Rough Day For Coffee Holding; Should Green Mountain Investors Worry?

Includes: CBOU, GMCR, JVA
by: Ian Bezek

Coffee Holding Co. (NASDAQ:JVA) plunged 13% Wednesday following an odd sequence in which material information was leaked to the marketplace, resulting in the company deciding to pre-announce sales information for the three months ending July 31. The results were much less than what investors had been anticipating, leading to sharp sustained selling. From the company's unusual 8-K, we find:

On August 30, 2011, Coffee Holding Co., Inc. (“Coffee” or the “Company) became aware that there is certain information in the marketplace regarding its operating results for the three months ended July 31, 2011. As a result, the Company is providing certain preliminary financial information about its sales and cost of sales for the three months ended July 31, 2011. The Company’s sales for the three months ended July 31, 2011 are expected to be approximately $35.7 million and the Company’s costs of sales for the period ended July 31, 2011 are expected to be approximately $33.6 million or 94.2% of net sales. The increase in cost of sales reflects the increased cost of green coffee.

In the same quarter of 2008, Coffee Holding's cost of sales only made up 88.6% of net sales. As such, their gross margin has been cut in half, from 11.4% to 5.8%. As the company explained, and I warned back in July and I reiterated Wednesday, the cost of green coffee is on the rise, thus forcing margin compression across the coffee industry.

Up until now, it has been a bit of a guessing game to try to figure out who the winners and losers would be. For now, it appears Coffee Holding is a loser, as its margins have been squeezed to the point that the company is only marginally profitable. The company earned 86% of its profits from hedging in the first half of 2011. With the hedge book perhaps running out of profits and the core business struggling, it seems that Coffee Holdings' shares remain overvalued despite Wednesday's decline.

The bigger question at this point is whether Coffee Holding's fall will cause aftershocks in other industry players. The most logical candidate here is Green Mountain (NASDAQ:GMCR), since Green Mountain represents 47% of Coffee Holding's revenue. With Coffee Holding seeing its margins get badly compressed, it is only logical that Coffee Holding would try to pass through a price increase to its largest customer.

From Green Mountain's perspective, a potential price hike from Coffee Holding in itself would not be a major event. Coffee Holding only represents ~3% of Green Mountain's own cost of goods sold figure per quarter. Even if Coffee Holding successfully hikes prices, that event won't singularly hurt Green Mountain's results too badly. However, we have to expect that many of Green Mountain's other suppliers are facing similar margin compression.

If Coffee Holding's gross margin decline from 11% to 6% is representative of what other suppliers' margins look like, Green Mountain will almost certainly be facing higher input costs in coming quarters. While Coffee Holdings has substantial liquidity resources available to it due to its high share price (such as the $100 million placement currently in progress), Green Mountain's other suppliers may not be so fortunate, and be forced to increase prices to merely ensure their survival.

In addition, the coffee bean market currently appears to be a sellers' market. Not only is the price of coffee (Coffee 'C' futures) in general rising, but there is a growing shortage of high-quality of Arabica beans. This appears to be a problem that particularly impacts Green Mountain. From their latest annual report, we find this risk factor:

Because an increasing amount of our supply of Arabica coffee beans comes from specifically identified specialty farms, estates, and cooperatives, we are more dependent upon a limited number of suppliers than some of our competitors [...] Any deterioration of our relationship with these suppliers, or problems experienced by these suppliers, could lead to inventory shortages. In such case, we may not be able to fulfill the demand of existing customers, supply new customers, or expand other channels of distribution. A raw material shortage could result in decreased revenue or could impair our ability to maintain or expand our business.

As you can see, Green Mountain appears to be a very weak bargaining position with its suppliers. It is more reliant on its suppliers than its competitors, and any shortage could impair the company's ability to maintain and expand its business. With margins falling for Coffee Holding, and presumably other Green Mountain suppliers, we should expect that Green Mountain will be faced with price increases in the near future on their raw supplies.

While Coffee Holding appears to be the loser in the coffee margin compression cycle to this point, I think those struggles may well spread to Green Mountain, and to a lesser degree, other end customers. Thus, I am forced to change my relative outlook within the coffee sector. In an article published before the market open Wednesday, I stated that I was looking to short Coffee Holdings and Caribou Coffee (NASDAQ:CBOU) in the next 72 hours. But, given that I missed the decline in Coffee Holding and that Caribou is seemingly less impacted by potential supplier issues than Green Mountain, I have switched my focus. It now seems that Green Mountain is the most interesting short within the coffee sector as margin compression looms.

Disclosure: I am short GMCR.

Additional disclosure: I may also short JVA, if it bounces, within the next 72 hours.