Coffee drinkers read on. Come November, Starbucks (NASDAQ:SBUX) will sell its coffee and Tazo tea in Keurig single-cup packets, known as K-Cups. The news is music to the ears of momentum investor Richard Driehaus, whose seventh-largest holding is Green Mountain Coffee Roasters (NASDAQ:GMCR), owner of the Keurig coffee makers.
Green Mountain’s stock is up 200% year-to-date, the 10th-best-performing stock out of a universe of almost 6,000 U.S. equities. Green Mountain’s run has been nothing short of extraordinary, and its relationship with the world’s biggest purveyor of coffee can only help. Nonetheless, I think it’s time for the stock to cool down, and Driehaus’ presence tells me I might just be right.
How Much Growth
Its compound annual growth rate for revenue the past five years is 53.2%. It’s doubling in size every two years. You’d think it was selling the next great cloud computing software. Alas, it’s just a cup of joe. But if you’re making almost 14 cents operating profit for every dollar of revenue, not many people are complaining.
If the third quarter is any indication, the gravy train appears ready to continue. Its operating margin jumped 380 basis points year-over-year to 18.4%. At this pace, it could soon be bringing in a quarter of profit for every dollar in revenue. If — and that’s a big if — it achieves this seemingly difficult target, its current forward P/E of 38 is too high. Of course, it still has to stick through its relationship with Starbucks. Failure there, and it’s hard to know where the growth will come from.
According to an article in Financial Times, portioned coffee accounts for just 8% of the coffee market, leaving plenty of room for growth. In the U.S., Green Mountain has 70% to 80% market share in the single-cup business, which last year amounted to $2 billion.
This untapped market hasn’t gone unnoticed by Nestle, the world’s largest food manufacturer. Nespresso — its version of the single cup — along with its coffee capsules, delivered $3.6 billion in global revenue in 2010. Yet its U.S. business, although doubling in the past three years, is only its eighth-biggest market. It’s leaving money on the table, but it won’t be for long if commercials featuring George Clooney continue to penetrate households.
Further, what happens to GMCR if Starbucks finds its customers don’t like paying exorbitant prices for portioned coffee that never tastes as good at home no matter the machine? And if price doesn’t become an issue, what if we get bored of the novelty of six different flavors of coffee at home? And don’t think it can’t happen. How many flavors of coffee do you currently drink outside the home? I drink Starbucks’ mild blend in the morning (it has more caffeine) and its bold blend in the afternoon. That’s it.
Lastly, assuming it’s not a fad — and Nestle’s sales suggest it’s not — how will Green Mountain defend its home turf against a much stronger competitor? With or without Starbucks, I don’t see Nestle giving this up without a fight.
Best Case/Worst Case
Assuming a doubling of sales twice in the next four years along with a valuation of seven times price-to-sales, I get an estimate of $558 for a 442% return. Where do I sign up? Unfortunately, everything has to go right for this scenario to play out, and we all know life’s usually not so accommodating.
What happens if everything goes wrong? Either the world decides single-cup coffee is the next Edsel, or Nestle takes half its market share in the U.S.
Well, in either case, it’s business as usual for Nestle but catastrophic for Green Mountain. In the former, Nestle loses less than 3% of 2010 revenue. In the latter, it adds to an already successful business. According to Green Mountain’s 2010 10K, Keurig-related revenues account for 88% of its overall sales. Since almost all of its sales are in the U.S., shedding half its single-cup market share would result in a revenue loss of almost $900 million, and the stock price would race to zero.
Richard Driehaus is a bright person. However, he has bets on 424 stocks. He can afford to lose a few bets.
As of this writing, Will Ashworth did not own a position in any of the stocks named here.