Green Mountain Breakdown

by

Ross M. Miller
Miller Risk Advisors
www.millerrisk.com
April 12, 2010

(Note: I thought that I would write about tablet computing this month, but I changed my mind once the iPad became a reality.)

This month I will complete my sixth year of teaching the introductory finance to grad students at SUNY/Albany's B-School. Except for my second semester of this professorial stint (Spring 2005), I have taught at least one section of this course every semester. Each semester I have chosen a "pet stock" for the course. Students have to predict the price of the stock over a short period of time-four weeks at first, but eventually just two weeks-as well as build a long/short portfolio around it that is grading based either on its realized volatility or holding period return over the period.

My choice of pet stock has always been intentionally diabolical. I started in Fall 2004 by picking Google. Because the company had just gone public, it left students with insufficient data to perform any reasonable financial analysis on the company. I continued using Google until it got big and boring. In Fall 2006, I switched to Green Mountain Coffee Roasters (GMCR). Like Google, it had an unconscionably high P/E. Also like Google, it nonetheless continued to skyrocket in price all the while it was my pet stock. (I do not purchase my pet stocks so that I can maintain a certain objectivity.) This semester, I booted Google out in favor of one of my consulting clients from a previous lifetime, Bank of America. I actually would have preferred to use Citigroup, but its low price leads to high quantization error that most Ph.D.s, especially those from a large city in the Midwest, fail to recognize, much less incorporate into their analysis. (In other words, a one cent move in Citigroup currently translates into over 20 basis points, enough to mess up certain hedging strategies.)

I've already written about Google, and any comments about BofA may have to wait a long time. So, this month I will rag on GMCR.

Green Mountain has a high profile about Albany, NY, but that's not why it became my pet stock, not that it hurt any. By the summer of 2006, the publicity about my research on mutual funds expenses had made me a popular enough guy that I had run out of minutes in a day. On a business trip to Boston, I discovered that there were single-cup coffeemakers that using sexy little pods to turn water into coffee in a hurry. For years, those execrable Mr. Coffee machines would pop up in my hotel rooms. This hotel, however, the Hilton Financial District, was where I saw my first pod coffeemaker of any kind, Braun's Tassimo system.

Upon my return from Boston, a quick Googling determined that a company called Keurig made the best pod coffeemakers. A few days later Amazon delivered their deluxe B60 model to my doorstep. Keurig had been acquired by Green Mountain. It was a cool product from a hot company, and so I had my new pet stock.

Coffee and I go back a long way. You could say that coffee is in my blood, since most of my father's family settled in Guatemala. My cousin (technically, my first cousin once removed) was a bigwig at the legendary MJB coffee in San Francisco until it was acquired by Nestlé in 1985. (MJB has since changed hands several times.) After my freshmen year at Caltech, I rarely returned to the East Coast during vacations; instead, I headed to the Bay Area to visit my friends and, on more than one occasion, my MJB cousin. Among the cool things that I learned from him was how to make coffee the way that someone who buys the stuff by the ton makes it. The basic method is the same as that of "cowboy coffee," only the soaked grounds are put through a wire strainer before serving. The important thing for getting the full flavor out of coffee is not to use a paper filter, just pure metal.

After I moved from California to Cambridge (MA, not UK) in 1975, I quickly happened upon the Coffee Connection in the Garage. Unlike the present-day Starbucks, which ultimately purchased and destroyed the Coffee Connection, the Coffee Connection was a coffee aficionados' Mecca. (I was a big fan of the original Pike Place Starbucks and would always cart freshly roasted whole bean back with me from Seattle.) It was at the Coffee Connection that I discovered the French press, which greatly simplified my cousin's coffee-making method. While my fellow yuppies-in-the-making (or young coffee achievers) were still fixated on Chemex coffeemakers and the wannabe Melittas, I went straight to the French press. The Coffee Connection also sold freshly roasted whole bean coffee for grinding at home. They even sold French-pressed coffee at their counter until Starbucks ate them.

There are two problems with making your own French-pressed coffee (aside from the mess)--it takes a lot of time and it could eventually kill you. Between boiling the water, grinding the beans, and waiting the four minutes or so for the coffee to steep, even with intense multitasking, the coffee-making process eats around five minutes. With my twice-a-day habit, that rose to ten minutes. Keurig coffee is essentially instant; in the time it takes me to get the skim milk and a spoon, the coffee is made. As for lethality, French press coffee taste great because the straining process leaves all the nifty coffee chemicals, including several that are grabbed by paper filters. Twenty-year-old research shows that unfiltered coffee raises LDL ("bad") cholesterol, and my blood tests confirm that research. The Keurig coffee pods, known as K-cups, have paper filters built into them that suck both the flavor and toxins out of the coffee. At some point in life, better taste is no longer worth the increased mortality risk.

Despite my continued use of their premier product, I am certainly not a Green Mountain fanboy. As noted in the previous paragraph, Keurig coffee is far from a gourmet experience; nonetheless, it can be quite drinkable. There are, however, two very disturbing things about the Keurig system, both of which have the potential to pulverize GMCR stock.

First, K-cups are an environmental disaster waiting to happen. They make better coffee than the competing pods largely because there are virtually air-tight until punctured by the Keurig machine. The only way that they can be so impervious to air is by making them completely non-biodegradable. Competing pods are pure paper or something that resembles paper. When the foil container that holds a pack of pods is opened, the coffee in each pod immediately begins to go rancid.

The high price for GMCR stock is predicated on the ability of K-cups to conquer the world. Were this to actually happen, in a world where everything else is getting more and more biodegradable, K-cups would dominate the end-point of the waste stream, just as plastic six-pack holders did in times past (until they were banned). GMCR acts like a superior environment citizen and "papers over" this monumental problem. Indeed, with nothing new good to say about the environmental impact of K-cups, the "Protecting the Environment" page of GMCR's website has not been updated for two years. GMCR appears to have recognized the impending K-cup environmental disaster, but so far they have done nothing to prevent it.

The second big problem is that quality control is seriously lacking in the Keurig coffeemakers. My 2006 vintage Keurig machine did not quite heat the water hot enough to make optimal coffee. I know this by comparison with the coffee made by nearly a dozen units I have used "out in the wild." My concern with the Keurig machines is just like my old GE Profile dishwasher, their coffeemakers could turn out to be a big-time fire hazard. (My dishwasher never caught fire and I never knew about the recall until I decided to replace because of its inability to get dishes clean, a major failing for such an appliance.) Like dishwashers, coffeemakers have high-wattage heating elements with the potential for mass destruction. A large, diversified company like General Electric can survive a slew of fires so that it will still be around to pay my pension; Green Mountain (and its stock) may not.

I figured that my Keurig coffeemaker was good for about three years before it would either need to be replaced or I would move on to something else. Just as the "spring" semester began in late January, my three-and-a-half stopped making coffee. At first, it spit out partial cups. Eventually, despite my quick efforts to clean it out, no coffee emerged at all. (I do run pure vinegar through it and let it sit for four hours every six months, as recommended, so I am blameless.)

My record at repairing out-of-warranty appliances is decidedly mixed. I figured that given that my Keurig machine was already past my perceived useful life for it, that I would just buy a replacement for it rather than sink serious time into trying to fix it. Five minutes at the local Sam's Club on my way to class in the morning and I was good to go.

Well, that's what I thought.

Within weeks, the new machine was behaving erratically. The old machine, which was now gathering dust in my basement, at least spit out the right amount of water when no K-cup was present. The new one could not even manage this. I was not about to return Keurig machines repeatedly until I finally got a good one. I would first try to fix the new one. If that failed, I would try to resurrect the old machine. If that failed, no more K-cups for me.

The manual for the Keurig machine is incomplete and misleading. It refers to illustrations that are not where they should be. More importantly, it fails to note that the machine has two "exit needles." One where the water exits and another where the brewed coffee exits. Green Mountain's website provides no additional support beyond the misleading manual and no forums that discuss issues with it. Fortunately, such forums are to be found through a simple Google search. After cleaning both exit needles, my new Keurig machine still could not measure water properly. Back to Sam's Club it went. Based on the Amazon reviews, many have had similar quality control issues.

My old machine, however, did work after the proper exit needle was cleaned, and it is back in service. It still does not make the water as hot as it should be, but I did discover something else. It really does make drinkable coffee. After weeks of drinking some of whatever the new machine was making, the coffee from the old machine was stunningly splendid. Indeed, soon after I bought my machine, the Keurig machines were redesigned, mainly so that they could house a water filter than would serve as a new revenue stream for GMCR. They were also quieter, which is good for those living in close quarters. They also make dreadful coffee, or at least mine did. I can easily imagine that my as-good-as-new vintage machine will someday be worth thousands of dollars on eBay.

Even before my crisis of Keurig, I had decided that Green Mountain was history as my pet stock. BofA was just a lot more exciting. Perhaps things would have worked out differently if the GMCR folk had agreed to come speak to my class rather than offering us some coloring books, but life moves on anyway. In my next commentary, "Evolving and Hibernating," I will discuss how I will be moving on in the months and years to come.