Green Mountain Coffee Roasters: 7 Troubling Scenarios for Investors
NEW YORK (
) -- While many investors engaged in a
rapid-sell off of Green Mountain Coffee Roasters (GMCR) stock
in September upon the announcement of an SEC inquiry into the company, some analysts have also been concerned about other potentially more problematic scenarios for the company.
Moody's vice president and senior credit officer Brian Weddington, for one, said that the Sept. 28, 8K filing regarding the SEC investigation of Green Mountain Coffee Roasters' (GMCR) revenue recognition practices and relationship with one of its key distributors may be cause for alarm, but that potential vulnerabilities in the company's supply and distribution infrastructure and an impending patent expiration may be at least as concerning as the former.
Ken Shreve, the manager of TheStreet's Market Movers model portfolio also lays out other problems that the company is facing and that investors might want to learn more about.
Read on for the best-case and worst-case scenarios for the SEC inquiry into Green Mountain Coffee Roasters and the various potential outcomes of possible weaknesses in its supply and distribution infrastructure and upcoming patent expiration....
Scenario #1: The SEC Inquiry Amounts to Nothing
Moody's Vice President and Senior Credit Officer Brian Weddington: The SEC look at GMCR is currently just a general-information inquiry. "What happens in some cases is they just don't have enough information and part of the inquiry is to fill in those blanks, then often times once the company provides information they get their questions answered and then the issues just goes away.
"So, for example, sometimes you're looking at revenue recognition and the company's accounting for one way and then the next year they change the accounting method, but then they find out it's because they've changed their vendor or they have a legitimate reason for doing it, and that they've adequately disclosed in their financials -- and then there's no issues at all."
Ken Shreve, manager of TheStreet's Market Movers model portfolio: "It's an informal SEC inquiry at this point which means the SEC has requested information and will take a look. The best-case scenario is that it stays informal."
Scenario #2: The SEC Inquiry Runs Into Issues
Weddington: "In some cases it could just be differences of opinion and the SEC believes that things should be done one way or might be done the other way. In that case, what you have is most likely a revenue recognition -- it's a timing difference -- and you may have revenue or earnings shifted into one period vs. another, but it's still earnings. It's just whether those earnings occurred in October, in September, or before the quarter or after the quarter.
"So those are kind of timing difference issues, and that may require restating some of their financials, but doesn't change anything fundamental to their business."
Scenario #3: The SEC Inquiry Uncovers Accounting Manipulation
Shreve: "If it turns into a formal inquiry, that wouldn't be good news for GMCR because it generally means that the SEC has found problems with the books and has reasons to proceed."
Weddington: "The next level would be accounting manipulation. Accounting manipulation would be using questionable accounting practices to manipulate earnings, to either accelerate or defer earnings for the purposes of managing your earnings per share. That's a much more serious charge.
"If something like that were to happen, the individuals involved could be held liable and then the company could be subject to a fine. I looked at some cases where companies were fined, and most of the time, they were significant amounts, but not enough to fundamentally impact the business.
"A recent case was settled for $100 million. Dell (DELL) - Get Report computer was manipulating their accounting and they agreed to pay a $100 million fine. Dell is a $52 billion company; I'm assuming that they take the size of the company into consideration when levying these types of fines. But even in Green Mountain's case, if you look forward and even if you lay $100 million of additional debt on the balance sheet, it still doesn't change the fundamental business. So even if there were manipulation, that kind of wrongdoing, it doesn't change the fundamental business and the fine wouldn't significantly" bring down the company.
Scenario #4: The SEC Investigation Takes a Turn for the Worst-Case
Weddington: "They haven't been accused of anything. It could turn out to be absolutely nothing. On the far extreme would be just out-and-out fraud, where there is no business or they're double-counting sales and sales are actually only half what they appear to be. But I think there's no real evidence of that.
"Pricewaterhouse is their auditor. They have stood by their audit, we've seen audits from companies they've acquired -- audit statements from them, we've seen cash flow statements, and so the cash seems to be there. We've done channel checks.
"If you go into Bed Bath & Beyond (BBBY) - Get Report or Costco (COST) - Get Report, wherever you see the product, they're moving off the shelves. The sales are moving consistent with what we see among their competitors too. This single-serve coffee category is increasingly attractive and gaining acceptance from consumers. We feel comfortable that the business is at least in substance what they say it is."
Scenario #5: The SEC Inquiry Is the Least of GMCR's Problems
Shreve: "In terms of other worries for GMCR, I've heard rumblings about increased competition from the likes of Nestle (NSRGY) - Get Report. Editor's Note: Nestle makes Nespresso machines that compete with Green Mountain's Keurig brewers."
Weddington: "In our view, the two bigger issues are managing the growth in the business."
The first, according to Weddington, includes controlling "their infrastructure and the infrastructure of their vendors to manage the growth effectively, because they source the manufacture of their brewers from a single company in Hong Kong. So there's some concern there that, as the business grows rapidly, the manufacturer is able to keep up manufacturing brewers without suffering any quality-control issues, delay in shipments, etc. And then all those brewers, in turn, are being distributed by a single company, which is M. Block, which distributes all of their brewers and probably a third of their K-Cups. So a breakdown anywhere in that chain could significantly impact their K-Cup sales, which is where the margin is.
"There could be a connection between this whole SEC investigation and the kind of stress that is being placed on their vendors. Maybe some of the accounting is getting sloppy -- we don't know. Also, to the extent where they are no long satisfied or become dissatisfied with the quality of work that Simatelex -- which is the manufacturer -- it's going to be time consuming and costly for them to find another manufacturer. We would prefer to see them have multiple vendors manufacturing the machines and multiple distributors who are responsible for getting those out to the retail channels.
"This is something that they have paid attention to, it's just that they haven't done anything about it yet," Weddington said. "I think they're aware of other manufacturers that can make the product for them, I just don't think they can make it for them at the same cost, so the cost of manufacturing probably would go up. How much more is hard to say."
Scenario #6: The Problem of the Expiring Patents
Weddington: "The second-most significant issue -- and this is becoming a more significant issue by the month -- is the fact the patents that protect the manufacturing of the K-Cups is expiring in two years, 2012. And once those expire, in effect, anybody can make their K-Cup, so the cartridges that fit in the Keurig machines can be manufactured by anyone."
"Therefore you have this free-rider problem where Green Mountain is absorbing all the costs of manufacturing these machines or selling them at either a loss or a very thin profit or no profit at all because they have an exclusive right at the moment to manufacture K-Cups. Several years ago there were several companies that had that right -- including Tully's, Diedrich Coffee, Van Houtte -- and that's why they bought them in."
As for the potential financial impacts, Wellington notes that, "there's no question that in 2012, Green Mountain's market share of K-Cup manufacturing is going to start declining -- and probably their profit margins are going to start declining as well -- because at that point they'll be competing to sell their K-Cups against anyone else who decides to manufacture K-Cups," Weddington said. "So we expect market share and end margins to decline steadily. But it's not going to fall off a cliff."
"Now, if all other participants come into the marketplace, and decide they want to make K-Cups, then that's going to help expand the market for K-Cups as well. In some ways you can argue that it's better to have competition so Green Mountain is not the only one out there creating awareness about the single-serve category. Right now, what they say is only 7% of households with coffee makers are using single-serve machines, so there's still a significant amount of potential."
"If you talk about going from 7% to, let's say, 30% or about a third, that's a lot of machines ... and that gives you a lot of room for growth. So a declining share of a rapidly expanding market still may leave enough room for pretty attractive growth rate."
Scenario #7: GMCR Becomes a Possible Takeover Target
Shreve: "Interesting that Nestle has also been mentioned as a possible buyer of Green Mountain because Nestle wants to continue to expand in North America."
"It's rare when you have an SEC inquiry followed up by news that the company being investigated could be a takeover target."
"Shares of Green Mountain have rallied nicely off their lows but most of the gains have been in light volume which tells me that it's been more retail buying (little guys) than institutional buying (mutual funds, etc). This makes for a shaky foundation frankly. Yes, a takeover premium is probably being built into the stock, but I don't think institutional investors are interested in going anywhere near GMCR until the SEC investigation concludes."
"Green Mountain's earnings will be out soon (on or around Nov. 11) and big growth is expected again (eps est. $0.20,up 82% from the year-ago quarter, sales est. $358.5 million, up 61% from year earlier)."
Weddington: "There's been a lot of stories recently about whether or not Green Mountain is even going to be around for much longer because companies interested in gaining a footprint in the retail coffee business are saying Green Mountain is a great way to do it and there are some rumors that Nestle would be interested in this business. It's certainly a business that Nestle could buy."
"Nestle just sold a major business so they have plenty of liquidity -- they're an AA-rated company -- they have the capacity to pick up Green Mountain. Green Mountain's market cap is about $4 billion, so it wouldn't be a transaction that Nestle couldn't handle."
GMCR Metrics and Credit Ratings:
Number of Analysts:
10
Average Recommendation:
Outperform
Stock Price/Earnings Ratio vs. Industry's:
298.86%
Market Cap:
$4.4 billion
Trailing Twelve-Month Operating Margin:
10.6%
Trailing Twelve-Month Revenue:
$1.21 billion
S&P's Rating on GMCR: On Nov. 2, 2010, Standard & Poor's raised its outlook on Green Mountain Coffee Roasters Inc. to stable from negative. At the same time, it affirmed the preliminary "B" corporate credit rating on GMCR. "We revised the outlook to stable from negative because Green Mountain Coffee Roasters should improve its liquidity for at least the next 12 months through the proposed issuance of additional $200 million term loan B debt, while reducing the revolver size by $100 million."
Moody's Rating On GMCR: "I think we have the rating correctly positioned," said Weddington. "It's not investment grade because the inevitable competitive challenges that are going to be intensifying in 2012 and 2013, balanced against a financial profile that is pretty low leverage -- today it's 4X but leverage should be below 4X debt to EBITDA by the end of the next fiscal year -- so we think by the time you start to see serious competition in K-Cups, the leverage should be fairly low, so they won't have the kind of sensitivity to competition or their rating won't be sensitive to that kind of competition because the leverage will be sufficiently low that I think investors will remain fairly comfortable with the leverage versus the prospects for the business.
"It's not highly speculative; it's got other negatives; it's only in a very narrow sub-category of the coffee business, but it is a fast-growing segment; the demographics look very good, the growth is rapid. We think the risk is going to increase over the next couple of years, but while the business risk increases, the financial risk should be decreasing commensurately , and so we think a (SGL-3 ) speculative (grade liquidity) rating is appropriate.
"At this rating level, we're stable. Our outlook is stable."
* The SGL-3 rating is based on Moody's expectation that GMCR will have adequate liquidity over the next twelve months, but will be reliant on revolver borrowings to fund operations.
-- Written by Andrea Tse in New York.
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