Keurig Green Mountain's (GMCR) CEO Brian Kelley on Q3 2014 Results - Earnings Call Transcript

| About: Keurig Green (GMCR)
This article is now exclusive for PRO subscribers.

Keurig Green Mountain Inc (NASDAQ:GMCR) Q3 2014 Earnings Conference Call August 6, 2014 5:00 PM ET

Executives

Suzanne DuLong - Investor Relations

Brian Kelley - President, Chief Executive Officer, Director

Fran Rathke - Chief Financial Officer, Treasurer

Analysts

Bill Chappell - SunTrust Robinson Humphrey

Akshay Jagdale - KeyBanc Capital

Bryan Spillane - Bank of America Merrill Lynch

Mark Astrachan - Stifel

Matt DiFrisco - Buckingham Research Group

Jon Andersen - William Blair

Scott Van Winkle - Canaccord Genuity

Phil Terpolilli - Longbow Research

Chuck Cerankosky - Northcoast Research

Marc Riddick - Williams Capital

Operator

Good afternoon. Welcome to the Keurig Green Mountain Fiscal Year 2013 Third Quarter Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to the company's Vice President of Investor Relations and Corporate Communications, Suzanne DuLong. Suzanne, please go ahead.

Suzanne DuLong

Thank you, Danny. Welcome, everyone. Today's press release is available on our website at keuriggreenmountain.com. Our Form 10-Q for the period has been filed as well and also available on our website.

On today's call, Brian Kelley, our President and CEO, will provide some brief introductory remarks. Fran Rathke, our CFO, will discuss aspects of the quarter’s financial results, as well as our outlook for our current quarter and our fiscal year 2014. Brian will provide some additional commentary about the business and we will open the call to questions from the sell-side analysts.

To ensure we have the opportunity to address everyone's question during the time we have allotted for this call, we ask that you limit yourself to one question.

Finally, I will remind everyone that certain statements will be made today which are forward-looking within the meanings of securities laws. Given the uncertainties of forward-looking statements, our actual results may differ materially from anything projected in these forward-looking statements.

We can give no assurance as to their accuracy and we assume no obligation to update them. For further information on risks and uncertainties, please read the company’s SEC filings and the paragraph in today’s press release that begins with the word Certain Information.

Now, I will turn the call over to Brian Kelley.

Brian Kelley

Thanks, Suzanne, and good afternoon, everyone. We are very pleased with our performance this quarter. We delivered ahead of our mid-teens earnings growth target, which is significant given the dilutive impact of the share issuance to both, Coca-Cola and Lavazza earlier in the year.

Excluding that impact and adjusting for currency, our earnings growth rate was nearly 30% over the prior year period. This outperformance resulted from a balanced contribution of revenue growth, gross profit expansion, productivity and operational improvements.

In terms of revenue for the quarter, our core single serve business, the primary driver of our profitability grew 9% on a currency-neutral basis. This was offset by a continued decline in our traditional coffee business, which includes our bagged and fractional pack business.

Our overall 7% currency-neutral revenue increase came in at the lower end of our guidance range. This was driven by an impacting from portion pack shipment timing. That said, we expect revenue to accelerate in Q4, particularly in portion packs due to a few things. One, the Keurig installed base growth, which we estimated to increase 25% to 30% year-over-year in line with our expectations. Importantly in the third quarter, the system-wide portion pack sell-through remained consistent with the growth of our brewer installed base.

The second driver of accelerated revenue in Q4 is a more meaningful revenue contribution from a number of new Keurig system partner brands both, announced and unannounced. The brands we have announced include Target and its Archer Farms brand, BJ's Wholesale Club and its Wellsley Farms brand, Harris Teeter and its store brand as well as Nestlé coffee-mate K-Cup packs.

Also in the third quarter, we gained agreement with a number of new previously unlicensed brands and we expect to add others in the fourth quarter. These additions will impact shipments beginning in the fourth quarter. We were pleased to expand our brand portfolio while executing across our key strategic initiatives for the year.

During the third quarter, we expanded both, gross and operating margin consistent with year-to-date trends. We improved gross profit by 9% in the quarter with gross margin improvement 140 basis points. Non-GAAP operating profit grew by 18% in the quarter and operating margin expanded 250 basis points to 23.8% of sales. Non-GAAP earnings per share increased by 29% for the quarter, excluding currency and the dilutive impacts I have already mentioned. Free cash flow delivery has been very strong with just over $600 million in free cash flow on a year-to-date basis.

Finally, we ended the quarter with more than $1.2 billion in cash on our balance sheet, which gives us the ongoing flexibility to invest behind the many exciting growth opportunities in our hot and our cold systems. It also allows us to maintain our recent share repurchase and dividend activity for the benefit of shareholders.

As we head into the holiday season, we continue to execute on our three key priorities. The imminent launch of our Keurig 2.0 hot beverage system, the transition to portion packs that are compatible with the 2.0 system and adding breadth to the Keurig system that will provide consumers with even broader choice and variety

We are also expanding our away-from-home channels. We are hitting the necessary milestones to lunch our Keurig cold system in fiscal year 2015. Finally, we are selectively evaluating, pursuing opportunities for growth outside of North America. I will speak to each of these later in the call, but in summary we feel very good about our plan and we are confident in our ability to execute on our growth initiatives and deliver on our financial objectives for the year.

Before I turn it over to Fran, I want to thank the Green Mount team, our partners and our customers for their support and effort in delivering these results in preparing for the significant product introductions ahead of us. Fran?

Fran Rathke

Thanks, Brian. Hello, everyone. I will walk through some of the specifics of the quarter's financial performance. The primary driver of the 6% increase in our net sales for the third quarter was a 10% increase in total portion pack net sales. This was driven by 15 percentage points increased due to volume, offset by a three percentage point decrease due to portion pack product mix and an approximate two percentage point decrease due to portion pack net price realization.

In Q3, our portion pack net sales mix was affected by our sale of more portion packs to brand owners with a lower average selling price relative to the prior year period. Having invested considerable dollars and years launching and expanding Keurig system, when we bring a partner in, we work closely with them to ensure a successful and mutually beneficial relationship.

Specifically, when we sell portion packs to the brand owner, we generally charge a lower wholesale average selling price, because the brand owner is responsible for some elements of the value chain. Generally, when we sell portion packs directly to the retailer or the consumer, we charge a higher average selling price, because we are responsible for most or all elements of the value chain from procurement to selling and distribution.

As we continue to broaden consumer choice in the Keurig system, welcomed formally unlicensed brands and add brand owners with their own distribution, we anticipate greater variability in mix going, but ultimately our investment here bodes well for the long-term strength of our growing system.

Brewers for the quarter, brewer and accessory net sales declined 4%, driven by a 13 percentage point increase in brewer sales volume, including the sale of $1.6 million Keurig brewers. Offsetting volume and positive mix, was a 21 percentage point decrease from net price realization.

Approximately half of that impact was our strategic decision to drive brewer volume to be in an appropriate inventory position ahead of our Keurig 2.0 launch and to further expanding installed base of our Keurig hot platform. The other half was due to a difficult year-over-year comparison from a reduction in our brewer sales return reserve in the third quarter of fiscal 2013 to reflect improved brewer return rates. Additionally, accessory net sales increased by $2.3 million or 26% over the prior year period. Excluding the unfavorable reserve comparison, brewer and accessory revenue grew by 6% compared to the prior year quarter.

During the quarter, net sales of other products decreased $14.2 million or 17%, as a result of continued headwinds from products in this category, including traditional coffee package format and bulk coffee, which had been challenged by the growth of portion packs. We estimate that this adversely affected our total revenue growth rate by about 1%.

Looking at net sales regionally, for the quarter, our domestic business delivered 7% revenue growth over the prior year while our Canadian business declined 2%. On a local basis currency basis, revenue in Canada was up 5%.

Moving to a review of gross profit, for the quarter gross margin improved 140 basis points to 43.5% from 42.1%. We continue to invest in Q3 behind both, portion packs and brewers while also benefiting from a combination of favorable coffee cost and incremental productivity benefits and partially offset by a number of items as detailed in today's press release.

Turning to operating results for the quarter, we were pleased to hold SG&A roughly flat from the prior year period. We continue to invest in research and development at a rate more than double our sales growth. We also were more efficient year-over-year in supporting our growth as selling, operating and marketing expenditures were all down. This approach left our non-GAAP SG&A at 19.7% of net sales for the period, a 120-basis point improvement compared to the 20.9% delivered in the prior year.

Our Q3 tax rate of 33.9% was more favorable than our outlook and prior year. The tax rate benefited from domestic production credits and a number of other small drivers. In-all, the lower tax rate added approximately $0.03 to our non-GAAP earnings per share.

Our Q3 non-GAAP diluted EPS of $0.99 includes roughly $0.08 dilution from the recent equity transactions net of our share repurchases and $0.01 from foreign currency.

As Brian stated, this is better than our mid-teens earnings per share growth rate target representing a 21% increase over last year's non-GAAP EPS of $0.82.

On a currency-neutral basis and excluding the impact of the recent equity transactions, and diluted non-GAAP EPS was $1.06, which represents a strong 29% increase over last year.

Looking at the balance sheet and free cash flow, our balance sheet remains very strong with cash of $1.2 billion and total debt of $274 million at the end of the quarter. We generated free cash flow of $127 million in the quarter with $602 million year-to-date. It's also worth noting that we delivered 132% free cash flow productivity on a year-to-date basis.

We noted last quarter that we expected inventories and capital investment to accelerate in the back half of the year as we prepare for new product introductions, holiday in our SAP implementation. At the end of the quarter, inventory was $639 million, an increase of $53 million or 9% over the prior year period.

Some of this increase is related to normal Q3 seasonality as we prepare the shippers for the holiday season. This year, our normal Q3 inventory seasonality has been amplified as a result of the higher cost of our Keurig 2.0 Brewers compared to Keurig 1.0 platform as well as some portion pack inventory needs related to bringing new brand into the system.

Our investment in the Keurig 2.0 brewers is greater for a number of reasons, including normal new product cost cycle as well as initiative to encourage trial and adoption of the system new carafe functionality. Specifically for the introduction, we've included a K-carafe and sample starter carafe packs in every brewer box.

We are already working to reduce the cost of our Keurig 2.0 brewers, but in the short-term we expect to experience some gross margin and inventory headwinds as a result of our added investment in the system. We invested $103 million in capital during the quarter, roughly $60 million compared to a year ago.

Part of the increase is associated with setting up our Keurig cold dedicated early production center in Vermont facility. We also made an initial investment in support of our new Keurig cold dedicated facility in Lithia Springs Georgia as we mentioned last quarter we expected capital expenditures to ramp in the second half of the year Q4 14 is expected to continue on this trend as we invest behind the numerous growth opportunities with our hot and cold platform.

Now, for an update on share repurchases and dividends before I turn the call back to Brian. Following a very active second quarter, when we returned nearly $800 million to shareholders. During the third quarter, we repurchased a total of $1.1 million shares of approximately $117 million and an additional $25 million through August 5th.

We intend to be active and opportunistic in our effort to repurchase shares, particularly given the strength of our balance sheet.

Now, I will turn the call back to Brian.

Brian Kelley

Thanks, Fran. We are executing three strategic initiatives this year. The transition to our new Keurig 2.0 hot system, the transition to portion packs that are compatible with the Keurig 2.0 system and our ongoing efforts to add new brands as licensed Keurig partners.

Let me first talked about 2.0. We continue to hit all the necessary milestones and are on track to introduce our new Keurig 2.0 hot platform to consumers this fall. We have ramped production of our Keurig 2.0 brewers and began shipping product customers last week in preparation for the imminent launch.

With Keurig 2.0, we've leveraged our knowledge of consumer behavior and our technical expertise to bring new features and enhanced functionality.

As Fran mentioned, during the introductory period, each Keurig 2.0 brewer will be shipped with a K-carafe and assortment of K-carafe packs. This will enable consumers to immediately experience all the benefits of the brewer carafe to a single cup.

Over the holiday season, we will ship both, Keurig 2.0 and Keurig 1.0 platforms, but our and merchandising will be focused almost exclusively on Keurig 2.0. We expect that 2.0 will appeal to non-Keurig users who are yet to purchase a brewer, because they want the option to brew larger volumes with Keurig's simplicity.

This was validated in our recently closed home use test, where owners of non-Keurig drip coffee machines preferred the Keurig 2.0 versus their current drip brewer by at least 5 to 1.

Consumers will also get convenience and variety of the more than 50 brands and 275 beverage choices available today in our Keurig system, plus they get the ability to brew up to a four serving carafe in many of our best-selling coffees. We also expect that Keurig 2.0 will allow us to capture some portion of the 25% of coffee consumption. We estimate that we are currently not getting in existing Keurig households, due to the occasional need for multi-served brewing.

Retail customers are excited about the introduction of Keurig 2.0 this fall and you will see evidence of that excitement in the broad product distribution and strong merchandising support. We are also successfully transitioning to interactive portion packs. Since July of this year, 100% of our at-home K-Cup pack inventory has been 2.0-enabled with our proprietary technology, which will provide consumers with the full features and benefits of our new Keurig 2.0 brewers.

Since January, we've been working closely with customers and retailers to ensure that they are appropriately rotating portion pack inventories in preparation for the launch of cure 2.0. While we know it won't be perfect, we are confident in our plan and our execution thus far and we will be prepared to deliver our world-class customer care to ensure a wonderful consumer experience.

Now, turning to our growing portfolio of license portion packs, we are very pleased with the progress we are making in adding previously unlicensed brands to the Keurig system. We are now seeing unlicensed share flattened out and begin to decline as we have started shipping newly licensed packs including, Peet's and Archer Farms among others.

With the recent introduction of new license partners like BJ's Wholesale Club, Harris Teeter, Nestlé and others, we expect the share of owned and licensed brands in the system to increase noticeably through the end of fiscal 2014 and into 2015. We are attracting new brands, because they see the benefits of our substantial investment in R&D, which will enable new innovative platforms and incremental growth opportunities.

We also believe that license partners will benefit from our holistic system approach, where we designed the brewer, pod, the beverage and the manufacturing lines for the Keurig system to assure the quality taste and safety of every cup brewed. This system approach allows innovation and continuous improvement happen naturally and consistently across our system.

In summary, our hot platform strategy including the transition to 2.0 is playing out as expected and we now see an even greater opportunity for a hot system in the U.S. and Canada.

Before I wrap up, let me touch briefly on three additional topics. Our progress in our away-from-home channel, our progress in moving toward commercializing our Keurig cold system and a little bit on how we are prioritizing our international opportunities, we've achieved to key milestones in are away-from-home channel strategy and execution this quarter.

First, we were able to announce our early success in foodservice with our subway win. We now have a Keurig single-serve solution install it approximately 20,000 Subway locations. Franchisees that have deployed a Keurig solution help the operational ease, cost efficiency, increased beverage freshness incremental choice for consumers and reduce coffee waste as key benefits of the Keurig system.

We believe there are a number of quick-serve restaurants where single served Keurig solution can deliver significant benefit both, both the operators and consumers and we are actively pursuing these opportunities. Also in away-from-home, we officially launched our Keurig both, 64-ounce commercial batch brewing system in late June to more than 20 Keurig authorized distributors with a plan to increase distribution meaningfully this fall.

Our initial target for both his office applications with high-volume brewing requirements that we will also be targeting some foodservice applications for the product going forward as well.

Now turning Keurig cold, we continue to work toward commercializing Keurig cold and we plan introduce the product in fiscal 2015.

As Fran mentioned, we are well into the startup for early charcoal production center in Vermont, where will operate the first pod production lines. Also during the quarter, we closed on the $585,000 square foot site for our first dedicated Keurig cold production facility in Lithia Springs, Georgia.

At this point, we expect to invest more than $300 million in this site over the next five years creating more than 500 new jobs. Meanwhile, we are on track and working closely with Coca-Cola Company to develop and perfect some of their brands for our system. We are also developing and perfecting a variety of our own new brands to be launched in our cold system we are working other potential copartners.

Finally, I will spend a minute on our international strategy and progress. The start of our global expansion began with the launch of a hot system in the U.K. away-from-home channel earlier this year. While we believe there is significant opportunity for both, our hot and cold systems in international geographies. We will be selective and disciplined in pursuing them and we do not expect meaningful contribution from international revenue in the short-term.

I will pass the call back to Fran for the outlook. Fran?

Fran Rathke

Thanks, Brian. AS noted in the press release we provided our outlook for our fiscal fourth quarter and raised our outlook for fiscal year 2014 accordingly.

For the fourth quarter of fiscal year 2014, we expect net sales growth in the high single-digit to low double-digit range. I will note that on a 52-week adjusted basis, we had tough brewer volume and revenue dollar comparisons with brewer volume up 47% and brewer and accessory revenue up, 37% in last year's fourth quarter.

While we don't typically provide gross margin guidance, I would note several things. First, we expect transition costs due to the introduction of our Keurig 2.0 system and the addition of new brands to the system.

Second, the benefit from lower coffee in Q4 will be less favorable than year-to-date trends. We are 100% contracted on coffee for fiscal year 2014 at approximately 75% locked for fiscal 2015 at higher rates year-over-year. Finally, we will also see commodity cost increases across other portion pack packaging inputs. We have built these factors into our bottom-line outlook.

We expect SG&A to increase year-over-year in our fiscal fourth quarter as we support the G&A to increase year-over-year in our fiscal fourth quarter as we support the launch of Keurig 2.0 and continue to invest in R&D resources behind the launch of Keurig cold in fiscal year 2015. These shorter-term investments in both, gross margin and SG&A are key to delivering long-term sustainable growth in line with our target.

We expect an effective tax rate of 36.5% in the fourth quarter. Please note that last year our Q4 tax rate was 27.8%. We also experienced a below the operating line benefit of $3 million from foreign currency in last year's Q4. Together these are creating a roughly $0.12 headwind in this year's fourth quarter. We estimate fourth quarter non-GAAP earnings per diluted share of $0.68 to 75%. For modeling purposes and estimated weighted average share count on August 5, 2014 would be approximately 165 million shares.

Now for the full-year guidance, we are very pleased to be raising our outlook for the full fiscal year. We continue to expect net sales growth in the high single digits over fiscal year 2013. We estimate non-GAAP earnings per diluted share of $3.71 to $3.78, up from our prior guidance of $3.63 to $3.73, including an annual effective tax rate of approximately 35.6%.

On a currency-neutral basis and excluding the diluted impact from recent equity transactions and absent any additional actions to we may take to offset dilutions underlining earnings per share growth is projected to increase 16% to 18% over the prior year period. This is consistent with our long-term mid-teens earnings per share growth outlook.

We are pleased to be able to meet this target while investing behind the many exciting growth initiatives we have in our pipeline. Given our strong cash flow generation year-to-date, we have narrowed our free cash flow expectation upward for the year to a range $300 million to 350 million from $259 million to $350 million.

Finally, given our near-term investments in our new product platforms, including our Keurig cold production facilities and our business systems investments in SAP, we continue to expect capital investment in the range of $350 million to $400 million.

With that I will pass the call back to Brian to wrap up.

Brian Kelley

Thanks, Fran. In conclusion, we are very pleased with the results we delivered in Q3 and we are excited and optimistic about the growth opportunities that lie ahead. We continue to believe that our unique combination of deep beverage expertise and innovative technology capabilities position us well to address consumers' needs across multiple beverage platforms. Achieve continued success in the marketplace and generate strong returns for shareholders.

Thank you. Operator, we will now take questions from the sell-side analysts.

Question-and-Answer Session

Operator

Thank you, sir. (Operator Instructions) Our first question comes from Bill Chappell with SunTrust Robinson Humphrey. Please go ahead, sir.

Bill Chappell - SunTrust Robinson Humphrey

Thanks. A housekeeping question and then a "real question" On housekeeping, I just want to make sure look at the full year guidance the right way. If I look at your 2Q release and 3Q release. It looks like you got about a $0.04 benefit from lower Coca-Cola and Lavazza dilution $0.04 and benefit from lower [FX] and about $0.05 benefit from a lower tax rate, so kind of a $0.13 tailwind, but you are raising your guidance by about $0.07 at the midpoint. Am I looking at that the right way?

Then kind of the real question if that is the right way to look at it, on coffee cost Brian, can you just kind of - with the rise of green coffee with every bad player raising coffee prices the only thing that hasn't gone up is K-Cups. What's your kind of long-term thought of or these the prices we want to hold to kind of drive trialed, which was, kind of the prior CEO's view or at some point we need to protect our margins as we move into '15 and beyond?

Brian Kelley

Bill, let me take that second question first. Then we can address your first question, housekeeping question had. Green coffee costs are going up and we have all seen that. We mentioned both in the script and in the press release, how we are locked for this year and for '15. While we don't talk about our pricing strategy, we are going to continue to make sure that we stay competitive in the marketplace. It's a very competitive marketplace, and that we are also rational as we look at it. We are well aware of it and we just don't talk about our pricing strategy.

Fran, you want to address the…

Fran Rathke

Yes. Bill, I just was checking notes quickly. You said $0.04 dilution.

Bill Chappell - SunTrust Robinson Humphrey

I am sorry, if I go back to the second quarter guidance it said it was $0.20 dilution from Coca-Cola and Lavazza. It's now '16. If I was looking at FX, it went from 9 to 5. Then tax I am just kind of guesstimating about $0.05 benefit. It's 13 in total?

Brian Kelley

Bill, I would just say that the $0.07 roll through that we did for the year we think is reasonable given the fact that we are going to invest in the fourth quarter. We are going to continue to invest. We also know that when you look at that operational beep, we really look at the operational beep and we flowed most of that through.

Fran, would add anything?

Fran Rathke

No. I would just say we did about the mid-point of the range by about $0.13, where just to recap about a $0.01 and beat was dilution, $2.00 was foreign exchange, about $0.03 was tax rate and then were flowing through about $0.07 that we beat on this quarter into the year guidance, basically due to operational frameset.

Bill Chappell - SunTrust Robinson Humphrey

Got it. Okay. Thank you.

Fran Rathke

Thanks, Bill.

Operator

Our next question comes from Akshay Jagdale with KeyBanc Capital.

Akshay Jagdale - KeyBanc Capital

Good afternoon.

Brian Kelley

Hi, Akshay.

Akshay Jagdale - KeyBanc Capital

Hi. First question, Brian, you mentioned that you now believe the opportunity for your hot platform is even greater than you previously thought. Can you talk about why that's the case and is that a category growth being higher than previously thought or a combination of category growth and share gains.

Obviously, you are having success with share gains and you have announced some of those new partnerships, but I am curious to know why you are more confident about the hot platform and perhaps you can give us a sense of how much more confident and why.

Brian Kelley

Yes. Thank you, Akshay. I would say, there are a couple of reasons why. First, with the 2.0 launch, we have gotten very, very positive feedback in the consumer test. The home use test we have done. What's critical to the 2.0 system is we wanted it to be able to expand and bring new users into the Keurig system and it's indicated a strong capability to do that.

As I mentioned earlier, we have a 5 to 1 preference rate of home who previously had a traditional brewer and we gave them a Keurig 2.0 and all of a sudden they could get what they wanted. They could get a multi-serve carafe of coffee as well as brewer single-cup, which is really what they are looking for, so I would say that is the primary reason we continue to see the ability to convert more and more coffee households to Keurig.

The second piece we look at is, we look at the ongoing expansion of the installed base and the ability to hold the attachment rate that we have been able to hold throughout the growth of the Keurig system. As we look at the portion pack growth as we bring new previously unlicensed products in and other brands. We are seeing continued success there and we think that bodes well for future growth of the system.

I think those are the two major reasons and we look at our continued ability to win with Keurig and with the pods and that gives us that increased confidence.

Akshay Jagdale - KeyBanc Capital

Does that mean you expect category growth rate to accelerate relative to what we are seeing. A follow-up on the share gains that you alluded to, can you give us a sense of if those are going to be dilutive to margins next year. Then I have one more follow-up.

Brian Kelley

I would say, it doesn't change the acceleration of the growth, but it changes the duration of how long we think we can grow the Keurig system here in North America, because we see that the upside potential of the percent of households that can have a Keurig, we think is higher than we would have previously thought. We have confidence, expectations that we can continue to growth the hot system well into the future. That's how we would look at that.

On the second question, is it do we think it's going to be margin dilutive. Certainly as we launch, we are going to invest behind Keurig 2.0. We have very, very high consumer acceptance with the machine and we are going to invest to make sure we can get it out there to the consumers who don't have Keurig today and get them to experience what we think is the best machine out there in the marketplace.

Early on do we think, we do believe that we will have - we will invest and so while you may say that's slightly dilutive, we believe the investment is wise.

You asked also about specifically about share gains. We have seen unlicensed flatten out and begin to decline. We are seeing our share begin to grow in the Keurig system and we think you will see that accelerate come into the fourth quarter and as we roll into 2015.

Akshay Jagdale - KeyBanc Capital

Just last one, again, on looking into '15. I know you are not ready to give guidance yet, but what's clear to us on the outside is, coffee costs are increasing, so that's a negative. Generally speaking, I think most of investors are assuming that this transition is going to be dilutive and you have already guided to dilution from the Coke deal and investment in the core platform. Can you talk a little bit about what the positive offsets might be just a few buckets that could offset that? I mean, should we still expect in light of some of these headwinds, should we still expect high teens growth rate from your base hot platform in '15? Thanks.

Brian Kelley

Yes. Thanks, again, for that one, Akshay, I think that as we look at it, we are as confident about delivering on the outlook we have as we have been. If you look in that last year, despite the dilution, despite the investments, despite the transitions we were going through, which always caused probably more variability.

We believe that we can continue to deliver like we did this year on our long-term outlook, but specifically to 2015 guidance range, we generally provide that information in the fourth quarter and we will be doing that again then.

Akshay Jagdale - KeyBanc Capital

Thank you. I will get back in line. Thanks a lot.

Operator

We will take our next question from Bryan Spillane with Bank of America Merrill Lynch. Please go ahead.

Bryan Spillane - Bank of America Merrill Lynch

Hi. Good afternoon. Just one question, as you are launching 2.0 this fall, I am just interested in the consumer positioning of the 2.0 versus the 1.0, because if I am hearing it, it sounds like at least early on you are going to be talking more about the carafe and the optionality of the carafe, which is clearly different the 1.0. I guess, my history at least my experience with the 1.0, seemed to had me think that part of what made the 1.0 successful was it was just a 1.0 and it was very simple it did a few things very well.

I guess, if that's true, if you are going to be talking about some of the other attributes, the additional attributes, is there some sort of risk that consumers kind of get confused and don't understand or lose sight of the fact that it still does what the 1.0 does. Then also as you are launching it, a price point differential between the 1.0 and 2.0. I am assuming there is going to be a pretty big price gap.

Brian Kelley

On the first point, consumers told us loud and clear. Anything we do to improve on Keurig has to be simple and 2.0 will be as simple. You put a pod in, you push a button and you get a great cup of coffee or a carafe coffee.

One of the things about the new technology that we have is it actually enables even more simplicity. What we are going to about with the consumer here is that literally they put in the pod and the variety they now have is much greater, a greater variety of brands, a greater variety of sizes. No matter what pod they put in, they put in any shape of the pod we make, they put in any type of pod. All they have to do is then push the button, because the machine does the rest. That's what the technology enables.

Consumers did tell us exactly what you said Bryan, and that is they just want to put a pod in and push a button and that's what we will be able to do. If you look at then, you asked about the marketing and emphasizing simplicity in choice. That's exactly what we are going to be emphasizing. We are going to show that it does everything 1.0 does, with the same Keurig simplicity, plus you have a greater variety of size and brands.

Fran Rathke

This is Fran. In terms of you asked about you anticipate the prices to be significantly higher. I would say we haven't given guidance what exact price points, but we have noted that and we will, you will see, with the more features and benefits. We still have three models out there at the launch to have different price points to allow consumers to select which types of features and designs of the brewers they like and provide attractive price points.

Brian Kelley

Bryan, I would say this on pricing. As Fran said, we know what price points work with consumers - at prices that work with consumers and we know that really well.

Bryan Spillane - Bank of America Merrill Lynch

If I could just follow-up just briefly, in terms of the communication with the consumer, will there be more heavy presence I guess in traditional media like television advertising or are you going to be more trade-heavy in terms of in-store sampling, being in the circular or just trying to get understanding of sort of how you plan on getting the message to consumer.

Brian Kelley

It's going to be a good mix of both, what we consider the air-game and the ground-game. If you look at the media presence, we need to be there in the right markets to ensure that people know and they are aware of the new Keurig. It's important when you run television advertising or any kind of advertising that it's in the right place and it's at the right timing. We know when they are being bought and we know that being on the right time and in the right place is important, but I would say all that said, the ground-game is the most important.

What we do in the store, sampling with consumers in-store, having great displays with our partner retailers making sure we have terrific in-store signage and capability for the consumer to see the benefits and experience the benefits. That's what really drives the sales of the Keurig system. While we have both, we are really focused on excellence in-store.

Bryan Spillane - Bank of America Merrill Lynch

Okay. Thank you.

Brian Kelley

Thank you.

Operator

We will take our next question from Greg McKinley with Dougherty & Company LLC. Please go ahead.

Greg McKinley - Dougherty & Company LLC

Thank you. Good afternoon. Could you talk with us a little bit more about the holiday transition, so you indicated you are going to have three of the 2.0 brewers in the market, but I think you also indicated you will be shipping 1.0 and 2.0. How much of the 1.0 goes away I guess immediately or when does that tail off. I guess, my general thought is we have seen a lot of brewer based growth occur at lower price points, so is it important to maintain a much lower price option in your view as you head to next June, 2.0, it is the 2.0 help you do that or - many still player in this system.

Brian Kelley

Good question, Greg. Thanks. We expect to transition all the 1.0 reservoir brewers to 2.0 within about a year of the launch. We are still evaluating the plans and we haven't announced the plans for the mini brewer model, which is a great model, but a niche model for us. It's a nice model that goes to certain locations, colleagues, returning to university and we will provide that as we get later in the year, but if you look at the broad, broad array of 1.0 brewers, within the year of the launch will be have been replaced by 2.0. Then the mini brewer, we will stay around for a while. It's a unique brewer and we haven't announced yet what we are going to do with that timing wise.

Greg McKinley - Dougherty & Company LLC

Okay. Thank you. Then is there any quantification, you can provide for us in terms of your coffee buying. I know you said you have purchased about 75% of your anticipated next year. Remind us maybe if you could how much of your COGS is coffee and can you tell us how we should expect that to compare against your '14 experienced COGS?

Fran Rathke

Sure Greg. It's Fran. I think, as you said, we have got essentially the first three quarters locked out and each one of those quarters will be at higher coffee input cost than the prior year quarter. I think, in terms of how much coffee contributes to our cost of goods sold, it tends to run depending on the quarter about 16% to 18% of our COGS. Obviously, if it's Q1, where we had heavy brewers it's a little less. For the year, it's been running around that 16% to 18%.

Greg McKinley - Dougherty & Company LLC

Thank you.

Brian Kelley

Thank you.

Suzanne DuLong

Thanks, Greg.

Operator

We will take our next question from Mark Astrachan with Stifel. Please go ahead.

Mark Astrachan - Stifel

Thanks and good afternoon.

Brian Kelley

Hi, Mark.

Mark Astrachan - Stifel

Given it's seems there will be a license manufactures producing 2.0 compatible pods. I am curious if see any legal issues preventing those from getting solved.

Brian Kelley

Mark, let me make sure I understand the question. Legal issues with what hitting the shelves, the other brewers or unlicensed pods?

Mark Astrachan - Stifel

I am saying there will be unlicensed manufacturers who seem to have cracked the code of 2.0, whatever that means, the material with the pods, so my question is do you see any legal issues presenting those products, the 2.0., knockoffs from hitting shelves, the pods, not the brewers.

Brian Kelley

I understand the question. I know there's rumors and speculation and we are not going to comment on those. It's not appropriate for us to comment on that. The 2.0 interactive technology, we are confident that in the proprietary nature, we are confident in its performance and we are confident that the Keurig designed and produced beverages will be the ones that work in Keurig 2.0 brewer.

It's the Keurig 2.0 brewer that allow us to perform consistently, in terms of optimal level, delivering the beverage quality that we want and the consumers demand, so we are not going to comment on the rumors. We have seen them and heard them as well.

We know the market is competitive, but we are very, very confident in the interactive technology we have and we will stick with that.

Mark Astrachan - Stifel

Okay. Then sort of related to that, could you talk about the economics of producing the 2.0 pods like you call out for gross margins and increased portion pack, material cost. Then what about the economics of the new pod manufacturing deals. Inclusive of that, have you paid any fees to secure exclusive arrangements with those that you have done deals with?

Brian Kelley

The pod costs for 2.0 are really not that different versus the current pod cost, so if you think about what we have added, it's a very, very minor addition in terms of a per pod cost in terms of putting something on those pods, so there is not a material difference at all between pods today and pods tomorrow. In terms of fees paid if there were any, would that be included in cost of producing?

Fran Rathke

Mark can you ask the question again?

Mark Astrachan - Stifel

Yes. I am trying to think about if there were any exclusive arrangements that you made with some of these converted unlicensed to licensed partners and if you are paying them for part of that conversion, are you having to expense that as you have incremental costs and not necessarily in the product themselves, but just relating to the cost of producing the 2.0 pods versus the 1.0?

Brian Kelley

I am not sure I understand the question. We are not doing that, but that said we are attracting new brands because they benefits of Keurig 2.0 system and the investment we have made and the innovation platforms that we have going ahead. I am not exactly sure I am answering your question, because we don't do that, so I don't know if you are referring to something else.

Mark Astrachan - Stifel

Okay. Maybe just finally to wrap this up, so what is the increased portion pack material cost that you talked about in the press release?

Fran Rathke

Mark, this is Fran. In terms of the increased portion pack packaging costs, as you know, we have cardboard, cups, lids, all the packaging, the outer box.

Mark Astrachan - Stifel

Got it. Thanks.

Fran Rathke

Thank you.

Brian Kelley

Okay. Thanks, Mark.

Operator

Our next question is from Matt DiFrisco with Buckingham Research Group. Please go ahead

Matt DiFrisco - Buckingham Research Group

Thank you. I wondered if you could help me having to trying to understand better the price realization and now I guess the comment that it is also on the portion packs, some of that negative effect to the gross margin is the incorporating of some of these new brands and these new relationships, I recall always hearing that you are sort of agnostic to the margins as far as the license partner versus the company-owned partner, or company-owned brand, I am wondering does that still hold and I guess the argument spans from, made by some people that licensing is going to over time be a lower margin business and it's a faster growth vehicle, so that was a concern to the long-term margins. What's the offset to the net price realization that you are experiencing now.

I know you are calling it an investment, but is it an investment and it goes away after year-one and you are going to have a stabilization in that or is this an ongoing thing where the growth rate of having the targets of the world and the private label guys if you were to get Walmart or something like that that they would be at lower margins than your incremental sale from running your own company-owned brands?

Brian Kelley

Yes. Thanks for the question. We believe margins are going to stay in healthy ranges given all the moving parts of new and existing brands as we bring them in and to your question, there are a number of levers we have and we always pull those levers in terms of productivity. There is a variety of productivity both, operationally and in revenue productivity in the marketplace, which is always competitive and we expect it to always be competitive, but we believe margins can and will stay in healthy range even with all of the new parts and pieces coming into the system.

Matt DiFrisco - Buckingham Research Group

I guess, if you have the growth rates continue to be faster from the incremental sales given that they are completely new and incremental to your sales, they are Archer Daniels of the world coming on and the BJs of the world. As they get integrated into your system and before they are lapped in their initial year, would it be correct to assume that they are going to be dilutive to gross margin, to the margin itself? Gross profit dollars grow? I am just looking for the offset there. Is there something where the selling doesn't grow as much or I am just trying to see how that stays sort of flat margins?

Brian Kelley

You are making an assumption that we don't talk about and we don't comment on what the margins are of the variety of partners that we bring in? As I said, I will go back to saying, we believe the margins as a portfolio will stay in the healthy range and we have a number of levers, both on the cost side and the revenue side to continue to drive the business.

Fran Rathke

Just to echo Brian, I mean, our mix portion packs varies, it fluctuates quarter-to-quarter whether brand owner portion packs or own brands brining on these new players. It moves around proportionately and I think as Brian said, overall, we feel this will have margins in a healthy range and we will continue to look at levers to continue to drive productivity.

Brian Kelley

I think you also had the perspective that it's not like it's 50% of the system out there. It's a fairly small portion of the system. When we bring them in, we expect to have healthy margins.

Matt DiFrisco - Buckingham Research Group

When you made the comment earlier Fran, about those new business relationships, they are the new brands. They are not necessarily the renewed contracts, whether it's with the Starbucks, but it's the new brands?

Fran Rathke

I think what we have do not disclose the terms and conditions of any of our various partner brand portion pack agreements, but what we can say is, we want to have a healthy ecosystem where both, our partners and we feel really excited about what we all can generate in terms of sales and earnings, so we haven't given out any information as we have any amendments to our agreements.

Matt DiFrisco - Buckingham Research Group

Okay. Last question, just with respect to the Coca-Cola relationship and the three year standstill is that something within your power that is protective of you and you have the power to wipe it away if you felt inclined to?

Brian Kelley

We really don't comment again on terms or agreements. We made public the agreement and I think that can pretty well speak for itself.

Matt DiFrisco - Buckingham Research Group

Okay. Thank you.

Brian Kelley

Thank you.

Operator

Our next question is from Jon Andersen with William Blair & Company

Jon Andersen - William Blair & Company

Good afternoon, everybody.

Brian Kelley

Hi, Jon.

Jon Andersen - William Blair & Company

On 2.0 release and the carafe functionality, what are your expectations in terms of I got to know if the right term is share requirements or share of usage, so when 2.0 goes into a home, do you have an expectation going in, what kind of role the carafe cup is going to play and are there are any margin implications we should be considering there?

Brian Kelley

Well, I will give you a couple of scenarios. One is, when we look at current Keurig households today, our rough estimate and it's not perfect, but our rough estimate is about 75% of the coffee consumption in the home is done by Keurig and other 25% would be done by some other machine and the predominant purposes, the consumer uses the other machine for is higher volume sizes many multiple serves, so we do expect the 2.0 it's certainly our expectation and it played in the use test at home that we get a portion of that 25%.

We will wait and see exactly how it plays out in the market, but our guidance expects a similar consumption rate per brewer. We have assumed a major increase or any increase at all in terms of consumption, but we expect that could come if the carafe does well.

Jon Andersen - William Blair & Company

Great. That's helpful. I am going to try and come at this maybe one more time. The 2015 outlook, I know, you are not commenting on it today, per say, I think a couple of quarters ago, you did talk a little bit about some of the investments in '15 driving more of a mid-single digit EPS growth outlook. Then maybe returning to kind of the long-term algorithm thereafter? Have any of the assumptions regarding those investments some of the transition costs like the Coke dilution, investments in the cold platform. Have any of those changed materially?

Brian Kelley

I will just say again, we provide that information in the fourth quarter and we will be doing so again at that time. That’s the best way to comment. We are just not going to provide 2015 guidance.

Jon Andersen - William Blair & Company

That's fine. Last question on cold more broadly and I apologize if this has already come up. Is there any more color around kind of where you are in the process in terms of previewing that retail customers and maybe a rollout timeframe for next year?

Brian Kelley

We have really said what we want to say about it. We planned to launch it in fiscal 2015. We don't think it's wise to talk yet about what are plans are or any more specifics, some we have already given.

Jon Andersen - William Blair & Company

Okay. Thanks, everyone.

Fran Rathke

Thanks, Jon.

Operator

Our next question is from Scott Van Winkle with Canaccord Genuity. Please go ahead.

Scott Van Winkle - Canaccord Genuity

Hi. Thanks. Good evening.

Fran Rathke

Hi, Scott.

Scott Van Winkle - Canaccord Genuity

Following-up on an earlier question about green coffee, I think, Fran you said the 16%, 18% of your cost of goods sold were green coffee and you mentioned green coffee about 75% commitment there is contract next year was higher this year. Could you give us a magnitude of where that commitment is relative to your average cost in fiscal '14?

Fran Rathke

No. We haven't provided that quantification.

Scott Van Winkle - Canaccord Genuity

Can we get a nudge small, high, middle? Anything you could..

Fran Rathke

I mean, I think that you can look at sort of where the sea price was as we say we tend to lock six months out to even sometimes go a little farther out even 12 months or some types, so I guess you could look at go to sea market and see how that's been tracing over the last 12 months just to get a sense of that.

Scott Van Winkle - Canaccord Genuity

Okay. Great. Then, on the launch of 2.0, you said there was going to be 2.0 and 1.0 brewers being sold with - I think, last year you shipped a little over 5 million brewers. Let's just say a number like that a little bit bigger. Does that mean that $2 million or 2.0 and $3 million to $4 million are 1.0, is it $3 million or $4 million or 1.0? I am wondering about the mix. How fast this switchover occurs.

Brian Kelley

Well, we haven't given that information and really we are not going to be honest. We have a great launch planned for 2.0, and we know that 2.0 launch can do a lot to bring new households into the Keurig family and we think that's the most important thing we can do. As we look across the country, there is still a number of markets where the penetration, the household penetration of Keurig is still very low relative to where we are in New England.

We mentioned that we began shipping last week or shipping to customers 2.0 was out there. We are very, very excited about what's going on. We know that in the next year as we convert to 1.0 to 2.0, we don't want to try to predict exactly machines of each will sell.

We want the consumer to buy both, but 2.0 will be the focus of virtually everything we do from a marketing standpoint.

Scott Van Winkle - Canaccord Genuity

Great. You talked about some investment obviously in the gross margin with the samples and - is there a level where the economics start to look like 1.0 from the standpoint of gross margin, when you get to the point where you got a run rate of 10 million brewers or something of that nature. 5 million brewers with the economics start to look like 1.0?

Brian Kelley

I wouldn't give you an exact timing, but I would say over time they do begin to approach just like 1.0. Any new platform you start off with investment costs and then the cost curve comes down a bit and you come down the cost curve and they will look very similar to 1.0. I wouldn't give the exact date as you when that will occur over time.

Scott Van Winkle - Canaccord Genuity

Thank you very much.

Brian Kelley

Sure.

Operator

Our next question is from Phil Terpolilli with Longbow Research. Please go ahead.

Phil Terpolilli - Longbow Research

Good afternoon.

Brian Kelley

Hi, Phil. Just one quick question on K-carafes, we talked about it earlier and it was help for the attachment rate. Kind of how you size that up, but from a pricing aspect, any detail you can give us there in terms of what price points to look like. I am just trying to think about 25%, bucket that the consumer home is using a regular drip coffeemaker. Obviously, huge price differential, so will it be a dilutive effect to you or how does the consumer think about it?

Brian Kelley

The consumer will see a value versus the cost of buying four cups. We will see healthy margin and as well as retailers, so that's the way I would sum it up.

Phil Terpolilli - Longbow Research

The margins, would they be similar to the single packs that you have now or it will be dilutive?

Brian Kelley

I would say they will be healthy margins.

Phil Terpolilli - Longbow Research

Okay. Great. Then just one follow-up if I could. I am just trying to make sure understand the top-line guidance for 4Q and kind of looking forward the high single low double digits, maybe just real simple terms that help me to understand what we are thinking about that, what’s related the timing of shipments that you mentioned earlier versus how much is maybe unlicensed wins. I am just trying to think about it as we think about modeling early '15. Thanks

Brian Kelley

We said this throughout the year, but as we look at shipping neary10 billion portion packs in a year, a $2 billion in a quarter, it’s not simple to be predictive as to when those shipments fall quarter-by-quarter, particularly when you are going through a transition, where we are converting pods to 2.0 pods, so we are confident as we said in the total year number. We have been throughout the year, we continue to be and what shifts quarter to quarter, we are concerned about making sure of the totality of the system is delivering, it’s growing, we look at point of sale, we look at therefore at the consumption of pods which are growing at a healthy rate and consistently.

We look at the installed based growth and we know the shipments are going to flow a bit quarter-to-quarter and they are not perfectly predicted, but we are very happy on the progress that we are making adding new brands and that's what gives us the confidence and the ability of our own brands to continue to grow that’s what give us the confidence in both, the fourth quarter end on going.

Phil Terpolilli - Longbow Research

Thank you.

Fran Rathke

Thanks, Phil.

Operator

Next we have Chuck Cerankosky with Northcoast Research. Please go ahead.

Brian Kelley

Hi, Chuck.

Chuck Cerankosky - Northcoast Research

Hi, there. A quick question about the mix from the consumers' point of view. You mentioned the mix has been affected as result of some of the licensing agreements. How about what the consumer is buying in terms of the price point per cup they have been treating up or down to in the most recent quarter?

Brian Kelley

I think you could look at any of the publicly available data that could show you the prices on K-Cups. It's pretty clear out there. It's a wide range of price point. It's a very competitive market. There is pods that sell some 20% to 25% lower from the top to the bottom of the portfolio and in the total system.

I look at in total, the pod, we think it’s healthy, we think the pricing is healthy. We have seen some decline in pricing not significant and we continue to expect that the value we offer with pods is good and we think there will continue to be a variety of price points with the different variety of brands in the portfolio, both ours and not ours.

Chuck Cerankosky - Northcoast Research

Brian, what I was try to get at, with some of the price points coming down at various brands is, that inducing the customers to trade up perhaps towards higher perceived quality levels?

Brian Kelley

We are seeing growth at the high end of the line, we are seeing growth in the middle, we are seeing growth in the lowest prices as well, but really the growth is about do you have a great brand, does it taste great to consumers, can they drink it every morning, do they love the beverage is a consistent and the brands that have that and deliver that are the brands that continue to grow.

A brand might get trial if it lowers its prices, but ultimately what drives repeat and loyalty is a great testing cup of coffee every day. That’s we have learned is what drives the growth of a brand in our system. That’s what we are focused and that’s what I would say that's occurring at the highest and the mid-end and the low-end of the price ranges that is offered out there.

Chuck Cerankosky - Northcoast Research

All right. Thank you

Brian Kelley

Thank you.

Operator

Our next question is from Marc Riddick with Williams Capital.

Marc Riddick - Williams Capital

Hi. Good evening, everyone.

Brian Kelley

Hi Marc

Chuck Cerankosky - Northcoast Research

I just want you to ask on the branding of 2.0 as we approach the coming month and into the holiday season. I wanted to get the sense of whether now we should expect to see maybe some co-branding opportunities with your partners. Then I have a follow-up after that.

Brian Kelley

You mean our current partners that we have on the appliance side? Do you mean, our brand partners in beverages or in coffees or our partners…

Marc Riddick - Williams Capital

The brand partners and beverages. Correct.

Brian Kelley

You will see work that we do with them and that they do on their own and that we do on our own to drive the combination of our system and their brand and we work with many of the brands of our beverage partners to drive that are large brand and some small brand as well, so you will continue to see that in 2.0, yes

Marc Riddick - Williams Capital

Okay. Excellent. Then the other thing is, I guess my traditional asking of where we are with Eight O’Clock coffee and distribution throughout the country? Thank you very much.

Brian Kelley

You are predictable and we like that. Eight O’Clock continues to perform very well in the Keurig system across multiple channels. If we look at IRI and the latest 12 weeks if you look the last quarter, it's growing well both, in dollar and units, so we continue to see distribution gains in the Eight O’Clock coffee brand and we continue to see success across all of our Keurig brew brands, but Eight O’Clock is certainly one of them is growing well

Marc Riddick - Williams Capital

Thank you very much

Brian Kelley

Thank you

Operator

This does conclude our question-and-answer session. At this time, I would like to turn the conference back over to our speakers for any additional closing remarks.

Brian Kelley

Well, thank you all. I would just like to thank you for joining us today and for our continued support of our company. Thank you very much.

Operator

As a reminder, that does conclude today's conference. We appreciate your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!