“Only 3 percent of animals are monogamous.”
With the US Dollar up and Oil down, I am feeling Empathetically Bullish on Global Consumer stocks this morning.
From an active Risk Managing Investor’s perspective, empathy is probably one of the most misunderstood feelings that you need to respect. In A First Rate Madness (great behavioral psych book by Nassir Ghaemi), that’s the neurobiological point Ghaemi emphasizes about the 3% of animals (i.e. the 3% of us).
“Besides humans, the only other monogamous primate species is the orangutan; chimpanzees, our closest evolutionary cousins, are highly polygamous” (page 80). Being Perma-Monogamous to a bullish or bearish Global Macro view for the last 5 years has not worked. You have to be able to empathize with swings in sentiment. You have to be able to change your mind.
Back to the Global Macro Grind…
I had an excellent day of client meetings in Boston yesterday and, not surprisingly, the #1 question was, “what will get you to change your mind?”
Generally when I get that question it has to do with US Equities. Which is fair – that’s not what I do in considering globally interconnected growth and inflation expectations, but it’s what most people are paid to do.
We’re obviously long Chinese Equities (CAF), German Bunds (BUNL), and US Treasuries (TLT) right now – those 3 asset allocations have done well during the last 6 weeks of Growth Slowing. So has cash.
Back to answering the question on US Equities, the answer is as simple as the repeatability of our risk management process. I have 2 baseline scenarios that my team and I are constantly considering:
- Strong Dollar = Strong Consumption = Accelerating US Growth
- Down Dollar = Accelerating Inflation = Growth Slowing
In Macro, what happens on the margin matters most. That’s why we are so focused on the Causality of Fed Policy. If you get the changes on the margin of Fed Policy right, you’ll get the US Dollar right. If you get the big moves in the US Dollar right, you’ll get the big beta moves in US Growth and Inflation Expectations right.
What would get me to change my mind on US Equities (particularly Consumption Growth oriented Equities – not Energy and Basic Materials stocks), is more of what we have seen in the last 48 hours – an arrest of the US Dollar’s decline and a fall in the inflation tax on US Growth (Food and Energy prices).
The most common and relevant follow on question I had to what would make me bullish is “why doesn’t Bernanke do Qe again?” Sadly, my answer to that is that he very well could. That’s what he arbitrarily did on January 25th(pushing his 0% rate of return on American Savings accounts to 2014), and there’s no reason why a man fighting for his academic career risk wouldn’t do it again.
Since Bernanke has been completely politicized, the timing of the politics (US Presidential Election) matters:
- If Bernanke is going to implement the iQe4 upgrade it’s most likely to happen in the next 2 months
- If Bernanke drives an iQe4 upgrade for Oil prices deep into the election debate (September), Obama might fire him too
- If/when Bernanke starts to leak “news” of iQe4, you’ll likely see it in the price expectations of USD, Gold, and Oil
So, today is a great day in America because you don’t have an Un-elected Central Planner devaluing the Dollar and driving up expectations for another Qe.
That may change if the jobless claims number is as bad as they have been for the last month (up +15% versus where jobless claims were in mid-March). But, for now, Mr Macro Market is saying no Qe (yet) = Up Dollar, Down Gold, Down Oil.
Timing Matters, so do our risk management levels:
- US DOLLAR: our long-term TAIL line of $76.13 has held and now we’re going to re-test intermediate-term TREND of $79.55
- GOLD: remains in a Bearish Formation (broken across all 3 durations, TRADE/TREND/TAIL); TREND resistance = $1689
- OIL: Brent finally snapping its intermediate-term TREND support of $119.17 today – that’s new (bullish for Consumers)
This is why I do what I do every morning. I never know what the market is going to give me, but I am very comfortable embracing that uncertainty – primarily because my process does. Market moves pick me; I don’t pick markets.
What’s uniquely perverse about all of this is that investors seem to really fear Bernanke’s next move. My sense yesterday was that multi-duration thinkers know that another Qe would give this country $5-6 at the pump, but it would still cause one heck of another short-term rally in stocks.
Trying to empathize with that unique career risk of our profession (short-term relative performance chasing) is as important as empathizing with what it means to a retired fireman like my Dad. If you are living on a fixed income, you do have to pay non-“transitory” prices at the pump.
It all matters. It’s all interconnected. And if we don’t start empathizing with what Burning the US Dollar at the stake means to the 99% of people on this planet, I think we’ll lose whatever respect they have for us that’s left.
My immediate-term support and resistance ranges for Gold, Oil (Brent), US Dollar Index, and the SP500 are now $1, $117.71-119.17, $79.02-79.55, and 1, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer
TODAY’S S&P 500 SET-UP – May 3, 2012
As we look at today’s set up for the S&P 500, the range is 24 points or -0.81% downside to 1391 and 0.90% upside to 1415.
SECTOR AND GLOBAL PERFORMANCE
- ADVANCE/DECLINE LINE: on 5/02 NYSE -377
- Down from the prior day’s trading of 908
- VOLUME: on 5/02 NYSE 780.19
- Increase versus prior day’s trading of 1.13%
- VIX: as of 5/02 was at 16.88
- Increase versus most recent day’s trading of 1.69%
- Year-to-date decrease of -27.86%
- SPX PUT/CALL RATIO: as of 05/02 closed at 2.69
- Up from the day prior at 1.74
CREDIT/ECONOMIC MARKET LOOK:
- TED SPREAD: as of this morning 39
- 3-MONTH T-BILL YIELD: as of this morning 0.08%
- 10-Year: as of this morning 1.93
- Unchanged from prior day’s trading
- YIELD CURVE: as of this morning 1.67
- Unchanged from prior day’s trading
MACRO DATA POINTS (Bloomberg Estimates):
- 7:30am: Challenger Job Cuts (Y/y), Apr.
- 7:45am: ECB rate decision
- 8:30am: Nonfarm Productivity, 1Q P, est. -0.6% (prior 0.9%)
- 8:30am: Unit Labor Costs, 1Q P, est. 2.8% (prior 2.8%)
- 8:30am: Jobless Claims, week of Apr. 28, est. 379k (prior 388k)
- 9:45am: Bloomberg Consumer Comfort, week of Apr. 29
- 10:00am: ISM Non-Manf., Apr., est. 55.3 (prior 56)
- 11:00am: Fed’s Williams speaks on economy in Santa Barbara, CA
- 1:00pm: Fed’s Lockhart speaks on economy in Santa Barbara, CA * 1:30pm: Fed’s Plosser speaks on economy in Santa Barbara, CA
- U.S. Treasury Secretary Tim Geithner, Secretary of State Hillary Clinton attend opening session U.S.-China Strategic and Economic Dialogue in Beijing
- President Obama hosts Cinco de Mayo reception
- House, Senate not in session
- Quinnipiac University officials discuss latest poll of “swing state” voters in Florida, Ohio and Pennsylvania, 10am
WHAT TO WATCH:
- April retail sales expected to gain 1.5%: Retail Metrics
- European Central Bank may leave benchmark interest rate at record low 1%, economists est. Rate decision at 7:45am, press conference 45 minutes later
- JPMorgan to take stake of almost 30% in France’s Technicolor, in move supported by Technicolor management: Les Echos
- U.K.’s Sage said to be in talks on putting its accounting software for small businesses on Microsoft’s Azure cloud platform: FT
- ISM’s index of non-manufacturing industries probably cooled to 4-month low of 55.3 from 56 in March, economists est.
- Nexon said to be in talks to distribute Electronics Arts’s next “FIFA Online” title in Asia rather than buy the company
- Carlyle sold 30.5m shrs at $22 each, less than $23-$25 range
- Temasek selling $2.4b in BOC, China Construction Bank
- CME raises margins for non-hedged accounts to meet CFTC rule
- BP wins tentative approval for $7.8 billion oil-spill pact
- Billionaire James Packer may sell his investment in Foxtel, held through his control of Consolidated Media Holdings, to help fund bid for Echo Entertainment: Daily Telegraph
- Philip N. Duff, founder of FrontPoint Partners, said to be struggling to attract assets for his latest money-management venture
- Lockheed Martin won’t lead a team to compete against Hewlett-Packard for $4.5b Navy network deal; may increase chances HP will hold onto its biggest U.S. govt. contract
- One of Edvard Munch’s four versions of “The Scream” set record for work of art at auction when it sold at Sotheby’s last night for $119.9m
- Lamar Advertising (LAMR) 6am, $(0.14)
- Cimarex Energy (XEC) 6am, $1.27
- Cigna (CI) 6:30am, $1.30
- Fortress Investment Group (FIG) 6:30am, $0.10
- Gildan Activewear (GIL CN) 6:33am, C$0.21
- NRG Energy (NRG) 6:45am, $(0.08)
- Teradata (TDC) 6:55am, $0.56
- American Tower (AMT) 7am, $0.74
- Alpha Natural Resources (ANR) 7am, $(0.06)
- BCE (BCE CN) 7am, C$0.73
- Cardinal Health (CAH) 7am, $0.88; Preview
- Apartment Investment & Management (AIV) 7am, $0.37
- HCA Holdings (HCA) 7am, $0.98
- Lear (LEA) 7am, $1.20
- GE Energy (OGE) 7am, $0.33
- Jean Coutu Group PJC (PJC/A CN) 7am, C$0.24
- Plains Exploration & Production (PXP) 7am, $0.62
- Elizabeth Arden (RDEN) 7am, $0.04
- Viacom (VIAB) 7am, $0.89
- Xylem (XYL) 7am, $0.36
- Beam (BEAM) 7:01am, $0.47
- ANSYS (ANSS) 7:03am, $0.66
- WPX Energy (WPX) 7:15am, $(0.02)
- SCANA (SCG) 7:22am, $1.03
- El Paso (EP) 7:29am, $0.28
- Airgas (ARG) 7:30am, $1.07
- General Motors (GM) 7:30am, $0.85; Preview
- Hyatt Hotels (H) 7:30am, $0.09
- Progress Energy (PGN) 7:30am, $0.65
- Sealed Air (SEE) 7:30am, $0.21
- Scripps Networks Interactive (SNI) 7:30am, $0.60
- Sara Lee (SLE) 7:30am, $0.25; Preview
- El Paso Pipeline Partners (EPB) 7:44am, $0.61
- Apache (APA) 8am, $3.07
- Level 3 Communications (LVLT) 8am, $(0.52)
- Pinnacle West Capital (PNW) 8am, $(0.07)
- Valeant Pharmaceuticals International (VRX CN) 8am, $0.97
- CenterPoint Energy (CNP) 8:15am, $0.33
- Cablevision Systems (CVC) 8:15am, $0.18
- Manulife Financial (MFC CN) 8:22am, C$0.37
- Denbury Resources (DNR) 8:30am, $0.38
- MGM Resorts International (MGM) 8:30am, $(0.16)
- Sempra Energy (SRE) 9am, $0.98
- SNC-Lavalin Group (SNC CN) 9:05am, C$0.52
- Great-West Lifeco (GWO CN) 12:38pm, C$0.52
- CareFusion (CFN) 4pm, $0.45
- Mohawk Industries (MHK) 4:01pm, $0.55
- LinkedIn (LNKD) 4:02pm, $0.09
- First Solar (FSLR) 4:04pm, $0.48
- Fluor (FLR) 4:05pm, $0.87
- Kraft Foods (KFT) 4:05pm, $0.56
- SandRidge Energy (SD) 4:05pm, $0.02
- American International Group (AIG) 4:15pm, $1.13
- Northeast Utilities (NU) 4:15pm, $0.67
- CF Industries Holdings (CF) 4:18pm, $4.95
- Southwestern Energy (SWN) 5pm, $0.32
- Public Storage (PSA) 5:03pm, $1.42
- Eldorado Gold (ELD CN) 5:41pm, C$0.17
- Pembina Pipeline (PPL CN) 6:12pm, C$0.25
COMMODITY/GROWTH EXPECTATION (HEADLINES FROM BLOOMBERG)
OIL – most important Global Macro move of the week right now is Brent Oil snapping my intermediate-term TREND support line of $119.17; Oil has been the big holdout of the major commodities deflating; if this holds, its bullish on the margin for Consumers (and Consumption Equities). The Divergence their yesterday (XLE -1.6% vs XLY up agrees).
- Crude Oil Extends Biggest Decline in Two Weeks on Jobs, Supplies
- Iran Embargo Impossible to Meet as Ships Depend on Blended Fuel
- Chesapeake Alone on Wall Street in Gas-Rally Bailout: Energy
- Barrick Gold Spending Faster Than Earnings Rise: Commodities
- CME Raises Margins for Non-Hedged Accounts to Meet CFTC Rule
- Gold Declines on Concern Slowing European Growth to Boost Dollar
- Copper Falls for Second Day as Slowing Economies May Curb Demand
- World Food Prices Fell in April as Cost of Dairy, Grain Declined
- Corn Set to Gain on Speculation China May Boost U.S. Purchases
- Shanghai Exchange to Start Silver Futures Trading From May 10
- Palm Oil Slumps to Six-Week Low as Weather May Aid U.S. Soybeans
- Real Yields Topping Asia as Rains to Cool Prices: India Credit
- New Europe Ports Seen Unprofitable With Slump Deepening: Freight
- Indonesia Ban on Unprocessed-Metal Exports to Proceed as Planned
- Sugar Falls to 19-Month Low on India’s Exports; Coffee Declines
- Proposed Rule Would Weaken Mad Cow Protections, Ranch Groups Say
US DOLLAR – Strong Dollar = Stronger Consumption, globally; that’s the only way out of this mess and it doesn’t take much. Yesterday’s +0.35% move in the USD Index was more of an arrest of its decline (down -6 of the last 7 wks) than a rip higher. If you see a sustainable breakout > $80 USD Index, Oil is going to come down a lot faster.
SPAIN – we learn a lot more about bear markets on the bounces than on the declines; the 2012 crash/decline in Spain’s IBEX is trivial to consider in the rear-view mirror (down -23% from YTD peak yesterday, making a fresh crisis low which matters vs 2011); the bounce would have to get > 7498 for us to change our view from bearish to bullish.
The Hedgeye Macro Team
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The Macau Metro Monitor, May 3, 2012
STEVE WYNN WANTS TO START WORKS IN COTAI "BEFORE JUNE" Macau Business
Wynn CEO Steve Wynn hopes to begin work on Wynn Cotai before June. The property would feature around 500 gaming tables, 1,000 slots and 2,000 hotel rooms. “[It will be] US$3.5 billion, US$4 billion,” Wynn said in response to a question regarding the budget. “We will build it like we did Encore [Macau]; out of cash flow and if we need any help, the banks are all there for us.” Asked if he planned to issue fresh equity to fund the Cotai venture, he replied: “I have no plans of doing that.”
SINGAPORE VISITOR ARRIVALS STB
February S'pore visitation rose 14.44% YoY to 1,133,022. Mainland chinese visitors rose 5.2% YoY to 157,788.
LESS PEOPLE VISITING MACAU ON LABOR DAY Macau Business
The number of visitor arrivals to Macau during the Labor Day holiday (April 29 to May 1) dropped 0.81% YoY to 351,000 visitors.
This note was originally published April 05, 2012 at 10:49 in Restaurants
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.
NOTHING TO BE ALARMED ABOUT
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 HIDE & SEEK INVENTORY METHOD
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?
FOLLOW THE MONEY
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.
MANAGEMENT IN THE KNOW?
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)?
FINANCIALS – THE BIG UNKNOWN
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.”
RETURN ON EQUITY
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.
POOR ASSET BASE & LOW QUALITY BRANDS
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.
CASH BURN GIVING BULLS HEARTBURN
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.
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 do 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.
Conclusion: Volumes are stabilizing. But playing the market share game in a commodity space in dangerous. 2H utilization should improve, but that's when GIL laps 30% growth largely from Gold Toe. Ultimately, this is all about pricing.
Volumes are stabilizing. But playing the market share game in a commodity space in dangerous. 2H utilization should improve, but that's when GIL laps 30% growth largely from Gold Toe. Ultimately, this is all about pricing.
1) Position in the screenprint channel: CREST data suggests unit sales have been coming in stronger than originally expected, running up +12% through February compared to management’s assumption of down -5%. The data suggests that the company is gaining share in the screenprint channel and we have no reason to dispute that. So, while margins will remain pressured, are likely to come in higher than originally planned. GIL's Q2 should reflect the third straight quarter of share gains after capacity constraints impacted share through most of last fiscal year, and GIL roared back with 25%+ cut in its price. In fact, Broder came out 5 weeks ago and noted that cotton is now priced at ~$1.00 for a t-shirt from ~$1.55 per pound at the peak, and almost all of it is being passed through to customers. In other words, margins in the supply chain remain tight. While Q2 typically represents GIL’s greatest share for the year, we expect 2H share to reflect incremental gains though we are still not convinced it will capture the 65% share in management’s plan as it competes against smaller players forced to be aggressive. If it does, GIL is likely to be buying it. Playing the market share game in a commodity space is wreckless.
2) Gold Toe contribution: Q2 is the last quarter of a full incremental Gold Toe contribution with the deal lapping in April. While there has been substantial opacity surrounding the performance of this business since its inclusion, management confirmed that it remains ‘on plan’ to deliver $0.20 in EPS this year. Gold Toe accounted for ~$85mm in sales in Q1 and is expected to generate a similar contribution in Q2, or +22% total revenue growth. In addition, ~$0.05 in earnings implies ~$6-$7mm in EBIT contribution in Q1 and similar amount to what we expect in Q2. We have no reason to think this business is not moving forward as planned. Though it's very important to remember that a 20%+ kicker to GIL's top-line goes away next quarter. That kind of opacity definitely helped over the past year. Bye bye.
3) Input Cost/Pricing impact: While the inventory GIL is selling through at ~$0.95 cotton is closer to current prices, it’s still 35%-40% below where the company likely secured the inventory based on the typical 6-9 month production cycle. Lower prices in the screenprint channel (~70% of revs) continue to pressure margins slightly offset by HSD price increases in the Branded Apparel. We’re modeling gross margins of 16% below consensus expectations of 17% and -1100bps below year ago levels.
All in we are shaking out at $0.21 in EPS for the quarter with higher revenues of $521mm lighter gross margins relative to the Street. We’re assuming gross margins of 16% in Q2 reflecting a sequential increase from Q1 due to the absence of an inventory devaluation (= 7pts), the impact of manufacturing downtime (=3-4pts), and higher unit volume. Similarly, with the closure of Rio Nance 1 at the end of Q2 and higher utilization, we have margins up to 24-25% in the 2H and up 450bps next year to 23.5% reflecting 300-400bps from lapping the interruptions of the 1H F12, higher utilization, and improved manufacturing efficiencies. While we expect SG&A growth (+20%) to outpace sales (+12%) in support of retail and international initiatives, we expect operating margins to expand 366bps in F13. For the year we’re shaking out at $1.10 and $1.93 next year reflecting a 26x and 15x earnings multiple, and 16.5x and 11.5x EBITDA.
GIL Forward Looking Commentary from 1Q12 call headed into 5/3/12 (2Q12) Conference Call:
Full year: $1.9bn
Printerwear Business: $1.3bn
Branded Apparel Business: $0.6bn
2H industry demand expected to be flat YoY when demand fell (-8%) in 2011
Assuming market share of 65% in the US Distributor Channel
Assuming 5% decline in industry shipments from US wholesale distributors to US Screenprinters in 2Q12
Expecting Strong Growth in Printwear due to penetration in international markets and some inventory destocking by distributors in the U.S. wholesale channel, and also increased market share
Pricing: Printwear Pricing expected to be slightly lower than Q1 for the balance of the year
Every 1% change in net selling prices for Printwear impacts projected EPS for the balance of fiscal 2012 by approximately U.S. $0.09
Pricing will reflect 4th quarter increases for the balance of the year which did not reflect full pass-through of high cost cotton
Cotton Cost: In line with 1Q12 and significantly higher than 2Q11
2H costs expected to be significantly lower than 1H based on cotton futures
Inventory at peak cost expected to be consumed early in 3Q12
Full year: $1.30
Second Quarter: $0.20
Higher cotton YoY expected to impact Q2 ESP by ~$0.70
Partially Offset by manufacturing efficiencies & Gold Toe
For every 1 million dozen change in demand for activewear, EPS is impacted by $0.05
Full Year: $100mm
Free Cash Flow:
Full Year: $75-100mm
Inventories: Expect to end F12 with unit volume slightly higher vs. last year
Rio Nance V: Will become the lowest cost facility for Activewear & Underwear
Expected to be fully ramped up by the end of F12
Expect additional production capacity and manufacturing efficiencies in F13
Temporarily retiring Rio Nance 1 at the end of 2Q12 and evaluating the modernization of Rio Nance 1 which would provide further cost efficiencies in the future
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