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Calling a Top on Keurig Green Mountain

August 26, 2014 | About:
Humble Money

Humble Money

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I'm going to do something that any self-respecting value investor should never do.

I'm forecasting GMCR has likely reached its top. To put it into numbers, I estimate roughly there's a 70% chance of it not going up more than 5% from the current price in the next three years (will not pass $140.50).

UPDATE 8/28: I think I may have been too confident here, and that 60% is more appropriate. Feel free to judge me on the first number though.


The reason being that we've reached the point where there are now so many large short- and long-term risks for the stock that a couple of them are likely to manifest.

Unstable GMCR pyramid

Image credit: Brad Wenner

The way I derived this number is not by a mathematical model but by combining various possibilities and an opinion on roughly how likely they are. Please see page 118 of The Warren Buffett Portfolio for further explanation.

The table below summarises the risks, many of them which I've mentioned in my previous two articles.

Risks

Implications

Fundamental

Long-term risks:

- High EBIT / EV of 24.4

.

- Multiple could revert to number suitable for medium-growth company

- Historically, high valuations have led to reduced stock growth

- Inventory fraud

- Inflated K-cup sales numbers

- Other accounting issues

- Investigation by Einhorn or SEC could shine further light

- Harder to inflate earnings

- Past overstatements may catch-up

- Suppliers can negotiate more favourable contracts with GMCR

- TreeHouse / Mother Parkers may capture a piece of the Keurig 2.0 market

- Reduced sales

- Compressed sales margins as returns forced towards cost of capital

- Saturated K-cup market

- Reduced growth

Short-term risks:

Keurig 2.0 could disappoint due to:

- DRM K-cup restriction

- not enough feature improvements

- extra costs of launch

.

- Reduced K-cup sales

- Higher costs

Keurig Cold could disappoint due to:

- smaller-than-expected addressable market

- waiting period before launch (Sep 2015)

- competition by Sparkling Drink Systems,

set to launch this October a pod that can be used

directly on a standard water bottle

& in a kitchen-top device

(admittedly, with small partners apart from ICEE & possible in pipeline, & questionable marketing)

- Lower-than-expected Keurig Cold sales

Catalysts

- Einhorn could present on GMCR at next Robin Hood Conference

- Otherwise, he may present at another venue

- Incorporation of information by market

- Possible herding panic

- Complacement, overoptimistic sentiment could mean-revert

- Return of negative media coverage

- More realistic sentiment

- Analysts could reduce their forecasts

Lower short interest means:

- Less chance of short squeeze

- Room for a return of past short-sellers

- Selling of borrowed shares could assist in stock drop

Macro

Long-term risk:

- High stock market valuation could mean-revert

.

Headwind for stock

Short-term risk:

- Less Fed QE means reduced liquidity

.

Headwind for stock


Below are some scenarios I've though of in which the stock could go up further:

Scenario

Coca-Cola acquires GMCR, buying it at a premium

Keurig 2.0 and/or Keurig Cold do surprisingly well

International rollout does surprisingly well (able to take share from entrenched competitors)

Bullish environment causes "growth" stocks to go up further without regard of valuation

Financial issues are ignored by investors or management succeeds in diverting their attention

I'm wrong about the fraud allegations, growth limits or K-cup competition

A short stock spike in the next few months because of something temporary


I've now made two probabilistic statements:

  1. Chance of Einhorn presenting GMCR as his Best Idea at the next Robin Hood Conference is 65%
  2. Chance of GMCR not passing $140.50 in the next three years is 70%

I've tried to set out clear criteria for you to judge them in the future. If both predictions fail, I think it is reasonable to say that my stock forecasts likely suck. I admit I wouldn't be the first person giving confident forecasts with little accuracy.

I appreciate feedback, including reasoned criticism. :-)

Full disclosure:

I added a paragraph on the way I derived my estimate on Aug 27, "Mother Parkers" to the table on Aug 29 and the Sparkling Drinks Systems part on Sep 2 , replaced 'optimistic' with 'confident' on Sep 8.

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


Rating: 0.0/5 (0 votes)

Comments

hbeetroot
Hbeetroot - 3 weeks ago

Great summary. While I won't comment on your probabilities, I think the sentiment that GMCR is on a knife edge regarding potenital negative catalysts in 100% correct.

The one I would add that I think you missed would be rising coffee prices impacting consumption, as price hikes begin to kick in.

It seems to me that if any of the negative catalysts you mention eventuate (and cumulatively, the probablity seems very high that at least some will) the stock will be in trouble - that's the risk of owning a stock that is priced for perfect execution.

Humble Money
Humble Money - 3 weeks ago

Hi,

Thanks for your comment. I appreciate you taking the time for it. I agree with your nice short description -- "the risk of owning a stock that is priced for perfect execution."

I agree that significantly rising coffee prices would affect consumption. I did consider writing about this possibility in my first article, but I don't feel confidence in it for the following reasons:

1. I have almost no experience in the supply and demand of commodity prices. I surmise a 'bad' increase in coffee prices would either come from less supply (e.g. the Brazilian drought) or more demand from other countries (especially developing ones with much less consumption, e.g. China). But I really can't predict what will happen here, especially in the short-term, and there are a lot of specialised traders who I'd be competing against if I did. I haven't found any good reasons for a large misvaluation.

2. Coffee has a low price-elasticity-of-demand, meaning that demand will change less than with other consumptions when a hike comes. I think this could be attributed to coffee's status a luxury product & coffee addiction. The big difference in price between K-cups and simple ground coffee appears to agree with this.

3. GMCR has fixed about 92% of the price of $410 million in coffee supply contracts for the next 6 to 9 months, according to the latest 10Q. They also have future hedges covering about another $43 million worth (which is small). The effect of a hike in prices should materialise only after halve a year.

4. GMCR hiking up K-cup prices now for past coffee bean price increases doesn't mean worse short-term results. The profit on the extra margin may compensate for lesser demand.

I've tried to list big factors in this article that on-the-whole would negatively affect GMCR's stock price, and as of now I don't see a coffee price increase as one of them. I think you could also argue the other way for mean reversion. With new evidence, I could change my mind, and add this risk to the table.

What are your reasons for thinking that there will be rising coffee prices affecting consumption?

Do you disagree with any of my arguments?

kpui
Kpui - 3 weeks ago

I am a major of Mathematics. I am amazed at how you arrive the 2 numbers even tho they are probabilities.

65 % for Davd Einhorn and 70 % chance of price top. Be pleased if you can elaborate how you arrive at those mathematical models.

Prediction is dangerous but that is what we do somtimes.

TQ

Humble Money
Humble Money - 3 weeks ago

I think you have a fair point.

The way I derived these numbers is not by a mathematical model but by combining various possibilities and an opinion roughly how likely they are. Please see page 118 of The Warren Buffett Portfolio, for further explanation.

This estimate will of course be very rough and I should have mentioned that more. I do want to point out that mathematical models can also have the problem of appearing smart & precise, while resting on past data not representative of the future, use oversimplified probability curves, have datamining biases, etc.

I admit by giving precise numbers, I'm giving a false sense of mathematical legitimacy. That's your domain and I'm sure you have a lot of knowledge about statistical methods that I could learn from.

Perhaps I should have stuck to using categories like "Almost certain, Very likely, Somewhat likely, Not very likely, Not at all likely".

I hope though that by giving these numbers and precise criteria to judge them by, that given enough samples, people like you will be able to judge their accuracy.

My short investment thesis does not, however, depend on these two probabilities but on what Seth Klarman (Trades, Portfolio) calls "compounding multiple conservative assumptions".

EDIT: For clarity's sake, and to avoid the seeming precision of my estimate to be misleading, I've now added my above statement to the article.

hbeetroot
Hbeetroot - 2 weeks ago

Humble Money,

I think your comments regarding coffee prices as a risk factor are fair and I would agree with your analysis.

The other risks your have highlighted I would certainly weight more heavily.

Humble Money
Humble Money - 2 weeks ago

Hi,

Thanks for the feedback.

Another risk which I didn't mention is their large stock repurchases at what I deem to be overvalued prices.

They authorised $1 billion since November 20 and bought back at least $700 million of that and have another billion in the pipeline until 2016. I wouldn't be surprised if they announced a new buyback plan before that date.

However, the extra demand caused by the share purchases might actually push the stock price up in the short-term, so I'm kind of getting myself by stating a stock price target.

I've been thinking for a while that I've been a bit too optimistic in stating a 70% chance (and perhaps because it made a nice headline). It understates the short-term fluctuations that could happen and there are scenarios in which GMCR makes headway in international markets, or Keurig Cold does quite well, perhaps because of the convenience of taking small Keurig Cold cups with you instead of having to put bottles in the fridge. I think around 60% is more appropriate.

In the end though, this number doesn't really matter to me. I think by adding the factors up, you have a nice risk-reward ratio owning GMCR puts.

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