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Driving from Vermont to New York City for the seventh annual Value
Investing Congress this week, I realized just how far off the beaten
path we are in the rural Green Mountains.
The six-hour drive was
a bit longer than expected, thanks to the more frequent stops that are
required when traveling with a small child. This was the first time I’ve
traveled to the Big Apple since our son was born in mid-2010.
While
I often feel that I’m best positioned to evaluate the financial markets
and individual stocks from the quiet comfort of our Vermont office,
every once in a while I need a dose of new ideas from like-minded
investors. The first day at the Value Investing Congress was exactly
what I needed.
In this market, stock prices have been incredibly
volatile. My economic outlook and investment approach has become more
cautious in the last six months. As a result, I’ve been favoring
value-oriented investments in this time of increased uncertainty due to
the possibility for slower economic growth in the U.S. and rising
European sovereign debt concerns.
Little did I know that I would
drive 300 miles to attend a hedge fund investor conference to hear a
presentation slamming a company located just 30 miles from my home in
Vermont.
The best presentation of the first day, on Monday, came
from David Einhorn of Greenlight Capital. Einhorn started his hedge
fund in 1996 with less than $1 million in assets, and has grown his
funds to over $8 billion today.
Value investors around the world
know Einhorn for his book titled "Fooling Some of the People All of the
Time" and his famous call to "short-sell" Lehman Brothers back in 2007
(a recommendation that he first shared at the Value Investing
Congress). At last year’s New York City Congress event, Einhorn
revealed his "short" interest in The St. Joe Company (NYSE: JOE). He’s since battled publicly with Bruce Berkowitz of The Fairholme Fund (FAIRX), who has taken over St. Joe Co. as chairman. (JOE shares have since dropped 21 percent in the last year).
Einhorn’s
110-slide presentation to the room of value investors – that included
hedge fund managers, mutual fund managers, large private investors, and
lowly investment newsletter editors – was titled "GAAP-uccino," and
revealed his bearish case for shares of Green Mountain Coffee Roasters (Nasdaq: GMCR).
It’s
no surprise that Green Mountain Coffee is attracting the interest of
short-sellers. After all, shares of the maker of the Keurig coffee
machines and K-Cup single-serve coffee were up 172 percent year-to-date
in 2011 (before Einhorn’s presentation). That alone is enough to get
short-sellers excited.
But Einhorn didn’t build his successful
hedge fund simply by short-selling stocks that have risen dramatically
in price. And his research into Green Mountain Coffee appears to be
exhaustive – including "channel checks" and numerous interviews with
current and former employees at Green Mountain Coffee and its partners.
Green Mountain Coffee has been a darling among growth investors who see the rapid top-line revenue
growth as an indication of a future gravy train of profits. The company
has evolved from a small coffee roasting company into a maker of single
serve coffee machines.
The company’s business model has evolved
and today resembles that of the "razors and razorblades" model used by
the likes of Gillette. This means that Green Mountain is selling coffee
machines at or near its cost (essentially making little or no profit),
while getting consumers hooked on its single serve K-Cup product. As a
result, all that really matters for Green Mountain is how successful the
company is at penetrating the market and then selling K-Cups (the
"razors") to customers.
Einhorn’s research indicates that Green
Mountain Coffee has already achieved significant market penetration and
that the addressable market may be smaller than forecast by the company
and bullish analysts.
Currently, K-Cups sell for around $0.85
apiece. They’re a bargain compared with a latte from Starbucks, but
expensive relative to making a pot in your Mr. Coffee Machine. The
Keurig machines are similarly expensive, making them an unaffordable
coffee brewing option for many consumers. Einhorn suggests that the
affluent early adopters have already purchased their machines, and that
growth of the market is smaller than expected.
Similarly, Einhorn
believes that the number of K-Cups sold per Keurig machine (known as
"attachment rate") is actually declining. The reason for this is that
early adopters of single serve coffee are the biggest coffee drinkers,
and new buyers are consuming less.
However, it’s been hard for
investors to get a complete understanding of the falling attachment
rate, since Green Mountain management has changed its disclosure policy
and is no longer providing this information to investors.
Einhorn
is publicly critical of Green Mountain’s management team for regularly
changing its disclosure in quarterly S.E.C. filings, an effort that he
believes is designed to mislead investors and make it difficult to
analyze the stock.
In spite of these concerns, investors have embraced GMCR shares. Big deals with Dunkin’ Donuts (Nasdaq: DNKN), Smuckers and Starbucks (Nasdaq: SBUX) sent Green Mountain shares soaring.
However,
Einhorn points out that the deals with Starbucks and others are not
exclusive. Add on the fact that Green Mountain’s patent on K-Cups
expires in September 2012, and he believes that some partners and other
competitors will begin making K-Cups for use in the Keurig (less than
one year from now, they will be allowed to do so). The introduction of
new single serve cups that could be used with Green Mountain’s Keurig
will hurt profit margins for the company, as the company’s "virtual
monopoly" will come to an end.
Today Green Mountain earns a
profit of about $0.15 per K-Cup sold. However, data from its partnership
with Smuckers indicates that on sales of these K-Cups for which Green
Mountain licenses the Smuckers brand, the profit per K-Cup is around
$0.06 – $0.07. With Green Mountain reporting that the Starbucks
relationship is similar, investors should be expecting falling profit
margins in the future.
Perhaps the most concerning part of
Einhorn’s presentation was the feedback he had received from current and
former employees at Green Mountain Coffee and its distribution
partners. It seems that numerous people who have worked with the company
have reported that Green Mountain Coffee uses shipping and transport of
both Keurig machines and K-Cups between facilities in order to book
revenues in an attempt to meet or beat quarterly financial estimates.
Such efforts are considered fraudulent, since the only reason to perform
these activities would be to inflate earnings and intentionally mislead
investors.
The growth-oriented company also appears to be
playing it fast and loose with its financial performance, as highlighted
by a recent S.E.C. inquiry and Green Mountain Coffee’s public admission
that its accounting systems and processes were not sufficient.
The
actions of company insiders are similarly concerning. Thus far in 2011,
company "insiders" who are "in the know" have been selling massive
amounts of stock. Year-to-date insider sales total an impressive $172
million of stock, allowing management to personally cash in on the rise
of GMCR shares.
When will the company’s growth come to an end?
It’s hard to say. Green Mountain has been investing heavily in its
growth, so much so that the company has had negative cash flow for
years. Meanwhile, their capital spending in 2011 is expected to equal
130 percent of net income, and is slated to rise to 200 percent of net
income in 2012.
It’s unclear where the S.E.C. investigation into
Green Mountain Coffee will lead next. But Einhorn presented a compelling
case for staying far away from this growth stock darling. In fact, his
recommendation to the Value Investing Congress was clearly to "sell
short" GMCR shares. Given the stock’s 10 percent drop yesterday, it
appears that many conference attendees (myself included) agreed with the
analysis.
Before Einhorn’s presentation, shares of Green
Mountain Coffee were trading at 55-times estimated 2011 EPS and 35 times
estimated 2012 EPS. Thus far, most investors have accepted those as
fair multiples for this high growth stock.
The risk to
short-sellers with a stock like GMCR is that the revenue and EPS growth
can continue for a long period of time, which can result in a rising
share price. That certainly could be the case with Green Mountain
Coffee – one of the best performing stocks over the last decade and in
2011. Caution is advised, and short-selling is not for the risk-averse.
However,
if Einhorn is correct about even part of his investment thesis
presented on Monday, it could spell trouble for GMCR shares. And any one
of these issues could send the earnings multiple for the stock
crashing.
It appears that there are many potential risks facing GMCR – and its stock – these days.
First
there is the market penetration and "attachment rate" issue. Second,
there is the patent expiration in just 11 months that could crush profit
margins. Third, there are shrinking profit margins from "partnerships"
with the likes of Starbucks. Fourth, there is an alleged intentional
lack of disclosure from management about the performance of the
business. Fifth, there is substantial insider selling. And sixth, there
are claims of fraudulent shipping in an attempt to book revenues and
profits.
On top of all that, it’s possible that the S.E.C. could
step up its investigation into GMCR’s accounting practices at any
moment.
Put simply, the risks involved with this stock are very
real. And so I personally initiated a "short" position in shares of
GMCR yesterday afternoon at $81.13 after hearing Einhorn’s presentation
first hand.
Given Einhorn’s track record for calling some of the
biggest "shorts" of the decade, I encourage you to do you own homework
and dig into Green Mountain.
I’ll be at the Value Investing
Congress again today, and will be sharing more takeaway ideas with you
in the coming days. Stay tuned.
Regards,
Ian Wyatt
Editor
Daily Profit
Full Disclosure: Ian Wyatt "sold short" shares of Green Mountain Coffee Roasters (Nasdaq: GMCR) following David Einhorn’s presentation on October 17. He intends to add to this position in the coming days.