The Economic Data calendar for the week of the 9th of April through the 13th is full of critical releases and events. Attached below is a snapshot of some (though far from all) of the headline numbers that we will be focused on.



Weekly European Monitor: How about that Spanish Auction?!

No Positions in Europe


Asset Class Performance:

  • Equities:  The STOXX Europe 600 is down -1.6% week-to-date vs -0.9% last week. Bottom performers: Italy -4.4%; Austria -4.0%; Greece -3.7%; Czech Republic -3.5%; Spain -3.2%; Portugal -3.2%. Top performers:  Russia (MICEX) +2.1%; Ukraine +1.1%; Denmark+90bps.  
  • FX:  The EUR/USD is down -2.13% week-to-date.  WTD Divergences: RUB/EUR +1.78%, TRY/EUR +1.47%, GBP/EUR +1.00%, ISK/EUR +0.93%; HUF/EUR -0.51%
  • Fixed Income:  Greek 10YR bond yields again led the upward charge, gaining +109bps week-to-date to 22.13% (after a +100 bps move last week). In close step was Portugal, gaining +83bps to 12.23%, followed by Spain’s +37bps to 5.80%. Critically, both Spain and Italy continue to see rising yields in recent weeks, bucking an early March hold in and around 5.00% level.  The German 10YR contracted -7bps to 1.75%, and remains the “risk-free” stand-out in the politically compromised Eurozone. We’ve long wondered why the lack of sovereign buying from the ECB’s SMP program in the last two months (including zero buying in the last three straight weeks) didn’t equate to rising yields. This week we clearly witnessed a reversal in this trend across the Eurozone’s weaker members.

Weekly European Monitor: How about that Spanish Auction?! - 111. yields



Call Outs:

LTRO - Some of Europe’s biggest banks are preparing to return a chunk of 3yr LTRO money: senior bankers said UniCredit, BNP Paribas, SocGen, and La Caixa in Spain are preparing to pay back up to a third of the money they borrowed – estimated at €80-€100B in total – within the next 12 months.


Spain - The government said total borrowing needs will reach 79.8% of GDP for 2012, 30% below what was needed in 2011.

  • PM Rajoy said: “The worst we could do now is nothing…It will be intense and difficult, but we’re laying down the grounds for Spain’s future recovery.”
  • Finance Minister Luis de Guindos said:  "From a budget perspective, the government is facing a lose-lose situation. If you don't make enough adjustments, markets will penalize you. But if you go too far, markets could also penalize you."

Italy - PM Monti reached an agreement with Italy’s main political parties on his proposal to ease firing rules and speed its passage through parliament.


Italy - BlackRock is buying Italian stocks amid optimism that PM Monti will succeed in cutting debt and boosting economic growth.


Swiss Franc - Broke through 1.20/euro for first time since the central bank set that rate limit but the SNB said it’s ready to buy unlimited quantities to prevent it from dropping below. 


Hungary - Hungarian President Schmitt Resigns. Reason – Plagiarism.


Czech Republic - PM Petr Necas warned snap elections may be held quickly if the smallest member of the three-party ruling coalition makes good on its threat to quit amid preparations to cut the budget deficit.



In Review:

This week showed once again how much headline risk is governing European markets, especially on the equity side. Wednesday’s €2.6B Spanish bond auction, which came in at the lower range and saw yields on the 2015 maturity security jump to 2.89% vs 2.44% on March 15th and the 2016 maturity jump to 4.319% vs 3.376% on March 1st, rattled markets. The DAX closed down -2.8% on the day (Wednesday), CAC -2.7%, and FTSE -2.4%.


But the sovereign and banking risks in Spain aren’t new!  We’ve signaled our bearish positioning on the PIIGS in recent months and continue to believe that the region is far from “out, and in the clear”. Not only has the fundamental data come in largely worse for the month of March (PMIs and confidence readings in particular--see below), but we continue to think the combined ESM and EFSF (€800B) is undercapitalized to deal with a sovereign default from the likes of a Spain or Italy.


Related, but getting less press, the German parliament (Bundestag) has agreed (across party lines) on a new decision-making process that requires all 620 members of the Bundestag to vote on nearly every detail of the euro rescue fundversus the previous quorum from a 41-member budgetary committee (with knowledgeable experts from all parties). Therefore, if the EFSF wants to make important decisions, in the future the entire Bundestag will have to regularly convene, in compliance with all legislative deadlines and regulations, with at least 311 parliamentarians present in order for a decision to be valid.


Can you say roadblock!



CDS Risk Monitor:


Week to date Spain saw the largest CDS gains, at +38bps to 475bps, followed by Italy (+27bps) to 424bps and Portugal (+23bps) to 1,097bps. The move in Portugal comes after two weeks of material declines, -143bps and -94bps, respectively. 


Weekly European Monitor: How about that Spanish Auction?! - 111. cds   a


Weekly European Monitor: How about that Spanish Auction?! - 111. cds   b


Data Dump:

Weekly European Monitor: How about that Spanish Auction?! - 111. PMIs

Eurozone Unemployment Rate 10.8% FEB vs 10.7% JAN

Eurozone Retail Sales  -2.1% FEB Y/Y (exp. -1.1%) vs -1.1% JAN

Eurozone PPI 3.6% FEB Y/Y (exp. 3.5%) vs 3.8% JAN   [0.6% FEB M/M (exp. 0.5%) vs 0.8% JAN]


UK New Car Registration 1.8% MAR Y/Y vs -2.5% FEB

UK Industrial Production -2.3% FEB  Y/Y (exp. -2.1%) vs -4.0%

UK PMI Construction 56.7 MAR (exp. 53.4) vs 54.3 FEB

UK Manufacturing Production -1.0% FEB M/M (exp. 0.1%) vs -0.3% JAN   [-1.4% FEB Y/Y (exp. 0.1%) vs -0.1%]

UK Halifax House Prices -0.6% MAR Y/Y (exp. -1.7%) vs -1.9% FEB


Germany Factory Orders -6.1% FEB Y/Y (exp. -5.5%) vs -6% JAN  

Germany Industrial Production -1.0% FEB Y/Y (exp. 0.5%) vs 1.5%


Italy Unemployment Rate 9.3% FEB Prelim vs 9.1% JAN

Italy 2011 Deficit to GDP = 3.8%


Belgium Unemployment Rate 7.2% FEB vs 7.2% JAN

Ireland Unemployment Rate 14.3% MAR vs 14.4% FEB

Denmark Retail Sales -0.5% FEB Y/Y vs -3.3% JAN

Norway Credit Indicator Growth 7% FEB Y/Y vs 6.9% JAN


Switzerland Retail Sales 0.8% FEB Y/Y vs 4.7% JAN

Switzerland CPI -1.0% MAR Y/Y (exp. -1.1%) vs -0.9% FEB


Russia Q4 GDP 4.8% Y/Y vs 5.0% in Q3


Turkey Consumer Prices 10.43% MAR Y/Y vs 10.43% FEB

Turkey Producer Prices 8.22% MAR Y/Y vs 9.15% FEB


Romania Retail Sales 3% FEB Y/Y vs 9.9% JAN

Romania Producer Prices 5.9% FEB Y/Y vs 6.0% JAN


Interest Rate Decisions:

(4/4) ECB Interest Rate UNCH at 1.00% (in-line)

(4/4) Poland Base Rate UNCH at 4.50% (in-line)

(4/5) BOE Interest Rate UNCH at 0.50% (in-line)

(4/5) BOE Asset Purchases UNCH at 325B Pounds (in-line)



The European Week Ahead:

Monday: Mar. Germany Wholesale Prices (Apr 9-12); Mar. UK Lloyds Employment Confidence, RICS House Price Balance; Mar. Greece CPI; Feb. Greece Industrial Production


Tuesday: Apr. Eurozone Sentix Investor Confidence; Feb. Germany Exports, Imports, Current Account, and Trade Balance; Feb. UK House Prices; Mar. France BoF Business Sentiment; Feb. France Industrial Production, Manufacturing Production; 1Q Spain Business Confidence; Feb. Spain House Transactions


Wednesday: Feb. Spain Industrial Output


Thursday: Apr. ECB Publishes Monthly Report; Feb. Eurozone Industrial Production; Feb. UK Total Trade Balance, Trade Balance in Goods; Mar. France CPI; Feb. France Current Account; Jan. Greece Unemployment Rate


Friday: Mar. Germany CPI – Final; Mar. UK PPI Input and Output; Mar. Italy CPI - Final; Feb. Italy Industrial Production; Mar. Spain CPI - Final



Extended Calendar Call-Outs:

22 April:  French Elections (Round 1) begins, to conclude in May.


29 April, 6, or 13 May:  Potential Greek Presidential Elections.


30 June:  Deadline for EU Banks to meet €106B capital target/the 9% Tier 1 capital ratio.


1 July:  ESM to come into force.



Matthew Hedrick

Senior Analyst

Retail: SSS Not Good Enough


March sales were good, but not good enough. The beat-to-miss ratio was 12 companies coming in ahead of expectations and 7 misses. Given the Easter shift and the best March weather on record, we were expecting better on the event – so too was the market based on how these names are trading. The bigger callout of the day are the revisions. With 4 upward revisions compared to zero negative adjustments, April sales day is setting up for some surprises. Companies will be reporting the final month of the quarter in what will be a zero gravity environment at best against 2011 Easter compares.


Here are some additional callouts on this morning’s event:


  • High Low End Bifurcation Remains Intact: Though the spread between the high and low end department stores compressed slightly in March, it remains ~5pts wide. JWN (+8.6% vs +5.7E) & M (+7.3% vs +4.7E) posted strong beats with SKS (+6.3% vs. +6.4E) coming in-line to slightly below consensus. On the low end, BONT (-0.1% vs. +1.7%) missed while KSS (+3.6% vs. +2.4E) and SSI (+4.7% vs. +3.3E) beat estimates for the month. 
  • KSS: After coming in light in February (-0.8% vs. -0.1E), KSS  beat expectations this morning driven primarily by kids (13% of sales) which came in +mid teens and accounted for 2pts of the 3.6% comp. While March sales came in better, the shortfall in February requires April comps to be +0.8% or greater in order to meet guidance of +1% for 1Q12 vs. +0.7E suggesting a +7.6pt sequential acceleration in the underlying 2yr trend. With the Easter shift now a stiff headwind, we see continued risk in Q1 EPS.
  • Off-Price Remains Robust: TJX and ROST both reported March comps +10% beating expectations by 5.1 and 5.4pts respectively, increasing the spread between the off-price space and the rest of retail to 4.6 pts, up 50bps sequentially (see chart below). ROST inventories were down -4% on +15% sales growth droving the sales/inv. spread up +6pts sequentially to +19%. Based on our industry SIGMA analysis (see below), while the sales to inventory spread improved on the margin in 4Q11 at the expense of additional EBIT margin, the spread remains down -7% on +16% inventory growth. As inventories build throughout the industry, we think TJX and ROST will continue to be positioned for more favorable buy-ins over the intermediate term TREND.
  • Earnings Updates: For much of retail, March marked the second month of 1Q12 with April accounting for the remaining ~32% of the quarter. Surprisingly, with 12 beats & 7 misses by an average spread of 3.5 and (-1.7) points respectively, all of this morning’s updates to guidance were to the upside. Major increases to EPS guidance for the first quarter came out of TGT, ROST & TJX. For the second time in a row, TGT comp’d positively in all of its major categories in over a year with Food & Apparel accelerating sequentially (19% & 19% of sales respectively).


Below are the changes to first quarter guidance out of TGT, ROST & TJX:

  • TGT:  Increased EPS to $0.96-$1.02 vs. $0.98E (up from $0.88-$0.98)
  • ROST: Increased EPS to $0.89-$0.91 vs. $0.88E (up from $0.82-$0.86)
  • TJX: Increased EPS to $0.51-$0.52 vs. $0.48E (up from $0.45-$0.47) 
  • M: increased comp guidance for the combined March-April period to +4.3%-4.5% vs the prior +3%-3.5%. The increase implies that April is expected to come in around +1%-1.2%. Based on April coming in-line with expectations, M’s first quarter comp would come in near +4.5% vs. +3.9E. This is a positive read through into PVH with Macy’s its largest customer accounting for 9.4% of sales in 2011. PVH remains one of our favorite large cap longs in 2012 behind our Top 3 – see our recent note "PVH: Levers and Drivers". 
  • GPS: March Comps were +8% vs. +4.4%E on the heels of an upside surprise in February after months of posting misses and “less bad” numbers. These results suggest new product out of GPS’s international creative facility in NYC is gaining traction. While the underlying 2-year trend slowed across all of GPS’ domestic segments, this was the first month where every concept comp’d positively since March 2010 and will get investors thinking about $2+ in earnings power. While the near-term setup here is bullish, our TAIL call remains bearish based on an increasingly stressed share repo model and underinvested infrastructure. 
  • COST: missed expectations for the first time in 2 years +6% vs. +6.4E. Gas benefited comps by 1 point in the US while FX headwinds resulted in a 50bps detriment to growth. Though Electronics remained down MSD, all of Costco’s major categories were up with softlines (10% of sales) the outperformer up LDD. 
  • Category Performance: Consistent with the timing shift of Easter (April 8th this yr vs. April 24th ly) children’s and footwear were common categories highlighted as outperformers during the month. TGT cited particular strength in both boy’s and girl’s with toys also strong. ROST mentioned juniors and children’s shoes as the strongest merchandise categories. Footwear was +18% at BKE and mentioned positively at ZUMZ who also highlighted Juniors as an area of strength in March, though boys comp’d down. On the high end, JWN also saw strength in children’s. Additionally, consistent with what we’ve been seeing, designer handbags were of the strongest categories at both JWN & SKS.





Casey Flavin



Matthew Darula



Retail: SSS Not Good Enough - blended SSS high low spread chart


Retail: SSS Not Good Enough - total SSS


Retail: SSS Not Good Enough - industry SIGMA


Retail: SSS Not Good Enough - TGT Monthly Grid

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Burger King's return to NYSE too fast to swallow

BBBY: Tail Risk

We were looking for a comp driven beat into the quarter, but results came in even better than expected with comps up +6.8% vs. +3.8%E and our +5%E. Additionally, the sales/inventory spread improved 6pts to +4% from -2%, which is gross margin bullish near-term. However, the key highlight from the call is the incremental spending in 2H of 2012 associated with a refocus on e-commerce suggesting the first increase in SG&A per sq. ft. growth in six years. The underlying fundamentals here have not changed – the Bed Bath & Beyond concept’s strength lies in its “specialty shop” format, which is designed to enhance the customer’s perception of service in-store (see our store map below). However, online BBBY remains susceptible to competitors offering the same value at a lower price. Mind the tail risk here.


Our in store analysis outlined in our 3/30 note "BBBY: E-Comm Threat Revisited" shows that BBBY’s product overlap with is north of 90% and for like product, pricing was ~1% below Bed Bath’s. Moreover, the disparity in pricing between the two was greater in higher price point categories.


While top line compares ease into 1H and inventories are well positioned entering 2012, The underlying fundamentals to our longer-term TAIL call remain unchanged. We’re at $4.51 in F12, up ~11% vs. guidance of up HSD to LDD. 1-2 years out, we’re modeling EPS of $4.80 in F13 & $5.12 in F14 vs. $4.94 & 5.91 respectively.


BBBY: Tail Risk - SIGMA


From our 3/30 note "BBBY: E-Comm Threat Revisited":


TAIL: (Tail=3 Years or Less)

BBBY was the primary competitor that ‘nudged’ Linens n Things into Chapter 11 in 2008 alongside the recession and bursting housing bubble. After 3 years of shrinking operating asset turns and margins eroding, BBBY improved both in 2009 & 2010. While BBBY’s aggressive expansion and promotional cadence was largely the nail in the coffin for LIN, many people overlook the pressure from the e-commerce home category. Our analysis below shows that Bed Bath and Beyond has a 93% product overlap with which exposes BBBY’s primary store format (85% of the 1174 stores) to online competitive threat.  In other words, it was not just BBBY that put LIN out of business, it was Amazon and other competition. is still hungry, and with LIN’s $3.5bn in revenue gobbled up by BBBY ($10bn in revs), AMZN and the like, it will still go after bricks and mortar opportunities.


While alternative store formats like Christmas Tree shops and Buybuy Baby are less at risk, we expect the long-term tail risk to amass as the consumer focus shifts to omni-channel. BBBY has already begun to reaccelerate capital spending as a percent of sales on new stores, remodels, IT enhancements & a new fulfillment center but this might be too little too late. While this may increase customer retention, our concern here is that BBBY will need to spend more to stand still.


Check out our BBBY Management Scorecard


The BIG ideas in retail come when a company’s triangulation of EBIT margins and asset turns both improve simultaneously. Check out the chart below. The three years leading up to 2008 were abysmal. So was BBBY’s stock performance. From ’08 through ’11,  we’ve got asset turns improving along with EBIT margins. That’s a big RNOA accelerator. Pretty simple. But once margins OR asset turns start to stall, then multiple expansion goes out the door. That’s where the TAIL call with this company is headed.


For the past three years, earnings growth has been near 30%. For the next three, we have it hovering in the single digits. Take a look at history, this company is not afraid to shrink its net income.


BBBY: Tail Risk - RNOA


Product Overlap:


What we did: We conducted a detailed analysis on the different plan-o-grams in different sized Bed, Bath and Beyond stores. Then we looked at overlap among a variety of store formats. Then we literally scanned each product, and compared to either a) the exact product online, b) a ‘pretty darn close’ product by the same brand – one with enough tweaks for BBBY to call it exclusive, when its really close to being the same thing, and c) a competing product in a more commodity category that can act as a substitute.


Out of the product sold through Bed Bath & Beyond stores, our analysis showed there was a 52% direct sku overlap with However, assuming a 100% overlap in generic categories, the overlap was 93%. As a result of exclusive brands sold throughout various categories in Bed Bath & Beyond stores, certain product categories (i.e towels) had a 0% sku overlap. In reality, consumers are more sensitive to branded purchases in categories like cookware and appliances but neutral when shopping for items such as towels and sheets - a white towel is a white towel. As such, it’s important to keep the sensitivity of the overlap in perspective.


 BBBY: Tail Risk - sku overlap


BBBY: Tail Risk - store map


Matthew Darula



When we consider that GMCR has now declined for 10 days in a row and insiders are exiting the stock, it is easy to concoct a bearish story.  The question is: how bearish is bearish enough?  We think the stock could go to $25.


Green Mountain Coffee Roasters’ stock is one we have been wary of for some time.  Howard Schilit, renowned forensic accountant, mentioned the company in a highly insightful interview with Barron’s last weekend about accounting shenanigans.  Also over last weekend, we also got our hands on an amended Class Action Complaint filed against the company in the US District Court in Vermont.  It makes for fascinating reading and cites 14 confidential witnesses from many different tiers and roles within GMCR.


We can imagine a time when the senior management team at Green Mountain Coffee Roasters looked at each other across a table and said, “Starbucks is going to buy us one day”.  While that eventuality may materialize one day, our estimation is that it is more likely to occur in a bankruptcy context than any other. 


The first rumblings about GMCR’s accounting issues began in late 2010.  The company had acknowledged an overstatement of pretax income in September of 2010 and the SEC had notified the company of an investigation into its revenue recognition practices.  In 2011, when it became clear that Starbucks wanted to take a slice of the single-serve market, we were convinced that the Seattle-based titan would go it alone.  We were wrong then but, as time passes, our confidence is growing that our thinking was not a million miles off target. 


With a current market capitalization of $7 billion and sales of $4.2 billion, weighing the current fundamental risks leads us to believe that this company’s stock could go to $25 or even lower in short order.  We believe that there is a risk of inventory write-downs and other one-time but long overdue charges.  The overstatement of pre-tax income acknowledged in 2010, as we discuss in more detail later in this post, bore no relation to the company’s relationship with M. Block & Sons, GMCR’s single order fulfillment entity.  According to its website, M. Block is a leading provider of end-to-end supply chain solutions.  Our view is that some costs could arise from alleged improprieties outlined in an Amended Class Action Complaint filed against Green Mountain last week.  While our legal expertise is limited at best, the numbers corroborate with much of the detail in that complaint.  If even 10% of the allegations in the complaint are founded in truth, investors may begin to exit the stock en masse.


Before we begin this note in earnest, it is worth stating clearly that many of the points discussed in this post is merely alleged to be true, coming from the Amended Class Action Complaint filed against Green Mountain Coffee Roaster’s Inc., et al., at the United States District Court in Vermont and also various other sources where the information provided constitutes opinion. 





On September 28th, 2010, GMCR filed a form 8-K with the SEC announcing management’s discovery of an “immaterial” overstatement of pretax income related to an immaterial accounting error relating to “the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit”.  Having determined that the error arose in 2007, the company calculated the impact from that point through June 2010 as being $7.6 million in pre-tax income or, net of tax, $0.03 in EPS. 


Within the same filing, the company reveals that on September 20th, 2010, “the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information.  Based on the request, the Company believes the focus of the inquiry concerns certain revenue recognition practices and the Company’s relationship with one of its fulfillment vendors. The Company, at the direction of the audit committee of the Company’s board of directors, is cooperating fully with the SEC staff’s inquiry”.


The lead plaintiffs allege that the company knew about the SEC’s investigation for months. A confidential witness, “CW1”, cited in the case, states that the company’s revenue recognition methods were being investigated by the SEC.  CW1 was a former GMCR distribution planning manager, according to the Complaint.  Said witness recalled that in November and December 2009, internal discussions regarding the company’s revenue recognition practices were held at company meetings attended by many senior GMCR executives including CFO Frances Rathke and CEO Larry Blanford.


Our contention is that the inventory control and revenue recognition issues are one and the same largely due to the influence GMCR had over its supply chain “partner” MBlock (more on this later).  The confidential witness, referred to above, claims to have confronted two superiors, VP of Operations Jonathan Wettstein and Director of Operations, Don Holly about the company’s inventory processing practices on numerous prior occasions, dating back as far as October 2009.  His views were expressed to no avail; the inventory processing practices remained the same, as we discuss later.


While it is not appropriate or possible for us to take a stance on whether or not management knowingly and willingly manipulated inventory and sales numbers, it is surprising to us that management would have assumed such a bullish stance during the 7/28/10 conference call, if indeed SEC investigators were already meeting with company representatives regarding accounting practices at the company.  The following statement from management during that conference call was highlighted by the Complaint as being particularly misleading given that future sales growth was being guided down at the same time:


“And at the same time we'll be building our retailer inventories as we get into the fall season, with the expectation that we are going to continue to exceed our own expectations on brewer sales.”


Is it possible to have the expectation that one’s expectations are going to be exceeded? 





The “Class Period”, which is the stretch of time that the Action alleges that investors purchased GMCR’s common stock at inflated prices due to materially false and misleading statements, spans from 7/28/10-9/28/10.  At the center of the Action is the allegation that inventory was purposely accumulated with little or no regard for real demand for the product.


The confidential witness that claims to have approached management about the company’s inventory processing practices, CW1, outlined that management preferred a “standard deviation plus 3 [days’ inventory]” method versus the “ABC” method favored by the industry which categorized inventory as fast, medium, and slow moving items.  The witness stated to Wettstein that this method was “skewed” and would result in production of expired and expensive products to be produced solely to “carry-over” the inventory from one period to the next.  CW1’s input did not result in any change in policy, according to the Complaint.


Two other anecdotes, both of which – if true – are astounding, detail further improprieties that were carried out by GMCR, according to confidential witnesses cited in the Complaint.  CW1, stated, according to the Complaint, that “senior management stressed”, at weekly and bi-weekly meetings, “the need to continue to produce product regardless of whether or not the product could be sold.”  The resulting inventory problem was allegedly masked in two ways.  First, according to CW1, to “get rid of inventory” during audits, dated or expired coffee was loaded onto trucks and parked a few blocks away until after the auditors left the warehouse.  CW7, a lower-level employee in GMCR’s shipping department in Knoxville, Tennessee, corroborated CW1’s claims, adding that inventory was shipped to other company warehouses only to be returned untouched days later.  Additionally, CW1’s claims that expired coffee product was offered to pig farmers for inclusion in silage were strengthened by CW7 who said that he/she had witnessed vast amounts of product being dumped in land-fills near the Knoxville production plants. 


Why would employees, higher- and lower-level, have gone along with this strategy?  Why would M. Block have been so complicit in the alleged shenanigans?





Money is the ultimate truth serum and, we believe, following the money helps to tie a lot of this story together.  Details within the Complaint as well as actual insider transactions by officers of the company seem to rhyme with the narrative of shenanigans that has been touted by Green Mountain detractors for the last eighteen months or more. 


Firstly, it is worth starting with M. Block, a company that was Keurig’s single order fulfillment entity.  In addition to taking orders for GMCR, M. Block also had as much as 500,000 square feet of warehouse space, storing both brewers and coffee.  Green Mountain was an extremely important client for M. Block; the Complaint states that prior to mid-2009, GMCR represented 20% of the company’s business.  After a nationwide contract was agreed in July ’09, however, that share 4quickly grew to 75%.  According to the Complaint, confidential witness six, or “CW6”, a former VP of Operations at one of the company’s roasters and a CPA, stated that the SEC was questioning the existence of an arms-length relationship between GMCR and M. Block and whether or not the transactions between the two companies could be recorded as sales.  David Einhorn’s recent presentation, the research behind which included interviews with current and former employees of GMCR and its partners, alleges that GMCR exploited the relationship with M. Block to engage in a “variety of shenanigans that appear designed to mislead investors and to inflate financial results.” 


Given the importance of GMCR to M. Block from a revenue perspective, it is clear that the incentive existed for the smaller, dependent company to comply with the practices of its client upon which it relied so heavily.


Lower-level employees, both within GMCR and M. Block (although Einhorn cites employees of M. Block as feeling like they worked for GMCR) were incentivized to follow senior management’s plan of attack, according to the Complaint.  CW1 states in the document that all employee bonuses were awarded annually and based upon the amount of product produced, not on the amount of product sold.


Furthermore, the Executive Compensation section of the fiscal 2011 10-K contains a definition (that was also in a proxy detailing the policy for FY10) of the “Annual Bonus Opportunity or Annual Cash Bonus” as “cash reward paid to executives on an annual basis; currently based on two financial metrics: net sales and non-GAAP operating income.”  If the company was able to manage revenue figures by simply ordering K-Cups from licensed third-party roasters and warehousing the inventory at M. Block’s facilities, as the Complaint alleges, it seems that the calculus behind executive level bonuses may have provided some incentive for senior officers to follow that strategy.





From the outside, it is impossible for anyone to know what management was thinking during the Class Period.  Looking at the insider transaction of Scott McCreary and Michelle Stacy definitely doesn’t instill much confidence. In the table below, we provide a timeline of events interwoven with color provided in the Class Action Complaint by witnesses. 





When we consider that GMCR has now declined for 10 days in a row and insiders are exiting the stock, it is easy to concoct a bearish story.  The question is: how bearish is bearish enough?  We think the stock could go to $25.





The primary concerns from us arising from this Complaint are as follows:

  • There is a risk that management may have been derelict in their duty to provide investors with forthright guidance on business trends that is supportive by reasonable basis.
  • It appears that there is a significant risk that the relationship with M. Block was not “arms length”.  Since transactions between the companies are being booked as sales, the relationship should be “arms length”.  The SEC is investigating.  A change in revenue recognition more reflective of reality could be just as bad for net sales growth as it has been good.
  • No restatement has yet been made pertaining to GMCR’s relationship with M. Block, per the company’s 2010 10-K.  We believe that there is a high likelihood that the inventory number of ~$600mm will need to be written down.  The question is, by how much?  David Einhorn thinks that as much as 33% of the inventory in M. Block’s warehouse could be expired.
  • Uncertainty risk is extremely high.  How much inventory does the company have?  Will it need to revise its entire storage and supply chain system under scrutiny and the looming probability of further class action law suits (if media reports are anything to go by)?




One of the worst case scenarios for GMCR shareholders would be if management has been understating inventory which has resulted in margins being overstated.  The company is burning a tremendous amount of cash and taking on leverage to do it.  Taking it bit by bit, we can see that the return profile for this stock is not encouraging.  We see few reasons to own this stock beyond the size of the market and even that positive is greatly overshadowed by the plethora of negative risks facing the company.





You can see in the chart below that inventories are extremely high.  Despite management’s bullish commentary on its “demand model” – that was based on what were likely inflated sales data – the sales-inventory spread has contracted for six of the last seven quarters.  There are far more questions than answers when it comes to GMCR’s inventory.  Did managers overshoot the mark when sales did not keep pace?  Is there a write-down coming?  We think there has to be.


As we mentioned earlier, Greenlight Capital thinks as much as a third of the inventory in M. Block’s facilities could be expired.  Our take is that there is a strong chance neither M. Block nor GMCR itself knows exactly what its inventory is worth.  Not to single out Pricewaterhouse Coopers, but none of the major auditing firms have been strangers to financial scandals over the past ten years.  Many have been blamed for not holding clients to a high enough standard of scrutiny during audits.  Yet PWC was compelled to make the following statement in a report that was included in GMCR’s 2010 10-K:


“We do not express an opinion or offer any other form of assurance on management’s statement referring to the Company’s plan for remediation of the material weaknesses in internal control over financial reporting.”







Between 2008 to 2010 return on common equity declined from 18.6% to 15.2%.  At the same time, EBIT margins surged from 12.1% to 18.2%.  Despite higher margins, the declining returns are due to asset turnover decreases for both accounts receivable and inventory.  In fact, inventory turnover has dropped from 5.2x in 2008 to an all time low of 3.7x in 2011.  Equally troubling is the company’s inability to convert reported net earnings into operating cash flows from 2008 to 2011. 





The company growth by acquisition is only temporary and the assets the company bought (overpaid for) are of low quality relative to competing brands in the coffee space.


The first acquisition was in November 2009, when they acquired Timothy’s Coffees of the World Inc. The acquisition gave them the right to the little known Timothy’s World Coffee brand and wholesale business as well as licensed brands Kahlua and Emeril’s.   The acquisition also opened the Canadian market to GMCR.  Five month later, in May 2010, they bought Diedrich Coffee in a bidding war Peet’s Coffee.   This acquisition enabled the company to penetrate the Southern California market.  Included in this acquisition was Diedrich Coffee, Coffee People brands, and a perpetual royalty-free license in the U.S. for the Gloria Jean’s coffee brand, for use in K-Cup portion packs.  Peet’s was also sniffing around this acquisition so a big premium was paid.  In December of 2010, GMCR acquired LJVH Holdings, owner of Van Houtte and other brands, based in Montreal. 


We can make a lot of qualitative comments on these brands, and we do not believe that they were great acquisitions by any means, but looking at GMCR’s asset base at the moment is not encouraging.  Over 41% of the company’s assets are intangibles and goodwill.  Consistent with a company that has, in our view, been more concerned with superficial improvements than making substantial strides in the underlying business, GMCR is depreciating these assets over a period of 10-15 years when a much shorter period would be more appropriate.


The Current Assets don’t look much better.  At the end of FY1Q12, 48% of Current Assets is comprised of inventory, which is up 125% year-over-year.  As we have stated several times in this note, we think this inventory number needs to be written down.  Accounts receivable is up 73% year-over-year also.







The confluence of all of these factors – the excessive inventories, poor assets, and sub-par returns – is that the company burns cash.  We see the faulty yardstick – inflated demand – that management has used to run its business as being at the root of this problem.  The “demand model” has led the company to announce a staggering 135% increase in capital spending for FY12 versus FY11.   We have the company burning $935mm during the two year period FY11 and FY12.  If the capital markets decide to tighten the company’s access to capital it could be catastrophic.  How many companies in history have grown earnings over the long run while burning cash?


The cash conversion cycle cuts through the noise and offers a clear gauge of how effectively the company is managing inventory, accounts receivable, and accounts payable. 


GMCR: THE SLOW BLEED OF THE GREAT COFFEE BUBBLE - gmcr cash conversion cycle



Looking at the chart below, we can see that the proportion of earnings yielding cash is not a positive sign for the company.  Having a cash burn rate that is within the limits of available resources is not necessarily a negative but we feel that GMCR is going to test the goodwill of the capital markets if its cash flow generation does not improve.  With capex set to go through the roof in FY12, we don’t see that improvement coming about any time soon.







We are not legal experts but think that the looming possibility of further Class Action law suits coming down the pike does not bode well for GMCR.  Just this past Monday, for instance, Faruqi & Faruqi, LLP, a national law firm, announced that it is investigating potential wrongdoings at Green Mountain Coffee Roasters.  The financial outlook, irrespective of any legal struggles in the future, is also dire.  Favorable debt and equity markets have allowed this company to live on borrowed time – and live well.  With competition increasing and the high probability that capital-raising is set to become more difficult as time goes on, we believe that GMCR’s party is over.



Howard Penney

Managing Director


Rory Green