As you probably already know, shares of Green Mountain Coffee Roasters (NYSE: GMCR) fell off a cliff Thursday, losing almost half of their value. The company trimmed its outlook for the rest of the year. Still, the sell-off seems overdone. The stock now trades at a P/E of just 13, which appears to be an incredible value for a company still growing by more than 30%. However, investors are worried about patents expiring this September that would allow competitors to make their own K-cups, and are suspicious of Green Mountain's financial reporting and its inventory management.
Patent cliff
Green Mountain owns at least 37 patents on the Keurig, but two primary ones are expiring in September. One protects technology that keeps a specific amount of coffee grounds in each K-cup and the other patent is for the way the cup gets poked so the brewed coffee can flow. Some analysts have said the patent expiration could be significant, but it's hard to determine the consequences with any certainty. Green Mountain has filed for patents on different pod designs, including ones that hold more coffee, as well as for its new single-cup brewer, the Vue.
Even before the expiration date, competitors have already started to undercut the K-cup maker. Rogers Family Coffee, for instance, has already begun making coffee pods for the Keurig, and sells them at $6.99 for a 12-pack compared to $16.49 for a 24-pack of K-cups on Green Mountain's website. Green Mountain responded by suing Rogers last year, but the entrant has continued to produce the coffee pods.
Funky financials
Green Mountain's numbers have also been the subject of much criticism from shorts like hedge fund manager David Einhorn. The company has built up enormous levels of inventory, which has cut into cash flow. Operating cash flow for fiscal 2011, which ended last September, was just $785,000, with inventory additions making a $375 million dent. The Keurig-maker spent more than $283 million on capital expenditures, mainly on buildings and equipment to make more K-cups.
Some commentators have questioned the validity of these capital expenditures and think Green Mountain could be playing accounting games to boost profits. In a presentation for shorting the Keurig-maker's shares, David Einhorn said he believed the capital expenditures far exceeded the amount of money needed to expand K-cup production. While some skepticism may be deserved for the cash flow shortfall, the company has posted positive free cash flow in the last two quarters.
No need to run
The odd thing about Thursday's sell-off was that the patent expiration and accounting concerns were old news. Investors' reactions came purely from the coffee brewer not hitting its numbers for K-cup sales and dialing back its outlook for the year, which was interpreted as a dramatically slowing growth trajectory. According to management, warm weather also put a dent in sales of seasonal items like hot cocoa and apple cider pods, and they may need to write down inventory because of the off-base estimate.
And while investors should be concerned about the coming patent expiration, let's not forget that Green Mountain has developed a strong K-cup family around the Keurig and has partnered with coffee heavyweights Dunkin' Brands (Nasdaq: DNKN), Caribou Coffee (Nasdaq: CBOU), and Starbucks (Nasdaq: SBUX) to sell branded K-cups, which would seem to provide a buffer against the likes of upstarts such as Rogers Family. Of course, Green Mountain may be forced to lower its prices when competition arrives, but today's share price seems to be factoring that in already.
Some critics also see Starbucks' single-serve brewer, the Verismo, as a threat, but they seem to be forgetting the beauty of the razor-and-blades model. Anyone who has already shelled out for a Keurig brewer probably isn't going to buy a Verismo, and should continue purchasing K-cups. And as my colleague Rick Munnariz points out, even if knockoff K-cup sales take off, that will only be an incentive for Green Mountain to raise the price on the Keurig brewer, which still has years left on its patent, potentially turning it from a loss leader to a profit center.
For all of those reasons, I'm convinced the stock was oversold Thursday. Most of these concerns weren't new last week, and a revised growth rate from skyrocketing to merely speedy isn't enough of a reason to slice shares in half. I've decided to make a short-term bullish CAPSCall on Green Mountain. I'm looking for a rebound of about 20%.
I'll be paying close attention in September when the patents come off and things get interesting, but for now a P/E of 13 seems too cheap to ignore.
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