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Pardon my mistake – Einhorn likely to speak on GMCR at Robin Hood

August 21, 2014 | About:
Humble Money

Humble Money

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At the end of July, I did a rather detailed analysis on coat-tailing David Einhorn (Trades, Portfolio)'s Keurig Green Mountain short.

I stated at the time that there was, say, a 40% chance of him speaking about GMCR at the Value Investors Conference.

It is now 18 days before the actual congress, and the agenda does not show Einhorn on it. I think it is now very unlikely that he will speak there.

Turns out that he will be speaking at the Robin Hood Conference. He has been listed on there since at least July – and I completely missed it.

Source: BloombergLink

Below are my earlier arguments, which still describe why I think it's likely he will be speaking about GMCR:

Einhorn at Robin Hood Conference

This is what he mentioned in Greenlight's Q1 letter to investors:

"Our Keurig Green Mountain (GMCR) short, which jumped from $75.54 to $105.59, was our only significant loser. The company announced a major strategic partnership with Coca-Cola. We have lots to say about this, but we'll defer that discussion to another time and, perhaps, another format."

"Another format" suggests he might do his regular thing of presenting at a conference, but it could of course also be a self-organised event, webcast, article or interview.

In last week's Q2 letter, Einhorn remained hush, writing only the following:

"Finally, there's Keurig Green Mountain. We will again keep our thoughts about GMCR and Coca-Cola's minority investment (with rumors of a possible takeover) to ourselves."

To me, this suggests that Greenlight may have accumulated a large amount of new research after VIC 2012, that is more suited to being presented in a lengthier / public format.

Adding to that is, of course, the incentive of him talking about a long-underperforming short, with some danger of being acquired at a premium to its price (though there has been shareholder concern regarding Coca-Cola buying stakes for growth).

I'd now estimate, very roughly, that there is a 65% chance of Einhorn picking GMCR as his Best Idea at the Robin Hood Conference. In that case, Einhorn could act like a catalyst for what I've argued to be an overvalued stock that can deteriorate through a variety of pathways.

As stated earlier, I suggest playing this through out-of-the-money PUT options because they won't lose as much if the stock goes up a lot in the case of it being acquired by Coca-Cola, further growth, hyping-up of the stock, etc.

Here I again want to emphasise – this is risky, if you're up for it, please only speculate what you'd still feel comfortable losing.

Personally, I suggest buying Jan 17 2015 PUT options with a strike price of $80. They currently trade with an asking price of 75 cent.

It may also be possible to wait a month or so and buy cheaper (lower time value) Nov 22 PUTs at a strike price of $100 (of course, I don't know what the stock price has done by then), allowing you to profit from an immediate stock price drop if Einhorn speaks. That assumes that it drops enough, of course, which, judging by past drops, may not happen. But I do think it has a nice risk-reward ratio.

This short could also be used as part of a basket of small hedges against a market downturn (e.g. combined with puts on CMG, CAT & HLF if it goes back up).

I also have some further minor new points relevant to this short:

  • The options seem priced okay on a Black and Scholes (historical volatility) basis, using an online calculator. Inputting a 100-day historical volatility of 39.34%, a risk-free rate of 0.05% yields a value of $0.648 for the Jan 2015 PUTs with strike price of $80. This is based on a high historical value though, which could mean revert.
  • Lately, there has been news that GMCR has to increase its prices by 9% because of higher coffee bean prices. Though I had considered this possibility before because of previous quarters where GMCR's earnings had benefited from lower coffee prices, I felt at the time I was in no position to judge the supply and demand of coffee. I still feel that way.
  • Another minor news, is that McDonald's deal with Kraft to deliver McCafe K-cups to supermarkets does not seem to use GMCR as manufacturer. Kraft also sells unlicensed Maxwell House, Gevalia and Yuban K-cups

UPDATE: about an hour after I added this part, a press release came out about GMCR taking over Kraft's manufacturing after a transition period. As Kraft already had the manufacturing facilities available to them, except for DRM pods, GMCR should not have had much negotiating leverage, and the deal should have been favourable to Kraft. It seems GMCR is wilfully accepting lower margins. I can't otherwise explain the string of "multiyear" manufacturing deals that GMCR has been able to make, including with Starbucks, Unilever and Nestle. It's a deliberate strategy, as discussed by CEO Brian Kelley. Perhaps this is smart, as it makes it harder for any one manufacturer to approach GMCR's economies of scale and perhaps it's a bit of a confidence game. I don't know. But I hardly think it warrants today's 13% jump to $133, which makes this short look even more delicious.

  • Keurig 2.0 will go on sale on Sunday, with the flagship K500, which has a 3-star rating on CNET. I think it's a nice feature that it can brew both DRM K-cups and carafe / Vue pods. The price is reasonable (meaning razor-model margins), but the question once again is whether mainstream customers will upgrade to such a limiting system (which doesn't accept outdated, unlicensed or refillable cups), when there are other options. I'm biased, but given the loss of freedom and how people tend to overreact to that (what Munger calls deprival super-reaction syndrome), I don't think this will sell well. With all the hype about the Coca-Cola partnership, it's important to remember that GMCR still derives its profits from K-cups.

UPDATE: I just found a wonderfully balanced and analytical article by Seth Golden on the risks of Keurig 2.0. It draws comparisons with the failed Vue launch, mentions slowing margin improvements, names another cheaper K-cup brewer called Hamilton FlexBrew (price: $60 max), etc. Worth a read.

Another thing I've missed, is that TreeHouse Foods has cracked the Keurig 2.0 code since July, and is scaling up its "production for retail distribution before year’s end". They're not small players, and appear to be approaching this quite professionally.

Also, Keurig Cold is stated to be launched on September 2015.

  • The Fed tapered $10 billion of its monthly $35 billion mortgage-backed security and longer-term treasuries buys in August. The continued lowering of liquidity pumped into this overvalued market is the reason why I think it might drop significantly by the end of this year.
  • Finally, there has been news of George Soros (Trades, Portfolio) (or rather, Scott Bessent) vastly increasing his PUT position in the S&P 500 to $2.2 billion. I think it's safe to assume that the gross of them are far in-the-money. What wasn't stated is that his CALL position was also increased to $411 million. Nevertheless, I think this adds slightly to my bear case, which is a tailwind for this short.

I appreciate feedback, including reasoned criticism. :-)

Next time, I will write an article on a lucrative long.

Note: For full transparancy, I added the parts about the Kraft deal and Keurig 2.0 release on August 22, the Fed tapering on August 23 and the update on the Keurig 2.0 part on August 24. Further updates will be done in new articles.

I own out-of-the-money puts on GMCR, which may bias my analysis somewhat.


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