Green Mountain Coffee Roasters (NASDAQ:GMCR) announced its second quarter earnings last week which came in well ahead of the market expectations. In fact, the shares of the company have jumped close to 40% since the earnings announcement. The company has a history of either exceeding or trailing the market expectations by a wide margin, and we have been cautious on the stock given the threat of competition and the loss of its patents on K-cups.
The company was able to register a surprising 26% volume growth in K-cups, which generates most of the company’s sales. We also saw strong demand for its coffee pods, which bodes well for the company’s profitability. Previously, we were concerned that after its patents expired in late 2012, the volume growth would have slowed as more competitors entered the fray, but the company has defied expectations with two consecutive quarters (both of them after the patent expiration) of a 26% increase in K-Cup volumes. 
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Navigating The Competitive Landscape Better Than Expected
Two of Green Mountain’s patents expired in September last year, which opened the doors for private labels to introduce their own K-Cups, without having any obligation to pay royalty to the company. So, the fact that Green Mountain’s more profitable division is continuing to gain volumes is a really positive sign for the company. Note that Green Mountain generally sells its brewers at very low margins in order to boost their adoption rate. We have now raised our estimates for volume growth to about 25% for 2013 from our earlier estimate of 14-15%.
Furthermore, even if the company was able to grow the volumes at this rate, there should have been some deterioration in margins due to a downward pressure on the pricing. After all, now with the influx of cheaper private labels, Green Mountain might have to lower its prices in order to compete against the new entrants. It might have to balance pricing vs. volumes due to this increased competition.
But this doesn’t seem to be the case so far. The company’s margins expanded more than 500 basis points in the preceding quarter. Lower coffee costs have helped, but even if you exclude its impact, the gross margins would have still widened by 250 basis points. These are a very strong set of numbers. Keeping in mind the latest developments, we now expect the gross margins to rise by about 180 basis points for the full year. Previously, we had estimated them to decline by around 100 basis points.
The company also lowered its capital expenditure guidance for the fiscal 2013 to $275-$325 million from the previous estimate of $350-400 million. This is again something which will add to the company’s cash flows. We have increased our price estimate for Green Mountain Coffee Roast to $66, which represents a huge 80% jump.
The $30 difference in price estimates can be approximately broken down into:
Improvement in gross margins ~$13-14
Higher volume of single serve cups ~$6
Lower Capital expenditure ~$8-9
The Starbucks Deal
The fact that Green Mountain was able to extend its partnership with Starbucks for another five years was the icing on the cake. The financial details of the deal were not revealed, but Green Mountain will manufacture, market and distribute Starbucks single serve packs. In addition, more of Starbucks’ brands such as Tazo and Teavana teas, Seattle’s Best etc will be available in K-Cups and Vue packs. 
Many in the industry see this as a major victory for Green Mountain since investors feared that Green Mountain’s market share and single serve business would be overwhelmed by Starbucks’ financial muscle after it entered the single serve market last year. However, Green Mountain’s dominant position in the brewer market sold under the brand name ‘Keurig’ has not been threatened meaningfully given the large degree of compatibility of its brewers with third party companies.
Also, as already mentioned, third party companies are no longer under any obligation to pay a royalty to Green Mountain for selling K-Cups compatible with Keurig brewers. Thus, Green Mountain’s royalty could be minimal in this deal. The only reason why Starbucks would pay any money to Green Mountain is because the latter is doing all the work from manufacturing to distribution of these single serve cups while sticking the Starbucks brand on the package. So, its easy money for Starbucks, and this deal could actually benefit Starbucks more than Green Mountain.
Vue Sales Could Improve
On the bright side, the deal could spur the sales of the Vue brewer. Vue sales haven’t really picked up as the company envisioned before its launch. But now with Starbucks single serve packs compatible with the brewer, it could attract more customers towards the brewer.
Moreover, it could help the company start off a similar cycle as it did with the traditional Keurig brewers. Vue packs use a different technology than K-Cups, the patents of which haven’t expired yet. So, any company looking to make its products available in Vue packs (so that they are compatible with the Vue brewers) would have to pay a royalty to Green Mountain. Not only does this represent a huge opportunity for generating additional royalty, but the greater the number of pods that are compatible with the brewer, the more likely are the customers ready to buy it. Thus, it could kick start a positive feedback loop, one in which the high degree of compatibility boosts the brewer sales and the higher brewer sales attract more third party companies.
At the moment, there is nothing concrete which suggests that Vue sales will definitely pick up. Nor is it known what proportion of the existing customers will be happy to pay a significant premium for the brewer. Vue prices were slashed earlier in the year but the lowest priced model still costs around $170, considerably higher than the traditional brewers. We’ll be keeping an eye on this but as of now, and our updated price estimate doesn’t incorporate any sudden acceleration of Vue sales.Notes:
- GMCR 8-k [↩]
- STARBUCKS, GREEN MOUNTAIN COFFEE BREW UP SINGLE-CUP PARTNERSHIP, May 13, 2013, nacsonline.com [↩]