Green Mountain Coffee Roasters (GMCR) was founded in 1981 as a small café in rural Vermont, where it roasted and brewed premium coffee. Eventually, the company began selling coffee wholesale to local supermarkets, restaurants, and specialty shops. It wasn’t until 1998 that the company’s path crossed with Keurig, which had developed a single-cup brewing machine and K-cup that went along with it. This bit of coffee ingenuity allowed anyone to brew the perfect cup of Joe in around 60 seconds. From there, customers lined up around the block, so to speak, to get their hands on this marvelous invention. Green Mountain’s sales exploded, and so did its stock price. From 2006 to the end of 2011, GMCR’s stock price grew more than 1,400%.
The business model is simple. Sell the coffee brewing machines at near-break-even prices, and make your money on the expensive K-cups that customers then have to purchase for the life of the machine. Moreover, all the major brands readily signed on to get a piece of the action; Dunkin Donuts (DNKN), Folgers, Caribou (CBOU), and even the elephant in the room, Starbucks (SBUX) inked a deal in March, 2011. In addition, Green Mountain sells its own eponymous brand of Coffee, along with a number of other in-house brands that it acquired over the years.
And for a while there was no stopping Green Mountain Coffee Roasters’ upward tear, as everyone talked about the company’s seemingly monumental growth potential relative to the overall size of the U.S. coffee market, and all of the expansion possibilities that came along with the Starbucks deal. However, in September, 2011 the stock stumbled, and the beginning of its steep descent had begun. A number of reasons were behind the stock’s decline and we’ll explore a few of them here. First, the stock’s lofty multiple, over 30 at the time, did not leave any margin for error. The expectations were simply too high and relevant competitive forces, as well as possible internal missteps were not taken into account. A major concern for investors was, and still is, the expiration of the K-cup patent, that Green Mountain currently holds through September, 2012. After that date, anyone will be able to manufacture their own K-cups without having to pay Green Mountain a fee, and advertise them as compatible with the Keurig brewing system. Starbucks has said that it will retain its partnership with GMCR, but a few months ago it introduced its own Starbucks branded home-brewing machine called Verisimo.
Other concerns have surfaced around the company’s aggressive capital spending budget this year, estimated at over $500 million. So the question is, why is Green Mountain Coffee spending over half a billion dollars to expand its operations in the face of intensifying competition and slower sales growth? The credibility of the company’s management and accounting practices have also been called into question, not only by investors, but by the SEC as well (there has been an ongoing SEC investigation into GMCR’s revenue recognition methods since September of last year).
As of this writing, GMCR’s stock is trading for about $24.00 a share, or at about 9.2 times the midpoint of the company’s earnings guidance of $2.60 for 2012. Green Mountain’s shares have gone from selling at a massive premium to a substantial discount to the market, reflecting all of the issues that we’ve outlined above.
However, these concerns say nothing of Green Mountain’s prospects going forward. The company still has a fairly large installed base of brewers that is already in businesses around the country and in people’s homes. Many of those customers have some sort of subscription in place and will continue to purchase K-cups from Green Mountain Coffee even if other companies begin producing their own K-cups as the patents expire. Moreover, the big names such as Dunkin Donuts, Starbucks, and other licensees will probably continue to allow GMCR to manufacture the K-cups on their behalf and collect a royalty instead of jumping into that capital intensive business themselves. However, as a K-cup manufacturer, we believe Green Mountain’s profits from those deals will be considerably lower than what it makes from its own brands.
If the only issue here were the patent expirations, we might be inclined to say that Green Mountain’s shares now carry an attractive value proposition for investors. However, with the ongoing SEC investigation, unclear capital expenditure planning, and changing industry dynamics, the stock could slide further on any real or perceived negative news. Thus, we would not recommend picking up shares in the company just yet.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.