It's no secret that we often see events in the market that don't make sense when viewed in an objective manner. The theory of free markets points to the idea that stock prices will fluctuate based upon the individuals in the market making the best decisions they can with the information available and that the prices will thus reflect a current "fair" value of said stock. However, the reality is that the market is made up of millions of individuals who are often not able to remove emotion from their investment decisions. As a result, the market will tend to overcorrect, both up and down, not only in individual stocks but in the market overall as money flows in and out. One potential series of such overcorrections can be seen in the recent activity of Green Mountain Coffee Roasters (GMCR).
The stock took a 50% beating in May after issuing guidance below expectations, and then continued south to a 52-week low of $17.11 in July. After a bit more positive reporting in August, the stock then rebounded to above $30. Now the stock is beginning another retreat as more news comes out about Starbucks (SBUX) and their new competing single-serve brewer, the Verismo. The fact that Starbucks planned to enter the single-serve brewer market is not a surprise. The Verismo will compete directly with Green Mountain's Keurig and Vue brewing machines which are sold largely through Bed, Bath, and Beyond (BBBY) and also through Wal-Mart (WMT). Additionally, the expiration of the patent for the K-cup is placing downward pressure on the stock as competition is certain increase in the coming quarters. What we need to determine is if the news was already factored into the market price of Green Mountain before this most recent drop began. Additionally, what do we think will happen with the next earnings report?
It is likely that the past high stock price was driven by the then-seen growth rate, which was in the neighborhood of 70%. Now that growth rates have fallen to more reasonable levels, we need to decide if the company will be able to compete in the long term following its perhaps too-rapid expansion. Over the past four quarters, the company has increased the cash on hand significantly from $13 million to $139 million. Over the same period, management has reduced debt by $174 million. This is an encouraging trend, however with the increasing competition it is by no means guaranteed to last.
As of market close on September 20, the TTM P/E stands at 12.48. This current valuation would appear to be more than fair given the fact that this stock traded at over $100 within the past year. Unusually high P/E ratios don't tend to last forever. If we look at forecast earnings for the fiscal years ending both in 2013 and 2014, projections are for a 12% increase for the next 12 months and an approximately 10% annual increase over the next 24 months. Maintaining P/E ratios in line with the current valuation would provide a target price of $28 in the next 12 months and just over $31 the following year.
These numbers are lower than the targets presented by the analysts, who offer estimates ranging from $25 to $60. This wide spread does indicate the opportunity for increased volatility in the coming months, although with a somewhat positive spin on the data as the estimates are higher than the current price. One must recognize the need to use caution though, as the one $60 target may skew some of the numbers.
If an investor is willing to accept some short term volatility or paper losses, there may be the potential to either take a long position in the stock or else leverage a position with options over a significant time period. For example, the midpoint of bid/ask on March 2013 $20 call options is $9.70, indicating that if the stock were to increase $1.86 or 6.7% [($20 + $9.70) - $27.84/$27.84] at anytime in the next six months an investor could begin to realize leveraged returns. This is not unlikely given the stock's recent track record of 8%-10% moves in either direction in a day. The risk is that any continued downward pressure on the stock price would eat into the initial investment at an accelerated rate.
Covered calls present an additional opportunity for the long side, as October $28 calls are going for around $2.30 -- this would reduce the cost basis for a buy/write to $25.54 and result in a profit of $2.46 or 9.6 % in one month if the options are exercised. If the options expire worthless, the investor pockets the premium and then writes another covered call the following month to continue profiting.
Conversely, if you believe that Starbucks is the future of coffee and that generic K-cups will kill Green Mountain, you might wish to take an opposite position and consider an October $27 long put position at $2. A 3% drop in the share price will immediately place the trade in the money. With this stock's volatility, 3% is literally nothing. Once the price drops 10%, the position is guaranteed to be profitable even if the time value drops to zero.
The market is a tricky place. However, by doing some homework we can find opportunities to profit from the emotional decisions made by others. Green Mountain Coffee Roasters is in the position to consolidate and prepare for the next round following a rapid expansion, but there is no shortage of competition on the horizon. Starbucks and others have already taken action to enter the single-serve coffee brewer market and eat into Green Mountain's market share, but the resulting volatility does not have to be a bad thing for investors.
There is no substitute for doing your research and making an informed decision based upon facts and not emotions. This stock is volatile, and potential exists for both sides to profit as the future of this company becomes more clear. Using options to leverage your position can result in significantly greater profits, but a move in the opposite direction will quickly erode your initial investment.
Additional disclosure: I may additionally initiate a short position in GMCR and a long position in SBUX in the next 72 hours.