable by its Board. In fact the buyback announcement may be a ruse to put pressure on CBOU to agree to a buyout since it is clear that GMCR doesn't have the cash on hand for an accelerated buyback.

Caribou already has an agreement with GMCR to sell its Caribou branded K-Cups and GMCR's inventory problems in early 2012 decimated the shares of Caribou. As of April 1, Caribou had 585 coffeehouses, including 174 franchised locations, in 21 states, the District of Columbia and nine international markets. Many of its US locations are in the State of Minnesota and it has a good position internationally, especially in the Middle East. Caribou is a recipient of the Rainforest Alliance Corporate Green Globe Award and cultivates a culture of sustainability, environmental protection, and fair trade, in other words, Caribou tries to make you feel good about drinking its coffee.

There are other potential targets for GMCR. Peet's (PEET) was the most obvious, at a $600 million cap and $0 debt, but it recently agreed to a ~$1 billion buyout by Benckiser. Dunkin' and Starbucks would be great but are far too big to be acquired by GMCR, leaving CBOU as the obvious choice.

GMCR would benefit from an acquisition on many fronts. Caribou is a profitable business in and of itself and its acquisition would be accretive to earnings. Caribou's 585 outlets would give GMCR plenty of exclusive shelf space in coffee houses to sell Keurig brewers and K-Cups. Though Starbucks has about 20X as many outlets as Caribou, it would equalize the business model of buy a brand fresh in store and brew at home. Of course, this is pure speculation, but one thing is not, GMCR will be in a world of hurt when generic K-Cups start popping up on shelves if it doesn't move to maintain margins through the cultivation of a strong brand and give consumers an exclusive retail outlet for its brewers and K-Cups.

Source: Green Mountain's Next Move