Present a note on the financial misconduct at Green Mountain, if any and its impact on the valuations.
SELLING SHORT: GREEN MOUNTAIN COFFEE ROASTERS1
Marty Dirks wrote this case solely to provide material for class discussion. The author does not intend to illustrate either effective or ineffective handling of a managerial situation. The author may have disguised certain names and other identifying information to protect confidentiality.
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Copyright © 2012, Richard Ivey School of Business Foundation Version: 2017-08-21
It was a cool day on October 18, 2011, as institutional investor Marty Dirks looked out his office window at the Bay Bridge that led from San Francisco to Oakland. He wondered, “Do I feel lucky?”
The day before, Greenlight Capital (Greenlight), a highly-regarded long/short equity hedge fund, had presented a bear case (the analysis supporting a short position) for Green Mountain Coffee Roasters (NASDAQ: GMCR) at the Value Investing Congress in New York. It was an intriguing investment idea, but held huge risk.
Green Mountain Coffee Roasters (Green Mountain) was a volatile stock; in the past year its price had ranged from a 52-week low on December 16, 2010 of $31.21 per share to a 52-week high on September 20, 2011 of $115.98 per share2 (see Exhibit 1). If Dirks had sold Green Mountain’s shares short on December 16, by September 20 he would have had a loss of 270 per cent in the position — in a market in which the Standard & Poor 500 had declined 2 per cent over the same period of time.
Could Dirks ever obtain enough conviction from his analysis to take on the investment risk inherent in Green Mountain?
COMPANY HISTORY
Green Mountain Coffee Roasters was founded in 1981 in rural Vermont, where it was still headquartered. Initially, it roasted and distributed coffee to restaurants and supermarkets throughout the region. For most of Green Mountain’s history, sales of wholesale coffee represented the majority of the business.
In 1998, Green Mountain started selling single-serve coffee in ‘K-Cups’ for Keurig Brewing System machines, primarily for the office market. In 2002, Keurig introduced K-Cup brewing machines designed
1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Green Mountain Coffee Roasters or any of its employees.
The case is solely the work of Marty Dirks and was not prepared by, nor endorsed by, Greenlight Capital or its affiliates.
2 Thomson Reuters.
for the home market. At that time, Green Mountain invested $15 million in exchange for a 42 per cent ownership interest in Keurig. Four years later, Green Mountain bought the remaining ownership interest in Keurig for $104 million. This acquisition made single-serve coffee sales the majority of Green Mountain’s business.3
With full ownership of Keurig, Green Mountain had evolved its business model to selling the K-Cup brewing machine for at (or near) cost and locking in a long-term sales annuity of single-use consumables at attractive profit margins. Green Mountain grew Keurig through direct sales and by licensing the K-Cup manufacturing technology to other coffee retailers such as Tully’s, Timothy’s, Diedrich and Van Houtte. Green Mountain also struck agreements to manufacture K-Cups for well-known coffee companies, such as Starbucks Corporation and Dunkin’ Donuts, providing the K-Cup with an even stronger market presence.
Patents
Green Mountain’s K-Cup design was patented; however, the patents were due to expire in September 2012. Accordingly, Green Mountain had stated it would roll out a new brewing technology to provide new patent protection in the future.
Green Mountain’s fiscal year 2009 Form 10-K filing stated:
The two principal patents associated with our current generation K-Cup portion packs will expire in 2012, and we have pending patent applications associated with this technology which, if ultimately issued as patents, would have expiration dates extending to 2023.
Furthermore, during a conference call with investors in July 2011,4 Green Mountain’s chief executive officer (CEO) explained:
With respect to our patents and intellectual property, we have a broad portfolio of patents on portion packs, on brewing machines and on the system of both portion packs and brewing machines; and certainly to the extent that any other product might infringe on our intellectual property, we take that very seriously and we would, in fact, rigorously defend our intellectual property.
Financials
From 1991 to 2000, revenues grew at a 25 per cent compound annual growth rate (see Exhibit 2). From 2000 to 2005, revenue growth slowed to 14 per cent per year. From 2006 to 2010, revenues grew 57 per cent per year (see Exhibit 3).5 Approximately 96 per cent of Keurig brewing machines shipped in fiscal year 2010 were sold to a television-based shopping outlet, the At Home channel. In total, Green Mountain had sold over 13 million single-serve brewing machines and over 9 billion K-Cups.6
3 Green Mountain 10-K for FY 2010; http://investor.gmcr.com/background.cfm ; Green Mountain 10-K for FY 1997; Green Mountain 10-K for FY 2006; Green Mountain 8-K filed on May 22, 2006; Green Mountain 10-K for FY 2002.
4 Green Mountain’s CEO Discusses Q3 2011 Results, Earnings Call Transcript, http://seekingalpha.com/article/282507- green-mountain-s-ceo-discusses-q3-2011-results-earnings-call-transcript.
5 CapitalIQ.
6 Green Mountain 10-K for FY 2010.
( Page 18 )
According to the Wall Street consensus assumptions, Green Mountain’s return on invested capital was approximately 16 per cent (see Exhibit 4).
Consumable Attachment Rate
Analysts following Green Mountain developed a methodology for tracking and forecasting sales of K- Cups. They calculated a metric referred to as the attachment rate — the average number of K-Cups sold per day for the quarter, divided by the number of brewing machines in the installed base. Analysts assumed the installed base consisted of all brewing machines sold in the prior 36 months.
Until the June 2011 quarter, the attachment rate had declined an average of 13 per cent from the same quarter in the prior year (see Exhibit 5). Using the assumption that the attachment rate was therefore declining at a rate of 13 per cent from the same quarter in the prior year, a reasonably predictive model was developed to forecast the next quarter’s attachment rate (see Exhibit 6). However, in the June quarter the attachment rate was unusually high. Management did not offer any clear explanations for this increase, attributing the surprisingly strong June quarter sales to the cumulative effects of multiple factors.
Valuation Metrics
As revenue growth increased, valuation multiples had increased substantially over the past five years (see Exhibit 7). Enterprise Value was $14.9 billion (see Exhibit 8). Based on Green Mountain’s current stock prices, up-to-date Wall Street estimates were calculated for Green Mountain’s revenues, earnings before interest and taxes (EBIT) and earnings per share (EPS); retail distribution trends were similarly assessed (see Exhibits 9 and 10).
THE BULL CASE
Bullish investors viewed Green Mountain as a high-growth business in its early stages. In an investor conference presentation on August 10, 2011, Green Mountain pointed to the 90 million households that owned a coffee-brewing machine as the company’s potential market and, with an installed base of 7 to 9 million brewing machines, noted that Green Mountain had only penetrated eight to 10 per cent of the market.7
Most analysts were more conservative and focused on the 64 million households that drank more than two cups of coffee each day. The bullish investors believed Green Mountain could capture one-third of that market, attaining an installed base of 21 million brewing machines. As of May 2011, Green Mountain’s installed base was 7.5 million machines, suggesting that the installed base could triple from that level.8
Bullish investors cited a number of arguments to support their ownership decision. Firstly, Green Mountain was capacity-constrained and had been unable to meet demand. On the first-quarter 2011 earnings call held on February 2, 2011, Larry Blanford, Green Mountain’s CEO, stated: “We are definitely being stretched . . . demand is definitely stretching our ability to supply. And we have not quite
7 Green Mountain presentation given at conference on August 10, 2011.
8 SunTrust Robinson Humphrey research note published May 6, 2011.
caught up with that demand curve yet.”9 The company had stated that its sales were constrained by inadequate production capacity; therefore, as additional capacity was added, sales should grow quickly and Green Mountain’s profit margins would expand as additional infrastructure investments were made in 2012.
Similarly, distribution was likely to expand substantially from its current level. Retailers would commit additional shelf space to brewing machines and K-Cups going forward. Additional sales would also result from adding recognized brands like Starbucks and Dunkin’ Donuts to the Keurig system. Availability of these brands in the Keurig system would reduce the risk of competition.10 Growth of the Keurig installed base should continue as well. The K-Cup had become the standard format for single-serve coffee and the only prominent coffee brands that Green Mountain did not have in its portfolio were Maxwell House and Peet’s.
Furthermore, while coffee made with K-Cups was more expensive than coffee made with traditional brewing methods, it was still far less expensive than coffee purchased at certain retailers, such as Starbucks: the cost of coffee brewed from K-Cups was approximately one-third of the cost of coffee purchased at Starbucks. The K-Cup brewing system was a premium-priced, high-end system. Private- label coffee sales represented approximately 10 per cent of all coffee sold at retail and, since private-label coffee was a low-end, unbranded product, it was expected to penetrate only a small part of the K-Cup market.11
Finally, Green Mountain was well protected against competition. In March 2011, Green Mountain’s chief financial officer (CFO) stated: “We are a technology company with a host of patents.”12 In August 2011, Green Mountain’s CEO said, “I would define our company today as really a single-serve beverage company that is sitting on top of this magnificent technology — call it disruptive technology — platform.”13 Management had further described Green Mountain’s position in the marketplace as “the iPod of coffee.”14 Even after Green Mountain’s patents expired in 2012, there would be substantial barriers to entry by competitors. The capital investment required to produce K-Cups on a large scale was significant and new entrants would likely have a difficult time obtaining retail shelf space.
Some prominent investors had great faith in Green Mountain’s business model. In June 2011, referring to Green Mountain’s many relationships with branded coffee manufacturers, prominent investor, Jim Cramer, described Green Mountain as an “exchange-traded fund (ETF) on the rapid-growing single-serve market.”15 An optimistic estimate for long-term earnings per share (EPS) potential was calculated to be
$8.00 to $10.00 per share (see Exhibit 11).
9 Green Mountain’s CEO Discusses Q1 2012 Results, Earnings Call Transcript, http://seekingalpha.com/article/333992- green-mountain-coffee-s-ceo-discusses-f1q12-results-earnings-call-transcript.
10 Janney Capital Markets research notes and SunTrust Robinson Humphrey research notes.
11 SunTrust Robinson Humphrey research note published May 6, 2011.
12 Fran Rathke, GMCR CFO – conference on March 15, 2011.
13 Larry Blanford, GMCR CEO – conference on August 10, 2011.
14 Greenlight, “Value Investing Congress,” Wall Street Journal, October 17, 2011, http://online.wsj.com/public/resources/documents/EinhornGMCRpresentation_Oct2011_VIC.pdf , accessed June 28, 2012, Greenlight conversation with GMCR management.
15 Mad Money Recap, June 29, 2011, www.madmoneyrecap.com/madmoney_nightlyrecap_110629_3.htm.
