When value investors see any sudden and significant drop in the stock price, they often smell opportunities. Especially it was the drop of one of the most beloved ticker in the stock market; they would be getting more excited. So as value investors, should we begin with long position in GMCR at this price taking all business and financial consideration of the business combined?
Let’s briefly look at the valuation and some key operating matrix first:
For the valuation, it is trading at quite high valuation, with earnings yield of only 2%, P/B at 3.2 and P/CF at 20.6. However, the entire operating figures look astonishing, in EBITDA growth rate, the ROE, etc. The growth rate is very high, the 10 year EBITDA grew at 36.8%, 05 year growth of 66% and 136% year on year growth. But those growth rates were already in the past, whether they can achieved the equivalent or greater growth in the future, the investors like us have to figure it out.
GMCR Business and Starbucks deal
Anyone who is interested in GMCR story should read the detailed analysis of David Einhorn when he presented it in Value Investing Conference. GMCR began its growth when it acquired 42% of Keurig business, singe cup brewing machine for the coffee market, in 2002 for $15million and acquired the rest of the business in 2006. It grew the business via both channels of direct sales and license agreements. And when the stock price went through the roof, the company considered itself as the technology company. The company’s CFO once said: “we are the technology company with the host of patents”. And Larry Blanford, the CEO commented: “I would define our company today as really a single serve beverage company that is sitting on top of this magnificent technology, call it disruptive technology platform.”
One of the big deal that people often mention in GMCR business is the Starbucks deal, signed in March 2011. The agreement happened to be in two ways round. On one way, the GMCR would buy roasted coffee from Starbucks, package it into the K-cup and sell into the retail channel. Then GMCR pays Starbucks a royalty for that. It is called “Licensing”. On the other way, Starbucks buys and roasts coffee, delivers to GMCR, GMCR then package it into the K-cup for Starbucks to sells in its channel. Starbucks will pay GMCR the costs of packaging and manufacturing. So in effect, GMCR is doing “contract manufacturing” for Starbucks. The agreement between the two is non-exclusive and multiyear, and it doesn’t apply to the next generation brewer of GMCR.
As being the Technology Company and Starbucks deal not applying to next generation brewer, the patents of the K-cup is the extremely important key to GMCR success. Even though GMCR said that it had the broad portfolio of patents, in the SEC filings, it mentioned the two principal patents associated with the current generation of K-cup portion packs would expire September 2012. That is the very big risk for GMCR although it is said that it had the pending patent applications, if being issued, would valid until 2023. After September 2012, competitors and others would be legally able to produce K-cups themselves.
So the business operation could not be estimated confidently to grow at that past rate into the future. We would have to wait after September 2012 to see what would happen in its operation and its performance after patent is expired. The business might not be very sustainable, the earning power is susceptible. How about its asset value and its financial position?
As of September 2011, the D/A ratio is more than 40%, including 18% of total asset putting into the long-term debt. The big items in the asset are inventories (21%) and goodwill, intangibles (41.2%).
|Cash and cash equivalents||242||4||13|
|Net property, plant and equipment||136||259||579|
|Additional paid-in capital||451||474||1,500|
|Total stockholders' equity||590||699||1,912|
|Total liabilities and stockholders' equity||814||1,371||3,198|
The financial position of GMCR is being dampened over time; the investment into inventories, PPE, especially the item of goodwill and intangible assets has made the financial position less strong. Over the past 02 years, it is reported to pour $1.4 billion in cash on three acquisitions at the very high valuations. The large investment to grow its business is mainly to “increase the portion pack packaging” and “expand physical plants”. So how can GMCR finance the expansion and the acquisition? By using cash, issuing a lot more stocks (indicated by the more than 3 times increased in the “additional paid-in capital” from 2010 to 2011), and taking in a lot more debt in the past 02 years (it grew from $73 million only to nearly $580 million).
On the note of cash flow generating ability, GMCR is not the brilliant, but consuming cash, maybe. Even though the net income kept increasing from $8 million (when it began acquiring all Keurig), to $201 million in 2011, the jump of more than 25 times, its cash flow from operation has been extremely modest, with the maximum of $38 million in 2009, and it has only $1 million in the fiscal year of 2011. In addition, GMCR kept reinvesting to grow the business, making the capital expenditure growing at extremely rapid rate and making the free cash flow plunging into worse negative conditions. If taking into account the rich valuation acquisition it has made in the last 02 years, the free cash flow position would be much much worse, running to nearly negative $1.2 billion, equivalent to 13% of its total market capitalization.
|Free cash flow||-1||8||-47||-10||-129||-283|
The executive team is holding very little stock in the company, only the large holding which is concentrated in the hands of Robert Stiller, the founder and the chairman of the board, with more than 9% stake in the company. And altogether, the insider holds more than 10% of the company. So the insider action of Robert Stiller alone would be watched out very carefully. Below is the trade made by him since the middle of 2008:
In the very first glance, Robert Stiller kept selling shares in the market, since 2008, no buying action at all. And recently, he closed out some more position and realized more than $21 million in May 2011 and realized further more than $53.7 million when the price was at the peak of $107/share in August this year. With his consistent action, value investors should be worry about the motives behind his trade and about the long term prospect of the company.
With the high cash out flow onto making acquisitions, expanding the business financed by issuing stocks, taking more debts, and the fundamental of GMCR business relying on two patents which would be expired in just 9 more months, I would consider shorting GMCR gradually from now on with little amount, then increasing the amount much more when it approaches September 2012. Due to the time uncertainty in the stock market, investors might consider to buy call option besides shorting to somehow offset the possible loss if the stock experiences short-run advance in its price.
This is the subjective viewpoint of the author, and it is not the recommendation to buy, hold or sell the stocks mentioned in this analysis. Anyone who wishes to buy, hold or sell the stocks has to do his/her own analysis at his/her own risk.