Why Coca-Cola Will Acquire Keurig Green Mountain Outright

Back on May 8, Coca-Cola  quietly started adding to its previously announced 10% position in Keurig Green Mountain  by buying shares on the open market. The trades, placed over three business days, preceded an announcement that the company would exercise its option to acquire up to a 16% stake in GMCR.

Over the course of 945 separate transactions, from humble "round lot" 100-share trades, to single purchases in excess of $5 million, the company bought in force, in the end acquiring $302.3 million worth of GMCR stock.

There was just one hitch in this well-executed accumulation: Keurig Green Mountain's stock price was rising rapidly in real time. It wasn't propelled by exiting short-sellers -- those had largely scrambled down from the Green Mountain when Coke first announced its presence in the stock in February. The previous evening, GMCR had reported second-quarter 2014 revenue that increased almost 10% over the prior year, demonstrating to many that the company had regained its sales momentum.


From Coke's first purchase at $96.65 on the 8th, a Thursday, to its last trade the following Monday, Keurig Green Mountain's share price would climb almost 11.5%, as Coke found itself bidding against other buyers enthused by GMCR's earnings report, while simultaneously contributing to the upward pressure on the stock.

By the time the closing bell rang on May 12, Coke had acquired its total batch of 2.8 million shares at an average price of $107.75, meaning that it had seen its excursion grow more expensive by $31 million. 

Of course, $31 million is a pittance for Coke -- it sells that much of its products every six hours. But the rapidly rising share price of GMCR has ostensibly forced management to grapple with a fundamental question: How many shares of the company does Coke want to own, and how quickly?

Now we just need doughnuts. Image from Flickr/planetc1 under Creative Commons license.

Keurig Green Mountain reminds Coke of a company it already knows very well
Exercising its option to purchase more shares of Keurig Green Mountain just 14 weeks after its first announcement of ownership speaks volumes about Coke's future intent. The market responded so positively to news of its initial stake that Coke was quickly put in the position of having to buy shares at a premium it created itself.

I've argued that the market really can't value the future impact of Coke's trademark on GMCR revenue at present. This imprecision will provide buoyancy to the stock until earnings come in from Coke-branded drinks on the upcoming Keurig Cold carbonated single serve platform. You can read this analysis here. GMCR now trades at a 54% premium to where it did the day before Coke announced its initial position in February. It's evident that Coke has revised both its expectations and its interest level, and probably wishes it had negotiated a larger initial purchase.

Coke's desire to add to its GMCR position may have something to do with Keurig's resemblance to Coke itself. If you were to strip away the details from these two companies, you'd find two very similar operations. Coke is a $46.8 billion company that licenses its intellectual property (its brand formulas) to bottlers and restaurants, and returns about 18% net profit each year.

Keurig Green Mountain, which is compensated to distribute other brands' coffees through its proprietary technology, is approximately one-tenth the size of Coca-Cola (at $4.4 billion in annual revenue), and returns roughly 11% profit each year, although last quarter its net profit clocked in closer to Coke's, at 15%. As a financial model, Keurig Green Mountain is a younger version of Coca-Cola, with a higher growth rate.

Coke's money and distribution can scale GMCR quickly
Seeing the similarities, Coke's management probably recognizes that its resources could fuel Keurig's growth on a global basis. Keurig Green Mountain has existed as a North American company since its inception. At the end of its last fiscal year, it estimated that it had only a 13% market penetration in North America. While there is surely further potential on this continent, much opportunity lies ahead in other markets: The company's international push did not start until fiscal 2014.

If Coke owned GMCR outright, it could subsidize international expansion by using its balance sheet for price investments in GMCR's technology. In other words, Coke has the deep pockets to offer GMCR's Keurig machines at a discounted price in Europe and Asia (two major coffee markets), which will speed adoption of Keurig's technology versus existing competitors such as Nestle. Nestle's "Nespresso" single-pod machine is the current single-serve coffee leader, with 26% share of the global market. Hastening adoption of Keurig brewing systems will pave the way for Coke's unparalleled distribution system to move K-cups en masse -- and wrest market share from Nestle.

Image from Flickr/Taymaz Valley under Creative Commons License

GMCR is hitting the wrong line item on Coke's income statement
Perhaps the most persuasive reason for Coke to completely own Keurig lies in the mechanics of accounting. For the time being, Coke recognizes its GMCR holdings as "available for sale" securities. Changes in market value of the shares occur in the "other income" line of the income statement. As Coke's interest rises toward the 16% mark, it may change its accounting to reflect an equity investment, with its proportionate share of income from GMCR recorded in the income statement's "equity income" line item, net of any dividends received.

While such accounting would positively affect earnings per share, or EPS, the impact of owning a rapidly growing company whose prospects will improve under Coke's ownership is muted. If Coke owned GMCR outright, the smaller company's revenues and expenses would consolidate under Coke's income statement, and affect measures that Coke investors pay close attention to, such as operating income. More importantly, GMCR's revenue growth would improve Coke's overall reported revenue growth. As I discussed, Keurig Green Mountain is only one-tenth the size of Coke, but it's expanded revenue by a compounded annual growth rate of 28% over the past three years. It's conceivable that Keurig Green Mountain, even after factoring in slower growth, could double its revenue over the course of five to 10 years, at which point it would have a measurable influence on Coke's revenue. Coke loses all this benefit if it continues to hold just a 16% stake, accounted for in a single line item, at the very bottom of its income statement.

A final clue: close ties in the relationship
As I've written about previously, Keurig Green Mountain's CEO, Brian Kelley, is himself a Coke veteran, with an understanding of how Coke can assist the company to scale up its operations. During GMCR's most recently conducted earnings conference call, Kelley noted:

We are also in the final stages of closing on the site for the first dedicated commercial cold -- Keurig Cold production facility in the southeastern United States.

Source: GMCR quarterly earnings call transcript

Last week, Georgia Gov. Nathan Deal confirmed that Keurig Green Mountain has closed on a $337 million, 585,000-square-foot production facility for the upcoming Keurig Cold machine, just outside Atlanta -- Coca-Cola's corporate headquarters. This reveals from Kelly's perspective just how important both Coke's trademarks and expertise will be in selling Keurig Cold machines and "Cold" carbonated servings. It's also yet another clue that these two corporations are gearing up, perhaps inevitably, for a much closer relationship. 

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The article Why Coca-Cola Will Acquire Keurig Green Mountain Outright originally appeared on Fool.com.

Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends Coca-Cola and Keurig Green Mountain and has options on Coca-Cola. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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