Keurig Green Mountain Inc.'s K-Cup Is Half-Full, Not Half-Empty

Keurig Green Mountain (UNKNOWN:GMCR.DL) shares spiked in hyper-caffeinated fashion this past week, rising more than 17.5% after the company released its second-quarter fiscal 2014 results. The market responded heartily to a 9.8% improvement in revenue versus the prior year's quarter. Since the third quarter of 2012, Keurig Green Mountain's year-over-year quarterly top-line increases have gradually tapered off, hitting a trough last quarter, which outpaced its comparable period by only 3.5%. The first three months of 2014 seem to have reassured investors that the company is still capable of vigorous growth.

The Vermont-based coffee purveyor is benefiting from a trend in single-serve coffee consumption, which, far from being played out, is on the rise within the U.S., Green Mountain's primary market. According to the National Coffee Association's National Coffee Drinking Trends survey released this spring, U.S. single-cup brewer coffee consumption increased from 20% to 29% from 2012 to 2013. Moreover, a full 25% of those surveyed said they were likely to buy a single-serve coffee machine within the next six months. The U.S. is the world's largest consumer market for coffee, and a serious one at that: According to the NCA, Americans prefer coffee to a host of other beverages -- including tap water.

Stronger finances continue to brew
Investors welcomed the efficient use of the company's resources during the quarter. Management has recently displayed a deft handling of the components of working capital, particularly inventory. As you can see from the following chart, Keurig Green Mountain is keeping a tight handle on its raw materials and finished goods, even as revenue, and thus production demand, steadily increase:

GMCR Revenue (TTM) data by YCharts. 

Because of its working capital management, and a near doubling of its operating income margin over the last three years (from roughly 10% to just over 19%), Keurig Green Mountain also enjoys abundant free cash flow, and heads into the rest of the year with an extremely solid cash position. As of March 29, 2014, the most recent balance sheet date, Green Mountain held $1.1 billion of cash, which alone was well in excess of both current liabilities of $554 million and non-current long-term debt of $151 million.

Dealmaking ramps up

Keurig Display image courtesy Mike Mozart under Creative Commons license.

Another discernible boost to share price during the past week was the announcement of an expanded partnership with the J.M. Smucker Company, which owns the Folgers and Millstone brands, among others. Keurig Green Mountain is in full-blown licensing mode, having also announced new or extended licensing agreements with Krispy Kreme, Starbucks, Peets Coffee & Tea, Lavazza, and of course, Coca-Cola, in the second quarter alone. CEO Brian Kelley, a former Coke executive, appears to natively appreciate the importance of widespread distribution via licensing and partnerships -- a cornerstone of Coca-Cola company strategy.

Licensing deals explain why the bottom didn't fall out of Keurig Green Mountain's business when its original patents for the K-Cup expired in September 2012. Twenty months after patent expiration, Green Mountain's business model churns steadily along. This is because the company made an intelligent decision some years ago to aggressively partner up with brands consumers loved across a wide variety of price points, including Dunkin' Donuts, Starbucks, Newman's Own Organics, Eight O'Clock Coffee, and Timothy's Coffee, to name a diverse handful. 

By tying up consumer demand before patent expiration, Keurig Green Mountain carved away the greater part of the market. What's left for unlicensed K-Cups is largely a value or discounted segment; for example, private-label K-Cup brands sold in Costco and Safeway. This of course is a tangible portion of all available revenue, but hardly the lion's share. According to Rabobank global beverage strategist Ross Colbert, unlicensed K-Cups have the potential to increase to 10% to 12% of total market share over the next few years, from approximately 8% share today. This won't upend Keurig Green Mountain's earnings anytime soon.

Avoiding competition where possible: Making friends instead
Last week, Mondelez International announced that it will spin off its coffee business and merge the unit with Netherlands-based D.E. Master Blenders to create a $7 billion global coffee company. An analyst on Green Mountain's earnings call questioned whether this would translate into increased competition for Green Mountain. As CEO Kelley noted, JAB Holding Company, which acquired D.E. Master Blenders last year, also owns Peets Coffee & Tea and Caribou Coffee, two of Green Mountain's licensees. Kelley indicated that Green Mountain considers JAB a "strong partner," and this should be of interest to investors. Green Mountain needs to expand into Europe and beyond, and JAB's recent acquisitions have been driven by a desire to challenge the world's No. 1 coffee company, Nestle. Nestle owns the Nespresso pod coffee system, which happens to be the only single-serve coffee platform larger than Keurig Green Mountain. Thus, JAB and GMCR may become even stronger partners in the near future, to their mutual benefit.

Why GMCR's valuation may remain high
After last week's ascent, Keurig Green Mountain traded at nearly 31 times trailing-12-month earnings. But this level is actually off the company's peak P/E ratio of 36, gained in the heady weeks following the announcement of its exclusive agreement to offer Coca-Cola's sparkling and still beverages on the upcoming "Keurig Cold" machine. 

I've argued that the market cannot currently predict with accuracy the impact of Coke's branded products on Green Mountain's revenue, earnings, and cash flow. In lieu of a projected cash flow-based valuation, investors may be assigning some of the intrinsic value of Coke's powerful trademark to Green Mountain -- that analysis can be found here. 

I believe the company's second-quarter earnings report supports this reasoning and moreover, has provided a rationale for Green Mountain to trade at a higher multiple. The potential for expanded revenue and profits from the upcoming Keurig Cold now seems more realistic. Far from providing a safety net or a plug to declining revenue, the Coke deal and related equity interest will enhance an increasingly stable business.

You can see the stock price buoyancy Coke lends in the fact that this past week's surge wasn't driven by the exiting of short positions, which has been a factor behind some of Green Mountain's historical stock runs. In fact, Coke's sudden relationship with Green Mountain, effected near the beginning of this year, dramatically drove shorts from the building, as data through last month show: 

GMCR Short Interest data by YCharts.

Without the counterweight of substantial short interest, and with the potentially transformative revenue and earnings from Keurig Cold, price-to-earnings multiple contraction may be less likely than it seems, at least until the first quarterly results of the Cold are in the books. In plainer words, Green Mountain is operating under a Coke halo for the time being. 

Looking ahead: Potential coffee spills cloud the horizon, yet the K-cup is half-full
Despite its spate of licensing and muscular financial position, risks abound for Keurig Green Mountain. There's the risk that the Keurig Cold's technology may not come to fruition, although that risk is mitigating, as during the earnings call, Kelley confirmed that the company has a working model of the Cold machine produced under manufacturing conditions.  

A risk also exists that the company's other upcoming new machine, the "Keurig 2.0," may see underwhelming sales if current customers don't find a reason to upgrade. I believe this is one of the more tangible threats in the near term to Keurig Green Mountain's continued revenue growth. The Keurig 2.0, with an as-yet undisclosed price, will be able to distinguish between licensed and unlicensed K-cups, and may potentially rejected unlicensed cups. Too high a price point could de-incentivize customers, especially those new buyers without a pre-existing loyalty to Keurig: Would you pay more for a machine to have fewer brewing choices?

However, as the Keurig 2.0 eventually phases out the original Keurig model, this potential drag will dissipate by default. Keurig Green Mountain hopes that the 2.0's ability to brew larger "carafe" portions of coffee will offer consumers a tangible reason to trade up, or purchase for the first time. Most important, the greater portion of the global market, where Green Mountain hasn't had any presence before fiscal 2014, will see only the 2.0 and future versions. And at the end of the day, the global market is precisely where Green Mountain will find its next phase of growth, as it continues to attack opportunities in the vibrant U.S. coffee market.