Is Green Mountain Coffee Roasters’ (NASDAQ:GMCR) growth story dead? It sure trades like a broken one, after the 40% decline in stock price post-Q2 earnings last week. No doubt David Einhorn made out like a bandit with his well-publicized short position, while Patrick McCormack, Brett Barakett, and Philippe Laffont took hits to their long positions. Frankly, we think that the underlying growth is still there with GMCR’s Keurig as the dominant player in the single cup coffee category, with no foreseeable dramatic change in profitability or potential market share. GMCR remains a leader in the specialty coffee industry, selling coffee, hot cocoa, teas, and k-cup packs and owns the patented single-cup Keurig brewing system.
This week, Tata Global Beverages announced a multi-year partnership with GMCR to distribute and sell Eight O’Clock coffee, Tetley tea, and Good Earth tea in GMCR’s Keurig K-Cup and Vue packs.
In a joint statement, the companies stated that, “Eight O’Clock Coffee company and GMCR plan to make a select offering of Eight O’Clock coffee K-Cup packs available through in-home and away-from-home channels in US and Canada in 2012.” The terms were not disclosed. We think GMCR is taking the right step in diversifying its revenue streams and bolstering its international growth opportunities. We had felt for some time that given the patent expiries, GMCR would look for ways to be a co-packer for store brand K-cups. GMCR has an advantage vis-à-vis scale and, with this partnership, is well-equipped to deal with K-cup competitors.
GMCR’s Q2 was essentially in line with Street estimates, but the lowered guidance (revised down by 6%) disappointed and caused a major sell-off. Many investors were concerned with management commentary regarding moderating growth rates, but we don’t think this should have come as a surprise. Management guided Q3 non-GAAP EPS of $0.48 to $0.53 and Q3 sales growth of 20% to 25%, representing a slowdown in K-cup’s growth, probably due in part to some yet to be absorbed overhead. Earnings growth can be viewed as a product of GMCR’s installed base growth. This installed base is what drives K-Cup demand and now with a larger installed base, sales should still move upward. Also, given GMCR’s scale, we think earnings should be able to increase faster than volumes, alleviating some of our concerns. Now, it’s true that we are not sure how much of the decline in growth can be attributed to non-recurring events like over shipments in Q1 and weather as opposed to a secular decline but quarterly performance is on track from a general trending standpoint. Moreover, K-Cup profit per cup was $0.15, indicating that gross margin has been relatively stable despite a shift in to more licensed branded partner K-cups. We expect gross margins to further normalize in Q4.
We are confident that GMCR is riding the right trend in single serve but recognize that the landscape is getting crowded. GMCR and Starbucks (NASDAQ: SBUX) first paired up to sell Starbucks’ coffee in Green Mountain K-Cup machines in March 2011. Now SBUX is launching its new coffee maker Verismo. The Verismo launched as GMCR lost a couple patents for its single-serve system with a new partner, Krueger GmbH & Co. SBUX plans to sell the Verismo system online and at select retail stores, as well as specialty retailers. Sara Lee (NYSE: SLE) announced it entered a nine-year exclusive partnership with Philips for its SENSEO coffee brand. SLE and Philips currently co-own the brand, and under the terms of the agreement, SLE will pay Philips a total amount of EUR170 million. Even the retail giant, Wal-Mart (NYSE: WMT), wants a piece of the action, with plans to introduce Esio Beverage System this spring. The increasing competition is changing the single serve market landscape. Currently, there are an estimated 90 million US households with a coffee maker. GMCR’s product is only in 10 million to 12 million households, leaving ample expansion opportunity.
From a valuation standpoint, we think that it would be reasonable for GMCR to trade at ~13x FY 2013 earnings, factoring in management’s downward revised guidance, valuing the company at ~$40 per share. These are based on our slightly more optimistic assumptions as applied to Keurig momentum, incrementally lower K-Cup earnings power, higher SG&A expenses, and growth in the company’s installed base. We think the Q2 miss is bearable, and that investors are misjudging moderating growth. The so-called moderating growth on the installed base will still be in the ~35% range for this year, which is down from 67% last year but still a respectable number. Operating cash flow has been growing nicely up to $235 million in Q2 versus $76 million one year prior, and we are patient buyers of the stock at current prices.