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World's Scariest Stocks: Diedrich Coffee

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What else is stewing in our cauldron of evil? Prepare yourself before proceeding to the rest of our world's scariest stocks.

I'm not afraid of ghosts or goblins, werewolves or vampires. But I am scared of roller coasters -- and after the great ride that Diedrich Coffee (Nasdaq: DDRX  ) has given its shareholders, I think it's just a matter of time before you start hearing the screams as the coffee maker's stock chart plummets back to earth.

A great story ... so far
Right now, though, few stocks present a more compelling story than Diedrich. Struggling in penny-stock territory as recently as March, the stock has risen more than 10,000% -- a hundred-bagger! -- in just seven months. It's the small-cap investor's perfect dream come true.

Moreover, Diedrich can pitch its story as one of the most amazing comebacks ever. After years of losses at its Gloria Jean's, Coffee People, and namesake Diedrich coffeehouses, competing unsuccessfully against rivals Starbucks (Nasdaq: SBUX  ) and Peet's (Nasdaq: PEET  ) , Diedrich finally decided to close its company-owned stores and sell off its franchising operations.

In a huge gamble, it decided instead to focus on its coffee wholesale business, and most importantly on its role as a producer of K-Cups for Green Mountain Coffee Roasters (Nasdaq: GMCR  ) and its Keurig single-cup coffee maker. So far, that strategy has shown signs of success, as Diedrich has turned its history of losses into quarterly profits in each of the past two quarters.

I was K-Cup when K-Cups weren't cool
Now, as a consumer, that strategy doesn't scare me at all. In fact, during one short-lived assignment a few years back, the best perk my former boss offered his employees was a variety of single-serve brewing options, including one of the best cups of hot chocolate you'll ever find. I'm happy with my gig as a Fool, but I still miss that cocoa sometimes.

And even though Peter Lynch advised investors to buy what they know, I can't bring myself to pony up for Diedrich shares right now. Here's why:

  • The valuation gives me vertigo. At almost $29 per share, the stock trades at 100 times trailing earnings and 2.6 times its annual revenue. Even if the company hits the upper end of its earnings guidance of $0.90 to $1.00 per share in its 2010 fiscal year, that's still almost 30 times forward earnings.
  • Margins are terrible. Even during one of the most profitable periods in the company's history, its gross margin of 16% is barely half what Green Mountain Coffee has achieved, and Diedrich's net profit margins come in at a razor-thin 2.6%.
  • Diedrich's success is completely dependent on two things: its continuing status as a Green Mountain licensee to produce K-cups, and Green Mountain's ability to continue to dominate the single-serving market. Yet Green Mountain not only produces its own coffee lines, but also has other licensees competing against Diedrich. Moreover, Green Mountain itself could face a future battle from other makers seeking to supplant the Keurig. Either of those events would most likely push Diedrich into a nosedive.
  • The strategy is stuck in the middle. On one hand, Diedrich clearly wants to position itself as a cheaper alternative to ponying up for Starbucks every morning. But McDonald's (NYSE: MCD  ) has already pushed daily java costs down with its McCafe line. And for truly cost-conscious coffee drinkers, single-cup coffee can't compete with traditional brewing methods.

In the end, I strongly suspect that Diedrich will join past fallen fad stocks like Krispy Kreme Doughnuts (NYSE: KKD  ) and Crocs (Nasdaq: CROX  ) as another example of a stock that took its investors up and down the roller coaster. Even though momentum stocks make it especially hard for prospective short-sellers to avoid losing their shirts -- as many Crocs shorts can attest -- the eventual fall seems inevitable.

Bring on all the ghosts and goblins you want, but as for Diedrich, I'll be skipping that ride.

Warning: We've rounded up more scary stocks. Click if you dare.

Fool contributor Dan Caplinger looks forward to Halloween candy, but nothing beats a great cup of hot chocolate. He owns shares of Starbucks. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers pick. The Fool owns shares of Starbucks, which is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is lumbering slowly toward Haddonfield.

Read/Post Comments (2) | Recommend This Article (12)

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  • Report this Comment On October 30, 2009, at 12:32 PM, clanza875 wrote:

    I dont really understand the argument of another coffee maker supplanting the Keuring and how that would send DDRX into a nosedive.

    First, if that happened then the K-cups obviously wouldnt be a fad. Second, why couldnt DDRX license from this new manufacturer as well. Seems like a win/win to me.

  • Report this Comment On November 02, 2009, at 6:16 PM, misterinterfuel wrote:

    Now I know why you call yourself Pumpkinhead. PEET just acquired DDRX for $26 a share. You'd make a great fund manager. I sold two weeks ago for $24.50 and planned to buy them back tomorrow morning, but it looks like I'll be buying PEET. Everyone should listen to Peter Lynch. Diedrich is the best coffee and Peet's is second. Now Peet's is first and second. Peet's also has the best loose tea of any coffee retailer by far. RIP Starbucks.

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