Will Your Coffee Stock Get Roasted?

by: Bill Maurer

Shares of Green Mountain Coffee Roasters (NASDAQ:GMCR) have settled in nicely around the $50 range. This level is well above the $40 and below number the stock hit after its post-earnings drop. Green Mountain remains a heavily shorted name, with over 27 million shares short as of November 15th. With a float of just 121 million shares, that's quite a big short position.

Now could be the time to short this recent rally. But if you don't want to take the risk, why not look at some other names? There is a definite possibility that names like Starbucks (NASDAQ:SBUX), Dunkin Brands (NASDAQ:DNKN), Peet's (NASDAQ:PEET) or Farmer Brothers (NASDAQ:FARM) are better values.

Green Mountain has several headwinds currently preventing the stock from returning to those lofty, $100 plus levels we saw earlier this year. First, the recent quarterly report showed revenue growth was well below what analysts had expected. If the growth isn't there, why buy the name? The number was even scarier when the shorts remind you that some of their patents come off expiration in 2012, meaning that competition could surely increase. If revenues are struggling now, it could only get worse with more players in the market.

The second issue is accounting. They have been under investigation by the SEC for improper accounting, which has kept many potential investors on the sidelines. It doesn't appear that there is pure fraud going on there, but if some of their practices are at least a little bit questionable, you don't want to be a shareholder.

The third issue is cash flow. Green Mountain has barely any cash on their balance sheet, which they have been noted for historically. They have also been flagged for heavy capital expenditures in the past, and their need for future capex has raised questions as to where they will get the money from. A debt or equity offering seems rather likely at this point.

Now, nobody can question GMCR's growth potential. Just look at the following:

FY 2011 Revenues 95.38% 11.10% 11.70% 9.06% N/A
FY 2012 Revenues 60.00% 10.40% 9.80% 4.00% 4.90%
FY 2011 EPS 113.00% 23.58% 12.78% N/A N/A
FY 2012 EPS 57.32% 20.39% 18.67% 385.71% 35.00%

*Numbers are actual for 2011. GMCR and SBUX fiscal years end in September, FARM fiscal year ends in June.

Now GMCR has the highest revenue growth still going, but it will slow down as time goes on. EPS growth is also substantially above the rest of the industry. I don't count Farmer's numbers as legit because they go from zero to 14 cents to 68 cents. It is higher percentage wise, but the base level is low so that throws it off a bit.

Now Green Mountain is projected to have its first billion dollar revenue quarter this quarter, and it will need to at least come in-line with those expectations. Despite the company's ability to beat or be in-line on the bottom line, revenue growth is the key driver here. Last quarter's EPS number only missed by a penny, which was quite impressive considering the huge revenue miss. Analysts have trimmed fiscal 2012 and 2013 estimates for the company, but only by 3 cents for 2012 (23 cents for 2013). Net Income is not a problem for the company. The question is what is GMCR worth with this potential explosive growth?

P/E (Trailing) 40.02 26.84 41.99 N/A 42.31
P/E (Forward) 14.40 19.67 32.65 11.44 21.44
Price/Sales 2.85 2.69 1.98 0.23 4.96
Price/Book 3.95 7.17 4.39 0.90 4.12
PEG Ratio 0.61 1.32 1.93 N/A 1.83
EV/Sales 3.07 2.56 1.95 0.27 7.11
EV/EBITDA 16.51 14.25 13.93 -6.21 17.19

Green Mountain's valuation varies widely, depending on the metric being used. It is cheapest on the PEG ratio and nicely priced on the forward P/E. But then it is the second most expensive on enterprise value to EBITDA, and its valuation to sales ratios are near the upper end. Analysts still seem to like Green Mountain over the others, but for many, including myself, Starbucks is the name to be long right now. It has the lowest trailing P/E, and that is the valuation metric that most will look to first. I can't ignore that fact, even with the recent tremendous drop.

I think this current price is a tremendous opportunity, but only if those headwinds I mentioned before can be overcome. If the company doesn't get those issues revolved, then I see this as a great short opportunity. I currently have the name in my model short portfolio, only because of the huge bounce recently. If Green Mountain can keep its margins where they are, they are poised for good times ahead. Here's how those margins stand over the past year.

Gross Margin 34.13% 57.70% 20.65% 32.10% 80.27%
Operating Margin 14.32% 13.27% 9.03% -11.17% 32.68%
Net Margin 7.53% 10.65% 5.13% -10.92% 1.25%

Green Mountain will look for improvement on those margins, and they have improved over the last few years. You won't see them touch the gross margin numbers of Starbucks or Dunkin, but it's possible for them to get to 40% eventually. They could easily double that net margin in the next two years. But again, it will all depend on 2012. If they can't protect those expiring patents, increased competition will take a bite out of their margins.

Overall, Green Mountain has great growth potential ahead of it, but the company faces several hurdles that it needs to clear. The company's levered free cash flow over the past 12 months is a negative $341 million, and we've seen recently how companies with bad cash flow have fallen apart. Take Netflix for example (NASDAQ:NFLX).

Green Mountain has been one of the most controversial stocks this year, and I don't see that changing anytime in the near future. I initially disagreed with David Einhorn, but he's been right so far on stock price movement. In the long term, Green Mountain's growth could propel this stock back into the triple digits, but if they don't clear some major obstacles, they will get roasted.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.