Brewing Battle? A Hill of Beans.
Brandy is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If you’ve paid attention to any business section in the past week, you may have noticed that Starbucks (NASDAQ: SBUX) released its single-cup home espresso system, Verismo. Pun-filled headlines (see above) rolled out, mostly declaring that Green Mountain Coffee Roasters (NASDAQ: GMCR) is doomed thanks to this increased competition. Shares of GMCR, which were trading in the $100 range at this time last year, have fallen over 20% in a week to trade near $23.
GMCR doesn’t have to worry about the Verismo eating away a large portion of Keurig revenues. The company does need to focus on convincing investors that its accounting practices can be trusted. That time will come. For now, investors need to get better at sorting out the Green Mountain myths from the facts.
Myth #1: Verismo is a Keurig Killer
The Keurig system of machines and cups isn’t in direct competition with the Verismo. While the Keurig Vue models can do espresso (sort of), that’s not the overall purpose of any Keurig machines. Variety is the spice of its life: coffee, cider, hot chocolate…if it’s drinkable and brewed, there’s probably a Keurig cup for it.
Verismo can brew coffee but it’s supposed to be an espresso and latte machine. Early reviews on the Verismo have been lukewarm. A common and predictable complaint is that the espresso-and-milk pods for latte making don’t allow users to customize the amount of milk used. The pods also neglect the segment of users who prefer a milk alternative, such as soy milk, used in lattes.
- Will the Verismo bomb?
Starbucks has a decent amount of brand loyalty but its coffee products tend to be overpriced compared to the quality. The basic Verismo model is priced at $199 with an advanced model running $399. The domestic espresso market is small, accounting for only 4% of all coffee brewers purchased last year. Espresso aficionados could deal hunt and find a far superior system for a reasonable price. There’s the chance of overseas success, where espresso is more popular, but Nestle’s Nespresso has already been established in that region.
- Keurig Brewers Continue to Sell
Sales of Brewers and Accessories accounted for around 16% of GMCR’s net sales in the most recent quarter. This segment remains fairly strong despite the well-publicized competition coming to the market. In the 13 weeks prior to June 23, the net sales for the Brewer and Accessories segment were $139.1 million, a 32% increase year-over-year. Net sales were down only a smidge from the $140.2 in the previous period, which was a 21% improvement year-over-year.
Verismo could impact those figures slightly but Keurig brewer sales aren’t going to zero out. GMCR operates under a “razor and blades” model, where the brewer sells at cost while the replacement cups are sold at more of a profit, so losing a portion of the cups segment would be far more devastating.
Which brings us to….
Myth #2: Expiring K-Cup Patents Will Sink GMCR
There were K-Cup patents that expired this month. This will allow competitors to bring out low-cost equivalents that could drain GMCR of a segment that currently accounts for 73% of net sales…if customers were willing to sacrifice quality to pinch a penny.
Yes, the savings could be steep. The current rumor is that Kroger (NYSE: KR) plans to bring its cups out at a $6 price point. Assuming those are 18-cup packs, it would equal about $0.33 a cup. Kroger’s store brand products tend to taste pretty decent so the quality won’t be terrible. For a K-Cup example, the Newman’s Own Organics Special Blend Extra Bold K-Cups sell for about $12 for an 18-cup box, or about $0.66 a cup. (Online deal shopping can often result in K-Cup boxes closer to the bargain price-per-serving range).
The price could be half as much as K-cup but there’s two important considerations:
- Keurig owners tend to favor taste over cost. The machines have been out long enough for users to form loyalty to particular brands and flavors. Many of the most popular brands (Donut Shop, Green Mountain, Café Escapes) are owned by Green Mountain while others (including Starbucks) are locked into license agreements to keep them in K-Cups for the near future.
- There’s already a way for Keurig owners to use lower cost grinds in the machine. My K-Cups have been around for nearly a decade, offering a customizable filter and cup system for brands not available in K-Cup form.
GMCR also has the option to either create or partner up for a low-cost version of its own K-Cup lines in the future, though it seems like its plans rest more on the Vue system…
Myth #3: K-Cups Were GMCR’s Only Revenue Hope
Green Mountain, believe it or not, knew that its K-Cup patents would expire! Shocking, I know. Accordingly, the company planned for it with the launch of the Vue brewers, which offer greater customization on brew strength and work with a new type of cup, the Vue Packs. The Vue Packs are patented and will offer the chance for new license arrangements to be formed with manufacturers. (Starbucks is notably absent from the current Vue Pack line).
The Vue machines offer GMCR a way to diversify without huge cannibalization risks. The K-Cup machines are cheaper and easier to use. The Vue machines offer more customization, from brew to cup size, and offer a lower price than the cheapest Verismo. As I mentioned, though the Vue can brew espresso, it isn’t the primary purpose. The Vue is machine more aligned with the Tassimo from Kraft. The Tassimo is cheaper and easier to use than the Vue but hasn’t garnered consumer interest in part because it doesn’t have the brew branding that Keurig allows.
Is Green Mountain a Risky Brew?
Green Mountain has had some major issues in the past couple of years. There have been SEC investigations into the company’s accounting practices and questions regarding GMCR’s failure to disclose patent expiration risks in its recent filings. David Einhorn, Greenlight Capital founder and notable short seller, voiced serious concerns last fall about Green Mountain’s model and past successes. There were the massive, margin-call-covering selloffs from founder Robert Stiller and director William Davis that resulted in both men losing their positions. The string of bad news has led Green Mountain to become heavily shorted.
It’s going to take time for the GMCR execs to redeem the company’s reputation when it comes to accounting. But the signs of smoke don’t mean the entire building is burning to the ground. There are still strong fundamentals coming off the Mountain. Annual EPS growth for the past 5 years has been over 75% and EPS is expected to grow 12% next year. Net sales grew 73% between 2009 and 2010 and 95% the next year. Non-GAAP net income increased 125% (2009-10) and 135% (2010-11).
The current share price offers a good entry point if you’re willing to sit back and wait for the price to climb back up.
GMCR fans and foes: Sound off in the comments. Do you think Green Mountain will return to its past heights?
LynBetz has no positions in the stocks mentioned above. The Motley Fool owns shares of Starbucks and has the following options: long DEC 2012 $16.00 puts on Green Mountain Coffee Roasters, short DEC 2012 $21.00 calls on Green Mountain Coffee Roasters, and short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Green Mountain Coffee Roasters and Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.