GMCR: Life after the Patents

By Sandeep Gupta - September 11, 2012 | Tickers: DNKN, GMCR, PEET, SBUX | 0 Comments

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The much talked about doomsday for Green Mountain Coffee Roasters (NASDAQ: GMCR) is approaching as the company is about to lose its main patents on K-Cups on September 16th. Once the patents expire, unaffiliated competitors are free to enter the K-Cup market. The presence of competitors will be a huge set-back and will negatively impact margins. In addition, the development of private label and branded competitors may also eat into market share. However, in my opinion, it’s all been already accounted for in the stock price. Otherwise how would one justify a forward P/E of 9.8 for a company that reported a 20% increase in revenue and a 30% increase in earnings in its last quarter, and is expected to grow its earnings annually at more than 28% for the next five years? Moreover, the near-term impact may not be as large as investors fear and seems overblown, as it will take some time for rivals to get their products into the market. Moreover, Green Mountain does have the capacity to take on some private label business on its own.

The company has also made some progress to improve its forecasting and evaluation of its business. In response to recent forecasting challenges, the company commissioned a study to gain additional insight into the shape of the single cup category growth. The study indicates that the market is expected to grow to 35 million brewers by 2016, which is two to three times the current market size. With that insight, the company was able to provide a long term guidance of 15%-20% revenue growth and “mid-teens” EPS growth. Having a quantification of the market size and growth rate is helpful in beginning to estimate capital investment needs and the longer term view on free cash flow. The recent quarter (2Q12) marked the first time in five quarters in which revenues/profits were mostly in-line with the consensus estimates, and the stock has seen a huge upside following the earnings call. If the company continues to post consistent results in the coming quarters, investors will become increasingly confident that the company has made progress on this front, and I see a huge stock upside from current levels.

I am confident that the company can grow its top line as well as the bottom into the foreseeable future through further penetration of Keurig outside the company’s core New England market, K-Cup volume growth (from recent third-party signings) and rapid growth from newer non-coffee K-Cups. As a matter of fact, on a year over year basis, the demand for Keurig brewers and K-Cups actually accelerated at Wal-Mart as well as Target this summer. Moreover, despite increasingly difficult same store sales comparisons, demand growth for brewers held in Bed, Bath & Beyond over the last couple of months.

Green Mountain also remains immune to foreign economic headwinds as it generates ~99.5% of its revenues from the United States and Canada, while its competitors with a larger international presence, like Starbucks Corporation (NASDAQ: SBUX) and Dunkin' Brands Group (NASDAQ: DNKN), are exposed to global shocks. Let’s analyze the valuation multiple and growth rate for Green Mountain with respect to other coffee stocks, including Starbucks, Dunkin' Brands and Peet’s Coffee & Tea (NASDAQ: PEET).

Source: Yahoo Finance

From the above chart, Green Mountain appears highly undervalued whichever way you look at it. It is interesting to note that, despite the fears around the patent expirations and competitive threats, consensus estimates clearly reflect that Green Mountain has the best annual growth rate over the next five years. Even if we go by the company’s long-term guidance of mid-teen EPS growth, Green Mountain stock at more than a 50% discount to its peers is a good bargain. Thus, I suggest investors need to look beyond patent expirations and buy this stock.

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