Can Green Mountain Survive Without Its K-Cup Patent?

 |  About: Keurig Green Mountain Inc (GMCR), Includes: DNKN, FARM, PEET, SBUX
by: Paul Zimbardo

If you are a coffee connoisseur or just a casual coffee drinker you are likely familiar with Green Mountain Coffee Roasters (NASDAQ:GMCR). The company is best known for its popular K-Cup coffee pods which have been infiltrating both office kitchens and households over the past few years. Despite its rapid growth, recently the Green Mountain bears have outnumbered the bulls as the stock has tumbled 75% in the past year. The troubles began for the company in late 2011 as Greenlight Capital Chairman David Einhorn argued that the company lacked transparency and issued a generally bearish presentation on the stock. The company's explanation for the lack of forecasts is its difficulty predicting future sales and performance. I do not know if that information should make me feel better about investing in the company or cause me to run for cover. If management cannot forecast its sales, who can?

Green Mountain has been under further pressure in 2012 due to increased competition and the looming expiration of the essential K-Cup patent in September. In response to a Securities and Exchange Commission ("SEC") inquiry the company stated that "patents do cover significant aspects of its K-cup technology, but added that it has competitive strengths, aside from its intellectual property, which mitigate the potential impact of the patent expirations." If things are not scary enough for you yet it seems as if the SEC is always investigating Green Mountain for "accounting irregularities", another phrase you do not want to hear related to a potential investment. Despite these storm clouds overhead, Green Mountain reported third quarter earnings in early August and shares surged 25% for the greatest single day climb in nearly eighteen months. Green Mountain is an extremely volatile stock for a reason. There is no clear consensus as to what direction it is heading next. I hope to part the storm clouds and shed some light on to the coffee giant.

Below I rate the key risk, financial strength, valuation, and profitability metrics for Green Mountain to see if the stock is worth investing in. My ultimate opinion is based on criteria outside the metrics discussed and incorporates current events not fully captured. The information presented should simply be a starting point for further research in consultation with your professional financial advisor before you pursue any investment decisions. My preliminary research should not be considered a substitute for your own due diligence.

All data comes from and Yahoo! Finance.

Overall Risk Level:

Market Cap/Relative Size: I prefer to invest in companies with market capitalizations greater than $5 billion because there is an abundance of information available for these larger firms. Potential returns tend to be greater for smaller firms due to thin analyst coverage. Despite Green Mountain being a small cap stock with a market capitalization of less than $4 billion, the company has sufficient coverage and is a high profile stock which once had a market cap greater than $10B. As a result investors do not have to worry about finding necessary information about their investment. To the contrary, there is an abundance of information available for the stock.

Beta (β): This measures the company's volatility in relation to the broader market. For example, if beta equals 1.0, the firm will track the market's performance (commonly the S&P 500). For this reason, I prefer companies with lower betas (<1.0) because they are less volatile than the overall market. Green Mountain has a beta of 1.0 which means it should track the market well but be cautious as GMCR can be quite volatile and may not be appropriate for more risk averse investors.

Insider Ownership & Transaction Trends: There is one primary reason why insiders buy shares - they believe that the stock price will increase. On the other hand, there are many reasons why insiders may sell such as a personal need for cash, exercising options, or personal diversification. For this reason, I consider insider buying a strong signal but I do not put much faith into insider sales.

In August GMCR had about $390K of insider purchases which pales in comparison to the $136M of insider sales in May. The bulk of those sales were conducted by founder Robert P. Stiller who was compelled to sell as the part of a margin call. Mr. Stiller was famously removed as chairman in May for his trading practices of Green Mountain stock. While the August purchases were small I tend to put more faith in them because Stiller's sales were forced by his personal circumstances rather than his opinion of Green Mountain's prospects.

Institutional Ownership Percentage: Studies have indicated that there is a direct relationship between institutional ownership and stock price so this is a critical factor. If a company does not have greater institutional ownership in excess of 80% I can be hesitant to own it. Financial institutions have tremendous talent and resources unavailable to the average investor so I relish the opportunity to piggyback on the work of other intelligent investors. Green Mountain is essentially in-line with this requirement. The top three institutional owners are Fidelity (15%), Wellington Management Company (11%), and Capital Research Global Investors (11%).

Short Float Percent: The number of shares sold short (fundamentally borrowing shares of a company, selling the shares, and hoping that the stock declines before returning the shares) divided by outstanding shares that can be freely traded. The potential loses from shorting are unlimited so if there are a large number of investors selling short, this is a potent red flag that the stock may be heading for a tumble. Additionally, there is also a hidden advantage to a stock with a high short percentage: if there is unexpected good news, a short-squeeze can really make the stock skyrocket as shorts scramble to repurchase shares to cover. The short float truly reveals the degree to which a company is targeted by short sellers for one reason or another and Green Mountain has a huge bull's-eye on its back. If you take a long position and choose correctly your returns will be turbocharged but the related risk and volatility may be too much to stomach.

Financial Strength:

Short-Term & Long-Term Debt Trends: Debt in the capital structure can have significant benefits due to the tax deductibility of interest payments. While the cost of debt is lower than the cost of equity financing, just like eating ice cream, there can be too much of a good thing. As the level of debt rises, the interest payments can become prohibitive and force a short-term orientation that prioritizes bondholders over shareholders. For this reason, relatively low levels of debt are ideal. The absolute levels of short-term and long-term debt only tell part of the story: the trends over time should also be considered. Green Mountain's short-term debt has been insignificant for the past year and the long-term debt has declined from $575M to $400M over the same period. The long-term debt-to-equity ratio is a minute 0.18 so solvency is not a concern.

Cash/Trends: Everyone knows that cash is king. Pretty self-explanatory here: the company should be continuing to grow its liquid assets to prepare for uncertainty of capitalize on an external opportunity. Cash has climbed considerably in the past year despite current assets stagnating, highlighting a shift from receivables to cash. This trend is an indicator that the company has been collecting on receivables more quickly and/or has changed its sales policy; both of which have positive implications for long-term liquidity and solvency. The company has been active in the past with acquisitions in the past, most recently with a $905M deal for Van Houtte in 2010.

Cash Flow from Operations: Did I mention that cash is king? If I could only look at one characteristic when making an investment decision, this would be it. It will be a very rare situation when I invest in a company with negative cash flows from operations. Fortunately Green Mountain has strong cash flows from ops for the past three quarters with the lone exception being the third quarter 2011 where the company admittedly failed in forecasting which caused an inventory surplus that wrecked cash flows in the short-term. Green Mountain's operating activities have also been able to more than support capital expenditures, another indicator of financial strength.

Current Ratio: These next two metrics focus on a company's liquidity and ability to pay obligations as they come due. The current ratio is measured as current assets divided by current liabilities; therefore, a ratio of at least 1.0 indicates short-term strength. With that in mind, GMCR current ratio of 2.5 passes with flying colors.

Quick Ratio: The quick ratio is a variation of the current ratio with inventory and prepaid expenses excluded from current assets. This is an important ratio for companies that rely heavily on inventory. If there is a cash crunch the current ratio can be misleading because a company may not be able to easily sell its inventory at regular prices. This is especially important considering Green Mountain's past inventory forecasting issues. Again, GRMC has an excellent quick ratio of 1.0, further confirming liquidity.

Asset Quality: If the subprime mortgage fiasco taught us anything, it is that not all assets are created equally. Analysts and investors justifiably prioritize the value of certain assets over others. For example, one million dollars of cash is worth more than one million dollars of inventory. Taking the comparison one step further, intangible assets are worth even less than tangible assets; ideally your potential investment has primarily tangible assets with real value. This is the area where Green Mountain's financial position deteriorates quickly. $1.3B of Green Mountain's assets is either goodwill or intangible, which is nearly 40% of total assets. These intangible assets relate primarily to Green Mountain's acquisitions, most significantly the Van Houtte deal mentioned above. These assets are tested for impairments quarterly which could cause the company to write-down the value of the assets. Essentially the impairment test is whether the company will realize enough future benefits from those assets in the future to support the valuation. There have been very high profile write-downs at companies such as Microsoft (NASDAQ:MSFT) have taken billions of dollars in write-downs that flow directly to the P&L. Despite being non-cash expenses, the company's stock prices have suffered as assets suddenly disappeared from the balance sheet. With the expiration of the K-Cup patents I would not be surprised if Green Mountain is forced to take a haircut on its intangible assets. This is a very critical aspect to monitor going forward.

Valuation And Profitability:

Discounted Cash Flow: A discounted cash flow (DCF) analysis is the bread-and-butter method for getting a ballpark valuation for a stock by estimating future earnings and discounting back to the present. The EPS growth rate for the next five years is nearly 30% which I believe is far too high. Sales growth in the most recent quarter was 30% which represents an approximate 40% decline in growth year-over-year. A case can be made that household K-Cup adoption is rising substantially but I think a more reasonable growth rate is 15% (50% haircut). I conducted a DCF analysis assuming this 15% growth rate, 10% discount rate, and 1% terminal growth rate, and ultimately arrived at a valuation of $42.84. These assumptions may be conservative but I prefer to strengthen the margin of safety. This price represents a seventy percent premium over its current market price. Green Mountain has not traded in the low forties since April.

P/E Ratio (NYSE:TTM): An alternative way to value a company is to use the price-to-earnings ratio. Again, Green Mountain appears attractive from a valuation standpoint. If GMCR were to trade at the industry average multiple of 19.1 then it would be a $41.48 stock. For comparison purposes I have presented similar company's P/E ratios: Farmer Brothers (NASDAQ:FARM) - N/A, Peet's Coffee (NASDAQ:PEET) - 67.7, Dunkin' Brands (NASDAQ:DNKN) - 62.5, and Starbucks (NASDAQ:SBUX) - 27.3. This is in-line with the DCF analysis above.

P/E Ratio (Forward): Green Mountain's forward P/E of 10 still represents a notable discount to its peers which indicates a potentially undervalued corporation.

Return on Equity: Return on equity (RoE) measures earnings as a percent of shareholders equity and indicates the profit potential of the company. The DuPont decomposition of RoE explains why it is so valuable: one simple ratio incorporates profitability, asset management, and corporate management. Managers can utilize different strategies to achieve RoE which causes the ratio to be extremely useful for industry comparisons. My analysis of RoE depends on the industry and Green Mountain's 17% ratio meets expectations.

Performance vs. S&P 500/Price in Relation to 52 Week High or Low: I like to follow the axiom of buying low and selling high so I am very hesitant to buy near a 52 week high unless there is great news. Obviously you need to be careful here as well because you do not want to catch a falling knife. Green Mountain has trailed the S&P 500 by nearly 60% in 2012 and sits nearly 80% below its 52-week high.

Click to enlarge(Source: Yahoo! Finance)

In closing, I believe the expiration of the K-Cup patents as well as the constant threats of further competition will keep Green Mountain's stock from outperforming the market for the remainder of 2012. Even if Green Mountain is able to continue its rate of growth, the market will likely take a wait-and-see approach to let two quarters of earnings digest in a defenseless K-Cup market. It seems as if every potential positive catalyst (lower coffee prices in 2013) there is a counterbalancing negative (Europeans drinking less coffee). While the company appears to finally be attractively valued, the possibility of write-downs hangs in the air. For these reasons mentioned above, I rate Green Mountain a HOLD, subject to any catalysts, for the remainder of 2012. Green Mountain is at a turning point and the next six months could determine the long-term fate of the organization.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.