Green Mountain Coffee Roasters (NYSE:GMCR) is the leader in specialty coffee and single cup brewers. It sells more than 200 varieties of K-Cup portion packs. Apart from offering a variety of brands of coffee and tea, it also produces and sells hot apple cider, iced teas, hot cocoa and other dairy-based beverages. Brewers are sold under the brand Keurig – the company that was acquired by Green Mountain in 2006.
The last couple of years have been a roller coaster for its stock price with its quarterly results beating and missing expectations every now and then. Revenues in the recently concluded fiscal totaled $3.9 billion, up 46% over the previous year. Gross margins have historically been in the range of 30-33%. Going forward, we expect some deterioration in margins for reasons we discuss below. 
What’s All The Fuss About ?
Two of Green Mountain’s patents expired in September which has paved the way for private label entrants to introduce their own K-Cups without having to pay royalties to GMCR. Besides eating into GMCR’s K-Cup sales, the increased competition will result in more pricing competition which is likely to lower margins for the company.
Moreover, Starbucks Corporation (NASDAQ:SBUX) has also introduced its single cup brewer called Verismo. Given its financial muscle, Starbucks is seen as a major threat to Keurig brewers. Thus, quantifying the impact of these developments on the company’s financials is the reason why the market seems to be unsure where the stock is headed.
Earlier Green Mountain used to sell its brewers near cost price in order to encourage consumers to buy the product and profits were generated mostly through the recurring sales of K-Cups. The company has recognized the need to generate higher profits through the sale of its brewers and therefore launched two new brewers (the Vue and the Rivo) this year at much higher prices by positioning them as premium products. These brewers will help compete against the Verismo and the Nespresso as well as help widen the margins. 
Reasons To Be Cheerful
One thing working in Green Mountain’s favor is the high degree of compatibility of its Keurig single cup brewers. It gives customers the option of brewing drinks of their favorite brands on a single platform, something which acts as a strong reason to choose Keurig brewers over Starbucks’ Verismo or other single cup brewers. And the number of options is only rising. The company forged an agreement with Snapple which will see K-Cups of the iced tea brand available from 2013. Even Kraft has decided to introduce its own K-Cups compatible with Keurig brewers.
Thus, even if the K-Cups sold per brewer declines, a healthy growth of brewers will ensure that the total K-Cups sold by GMCR continues to rise.
Reasons For Caution
Green Mountain announced its Q4 results in November which were ahead of the market expectations. The stock has gained more than 40% since the earnings were announced. However, there are reasons to believe that the most testing phase lies ahead.
Firstly, the latest earnings were for the fourteen weeks ending September 29, 2012. Keurig’s patents expired in mid-September, so for the majority of the quarter, the effect of patent expiration did not play a part. How much the availability of inexpensive private labels will impact Green Mountain’s sales has yet to be seen. Margins will also tighten as the company might need to alter its pricing strategy to compete against the cheaper options.
Secondly, Vue sales (brewers and packs combined) have halved to $9.6 million from $20 million in the third quarter. Thus, the low adoption of Vue would imply an opportunity lost for generating profits through the sale of more expensive brewers. Also, any third party company that wants to introduce its Vue packs will have to pay royalties to Green Mountain. Thus, the lower adoption rates would signify an opportunity lost for generating additional royalty revenues. 
We have a price of $29.40 for Green Mountain Coffee Roasters, which is about 20% below the current market price.Notes:
- GMCR 10-k [↩] [↩]
- Green Mountain unveils Keurig Rivo cappuccino maker, November 8, 2012, reuters.com [↩]