Is Green Mountain Coffee Roasters About to Fall Off a Cliff?

Green Mountain Coffee Roasters signed deals with Starbucks and Dunkin' Brands, but are those partnerships enough for it to stay in front of the competition?

Jan 5, 2014 at 7:30AM

America is littered with the carcasses of companies that once showed promise but eventually succumbed to competitive forces. If the short-sellers are right, Green Mountain Coffee Roasters (NASDAQ:GMCR) will soon join the ranks of the has-beens. However, license agreements with big names like Starbucks (NASDAQ:SBUX), Dunkin' Brands Group  (NASDAQ:DNKN), and other coffee makers have the bulls excited about the company's future.

Green Mountain shows promise with Starbucks, Dunkin' Brands deals
Green Mountain's market leadership gives it a head start on competitors. It owns the four best-selling coffeemakers in the U.S. and has penetrated 13% of U.S. households with its Keurig hot brewer.

Green Mountain's market leadership makes it an attractive partner for companies that want to sell single-serve coffee. Deals with Dunkin' Brands and Starbucks have alleviated some investors' concerns about the company's ability to stave off competition. Green Mountain promotes, packages, and distributes five flavors of Dunkin' Donuts coffee in 14-count K-Cup portion packs. Dunkin' Brands is one of a handful of large companies that compete with Green Mountain for single-serve market share, so entering into a partnership with Dunkin' Brands seems to be a positive for Green Mountain.

Even better, the agreement with Starbucks -- which offers its own single-serve brewer, the Verismo -- may indicate that even the biggest competitors cannot overcome Green Mountain's market leadership. The Starbucks partnership began in March 2011; after Green Mountain successfully shipped more than 850 million Starbucks K-Cups portion packs in the first two years of the agreement, the two companies decided in May 2013 to extend the partnership another five years. Green Mountain's share price rose 10% when the extension was announced.

Green Mountain investors are counting on the company's market-leading household penetration and relationships with the biggest names in the coffee business to carry it through a competitive environment. But the bears are not so sure...

Starbucks deal may signal trouble for Green Mountain
At first glance, partnerships with Dunkin' Brands and Starbucks seem like a big score for Green Mountain, especially because Starbucks' Verismo competes with the Keurig brewer. However, investors should take note of the most important sentence from the press releases that announced the deals: "Financial terms of the agreement were not disclosed."

Although it may take Green Mountain's at-home brewer sales and its own single-serve coffee sales slowing down until we can know for sure, it seems unlikely that Starbucks would sign an agreement with a direct competitor on anything but the most favorable terms. Dunkin' Brands, too, probably would not have inked a deal with Green Mountain unless it got the better end of the bargain.

Investors should be skeptical of the agreements because of the low barriers to entry that have allowed numerous K-Cup manufacturers to spring up almost overnight. Panera Bread signed a packaging and nationwide distribution deal for its single-serve cups with Distant Lands Coffee. Many other companies sell single-serve cups that work in Keurig brewers, bypassing Green Mountain altogether, including Sturm Foods and Rogers Family. Given that portion packs represent about three-fourths of Green Mountain's total sales, the proliferation of third-party manufacturers and distributors of Keurig-compatible portion packs may cut into Green Mountain's profitability.

Green Mountain's plan to battle K-Cup knock-offs is to license brands that might otherwise go to a manufacturer and distributor other than itself. Since one manufacturer is as good as the next, and since large brands like Starbucks and Dunkin' Brands can easily get wide retail distribution, Green Mountain must offer generous terms in order to license big brands. The company's profit margin will likely decrease as a result of concessions made in partnership agreements.

Bottom line
Green Mountain is not a business that Warren Buffett would buy. It earns high returns on capital today, but future returns are hard to figure.

Clever investors may be able to figure out whether Green Mountain's profitability is about to fall off a cliff or if the company has a genuine competitive advantage that protects its profits from competition. Investors who take the plunge on Green Mountain's shares should pay particular attention to its quarterly reports and press releases to ensure that the thesis remains intact -- that Green Mountain really can fend off the competition.

This is not a buy-and-come-back-in-10-years stock; it is a stock that requires constant monitoring. If you would rather buy a stock and then forget about it, you should take a pass on Green Mountain.

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Fool contributor Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Green Mountain Coffee Roasters and Starbucks. The Motley Fool owns shares of Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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