Is Keurig Green Mountain Overvalued or Undervalued?

If you're looking for a stimulating armchair riddle for your spare time, try figuring out an appropriate valuation for Keurig Green Mountain  (NASDAQ: GMCR  ) now that the dust has settled on Coca-Cola's  (NYSE: KO  ) equity investment in the company. After appreciating more than 53% in the week following Coke's announcement in February, Green Mountain's stock has drifted below the $100-per-share mark, and while day-to-day volatility in the shares has increased, they are still about 21% higher than where they previously traded.

The Waterbury, Vt.-based purveyor of single-serve coffee trades today at a multiple of 29 times trailing-12-months' earnings and 5.6 times book value, versus 24 times earnings and 4.6 times book value before the announcement of the Coke investment. Investor enthusiasm is concentrated in the upcoming fiscal 2015 launch of "Keurig Cold," the delivery system that will take on SodaStream International's  (NASDAQ: SODA  ) dominance in the home carbonated beverage market. Keurig Green Mountain's 10-year deal with its new equity investor will introduce Coke's branded soft drinks for home dispensing for the first time.

Grab an envelope

Vintage envelope photograph courtesy Andrew Rennie under Creative Commons License.

To begin trying to value this deal, we'd like to make an educated guess about the size of the potential market. Current leader SodaStream estimates a vast market for home carbonated beverages: $40 billion in the U.S. alone. Long-term, this may represent legitimate market opportunity -- Chicago-based market research firm Mintel recently pegged carbonated soda penetration in U.S. households at an extraordinary 92.2%. All the same, let's reduce the home carbonated beverage market estimate to $10 billion as a more realistic near-term number. This will correspond to the current global single-serve coffee market of roughly $8 billion, grounding our number comfortably in reality.

Let's assume that Keurig Green Mountain's manufacturing, marketing, and distribution systems, as well as its finances, will accommodate a fast entry into the home carbonated beverage market. The company already has an existing customer base that should provide ready demand -- if those customers can be enticed into purchasing new hardware for a cold-beverage system. In theory, Green Mountain should be able to grab market share faster than an entrant that does not already have presence in the single-serve beverage arena.

Now for some back-of-the-envelope calculations. Assuming robust demand, and given its customer base and the unleashing of Coke-branded soft drinks, it follows that Keurig Green Mountain ought to be able to quickly equal SodaStream's current sales level of roughly $500 million a year (versus Green Mountain's $4.4 billion in annual revenue from coffee) within, say, one to two years.

From here, assigning a growth rate in line with Green Mountain's recent three-year compounded annual growth rate of 28%, we can project that within five to six years it's entirely possible Green Mountain could walk away with $1.7 billion of annual sales from Keurig Cold -- around 17% of the total projected available market. Not a life-changing amount of revenue, but not a pittance, either -- a solid addition to the overall top line. With some help from prior-year financial statements, we could start figuring out expected cash flows, discount them back to the present, and come up with a valuation that makes sense given the boost from Coke.

Alas, we should probably tear up that envelope. The problem with this type of analysis is that it works best when most of the variables are known. In this case, we have a new technology that will be introduced with Keurig Cold, in which carbonation will occur without the need for separate CO2 cartridges. The technology will be introduced in a new market for Green Mountain, with untested pricing of both machines and pods, against an entrenched if tiny competitor in SodaStream. We can add to this a number of broad variables, three of which jump out at me as particularly significant:

Variable No. 1: Not all drinks sparkle

Coke's Minute Maid: Coming soon to a Keurig Cold near you? Image courtesy Haleyface under Creative Commons license.

While all eyes are focused on Keurig Green Mountain's ability to sell Coke, Diet Coke, and Sprite to the home carbonation market, we can't ignore the potential for noncarbonated, or "still," sales, which is Coca-Cola's often overlooked strength. As I've written about previously, Coke is a monster in bottled tea, bottled juices, and ready-to-drink cold coffee. It's got a stable full of billion-dollar brands in cold still beverages that could find potential sales growth in single-serve format. In fact, when you remove Coke, Diet Coke, Coke Zero, Sprite, Fanta, and Schweppes from Coke's 17 billion-dollar brands, the next 11 are all still beverages. The Keurig Cold will support juices, teas, sports drinks, and other "still" formats. This is a revenue possibility that is only on the periphery of the relationship as presently stated.

Variable No. 2: Keurig and geographic scale
As of last year, Keurig Green Mountain was a North American company, with 85% of its sales coming from the U.S. and 15% from Canada (it plans to enter four or five new countries in the current fiscal year). Conversely, you'll be hard-pressed to find a company whose product is distributed and licensed in as many countries as Coke: 200 and counting. Should Green Mountain need help in rapid international expansion, it could find no better partner than the Coca-Cola Company. Green Mountain's CEO, Brian Kelley, not only was hired from Coca-Cola but has extensive supply-chain experience and headed up Coke's North American bottling operation, Coca-Cola Refreshments. Thus he understands better than most how Coke could help Keurig Green Mountain scale its products across continents.

Variable No. 3: Don't forget the Coke guys in lab coats
Finally, investors must ask themselves: What if the technology doesn't bear out? My Foolish colleague Ted Cooper has a nice piece on the Keurig Cold that touches on this topic. But perhaps as important as the introduction of a reliable home soda delivery system is the necessity of getting signature Coke-brand flavors right.

Some of the risks in flavoring are reduced by Coca-Cola's own technology. Not only does Coke have an innovation resource at hand in its bottling partners, it has what is arguably more sophisticated technology than either Keurig Green Mountain or competitor SodaStream do that can be applied to home drink dispensing machines. In developing its "Coca-Cola Freestyle" fountain, which is capable of dispensing over 500 flavors from a single drink fountain, Coke engineers used micro-dosing technology originally developed for the pharmaceutical industry. Between Coke's bottlers and its own engineering teams, it's no stretch to imagine that the flavor profiles of its drinks will meet the exacting expectations of Coke aficionados. 

So, just what is the market thinking?
Despite the difficulties surrounding the estimation of earnings and cash flows, the market seems to have settled on a premium for Keurig Green Mountain, albeit framed in the volatility that this stock seems to enjoy as a popular momentum play. I believe that the group wisdom of institutional and retail investors isn't, for the moment, hyperfocused on future revenues and cash flows. Instead, the market is grappling with the concept of intrinsic value -- that is, what a company is actually worth when you factor in everything: tangible and intangible assets, long-term debt, operational efficiencies, market opportunity, competitive advantages or weaknesses, and the like. 

More specifically, I believe the market is zeroing in on the following question: What's the value of Keurig Green Mountain's ability to stamp the world's most valuable beverage brand, estimated to be worth $79 billion, on the lid of the cup that will house the ingredients and formula to issue forth a cold, effervescent, refreshing glass of Coke?

In this instance, Keurig Green Mountain's future cash flows are being sprinkled with the pixie dust of the Coca-Cola brand. It's an eye-opening event, as we rarely get to watch the power of a valuable brand quantified in this way.

In his classic investment treatise The Intelligent Investor, Benjamin Graham eloquently described a certain valuation conundrum not far removed from that which Green Mountain finds itself in after the Coke investment:

The whole structure of stock market quotations contains a built-in contradiction. The better a company's record and prospects, the less relationship the price of its shares will have to their book value. But the greater the premium above book value, the less certain the basis of determining its intrinsic value -- i.e., the more this "value" will depend on the changing moods and measurements of the stock market.

You could apply this reasoning to many a highly valued company in the equity markets today, but it seems to make sense in a situation like this, where Green Mountain's prospects are bright, but its share price has really disconnected from book value. We're used to seeing this phenomenon in technology stocks like LinkedIn, less so for manufacturers of consumer goods. 

So, is the stock price of Keurig Green Mountain overvalued or undervalued? Most likely, it's neither, meaning that the stock is fairly valued and the roughly 20% premium at which it trades today, versus life before Coke, represents the market's best guess of the intrinsic value and power of the Coke trademark in Keurig Green Mountain's hands.

This premium is adjusting in real time, every day, and will continue to get adjusted with each earnings report, even before the release of Keurig Cold, but more significantly after, when the first pods hit the shelves and data starts to trickle in. At that point, it will be time to grab another envelope on the way to your armchair.

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