As fall arrives and coffee aficionados prepare to counter brisk mornings with steaming cups of java, Keurig Green Mountain (NASDAQ: GMCR ) is entering a particularly crucial period in its business. Since two of the company's patents expired in September 2012, Keurig has grappled with the proliferation of unlicensed K-Cups. The company has responded by developing the Keurig 2.0 brewer, which uses a proprietary method to brew only its own branded and Keurig-licensed cups. Investors will closely monitor sales of the new system over the next two to three quarters, as Keurig's stock has brewed up a 76% rise so far this year.
Much of the company's fiscal third-quarter 2014 earnings conference call early last month revolved around the 2.0, which launched on Aug 25. In this context, let's review five points management wanted analysts and investors to come away with on the call.
The first comment is from CFO Fran Rathke, while all the others are from CEO Brian Kelley.
1. Cash is flowing, and we've got plenty of it
[O]ur balance sheet remains very strong with cash of $1.2 billion and total debt of $274 million at the end of the quarter. We generated free cash flow of $127 million in the quarter with $602 million year to date. It's also worth noting that we delivered 132% free cash flow productivity on a year-to-date basis.
The Keurig 2.0 launch necessitated investments in inventory and marketing. In addition, the company is investing in production facilities for its Keurig Cold platform for carbonated beverages, which will be introduced next year. Net fixed assets increased 12% year over year in the quarter, to $1.1 billion as of June 28.
Management highlighted the company's cash position and positive cash flow to communicate that it has control over its expansion priorities. This is particularly relevant to shareholders attracted to the company's 0.75% dividend and stock buyback policy, which has repurchased just shy of $1 billion worth of shares year to date.
2. We're still aggressively pursuing licensing deals
The brands we have announced include Target and its Archer Farms brand, BJ's Wholesale Club and its Wellsley Farms brand, Harris Teeter and its store brand, as well as Nestlé Coffee-Mate K-Cup packs.
Two weeks after this conference call, Keurig Green Mountain added another prominent name to its list of licensees: Kraft Foods. As a complement to its strategy of introducing proprietary K-Cups, Keurig has engaged in a flurry of deal making this year to bring unlicensed K-Cup producers into the fold. By pursuing the largest companies first, the company is trying to undercut the growth in market share of unlicensed cups; that is, single-serving cups compatible with its brewer for which it doesn't get a cut.
3. We can handle the financial impact of this licensing push
We believe margins are going to stay in healthy ranges given all the moving parts of new and existing brands as we bring them in, and ... there are a number of levers we have and we always pull those levers in terms of productivity.
As Keurig seeks to maintain its market share by bringing unlicensed K-Cup retailers into its system, analysts on last month's call expressed some concern that gross profit margins might suffer. When Keurig strikes a licensing deal with a company such as Costco, it sells K-Cups at a wholesale price. As Rathke explained, this is because private-label retailers absorb some of the costs in the value chain (for example, marketing and distribution), as opposed to Keurig's own branded K-Cups, in which it bears all costs to the point of retail sale.
Management communicated that a variety of factors influence its gross profit mix, and that it had enough leverage in its cost structure to absorb the increasing number of portion packs sold at wholesale pricing. Investors should take this at face value, but continue to monitor the company's gross margin well into next year, when the impact of 2014 deal making will have worked its way fully through the profit and loss statement. Gross margin so far this year is solid at roughly 39%.
We want more from our Keurig customers
We also expect that Keurig 2.0 will allow us to capture some portion of the 25% of coffee consumption we estimate that we are currently not getting in existing Keurig households, due to the occasional need for multiserved brewing.
The Keurig 2.0 comes equipped with a four-cup capacity carafe, allowing customers to brew in volume. Keurig has made a reasonable assumption that 2.0 customers will use the carafe function for the 25% of the time they aren't brewing single K-cup servings -- a lost revenue opportunity in earlier machines.
The new feature also represents a potential pitfall, however. Should coffee drinkers decide that they like having a separate, higher-capacity brewing system for non-single cup servings, the Keurig 2.0 might be perceived as coming out of the box with an unwanted feature, potentially signaling price reductions for the system in the future. Investors will want to see if the carafe feature, one of the most heralded in the new system, is indeed a convincing reason for customers to upgrade.
That international expansion we talked up will have to wait a bit
The start of our global expansion began with the launch of a hot system in the U.K. away-from-home channel earlier this year. While we believe there is significant opportunity for both our hot and cold systems in international geographies, we will be selective and disciplined in pursuing them and we do not expect meaningful contribution from international revenue in the short term.
In last year's 10-K annual report, and in subsequent quarterly reports, Keurig promised that beginning in fiscal 2014 and on into fiscal 2015, the company will enter new international markets, with the launch of Keurig products in the U.K., Australia, South Korea, and Sweden. In earnings conference calls this year, however, management has played down the significance of this strategy, saying that it won't be material to results. Besides the U.K., the company hasn't yet disclosed further progress abroad.
The inference is that management has its hands full with the launch of Keurig 2.0 and the impending release of the Keurig Cold platform. It seems evident that Kelley and team are aware that these two products are vital to the company's long-term success. In particular, Keurig Cold will present operational challenges, as the company will need to flawlessly reproduce partner Coke's famous soft drink brands in its cold carbonated dispensing system for the launch to succeed. If all goes well with these two initiatives, the company appears to be saying, there will be plenty of time for a long run at international expansion.
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