Forget Starbucks: Green Mountain Coffee is Still a 'Buy'

James Brumley's picture

Wednesday, March 14, 2012 - 10:00am

by James Brumley

Last week, coffee icon Starbucks (Nasdaq: SBUX) announced it would begin selling its own single-serve, at-home coffee maker. The device runs hot water through small, disposable containers of flavored coffee grounds to produce one cup of the drink, after which the container is discarded.

If this rings a bell, it's because the machine is very similar to the highly-popular Keurig single-cup coffee maker sold by Green Mountain Coffee Roasters (Nasdaq: GMCR). Sales of the coffee maker (and the Green Mountain single-serving coffee that consumers can buy to use with the machine) led the stock to skyrocket past $100 at its peak in September 2011.

 

The stock has lost roughly half its value since then, primarily because of worries about competition and a frothy valuation for a company that may not achieve the lofty growth it once did.

So should investors stay away from Green Mountain now that Starbucks has officially entered the game?

Not so fast.

Starbucks insists its new Verismo machine won't undermine Green Mountain's coffee maker and cup-refills business. According to reports, the new machine will be primarily geared toward espresso drinkers, not simple coffee. And while a regular single-cup machine may be on the horizon for Starbucks, it's not really a threat at this point.

Given the market's knee-jerk 17.5% drubbing of Green Mountain shares following the news, however, investors don't seem to agree -- they see it as a threat. But before jumping to the same conclusion other traders did, bargain-seekers may want to think about some of the difficult-to-find data regarding the at-home coffee and espresso business. This may not be a time-bomb for Green Mountain Coffee after all...

•  According to Jannay analysts, espresso only makes up an estimated 10% of the at-home coffee market. And, in the United States, Keurig coffee makers already satisfy about three-fourths of the demand from single-serve coffee users. Point being, while espresso fans may go hog-wild for the new Starbucks machine, there still aren't a while lot of them. In fact, Nestle already makes such a machine, and its adoption has been lukewarm.

•  As it stands right now, Starbucks says it doesn't intend to allow other brands of cups to be used in its single-serve espresso machines. Clearly the company is going "all in," planning on building its own espresso ecosystem. Starbucks may learn the hard way that the attraction to the Keurig machine is the fact that multiple makers of the refill cups means selection is abundant and that K-cup prices are competitive. Consumers seem to like that...

•  If there is indeed a meaningful at-home espresso maker market, Starbucks isn't getting that much of a head start on it. Green Mountain Coffee Roasters is still working on its own single-serving espresso maker, jointly designed with Italian brewer Luigi Lavazza SpA. The device is rumored to be close to a launch, and it's presumable it will be an "open system" that uses all types and brands of refill cups.

•  At the end of the day, the big money in the single-serve coffee business isn't in selling the machines, but in selling the coffee packets/refills. Green Mountain is reported to earn between $0.14 and $0.16 per cup sold, and already has relationships with vendors as well as millions of Keurig owners. Consumers may feel that "going back" to accommodate a new system may simply be more trouble than it's worth.

While those points tend to lean back in favor of Green Mountain Coffee, there are still a couple of potential headaches, too.

•  While Starbucks is aiming the Verismo at the espresso market, it's tough to imagine the company not introducing its own single-serve coffee system, especially considering it already licenses its own brand of blends for use in Keurig machines. If it does, then it will likely be for the purpose of being more competitive on price with the Keurig (which typically run between $100 and $200, depending on the model) than its higher-end Verismo offering (which could be priced at the upper end of that range, at least). And while the Verismo is geared toward espresso-lovers, it can make regular coffee as well (although, as I said, it will likely only brew Starbucks coffee).

•  While Green Mountain and Keurig have become well-known names, neither carries the same weight as Starbucks -- not even among those who don't drink coffee. Starbucks has turned what was largely a commodity into an upscale business. Now that it has, it can capitalize on the brand name to sell top-tier espresso machines, K-cup refills, and yes, even single-serve coffee machines if and when the time comes.

And the winner is...
Weighing the good against bad, Starbucks' Verismo is less of a threat than the market seems to have first assumed. The fact that most consumers weren't even aware Nestle already had a single-serve espresso machine on the market may be less of an awareness problem and more of a not-caring problem that should concern Starbucks. The likely debut of a Starbucks-branded single-serve coffee maker may be equally unimpressive, especially if it only works with Starbucks-branded coffee. Consumers may be willing to pay a premium price when visiting a Starbucks coffee shop, but the premium may be more for ambience than flavor. At home, coffee fans may gravitate toward the less expensive non-premium brands more so than Starbucks is hoping, making the Starbucks coffee maker just a little too impractical.

Risks to Consider: The unexpected debut of the Verismo accents how quickly the tide can turn in the world of uncomplicated consumer goods, even when it seems they're patent-protected In fact, another single-service coffee or espresso maker could be introduced tomorrow that may or may not be just as disruptive. Consumers can be unpredictably fickle, for better or worse.

Action to Take -->
Not only did Green Mountain Coffee Roasters shares not bounce on after investors had some time to digest the news, shares slumped even further. Yet, the company still has a commanding lead in the single-serve market and is positioned to hold it. The high-growth phase for this company may be over, but the recurring revenue machine is alive and well. The market seems to have forgotten this realty for the moment, setting up a prime opportunity for newcomers to the stock.

James Brumley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.