Ahead of Green Mountain Coffee Roasters releasing 1QFY13 earnings on Wednesday, we wanted to highlight an apparent accounting change that may have boosted FY12 free cash flow. We have written in the past of the mounting pressure on sales and margin in GMCR’s core businesses and believe that investors should pay close attention to the reporting conventions being used by the company when releasing earnings.
Green Mountain’s FY12 cash flow seemed surprisingly strong to us when results emerged in November of 2012.
Specifically, we were not expecting the company to generate free cash flow. A closer look at the footnotes, however, shows that in FY12 the company may have used an aggressive accounting practice to produce more attractive cash flow than otherwise may have shown up in the financial statements.
The FY12 10-K makes for some interesting reading; the footnotes, in particular, have raised some important questions in our thinking on the company’s ability to generate cash going forward. FY2012 was the first time that GMCR acquired assets through capital lease obligations. The company’s accounting practices have been scrutinized in the past and it looks like the cloud of suspicion may linger on, despite the appointment of a new CEO. His tenure is still new, so it is far too early to judge, but addressing investor skepticism must be one of his foremost priorities.
The key question, by our thinking, is to learn what was behind the company’s decision to begin acquiring assets through capital leases. Was the switch made to inflate the cash flow numbers or is there another explanation?
The cash flow statement from Green Mountain’s most recent 10-K shows reported “fixed assets acquired under capital lease and financing obligations” of $66.5mm . This figure amounts to 86% of the reported $76.6mm of free cash flow reported for FY12. Some forensic accountants suggest that the acquisition of fixed assets under capital lease and financing obligations can serve as a means to “overstate” a company’s cash flow generation.
The classification of a lease depends on a number of criteria. Specifically, a lease is considered a capital lease if it fulfils any one of the following conditions:
- The agreement specifies that ownership of the asset transfers to the lessee
- The agreement contains a bargain purchase option
- The non-cancelable lease term is equal or greater than 75% of the expected economic life of the asset
- The present value of the minimum lease payments is equal to or greater than 90% of the fair value of the asset
Assets acquired through capital leases are, in terms of their impact on the financial statements, substantially similar to assets purchased and financed through credit.
As a refresher: “When assets are acquired through capital lease transactions, they are reported on the asset side of the balance sheet. The capital lease obligation is shown on the liability side. Depreciation on these assets and interest on the related obligations are represented as expenses. Since cash is not dispensed when the assets are acquired, they are not included with capital expenditures reported in the investing section of the statement of cash flows. Subsequent principal payments made on the capital leases are reported in the financing section of the cash flow statement. Note that while the company acquires the asset for use, cash flows related to the acquisition of the asset are never shown in the investing section of the cash flow statement. Although this is in keeping with the guidelines provided by SAFS No. 95, it can lead to miscalculated amounts of free cash flow.”
Understanding Green Mountain’s reasons for deciding to acquire assets through capital leases is important. One reason the company might have taken this step is that the appearance of strong cash flow generation could succeed in taking some momentum out of the short theses that were dominating the news flow around the company. The most well-known GMCR bear is, of course, Greenlight Capital’s David Einhorn. One of the most important components of his thesis was the idea that the company’s cash flows were unlikely to be sufficient to cover the bloated capital spending plans going forward. One way to help the company’s free cash flow numbers could have been to acquire $66.5mm of fixed assets under capital leases and financing obligations in 2012.
The company expects capital expenditures in the range of $380-430 million in FY13, versus $401mm in FY12. The company also expects free cash flow of $100-150 million in FY13. Our focus will be on the “assets acquired under capital lease and financing obligations line item” this year.
The company is reporting EPS on 2/6. Like other’s following the stock, we are eager to hear the new CEO, Brian Kelley’s, input as the Street develops a more complete picture of his vision for the future of Green Mountain Coffee Roasters. In particular, he will need to assure investors that the SEC investigations and class action lawsuits are in the rear view mirror, and unlikely to command much of his team’s attention going forward. Such issues aside, the company has plenty of competitive issues to address, so Kelly will need all minds focused on GMCR’s profitability rather than worrying about investigations or litigation.
Howard Penney
Managing Director
Rory Green
Senior Analyst