The Oxen Group Initiates Coverage of Green Mountain Coffee Roasters at Sell, Price Target $22

 

 

 

The company’s growth has been so substantial that it is actually surpassed Folger’s and Maxwell House in sales this past year. The company’s stock as a result has taken the same path over the past five years, rising from 2.30 a share five years ago to over $31 per share – an increase of nearly 1250%. Green Mountain has definitely gotten its foot in the door and established itself as a leader in the coffee industry; however, the company has grown at phenomenal rates over the past few years. The company in Q1 of 2010 missed estimates and saw its stock plummet. The company again had problems in September after announcing that the company would not be able to meet EPS estimates. The latest development for the company that the company was being investigated by the SEC in its first day signaled an 18% drop in value. 

 

The pattern that is being established is that the stock is heavily overvalued, and any disappointment or negative news will have drastically negative effects on the stock. The great growth that the company has had has led to a P/E ratio of 61. The industry average in the Packaged Foods industry is around 16. The market tends to average between 17-19 P/E ratio. At 61, the company is carrying a lot of overvaluation, and it takes continuous positive earnings, growth, earnings beats, etc. to maintain such a ratio. When earnings start to taper off, estimates are met or only slightly hit, and the growth is not the same, this stock will be rocketed downwards. Such overvaluation has created short interest as well, which is risky.

 

Another worrisome aspect of GMCR is the rate of acquisitions it is undertaking. The company is buying smaller rivals at alarming rates, and it seems it has no reason to slow down. The latest quarter, however, showcased the effects of such quick expansion. The company is becoming debt laden. The company’s long term debt as percentage of sales rose in Q2 2010 from Q2 2009 from 65% to 80%. From Q1 2010 to Q2 2010 the rate rose from 21% to 80%. The amount of debt the company has compared to sales is definitely worrisome. The company’s current ratio has also been falling. From Q1 to Q2 in 2010 the current ratio dropped from 2.9 to 1.85. The company is taking on a lot of liabilities, which will hurt the company’s free cash flow.

 

Another worrisome aspect of the company is that it is heavily dependent on coffee prices. The price of coffee has been increasing significantly throughout 2010. So much so, that GMCR had to actually raise the price of each K-Cup $0.10 – $0.15 depending on the roast. That increase in price is never a good sign for any company because it means simply a loss of business. Especially during these economic times, price hikes will never go over well. It also signals the fact that GMCR does not have a strong hedge against future coffee prices, which could be devastating if they continue to increase.

 

The most important blood of any company is its cash flow. Free cash flow must continually be maintained. If it is not, then a stock will not be able to maintain healthy balance sheet, will need to take on debt packages, and will lose share value. GMCR has never had sound free cash flow. Typically, the company is in the red on FCF. The company’s FCF margin in its latest quarter was negative. Anything below 10% is definitely worrisome. Taking on new companies could be a reason for this, but at the same time, we are seeing a rise in liabilities. So not only does the company lack FCF, but they also are taking on debt…not a good sign.

 

Further, the company has very low net margins. They do no turn a lot of revenue into income with net margins around 5-6%. Most strong long term investments are around 15% because it means the company does not have a lot of selling, general, and administrative expenses and interest payments. GMCR has really great gross margins above 25%, but they have net margins around 6%. That discrepancy shows way too much money is being serviced into debt and administrative expenses. The company’s profitability will need to have a lot of sustained revenue growth to cover the expenses in debt and takeovers. As they start to reach limits in selling capacities, they will being to start to see problems in profitability.

 

Another issue to raise is that GMCR is seeing is accounts receivable outgrow its sales at an alarming rate. A company never wants to have a much higher percentage growth in accounts receivable over sales. In the company’s latest quarter, it saw its A/R rise 88% while sales only grew 63%. When receivables rise above sales, it means the company’s backlog is building up and cannot be met. If this trends continue, then buyers will become angered with the company and could cancel orders. This would have a devastating effect on the company’s profitability.

 

The company’s ability to be efficient has gotten better over the years, and it has allowed the company to continue to see great growth. Yet, in 2010 so far, the company is seeing the days sales outstanding start to rise, the cash conversion cycle decreasing, and inventory turnover taking much longer. There is definitely an issue in GMCR’s distribution line that is going to need to be fixed because again it will threaten the company’s ability to expand.

 

A final issue that I see with the finances in the company is its ROIC is actually falling in the TTM. If a company’s ROIC starts to fall, it signals that the company is starting to be able to make less on its capital pool. That means lower margins and less profitability. The company’s ROIC topped out in 2009 at 12, which is not a significantly high ROIC, and it has dropped to 11 in the TTM, which means it could be as low as 10 in 2010.

 

All these issues with overvaluation and problems in the company’s finances create a major dilemma for the company, and competition still looms…

 

Finally, GMCR has heavy competition. Starbucks, Maxwell House, Folgers, Dunkin’ Donuts, McDonald’s, and others are all in this industry. These are established companies that have lost market share to GMCR’s success. Each of these companies is beginning to realize that the K-Cup is extremely successful product. In the fast-paced economy in which we live, the single serving cup is a great way to get coffee and go. Starbucks released their VIA line and Maxwell House is about to undergo a major promotions campaign in Q3 of 2010. These companies will not be undone and should begin to tap into GMCR’s recipe for success. The competition is definitely there, and while GMCR has created a small economic moat with its K-Cup idea, the idea is obviously one that can be adapted by other companies established.

 

 

 

My fair value estimate for Green Mountain Coffee Roasters is $22 per share based on a discounted cash-flow analysis. The company has seen incredible growth in its operating income in the past five years, but the amount of growth the company has seen will start to decline. As that declines, the company will not be able to maintain its extreme valuation. Additionally, the company has shown a number of financial issues with profitability and efficiency this year, which should threaten the company. Further, they have no free cash flow, which is the red alarm that further growth is threatened. My estimated available cash flow starts at $188 million for this year, which is a gift. Things could be much worse moving forward. $22 is a best case scenario.

 

The company is a Buy below $17 and Sell above $25. Therefore, the company is currently a strong Sell.

 

 

Risk is medium with Green Mountain Coffee Roasters. The company has been for the past couple years been told it could not continue at this rate, and they have. Yet, over the past couple years they have improved everything from growth, to profitability ratios, to financial health, to efficiency. For the first time, we are starting to actually see these numbers start to not be able to maintained or slow down. That threatens the company. Yet, the K-Cup is very popular, and if the company can overcome some of the obstacles and maintain a high level of growth, there stock is in good shape.

 

 

 

President and CEO Lawrence J. Blanford has been with the company since May of 2007. He has a background in consumer goods but on the technology side. He was involved with Philips, Maytag, and Royal Tech before involving himself with Green Mountain. One issue with with Green Mountain is that it does not separate its CEO and President title. Another issue with Blanford is that he has in just three years seen his compensation triple while most other board members have seen no increase. One positive is that the company’s Chairman and former CEO before Blanford, Robert Stiller, holds a 51% stake in the company. Therefore, he treats the company like a shareholder. The move from him to Blanford was seen as a move to help take the company to the next level.

 

 

Good Investing,

 

David Ristau