Following the underwhelming debut of its Keurig 2.0, Keurig Green Mountain (UNKNOWN:GMCR.DL) has pegged its future success to the Kold beverage system.
Meanwhile, Skullcandy (NASDAQ:SKUL) moves forward with its expansion efforts as its multi-year turnaround seemingly takes hold. With both stocks suffering significant losses year to date, is this the right time for investors to buy?
A full transcript follows the video.
Sean O'Reilly: Would you pay $1 to make a glass of Coca-Cola in your home? On this consumer goods edition of Industry Focus.
Greetings, Fools! Sean O'Reilly here at Fool headquarters in Alexandria, Virginia. Joining me today to discuss the consumer goods sector is the eminent Vincent Shen. How's it going today, Vince?
Vincent Shen: I'm doing well, Sean. How was your weekend?
O'Reilly: It was pretty good. Nice long weekend. We definitely got outside. I took my son to the park with the big water fountain deal going on and he got really wet.
Shen: Not surprised by that.
O'Reilly: Then he jumped on me.
Shen: I'm glad you had a good weekend because we're going to talk about some beaten-down consumer goods stocks.
O'Reilly: Beaten down consumer goods stocks?
O'Reilly: First up, we're going to be talking about Keurig Green Mountain, and I know it's basically do or die time for them. How are things looking in your estimation post Keurig 2.0 -- which just got rolled out -- and pre-Kold? Our listeners may or may not be aware, but that is their in-home beverage system for cold beverages that's going to be coming out.
Shen: The best way I can describe that is probably stuck between a rock and a hard place. They're in a very precarious position. I think they fumbled the Keurig 2.0 significantly, building up a lot of ill will instead of goodwill with their customers.
O'Reilly: You see these videos on YouTube? Basically consumers are teaching other viewers how to hack the 2.0.
O'Reilly: This isn't to say that they're not profitable though. They're still making money, it's just a little bit less.
Shen: Yeah. Admittedly, the stock has really taken a beating.
O'Reilly: It's down 60%.
Shen: Yeah. I think its high was in the $150's. Now it's in the high $50s range over the past year. Like you mentioned, the customers were not happy with the Keurig 2.0 when they tried to lock out third-party pods. The thing is, it's an understandable business decision if you look at it strictly from that view, in that the pods make up the lion's share of their top line.
O'Reilly: I like Keurig's basic business model a lot. You've got 20 million of the original Keurig machines across the country, and that's supporting all the pod sales, which is 84% of their business. The analogy I always make is, it's the Gillette disposable razor-blade model. Can you imagine Gillette actually selling the handle for razor blades, and then letting competitors' blades go on there? That wouldn't work.
To Keurig's credit I can't blame them for doing that; but there was a backlash. People were figuring out how to hack it, and they just stopped. To give everyone a little context before we move on, I'll give everybody some numbers. Their third quarter for fiscal year 2015 came out a month ago. Non-GAAP earnings per share came in at $0.80, GAAP earnings per share of $0.73; that was a little below consensus estimates.
This is actually the troubling stuff, though. Net sales declined by 5% -- 4% excluding foreign currency fluctuations. Pod equivalent servings volume growth of 5%. So they sold 5% more pods in the quarter than last quarter, but revenues were still down because of the price competition, which they called the "product mix." That just means people were buying the cheaper pods.
Shen: I think that's the real problem that we should be calling attention to. The number of their unit sales for their pods went up, but their actual dollar number for revenue went down, and that's coming from the fact that they have to compete with the lower price third-party pod providers and makers.
Overall, their gross margin for that quarter plummeted. It really took a hit, going form 43.5% to around 36%. The net margin fell also from 15% to 12%. Those declines are not what Wall Street wants to see, that's for sure. It explains why the stock fell 30% that day after the report. Brutal trading.
O'Reilly: Like any good, self-respecting company that wanted to engender confidence from its shareholders, they announced a $1 billion share buyback. So they fumbled the 2.0 release, nobody's buying the machines. I think machine sales were down 30% or so.
Shen: The brews and accessories sales were down 22% year-over-year for the quarter.
O'Reilly: I overshot a little. So they fumbled the 2.0 release, which is supposed to be their answer to the problems they've been experiencing with competition pods and super pods; they've locked them out, but it's not taking. They're also getting competition. I was walking through Target yesterday with the wife and son, and they've got a very nice Keurig base display with the 2.0, and you've got all the pods and machines and everything.
In the next endcap was the Nespresso machine that's basically a competitor for the machine. It's more expensive coffee; but it's also awesome. Basically, all their hopes for future growth -- and all shareholder's hopes for future growth -- are pinned on this Kold -- which is spelled with a K, of all things.
Shen: Before we get into that, the last thing you mentioned before we jumped into the Kold details is the buyback program. That one really hit a nerve with me, too. You just released a weak quarter.
O'Reilly: Where are they going to get the money for that, though? I actually have a note here to myself: "Their cash and cash equivalents fell." Cash and cash equivalents last year, on June 28th, 2014, was $1.2 billion. Guess what it is at the end of June this year?
Shen: Very, very low.
O'Reilly: $80 million.
Shen: The reason for that?
O'Reilly: R&D, investments into their other buyback program.
Shen: The last buyback program ... I think I saw that they purchased their shares at an average price of about $120.
O'Reilly: That's where Coke bought in, too. Coke owns 16.8% of the company; that's why they're developing the Kold with Coca-Cola. Their purchase price is way higher.
Shen: Considering the fact that last buyback program -- at least on a short-term basis -- has been disastrous, that's basically a 50% loss on that. They crushed their cash position, increased their debt levels, and now they're announcing another one. I know that management wants to signal that they think their stock is a good value right now, but when you're juggling all this and your core business is in dire straits, do you really want to worry with juggling another ball with the buyback program?
Shen: Going from there, now, we're looking at the Kold. This one is funny. I always bring up a company that I think represents what could potentially happen on the negative side, which is Sodastream.
O'Reilly: This was a Foolish pick, not our best. They're an Israeli company, and the analogy is actually perfect, because they, too, have a solid, basic, profitable business just like Keurig Green Mountain does with their hot beverage business. Sodastream has a lock on the carbonated water in Europe. Europeans love carbonated water, and they don't even need flavor. They just love carbonated water.
Everybody has a Sodastream, they use the CO2 cartridges, and that's it and it's profitable. All the upside with Sodastream for the theory a couple years ago was the United States, and flavored water here, and it has not panned out at all.
Shen: Here are the positives for the Kold: first of all, they mentioned that the addressable market is 5x that of the hot beverages.
O'Reilly: Right. That was actually crazy because you think about all the money that Americans spend on Starbucks and Dunkin' Donuts and Folgers in the house, and Keurig machines. On the flip side, the cold beverage market in the United States includes everything from water, iced tea, Coca-Cola, Pepsi; it goes on and on. It is huge. If you get a small chunk of that, they can make a bunch of money.
Shen: That's a positive. Very large, addressable market; won't deny that. I also think they've lined up some very strong partnerships for the Kold.
O'Reilly: If you're going to partner with somebody, you're going to partner with ...
Shen: They've got Dr. Pepper, they've got Sprite, I think they have Canada Dry, too. They've locked down some excellent partnerships for products on the Kold beverage side that people are going to want. My biggest problem, going from the positive side to the negative side, is the price tag on the beverage system.
O'Reilly: For our listeners that don't know, the Kold machine is going to roll out in limited quantities later this year, online through the website, and it will be completely in stores and all retail outlets by the holiday season 2016. The price is $299, and the pods -- from the investor presentations -- they're saying the pods for an 8oz Coca-Cola glass will be $0.99 to $1.29, depending on the brand we're talking about.
It will cost you $1 to make an 8oz serving of Coca-Cola in your home, with a $300 machine.
Shen: The Sodastream is in the $100 range.
O'Reilly: That limits your potential market. I don't know too many people that will drop $300 on one.
Shen: That really boggled my mind.
O'Reilly: The Sodastream costs, what? $80? $100?
Shen: They're already seeing how people are moving toward the lower cost wherever possible on their coffee on the hot beverage side, with the third-party pod providers. I think that price tag, plus the fact that management is really pegging all their hopes on the success of the system, is a little scary to think about.
O'Reilly: It's almost like they really need to build up. Arguably, it's early in the game for in-home single-serve beverage brewing. It seems like they need to build up their brand. You know how, even if it's cheaper, you don't usually buy the in-store brands of Coca-Cola?
Shen: I can see that.
O'Reilly: It's almost like they need to get in everyone's heads that the Keurig brand pods are the best darn coffee. That's actually how they got their start; really good beans. It's almost like they need to get the consumer to buy into buying their pods, and then they can charge a premium price and everything's peachy. I don't know about this Kold.
Shen: Looking at the stock now, we're trading in the high $50 levels for the price. Valuation-wise, it's about 17x expected fiscal 2016 earnings. This is the lowest priced earnings multiple it's been at in several years.
O'Reilly: It's at the market P/E.
Shen: At best, this is a wait and see, because they need to show that they can regain these margins, boost sales, handle their pod competition, wisely buy back shares, and successfully introduce a whole new beverage system. That's a ton.
O'Reilly: Not only that, but if you bust out your original copy of The Intelligent Investor, by Benjamin Graham, he wouldn't pay 17x earnings for a company that's not guaranteed to grow. Let's pretend it grows with the U.S. economy. It's worth 10x earnings.
Shen: I will say that it does have a very strong base.
O'Reilly: There are 20 million machines in the United States.
Shen: It is generating pretty strong cash flows from when I last checked. I think they have some resources that they can push into the rollout of the new system, and it's not a dead stock; but there are a lot of balls in the air.
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Moving on to our mailbag question of the week, Jessie Flynn, Jr. writes in and asks:
"What are your thoughts on Skullcandy going forward? They have zero debt and are a leader in mid-range priced headphones and speakers."
That's literally all he wrote. I don't know if he wants to know if we think it's a buy or sell, or what. Real quick, for our listeners that aren't aware; what is Skullcandy, Vince? Fun name, by the way.
Shen: Yeah. I have some experience with their products, too. They've expanded their offerings, especially a very notable part of their business, which is when they acquired Astro. That really got them to the gaming segment. They produce audio products like headphones, earbuds, and Bluetooth speakers.
O'Reilly: If I'm a heavy, big-time PC gamer or something, they sell the best darn headphones there are?
Shen: Very strong, leading products on both ends. Both with Skullcandy and Astro brands. I can understand why some of our members are interested.
O'Reilly: They have to compete with Bose.
Shen: That's actually not really the case, because you have a company that knows what its target market is. As Jessie mentioned, they hit a price point between $25 and $100, at least on the Skullcandy side. They really dominated that segment. Something that the company definitely has going for them is that they have some of the leading products in that price segment of that target market. They're doing very well there.
O'Reilly: So Bose and Beats they're up to $200?
Shen: They're the high end, up to $400. They're basically targeting a different segment of the market.
O'Reilly: At the end of the day, it is a consumer-electronics company. Are they profitable? What's been going on with them?
Shen: I think the reason why Jessie brought this question up is the fact that the stock is down 20% year to date, it's trading around $6.68 at the last close, and it's fallen about 40% since the peaks that it reached in April and May. The thing is, the shares really took a cliff dive when they released their first quarter earnings.
On the surface, the report didn't seem all that bad. They experienced some negative foreign exchange impacts, which is not surprising. That's happening to pretty much any global company. The thing is, excluding those effects, sales were up 21% year-over-year, the company reduced its operating loss, and it either met or beat Wall Street expectations on their top and bottom lines.
Like I mentioned, it continues to lead. It's sold the most by dollar value, or by units in those price segments that it targets.
O'Reilly: Is there any hope of profitability?
Shen: The company is going through a turnaround period right now since things took a dive around 2013. I think some pain points that scared investors for the quarter were similar to Keurig. The gross margin weakened significantly. It fell six points to about 40%. The company is trying to offset that by reducing some of their operating expenses as a percentage of revenue, as well.
There are reasons driven behind that. They're really trying to grow their Astro gaming division, which, compared to the broader gaming industry, is growing at multiples.
O'Reilly: So it's capturing market share?
Shen: Yeah, but the margins are lower in that segment. It's going to see a shift in that product base that you like to see. This is a positive development because, ultimately, that's a very high growth area for them. The products are leading in that segment.
For the second quarter -- how the company has been doing since then -- revenue was up double digits again, and the gross margin was down, but only 220 basis points. That's not as bad, year-over-year. It was just shy of estimates on the top line, but it beat on earnings.
Astro growth is still phenomenal. International growth, management is targeting sales to go from 30% of the top line for international to about 50%. It's been growing very well in the high teens, and low 20s on the international side. That also explains why those currency impacts are hitting a little bit.
O'Reilly: What do you want to see from them to make the company of interest to you?
Shen: I think it has a lot of long-term potential. It is executing a turnaround plan, and it's expanding into more products, like the Bluetooth speakers. They're also hitting on a women's line for the holiday season, and they're also inking some good partnerships with retailers, whereas they were usually focused on specialty action-sports stores.
Now they're hitting on big retailers like Target, Wal-Mart, Best Buy; and they're doing a lot of the store-in-a-store experiences like we talked about last time where Apple was doing really well with that at Best Buy. Otherwise, if we're focusing on their online sales, as well, potentially working with Amazon -- and this is all with a delicate balance of maintaining a very good partnership with those specialty retailers that are so important for them.
The customers go there, purchase the Skullcandy products, and introduce it to wider demographic. Overall, the stock currently trades about 16x and 12x forecasted 2015 and 2016 earnings; so it's not expensive. It has zero debt on the balance sheet, which is always ...
O'Reilly: That's so rare.
Shen: Overall, I think, as it continues to execute very well on the turnaround plan, I think those margins are going to hit what management believes to be a steady stay level of 44% to 45%, and that growth from some of the segments like international, Astro, they're seeing a lot of positive developments in places like India, Europe, and China that will push them into profitability, and the stock will rebound to its $11 levels it was trading at previously.
O'Reilly: Cool. Thanks for your thoughts, Vince.
Shen: Thanks, Sean.
O'Reilly: If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at IndustryFocus@Fool.com. Again, that's IndustryFocus@Fool.com. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!
Sean O'Reilly has no position in any stocks mentioned. Vincent Shen has no position in any stocks mentioned. The Motley Fool owns and recommends Amazon.com, Apple, PepsiCo, and Starbucks. The Motley Fool owns shares of SodaStream and has the following options: long January 2016 $37 calls on Coca-Cola, short January 2016 $43 calls on Coca-Cola, and short January 2016 $37 puts on Coca-Cola. The Motley Fool recommends Coca-Cola, Keurig Green Mountain, and Skullcandy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.