On Thursday evening, Monster Beverage Corporation ("Monster" or the "Company) (NASDAQ: MNST) disclosed, buried in a footnote of its Form 10-Q filed with the United States Securities and Exchange Commission, that it recently received a subpoena from an unnamed state attorney general in connection with an investigation into its flagship product. On Friday, August 9th, Monster shares traded down 11.3% in light of the company's financial results failing to meet Wall Street analyst estimates, slowing growth in 2q12 relative to prior years, and concerns regarding the state attorney investigation. However, for the reasons outlined below, RichardWorley.com believes MNST shares may have further downside as the state attorney investigation continues and the business faces further headwinds.
Monster's Deficient Disclosure to Shareholders
On Wednesday, August 8th after the market close, Monster published a press release with its 2q12 fiscal results and hosted an analyst call with Q&A. At no point in any of these critical shareholder communications did the Monster management team disclose that its core product, the Monster Energy® brand of energy drinks, had become the subject of a state attorney investigation since at least July 2012. Instead, the Company chose to bury the disclosure of this material business development on page 49 of its Form 10-Q via the following statement:
"State Attorney General Inquiry - In July 2012, the Company received a subpoena from a state attorney general in connection with an investigation concerning the Company's advertising, marketing, promotion, ingredients, usage and sale of its Monster Energy® brand of energy drinks. As the investigation is in an early stage, it is unknown what, if any, action the state attorney general may take against the Company, the relief which may be sought in the event of any such proceeding or whether such proceeding could have a material adverse effect on the Company's business, financial condition or results of operations."
Moreover, the Monster management team has refused to disclose which state attorney general is conducting the investigation, further depriving investors of the information they need to make a fully informed investment decision and gauge the severity of this potentially significant legal problem.
The Anais Fournier Tragedy
At the end of last year, fourteen-year old Anais Fornier consumed two 24-ounce Monster Energy® drinks while hanging out with her friends at a local mall. Less than three hours later, the Maryland teenager went into cardiac arrest and just six days later, despite the heroic efforts of the John Hopkins Pediatric Intensive Care Unit (one of the best children's hospitals in the United States), Anais Fornier died of "cardiac arrhythmia due to caffeine toxicity." By drinking two 24-ounce Monster energy drinks in a short period of time, Anais Fornier unwittingly consumed over 480 milligrams of caffeine, which is nearly five times the daily limit recommended by the American Academy of Pediatrics. Put another way, Monster made it possible for Anais to quickly drink the caffeine equivalent of 14 cans of Coke before her cardiac event and death. Because the Anais Fournier tragedy occurred in Maryland and based on other channel checks, I believe the Maryland Attorney General, Mr. Doug Gansler is currently investigating Monster's marketing strategy and product.
Monster Regulatory Framework
While Monster vehemently denied that "drinking two cans of Monster Energy by itself can cause a death from caffeine toxicity" after the Anais Forneir tragedy, a recent publication in the Journal of the American Medical Association entitled "The "High" Risk of Energy Drinks" identified numerous concerns regarding the marketing and consumption of energy drinks in the United States. Currently, the maximum allowable caffeine limit set by the FDA for cola-like drinks is 0.02%, or 71 mg per 12-oz serving, but FDA limitation does not apply to energy drinks like Monster Energy® drinks, which contain concentrations of caffeine as high as 505 mg per serving, a seven times increase in toxicity. If the FDA revises its maximum allowable caffeine limits to also include energy drinks, the Monster Energy® drinks caffeine dosage would have to be reduced to the equivalent of Coke or Pepsi cola products. Considering many consumers drink Monster Energy® drinks solely for the outsized caffeine dosage, it is hard to image many consumers would continue to drink something that tastes like "cough medicine" if the FDA updates its regulation and forces the Monster to reduce its caffeine content. Moreover, with a practicing Mormon (which refrain from caffeine consumption) as potentially the next President of the United States, the FDA may be encouraged to fast-track its review of the regulation of energy drinks.
In addition, state regulators can move much quicker than the FDA in forcing companies to pull product off store shelves that they view to be potentially harmful to consumers. For example, Four Loco was a similar energy drink to the Monster products that also included malt alcohol. In New York State, Governor David Paterson forced Four Loco distributors to clear their inventory of the product months before the FDA took a similar action in order to protect consumers. If the Attorney General in Maryland, or any other states, pursues a similar course of enforcement action against Monster to protect consumers, it could have a material impact on the Company's sales and growth trajectory.
Mr. Doug Gansler, the current Attorney General of Maryland, is known as a tenacious attorney that utilizes the bully pulpit of his position to obtain favorable regulatory outcomes on behalf of his constituents. For example, on 02/09/12, Mr. Doug Gansler reached a $957mm settlement with the nation's five largest mortgage servicers following an extensive investigation into foreclosure abuses, fraud, and unacceptable mortgage servicing practices such as "robo-signing." In addition, Mr. Doug Gansler is has historically been willing to bend the rules of law in his egotistical quest for results and fame; Mr. Doug Gansler is the first State Attorney to be sanctioned by the Maryland Court of Appeals for making impermissible public statements about possible confessions and possible pleas in high-profile cases. Based on this case history, it seems quite likely Mr. Doug Gansler would relish in the opportunity to pursue Monster and the associated attention a case such as this would garner.
Monster's Premium Valuation Appears Unsustainable
Monster has historically been valued at a significant premium to its peers in the consumer beverage segment due to the rapidly increasing popularity and sales of energy drinks. In light of the recently disclosed Attorney General investigation and potential changes to the FDA regulatory framework, it seems likely that the Monster equity valuation may decline to be more in-line with its traditional consumer beverage producers. In addition, it seems difficult for any potential "white-knight" acquirer (i.e KO, which is Monster's largest customer (~30% of sales) and distributor), to put a bid in for the Company in light of the current heightened regulatory oversight of energy drink sector and Monster's premium valuation would make any transaction highly dilutive for the acquirer.
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If Monster was valued by the market based on the consumer beverage sector median FY13 earnings estimate multiple of 15.2x, the Company's share price would decrease 31% to $37.70/share.
Disclosure: I am short MNST.