GMCR: How Green is the Mountain Now?
Green Mountain is once again plumbing new depths as it sinks to lows not seen since the fall of 2010 when the SEC announced its interest in Green Mountain’s accounting. At the time, that represented a buying opportunity as Green Mountain rebounded from around $27 to $110 one year later -— a three-fold gain. It has given back all those gains in the past six months as bad news and short-sellers chase it down. Do current prices give us a buying opportunity this time? Not as likely.
The David Einhorn Effect
In October 2011 in a detailed presentation, Einhorn gutted the company.
• lack of transparent accounting,
• maturing market and less expansive growth going forward lack of cash flow in spite of super-charged growth
• changing business model to a manufacturer
• patent expirations
• expensive acquisitions
• high capital expenditures
• uneven sales of K-cups
Inventory and revenue recognition
When I looked at them in October 2010, the most troubling aspect of Green Mountain was its accounting and the shifting relationship with M. Block & Sons variously described as a fulfillment entity and/or a vendor. GMCR has called it both. Fulfillment means M.Block & Sons (MBlock) takes orders from retailers and fills them for GMCR holding its inventory; a vendor buys product and resells it. MBlock processes nearly 50% of GMCR receivables and is unfortunately a black box neither we nor the SEC has been able to crack. A change in revenue recognition in 2009 allowed GMCR to recognize the revenue on shipment rather than delivery and that makes MBlock a great place to store high levels of product that are counted as revenue, but not necessarily sold.
MBlock can absorb tremendous amounts of inventory that we can’t adequately track allowing GMCR to grow revenue while citing production capacity constraints--all that inventory was presumably at some point sold--or not. Rate limiting manufacturing bottlenecks give GMCR a plausible motive for increasing capital spending. Is it really necessary? Over the past two years, there has always been 6 weeks of inventory on the books making the need for high cash-flow-eating capital spending questionable.
No cash flow
The capital spending has resulted in negative free cash flow in the last five out of six years creating capacity that now appears to be in excess of demand. Capital expenses can be subject to creative accounting and include expenses that should rightfully be counted as operating expenses. Much like MBlock, it can be a black box. Was it? Coincidentally, while capex was growing, SG&A declined allowing expansion of operating margins. Were some operating expenses transferred to capex spending? Green Mountain’s comment was they overestimated costs and were pleasantly surprised at the margin expansion in the most recent quarter.
GMCR has always managed to increase inventory in the six-month period before Christmas to new highs, sell through Christmas at record revenue and continue to increase sales of both brewers and K-cups post December at 60% or greater revenue growth. In fact, days in inventory actually increased in last years Q2, March 2011, from 50 days to 68, indicating adequate inventory.The shelves were not bare.
If capacity was more than adequate and MBlock continued to soak up excess inventory, it should come as little surprise to investors (although management expressed bafflement at the March 2012 Q2 results) that K-cup sales declined sequentially from Christmas and brewer sales dropped precipitously and left GMCR with a big pile of expiring K-cups, dusty Keurig brewers and MBlock unable to take more product and that would allow high revenue growth. Normally K-cup sales increase sequentially in Q2 as the new brewers expand the single serve user base. Capacity, it would appear, is sufficient.
It does not look like the Q2 March quarters were significantly short of product. For 2010-2011, there were high levels of finished product on the balance sheet.
If we look back to March 2009 and 2008, DIO never dips below six weeks. In March 2012, it rockets to 96 days, suggesting their record 134 days in September, building for Christmas, was a gross miscalculation of demand for product in 2012.
By my calculations, GMCR had nearly 10 weeks of inventory in Q2 March 2011 (includes brewers) supporting average organic revenue growth of 60%-70%. Where was the need to intentionally increase the weeks of product on hand? Perhaps it was not by design, but by necessity with a big overhang hiding at MBlock that required explanation this year.
From the Q2 2012 conference call
… we had a $141.6 million or 66% increase in finished goods inventory with approximately 54% of the increase due to Keurig brewers on hand. You’ll also recall that this time last year we were having trouble meeting orders for both brewers and portion packs. The year-over-year inventory increase reflects our deliberate decision to carry more weeks of portion pack inventory on hand so as to better respond to our customers’ ordering patterns and demand. Specifically, we deliberately increased our portion pack inventory coverage from four weeks to between five and six weeks. Consequently at the end of our second quarter portion pack forward inventory of approximately six weeks is in line with our expectations.
Between Q2 2010 and Q2 2011, there was a 272% increase in finished goods to support a 100% increase in revenue—that would appear to be adequate finished goods.
In Q2 2012, gross margins decreased from 37.5% to 35.4% year-over-year
From the conference call:
The decline in gross margin over the prior year quarter primarily was due to the following: approximately 290 basis points due to the combination of underutilization of our current manufacturing base as a result of lower than expected K-Cup pack demand and the resulting efforts to reduce K-Cups pack inventory which together increased average labor and overhead cost per K-Cup pack. Approximately 170 basis points was due to higher green coffee cost.
Approximately 150 basis points due to a higher write down of finished product and anticipated obsolescence of raw material inventory due to lower than anticipated sales of seasonal and certain coffee products. Approximately 50 basis points increase in warranty expense over the prior year quarter that had benefited from a new program that reduced packaging materials on more insulated brewer.
The important items to note are the underutilization of the plants and the substantial margin-reducing obsolete inventory charge. How much inventory has languished past expiration at MBlock in the past year that was not highlighted at conference calls?
In response to the disappointing sales in Q2, guidance and capital spending were cut.
Q2 2012 and beyond
Green Mountain's results appear fine at first glance. Revenue was up 37% to $885.1 million and adjusted earnings increased 33% to $0.64. Previous guidance was a problem as Green Mountain told investors to expect a 45% to 50% revenue growth for Q2 2012.
Green Mountain cut 2012 sales estimates from $4.3 -$4.5 billion down to $3.8 to $4 billion. The 2012 EPS went from $2.55 to $2.65 down to $2.40 and $2.50—far below analysts’ expectations of $2.67. GMCR always meets or beats and this shocking miss sent shares down to 52-week lows.
Q3 guidance is also chopped to $0.48 to $0.53 below estimates of $0.71 to $0.72 cents on revenue of $881 million to $897 million missing estimates of $1.05 billion.
What should be more troubling to investors is the cut in capital spending -- admission that capacity was perhaps not as much of a limiting factor as investors were led to believe. Perhaps Green Mountain is now suffering from capex overspending in the past (if decreased demand in Q2 is a guide for the future). Earlier this year,GMCR expected to spend $630 million to $700 million for capital expenditures in 2012. Now the company is only looking to invest $525 million to $575 million.
While the current price around $25 could be construed as a buying opportunity as it was in the fall of 2010, the company faces some fast approaching threats to its business that acquisitions and new brewing platforms cannot hide and the decline of business in Q2 could be the first of a series of warning shots.
Important patents are expiring in September 2012 that will allow any private label to make K-cups and decrease the somewhat outrageous pricing per cup by providing cheap competition. GMCR stands to lose market share and margin.
Then there was the unwelcome news that Starbucks would be launching a latte/cappuccino/espresso machine, Verismo, in the fall of 2012. Coincidentally, that is just in time to deliver a second body blow this fall to Green Mountain. While careful to acknowledge that Verismo is not a direct competitor, they dismiss Keurig as just a coffee brewer.
Other concerns are a maturing market for single-serve brewers and less brisk uptake going forward; GMCR’s changing business model to low margin manufacturer for partners like Starbucks and Dunkin’Donuts; and the inability to match capital expenditures to sales requirements with excess inventory and capacity eating away at margins.
There will always be a business, but it may not be the one we wish we had bought into a few years ago. Times change and companies mature and evolve. However you look at Green Mountain, fall 2012 is going to be a tough season.