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The title of this note may be a little harsh but there is a chance that it is not.  Some are betting that there is more pain to come and some are buying the stock on account of the "massive" 50% decline.  We are not buyers here and see potential for, if anything, further downside.   We see no reason to own this stock besides the size of its market and that lone positive is overshadowed by the plethora of negatives and possible future negatives facing the company. 

“It ain’t what you don’t know that gets you in trouble.  It’s what you know for sure that just ain’t so.”

-Mark Twain

There are a lot of red faces among the sell-side analysts covering Green Mountain Coffee Roasters.  Anyone in the business can empathize with those putting forth a mea culpa to clients today but still, even after last night’s “surprise”, Mark Twain’s aphorism is worth bearing in mind.  What investors knew “for sure” has caused a wild ride in this stock over the past 18 months.  Giving management the benefit of the doubt, despite huge cash burn and recurring accounting concerns, was a leap of faith that has proved costly for many. 

We wrote a note on April 5th stating the following: “The question is: how bearish is bearish enough?  We think the stock could go to $25.”  In that note, “GMCR: THE SLOW BLEED OF THE GREAT COFFEE BUBBLE”, we highlighted several things we didn’t know for sure and the worrying harmony that existed between the most negative scenarios in our model, insider selling, and allegations outlined in a Class Action Complaint filed against the company.  The financials, we said, were the “big unknown”.  To a large extent, they remain so.  The emperor has fewer clothes than the market thought.  Does he have any at all?  We think Green Mountain has a business, and is a going concern, but there could be more pain in store.  With management’s credibility essentially vaporized over the course of a staggeringly poor showing during last night’s earnings call, the unknown unknowns are taking more mind-share among investors.

These unknowns are like landmines; there are difficult to see until it’s too late.  We think an accordingly prudent approach to this name is appropriate; investors should take a "show me" approach to management's projections, given the reputational blow that this company has inflicted upon itself.  If one of these still-buried landmines blows up, not only would that pose a problem in and of itself, it could set off others.  As sales disappoint, disgruntled shareholders are likely to add their voice to class action complaints and other investigations.  There is potential for it to get ugly. 


Still-Buried Landmine: Accounting Shenanigans

Given management’s hour long fumble last night, the question that people are asking is what type of internal controls the company has in place.  When prodded about what factors were behind the “moderating” sales growth, CEO Larry Blanford provided a telling response: “I think all of us are trying to take into account the – kind of these underlying factors and we’re still trying to understand them.  So that’s the honest answer.” 

Whether that is actually an honest answer is a risk; suspicions we referenced in our April 5th note about Green Mountain’s compensation structure being levered to net sales could hold an explanation.  Has the company been managing revenues by ordering K-Cups from third-party roasters?  The calculus behind executive level bonuses may have provided some incentive for senior officers to follow that strategy. 

Still-Buried Landmine: The Demand Model was Not a Model To Begin With

Six months ago, on November 9th, Green Mountain’s CFO Frances Rathke said the following on her company’s “demand model” and its efficacy: “as we noted in our remarks, we’ve had it tested now by outside experts and we, as well as the experts, feel it’s a very accurate and predictive model.  So, I think, overall, for fiscal '11, the portion pack volume came in very close to what the model predicted, and I think, once again, we were comfortable that we can rely on this as we go forward, into fiscal '12 and the future.”

We cannot reconcile that statement with what the CEO said last night: “over the last several quarters we have seen a dramatic increase order volatility, which comes, we think, from the dynamic growth of our business, the expansion of brands and varieties in our Keurig Single-Cup brewing platforms and demand shifts between our channels.”  Time will tell whether or not there was any real model in place besides the model that dictated executive compensation as being a function of sales. 

This dramatic shift in tone has shaken the conviction of the firmest believers in the Green Mountain story and rightly so.  The company clearly has a very poor handle on the demand for its product and the sales-inventory spread (chart below) is illustrating a company in dire straits.



Still-Buried Landmines: Capital Requirements, Capacity Glut, Margin Contraction

Despite the myriad concerns facing the business, management continues to invest a staggering amount of capital into its business.  Its capital expenditures for 2012, projected at $525-575mm versus $630-70mm prior, and beyond are aimed at supporting the future growth of the business, per the company’s most recent 10-K filing.   Of this2010 guidance for capital expenditures, $165 million will be invested in increasing packaging capabilities related to the Keurig K-Cup brewer platform, $65 million will be invested in packaging capacity related to the Vue brewer platform, and the balance is spread between expanding the physical plants, coffee processing and other equipment and investment in information technology infrastructure and system.  It is clear that the company will still be burning cash in FY12. 

Our question is, given that its capex is aimed at future growth, to what end will this cash be burned?  If the growth outlook is changing and the company obviously cannot offer a lucid picture of what demand is looking like for their product, how is ~$550mm in capex arrived at?  The changing demand outlook has caused management to alter its capex outlook but will the company also be burdened by over-capacity?  Given that the company has been building capacity in anticipation of future demand growth, is moderating demand about to saddle the company with underutilized assets?

Finally, it seems possible that further write-downs could be on the way which would further weigh on margins.  What are the chances that management came clean on all of the company’s problems at once yesterday?  There are clearly too many questions still hanging above this stock and the management team is not inspiring confidence in anyone.

Is it “all priced in”, as some amazingly resilient bulls want to believe?  We think there are too many risks that that just ain’t so.

Howard Penney

Managing Director

Rory Green