Sellers Beware: GMCR is Now a Value Buy, Even by Einhorn’s Standards

By Ashish Sharma - May 9, 2012 | Tickers: DNKN, GMCR, KRFT, PEET, SBUX | 0 Comments

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Green Mountain Coffee Roaster’s (NASDAQ: GMCR) stock recently got roasted after the company missed earnings expectation and management talked about a slowdown in growth. The stock is in a downward trend ever since David Einhorn made his famous bearish presentation on GMCR at the Value Investing Conference in October last year. The presentation cited lofty expectations the market was building in for GMCR and its significant premium versus consumer peers which was unsustainable. 

Things certainly have played out the way Einhorn outlined. The stock is currently trading at $24.30 down significantly from its all-time high of $115.98 which it made during the last year. As usual, many sell side analysts were late to join the party and are now lowering the target price and ratings on the stock. However, I would like to caution sellers that at this point most of the Einhorn’s bearish thesis has already played out and GMCR is now a value buy even if we go by Einhorn’s argument.

The following table shows David Einhorn’s estimate for the long term EPS of GMCR and compares it with the bullish estimates out in the market as of October last year.

Table 1: David Einhorn’s adjusted estimates for GMCR versus the bull case estimate

Source: Slide 66 of David Einhorn’s VIC presentation

After accounting for decreased attachment rates, private label penetration after k-cup patent expiry and reduced profit on contract manufacturing arrangements for the partners; David Einhorn came to a realistic EPS estimate of $3.50 for GMCR. He also mentioned in his slide # 99 of the presentation that

“A more realistic assessment of potential earnings is closer to $3.50 than $9.00 and at that point GMCR should garner a market multiple rather than a premium valuation”

S&P 500 is currently trading around 13.25x forward earnings. Assuming GMCR is able to achieve the similar multiple on its long term EPS of $3.50, we get a long term target price of $46.38 for the stock which is almost a 100% upside from current levels. From a near term perspective, if we take the mid point of management’s current year guidance ($2.45) and apply S&P 500's multiple, we get an immediate target of $32.46 on the stock which means a cool 30% plus upside from the current levels.

Even if we don’t go by David Einhorn’s argument and apply more traditional relative valuation method for GMCR, it still appears significantly undervalued. The following table compares GMCR’s growth rate and relative valuation multiples with some of the consumer companies.

Table2: GMCR’s relative valuation and growth rate

Source: Consensus estimates, Yahoo Finance

It is interesting to note that although GMCR’s management has indicated slowing growth, the company is still likely to witness significantly higher growth than most of its peers which are trading at a significant premium to GMCR.

When David Einhorn first gave his presentation, GMCR was trading at a significantly higher multiple versus its consumer peers. That significant premium has turned into a significant discount particularly after 50% plus correction following the recent earnings results.  I believe this over reaction to earnings is not justified and would caution investors against reading too much into the earnings. Quarterly earnings results have been very volatile for GMCR in the last four quarter and GMCR has witnessed an alternate beat and miss pattern.

While, skeptics call it “earnings management” on the part of GMCR, GMCR’s management has given its own fundamental explanation for the volatile trend. For example, according to GMCR’s management, distributors and retailers stocked K-cup inventory in anticipation of a price rise in the June quarter last year. So, there was a pull forward in demand from the September quarter to the June quarter leading to a beat in June last year and a miss in September. More recently, warm weather adversely affected GMCR’s sales in the March quarter partly contributing to a miss.

Either way, the straight line extrapolation from recent quarterly results haven’t yielded accurate trends and I believe the trend line for actual consumer demand is likely somewhere between these beats and misses. The following table is helpful in understanding GMCR’s quarterly revenues seasonality.

Table 3: GMCR’s quarterly revenues

Source: GMCR 10Q, 10K filings

If we go by historical seasonality (FY2009 and FY2010), sales usually decline slightly from the December to March quarter and then from the March to June quarter. Sales start picking up from the September quarter and then show a significant jump up in the December quarter which is holidays plus winter season.  

However, this pattern was broken in FY2011. The company witnessed a sequential increase of 10.74% in June quarter revenues versus the March quarter. This was attributed to demand getting pulled forward from September to June quarter leading to a miss in the September quarter later. Further, sales saw a very significant jump up (62.70%) in 1QFY12 (Dec. quarter) which was the highest in the last four years. I see a good likelihood that some of the sales from 2QFY12 (March Quarter) also got pulled forward and there was some distributor/retailer overstocking. The March quarter likely saw an inventory destocking which coupled with warm winter adversely affected K-cup sales. So, I wouldn’t suggest investors to read too much into this sequential decline and would caution against extrapolating it. On the YoY basis also, GMCR was against the tough comparisons from 2QFY11. I believe as things normalize going forward, we might see better trends -- particularly in 4QFY12 (September quarter) -- which might help in improving investor sentiments.

Stock movements aside, GMCR is a real business and its does have a significant brand loyalty among the customers. Its leadership position, customer preference and current low valuation make it an attractive buy candidate in the current environment. The same characteristics also make it a very attractive acquisition target and with just $3.74 bn market cap, I won’t be surprised if it does start receiving bids from the larger players like Starbucks in the near future.

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