Monster growth

(Fortune Magazine) -- Beverage maker Hansen Natural has spent the past few years delivering such rapid and robust growth that one might think the company was mainlining its flagship Monster Energy drink (one can has more caffeine and "energy boosters" than eight cups of coffee).

Earnings more than doubled in 2005, increased by 54% in 2006, and jumped 50% in 2007. Net margins averaged 17% over the same period, and the company, which has a market cap of $2.7 billion, is debt-free and generating positive cash flow. No wonder Hansen, based in Corona, Calif., earned a No. 2 spot on Fortune's Fastest-Growing Companies list for 2007.

The hyperactive results are all the more impressive considering that in 1988 the company was a struggling soft drink maker that had just filed for bankruptcy, and that the turnaround plan that began in 1992 didn't bear fruit until Hansen dove into the energy-drink market in 2002. Monster is now the No. 2 energy drink, with 28% of the market, vs. 35% for Red Bull.

However, if you've pulled an all-nighter thanks to the power of a Monster, you know you can't sustain the high forever. The same seems to be true for the stock. Even though net sales increased by 28% in the first quarter of this year, that was about five percentage points below expectations, according to Morningstar. The company also posted earnings of 29 cents a share, a 38% gain from the same quarter a year ago, while Wall Street analysts had expected 35 cents.

Those numbers were a blow to a company that "lives and dies by its ability to sustain above-average growth in both its sales and earnings," according to Morningstar analyst Greggory Warren. To wit, the shares lost 15% of their value the day after the earnings announcement this May and are down 33% since Hansen appeared on our list; the stock now trades at only 12 times next year's expected earnings.

After Hansen's (HANS) disappointing quarter, investors overwhelmed the company with so many calls that the management team, led by chairman and chief executive Rodney Sacks, has stopped meeting with investors for the time being. Instead, the company is holding additional conference-call updates. Meanwhile, short-sellers have been circling the stock.

The problems with earnings growth stem from outside forces weighing on Monster, the brand that accounts for more than 85% of Hansen's sales and profits. About 70% of all energy drinks are sold at convenience stores, and customers at these chains are cutting back on discretionary purchases to meet rapidly surging gasoline costs. Hansen must also pay for the raw materials used in its drinks and packaging, so higher commodities prices for everything from sugar to petroleum have cut into margins.

Hansen has high hopes for its new coffee-based beverage, Java Monster, but it creates some near-term troubles - Java is cannibalizing sales of traditional Monster products, and its gross margins are 20 percentage points lower than those of regular Monster drinks, notes Scott Van Winkle, an analyst at Canaccord Adams. "The company is replacing a higher-margin product with a lower-margin product, and this dynamic is exacerbated by rising commodities prices," he says.

The outlook is not all bad for Hansen. Java Monster is being moved from the soft drink shelves to the dairy cooler, where it may be able to take market share from coffee drinks. And energy drinks are still the fastest-growing part of the beverage market, says Van Winkle, so the company - which also makes sodas, fruit juices, iced teas, and nutrition bars - should be able to boost earnings at more than twice the rate posted by beverage behemoths like Coca-Cola and PepsiCo (PEP, Fortune 500).

In a research note published by Stifel Nicolaus, analyst Mark Astrachan says Hansen's new distribution agreement with Anheuser-Busch is likely to boost sales and give its beverages an even higher profile. He adds that this agreement is unlikely to be hurt by a possible acquisition of Anheuser-Busch (BUD, Fortune 500) by InBev, since it is a potentially profitable arrangement for the distributor too.

Speaking of M&A, speculation that a company like Coca-Cola (KO, Fortune 500) might be interested in buying Hansen once supported the company's lofty stock price, and most analysts agree that Hansen will not be a standalone company forever. "All beverage categories are dominated by an oligopoly of drinkmakers. When the company's valuation drops lower, we'll see Hansen get acquired. For now there is no rush," says Van Winkle. Until the M&A markets improve and someone is thirsty for Hansen, the company has the balance sheet and the market share to weather the coming consumer spending drought.