Keurig Brewer Sales Continue To Slide And K-Cup Sales Have Now Followed Suit

| About: Keurig Green (GMCR)

Summary

Brewer sales fall for a 4th consecutive quarter.

Away-from-home impact on YOY results proves noteworthy.

At-home K-cup business remains strong, but profit margins for the segment weaken further.

Keurig revises full-year guidance to show declines on top and bottom line.

Unfortunately for many investors of Keurig Green Mountain (NASDAQ:GMCR), the company's most recent quarterly results did not prove to stabilize the stock performance. Going into last week's Q3 2015 reporting cycle, shares of GMCR were already down nearly 40% year-to-date. Once the company released its 3rd quarter results, the situation worsened for investors of record as the stock dove another 30% in the after hours trading session. Naturally, as a swing trader I look for these specific volatile situations to take advantage of a possible bottom feeding frenzy as indicated in the table below taken from my Scottrade account. After purchasing shares for $52.80 a share, I was able to flip 430 shares out at $54.90 with a strong profit...but I digress. So let's look at why investors bailed on the company post-3rd quarter results.

 

8/6/2015

8/11/2015

GMCR

SOLD 430 SHARES OF GMCR AT $54.90

($7.48)

$0.00

$23,599.52

Yes

 

8/5/2015

8/10/2015

GMCR

BOUGHT 430 SHARES OF GMCR AT $52.80

($7.00)

$0.00

($22,703.19)

No

The company entered the 3rd quarter having reported 3 consecutive quarterly declines in brewer shipments. In the 3rd quarter the trend remained in place as the company witnessed brewer shipments decline by another 18% during the quarter. Brewer net price realization declined 6% as the company had higher promotional levels in an effort to clear inventory and in contrast to analysts notes disseminated from Keybanc's Akshay Jagdale. Given these factors surrounding declining brewer sales the company took a charge of $18mm during the quarter.

I have issued the most prominent and accurate forecast for Keurig brewer sales to Seeking Alpha readers since the introduction of the Keurig 2.0 brewers late in 2014. So with that in mind, readers can utilize the Seeking Alpha platform to review my articles with great detail. Having said that, I will reiterate that the writing has long since been "on the wall" with regards to pending and now real declines in brewer sales for Keurig Green Mountain. As early as February of this year, I warned investors and readers of what Capital Ladder Advisory Group (for whom I am employed) was seeing in the point-of-sale data for Keurig 2.0 brewers. I offered the following statement upon receiving the data here on Seeking Alpha and for investors to consider.

Return rates remain at elevated levels when compared to predecessor Keurig hot beverage brewer systems.

Only now in the 3rd quarter have analysts considered this issue in their forecasts and models for earnings and revenues. The following question was issued to Brian Kelley, Keurig Green Mountain's CEO on the Q3 2015 Conference Call:

And I guess related to that, one of the things that we had heard through the quarter is that returns have been a little bit abnormally high on the 2.0, and I see that in the balance sheet or on the cash flow statement, the reserve for returns has gone up. So, if you could talk at all about whether or not there has been sort of an higher than normal level of returns on the 2.0.

Keurig's CEO Brian Kelley answered the question directly.

On the second question, we have seen higher returns on 2.0."

It is unfortunate that some analysts do not have access to all the necessary sales data in order to assess the company's fundamentals quarter-to-quarter. This may be one of the reasons most analysts covering shares of Keurig Green Mountain has found themselves reducing their respective rating and stock price target on the company in the last 3 months.

With all that being better understood and with brewer shipment volumes still on the decline, the company has continued to grow its user base. As of the most recent quarterly release, the company believes they will grow its user base by roughly 10% in fiscal 2015. This will leave the company with between 22 and 23 million users in North America by year-end. I will discuss how the company plans to achieve this feat in another article, outlining the tools the company has in its arsenal to deliver on this forecast that has been adjusted twice already this year. CEO Brian Kelley believes the company can eventually achieve a user base of 50 million households.

Overall, net sales declined for the company 5% in Q3 2015 versus the same period a year ago. The decline was due to slower than expected installed base growth and increased competitive activity in pods. Pod revenue declined 1% while volume increased 5% with three percentage points of pricing offset by eight percentage points of negative mix, and a roughly one-percentage point unfavorable impact from currency. Keurig had already outlined in its previous forecast that they still expected a challenging environment for brewer sales in the Q3 period. What was not expected from many investors was a decline in K-cup sales also. I'm not sure why this wasn't expected from many, but I will outline why I did very much expect a significant headwind for K-cup sales in the Q3 period and how I had forewarned investors of this concern.

In recognizing the company's decline for K-cup sales, it is important to recognize that the at-home pod volumes increased 12% in the quarter, while the away-from-home volumes declined in the mid-20 percent range. In addition to the volumes, mix was slightly worse than expected driven by weakness in Keurig's digital channel and lower share performance of the company's own Keurig brand K-cups. Pricing was also below company forecast due to higher than planned competitive activity. If we break down results regionally for the quarter, the U.S. business revenue declined 4%, while the Canadian business declined 14 percent. Excluding the impact of currency, the Canadian business declined 3% for the quarter. Let's try to clean this up a little bit to put the K-cup declines into laymen's terms.

Keurig's most basic problem for K-cup sales presently is the extreme number of licensed K-cups in the system and how each brand partnership is fighting for both retail space and consumer purchase. In the previous quarter, K-cup profit margins were negatively impacted by the broad launch of the MyCafe K-cup, even though the distribution of the MyCafe K-cup improved volumes.

The success of McCafé in the quarter had a larger than expected impact on volumes. In addition to volumes, mix was worse than expected driven by weakness in our digital channel that Brian referenced earlier, strong promotions by some of our partner brands and lower levels of innovation on our own brands.

The same issue impacted both volumes and margin mix for K-cup sales during the 3rd quarter. Take for example Dunkin Donuts (NASDAQ:DNKN) K-cups, which only recently launched in 1000s of retail locations nationwide. At Target (NYSE:TGT) stores, these licensed K-cups were featured in a prime retail location at the end of the coffee aisle on an end-cap for consumers to not only grab quickly, but purchase at a promotional price point. For those consumers who did grab these Dunkin Donut K-cups, they didn't likely even go down the coffee aisle as they didn't have to. This creates an issue for all other K-cups located down the coffee aisle during the period and at this particular retailer. Additionally, such promotional pricing activity breads additional promotional pricing activity, which continues to perpetuate itself due to all brands desiring to capture share in the single-serve K-cup market.

Moreover, as Keurig Green Mountain has gained more unlicensed brands, other pod manufacturers have excess capacity, which has led them to respond with more aggressive pricing. Additionally, some branded partners have remained promotional. During the third quarter, the challenges were greater than anticipated and impacted pod volumes as has been recognized by Keurig Green Mountain.

As noted earlier, the away-from-home K-cup business suffered greatly during the quarter and when compared to the same period a year ago. Way back in the beginning of the year I had forewarned of this problem and the timing that investors might very well be impacted by K-cup sales faltering.

If the company is offering a tough Q2 comparison as being a headwind for brewer sales, I'm not sure it gets any easier for them as Q3 brought with it a few major pipeline builds including last year's Hilton Hotels and Subway partnerships. The away-from-home pipeline builds modestly helped the company grow brewer sales last year, but they will be of greater importance to the company this year as their at-home brewer business is in decline. (FY14 only grew brewer shipments by 600,000.) Not oddly enough, if you are carefully listening to the company's quarterly outline of the state of the business, it made no mention of the away-from-home business or the international business on the latest conference call.

Investors should always keep in mind, when investing in a consumer packaged goods company, one must always consider major pipeline builds that occurred in the previous year. Often, if not always, pipeline builds are in excess of consumer takeaway (pipeline builds force distributor to purchase more inventory than consumers usually purchase in order to have enough inventory to restock). Unfortunately in the case of Keurig Green Mountain, Hilton Hotels and Subway did not see the takeaway/consumption activity that would force the two Keurig distributors to reorder in a manner that equaled the original purchase orders from the Q3 period a year ago. In addition to this variable, the company did not achieve similar distributor accounts for the away-from-home division to supplement smaller orders from the two aforementioned distributors. With no press releases concerning new distribution partners for the Keurig away-from-home business during the quarter, investors would have been wise to include this variable in their quarterly forecast and/or expectations. With this in mind, investors would be wise to remember the pipeline builds for K-cups in Q2 with MyCafe and Q3 with Dunkin Donuts K-cups. After the launch of these two licensed brands this year, it is unlikely that retailers will reorder to the degree they ordered during the launch period. And with regards to Dunkin Donut K-cup sales specifically, I would suggest there will be no possibility of retailers reordering anywhere near the original strength of the launch period given that Dunkin Donuts struggles to deliver on expected sales for K-cups in their own stores as noted by Keruig's outgoing CFO Fran Rathke during the Q2 2015 Conference Call:

This was due to softer than expected performance in certain channel such as specialty and digital along with Dunkin Donuts store sales performing below our expectations.

Now that investors and readers have a more defined understanding of exactly what went wrong with K-cup sales during the Q3 period and how brewer sales declines continue to impact top and bottom line results, let's briefly look at gross profits. For the quarter, Keurig Green Mountain's gross margin declined 750 basis points to 36% of net sales. Excluding the $18 million charge related to lower than anticipated sales of 2.0 brewers, gross margin declined 560 basis points. The decline was largely driven by higher obsolescence, higher coffee cost, negative brewer mix, as the company sold a greater percentage of 2.0 brewers and higher logistics cost. Keurig also experienced negative pod mix and negative price realization on brewers, where they executed higher promotions in an effort to lower inventory levels from retail partners.

For the 3rd quarter of 2015, Keurig Green Mountain reported Non-GAAP EPS of $0.80 that includes a negative $0.02 impact from foreign exchange, and a negative $0.08 impact related to the brewer write-down. Excluding the impact of foreign exchange and the brewer write-down, non-GAAP EPS was $0.90 a share.

Moreover, for the 4th quarter of 2015, the company expects net sales decline in the low teens and non-GAAP EPS of $0.70 to $0.75 per share. Keurig Green Mountain expects the 4th quarter revenue to be impacted by several factors. The prior year 4th quarter included approximately four-percentage-point benefit from retailers buying ahead of the fiscal year end SAP implementation and a two percentage point negative impact of the reserve for the MINI recall, netting two points of difficult comparison. Additionally, the company expects negative brewer shipment growth year-over-year of approximately 20 percent. Pod volumes will be affected by the impact of lower brewer sales on the installed base, continuing elevated competitive activity, particularly in the away-from-home channel, as well as a difficult comparison against SAP advanced ordering impact in the prior year. The company only expects minimal sales contribution from Keurig KOLD in the 4th quarter. And lastly, Keurig expects foreign exchange to negatively impact total revenue growth by approximately two percentage points.

For fiscal 2015, Keurig now expects a net sales decline of low single-digit to mid single-digits relative to fiscal 2014. Previous guidance called for flat to low single-digit growth for net sales. Once again, the company is revising non-GAAP EPS guidance to a low-teens decline. Previous guidance called for non-GAAP EPS to decline mid single-digits. This EPS guidance embeds a tax rate of 34.5% to 35% and includes an estimated $0.13 negative impact from foreign currency exchange rates. This guidance excludes any restructuring and one-time charges related to the company's productivity initiative. Additionally, the current EPS guidance takes into account KOLD investments of slightly over $100 million in fiscal 2015. With regards to free cash flow, the company now expects free cash flow in the range of $150 million to $200 million and capital investment in the range of $400 million to $450 million. Keurig Green Mountain Board of Directors has authorized a new share repurchase authorization for an additional $1 billion for a total available authorization of nearly $1.3 billion.

I continue to monitor developments in the Keurig Green Mountain business in recognition with its long-term prospects and hurdles for which the company must overcome in order to deliver on shareholder expectations. Presently, my forecast shows a return to brewer shipment growth in the Q1 2016 period with K-cup sales also showing growth in this period. Having said that, my model also includes lower gross margins for this period and yet another hurdle the company must overcome during the next 12-month period. As I have been highly critical of Keurig's executive decisions over the previous 12-month period, I do not see the decision making process of management improving. The limiting capabilities of the Keurig 2.0 platform, the removal of the My K-cup application and the development of the Keurig Kold platform have all been accurately and logically analyzed in my articles and research reports. The company is only now, adjusting to the shortcomings from management's poor decision-making processes. With that said and as I have outlined in my most recent Coca-Cola (NYSE:KO) related article, if Keurig Green Mountain does not improve its pricing model for the Keurig Kold platform, this product development has the potential to cost the company hundreds of millions in write-downs. With that being said, I would offer to readers and investors that the pricing for Keurig Kold products, in my opinion, does not exhibit the ability to be improved upon but modestly and without meaningful impact to consumer purchase intent. For the great many analysts and investors suggesting that the pricing for these products can be brought down in some meaningful way I would pose a couple of questions. What company sets out to manufacture a product that quadruples the price for a cold beverage at home and for only an 8oz. serving per brew when compared to grabbing the same cold beverage out of the refrigerator if they could avoid doing so? What company spends 5 years developing a small appliance system designated for mass-market adoption in the price range ($300-$369) where no such small appliance exists in that price change for mass-market adoption if they can avoid doing so? The answers to these two questions is likely quite simple; the company has no choice and this is what it costs based on the technology needed to produce the products. Nothing more than pure logic.

For investors who desire to hear some additional thoughts and insights regarding the most recent quarterly results and my forecast going forward on Keurig Green Mountain's business, tune into my interview with Vermont Public Radio (VPR.net) this Monday at 12:00P.M. EST where I will be answering questions directly and disseminating some additional points of consideration.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in GMCR over 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.

Additional disclosure: I have acquired information and documentation regarding Keurig Green Mountains Kold development and am presently discussing with litigating parties.

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Tagged: , Processed & Packaged Goods, Earnings
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