Three reasons to be cautious about Green Mountain
Now that the patents have expired, anyone can introduce their own K-Cups without having any sort of obligation to pay royalties to GMCR.
1) Profits may not match sales growth
For the full year, Green Mountain's management expects sales to rise 15-20%. However, margins may not keep pace with the sales growth. In the fourth quarter, gross margins jumped to 31.3% from 29.1% in the prior year period but that was largely due to lower coffee costs.
Although margins improved on a year-over-year basis, they were down 210 basis points on a sequential basis. Comparing on a sequential basis would give you a good idea of the kind of margins the company can sustain in the long run, now that the market has been flooded with inexpensive private labels. The presence of cheaper alternatives will probably slow down the sales growth of its K-Cups as well.
The Keurig brewers will continue to sell briskly, given that no other brewer in the market enjoys compatibility with so many pods. But it is important to note that Green Mountain hardly makes any money through the sale of its Keurig brewers, since the company often sells them at cost price in order to boost its adoption rate. So, while total K-Cups sold will continue to rise, a greater proportion of the sales will come from the less profitable Keurig brewers.
2) Disappointing Vue sales
Green Mountain has been trying its hand at the more expensive brewers. The idea is to compete against premium brewers such as Nespresso or the Verismo, while generating profits at the same time. The company launched the Vue in the first half of 2012, but its sales have been tepid so far. Even six months following its launch, sales were a disappointing $19 million in the previous quarter.
The device sells for about $200, and has definitely less than 100,000 units sold. On the other hand, Starbucks (SBUX) seems to have done much better with its Verismo, selling 150,000 units within the first three months of its launch.
3) Royalty revenues
Green Mountain derives royalty revenues from third party companies who use its patented technology. Before the K-Cup patents expired in September, any company which sold coffee pods compatible with Keurig brewers were supposed to pay royalty fees to Green Mountain. Now that the patents have expired, anyone can introduce its own K-Cups without having any sort of obligation to pay royalties to GMCR. Green Mountain still derives royalty revenues from private labels who manufacture brewers that fit these K-Cups though.
Royalty, as a business, is extremely profitable. Although it may only contribute a fraction to the top-line, its percentage contribution is much higher to the bottom-line. In 2012, Green Mountain's royalty revenues dipped 22% to $376 million, largely due to the effect of patent expirations. Going forward, the highly profitable royalty revenues are expected to decline which again, will impact the company negatively.
We have a $36 price estimate for Green Mountain Coffee Roast, which is about 20% below the current market price.
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Bill Stiritz owns more than 5% of the company, and has experienced an estimated $145 million in paper losses on his investment.
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