Green Mountain Remains A Short Candidate

| About: Keurig Green (GMCR)

When it comes to Green Mountain Coffee Roasters (NASDAQ:GMCR), there are many skeptics out there. These non-believers question the company's growth potential, inventory levels, sometimes even the accounting methods. Green Mountain shares plunged during 2011 and throughout most of 2012 on a variety of these concerns.

Recently, Green Mountain answered its critics when it reported fourth-quarter results. The company did beat on both the top and bottom line, and guidance appeared to be ahead of analyst expectations. But when you look at the rally in the stock, you have to realize where things are versus where they have been. Today, I'll explain why Green Mountain remains an attractive short candidate. That doesn't mean you have to run out and short it today, but it is a name to keep on your list.

Actual Growth Numbers

Unfortunately, many seemed to miss what Green Mountain said in its earnings report. Everywhere I look, I see people stating that Green Mountain is in good shape because Q4 revenue rose 33% over the prior-year period. But that's not entirely accurate, as described in the following statement from the report.

Please note that the Company's fiscal year 2012 included an additional week (53rd week). This unique calendar shift last occurred in fiscal year 2006 and is not scheduled to occur again until fiscal year 2017. The 53rd week added approximately $90.0 million in net sales; approximately $11.0 million (net of income taxes of $5.8 million) in net income; and, approximately $0.07 in diluted earnings per share in the fourth quarter and fiscal year 2012.

If you subtract that $90 million, which was an above-average revenue week for the company, you'll realize that true fourth-quarter growth was just 20.35%. Also, the 11 and 17 cent rises in GAAP and non-GAAP earnings, respectively, look a lot worse when you take out those 7 cents. Recently, a similar situation with Apple (NASDAQ:AAPL) caused confusion over growth numbers.

But if you still don't understand how this works, think about this hypothetical example. I run a lemonade stand. In the first 10 days, I make $4 each day, or $40 total. In my next period, which is 11 days, I make $5 each day, or $55 total. I could easily say that my growth is 37.5% from one period to the next, but if I normalize that growth for a 10-day period, my growth is just 25%. There's a big difference here.

Margins still pressured

Green Mountain shares rose on what many believed was better-than-expected guidance. Guidance for the fiscal first quarter was better than analysts expected, but there are some real issues to explain here.

First, the company guided to first-quarter revenue growth of 14% to 18%. You don't have to be a genius to realize the midpoint of that guidance is 16% growth. But look at the earnings per share guidance. The company guided to non-GAAP earnings per share of $0.62 to $0.67. In last year's first period, non-GAAP earnings were $0.60. So in terms of earnings per share growth, you're looking at a rise of just 3.33% to 11.66%. The midpoint of that range is just 7%.

But consider as well the company's buyback. Here's what the company stated about the buyback on the conference call:

In addition, as of today, we've repurchased 7.38 million shares under our previously announced share repurchase plan. We've used $175 million of our authorized 500 million towards the repurchase of these shares at an average price of $23.72 per share.

What's the significance of this? Well, in the fourth-quarter earnings report, the company stated that it had bought back 3.1 million shares. That means that the company has bought back about 4.3 million shares since the last quarter ended. Now it noted that there will be some executive option dilution, meaning the share count won't drop by that full 4.3 million. You can figure out the impact. When you combine the lower share count with earnings per share growth guidance about half of revenue growth guidance, you can see margins are still going down.

The company did refer to pressured margins on the conference call, as stated by CFO Fran Rathke:

I think in general, it's the same theme that we had last quarter in terms of our guidance for '13 is we think we believe we're going to have some pressure on gross margins, as I said primarily just due to the mix of the portion packs towards the value pricing.

Green Mountain's GAAP gross margins in fiscal 2012 were just 32.89%, and net profit margins were just 9.42%. If gross margins were to decline to say 32%, the company would either need to cut a bit of operating expenses, have the tax rate improve a bit, or receive some benefit from "other income" items, like currency gains or lower interest expenses. Pressured margins are an issue as worries over increased competition continue to increase.

Back to the buyback

The company stated that through November 27, it has bought back $175 million worth of stock from its 2-year, $500 million buyback plan. That means more than 1/3 has already been spent. But on the cash flow statement for the year, the company shows $76.47 million spent. As I referenced above, it has stated that it bought back more than 4 million shares already in the first fiscal quarter, for a little more than $98 million.

So where is this money coming from? The company's cash balance at the end of the fourth quarter was just $58.289 million. Either the company's receivables have dropped a bit, it has sold a lot of inventory and been paid for it, or it has taken out more debt. I'm hoping it's one of the first two, and not the latter.

But here's another thing to consider. It bought back 7.38 million shares for $175 million, an average price of $23.72. The stock is now at $36.67, more than 50% higher. If the company was buying back heavily under $24, I would think it might be hesitant to buy back at $36.67 just a few weeks later. Also, consider the remaining $325 million. At $23.72 a share, the company can buy back 13.70 million shares. At $36.67, it can buy back just 8.86 million.

The main takeaway here is that while the stock has soared and that's good for those already in the name, new investors looking at the name won't get as much bang for their buck. Just look back at high growth names whose buybacks in the past year or two have not worked well, Netflix (NASDAQ:NFLX) and Deckers Outdoor (NASDAQ:DECK). Those names bought back stock at very high prices. Green Mountain must be careful to not do that here.

Stock Buyback versus Capex

You would think that a growth company like Green Mountain is investing heavily in the business through capital expenditures, right? Well, you would be wrong. Green Mountain is actually reducing its capital expenditures, which is probably why it is buying back stock. The following is a history of its Capex plans.

When the company reported third-quarter results in 2011, it provided the following guidance for fiscal 2012:

Capital expenditures for fiscal 2012 in the range of $650 million to $720 million. In addition, as the Company secures new production facilities for future growth it may incur additional capital expenditures in the range of $50 million to $60 million in fiscal 2012.

When the company reported fourth-quarter results in 2011, the guidance changed to the following:

For fiscal 2012, we currently expect to invest between $630.0 million to $700.0 million in capital expenditures to support the Company's future growth.

The company did not revise its Capex guidance after first quarter results, but when it reported second-quarter results, it took down the forecast again:

Capital expenditures in the range of $525 million to $575 million.

When the company reported third-quarter results, linked above, it again took down the forecast for 2012 Capex.

Capital expenditures in the range of $475 to $525 million, down from prior estimates of $525 to $575 million.

But on the conference call, CFO Frank Rathke was asked about where Capex ended up, and the following response was given:

Yeah. So I think just rattling -- so CapEx, why was CapEx down from our prior guidance? I mean when you look at our CapEx on the statement of cash flows, I think it's about $400 million and then also down below on the statement of cash flows, there is about $50 million to $55 million of CapEx acquisitions we made that are in accounts payable, so technically not a use of cash yet. So that's around $450 million our guidance -- prior guidance, was in the range of $4.75 or so and I think so slightly lower, but that's a tougher number to gauge when exactly that's actually going to be deployed.

So when it initially gave guidance, it was looking at potentially $700 million to $780 million in capital expenditures. Ultimately, that number turned out to be roughly $450 million or so. The company then established fiscal 2013 capex guidance at Q3's results, of $380 million to $430 million, which it reiterated at the Q4 results. It would seem to me that it believes buying back stock is more important than investing in the business. If you don't believe that, look at the roughly $76.47 million in shares repurchased during Q4, and note how the roughly $450 million in yearly capex was $75 million below the lower end of the previous guidance range.

Guidance - was it really that great?

Everyone seemed to focus on the fact that the company raised its fiscal 2013 earnings forecast. But they missed a couple of points here. First, the revenue forecast was not raised. Second, the earnings forecast was only raised because it didn't include the buyback. Here's the statement from the original guidance at the Q3 report:

Fiscal year 2013 non-GAAP earnings per diluted share in a range of $2.55 to $2.65 per diluted share, excluding approximately $0.18 per share due to the amortization of identifiable intangibles related to the Company's acquisitions; any acquisition-related transaction expenses; legal and accounting expenses related to the SEC inquiry and the Company's pending litigation; and, any impact from anticipated Company share repurchases

"Excluding any impact from anticipated company share repurchases" is the key point here. Since the company had bought back over 7 million shares as of the earnings date, that is really going to impact things. Now here is the revised guidance:

Fiscal year 2013 non-GAAP earnings per diluted share in a range of $2.64 to $2.74 per diluted share, excluding approximately $0.23 per share due to the amortization of identifiable intangibles related to the Company's acquisitions; any acquisition-related transaction expenses; and legal and accounting expenses related to the SEC inquiry and the Company's pending litigation. The Company's fiscal year 2013 non-GAAP earnings per diluted share estimate includes the impact of shares repurchased prior to November 27, 2012 as part of its previously announced share repurchase program, but excludes any impact from potential future Company share repurchases.

So the new forecast includes the 7 million shares purchased, but doesn't include any future buybacks. This means that if the company continues buying back shares, it probably will raise the forecast accordingly. The important point to make here isn't that the business is getting better. It's that earnings per share are rising only because of the buyback. Always read the fine print.

Expectations - then and now

I mentioned this a little in my earnings wrap up, but people don't remember that Green Mountain warned on Q4, which set up this "beat." On the day that Green Mountain reported Q3, expectations for Q4 were for $952 million in revenue and $0.62 in non-GAAP earnings. Green Mountain actually came in at $946.7 million and $0.64. So it missed on revenue and beat on earnings. But if you take into account the fact that probably zero analysts were looking for a buyback, the company probably only met expectations or beat by a penny. Had analysts known about the buyback, I'm sure expectations would have been higher.

But the real interesting angle is to look at the full-year numbers. The following table shows analyst expectations and stock price as of August 1, and December 2. Notice something? You should.

So expectations are a bit lower, but the stock has more than doubled. Now, you can make an argument that Green Mountain was priced for too negativity on August 1. I'll buy that, but not to this extent. Look at Green Mountain's current guidance. The current revenue forecast calls for a range of $4.44 billion to $4.63 billion, and earnings of $2.64 to $2.74. Analysts are at the low end of the range currently, probably because not all of the analysts have revised their forecasts yet. Also, given this company's history of warnings, some probably believe the company will warn again. But even if you go to the high end of those ranges, they are still well below the expectations on August 1, and the stock has more than doubled since then.

For fiscal Q1, the story is the same. The company guided to revenue growth in a range of 14% to 18%, and analysts are currently looking for 13.8%. That's up from 11.7% expected when the company reported, and I figure it will trickle up a little more. The company guided to earnings per share of $0.62 to $0.67 for Q1, again only counting for shares bought back through November 27. Analysts currently expect $0.63, up from $0.59 before the latest report.

Final Thoughts

Green Mountain shares rallied because of what appeared to be very good results, but there were a lot of numbers that aren't what they originally appeared to be. An extra week provided a huge revenue and earnings boost to the quarter. The company's buyback is really throwing off numbers, as the company has bought back more than 7 million shares already. Investors need to be realistic about the difference between an improvement in company fundamentals, and earnings rising due to a lower share count.

For the reasons outlined above, Green Mountain remains a short candidate. Now, I know that many don't understand what that exactly means. A short candidate means that a company has identifiable issues that make a short position logical, if those potential issues turn out to be a reality. There is a huge difference between a short candidate and a short recommendation. Green Mountain belongs to the first category. If investors think there are issues with this name, they might want to short the name, but they have to figure out at what price to do so.

I'm sure I could poll a dozen investors now, and each would give me a different price to short at. Some could say they would short it above $30, others at $35, and some might not short it until say $50. The number of shares short in Green Mountain was nearly 51.5 million as of November 15, compared with just 23.25 million as of June 15th. Once we get the end of November data we'll be able to figure out how many of those shorts ran for cover after the latest earnings report.

I want investors to remember the following point. One good quarter doesn't necessarily mean this company is back for good. Green Mountain reported a great Q1 back in February, and shares soared to nearly $70 afterwards. How did that work out? Well, they were back to $50 by early May and when Q2's report was bad, they dropped to $25 in days. Green Mountain shares are up roughly 140% from their approximate low of $15.25 during the after-hours session following the Q3 results.

That's a huge rally, and it could continue. If we get more analysts jumping on the bandwagon, short covering could easily push this name to $40 or more. Green Mountain remains a short candidate, but that doesn't necessarily mean you have to short it today. Each investor needs to figure out a logical price at which they want to short it.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in GMCR over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.