Monday, December 23, 2013

Monster Beverage- Quantifying Price of Growth

Monster Beverage Corporation (MNST) develops, markets, sells and distributes alternative beverage, such as non-carbonated ready-to-drink iced teas, lemonades, juice cocktails, single-serve juices and fruit beverages, ready-to-drink dairy and coffee drinks, energy drinks, sports drinks, and single-serve still water (flavored and unflavored) with beverages, including sodas that are considered natural, sparkling juices and flavored sparkling beverages. Company markets its products through retail chains, club stores and specialty stores using exclusive distributor network. 

Energy drinks and shots represent small portion of non-alcoholic beverage market, this industry has seen tremendous growth since 2008, with total sales in United States close to $13.0 billion dollar presently. This growth has been attained on the backdrop of increased consumer penetration and drop in sales for traditional carbonated soft drinks due to health concerns related with cola products. According to “Energy Drinks and Shots: Market trends in US”, sales for energy drinks & shots is expected grow to $ 21.7 billion dollar supported by improvements in distribution channels and sustained economic growth. Energy drinks market is currently in its infancy and is expected to grow significantly as energy drink usage increases among its target consumers (Source: Presently energy drinks account for 78% market share followed by 18% for energy shots and 4% for energy drink mixes.

For the last twelve months, company reported revenues of $2.2 billion, operating income of $552.0 million and net income of $331.0 million or $1.98 earnings per share.  Company has realized huge growth in the past 9 years with revenue growth of 12.7%, operating income & net income growth of 16.8% annually, capturing a market share of 35%. Figure 1 highlights y-o-y growth Monster Beverage has realized since 2004.

Year over Year Growth in Revenues, Operating Income & Net Income for Monster Energy

Monster Beverage has been able to maintain its operating margins and net margins for past several years with only exception of compression in margins during 2008. This supports the fact that company is not growing revenues by compromising on margins.  It competes directly with other energy drink manufacturers such as Red Bull and with big stalwarts like Coca Cola (KO) and Pepsi (PEP) to gain the shelf space at convenience stores. Increased health concerns among consumers with the usage of carbonated soft drinks have worked favorably for Monster’s favor but recent allegations related to safety of its products seems to offset the tail wind it had. Figure 2 compares the operating & the net margins for Monster Beverage against Coca- Cola (KO) and Pepsi (PEP).

As business has grown over the last several years so have the reinvestment requirements – enabling the company to grow its revenues.  Management has been very effective in analyzing industry trends, growth opportunities and making decisions to reinvest. Figure 4 highlights relationship that exists between revenue growth and reinvestment rate (Part of Operating Income after taxes which gets invested back into the business)

Monster Beverage has created a huge brand in the marketplace and is aggressively marketing its products to attract youth to switch from coffee & carbonated soft drinks to energy drinks and turn them into loyal customers of the brand.  Additionally it is expanding internationally with sales growing in Europe, Japan, Middle East, Africa and partnering with industry peers to develop a strong distribution network.  

Valuation of Monster Energy

Growth story for Monster energy moving forward is international expansion but the firm also faces strong competition from Red Bull which already has an established international distribution network. Even though the firm currently enjoys strong brand loyalty, maintaining pricing power at the current margin levels will be a challenge, as reinvestment requirements for expansion of business starts to grow.  Growth in future for this company is where the investors need to realize the risks are and factor them in their valuation methodologies. From a valuation perspective, value generated by growth can be categorized in three categories

  1. Growth Rate
Revenue Growth Rate expected for next 5 year is 15.6 %, operating income is expected to grow 16.3% per year for next 5 years.

  1. Sustainability of growth
Developing a globally recognized brand and establishing partnerships for scaling up their distribution network provides a strong competitive edge for Monster.

  1. Return on capital
Brand loyalty, product mix and appealing marketing campaign has helped the company earn higher returns on capital invested. Median ROIC for Monster Energy since 2004 is 47.9% against cost of capital of 8%. Returns generated over and above the cost of capital reflect quality growth generated and value creation for share holders.   

As an investor we should know how much we are paying for growth in business and should be cautious about paying any premium for lower quality growth. Separating value of assets currently in place from market price helps in determining how much price for growth is built in the stock price. Using a cost of capital of 8% (Beverage Industry –US Average), we can see the value of assets in place, value that growth will add and price we are paying for growth.

As illustrated in the table above, assuming Monster Beverage will only be able to earn its cost of capital; price of growth comes at 3.7 times the value which growth assets will generate. At current price level, market is implying a growth rate of 23% in the operating income for the next 5 years. This level of implied growth rate seems higher than our expectations of growth in operating income but Monster’s ability to generate returns far higher than its cost of capital add value for share holders which needs to be factored in company’s valuation. Price investors pay for growth is a variable that investors should pay close attention to. Using the median ROIC which Monster Beverage since 2004, we come up with value of assets currently in place, value added by future growth, price we are paying for future growth, intrinsic equity & enterprise value of the business. For growth oriented investors, entry price lower than the sum of value of assets & price paid for growth ($62.87) – offers growth at a reasonable price and provides margin of safety as well.

I will publish a follow up article highlighting in detail the inherent business risk for Monster Beverage,  quantify stock price risk with ±1% growth variation , risks reflected in options markets and relationship which exists between business risk, growth risk and options market perceived risk 

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