Hackett Advisors in the News

How Green Mountain Coffee Roasters Stays Hot in a Tough Market

Justin Rohrlich August 12, 2010 1:30 PM|

       Premium products, patents, and price are all factors working in GMCR's favor.

It seems like there’s disappointment after disappointment followed by bad news followed by a more pessimistic economic outlook than the pessimistic economic outlook broadcast the day before until the financial pundits come back from commercial and the next segment leads off with another reason to be bearish.

Then comes another set of commercials imploring all Americans to hoard gold in an underground bunker that can withstand the force of an atomic bomb that is almost probably going to potentially perhaps destroy the world as we know it.

But, finding the good news amidst the bad takes some effort. And Mike Catalano, co-founder of Krueger & Catalano Capital Partners, a Houston-based money-management firm, likes one name that he sees in an ocean of red:

Green Mountain Coffee Roasters (GMCR).

“When the market peaked in the fall of ’07, GMCR was trading around nine bucks,” he tells Minyanville. “Today, it’s $32 -- up fourfold, when most others are down 30-40%. A company that’s actually up from the 2007 peak is an incredible find.”

Catalano points out that Green Mountain not only owns Keurig, the company that makes the coffee machines that use the convenient K-Cups seen in many offices (and homes -- and yes, GMCR is working on making them “greener” -- but Green Mountain Coffee Roasters also owns the patent to the K-Cup design and technology (33 domestic and 73 international in all), which it not only uses for the Green Mountain brand (which includes not only Green Mountain coffee, but Newman’s Own, Timothy’s, Tully’s, Caribou Coffee, Café Express, Donut House, and Celestial Seasonings teas) but collects licensing fees on from all other companies packaging and selling their product in K-Cups, at a rate of $0.06 per cup.

The licensing agreements are certainly lucrative. Kraft (KFT) agreed to pay Keurig a lump sum of $17,000,000 for a limited, non-exclusive license under certain Keurig patents. Jarden's (JAH) Mr. Coffee brand has licensed Keurig technology and J.M. Smucker (SJM) will be releasing Folgers and Millstone coffee in K-cups this fall. Cuisinart brewers with Keurig technology were released earlier this year. Celebrity chef Wolfgang Puck is getting ready to release a line of branded coffee in K-Cups.

“GMCR has only penetrated about 6% of the market so far,” Catalano says, “So they have plenty of room to grow. The Keurig machines are flying off the shelves and once you’re using the machine, you’re using the K-Cup. It’s the classic Gillette (PG) razor/razor blade model.”

The numbers in GMCR’s latest 10-Q, released on August 5, confirm that the machines -- and the K-Cups -- are selling at a brisk pace.

To wit:

Keurig segment net sales, after intercompany eliminations, increased by $67.1 million, or 74%, to $157.2 million in the third quarter of fiscal 2010 as compared to $90.1 million reported in the prior year period, with approximately two-thirds of the increase driven by K-Cup sales to retailers and consumers.

During the third quarter of fiscal 2010, K-Cup portion packs shipped system-wide by all Keurig licensed roasters was 683 million, an increase of 72% over the prior year period. Additionally, there were 846,000 system-wide brewers with Keurig-branded brewing technology shipped during the third quarter of fiscal 2010 as compared to 444,000 shipped during the prior year period.

Green Mountain’s Specialty Coffee Business Unit, the division that handles the actual coffee itself, after intercompany eliminations, “increased by $53.9 million or 54%, to $154.3 million in the third quarter of fiscal 2010 as compared to $100.4 million in the prior year period. Over 90% of the increase in SCBU’s net sales was due to higher K-Cup sales.”

As for input costs?

Shawn Hackett, CEO and president of Hackett Financial Advisors, a firm with a special focus on agricultural commodities, tells Minyanville that he believes “there’s a possibility coffee prices are going to make near all-time record highs in coffee over the next 12 months.”

He says:

"Prices have been as high as $3-$3.50/lb; right now they’re around $1.70-$1.75. That’s high in terms of the last decade, but pretty modest as far as where they could go in a real supply squeeze. Brazil used to have huge buffer stocks, then every year, they dwindle them down, dwindle them down a little more, then dwindle them down even further. Now they have very little left to satisfy the gap. There’s been a total supply/demand mismatch for an extended period of time, and I don’t see how anyone in the space would be able to avoid either raising prices or eating increased costs if I’m correct in my estimations that the price of coffee’s going up. Not today, not next month, but coffee is one of the very few commodities that has not doubled from its prior record high prices in a decade. I see tons of room to go on the upside, so I’m long coffee futures and short coffee stocks. Not just GMCR, but the whole sector, Starbucks (SBUX) included."

With this in mind, Catalano says, “Sure, I’m worried about all input prices potentially rising, but that doesn’t stop me from loving GMCR as a stock.”

If Green Mountain’s hedging operations work out in the company’s favor, it should smooth input costs for a while, at least.

Again, GMCR’s latest 10-Q confirms this:

We enter into fixed coffee purchase commitments in an attempt to secure an adequate supply of coffee. These agreements are tied to specific market prices (defined by both the origin of the coffee and the time of delivery) but we have significant flexibility in selecting the date of the market price to be used in each contract. We generally fix the price of our coffee contracts three to nine months prior to delivery, so that we can adjust our sales prices to the market. At June 26, 2010, the Company had approximately $148.2 million in green coffee purchase commitments, of which approximately 58% had a fixed price. At September 26, 2009, the Company had approximately $90.8 million in green coffee purchase commitments, of which approximately 46% had a fixed price.

Of course, some say that a tight economy pushes consumers toward other, lower-priced alternatives. However, Morningstar writes in a report:

In our opinion, even in a challenging economy, consumers aren't willing to give up on all of their indulgences. Their loyalty to certain brands remains sticky. We contend that it is more likely that consumers will pay up for innovation in the packaged food space, which is in contrast to the household and personal care sector, as well as increase their spending on food, assuming the quality supports the higher price tag. For instance, Unilever (UN) is marketing its Bertolli Italian entrees in this fashion, by promoting the restaurant-quality food consumers can receive without the restaurant price. Further, while many consumers have been trading down to lower-priced private-label alternatives, we believe that consumers will eventually trade back up to branded products over the next several years as the economy improves.

Now, about those patents. They expire in two years. Then what?

"The two principal patents associated with our current generation K-Cup portion packs will expire in 2012, and we have pending patent applications associated with this technology which, if ultimately issued as patents, would have expiration dates extending to 2023," GMCR states in its latest 10-K. "Our agreements with our roasters are more than simple patent licenses. Roasters with agreements with the Company have access to and benefit from Keurig's technology and distribution network and we believe these benefits will help us to maintain royalty revenue irrespective of our patent status."

Considering that Keurig was first-to-market ( (AMZN) vs. (BN) anyone?) and has superb name recognition, there shouldn’t be much to worry about regarding others encroaching on GMCR’s market share.

A couple of other bright spots for GMCR:

* On Tuesday, Luigi Lavazza S.p.A agreed to purchase $250 million, or 7%, of GMCR’s common stock, with an option to buy up to another 8%, as the two companies jointly develop new single-serve espresso capsules.

* Yesterday, GMCR call volume was 22,229 contracts -- four times the average daily volume of 5,991. While K&C’s Catalano says that “volume alone cannot be viewed in a vacuum,” he makes clear that, in general, outsized call volume like this is an indicator that investors are bullish on a stock.

And, with that, I’m headed over to the Minyanville kitchen area to brew a K-Cup of Green Mountain Coffee Roasters Breakfast Blend (even though it’s after noon…) in our brand-new Keurig coffeemaker.


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