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    MARKET EDGES

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Senior management at GMCR believes that there is a true evolution underway in coffee making with Keurig holding the number one market share. The coffee evolution goes like this - first, there was percolated coffee, then there was drip, now there is single-cup brewing. How big is the market? Currently, there are 90 million U.S. households that have coffee makers and now they have the opportunity to buy a single-serve system. And the numbers are impressive. In 1Q08, at home brewer unit sales were up 144% and Green Mountain K-Cups were up 68% YoY, respectively. The best part of the story is that that the razor-razor blade model is in full force and the more machines in the marketplace, the more K-Cups will be sold.

If all this is true why are key executives leaving and other insiders selling record levels of stock?

  • ValuationAt 20x EV/EBITDA the current rate of growth needs to be maintained or there will be multiple compression quickly. The chart is from our friends at FactSet.
  • Gross margins - Selling more, but at lower GMsIn 1Q08, GMCR's gross margin declined 220 basis points. The decline is largely due to the increase in sales of Keurig at Home brewers and related K-Cups, which have lower gross margins than most of the other products. GMCR is also experiencing higher green coffee and other commodity costs, and higher manufacturing costs due to the continued capacity investments. None of these issues appear to be going away any time soon, if ever. Despite a severe drop in gross margins in 1Q08, GMCR operating margin improved to 9.6% from 8.5%. The improvement in EBIT margins was driven by the lower SG&A as a percent of sales. Again, I believe that this is a trend that can last only so long, considering the current growth rate of the business.
  • The profitability of the Blade...From a consumer's point of view, brewing a cup of coffee from a Keurig home brewing system is slightly more expensive than traditional brewing methods. Therefore, critical to the GMCR investment case is the profitability of the K-Cups. On the internet, we find Retail prices for K-Cups are around $0.55 per K-Cup. On the most recent conf call management did not argue against prices in the wholesale channel at $0.30, with a 20% contribution margin. That implies a $0.06 profit per K-Cup. For licensed roasters, GMCR raised the royalty rate to $0.064 per K-Cup. The conclusion we can draw from this, is that on the surface there does not appear to be enough margin in the K-Cups for the supply chain to make any money.
  • The current need for cash is growing.The current need for cash is growing.