Green Mountain Earnings Preview: Stock Worth $81 On Rising Competition

Green Mountain Coffee Roasters (NASDAQ:GMCR) is scheduled to announce its second fiscal quarter earnings on May 7, 2014. The Vermont-based coffee company expects earnings per share (EPS) of $3.75-3.85 per share on high single digit revenue growth for its fiscal year 2014 (Oct’ 13 -Sept’ 14). After Coca-Cola acquired a 10% stake in the company at the start of Q2, the shares of the company skyrocketed by 53% to reach their highest ever price level of $123.74. Subsequently, the company’s shares sank by around 37% because of profit booking and the entry of other competitors in the coffee brewer market.

During the second quarter, the company changed its name from Green Mountain Coffee Roasters Inc. to Keurig Green Mountain, Inc.((Exhibit 3.2 , 8-k, SEC filings)). It also announced the release of new brewers, Keurig 2.0. With the new version of the brewers, Green Mountain aims to combine the features of the traditional Keurig brewers and Vue brewers. Moreover, both K-Cups and Vue packs will be compatible with the new brewer.

The most significant development for the company in this quarter was the completion of its transaction with the Coca-Cola Company (NYSE:KO) in February. The beverage giant agreed to acquire a minority 10% stake in the specialty coffee company for $1.25 billion and now owns 16.7 million newly issued shares of the common stock of Keurig Green Mountain, Inc. The coffee-brewer giant dwelled on its intention to use some of the transaction’s proceeds for share repurchase to reduce dilution of its stock price and to finance its capital expenditures for its Keurig Cold beverage system over the next several years.

We have a $81 price estimate for Green Mountain Coffee Roasters, which is about 10% lower than the current market price.

See our full analysis of GMCR here

High Coffee Prices Could Deteriorate Margins

The March quarter was a tough period for all the coffee brewing companies as the price of coffee mushroomed up by 85% due to concerns over dry weather in Brazil, effectively increasing the cost of raw materials. This is an area of concern for coffee-buying companies such as Keurig Green Mountain, Inc., which typically have some fixed price contracts along with variable pricing. The spike is large enough to make a visible difference in the bottom line performance of the company.

According to GMCR’s latest annual report ^[1], the company bought 216 million pounds of coffee, outside brokers being its largest source of green coffee supply. The price of coffee rose from $1.20 per pound in early January to $1.90 at the end of March, with a high point of $2.08 in the quarter. Assuming the company purchased a similar amount of coffee during the quarter, even a conservative estimated increase of $0.70 per pound could diminish pre-tax profits by over 20%. Even if the company is dealing with hedges, it can only insulate itself from price movements for a short while, after which the price hike will come into effect.

The second quarter typically observes a seasonal decline in sales of brewers as compared to the first quarter. Moreover, the Keurig 1.0 is also facing a threat of low sales because the customers are moving towards competing products of companies such as SodaStream and PepsiCo’s Bevyz, and are also facing technical issues with the Keurig 1.0. ^[2] Furthermore, the expenses incurred by the company in R&D for Keurig 2.0, the company’s new model, swelled up to $58 million last year. These expenses are expected to grow, now that Keurig Cold, a new division focusing on cold beverages, has been introduced.

The overall impact of these factors clearly indicates that the gross margins in Q2 would not be an impressive figure to watch. A major factor to counter these effects could be the price adjustments of the sales, but the company is yet to give clear guidelines on the same.

Keurig 2.0 : A Wildcard

The company has a lot of faith in Keurig 2.0 and believes it can revive the revenues lost due to patent expiration. Keurig 2.0 has proprietary technology allowing only Keurig licensed packs to be used in the machine and deals with the issues faced with Keurig 1.0, such as not being able to make more than one cup at a time. Keurig Green Mountain hopes that its combination of interactive readability and K-Carafe technologies will entice customers to upgrade. However, Keurig 2.0 won’t be available until the fall this year. It is likely to have a large price tag, pushing $200. Without Keurig 2.0 success, the company’s waning cash flow could put downward pressure on the stock, which it is likely to provide the company growth in the coming years.

Volumes of single pack servings could once again accelerate after the company launches Keurig 2.0 later this year. Only those companies that have royalty agreements with  Keurig Green Mountain will be able to release their single serve packs, restricting the entry of private labels and other third-party companies. This can boost volumes, as well as help the company realize better pricing.

K-Cup Volume Growth : A Key Factor

In the first quarter, the company reported that K-Cup volume growth had slowed down to 12% y-o-y, compared to 16% annual growth last year. This is attributable to the increased momentum in the sales of competing coffee brewers. Additionally, two of Green Mountain’s patents expired in September 2012, which opened the doors for private labels to introduce their own K-Cups, without having any obligation to pay royalty to the company. Typically, the K-Cup volume increases in the second fiscal quarter for the company due to the cold weather. But the entry of competitors into brewer market and the loss of customers suggest that the volume growth would be similar to the first quarter or may even decline by a few hundred basis points year-over-year.

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1. GMRC, 10-k, September 28, 2013 [↩]
2. Keurig 2.0: Green Mountain’s Saviour, Fool.com, February 1, 2014 [↩]