4 Reasons to Sell This Stock

Chad is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I’m all for investing in growth companies, and I’m also not afraid to invest in companies that sell for a premium to their expected growth rate. However, there is a fine line between a strong belief in a company’s ability to grow, and delusional hope because you don’t want to be wrong. For Monster Beverage (NASDAQ: MNST) investors, it seems like delusion is driving the stock and not logic.

Up 31% in six months and it means nothing
Several months ago, investors believed that Monster Beverage was worth about $48 a share; today investors think the stock is worth about $63. Just in case investors think that stock returns are a predictor of a company’s strength, let me assure you, the two are not always connected.

The mistake of assuming a company is doing well because the stock goes up is common in the stock market. What’s even more disconcerting is assuming a company is doing well in a highly competitive industry. Monster Beverage faces large multi-national competitors such as Coca-Cola (NYSE: KO), PepsiCo (NYSE: PEP), and Dr. Pepper Snapple (NYSE: DPS). Each of these companies has the ability to out-spend, out-advertise, and out-promote Monster Beverage.

You know what they say about assumptions?
I’m sure one of the reasons investors have bid up the shares of Monster Beverage has to do with analysts’ expectations for earnings growth of nearly 16%. In today’s market, any company that can deliver superior earnings growth is afforded a premium valuation.

If you look at Monster’s competition, none of their peers can come close to the company’s assumed growth rate. For everything that Coca-Cola is, the company isn’t a growth stock like it used to be. Analysts are calling for 7.9% EPS growth at the beverage giant, and PepsiCo is expected to grow just slightly faster at 8.3%. Of the peer group, Dr. Pepper Snapple is actually expected to grow even slower than the rest at 7.53%.

The first problem with Monster Beverage’s growth story is the company can’t seem to match existing estimates. If you are betting that a company will grow earnings by 16% in the future, wouldn’t you want to see the company at least match estimates in the past? Over the last four quarters, Monster has missed estimates every quarter by an average of almost 8%. Though past performance isn’t indicative of future results, Monster’s past performance doesn’t exactly give investors a lot to hope for.

3 warning signs
I hate to be the bearer of bad news, but Monster investors should realize that their company is raising red flags left and right about future growth. Theoretically, a company that is expanding and prospering should be able to grow revenue and earnings, report expanding margins, and spend less on promotional expenses as they become more well known.

One of the best ways to gauge the strength of a company’s brand is to see if they can expand their gross margin. A great example of this is Coca-Cola, which has been able to maintain an over 60% gross margin for a while, and this margin has expanded over time. Even though Dr. Pepper Snapple is heavily focused on the carbonated beverage industry, the company reported a 58% gross margin in the last quarter. PepsiCo is equally focused on both the beverage and snacks industry, and even with this divided identity, the company still managed a gross margin of 53% in the current quarter.

By comparison, Monster’s gross margin came in at 52.1%, which was lower than last year’s margin of 53.1%. Given that Monster operates in an industry where volume growth has been outpacing the overall beverage industry, where is the pricing power that should come with this growth?

The second issue facing Monster is the company’s use of promotional expenses are expanding in their effort to drive sales growth. In the energy drink industry, it’s common for companies to use promotions to drive sales. If you think about it, energy drinks aren’t exactly a necessary beverage for most customers. While it’s one thing to use promotions to drive sales, Monster seems to be losing control of these expenses. In the current quarter, the company’s promotional and allowances expense was 14.61% of revenue, which was up from 13.79% last year.

The third challenge facing Monster is the company’s selling, general, and administrative expenses are also increasing on a year-over-year basis. What is equally troubling is that the company doesn’t report SG&A expenses in the same way that their peers do. For instance, Coca-Cola reports SG&A expenses at 34.39% of revenue, PepsiCo reported 35.78%, and Dr. Pepper Snapple reported 38.42%. If you consider SG&A expenses for Monster, and include promotional expenses, selling, general, and administrative expenses together, the company spent 39.91% of their revenue, which I think is a more direct comparison.

A premium for this?
Given that Monster keeps missing earnings estimates, investors should already question the company’s ability to report strong growth in the future. When you add in the fact that the company’s gross margins are dropping due to higher expenses, there are too many unanswered questions to afford this company a premium.

It’s one thing for investors to pay a premium for Coca-Cola’s class leading carbonated and still beverage performance. It’s something else to believe in PepsiCo and the strength in their snacks business. I can even understand paying a premium for Dr. Pepper Snapple’s over 3% yield, but paying a premium for Monster Beverage at this point just makes no sense.

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Chad Henage has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola, Monster Beverage, and PepsiCo. The Motley Fool owns shares of Monster Beverage and PepsiCo. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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