Keurig Brews Plan For Coffee Domination, Fizzy Profit

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Patent expiration often heralds slower growth for innovative firms.

Such has been the case withKeurig Green Mountain ( GMCR ), which sells single-cup coffee brewers along with single portion K-Cups of their own and licensed brands of coffee.

The expiration of key patents in September 2012 let unlicensed rivals win share in the lucrative K-Cup market.

Keurig, which boosted sales at a compound annual clip of roughly 55% from 2009 to 2013, was forced to make do with more pedestrian low double-digit growth levels. Some bearish observers wondered if the market for single cup-coffee was as robust as Keurig claimed.

But Keurig, on the verge of introducing two major products, thinks it has the solution to slowing growth. And Wall Street seems convinced. Keurig stock, which ended 2013 priced just under $75, recently fetched over $120.

Keurig's Composite Rating -- 98 of a possible 99 --puts it first among the eight firms in IBD's Wholesale-Food industry group. With a market value of just over $20 billion, it ranks second in size only toSysco ( SYY ) among those eight.

Still, the company has had to weather declining revenue growth in the past two years. Sales growth, which as recently as the quarter ended Sept. 30, 2012, stood at 33%, was just 10% in the quarter ended March 31. Even with slower revenue growth, Keurig has been able to expand earnings per share nicely: EPS rose 16% last quarter.

Later this year, Keurig will unveil a new system that brews whole carafes of coffee as well as its familiar one-cup servings. Perhaps more important, the Keurig 2.0 brewers threaten to lock out unlicensed purveyors of K-Cup compatibles.

Coca-Cola Stake

Next year Keurig will carve out new product territory with its Keurig Cold system for at-home carbonation of soft drinks.

Coca-Cola Co. ( KO ) has invested in the at-home carbonation concept by purchasing 16% of Keurig shares. Coke's share purchases seem to validate Keurig's carbonation product plan. They've also fueled speculation of a buyout.

Akshay Jagdale, analyst with KeyBanc Capital Markets, makes the bullish case. "We think the company can triple to quadruple its earnings in a three to five year period. It has the potential to do that," he said in a phone interview.

He believes Keurig's core brewing business is far from saturation and that Keurig Cold will offer new capabilities beyond those of existing home-carbonation platforms.

"Five years from now, they have the potential to earn $8.20 from the hot platform and $3.50 from the cold," he said. Jagdale has a price target of $150. If Keurig's hot and cold businesses flourish as he anticipates, the stock would be "a steal" at his price target of $150.

Others have their doubts. Theo Brito, an analyst with BTIG, a New York-based trader for hedge funds, mutual funds and other institutional clients, begins by throwing cold carbonated water on the notion of a Coke buyout, which he terms "very unlikely." His fundamental skepticism is centered on Keurig's core brewing business.

Pods And Profit

Keurig brewers are in roughly 18 million U.S. households. Suzanne DuLong, Keurig vice president of investor relations, notes that there are 90 million coffee-drinking households in America. "We think there's still ample opportunity with our Hot systems," she said.

Brito questions whether all those 90 million households have the income or inclination to purchase a Keurig brewer, which can run from $80 to $189.

Brito claims that as Keurig has expanded sales, the average number of cups brewed on its machines -- the attachment rate, in industry lingo -- has declined.

"Over the last five years, there's been an annual decline of around 10%," Brito told IBD. "I expect the decline to continue."

That's important because Keurig derives the bulk of its profit from K-Cups, not brewers. Declining K-Cup sales would definitely pinch margins, he contends.

Still, Wall Street bulls have been winning the argument on Keurig this year. And KeyBanc's Jagdale tackles the bearish doubts head-on. He contends that Keurig has the potential to vastly increase the household presence of its brewers.

In Europe, he notes, single-serve brewers are in 30%-35% of households. Keurig currently has just 20% penetration.

And Jagdale foresees huge gains in single portion coffee as the new Keurig 2.0 locks out unlicensed packet providers. In just the last year and a half, unlicensed sellers have gone from zero to roughly 14% of the K-Cup market, he notes.

"The Keurig 2.0 brewer will not allow any unlicensed cups to work with it," he said.

Jagdale sees signs that the strategy is already working. He notes that several retailers -- includingTarget ( TGT ) -- that had been unlicensed have recently entered into licensing arrangements with Keurig. He suggests that retailers prefer sharing coffee packet revenue with Keurig to being locked out of the business entirely.

Jagdale does not venture to predict the likelihood of Coca-Cola expanding its equity ownership in Keurig Green Mountain. "It's hard to predict what will happen with buyouts," he said.

He does think the likelihood of buyout "will increase with the success of Keurig Cold."

The Cool Factor

Keurig Cold systems will hit the market in 2015. Keurig spokeswoman DuLong says that at $80 to $189, Keurig Cold units will carry similar pricing to Keurig brewers.

Consumers have other choices for at home carbonation, including products from market leaderSodaStream International ( SODA ).

Still, the market is in its infancy and Jagdale is impressed with one expected Keurig Cold feature: "It will be the only product that can produce a cold beverage."

The Keurig carbonators could begin to contribute as much as $3.50 in EPS just three years after their 2015 introduction , Jagdale estimates. That's one reason he expects Keurig to get back on the fast growth track.

"You're going to see an acceleration in top-line growth for Keurig," he said.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas

Referenced Stocks: GMCR , SYY , KO , TGT , SODA

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