HOW THE MIGHTY (GMCR) HAS FALLEN

Takeaway: $GMCR could have further to fall. A "cheap" multiple does not make up for declining margins and uncertain future earnings prospects

Green Mountain is now down 62% since Starbucks announced the arrival of the Verismo home brewing system.   We believe more pain could be on the way for GMCR shareholders.  

 

 

Uncompetitive Brands

 

Green Mountain’s brand portfolio consists largely of regional coffee brands that, even collectively, do not hold a significant share of the overall market.  The brands are as follows: Barista Prima, Café Escapes, Coffee People, Diedrich Coffee, Donut House Collection, Green Mountain Coffee, Green Mountain Naturals, revvTM, Timothy’s, Tully’s, Van Houtte.

 

 

Brewer Margins Declining From Almost Zero to Virtually Zero

 

The management team at Green Mountain has, since beginning its quest to conquer the home brewing segment, ran its business as a razor-razor blade model.  That is, the company has always sold its brewers (razors) at little margin in order to support sales of K-Cups (razor blades). 

 

Starbucks’ new brewer is adding competitive pressure to the home brewer industry and we believe that the Verismo and any further Starbucks machines will pose a significant threat to Green Mountain’s Keurig brewer.  There is a viable argument, that we happen to agree with, that consumer loyalty is more aligned with the coffee than the brewer.  If this is true, it would suggest that the Keurig brewer could struggle to maintain its market share over the longer-term as customers replace their old brewers and new customers purchase their first home brewer based on its compatibility with their favorite brand of coffee.

 

A mere week after Starbucks began taking orders for its Verismo machine, Green Mountain announced discounting in the form of a rebate on some brewer sales.  Management has adopted a defensive tone when addressing concerns about the Verismo’s impact on its business:

 

“…But should something like that happen we have a number of tactical responses, one of which could in fact be deciding to raise the price of the K-Cup brewing system.” – Larry Blanford, CEO of Green Mountain Coffee Roasters, Piper Jaffray Consumer Conference, June 6, 2012

 

How can they be now discounting their brewers?

 

It seems that the balance of the evidence suggests that an inventory issue may be underlying and discounting already-low-margin brewer sales will almost certainly bring about even lower margins for the company.

 

 

A Contract Manufacturer With Declining Margins

 

Green Mountain is a contract manufacturer for the following brands:  Starbucks, Tazo, The Bigelow, Caribou Coffee, Celestial Seasonings, Dunkin’ Donuts, Emeril’s, Folgers Gourmet Selections, Gloria Jean’s, Kahlua, Millstone, Newman’s Own Organics, Swiss Miss, Twinings of London, and Wolfgang Puck.

 

All of these licensing partners could, at some point in the future, detach themselves from their respective agreements with Green Mountain Coffee Roasters.   It is likely only a matter of time before Starbucks leads the way.  The K-Cup patent expiring alone will cause margins on K-Cups to decline but the possibility of partners such as Starbucks or Dunkin’ walking away would be highly damaging to Green Mountain’s profitability.  We would point to the unraveling of the Starbucks-Kraft agreement as evidence of a lack of leniency on the part of Schultz et al. when it comes to issues involving control of the Starbucks brand and consumers’ experiences of it.

 

Caribou Coffee offered some insight into its relationship with Green Mountain when management said:

 

Additionally, in the early part of this year, the Caribou brand was repositioned within the Green Mountain portfolio to more premium pricing group.  The Caribou brand can command a premium price from consumers, but the retail implementation of the Green Mountain pricing strategy is having a meaningful impact on our club volume, at least, in the near term. This channel represented a large portion of our total business and is the primary driver of our actual and forecasted volume declines.” 

 

The apparent lack of control, on Caribou’s part, over the retail pricing of its own brand, at least in club channels, suggests that Green Mountain could be taking steps to increase the rate of sales growth of its own brands.  While this may the best move in the short term, such a strategy cannot be encouraging for its licensing partners.

 

 

Getting All Done Up For Nothing

 

Green Mountain has been readying itself for near-parabolic growth in demand for its products, ramping up capital spending dramatically over the past two years.  Unfortunately, management’s forecasting of demand has been less-than-stellar, not helped by misaligned compensation incentives, and the company has clearly invested money in anticipation of demand that is not materializing. 

 

 

Rule #1: Don’t Lost Money

 

Many indications point to Green Mountain’s profitability continuing to decline and, we believe, there is a potential for GAAP earnings turning negative in FY13.  The following points underscore our concern:

  • Excess inventories including brewer inventory?
  • The potential for excess K-Cup capacity
  • Increased competition and the potential for lost customers
  • Patent expiration leads to retail price competition
  • Burning cash
  • Owned brand market share losses
  • Declining margins 
  • Management creditability

With the company’s financials almost incomprehensible from an analytical perspective, given the well-documented accounting issues, forecasting earnings for the company has become even more of an art, and even less of a science, than it was before.  With the increasing competition and emerging fragility of Green Mountain’s business becoming clearer, the most significant near-term challenge will most likely be 1QFY13 as the possibility of a disappointing holiday season becomes more distinct for the company. 

 

 

Howard Penney
Managing Director



Rory Green
Analyst




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