David Einhorn Short Green Mountain Coffee Roasters (GMCR): Value Investing Congress Presentation ~ market folly

Monday, October 17, 2011

David Einhorn Short Green Mountain Coffee Roasters (GMCR): Value Investing Congress Presentation

At the Value Investing Congress in New York today, David Einhorn of hedge fund Greenlight Capital revealed he is short Green Mountain Coffee Roasters (GMCR) in a presentation called "GAAP-uccino".

Be sure to check out our notes from the Value Investing Congress.

David Einhorn (Greenlight Capital): Short GMCR

Einhorn famously gave a presentation on shorting Lehman Brothers a few years ago and shorting St. Joe (JOE) last year at the same conference. This year he's back with a short of GMCR. Whitney Tilson of T2 Partners has been short GMCR for a while as well.

Embedded below is his full slideshow presentation:

Einhorn began with company background and the well-known bull case. Green Mountain Coffee is a K-cup company with a razor-razor blade model; 95% of business is at-home use.

Bull case: 64 million households drink coffee, 1/3 buy K-cup machines, 2 cups per day, 15.5B k-cups, 0.15 profit per cup, get $1.4B profit, on 160M shares is $8 eps. Recognized brands like Starbucks, Dunkin Donuts will grow installed base, and bring higher margins. Management calls itself the “iPod of coffee.” Great income statement growth in last few years, aided by acquisitions. And the stock has done very well: 57x P/E, 35.6x next year estimated eps. Up 185% this year, best stock in SPX 1500.

Einhorn then moved onto criticizing the company: Poor transparency. Doesn’t even report lbs shipped, k-cup units, or precise Keurig brewers units. GMCR has cut their amount disclosure over time, which is what companies usually do when metrics are deteriorating.

Bear case: The opportunity is smaller than bulls believe. Attachment rate is smaller than bulls believe and is declining. They already have widespread distribution and brand awareness. Machines are expensive, $250 vs. $80 Mr. Coffee, or cheap $20 brewers. K-cups are much more expensive compared to buying the bags of coffee yourself, 60 cents per serving vs. as cheap as 5 cent per serving. This limits the actual available market to about 20M households, not 64M. Growth in retailers selling Keurig is slowing.

Attachment rate is declining or flat, only about 1.3 per brewer per day. GMCR doesn't disclose the attach rate!

Starbucks deal: non-exclusive and multi-year, in stores and at SBUX. Deal does not apply to next generation brewer - SBUX keeping its options open? About $0.22 estimated profit per K-cup. How will they split it? Using Smucker’s deal, can estimate that GMCR only got .06 of .17 total profit, to make the k-cups. Therefore, SBUX should get 2/3 of the 22 cents, leaving GMCR only 7 cents. In fact, SBUX deal could cannibalize their other K-cup sales.

GMCR hasn't generated much FCF. In fact, it's been negative for 4 years. Due to acquisitions and CAPEX, they are burning cash and expect to continue. ROIC only 16.3%, yet high multiple, doesn’t justify current stock price.

Competition/Patents: Bulls say patent expiration unimportant due to large market share. However, patents that keep others from making k-cups for the existing brewers may be expiring in 2012. Competitors will be able to produce k-cups!

GMCR has been buying out licensees and paying too much. Usually allocates 95-104% of the purchase prices to good will when buying them. Goal may have been to avoid competing with licensees when patents expire. Big deals with SBUX, Dunkin are to mitigate competition when patents expire. Only advantage they have is contract manufacturing, which is a lousy business. GMCR may instead create a totally new system to stop others.

Bear Case Summary: GMCR will no longer have monopoly on making the K-cups next September. Others will gear up to enter the market with much cheaper alternatives- they already have the equipment to do it (Crystal Lite maker example). There is lots of branded competition: Kraft, Nestle, and Maxwell House.

Bear case, vs. the bulls $9 eps estimate. Cut attach rate to 1.25 K-cups per brewer, add 20% private label penetration, cut profit per cut to 0.12 from 0.15, gets you $3.50 eps, not $9.00.

CAPEX: Spending a lot on CAPEX that is “unexplained.” As much as $186M in 2011- where is this money going? Next year it looks even worse, $431M in unexplained CAPEX based on their guidance. CAPEX growing faster than the business, when the opposite should be happening.

Recent summer quarter revenue was $717M, 100M higher than Street, all upside on K-cup sales. Historically, they’ve been very predictable. What happened? Implies attach rate soared by 11%, no good answers on the conference call.

SEC inquiry: Revenue recognition practices. Internal investigation exonerated the company. “We believe there may be a material issue.” Something fishy with MBlock, the third-party fulfillment company that handles their distribution and inventory. 51% of accounts receivable were to them. Einhorn’s people have interviewed witnesses who spoke of phony transactions that had revenue recognition issues. Former workers may have been fired for asking too many questions! The company uses excel instead of stronger ERP software; open to abuse and mistakes. Keurig was shipping stuff to themselves according to an interview. Believes this may explain the excess K-cups sold in the quarter. Significant problems with expired coffee. His interviews with ex-employees showed astounding levels of inventory discrepancies- shipping to themselves, expiring coffee, sales that never happened.

He says there's been a lot of surprises with recent accounting and he accused management of "shenanigans" (SuperTrooper anyone?) After his presentation, GMCR stock was down as much as 12%.

Conclusion: Market is smaller and more penetrated than bulls believe. Attachment rates matter and they are falling. $3.50 eps is more likely than $9.00. The patent expiration is a real problem. The March quarter was such a surprise that it was suspicious, especially in light of conversations with workers. GMCR did a big stock deal, where insiders sold, right after the 19% jump in the stock after the quarter. The accounting is aggressive, transparency is limited, and controls seem to have material weaknesses. GMCR is a serial issuer of stock for acquisitions, while insiders have sold in droves. Limited FCF, large number of warning flags here.

It should be noted that GMCR has largely been labeled a "momentum stock" and some of the top holders include hedge funds like Philippe Laffont's Coatue Management, Steve Cohen's SAC Capital, and John Thaler's JAT Capital.

Q&A Session:

1. MBlock owners or relationship? Unclear.

2. NPD data shows evidence of good growth - how do you reconcile this with what you find? "No doubt they are selling a lot of coffee. We have seen an increase in expired or nearly expired coffee."

3. Will the SEC do anything here? They've been here for a year, there is some hope.

4. Vodafone? Says the thesis is playing itself out.

5. Sprint, any change in outlook? They're trying to do a lot of things at once. Still like the stock, despite high amount of debt, company still has access to funding without diluting shareholders. Strategic asset to a number of large players. What they are doing now makes a lot of sense, if we are sufficiently patient, if anything goes right, we have a chance at an asymmetrical return.

6. Japanese bonds, surprised they've rallied? Yes, but Japan is in a tough spot due to so much debt and budget deficit, bad demographics (Kyle Bass of Hayman Advisors has been short Japanese JGBs).

In our September hedge fund performance numbers post, we highlighted that Greenlight was -0.76% in September and -6.16% for the year at that time.

About David Einhorn: He manages the $7 billion hedge fund Greenlight Capital. He is the author of Fooling Some of the People All of the Time which is a great read. We've also posted up David Einhorn's recommended reading list for all aspiring fund managers.

Earlier this year we also posted up Einhorn's presentation on Microsoft (MSFT).

You can view our notes from the Value Investing Congress for the rest of the hedge fund manager presentations.

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