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
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
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
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
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
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
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
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
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.