The Oxen Group Reiterates Sell on Green Mountain Coffee, Reduces Price Target to $21.50

@font-face { font-family: "Cambria Math"; }@font-face { font-family: "Arial Unicode MS"; }p.MsoNormal, li.MsoNormal, div.MsoNormal { margin: 0in 0in 0.0001pt; font-size: 12pt; font-family: "Times New Roman"; }.MsoChpDefault { font-size: 10pt; }div.WordSection1 { page: WordSection1; } Profile: Green Mountain Coffee Roasters Inc., founded in 1981 in Waterbury, Vermont, is one of today's growing leaders in coffee beans and ground coffee sales. The company sells nearly 200 various selections of coffee, cocoa, and tea, operating under the Green Mountain Coffee, Tully's, and Newman's Own Organics names. The company also mastered its single-cup brewing system using the K-Cup portion packs that allow consumers to use one pack for one cup of coffee, tea, or cocoa drink. Thesis Green Mountain Coffee Roasters Inc. (GMCR) was one of the greatest success stories of 2009/2010. The company has seen great success with its unique Keurig designed single serving coffee, known as K-Cup. The single serving coffee allows drinkers to brew a single cup in just a matter of seconds. The company's two-pronged approach of selling coffee beans and grounds through distributors and selling instant-brew machines through its Keurig brand that offer single cup servings of coffee and tea right has helped the company to grow its revenue over 350% in the past five years and its net income by 800%. The company's growth has been so substantial that it has actually surpassed Folger's and Maxwell House in sales and is now the eleventh largest packaged foods company in the country just above Del Monte (DLM). The company's stock as a result has taken the same path over the past five years, rising from 2.30 a share five years ago to over $40 per share – an increase of nearly 1650%. Green Mountain has definitely gotten its foot in the door and established itself as a leader in the coffee industry; however, the company has grown at phenomenal rates over the past few years. The company now sits with a hefty P/E ratio at 61, has slowed down significantly in growth to actually decline in many margins and income levels YOY, and no final conclusion has still been made on an SEC investigation. The latest quarterly results, while better than expected, still do not justify the stock’s price. The recent run-up in price is yet another great short-selling opportunity. The pattern that is being established is that the stock is heavily overvalued, and any disappointment or negative news will have drastically negative effects on the stock. The 61 P/E ratio, while excessive in industry standards, is especially unheard of in the foods industry. The average P/E in the Packaged Foods industry is around 16. The market tends to average between 17-19 P/E ratio. At 61, the company is carrying a lot of overvaluation, and it takes continuous positive earnings, growth, earnings beats, etc. to maintain such a ratio. When earnings start to taper off, estimates are met or only slightly hit, and the growth is not the same, this stock will be rocketed downwards while upwards growth continues to be limited. Another worrisome aspect of GMCR is its acquisitions and what it has done to the company’s balance sheet. The company in 2010 bought up smaller rivals at alarming rates to feature their coffee in K-Cups. The latest quarter, however, showcased the effects of such quick expansion. The company is becoming debt laden with now over $355M in debt at the end of 2010FY, a 35% increase TOT. The company's long term debt as percentage of sales has gone from 9% to 26%. The amount of debt the company has compared to sales is definitely worrisome. The company's current ratio has also been falling from 4.34 in 2009 to 2.17 in the TTM. This might not be so bad if the company was producing free cash flow (FCF), but they are not as will be discussed soon. Another worrisome aspect of the company is that it is heavily dependent on coffee prices. The price of coffee increased significantly in 2010 and appears in no hurry to slowdown. So much so, that GMCR had to actually raise the price of each K-Cup $0.10 – $0.15 depending on the roast. That increase in price is never a good sign for any company because it means simply a loss of business. Especially during these economic times, price hikes will never go over well. It also signals the fact that GMCR does not have a strong hedge against future coffee prices, which could be devastating if they continue to increase. Yet, the overall largest worry for GMCR is cash flow. The blood of any company is its cash flow. Free cash flow must continually be maintained in order to grow, expand, and remove debt. If it is not, then a stock will not be able to maintain healthy balance sheet, will need to take on further debt packages, and will lose share value. GMCR has never had sound free cash flow. Typically, the company is in the red on FCF. The company's FCF margin in the TTM is at -7%. Anything below 10% is definitely worrisome. Taking on new companies could be a reason for this, but at the same time, we are seeing a rise in liabilities. So not only does the company lack FCF, but they also are taking on debt…not a good sign. Financially, the margins also seem to be weak and getting worse. Operating margin, gross margin, and net margin have all decreased since the beginning of 2009. They do no turn a lot of revenue into income with net margins under 5%. Most strong long term investments are around 15% because it means the company does not have a lot of selling, general, and administrative expenses and interest payments. GMCR has decent gross margins at 30%, but they have net margins around 6%. That discrepancy shows way too much money is being serviced into debt and administrative expenses. The company's profitability will need to have a lot of sustained revenue growth to cover the expenses in debt and takeovers. As they start to reach limits in selling capacities, they will being to start to see problems in profitability. Another issue to raise is that GMCR’s current patent on the K-Cup design is up in 2012. The company will no longer be able to hog the single serving market in the fashion they are currently. Other companies on the electronics and coffee side are definitely going to want to share the market that Keurig has created for itself, and these risks limit potential upside that seems to not even be winked at in current valuations. The company's ability to be efficient has gotten better over the years, and it has allowed the company to continue to see great growth. Yet, in 2010, the company saw the days sales outstanding start to rise, the cash conversion cycle decreasing, and inventory turnover taking much longer. There is definitely an issue in GMCR's distribution line that is going to need to be fixed because again it will threaten the company's ability to expand. A final issue that I see with the finances in the company is its ROIC is actually falling in the TTM. If a company's ROIC starts to fall, it signals that the company is starting to be able to make less on its capital pool. That means lower margins and less profitability. The company's ROIC topped out in 2009 at 12, which is not a significantly high ROIC, and it has dropped to 11 in the TTM, which means it could be as low as 10 in 2010. All these issues with overvaluation and problems in the company's finances create a major dilemma for the company, and competition still looms… Finally, GMCR has heavy competition. Starbucks, Maxwell House, Folgers, Dunkin' Donuts, McDonald's, and others are all in this industry. These are established companies that have lost market share to GMCR's success. Each of these companies is beginning to realize that the K-Cup is extremely successful product. In the fast-paced economy in which we live, the single serving cup is a great way to get coffee and go. Starbucks released their VIA line and Maxwell House is about to undergo a major promotions campaign in Q3 of 2010. These companies will not be undone and should begin to tap into GMCR's recipe for success. The competition is definitely there, and while GMCR has created a small economic moat with its K-Cup idea, the idea is obviously one that can be adapted by other companies established. Valuation Our fair value estimate for Green Mountain Coffee Roasters is $21.50 per share based on a discounted cash-flow analysis. The company has seen incredible growth in its operating income in the past five years, but the amount of growth the company has seen will start to decline. As that declines, the company will not be able to maintain its extreme valuation. Additionally, the company has shown a number of financial issues with profitability and efficiency, which should threaten the company. Further, they have no free cash flow, which is the red alarm that further growth is threatened. The company is a Buy below $18 and Sell above $24. Risk Risk is medium with Green Mountain Coffee Roasters. The company has been for the past couple years been told it could not continue at this rate, and they have. Yet, over the past couple years they have improved everything from growth, to profitability ratios, to financial health, to efficiency. For the first time, we are starting to actually see these numbers start to not be able to maintained or slow down. That threatens the company. Yet, the K-Cup is very popular, and if the company can overcome some of the obstacles and maintain a high level of growth, there stock is in good shape. Management & Stewardship President and CEO Lawrence J. Blanford has been with the company since May of 2007. He has a background in consumer goods but on the technology side. He was involved with Philips, Maytag, and Royal Tech before involving himself with Green Mountain. One issue with with Green Mountain is that it does not separate its CEO and President title. Another issue with Blanford is that he has in just three years seen his compensation triple while most other board members have seen no increase. One positive is that the company's Chairman and former CEO before Blanford, Robert Stiller, holds a 51% stake in the company. Therefore, he treats the company like a shareholder. The move from him to Blanford was seen as a move to help take the company to the next level. Management gets a 7 out of 10 rating (10 being the highest).

The Oxen Group Reiterates Sell on Green Mountain Coffee, Reduces Price Target to $21.50

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