Green Mountain Coffee Roasters is a vertically integrated company with two business lines. Vertical integration means that the company controls all stages of processing, except for growing the crop. GMCR buys the coffee and then processes, roasts, warehouses and sells it. The first business line sells the Keurig single-serve coffee maker along with its individual coffee, tea and hot chocolate pods called K-Cups. Keurig coffee-makers are sold to individual consumers through mass-market and department stores. GMCR also sell Keurigs directly to offices and hotels. The second part of the business is the Specialty Coffee Business Unit, which sells coffee beans, ground coffee and Keurigs to grocery and retail stores. Overall, the Keurigs and K-Cups account for 52 percent of net sales, while the SCBU accounts for 47.6 percent.
GMCR copies and benefits from the razor-and-blade business model created by Gillette, whose strategy was to sell its safety razors so cheaply that customers wouldn’t hesitate to buy them. The plan, however, was that only Gillette blades worked with the razors. When the customers had to replace their razor blades, they could buy only significantly marked-up blades from Gillette. Similarly, although the Keurigs are not cheap, GMCR sells them at a very low margin. Then, because customers can only use K-Cups, GMCR marks them up, thus providing a large part of its revenue.
So if GMCR has such an innovative coffee machine, large market share in the coffee world and a monopoly on the profitable K-Cups, why sell short? There are a variety of reasons. First, when you buy something, you have to consider the price. For example, let’s say that somebody offers you a new 5 Series BMW at $250,000 instead of the usual $50,000 price. Is it still a great car? Of course. But though it may be a wonderful car, you wouldn’t pay the $250,000 because the asking price is much higher than the known market value.
This same concept applies to stocks. One measure of a stock’s value is the ratio called P/E, which stands for price/earnings and is most simply derived by dividing the current price of one share of common stock by the company’s earnings for that year. An ‘average’ valuation, if there can be one despite the diversity of industries, would be somewhere between 15 and 20. In the case of GMCR, its P/E is a staggering 68. To give some context to this number, it is important to compare it with other, similar companies. Peet’s Coffee and Tea Company trades at a P/E of 30, Coffee Holding at 11.11, Nestle’s P/E is 19.38 and J.M. Smucker — which makes Folger’s coffee — is at a modest 14. This comparable analysis leads one to believe that GMCR is overvalued.
The bull — one who believes a stock’s price will go up — would acknowledge these facts but disagree with the conclusion. That analyst would say GMCR has a very high stock price compared to its earning because it sells a solid product and has remarkable growth potential for both the Keurigs and K-Cups. Factoring in this high growth — net income has risen from 8.4 million in 2006 to 55.88 million in 2009 — a P/E of 68 would not mean the company is overvalued but that earnings will increase to justify the high price.
Regrettably, the bull analyst is just looking at the numbers and buying into the hype without looking more critically into the fundamental issues. First, GMCR’s machines, even if marked down, are still expensive. The cheapest unit costs $100 and can go up to $250. With the continued high unemployment and shaky economy, many consumers will be hesitant to drop $100 or more on a coffee machine. Competitors are catching on to the trend — Black and Decker and Hamilton Beach are making cheaper single-serve coffee machines.
The second issue is the K-Cups upon which GMCR depends for its profit. Currently, GMCR holds a patent on the K-Cups. But that patent will expire in 2012, which means other coffee-makers (Starbucks, Nestle) will be able to manufacture them. A bear analyst pointed out that GMCR actually makes a reusable K-Cup that allows the customer to use his own coffee. This product totally undermines the razor-and-blade business strategy of forcing consumers to buy only new K-Cups. Most consumers are offended by the waste — just read the reviews on amazon.com — of throwing K-Cups away after each use and prefer the more sustainable option. The combination of the patent expiration and the reusable K-Cups will reduce the fat of GMCR’s cash cow.
Finally, GMCR’s titanic growth is bound to slow. It already have contracts that allow the company to sell products to all the major department stores in the United States. Now, GMCR has to depend on ever-increasing SSS (same store sales) to justify the high price of the stock. Unfortunately for the company, this extraordinary growth is just not sustainable for the long term. Most concerning is the fact that the number of K-Cups sold per Keurig (the attachment rates) has been steadily decreasing, indicating customers buy the Keurig as a novelty but buy fewer high-margin K-Cups.
And as if that weren’t enough, the Securities and Exchange Commission just started an investigation yesterday into GMCR’s possible revenue issues and its relationship with a fulfillment distributor.
Nevertheless, GMCR is, on the whole, a unique company with a good product. But its shares are too expensive and, with many headwinds on the horizon, it is unlikely the current trend will continue.
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