Have Keurig Green Mountain Shorts Been Proved Wrong?

David Einhorn is deep in the red on his Keurig Green Mountain (NASDAQ: GMCR  ) short sale. The famed short-seller caused Keurig shares to fall 10% on the day he shared his short thesis on the company in 2011. The company traded below $20 per share in mid-2012, and Einhorn was sitting pretty. However, Keurig's dealmaking with Starbucks (NASDAQ: SBUX  ) and Coca-Cola (NYSE: KO  ) , among others, propelled its stock to over $120 in the ensuing two years.

Einhorn is still short on the stock – and so is former Fool contributor Whitney Tilson. Is there reason to be concerned about Keurig's business, or are the shorts in denial?

Image credit: Keurig Green Mountain

Mountains of improvement since Einhorn went short
Keurig stockholders evidently believe that the company has come a long way since Einhorn's presentation. In 2011, Einhorn predicted the company's high-priced brewers and K-Cups were nearing saturation and could be manufactured more cheaply by third parties. However, Keurig's soaring stock price is a clear indication that the market no longer believes the short case.

The key part of Einhorn's thesis – that K-Cup margins will be crunched by new competition – has yet to pan out. One-and-a-half years since its patents expired, Keurig still sells 86% of all K-Cups and generates an even higher overall gross margin than before the expiration. In addition, Starbucks signed on to be a partner on Keurig's second-iteration brewer, Keurig 2.0.

Starbucks has failed to sell enough of its own countertop brewers, called Vue, to warrant mention in quarterly conference calls or company filings. Meanwhile, Keurig sells over 1.5 million brewers per quarter. Clearly, the company is still rolling along.

Coca-Cola's investment and partnership on Keurig Cold have also raised expectations and gives a legitimate boost to the at-home carbonation platform's prospects. As the largest soft-drink company in the world, Coca-Cola's brands, distribution capabilities, and marketing know-how give Keurig Cold a strong chance at success. In fact, Keurig Cold's strong prospects have led many to speculate that Coca-Cola may acquire Keurig outright. All of these factors have combined to put the squeeze on short sellers.

Stock could be heading downhill
Despite its strong performance, Keurig may be nearing a peak. Kase Capital founder Whitney Tilson believes that competition is about to get a lot more fierce. "I am shorting it because I think the company's top- and bottom-line growth will continue to decline (and may even begin to shrink) as generic K-Cup competitors continue to take market share and cut prices," wrote Tilson in an April email to Bloomberg Businessweek.

Keurig may in fact gain share in the coming quarters as it licenses additional brands in preparation for Keurig 2.0's launch, making it appear as though the competitive threat does not exist. However, terms of the deals are not public; given coffee brands' negotiating leverage now that the original patents have expired, Keurig may be taking less profit per K-Cup than before the patents expired. There is no way to know for sure unless the company changes its policy on releasing K-Cup gross margin data.

Unfortunately, Keurig 2.0 is unlikely to reclose its platform. Even if existing Keurig customers trade up to the next-generation brewer – and thus shrink the competitive market that Keurig 2.0 must compete with – it is not certain that the new brewer will be immune to competition. An executive at one of the largest white-label K-Cup manufacturers predicts that his company can crack Keurig 2.0 technology in less than a year, opening it up to competition. If he is right, Keurig will have to compete on an open playing field in the single-serve coffee brewing space, something that could eventually prove short-sellers right.

Foolish takeaway
Keurig's impressive stock gains have caused a great deal of pain for short-sellers. The stock is up over 33% since right before Einhorn's October 2011 presentation and could go higher as investors grow excited about upcoming product launches. However, the company's long-term competitive dynamics are less than ideal. If Keurig cannot keep third parties from producing portion packs for its brewers, the company will almost certainly earn a lower profit per K-Cup in the future. Investors should keep an eye on unlicensed market share and gross margins to gauge the competitive impact as the quarters roll by. It's too soon to call this one for the bulls.

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  • Report this Comment On July 21, 2014, at 8:44 AM, giuliobox wrote:


    Coffee Wars: Non-licensed manufacturer cracks new Keurig code

    July 14, 2014

    Checks indicate that a non-licensed manufacturer has already developed technology that allows non-licensed K-Cups to be

    used in the new Keurig 2.0 brewer.

    We recently reviewed a presentation which shows non-licensed K-Cups being used in the new, Keurig 2.0 brewer. Despite

    indications from GMCR that non-licensed K-Cups would not work in 2.0, we have observed tests of a non-licensed

    manufacturer's K-Cups using an independent, proprietary ink compound that can be "read" by the 2.0's technology to

    circumvent GMCR's walled garden. We believe that the new lids on these non-licensed K-Cups use ink compounds that are

    available for sale in the public market but are not part of the GMCR supply chain, avoiding patent or supply chain conflicts

    with GMCR. In brief, the competition appears to have effectively unlocked the 2.0 system before it has been closed. As

    non-licensed 2.0 K-Cup technology becomes more accessible to retailers and coffee brands, we believe all K-Cup

    manufacturers, GMCR included, will face more intense price competition which will pressure category profits.

    Despite this disruption, we still see GMCR gaining K-Cup volumes in the back half of 2014 as it benefits from the

    acquisition of new co-packing contracts, including Peet's, Harris Teeter (KR) and Target (TGT). We also believe GMCR

    will gain volumes as more households become equipped with current generation or 2.0 brewers throughout the back half of

    2014. Longer term, however, we believe that GMCR's competitive moat will shrink significantly as non-licensed K-Cups

    gain access to 2.0. As the hot-coffee, single-serve segment becomes more competitive and less profitable in North America,

    we believe that an acquisition of GMCR by a global beverage company becomes more attractive to GMCR in order

    accelerate global growth. Coke (KO), Nestle (NSRGY) or even Joh A. Benckiser remain potential suitors that we view as

    better positioned to drive global growth of the GMCR platform as the US market matures.

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Ted Cooper

Ted Cooper is a value investor based in Texas. He does not ride a horse to work.

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8/28/2015 4:00 PM
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