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At the end of 2008, investors were fleeing the stock market in droves, selling stocks as fast as they could. The few investors that had the temerity to buy stocks when others were selling often focused on seemingly defensive plays such as dividend-paying utilities or cash-rich, debt-free blue chips. Pursuing growth stocks at the time would have seemed foolhardy. Yet, in hindsight, an investment in a stock like Green Mountain Coffee Roasters (Nasdaq: GMCR) would have been a brilliant move. The stock opened the just below $9 (split-adjusted) and finished 2009 at around $27 — a 200% gain. Shares rose only 15% in 2010, but since the start of 2011, they managed to rise more than 200% once again –until a recent sharp pullback.
After falling more than $40 from its 52-week high, it would seem this former highflyer has already peaked. Not hardly, according to one analyst. SunTrust’s William Chappell thinks the sell-off is completely unwarranted, and expects the stock to climb up to $120 (from a current $73) once the noise around the stock abates. That noise: it’s coming from highly-respected short-seller David Einhorn, who has been jawboning the stock down in recent months through a series of high-profile speeches, and sees even further downside.
“What’s less impressive is Green Mountain Coffee’s $15 billion market value, which puts the stock’s value at more than 50 times projected fiscal 2011 profits. You have to question the wisdom of owning such a richly-priced stock in these sobering times. It would also be foolish to short the stock, simply because the company is unlikely to see sales slow in coming quarters.”
I failed to make a stand, but these two men surely will. (For the record, I still think my advice at the time was prudent.) Only one of them can be right. Let’s look at their respective cases for and against this stock to see which argument really holds water.
The bear case
To be sure, Einhorn has a great track record, achieving a cult following among short-sellers. He’s made many great moves, most notably a big bet against Lehman Bros. before most investors were wise to that house of cards. What’s his beef with Green Mountain? Well, they are numerous, starting with the company’s accounting policies, which he says have a way of obscuring the company’s true expenditures when it comes to acquisitions and capital investments. He sees a management team that totally lacks discipline when it comes to allocating capital, and suggests the company’s math doesn’t add up. (The Securities and Exchange Commission looked into Green Mountain’s accounting in 2010, and the company went on to restate four years’ worth of results last November. Still, Einhorn insists that more shenanigans are taking place, including under-counting of inventory.)
Reality check #1: The company has generated negative free cash flow for each of the three last fiscal years (ended September). The fact that it intends to spend $650 million to $700 million in capital spending in fiscal 2012 implies that this won’t be a free cash flow story any time soon. Merrill Lynch forecasts negative free cash flow of $102 million, but also thinks free cash flow will turn positive in 2013.
Einhorn also thinks the whole frenzy over K-cup coffee-making will soon die down as consumers increasingly realize that it’s a fairly expensive way to sate your morning coffee craving. “This is a luxury item that is priced outside the range of many households,” he said at the Value Investing Conference last week.
Reality check #2: On a personal and anecdotal basis, a number of friends are now converts to the single-cup system, noting its ease of use and wide choice of flavors. The real test for Einhorn’s thesis will come when all of the recently-bought K-cup coffee makers wear out. Consumers will then have to decide to buy another $100-$150 k-cup machine or switch back to a plain old $30 coffee maker.
Perhaps the greatest challenge to this stock has to do with its patents. Ostensible rivals invariably aimed to come up with their own single-cup brewing systems but realized that Green Mountain’s patents were quite solid. So the company has racked up an impressive amount of licensees. Yet a key patent expires next September, and you can assume that a number of foodservice companies will quickly move to sell lower cost machines and pods — without any royalties flowing to Green Mountain. In response, the company is expected to alter the system design, protected by new patents.
Reality check #3: This is the chink in the armor. Coffee-brewing has always been commoditized, and when consumers have a chance to buy less expensive machines and pods, they will.
The bull case
SunTrust’s Chappell disagrees with Einhorn on almost all points. First, he thinks Einhorn miscalculates the profits per pod that Green Mountain will make when partners such as Starbucks (Nasdaq: SBUX) sell into their own retail bases. Chappell suggests that Green Mountain’s packaging costs have been erroneously included in the sales arrangement. “SBUX is paying GMCR for the packaging services,” wrote Chappell in a recent note. So he thinks Einhorn greatly underestimates Green Mountain’s earnings power during the next few years.
He also refutes Einhorn’s assumption that when the key patent expires, private-label vendors will quickly garner 20% of the market. Chappell says that’s an absurdly high figure in any beverage category outside of water and milk.
Reality check #4: This is an expensive purchase, led by a $100-$150 machine — very unlike milk and water. Score one for Einhorn.
SunTrust’s Chappell thinks Green Mountain can eventually earn $9 a share on an annual basis, once the business model matures. Einhorn thinks EPS will peak at $3.50.
Reality check #5: Chappell’s math implies that Green Mountain will earn $1 billion in yearly net income one day. That’s a lofty goal for a company that only recently cracked $1 billion in sales.
Action to Take –> These dueling analysts have set the stage for a showdown on Wednesday when the company weighs-in with quarterly results — and perhaps on these contentious issues. On the face of it, Einhorn scores some strong points, most notably that the company has failed to generate real cash out of this business and may fail to do so once the key patents expire in 11 months. Even assuming that Einhorn is too bearish, this stock still looks expensive, trading at 40 times Merrill Lynch’s projected fiscal 2013 free cash flow forecasts.
If you are a fan of Green Mountain’s business model, it makes sense to wait until the dust truly settles around all of these allegations. But if you’re already bearish on this name, Wednesday’s comments may be the proverbial blood in the water to get you either established or adding to a short position.
– David StermanSource: StreetAuthority
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