2 Stocks With a New $1 Billion Opportunity

Ryan Fuhrmann's picture

Friday, April 22, 2011 - 11:00am

by Ryan Fuhrmann

Coffee chains like Starbucks (Nasdaq: SBUX) get the lion's share of press when it comes to the $7 billion fresh coffee market. And up until now, the company has focused primarily on the chain's retail side of the coffee business. What investors haven't realized is that 86% of coffee drinkers consume coffee at home. That's $2 billion worth of business that has largely gone ignored. Until now, that is.

Firms formerly focused on the retail side of the coffee business, are venturing into the all-important home coffee market. This includes Starbucks -- the very company that brought coffee shops to the masses -- which is combining forces with the market leader in the space. The combination represents a compelling investment opportunity.

The vast majority of the coffee market's growth potential lies with in-home product offerings. For investors, the profit potential lies in single-cup serving home machines. Back in 2004 and 2005, the leading food players came out with single-serve coffee systems, whereby a single "pod" is placed in a coffee machine that combines the pod with hot water for a single-serving cup of coffee. Sara Lee's (NYSE: SLE) Senseo machine came out in 2004 and was followed by the Nespresso machine from Nestle and the Tassimo device from Kraft (NYSE: KFT) in late 2005.

These single-serve systems have seen modest success since being introduced, but they have been eclipsed by the popularity of Green Mountain Coffee Roaster's (Nasdaq: GMCR) Keurig brewing system. Green Mountain is currently the only pure-play firm in the space, and the stock's incredible 458% gain in less than two years illustrates the fact that it now commands between 70% and 80% of the single-serve coffee market in the United States.

 

Green Mountain's share price jumped more than 40% on March 10, 2011, the day it was announced that Keurig would be offering Starbucks pods. The stock now trades at a lofty forward price-to-earnings (P/E) ratio of 53. However, this is arguably justified, given that adding Starbucks to its system should keep growth going at a rapid clip. A sky-high valuation is also justified by historical growth, when sales expanded more than 32% annually during the past decade and earnings at greater than 29% each year during this period. Growth has only accelerated since then; during the past three years, annual sales growth has averaged 58%. Earnings have grown by an average of 71% annually. 

Starbucks anticipates its single-cup packages will bring in $1 billion in annual sales within a couple of years. This would boost sales by about 10% from current levels. However, given that profit margins of 30-35% for single-cup coffee are much higher than its store margins of about 20%, the positive profit impact is even higher. I estimate this can boost earnings to $2 per share, up from current projections of $1.50 per share.

Action to Take --->
With a number of avenues for investors to profit in the space, I find buying the stocks of both Green Mountain and Starbucks to be a great combination for big shareholder gains.

With Starbucks anticipating $1 billion in sales from single-cup coffee, Green Mountain can capture at least half of this amount, which means a 30% or more jump in sales from current levels of $1.6 billion. A corresponding earnings boost of 30% would increase forward projections of $1.77 to $2.30 per share. At the current share price, this represents a forward earnings multiple of 28, which looks downright reasonable given earnings are growing at more than 50% annually.

As for Starbucks, single-serve coffee could further boost already-improving store growth trends and should breathe more life into the company's domestic growth prospects. Starbucks remains firmly committed to store expansion overseas, and combined with the single-serve pod potential, this could allow earnings to grow at a 20% annual clip for the next few years. With the earnings projections I gave above, the forward P/E would be less than 17 -- also quite reasonable, given the growth potential.

Overall, I see the potential for at least 50% gains in both Green Mountain and Starbucks shares within the next three years.

Ryan Fuhrmann does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of SBUX in one or more of its “real money” portfolios.