Keurig’s Little Coffee K-Cups Brew Up Big Profits

Before the advent of the single-cup brewing system, coffee sat in a pot on a warmer, slowly becoming acid. Although the K-cups sold by Keurig Green Mountain Inc. (GMCR.O) price coffee at the equivalent of $50 a pound, the single-cup brewing system is here to stay. The company’s share price has been on a caffeine high, up more than 100% year-to-date. Let’s sit down with an espresso and look at its prospects.

Keurig single cup brewers are the dominant product in the market, now in millions of kitchens and office coffee rooms. Keurig has also secured major brand partnerships, including Starbucks Corp. (SBUX.O) and Kraft Foods Group Inc. (KRFT.O). It is also working with its largest investor, Coca-Cola Co. (KO.N), with a 12% stake, to develop a cold brewing system that could pop open an even larger market.

Brewing up profits

Coffee lovers demand consistent quality. Similarly, robust earnings quality boosts a company’s financial health. Earnings from sustainable sources are likely to generate better results over the longer term. GMCR has a StarMine Earnings Quality (EQ) score of 100 on a scale of 1 to 100.

That places Keurig at the top of North American companies and far above the food products industry’s median score of 47. A look into some of the model’s components helps show the special kick that keeps Keurig up at this level.

Keurig has that get-up-and-go when it comes to cash flow, which is a sign of quality earnings. It generates more than double the cash from its operating assets than its food products industry peers. The ratio of trailing four quarter (T4Q) cash flow from operations to average net operating assets is 35.1% compared to the food products industry median of 13.4%. This contributes to an EQ cash flow component score of 93 out of 100.

Exhibit 1: Keurig’s T4Q return on net operating assets vs. the food products industry mean

Source: Eikon/StarMine

The perfect blend

A substantial boost in operating profit margin (OPM) mixed with smooth net operating asset turnover (NOAT) growth created the right blend to perk up Keurig’s operating performance.

After hitting a five-year low in December 2010, T4Q return on net operating assets (RNOA) grew 20.8 percentage points to 35.6% from 14.8%. Apparently, the food products industry wasn’t drinking the same cup of tea, as the industry median declined 1.5 percentage points to 13.3% from 14.8% over the same period.

This means that Keurig’s management strategies are strong and tasty, such as the decision in Q2 2014 to increase volume and decrease net price realization in order to position inventory levels ahead of the Keurig 2.0 launch and expand the hot platform base. As a result, strong RNOA performance helped contribute to GMCR’s EQ operating efficiency component score of 93 out of 100, compared to the food products industry’s score of 56.

Exhibit 2: Keurig’s T4Q operating profit margin vs. the food products industry mean

Source: Eikon/StarMine

Caffeinated productivity

Keurig continues to become more efficient. T4Q OPM for GMCR has consistently increased over the past two years to 19.7% from 14.8% in Q2 2012, and surpassed both the food products industry median of 9.4% and consumer discretionary sector median of 9.6%. Over this period T4Q selling, general, and administrative expenses to revenue remained near its current level of 18%; this along with gross margin expansion helped battle deceleration in T4Q revenue growth, which dropped to 7% from 57%.

Net operating asset turnover (NOAT) measures how efficiently a company uses its assets to generate revenue, and our model measures both the absolute level and the rate of change in asset turnover. Over the past 11 quarters, T4Q NOAT has steadily improved at an average quarterly growth rate of 4.2%, rising 50% to 1.80 from its five-year September 2011 low of 1.21, while the food products industry median declined 10% to 1.92 over the same period.

Exhibit 3: ICE-US Coffee C Futures Electronic Commodity Future Continuation 1

Source: Eikon/StarMine

Tomorrow’s coffee costs

Over the past few quarters, gross margins have benefited from lower green coffee price contracts, which account for roughly 16% to 18% of cost of goods sold. However, according to Keurig CFO Fran Rathke, lower coffee costs in Q4 will be less favorable than the year to date trends. While prices are 100% locked in for FY14, and 75% in FY15, the value was not provided. In a year that saw ICE U.S. Coffee C futures hit a high 100% above the Dec. 31 close, management may be put to task if it wants to continue to expand margins.

Earnings aren’t the only thing that separate Keurig from the food products industry. Keurig looks more like a tech company and trades at 37.4 times 12-month forward earnings, well above its 10 year median of 28.2.

High scores on StarMine’s Price Momentum (Price Mo) model signals that this darling of the industry’s stock price has momentum on its side and may continue on its upward trajectory. Valuations like these are signs that investors expect this coffee maker to serve up some high quality energy when GMCR reports earnings on Nov. 19.

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