A deal between rivals Green Mountain Coffee Roasters Inc. and Starbucks Corp. to sell single-serve coffee sent shares of both companies soaring Thursday, raising the question whether there is a bubble brewing in the caffeine business.
Green Mountain, which dominates the single-cup home-brewing market, agreed to sell Starbucks coffee and Tazo tea for its Keurig system. For Green Mountain, the arrangement is expected to boost revenue for both its brewing systems and its coffee and hold off further competition in the $2-billion (U.S.)-a-year market. Starbucks, in turn, is spared having to develop its own single-cup brewing device, potentially saving the company hundreds of millions of dollars.
Investors and analysts loved news of the deal. The shares of Waterbury, Vt.-based Green Mountain surged more than 40 per cent and Starbucks' valuation rose 10 per cent following the announcement, while several analysts boosted their earnings and price targets on Green Mountain.
"It's kind of game over in terms of who's going to win the single-cup. It's Keurig, period," said Scott Van Winkle, an analyst with Canaccord Genuity. "I don't think the stock is overvalued. By signing these deals, they have knocked off [potential competitors]who could do their own K-cup."
The Starbucks partnership serves to remove the threat of a major competitor, significantly expand Green Mountains' distribution network and further validate the Keurig system - which brews individual servings of coffee, tea, cocoa and iced beverages - Mr. Van Winkle and other analysts contend.
Two factors, however, could kill the buzz on the deal. First, valuations of both stocks are getting high. Starbucks trades at 27 times earnings, while Green Mountain shares boast a multiple of 95. In less than two years, Green Mountain shares have risen sixfold and Starbuck's stock is up almost fourfold. Last month, Bloomberg Businessweek labelled Green Mountain shares the most expensive in the U.S., trading at 295 times cash flow. That was before the recent jump.
Second, while the deal removes the threat of an immediate showdown between Starbucks, the world's largest coffee chain, and Green Mountain, a battle may loom several years from now. Green Mountain has expanded its business to include its own coffee shop chains. It has acquired Seattle-based Tully's Coffee and Toronto-based Timothy's Coffees of the World Inc.
Meanwhile, key patents for Green Mountain's Keurig brewing are set to expire in September, 2012, and Starbucks hasn't ruled out building its own home-brewing platform. "This [partnership]won't be the only thing we do. In coming years, we will be very active in this space," Starbucks' chief financial officer Troy Alstead told Dow Jones.
Other powerful companies are also pouring resources into the single-serve market, although with limited success to date, including Nestlé SA and Kraft Foods Inc.
For now at least, investors are attracted to Green Mountain shares by the new product category the company has developed and its leadership position, estimated to account for 80 per cent of the single-serve market in North America. With the exception of Maxwell House, all the top U.S. coffee brands have now partnered with the firm, including Folgers Coffee Co., Dunkin' Brands Inc.'s Dunkin' Donuts and Starbucks.
As part of the deal, Starbucks will sell its own K-cup coffee packs as well as Green Mountain's Keurig brewing system at its more than 11,000 outlets in the U.S. and Canada. Mr. Van Winkle expects Green Mountain to sell almost seven million brewing machines in 2012, nearly one million more than before the deal was announced. In the next three-and-a-half years, the company's products stand to be in 30 per cent of U.S. homes, he says.
The analyst, who rates Green Mountain's stock a "buy," had raised his price target on Tuesday to $50. On Thursday, after news of the deal, he boosted it again to $65. That price assumes a price-to-earnings multiple of 30 times estimated 2012 share profit of $2.18.
Profit: 15 Cents a Cup
Mitchell Pinheiro, of Janney Capital Markets, raised his 18-month price target to $90 a share, up from $62, based on a price-to-earnings multiple of between 28 and 30 times estimated 2013 share profit.
He expects that the partnership will lead to an additional one million brewer sales for Green Mountain and sales of 600 million Starbucks K-cups in the first year.
Although the two companies did not detail their revenue sharing arrangement, Mr. Pinheiro estimates that Green Mountain will receive 15 cents of gross profit for each Starbucks K-cup sold, in line with what it currently records on the sale of its own K-cups.
In the last few years, more North Americans have started drinking coffee at home, and the single-cup brewing system has become one of the preferred methods. According to the New York-based National Coffee Association of U.S.A., 86 per cent of drinkers made cups at home last year, up by 4 per cent from 2009.
Starbucks has recognized the need to develop its own single-serving business to stay competitive and the company had weighed several options that included developing its own product, expanding its VIA Ready Brew brand, or forming a partnership.
"Our research shows that more than 80 per cent of current Starbucks customers in the U.S. do not yet own a single-cup brewer," Howard Schultz, president, CEO and chairman of Starbucks said in a news release.
Single-serve home systems have perfected their brewing technology in recent years, driving up their popularity. Here are some of the choices on the market:
Brews coffee, tea, cocoa and iced beverages; $80 and up
Brews coffee; $299 and up
Brews coffee: $70 and up
Brews coffee, tea and hot chocolate; $125 and up
Brews coffee, tea and hot chocolate: $100 and up