Last October, David Einhorn of Greenlight Capital gave a bearish presentation on Green Mountain Coffee Roasters (GMCR) to the Value Investing Congress. At the time, the stock was at $82.50. His 111-page presentation, entitled "GAAP-uccino" made the rounds on the Internet. Apparently, a lot of investors took the presentation seriously because the stock slid into 2012.
Since the Keurig acquisition in 2006, Green Mountain has sold over 13 million single-serve brewers and over 9 billion K-cups. From 2006 to 2010, revenue has grown at a 57% consolidated annualized growth rate.
The bull case for the stock is simple. There are approximately 90 million households in America that own a coffee maker. Of those, there are 64 million to 65 million households that drink two or more cups of coffee a day. If Green Mountain can capture just a tiny sliver, say, one-third of the market, it would represent an addressable market of over 21 million brewers. Twenty-one million brewers would consume some 15.5 million K-cups. If the company makes $0.15 per K-cup, after taxes and interest, the company stands to make a $1.4 billion profit on all those K-cups, which works out to a long-term potential of $8 to $10 per share.
Last March, investors could hardly contain their excitement when Green Mountain and Starbucks (SBUX) announced an agreement to bring the K-cup to the Keurig brewer. The non-exclusive deal allowed the company to tap Starbucks giant installed customer base. The estimated $0.22 operating profit per K-cup had investors drooling. The deal launched the stock into the stratosphere; it went from $40 to a peak five months later at $110.
To avoid competing with its K-cup licensees, when its patents expire in September 2012, Green Mountain went on an acquisition spree. In 2009, the company acquired Tully's and Timothy's Coffee. In 2010, Green Mountain gobbled up Diedrich and Van Houtte.
While the bulls ignored the company's accounting treatment of these deals, the bears looked a bit more carefully. If you did the math, Green Mountain attributed between 93% and over 108% of the purchase price of these acquisitions to goodwill. In other words, on its books, Green Mountain was saying the companies it bought were of little value. They were simply coffee roasters, and the real value was in the K-cup license. While not totally out of line with accounting practices, the bears began to question the mounting goodwill on Green Mountain's balance sheet, since high levels of goodwill can call into question earnings quality.
For years, the bulls have ignored warnings that K-cups were an expensive way to consume coffee. While Folgers and Maxwell House coffee costs just $0.03 to $0.04 a serving, fancier brews such as Dunkin Donuts can cost upwards of $0.86 per serving. If you go to the grocery store and look at the price for a box of K-cups, you might notice the price expressed in pounds of coffee. A box of K-cups will often cost $8 or $9, but expressed in pounds, you quickly discover you are paying $28 per pound for the same coffee that sits in a can for $6. Those juicy profit margins leave Green Mountain exposed to private-label competition when its patents expire.
Because of the huge profit margins, Sturm Foods, a maker of private-label foods, is actively looking to get in on the K-cup competition. Sturm believes it can take market share in the K-cup arena with supermarket brands such as Kroger (KR), Safeway (SWY), Supervalu (SVU), Wegmans and Costco (COST). By stuffing supermarket-brand coffee into the K-cup design, Strum believes it can achieve a 20% penetration level, twice the penetration level of the entire private-label coffee business. (Strum already is on the shelves with a filter-less design, but it wants to attack the filter design market of the K-cup.)
If you assume that Strum is correct and can take 20% of the K-cup business, there is no way Green Mountain can get to $8 to $9 per share. In fact, with some aggressive competition, long-term earnings potential for Green Mountain looks to be in the $3- to $4-per-share range. What big coffee brand wants to pay Green Mountain's sky-high royalty rates when it can have Strum stuff its coffee into little generic K-cups and pay no royalty? All you have to do is pay for the packaging.
If that's the case, then Green Mountain looks far less exciting. What makes the razor/razor blade business model work is limited competition. Patent protection in the razor blade side of the business is crucial. If Green Mountain is selling millions of brewers that generate little or no profit and is reduced to just another maker of generic K-cups, then the stock is going much lower. Why do I want to own a coffee packaging company with an unprofitable brewer manufacturing operation?
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