Was Einhorn Right to Go After Green Mountain?

GREENLIGHT CAPITALDavid Einhorn is back at it again—going after Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR) yesterday, on day two of the 8th Annual Value Investing Congress. Green Mountain was down almost 5% after Einhorn’s announcement, but ended up finishing up almost 3% on the day.

In his presentation, Einhorn noted that Green Mountain’s audit committee had reviewed Einhorn’s allegations and concluded no misconduct. Einhorn, of course, thinks Green Mountain is merely sweeping Greenlight’s critique under the rug as quickly as possible. Einhorn also discussed Starbucks Corporation (NASDAQ:SBUX)’s initiative to enter Green Mountains key business segment. Green Mountain has played Starbucks’ new product—the Verismo—as an espresso maker, while Howard Schultz claims it is most definitely a coffee machine.

Einhorn noted that Green Mountain has plans to reduce CapEx spending, but that it still remains too aggressive. Where normal capital spending in the food industry is around 3.3% of sales, Green Mountain is spending over 9%, putting Green Mountain’s CapEx spend rate is well above the industry. Green Mountain also spends about $0.15 per K-cup produced in CapEx, but Einhorn believes that lower cost competitors will give Green Mountain problems going forward.

Major headwinds for Green Mountain include the loss of its patents, and most key relationships being held through license agreements. Einhorn thinks many contracts will be renegotiated at terms less favorable to Green Mountain. He sees Kraft entering the market through Maxwell House, and according to Greenlight research, K-cup prices are already down 14% from $.62 per cup to $.51 per cup. Considering the EBIT per cup is roughly $.08, he thinks this discount is very material to margins.

Other key competitors include the likes of top coffee roasters and stores, such as Peet’s Coffee & Tea, Inc. (NASDAQ:PEET), Tim Hortons Inc. (NYSE:THI) and Dunkin Brands Group Inc (NASDAQ:DNKN). In July, investment group Joh. A. Benckiser agreed to take Peet’s private for around $1 billion. The premium on the coffee roaster and marketer was 30% on the company’s shares. Before the announcement, the company was struggling with high coffee prices and less than stellar revenue numbers. Peet’s outlook also remains uncertain, with no participation in the fast-growing single-serve coffee market.

Tim Hortons and Dunkin Brands are two quick service coffee shops. Green Mountain has been attacking Tim Hortons and Dunkin from the lower-end, allowing people to quickly and easily make coffee at home, while Starbucks is attacking their businesses from above. Dunkin is a solid competitor to both Green Mountain and Starbucks, playing the middle of the market—with revenues expected to increase 8% in 2012. One key risk for Dunkin is a slowing global economy, where consumers may well trade down to Green Mountain’s products. Overall, coffee sales are expected to increase as the product continues to gain popularity in the U.S. Dunkin is primarily on the East Coast and has key plans to expand west. Also worth noting is that Lone Pine Capital has been trading out Green Mountain for Dunkin recently.

Tim Hortons is a leading baked goods and coffee restaurant in Canada with operations in the U.S. as well. The company is expected to up revenues 10.4% in 2012. New menu items, such as fruit smoothies and espresso-based drinks are expected to increase same-store sales by 4.5% in 2012. Tim Hortons may be able to take some market share from Dunkin as it redesigns some stores to a more contemporary look and continues to expand through the U.S.

Starbucks is expected to have an increase in revenue of 11% in 2013, with same-store sales growth at 5%. In particular, what drives same store sales is strong international demand, with an 11% increase in China and Asia. Starbucks boasts strong fundamentals and the economic recovery for the U.S. only bodes well for the company, as spending on small discretionary items picks up, including specialty coffee. As well, entry into the at-home premium single-cup segment—an estimated $8 billion market—is a big positive for the company.

Overall, we believe that Green Mountain still has a number of questions surrounding its business model and expected growth. From a valuation standpoint, it would appear that Green Mountain trades at the largest discount of all the peers—at a P/E of 11 and a P/S of 1.0, where the peer average P/E is 43 and P/S is 3.5. However, we feel that the stock might be a value trap.

Last month Green Mountain posted 3Q 2012 sales that were up 21%—seems positive—but it shows that growth is slowing significantly from 2Q 37%. Green Mountain faces intense industry competition, including Starbucks’ single-serve coffee machine. On the other hand Tim Hortons has key initiatives that opens the company up to impressive growth opportunities, and the company trades at a P/E of 20 and a P/S of 2.7, which are both at a discount to its key competitor Dunkin.

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