Keurig Green Mountain’s Q3 2015 Earnings Preview

On Wednesday August 5th, Keurig Green Mountain (NASDAQ:GMCR) will announce the firm’s Q3 2015 results after the closing bell. The Vermont-based coffee maker and k-cup company’s share price performance is down roughly 44% year-to-date in light of missing analysts’ estimates in the previous reporting cycle and lowering FY15 guidance in each of the previous two reporting cycles. The average analyst estimate for Q3 2015 results forecast Keurig Green Mountain to report $.79 a share in earnings on $1.04bn in revenues. Noted below are the Q3 2014 results:

1. Net sales of $1.02 billion, up 6% from year ago
2. GAAP diluted EPS of $0.94, up 24% from prior year period; Non-GAAP diluted EPS of $0.99, up 21% from prior year period
3. Free cash flow of $127 million in the quarter and $602 million year to date with 132% free cash flow productivity as a percent of GAAP net income
4. The 10% increase in portion pack-related net sales in the quarter over the prior year period was driven by an increase of approximately 15 percentage points due to sales volume partially offset by an approximately 3 percentage point decrease due to portion pack product mix and a roughly 2 percentage point decrease due to net price realization and the impact of foreign currency exchange.
5. For the quarter, 1.7 million Keurig system brewers were sold including 1.6 million sold by Keurig with 0.1 million reported sold by Keurig’s licensed brewer partners. This brewer shipment number does not account for consumer returns.

Unfortunately, based on last year’s results, analysts expect earnings to fall by roughly 20% as revenues climb just over 1.5% for the Q3 2015 period. The earnings decline likely represents gross margin pressures from high input prices and exceptional costs related to brewer manufacturing. Last year, Keurig Green Mountain managed to expand gross margins 140bps during the Q3 period as the company lapped lower green coffee prices. This year, the company is being affected by higher green coffee prices, which was outlined to investors.

“During its conference call with analysts and investors, the company stated that it has secured coffee prices for 75% of its 2015 needs at higher prices than 2014.”

During the 3rd quarter last year, Keurig managed to mitigate the potential headwinds for the company going forward by commencing new partnerships with formerly unlicensed brands such as Target Corp.’s (NYSE:TGT) Archer Farms brand coffee, BJ’s Wholesale Club and its Wellsley Farms brand, Harris Teeter and its store brand as well as Nestlé (OTCPK:NSRGY) coffee-mate K-Cup packs. During the 3rd quarter this year, the company will mark the anniversary of these partnerships as it is expanding new partnerships and distribution of Dunkin Donuts (NASDAQ:DNKN) and McCafe (NYSE:MCD) brand K-cups.

In February, Dunkin’ Brands, The J.M. Smucker Company and Keurig Green Mountain expanded their partnership by signing agreements for the manufacturing, marketing, distribution and sale of Dunkin’ K-Cup pods at retailers nationwide in the U.S. and Canada, and online. In addition to today’s launch of Dunkin’ K-Cup pods online, under the new agreement, Smucker will distribute and market Dunkin’ K-Cup pods exclusively to grocery chains, mass merchandisers, club stores, drug stores, dollar stores and home improvement stores. Keurig Green Mountain will distribute and market Dunkin’ K-Cup pods exclusively to specialty stores such as Bed Bath & Beyond, Kohl’s and Macy’s, as well as office supply retailers such as Staples and Office Depot beginning this summer. Keurig is the exclusive producer of Dunkin’ K-Cup pods and will remain so with the expansion of the partnership.

Moreover, Dunkin Donuts and McCafe are not the only expanding product line undertaking by Keurig Green Mountain during the 3rd quarter. The company also launched the K200 brewer system in May. The pipeline build is sorely needed for the Keurig company as sales for brewers has fallen for two consecutive periods and by 22% in the last reporting cycle. The Keurig 2.0 brewer system has seen weak demand from the consumer due to the higher price-point, digital rights management operating system and constant clogging factor of the system. Due to the weak reception of the Keurig 2.0 system, retailers have been left with several months of inventory overhang that they continue to work down with pricing promotions and incentives. Keurig has also participated in supporting retail points of sale by instituting manufacturer rebate programs during the 3rd quarter.

Most every analyst covering Keurig Green Mountain has been forced to lower their expectations since May 14th and in light of the negative brewer sales results and product development issues surrounding the Keurig Kold platform. Below are some of the analysts’ downgrades that occurred during the Q3 2015 period.

• CSLA lowered price target from $108 to $103 per share. CLSA also cut its 2016 estimates after the K-cup maker gave its Kold system a higher-than-expected suggested price. Analysts at the firm added that they now expect lower household penetration. Keurig Green Mountain announced its new cold brewing coffee machine, “Keurig Kold,” will not be released in all of its retail stores until 2016, which is later than investors expected.

• SunTrust Robinson Humphrey analyst William B. Chappell, Jr. maintained a Neutral rating on Keurig Green Mountain Inc. GMCR, while lowering the price target from $95 to $70. The analyst believes that the stock would continue to be pressurized till the company provides “a more realistic earnings outlook.” “In our opinion, the company will need to address the share losses for its company-owned brands sooner than later, which will likely put pressure on earnings. Recall, GMCR-owned brands have lost 700bps of market share over the past year and posted a 5 percent sales decline in the most recent 4-week period according to Nielsen,” Chappel stated. “We are concerned that GMCR’s aggressive push to win private label business has impaired the long-term profit model of the hot business. We have heard from several competitors that GMCR offered highly favorable terms to win over previously unlicensed businesses. We now worry that the legacy licensed partners will ask for improved economics when their contracts come up for renewal, if not before,” Chappel mentioned. Although the launch of Keurig Kold is one year away, the analyst believes that it could be difficult for the company to find consumers willing to pay the initial price of almost $300, as well as $5 for a 4-pack of Kold pods. The analyst also expressed concern regarding dilution due to this product. According to the SunTrust report, “The question is: can the company cut the cost to manufacture by 30-50 percent so that it does not become highly dilutive at those lower price points? In our opinion, GMCR needs to rethink the entire Kold strategy but, with KO’s $1.2B investment already in place, it may be too late to turn back.”

• UBS Financial downgraded its outlook for the company and its share price. UBS analyst Stephen Powers downgraded Keurig Green Mountain to Neutral saying the company is facing execution issues on three fronts; namely the transition to 2.0, reviving the K-Cup franchise and making Kold more mass-market. Powers believes Keurig needs to be successful on all three fronts. He sees downside risk for shares below the $70 level if execution fails. Powers cut his price target for Keurig to $86 from $114.

• Wedbush recently initiated coverage on Keurig Green Mountain. Wedbush initiated coverage of Keurig Green Mountain with a Neutral rating and $100 price target, as the firm believes ongoing questions around its Keurig 2.0 brewers and upcoming Kold machines will continue to be a drag. The firm thinks Keurig is unlikely to experience meaningful earnings acceleration while it spends to support both newer platforms.

• Brian Spillane of Bank of America/Merrill (NYSE:BAC). Mr. Spillane lowered Neutral rated Keurig Green Mountain’s price target to $95 from $117 and lowered estimates to reflect 2016 spending and slower hot platform growth. The firm expects 2016 to be a significant investment year and lowered its hot brewer expectations due to a muted consumer reception for second-generation brewers (K2.0).

• Last week, Keybanc’s Akshay Jagdale finally coalesced around the already poor sentiment among analysts by lowering the firm’s price target from $175 a share to just $120 a share. That’ s a pretty steep cut in share performance expectations. But with respect to where shares are currently trading, it represents significant upside potential for investors. “For perspective, for the six months ending March, brewer shipments were down 14% YOY (sales down 19%) compared to “flattish” volume growth trends in the June quarter based on our channel checks. We attribute the improved trends to lower price points (driven mainly by mix rather than increased promotional intensity), much better online reviews, the introduction of the entry level price point 2.0 technology K200/250 series brewer and the restocking of the Mini following the recalls last December. Also, recently introduced “non licensed” 1.0 technology brewers have not gained much traction (as implied by their less than 1% share) pointing to the strength of the Keurig brand. Taken together, although still relatively early days, we believe brewer sales have likely turned a corner following the disappointing holiday season, which bodes well for future installed base growth.”

There is obviously a lot of negative sentiment surrounding Keurig Green Mountain and as the company has failed to develop new brewer platforms that not only secure their business, but are received well in the consumer marketplace. With the share pricing hovering around 52-week lows and down roughly 45% year-to-date, the share price looks a lot more compelling than when it was trading in the $130 range and carried a multiple greater than 30 times forward looking earnings.

Investors and those who see the current valuation as compelling will need to pay close attention to brewer and K-cup sales in this quarterly report. Keurig Green Mountain management has already stated they expect brewer system sales to be negative for the Q3 period, but just how negative remains to be seen. With this in mind the company has also forecasted flat user base growth for all of 2015. I would look for an update of this metric as well in the company’s conference call. It should also be recognized that K-cup sales have seen growth slow dramatically from the double-digit range last year to just 7% in the last reporting cycle. As the company has gained new licensed brands for the system, Keurig may have sacrificed some profit margins in doing so. At this stage in the company’s business cycle, I think it is safe to say that any new licensed K-cup sales will be cannibalizing other licensed brand sales or Keurig brand sales and as the user base remains flat. Lastly, but certainly not least, investors should consider the company’s updated guidance for the remainder of the year and any specific plans related to the holiday merchandising season that could boost flagging sales for the company. I’m of the opinion that many investors are in the “show me” state of mind when considering shares of GMCR as a long-term investment. I believe shares represent fair value for the company based on the hot platform business, constant free cash flow generation, strong core user base of roughly 21mm users, dominant position in the coffee brewer category, strong alliance of brand partners in the beverage industry and future growth still remaining for the single-serve category in North America. Any meaningful improvement to the fundamentals could provide incremental sales and earnings growth long-term. I look forward to recapping Keurig Green Mountain’s Q3 2015 results next week.

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