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Green Mountain Coffee Roasters (Nasdaq: GMCR ) continues to percolate. Its stock performance over the past few years has been nothing short of outstanding. Will it last? In this edition of Long or Short, I'll dig into the coffee grounds to see if Green Mountain will continue to provide investors a rich, full-bodied flavor or a bitter aftertaste.
Rich, full-bodied flavor
Green Mountain makes a mean cup of joe. I am not a coffee connoisseur, but I have to say that I have enjoyed a few K-Cups. And with more than 6 billion K-Cups sold cumulatively, I am not the only one. It's certainly better than Kraft's (NYSE: KFT ) Maxwell House or Smucker's (NYSE: SJM ) Folgers instant coffee/paint thinner. And Starbucks' (Nasdaq: SBUX ) Via, in my opinion, has a ways to go to achieve the same penetration. There's no doubt that Green Mountain has a product people want.
I love the business more than I love the product. Green Mountain uses a razor-and-razor-blade model. It sells Keurig brewers (the razors) that take only K-Cups (the blades). Management sells brewers at close to cost and creates its profit from high-margin K-Cups.
Green Mountain combines a good product and better business model to generate incredible sales and earnings growth. Over the past five years, sales have increased 48.5% per year, on average. Net income grew even faster, averaging 51.3% over the same period. It's hard to argue with growth like that.
But I do wonder if the concept is reaching saturation. As the company has sold more brewers and K-Cups, consumption stats have been slipping, as measured by K-Cups/brewer/day. It's fallen from 3.7 in September 2007 to 1.8 in March 2010. To me, that says incremental brewer sales are generating fewer and fewer incremental K-cup sales. That's a sign that the company may be saturating its markets.
Earnings growth has been stellar. But as the saying goes, "Earnings are an opinion, but cash is a fact." In the past two fiscal years, operating cash flow has been below net income, showing low earnings quality. And you can just forget about any free cash flow. Free cash flow margin has been dipping lower, from 5.3% in 2001 to -3.3% for the 12-month period ending March 2010. Those numbers are going in the wrong direction for a company that's experiencing tremendous sales growth.
So why has the company generated incredible growth without generating free cash flow? It's simple. Cash flow on a per-K-Cup basis is just not there. One would think the business would be able to generate some economies of scale and have some pricing power with the branded K-Cups. But it just doesn't seem to be there.
Companies create value by earning returns on invested capital higher than their cost of capital. Green Mountain may be able to roast a mean bean, but it also knows how to destroy value. ROIC has been trending down since 2003. Fiscal 2006 marked a turning point where Green Mountain went from value creator to value destroyer. That's not a recipe for success over time.
I know what you're saying. "That's great, Dave. But Green Mountain's stock price has done nothing but go up." Absolutely true. But per the chart below, short covering has played a huge role in driving Green Mountain's stock price higher. If the cash flows don't fill in to justify the valuation, which doesn't seem likely, then the stock price is likely to go lower again.
My bottom line
As soon as the price breaks $30 per share, I am going to short Green Mountain again in CAPS. Green Mountain may have a good product and a strong business model that drives sales and earnings growth, but it's lacking where it really counts: ROIC and cash flows. If those measures don't improve over time, the stock is likely to leave a bitter aftertaste in investors' mouths.