Green Mountain’s stock has at least 60% downside even assuming a relatively benign competitive environment in which they still can generate 15-20% ROICs, a ROIC which compares favorably to those generated by other food companies, especially those that are private label providers. The short thesis is widely disseminated, so it would be fair to ask, “What’s new?”  and “Why now?”  What’s new - - I know unit economics highly incentivize entry even at profitability levels that are 20-25% of Green Mountain’s current unit economics.  I also know entrants have piled in and gained substantially more share than the Company had guided to.  One year ago, GMCR expected unlicensed entry to gain 5% over the “short to medium term.” This share is likely to end the year at ~20%.  Why now - - Share gains are accelerating, and price competition has begun.  In my opinion, this opportunity exists because the widely known short case elevated short interest and overly depressed expectations (what did shorts expect to happen last year when GMCR traded for ~6x forward earnings and the patents had JUST expired?). 

Overview of the thesis:

• Entry is lucrative and easy.  A new entrant into the K-cup packaging market could generate a 20% ROIC with only $0.01-0.03 of profit per cup compared to GMCR’s profit of $0.08-0.11 per cup.  I spoke with a primary research contact who will likely do “a few hundred million in cups” this year.  Three years ago he and his partner were a lawyer and doctor, respectively.  Starbucks, however, recently renewed its contract with GMCR, which sent GMCR’s stock price higher when it reported 2Q 2013 results (despite a top line miss).  While investors are enthused that this renewal validates GMCR’s value proposition, SBUX has a history of being a tough negotiator, so I doubt the contract’s terms were that favorable to GMCR. 
• Nestle is a telling example.  Nespresso patents rolled off in 2010-2012.  Nestle sued new entrants to slow entry.  Even so, competitors gained ~20% market share within 18 months, well above GMCR’s guidance of unlicensed shares of 5% and 15% over the short and long term, respectively.  According to a top 3 unlicensed Nespresso company, GMCR has even less IP protections given Nestle’s work in single serve dates to the 1970s, so share gains by unlicensed packagers could be worse for GMCR.
• Management changes.  The head of the specialty coffee unit was removed from his role on May 8th (earnings day), yet this announcement wasn’t made until his full departure from the company on June 26th.   Why didn’t the Company take the time to negotiate a full separation before removing him from his post?   The Company has now removed every major division head in 2013.  Certainly some of it could be attributed to the new CEO bringing in “his guys,” but one would think that this change would be implemented in one fell swoop. Additionally, the two founders of the original GMCR resigned from the board over the summer.  One of them owns ~6% of the Company (85% of insider shares).  Well that is convenient…..for selling shares.

Let’s first address the key unit economic issues that make the short case compelling regardless of any other details.

Is entry attractive?

Without a doubt.  Let’s take a large coffee roaster as the marginal entrant.  Their only required investments to enter are packaging machines.  These companies could generate a 20% ROIC on purchasing these machines even at less than 25% of the profitability per cup that GMCR garners. As an aside, this profitability requirement drops every day (and is actually probably lower now than when I conducted my due diligence) as growing equipment standardization is affording new entrants a second mover advantage.

Note:  Unit economic data points suggested profitability per cup was $0.11.  This would’ve implied ~$200mln in growth opex and SG&A losses on brewers.  Because this was imprecise and to be conservative, I assumed a plug of $0.03 in “Additional Fixed Costs” which results in growth opex and brewer SG&A being $0.

Based on my calculations from data provided from my primary research sources, an entering K-Cup manufacturer can generate ~20% ROIC with a capex investment of ~$17 per 1k annual cup capacity (versus the ~$36 that GMCR has spent historically) and operating profit per cup as little as $0.01-0.03 (versus GMCR per cup EBIT of ~$0.08-0.11). 

Would it be attractive for GMCR to admit entry and become the scale private label provider?

Not in the least bit.  GMCR has little opportunity to offset price competition with improving throughput, thus lowering fixed costs per cup.  GMCR incurs a shockingly low (~$0.009 max) level of depreciation and amortization.  At most, GMCR could improve EBIT per cup by ~10% which would require a heroic doubling of machine throughput.

Nestle Precedent

Nestle’s Nespresso provides a foreboding case study.  The patents on Nespresso’s single serve capsules expired in Europe in 2011-2012.  Competitors entered soon thereafter with knock-off capsules, the top three of which have garnered an estimated ~20% market share within the first 18 months according to one of my  primary contacts (one of those three competitors).  GMCR’s patents expired last fall, and so far, there have been no signs of competitive pressure in its financials.  But it takes longer than one or two quarters for even large competitors to ramp up production, marketing, and distribution.  Nestle didn’t see competition the first quarter after its patent expiration either.  Yet, they stopped disclosing Nespresso growth for “competitive reasons” (Q2’12), one quarter after saying, “I think at this stage, the new entrants are still actually talking about it rather than doing it” (Q1’12 earnings call).  

GMCR likely suffers the same fate.  Roger’s Family Coffee boldly began selling knock-off cups almost a year prior to GMCR’s patents expired.  Today its cups sell on Amazon at ~40% discounts to GMCR and hold the #2 and #4 ranks in the coffee category.  Mother Parkers, a firm which GMCR followers inexplicably ignore (they are the #4 coffee roaster in North America), recently cut prices for its in-house brands substantially offering retail cups below $0.35.  Mother Parkers is a large private label packager under its Realcup flag.  If those prices still produce profits for MP, then that is very bad news for GMCR.  Big brands like Peet’s have announced plans to soon sell coffee in a knockoff K-Cup format.  Peet’s parent is one of the successful entrants offering knockoff Nespresso capsules in Europe.  Grocers like Supervalu and Safeway have also announced plans to roll-out private label K-Cups.  Any high-return business with a substantial addressable market and no barriers to entry is a recipe for declining market share, margins, and ROIC.  As more and more competitors begin selling knock-off cups at steep discounts on Amazon and Safeway store shelves, this outcome is inevitable. 

A primary research contact who is the #3 unlicensed Nespresso pod producer told me that his IP counsel, who has looked through both Nestle’s and GMCR’s portfolio, said that Green Mountain’s patent portfolio was like comparing their “molehill to Nestle’s mountain.”  Further supporting this, GMCR’s suit against Roger’s (who started packaging K-Cup compatible pods 2 years before GMCR’s  patent’s expired) was dismissed a few months after this conversation.

Keurig 2.0

Not to be overly dismissive, but Keurig 2.0 is irrelevant.  On the plus side, it will reclose the system for those willing to buy the new brewers.  However, GMCR had 80%+ market share in the single serve market as large brands neglected the slow growing US market in the early 2000’s.  They will not make the same mistake.  On the negative side, this move by GMCR should increase short term pressure.  GMCR will have to sell the new pods at competitive prices to Keurig 1.0 pods.  Given they cost more to produce, this will hurt profitability.  In addition, now that unlicensed brands know GMCR will be trying to shut them out, they have a huge incentive to cut prices to gain market share.  Happy customers of unlicensed Keurig 1.0 cups will be less likely to buy the Keurig 2.0 platform if they can’t consume their coffee of choice.