Monster (MNST) recently released earnings that saw the stock plunge some 20 percent. Deserved or not isn't the question at hand; the questions we have at Capital Ladder Advisory Group, LLC. ("Capital Ladders") surround the operations and future growth expectations for Monster Beverage. A lot has been made about the company's international expansion efforts during the last two years as the company has seen rapid growth in additional markets around the globe. Most recently, the company made strides to open new markets in Japan, Macau, Hong Kong, Ecuador, Slovenia and Thailand just to name a few.
Expansion efforts on a global scale can prove to be costly during the initial stages, but those costs usually decrease by year three when an individual market successfully reaches maturation as indicated in research reports conduct on behalf of NPD Group and Nielsen. The key piece of balance sheet information for investors to hone in on with regards to whether or not markets are maturing on schedule can usually be found by visiting the selling expenses portion of the balance sheet and/or company specific press release statements. In the case of Monster Beverage, in the most recent quarter, selling expenses decreased in the quarter to 11.6% from 12.9% in the same period a year ago. A bulk of the selling expense decrease came from reduced advertising spending. We're not suggesting that this will continue quarter over quarter, but it is a positive sign that the company is showing operational controls as the business grows and expands regionally. In the case of many companies, during rapid expansion efforts, expenditures can often be viewed as a necessity to drive efforts in new markets and the focus turns away from returning shareholder value in a timely manner. Using this logic, Monster scores high on our scale of Investor Led Operational Focus (ELOF).
Let's now dig into those expansion efforts and see where the company can improve and what investors should be aware of in the coming quarters as the company looks to gain market share in a profitable manner. If the goal of the company is to continue to improve upon returning shareholder value, it must remain focused on increasing its market share. Monster is currently the leading energy drink producer by units and closing the gap in terms of dollar sales, just behind Red Bull. The most recent study by Nielsen shows that Monster has captured 31% of the energy drink market in the US with Red Bull encompassing 34.5% of the US market. Each respective company has continued to show YOY market share gains while it takes share from smaller albeit capable competitors. Rock Star , the number four leading energy drink producer by unit volume, behind 5 Hour Energy, Monster and Red Bull, has recently discovered that pricing initiatives have provided the company with improved market share gains in North America and is continuing with its plan to aggressively lower price points in order to gain further market share in the region. As a private company, Rock Star can afford to commit itself to this strategy for the unforeseeable future as it doesn't have the added pressure to return equity to shareholders, but rather remain profitable. It would behoove investors to monitor those in-store pricing promotions for Rock Star products over the coming quarters to gage the efficacy of this strategy. Additionally, it would be foolish to dismiss the amount of promotions by Rock Star as a necessity for a company that can't sell its products at every day prices, as many investors have wrongfully done in the past. There are a litany of reasons for which products go on sale or price reductions are taken and market share acquisition objectives are very high on this list.
To elaborate on the issue of pricing with regards to energy drinks, the fact remains that they are quite expensive as a segment of the overall beverage market. With regards to the carbonated beverage market, energy drinks rate near the top in terms of pricing per can as an individual energy drink will cost the consumer $2.50 on average in the US. This seems awfully high for a carbonated beverage and likely sets a ceiling for market penetration going forward, but not any time soon.
So let's talk directly to expansion efforts and the hiccups the company has recently encountered by way of Japan, Korea and Brazil. With regards to Japan, the learning curve is officially in place and the company now has a better understanding of the details which encompass doing business in Japan. Yes, the costs of doing business in Japan are higher due to higher regulations, focused quality assurance procedures within the country and just the general logistical costs associated with shipping and procurement of goods from the US to Japan. We expect to see lower margins coming out of Japan for the balance of 2012, but margins should turn the corner as the company heads into 2013 with more experience and cost controls in place in accordance with a maturing market.
Korea poses an entirely different issue for the company as it attempts to get its individual products (SKUs) to pass regulatory requirements in the nation. The energy drink category is relatively new to Korea and as such, ingredients within energy drinks produced by Monster are being carefully scrutinized by the governing bodies. Fortunately for Monster, several products have passed regulations as the company is currently sitting on a healthy inventory of goods slated for the Korean market place. What investors should consider in this case is the deferment of sales gains for future quarters. Analysts had likely baked Korean orders into Q4 and possibly even the current quarter on the likelihood of sell through rates from Korea. Now, these expectations will have to be deferred for future quarters as it takes considerable time for products to get from port to distributor and ultimately onto retail shelves. It is the opinion of Capital Ladder Advisory Group that not all Monster Beverage products will clear regulatory requirements in Korea, but we are aware of a back-up plan for which the company has already planned for in the nation in case this does occur. It is important to understand that a company the size of Monster has to see sizable unit volume in a particular market to become profitable. Monster will not achieve profitability in Korea without a plethora of reliable and proven products selling there as has been the problem in other countries such as Switzerland, Austria and other Baltic nations.
Moving on to the nation of Brazil. Brazil boasts one of the world's largest populations of carbonated beverages. In the most recent earnings conference call, management noted that the company was having issues related to its distribution partner servicing the Brazilian market. Keep in mind, that a distributor controls any particular market and the retail partnerships within that specific market. If the distributor can't support the product development and supply chain within the market, a brand can see severely decreased presence at retailers. When choosing a specific distributor, companies usually look for the following requirements of that distributor: retail partnerships in existence, sales volume, existing capital, lines of credit, revolving credit, marketing presence for existing products supported by the distributor and much more. Agreements between wholesaler and distributor are typically outlined to the specifications of the wholesaler and span a time period of 5 years. Although management did not speak to the specific issues related to the distributor servicing Brazil, we would have to consider the possibility that as the economic conditions in Brazil have slowed and GDP declines, it is hindering orders and sales for the distributor which is impacting business related to Monster Beverage products.
In a case like this, Monster has to react quickly, usually within 60 days upon recognizing the above stated issues. If the distributor can't operate under the adverse conditions in the market place and service the market as outlined in its agreement with Monster Beverage, sales can be greatly affected coming out of Brazil. Once a distributor fails to shelve products for a retailer, that relationship can be completely severed beyond repair. While this scenario seems dire given the additional information provided in this article, there are several ways in which Monster could address the issue at hand as we would expect them to in the very near future.
As is often the case in situations where a distributor can no longer execute to the terms of the agreement, a wholesaler can step in and fund ongoing operations until additional lines of capital are acquired by the distributor. A second method of rectifying the situation can be an acquisition by the wholesaler of the rights of distribution to the region being serviced by the distributor (this is the most common approach used and the most profitable as margins can be greatly increased from direct sales). The third method of remedying the problem is an outright acquisition of the distributorship which in the case of the Brazilian distributor could position Monster Beverage perfectly in the South American market as it expands into countries like Peru, Chile and Argentina in the future.
The point we are trying to make here is that although this was not a focus event on the recent earnings conference call, it very well should have been as these distributor issues are ones that can cause big hiccups for future results that would-be and current investors had not anticipated. Distributors drive your business and if they don't, your business falters. We have seen instances in the past, and with other companies, where both bottom and top line results were greatly missed do to a company not addressing a distributor issue in a timely manner. Unfortunately, investors didn't see the miss coming as the company and the analyst community did not focus enough attention on the issue until it was too late.
What investors will have to discover over time is whether or not orders have ceased to the Brazil distributor since this announcement. If they have, the problem is serious and Monster is in the process of addressing the market. If orders have not ceased, then the problem is not that serious and Monster feels it can work with the distributor to resolve the issues plaguing its partner at this time.
To touch on the subject of Korea just one more time, with regards to this particular market, Monster could actually take on a partner in order to increase its SKU acceptance in the country. I will elaborate on this idea in an upcoming article as we understand that Monster is in talks with another distribution company that services the carbonated beverage market.
Lastly, I would recommend investors understand the possible obstacle which Monster will be confronted with in the coming quarters and years ahead. In the company's annual filing they note several important developments related to the energy drink market.
"Proposals to limit or restrict the sale of energy drinks to minors and/or persons below a specified age and/or restrict the venues in which energy drinks can be sold and/or impose taxation on the sale of energy drinks, continue to surface and are currently pending before certain state and/or county and/or foreign country legislatures and may from time to time be proposed and/or enacted by such legislatures. Should these current or any future proposals to enact legislation to limit or restrict the sale of energy drinks to minors and/or persons below a specified age and/or the venues in which energy drinks can be sold and/or impose taxation on the sale of energy drinks, succeed and become widespread, such legislation could result in a reduction in demand for our energy drinks and adversely affect our results of operations".
"Measures have been enacted in various localities and/or states and/or foreign countries that require that a deposit be charged for certain non-refillable beverage containers. The precise requirements imposed by these measures vary by jurisdiction. Other deposit, recycling or product stewardship proposals have been introduced in certain states and localities and in the Congress of the United States and/or in certain foreign countries, and we anticipate that additional legislation or regulations in this regard may be proposed in the future at the local, state and federal levels, both in the United States and elsewhere".
"Public health officials and health advocates are increasingly focused on the public health consequences associated with obesity, especially as the disease affects children, and are encouraging consumers to reduce consumption of sweetened beverages. Increasing public concern about these issues could result in the implementation of governmental regulations concerning the marketing, labeling or availability of our beverages".
The fact is that all of the above related statements are currently in the works and on a global scale. In Q4 of 2011, Monster discussed the tax which Hungary placed on energy drinks and how this disrupted that particular market. Mexico enacted a tax on energy drinks in Q1 of 2012 as well. France, Denmark and Belgium have also increased there respective tax on soda beverages which include energy drinks. It remains to be seen how Monster strategically addresses all of these concerns as the company is now faced with a spotlight shined on the company by way of a state Attorney General.
We hope that you have found some interesting points of reference in this article as we will study the progress of these topics related to Monster Beverage Corp going forward at Capital Ladder Advisory Group. At present, we do not hold a position in MNST nor do we plan to initiate a position before our meeting with management scheduled later this month. The growth and potential growth of Monster Beverage Corp is undeniable, but with growth comes growing pains and we hope to see Monster overcome the obstacles outlined within this article as they are manageable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.