GMCR – An Aggressive Business Model, Not Without Risk

GMCR reported 45% 4Q sales growth yesterday. Although this is an impressive number and management outlined its many “enabling moves” for future growth, there are real risks to GMCR’s business model. The first of which stems from the fact that the company’s sales growth projections rely on increased sales of the company’s Keurig At Home Single-Cup Brewers, which are sold at cost. GMCR’s sales mix has been shifting more toward this is zero gross margin product, which has resulted in lower YOY gross margins for the last five quarters (FY08 gross margins down 300 bps). Thus far, the company has been able to generate improved profitability by offsetting these huge gross margin declines with significant cuts to its SG&A line. GMCR has increasingly leveraged its SG&A expenses in the most recent quarters as gross profit margins have deteriorated further with SG&A as a percent of sales declining 280 bps, nearly 570 bps and 200 bps YOY in 2Q, 3Q and 4Q, respectively.
  • GMCR will not be able to cut SG&A forever. It is not a sustainable business strategy and does not match with the company’s future growth projections. The company expects to close on its Tully’s acquisition in early FY09 and is pursuing a national retail footprint for its Keurig brewers. Both of these initiatives will require increased investment. That being said, although GMCR did post 45% sales growth, the company’s sales trajectory is slowing on a 2 year basis. This will make it increasing more difficult for the company to leverage its SG&A expenses at a time when the company’s SG&A needs will be growing.
  • Looking out to 1Q09, these challenges will already start to play out. Management is forecasting operating margin contraction in the first quarter to 3.7%-4.4%, which represents at least an 80 bp decline from 1Q08’s reported 5.2% number. The company is expecting this YOY operating margin decline as a result of its planned sales of more at home brewers (so lower YOY gross margins) and flat selling and marketing expenses as a percent of sales. In the first quarter, GMCR will not be able to leverage its SG&A expenses, or pull the goalie as we like to say at Research Edge, and therefore, the gross profit losses will be reflected on the operating profit line. And, this is expected in 1Q09 with flat SG&A expenses YOY. I would expect SG&A as a percent of sales to grow as we trend through the year with gross margins still under pressure from increased at home brewer sales so according to my math, it will be very difficult for the company to achieve its FY09 operating margin objective of 8.5%-9.3% relative to its reported FY08 operating margin of 8.5%.
  • Other risks to the model:

    GMCR started producing K-cups at its new manufacturing plant in Tennessee at the end of the quarter. In the long-term, the company hopes this new plant’s increased capacity will provide the company with more flexibility to support its growth targets, but in the near-term, particularly in FY09, it could hurt margins as the company works through new plant inefficiencies. These plant inefficiencies will hit margins at the same time the company is working through increased SG&A expenses.
  • GMCR is trying to establish a national retail footprint for its Keurig brewers, but it does not have the support of national coffee brand. Instead, the company relies on a patchwork of regional brands: primarily Green Mountain, Newman’s Own, Caribou and Tully’s (assuming the deal gets done). GMCR does not even control two of these brands, but rather has a licensing agreement in place with Newman’s Own and only partners with Caribou, which leaves the company’s national growth strategy susceptible to risk.
  • Turning to the company’s balance sheet, GMCR reported its fourth consecutive quarter of inventory growth in excess of sales growth, which is another unsustainable business practice. In the fourth quarter alone, inventories grew 119% relative to the company’s 45% sales growth. The company said this increase in inventory was necessary to meet expected strong holiday sales of its at home brewers and K-cups. Although some inventory build is warranted prior to the holiday selling season, this seems aggressive and what was the reasoning for the outpaced inventory growth in the prior three quarters? For reference, Wal-Mart, which I would call a well-managed company, reported today that its 3Q inventory grew 3.4%, half the rate of its sales growth (also ahead of the company’s important holiday selling season).
  • GMCR is burning cash. The company’s FY08 capital spending exceeded its cash from operations (partly as a result of the significant increase in inventory) and GMCR is expecting its capital expenditures to go up in FY09…again, not sustainable.