Markets & Finance

Good Things Brewing for Green Mountain


By Mark Basham Specialty coffee roaster Green Mountain (GMCR) has an ambitious goal: to increase sales at an average annual rate of 20% to 25% -- and earnings at an even faster clip. To do so, the Waterbury (Vt.) company is pursuing three key strategies: boosting its share in existing markets, expanding into new territory, and making selective acquisitions.

Green Mountain, which carries Standard & Poor's highest investment ranking, 5 STARS (buy), is an emerging player in the specialty coffee market, the industry's principal source of growth in recent years. And this segment is likely to continue to account for most of the increase in coffee shipments for the foreseeable future. Green Mountain has a substantial opportunity to expand into new markets and gain share in the specialty coffee niche.

PREMIUM BEANS. Coffee is a commodity. In the mass-market segment of the industry -- lower-priced prepackaged brands sold in supermarkets -- product pricing is generally a function of supply and demand. Specialty coffee beans tend to trade somewhat differently than commodity beans. They're usually sold on a negotiated basis at a substantial premium cost over their commodity counterparts.

To procure its green (unroasted) coffee beans, Green Mountain uses a combination of outside brokers and direct business relationships with farms, coffee estates, cooperatives, and other parties. The latter account for a growing percentage of purchased beans, as much as 30% of the expected total in fiscal 2002 (ending September). The company gains several advantages from this direct strategy -- improved quality, product differentiation, and supply and pricing stability. Green Mountain also differentiates its coffees via its custom roasting, through which it processes over 75 different varieties of beans.

It has been able to increase market share and enter new markets through acquisitions. In June, 2001, Green Mountain acquired Frontier Natural Products Co-op in Norway, Iowa, to strengthen its position in organic coffees. In April, 2002, it raised its ownership stake in Keurig, a maker of single-portion packaging and brewing equipment, to 41%. Keurig, which makes the "K-Cup" single-serving coffee cartridge, has a large position in the office coffee service segment. Its products could potentially be sold to the home market as well.

GAS-STATION SERVICE. Green Mountain shipped a total of 12.4 million pounds of coffee in fiscal 2001, a 14% increase from about 10.9 million in fiscal 2000. It primarily sells through wholesale channels to over 7,000 customer accounts located mainly in the Northeast. Based on the number of total pounds, convenience stores accounted for approximately 29% of shipments in fiscal 2001, office coffee service 24%, supermarkets 24%, restaurants 9%, other food service 8%, and other retail 3%. Consumer direct mail and online ordering also accounted for about 3% of pounds shipped.

The New England region accounted for 55% of wholesale coffee pounds shipped in fiscal 2001, Mid-Atlantic 21%, South Atlantic 8%, Multiregional 7%, and the rest of the U.S. 8%. International wholesale sales were 1%. The company's largest single customer, the ExxonMobil network of convenience stores, accounted for 16.4% of net sales.

We expect Green Mountain Coffee to ship about 12% more pounds of coffee in fiscal 2002 than it did in the prior fiscal year. We see revenues increasing by around 5%, with the difference between pounds shipped and revenues being attributable largely to lower prices under a new contract with ExxonMobil. Both shipments and revenues this fiscal year are likely to fall below the long-term trend, as economic uncertainty has resulted in lower demand in the office coffee service and restaurant channels.

CHEAPER THAN STARBUCKS. But on the plus side, reduced green coffee prices and lower delivery and ordering costs related to the ExxonMobil account should help to boost margins. We estimate that earnings per share will increase 16%, to $0.93, in fiscal 2002. In fiscal 2003, we are conservatively projecting an 11% increase in revenues, further modest margin improvement, and a 19% increase in EPS, to $1.11.

We at S&P believe that our forecasts for growth in sales, earnings, and cash flow used to derive our per-share valuation are conservative. We assume that Green Mountain's free cash flow over the next five years will grow at a mid-teen annual average rate, then gradually decelerate to 3% over time. Green Mountain's share price is likely to be somewhat less volatile than the overall market, implying that a below-market

beta be used to discount future cash flows to arrive at a present value for the stock.

Using these assumptions, our estimate of intrinsic value for Green Mountain is $25 to $27 a share, levels that would value the stock at approximately 28 times our fiscal 2002 earnings estimate. This p-e multiple would still represent a substantial discount to that of Starbucks, a comparable company that was recently trading at 44 times its estimated fiscal 2002 EPS. Analyst Basham follows small-cap and emerging growth stocks for Standard & Poor's


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