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Boxes of Green Mountain Coffee K-Cups sit on sale at the company's visitor center and cafe in Waterbury, Vt. (Herb Swanson/Bloomberg)
Boxes of Green Mountain Coffee K-Cups sit on sale at the company's visitor center and cafe in Waterbury, Vt. (Herb Swanson/Bloomberg)


After a hot run, Green Mountain shares cool a bit Add to ...

Green Mountain Coffee Roasters has been one of the hottest stories on the Nasdaq, with shares nearly quadrupling in price from January to September.

The stock’s surge has made its critics – and there are many – look foolish. So when noted hedge-fund manager and short-seller David Einhorn rapped the firm at a value-investing conference last week, the company’s advocates dismissed the comments as the same old tired stuff.

Mr. Einhorn’s 110-page presentation, however, is remarkably thorough in melding the previous arguments with his fresh analysis of the company’s financials.

Green Mountain, which owns the Timothy’s coffee chain and Van Houtte roasting operation in Canada, became an investor darling thanks to its novel technology for brewing coffee. Some look at it and see a combination of Starbucks and Apple.

The company’s main business is selling Keurig one-cup coffee brewers and the prepackaged, single-serve K-cups that go with them. Its technology is the most popular single-serve system in the U.S., outpacing competitors like Kraft’s Tassimo and Nestlé’s Nespresso. According to Scott Van Winkle of Canaccord Genuity, “Our simple thesis is that Green Mountain and Keurig are changing the way Americans brew coffee.”

But how many consumers will ultimately make the change? Brewing machines using Keurig technology cost from $80 (U.S.) to $250, when quality multi-cup coffee makers can be had for a quarter of the price. Conventional coffee makers produce your morning jolt of caffeine for about 4 cents a cup; single-serve K-cups cost more than 60 cents.

While credit goes to Green Mountain for getting millions of customers to pay so much more for the privilege of brewing so much less, the pricing gap has raised questions about the size of the potential market: Is it the 90 million U.S. households that own a coffee maker – or a number much closer to the roughly 9 million Keurigs already sold?

Mr. Einhorn has some other questions about the company’s results.

Green Mountain’s operating expenses, as a percentage of sales, declined sharply in the first quarter despite the addition of Van Houtte, which had a significantly higher cost structure. The company’s explanation, according to Mr. Einhorn, was that “it turns out [Van Houtte]just spend[s]less than we thought.”

Mr. Einhorn is also puzzled by Green Mountain’s capital expenditures, which are growing far in excess of increased K-cup production. The midpoint of the company’s fiscal 2012 capex guidance, at $740-million, is more than $400-million in excess of what might be extrapolated from the expected K-cup numbers, he says.

And Green Mountain’s third-quarter revenue of $717-million beat expectations by $100-million, which Mr. Einhorn says implies the number of cups brewed per machine unexpectedly reversed a long-term decline.

(When contacted for a response to Mr. Einhorn’s allegations, the company declined, citing a self-imposed “blackout period” before its yet-to-be scheduled fourth-quarter earnings release.)

Analysts say they believe the capital expenditure growth is justified by long-term K-cup production plans and the likely introduction of a new type of Keurig brewer. In its third-quarter conference call, the company said it was surprised by the revenue growth, but attributed the gain to increased adoption of its brewing system, pent-up customer demand, and retailers stocking up before an upcoming price increase.

The company’s own accounting history may be prompting some of the skepticism. Green Mountain previously disclosed an informal investigation by the U.S. Securities and Exchange Commission – then, last November, restated nearly three years’ worth of financials. The company said an internal investigation revealed errors, not fraud, was to blame. That, coupled with continuing silence from the SEC, gives the bulls reason to believe Green Mountain is all clear.

Indeed, the company may come roaring back in the coming weeks with a strong defence of its accounting practices. Yet even as presented, the financial statements reveal Green Mountain has repeatedly had negative free-cash flow when money spent on acquisitions is included. The red ink has been increasing for four years and stands at a cumulative $1.7-billion since 2006, Mr. Einhorn notes.

Green Mountain’s shares appreciated an astounding 24,000 per cent from 1993 to its peak in September; since Mr. Einhorn’s report, the share price has retreated by a third. Rather than creating a buying opportunity, Mr. Einhorn makes a convincing case that there isn’t enough upside left to justify the downside risk.

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