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Green Mountain Coffee Roasters, Inc. (NASDAQ:GMCR)

F4Q08 Earnings Call

November 12, 2008 5:00 pm ET

Executives

Frances G. Rathke - Chief Financial Officer

Larry Blanford - President and Chief Executive Officer

R. Scott McCreary - Chief Operating Officer

Michelle V. Stacy - President of Keurig

John Whoriskey – General Manager, At-Home business unit, Keurig

Jon Wettstein -Vice President of Supply Chain

T.J. Whalen - Vice President of Marketing at Green Mountain Coffee

Jim Travis - Vice President of Sales

Dave Manly - Vice President of Marketing of Keurig

Analysts

Nicole Miller Regan - Piper Jaffray

Bill Chappell, Jr. - SunTrust Robinson Humphrey

Mark Astrachan - Stifel Nicolaus

Mitch Pinheiro - Janney Montgomery Scott

Scott Van Winkle - Canaccord Adams

Operator

Good day and welcome everyone to the Green Mountain Coffee fiscal 2008 fourth quarter and full year financial results conference call. (Operator Instructions) At this time, for opening remarks and introductions I would like to turn the call over to Vice President and Chief Financial Officer, Miss Frances Rathke. Please go ahead, maam.

Frances Rathke

Thank you, Kevin. I would like to welcome everyone today. If you have not received the earnings press release, it is on our web site at www.gmcr.com. Also on our website is a series of slides that summarize much of the information on this conference call. You can access them through the same link as our webcast from the Investor Services page of our website and I urge you to view them as they contain key messages and data we are discussing today relating to our performance and prospects.

I want to remind everyone that certain statements will be made today which are forward looking within the meaning of securities laws owing to the uncertainties of forward-looking statements our actual results could and may differ materially from anything projected in these forward-looking statements. So we can give no assurance as to their accuracy and we assume no obligation to update them.

For further information on risks and uncertainties, please read the company's SEC filings, the paragraph in today's press release that begins with the words certain statements.

We also request that you ask all of your questions on this call so that our answers are available to everyone.

And now, I would like to turn the call over to our President and CEO, Larry Blanford.

Larry Blanford

Thanks, Fran. Joining Fran and me with prepared remarks on this call today are John Whoriskey, General Manager of our Keurig at-home business unit, and Scott McCreary, COO of our Green Mountain Coffee business unit. I’m also pleased to introduce Michelle Stacy, President of Keurig, who just started last week. After these remarks, our management team will be available to respond to your questions.

It is great to be sharing such outstanding results today, both for our fourth quarter and fiscal year, which confirm the strength of our business. In today’s challenging business environment, I am thrilled to report fourth quarter EPS results of $0.28 per diluted share, up nearly 100% from the same quarter last year on a 45% increase in sales and a 62% increase in K-Cup shipments.

I’m equally thrilled with our 2008 fiscal year earnings per share growth of 68% that was driven by net sales of $500 million dollars, up 46% and system wide K-Cup shipments up 59%.

With our proprietary Keurig single cup brewing system, we are truly turning opportunity into success. Driving sales growth and profitability for our shareholders as depicted in slides 8 and 9.

Green mountain has always believed that a fantastic cup of coffee is one of life’s best affordable luxuries. The Keurig single cup system now offers consumers the ability to manage their tighter budgets by brewing their own coffee at home easily and conveniently and it makes a great holiday gift.

In a difficult economy, we are driving significant top line and bottom line growth. This is because we are the leader in a growing coffee brewing revolution from drip coffee makers to single serve gourmet coffee brewers. John Whoriskey will provide further insight on the at-home single serve segment and our holiday plans in a few minutes.

I am confident in our organization and our continued growth potential. This past year has been a year of great progress as we have laid the groundwork to deliver more strong sales and earnings growth with new model brewers, coffee products, and infrastructure to support our rapid growth.

The next few years, we expect that the most important growth drivers will continue to be first, a proprietary Keurig single cup brewing and K-Cup system. Second, our already well-established multi-channel geographic expansion model, and third, building a portfolio of strong brands, including Green Mountain coffee, whole branded, Newmans Own Organics, and after closing our pending acquisition, Tully’s, which greatly enhances our western geographic presence.

With respect to the Keurig single cup system, we are continuing to pursue a market penetration model and are focused on driving new customers into the single serve segment. Why? We believe the size of the opportunity is large with some 90 million US households owning coffee makers, while our total brewer sales to date are only about $1.6 million for the at-home market. As John will discuss, NPD data shows we are the single serve segment leader and we believe the Keurig brewed revolution is still early in its lifecycle.

To grow the single serve opportunity and maintain our segment leadership, we will first and foremost deliver great coffee to our consumers, conveniently brewed with a press of a button. Also, further supporting our segment leadership, we continue to develop proprietary technology, which projects and guides our current and future single serve systems.

As recently reported, we were pleased to reach a settlement with Kraft, under which they paid us $17 million dollars for a limited license. This patent is one of several of our portion-packed patents in our intellectual property portfolio.

A multi-channel marketing strategy surrounds the consumer with opportunities to enjoy our coffee, whether it’s at home or in a convenience store, work place, hotel room, or nearby restaurant. Cross-channel awareness now supported by Keurig and other opportunities helps us grow the awareness of our brands even more.

The pending acquisitions of the Tully’s brand and wholesale business will give us a complimentary west coast brand, flavor profile, and business infrastructure that can support our aggressive growth plans and further drive single cup system awareness and market penetration across North America.

We further distinguish ourselves in the highly competitive specialty coffee arena with our commitment and initiatives to protect the environment, be sociably responsible public company and adhere to the highest standards of corporate governance. I believe corporate social responsibility, CSR, is a key part of the foundation of our business model that supports our successful growth.

Consumers who can make a difference by drinking our coffee appreciate our values. Our commitment to CSR also appeals to business partners, like Newmans Own Organics, and it helps us to attract and retain a very talented group of employees.

Looking forward, w are focused on continuing to deliver strong sales growth and improve our operating margins for long-term sustainability and shareholder value.

For 2009, we expect to grow our top line by 40 to 45% and to increase our net income and earnings by share at the same or slightly higher rate than the growth in net sales.

Importantly, beyond 2009, the way we are thinking about this business is to put in place initiatives or enabling moves which support future portion pat growth rates similar to our recent experience of about 50% or slightly higher.

Several enabling moves that we have recently made are the introduction of the Keurig mini brewer, the rollout of new compact 12-count K-Cup packaging for supermarket distribution. Establishing a new plant in Knoxville, Tennessee for K-Cup manufacturing capacity, and the pending Tully’s west coast brand acquisition.

Now we are working on several more enabling moves this fiscal year. We will flag them as we go. Stay tuned.

In the context of this longer-term thinking and as we expand into new markets with Keurig, some of the basic dynamics of our business will continue to change as well. For instance, early on, when we were focused on building our business with office coffee distributors, there wasn’t a whole lot of seasonality. Then we entered the at-home market and the holiday season became an important element in our planning. Likewise, when we were exclusively serving large offices with our commercial brewers, pick-up sales for brewer were at a level of 10 to 15 cups per brewer on average. Our good better best brewer models for homes generate K-Cup portion pack demand about 2 to 2 and a half K-Cups per day. The hotel room brewer and now the new Keurig mini will generate their own unique consumption pattern.

Because of its importance and the complexity of these factors, we spend a great deal of time modeling and projecting portion pack growth rates. Beginning today, we are providing guidance for annual system wide K-Cup portion pack growth rates.

For fiscal 2009, we anticipate that system wide K-Cups will grow 50 to 60% shown on slide 10, which is in line with our financial guidance.

Beginning next quarter, we will report total brewer shipments and we will not attempt to break them out by segment or platform.

Our focus will be on the K-Cup portion pack growth rate which is our real goal and therefore more meaningful.

K-Cup growth is driven by a large and expanding base of brewers and the many different enabling moves I mentioned earlier. We believe it is an important indicator of our future results.

In summary, our success in 2008 is compelling evidence of a key change in the way Americans enjoy their coffee. We are the market leader in a new segment of growth and prospects. The enthusiastic endorsement of consumers lends even further credence to our belief that we will continue to deliver strong sales and profit growth for multiple channels and long-term sustainability and shareholder value.

And now, I will turn the call over to John Whoriskey, Vice President and General Manager of the at-home division of the Keurig business unit. John?

John Whoriskey

Thanks, Larry, and good afternoon everyone. The Keurig segment delivered tremendous top and bottom line growth this past quarter and year. Net sales were up 75% in Q4 and reached $254 million for FY08, up 88% on strong demand for K-Cups and brewers.

Annual system wide K-Cups increased 59% to over $1 billion as you’ll see on slide 10 and total Keurig brewer shipments increased 105% in 2008 over 2007 as you’ll see on slide 11.

Our good better best brewer offering allows consumer a variety of functional choices for their needs and allows us to sell successfully in multiple channels of distribution like department stores, specialty retailers, upscale mass merchants, wholesale clubs, and now supermarkets.

As you’ll see on slide 12, we have increased our distribution from 10,000 retail stores last holiday season to over 13,800 today and have also more than doubled our supermarket stores to over 2,600. Nearly all of these retail outlets offer K-Cups, manufactured by Green Mountain Coffee and our other license roaster brands.

Though we are still expanding distribution, we expect most brewer sales growth to come from existing brewer sales per store in existing stores rather than from the addition of new stores.

As you know, this fall we introduced a new consumer brewer called the Keurig Mini, with a retail price of $79 dollars. Since its launch in August, the initial sell through is meeting our expectation and proving to be a successful addition to our product line as a supplementary brewer.

I would add this new brewer is a great example of our understanding of the marketplace in our engineering ability. We continue to invest in research and development of new concepts to further delight our customers and consumers.

With Thanksgiving just two weeks away, we expect another strong holiday season for Keurig with strong growth over last year. There are a lot of reports now about the uncertainty relative to the strength of consumer spending this coming holiday season. I am pleased to report that so far as we review the latest retail sales data for Keurig brewers during the past few months, we are very happy with year-over-year comp store brewer sales with retailers that share this data with us.

Also, NPD group Dare reported that for the third calendar quarter, Keurig brewer sales were up 90% in dollars and 100% in units. So far, the month of October and first part of November are holding at the same rates of growth in spite of a challenging retail market based on point of sales data from a year ago.

Earlier in the year, we finalized our shipment, advertising, and merchandising plans for the Keurig system with our retail accounts for the upcoming holiday season. Despite a weak retail environment, we have heard from our retail accounts that the single serve category continues to be a bright spot and that trend is anticipated through the holiday season.

We believe that the demographics of our affluent target customers and their very high degree of satisfaction with our products, as well as market trends, are working in our favor even in this environment. As Larry noted, in a difficult economy, the Keurig single serve system now offers consumers better value by brewing their own specialty coffee at home quickly and conveniently.

As you’ll see on slide 13, our retail market share in the single serve category, as measured by NPD group, shows that Keurig was the market leader in dollar and unit share for the third calendar quarter of 2008 for the sixth consecutive quarter.

The NPD group data has Keurig with a 73% dollar market share, up from 48% in the prior year’s comparable quarter. This data also shows Keurig with a 60% unit share in the single serve category versus 33% in the prior year quarter.

Based on NPD data, the Keurig B-50 special edition model for $149 is the number two best-selling coffee maker as measured in dollars in the whole coffee maker category, not just single serve systems.

Further supporting our belief in the coffee brewing revolution, the single serve category is showing consistent growth in dollar sales, up 24% during the past quarter as compared to a year ago, while the total coffee maker category is down 3%.

The single serve dollar share is now 12% of total coffee makers, up from 9.4% last year, or an increase of 28%. Of note, Keurig is now 9% of the total coffee makers in dollars, up 100% from 4.5% last year.

To support accelerated growth and continue to build brand awareness this holiday season, Keurig is investing in its first national TV advertising program. This represents a $6 million dollar investment, doubling our advertising spend over last year. Additionally, when you add in-store demonstrations, retail advertising, and merchandising in Green Mountain efforts, we are providing about $20 million dollars in marketing support beginning this holiday season. This is all summarized on slide 6 of the company presentation that’s on our website.

Looking forward to fiscal 2009, we believe that Keurig will continue to deliver strong growth in sales and profits with further innovation.

Now I’d like to turn the call over to Scott.

R. Scott McCreary

Thank you, John. Today I’ll highlight the fourth quarter results and plans underway to continue growing our Green Mountain Coffee segment.

Net sales for the Green Mountain Coffee segment grew a healthy 38% in the fourth quarter with K-Cup shipments up 67%. Building on the synergy with the Keurig system is our brand strength that distinguishes us from the competition with both the Green Mountain Coffee and Newmans Own Organic’s brands, our coffee is known for excellent quality and continues to score very high in third party coffee ratings.

Our multi-channel distribution model has been and remains a critical advantage in achieving our growth plans. In August, we launched a new compact 12-count K-Cup package designed to expand our supermarket footprint with ten varieties of coffee. We now have 2,600 supermarket locations selling K-Cup portion packs. The latest from IRI reports that K-Cups now have a 33% share of single cup coffee sold in grocery. A number that is particularly impressive when you realize that we are only selling our coffee today in about 10% of this nationwide market.

We expect our share of single cup coffee to continue to expand as we bring our new supermarket customers with the 12-count K-Cups.

The market success of the Keurig brewer and K-Cup is clearly seen in our consumer direct business, which delivered K-Cup sales growth of 75% in the fourth quarter. The café express continuity program recently reached and passed the milestone of 100,000 members. These are customers who enjoy receiving regular shipments of their K-Cups right to their home.

Looking at slide 15, we’ll see our new tagline “a revelation in every cup,” which is part of a broader effort to strengthen our brand positioning through a campaign now being rolled out online in our catalog, on our cups, and in other communications. This new creative campaign in a unique way highlights exactly what consumers look for in a Green Mountain Coffee experience. A moment to reflect, we gain perspective and focus on what really matters.

This creative platform, which reinforces our leadership position in coffee quality and social responsibility, will be used in regional radio, newspaper, and out-of-home ads as we head into the holiday season with a strong call to action for the Keurig consumer.

Our anticipated acquisition of Tully’s coffee will enable us to accelerate our geographic expansion plans in the west.

In addition to the supermarket channel, we expect Tully’s will deliver incremental growth in the OCS and food service segment. The Tully’s brand has a loyal and enthusiastic consumer following and we plan to leverage the combined value of our brands to accelerate our growth, especially in western regions of the country.

In addition to our high sales growth, I’m proud of our success in managing costs and bringing that growth as a company to the bottom line. As a part of that success, an area of focus for Green Mountain Coffee is managing Green coffee costs. Coffee is the single largest expense we have comprising about 20% of our cost of sales.

Over the past four years, we’ve seen the price of commodity coffee almost double. While we don’t purchase this grade of coffee, it does translate to higher coffee costs for us. In light of the volatility in the market and to provide a greater degree of certainty in our planning, our practice is to purchase about six months of Green coffee which allows us time to appropriately respond to market dynamics.

We anticipate that for fiscal 2009, our coffee cost will be similar to fiscal 2008.

Our readiness efforts to meet our high growth in fiscal 2008 and 2009 have included investing in K-Cup production lines in Essex, Vermont and our new Knoxville, Tennessee manufacturing and distribution facility. Knoxville was producing K-Cups just six weeks after we bought the plant. This increase capacity also provides us with a high degree of flexibility to support our projected growth over the next several years as well as create opportunity for longer-term efficiency gains.

In summary, our success this past year was driven by the success of the Keurig single cup brewing system and enhanced by our ability to innovate and continued emphasis on outstanding customer service as well as great coffee. The synergy between Keurig and Green Mountain Coffee continues to drive growth while strengthening our market and brand development and giving Green Mountain Coffee a distinct competitive advantage.

With these results and prospects, it certainly is an exciting time to be here, and now I’ll turn the call back over to Fran to tell you more about the numbers.

Frances Rathke

Thanks, Scott. We have delivered 24 consecutive quarters of double digit net sales growth and K-Cup growth. Since the acquisition of Keurig in June 2006, we have accelerated our top line growth with this quarter making the ninth consecutive quarter with net sales growth in excess of 39%.

Reinforcing what Larry had said, our growth in sales in earnings would be impressive anyway, but in today’s difficult business environment, it is even more noteworthy. When combined with the strength of our balance sheet, even further strengthened by paying down approximately $15 million of outstanding debt on our credit facility just after the quarter closed upon the receipt of settlement of the Kraft patent litigation fund, we are in a very strong position enjoyed by few companies today.

In the interest of time, I will repeat very little of the information contained in the press release we issued earlier today, which is available on our website.

Net sales for our fourth quarter were up 45% over the last year. Keurig segment net sales were up 75% and Green Mountain Coffee segment net sales were up 38%.

Please look at slides 3-5 for these and more financial highlights.

In addition to strong volume growth, each segment net sales benefited from a price increase. About 10% of the increase in our Green Mountain Coffee segment net sales was attributed to price increased.

Keurig announced a royalty rate of a penny on all system wide K-Cup portion packs that went into effect on August 1. This increase contributed to about 4% of an increase in Keurig’s segment net sales over the prior year. Factoring in both segments’ price in changes helped increase consolidated net sales in the fourth quarter by about 6% over the prior year quarter.

Looking more closely at Keurig, just about half of the increase in Keurig sales this past quarter was due to higher K-Cup sales in the retail channel and on Keurig.com. In today’s difficult business environment, the away-from-home brewer sales were essentially flat in light of the downturn in the economy as well as the prior tougher year-over-year comparisons as we introduced a new line of office foods in fiscal 2007. It was, however, more than offset by an 85% increase in at-home brewer sales this past quarter, which represented another quarter of the total increase.

The additional quarter of the increase in net sales came from the increase in royalty income from the sales of K-Cups.

Our growth margin for the fourth quarter 2008 decreased to 34.4% f net sales as compared to 35.3% during last year’s fourth quarter. The reason for the change were detailed in the press release, so I won’t repeat them here. Both the business segments, Green Mountain Coffee and Keurig, did an exceptional job in actively managing SG&A costs while supporting increased demand, which enabled us to deliver improved operating margins and our strong earnings growth.

This improvement was achieved, even though as planned the company incurred litigation expenses of approximately a million dollars or $0.02 per share this past quarter. These expenses were related to the patent infringement filed against Kraft.

Interest expense was $1.3 million in the fourth fiscal quarter of 2008 and 2007 with an average boarding rate of 4.9% at the end of the fourth quarter 2008, down from the 6.7% in the prior year period.

Net income was $7.1 million in the fourth quarter of 2008, an impressive increase of 99% over last year.

Net income per diluted share was $0.28 in the fourth quarter of 2008, as compared to $0.14 in the fourth quarter of 2007, and was higher than our previous guidance of $0.19 to $0.20 per share.

Inventories increased as planned by 119% to $85.3 million at September 27, 2008 from $38.9 million at September 29, 2007, in order to meet expected strong holiday sales of at-home Keurig brewers and K-Cups.

We anticipate selling more than double the amount of at-home Keurig brewers and K-Cups during this holiday season in retail stores and the supermarket channel is now also a significant factor in brewer sales.

In addition, the product line of at-home Keurig brewers has been expanded to include the new Keurig amenity in other models contributing to the build in inventory.

Overall, we are extremely pleased with our financial standing and performance.

I will now review our fiscal 2009 financial guidance. Please keep in mind that my remarks and the information contained in the press release and today’s slides are based on current expectations and our belief that we can achieve such growth despite what we expect will be a difficult economic environment for some time to come.

Keeping caveat about uncertainty in mind, for full year fiscal 200, we expect total consolidated net sales growth of 40 to 45%. We anticipate total K-Cups shipped system wide by all Keurig licensed roasters to increase in the range of 50 to 60% for fiscal 2009, as Larry has said.

We expect to achieve a consolidated operating margin in the range of 8.5% to 9.3%, including the $4.8 million or $0.11 per diluted share for non-cash amortization expenses related to the identifiable intangible and excluding the pre-tax $17 million Kraft patent litigation settlement.

As a result of these expectations, we believe we can grow earnings in 2009 at a rate similar t or slightly higher than our sales.

We anticipate fully GAAP earnings per share in the range of $1.58 to $1.68 per share as detailed in our press release.

As announced earlier, the company intends to acquire the assets of Tully’s coffee brand and wholesale business from Tully’s coffee corporation for $40.3 million, subject to adjustment at closing. The company will finance the cash purchase through its existing $225 million dollar senior revolving credit facility and has received the required bank consent.

This transaction is subject to customer closing conditions, including approval by Tully shareholders and is expected to close in the next few months.

We anticipate the acquisition will be neutral to modestly accretive to our earnings for the first 12 months of ownership following the close of the transaction and accretive thereafter.

We estimate the capital expenditures for fiscal 2009 will be in the range of $50 to $57 million primarily related to add roasting and K-Cup packaging to our new Tennessee facility.

For the fiscal first quarter of 2009, we expect total consolidated net sales of 45 to 55%.

We anticipate an operating margin in the range of 3.7% to 4.5%, excluding the pre-tax $17 million patent litigation settlement.

The company anticipates selling marketing expenses as a percentage of net sales during the first quarter of fiscal 2009 to be about the same as a year ago.

Operating margins are expected to be less than a year ago, due to the planned increase in net sales of at-home single serve Keurig brewers with no contribution to gross margins.

We anticipate fully GAAP earnings per share in the range of $0.48 to $0.52 per share. This includes the non-cash amortization expenses related to identifiable intangibles that are estimated to reduce EPS by $0.03 per share and including the pre-tax $17 million or $0.38 per share patent litigation settlement. Excluding the Kraft litigation settlement, we anticipate fully diluted non- EPS in the range of $0.10 to $0.14 per share. Other factors including interest expense, tax rate, annual depreciation and amortization are contained in today’s press release.

Please keep in mind that these and any other forward-looking statements involve very real uncertainty and risk.

And now, I will turn the call back over to Larry.

Larry Blanford

Thanks, Fran. Before we start Q&A, I am delighted to welcome Michelle Stacy to our management team and introduce her to all of you. Michelle joined us last week as President of Keurig and is a graduate of Dartmouth and the Kellogg School of Management at Northwestern University. She has an impressive track record of success and organizational leadership in leveraging compelling brand opportunities with companies such as Gillette and Proctor and Gamble. Her depth of experience with and understanding of consumer packaged goods and technology oriented products with a razor blade business model is perfectly suited to our strong platform for growth at Green Mountain Coffee Roasters.

Michelle?

Michelle Stacy

Thank you, Larry. I am so impressed with the caliber of people and the unique growth prospects of this razor blade business. I look forward to our next earning call in reporting to you on what a fantastic holiday we’ve had selling the current system. Now back to Larry.

Larry Blanford

Thank you, Michelle, and welcome again.

Fran, John, Scott, Michelle, and I are joined today by T.J. Whalen, Vice President of Marketing and Jim Travis, Vice President of Sales at our Green Mountain Coffee business unit, and from our Keurig business unit, Dave Manly, Vice President of Marketing. We will now start the question queue.

Question-and-Answer Session

Operator

(Operator Instructions) First up, we have Bill Chappell with SunTrust.

Bill Chappell, Jr. - SunTrust Robinson Humphrey

First, a little clarification on your coffee costs being roughly the same in 09 versus 08. Is that just timing of hedges where the first half of the year they’ll be a lot higher than they were first half of last year and then second half a lot lower?

R. Scott McCreary

You have that pictured exactly correct. In fiscal 2008, we had lower coffee costs in quarter one and two and then we saw a tremendous increase in back half of the year and then with forward buy that we’ve done, we didn’t buy at the highest point, so we leveled off some of those peaks, but we will see higher costs in Q1 and Q2 and see it come down in the back half of the year.

Bill Chappell, Jr. - SunTrust Robinson Humphrey

What is the average price you’re looking at at least on a forward hedge?

Larry Blanford

On a forward hedge, basing it off of the C price, it’s around $1.45.

Bill Chappell, Jr. - SunTrust Robinson Humphrey

On the Tully’s acquisition, just trying to understand it, is there anything in terms of new distribution or expanding the Keurig placement on the west coast you can do before that deal closes or is it more of wait until the deal closes?

Larry Blanford

The Tully’s pending acquisition must wait until the deal closes before we can actually begin to generate any synergy of the acquisition. Prior to the deal closing though, we certainly can be doing planning both internally and with members of their team to a degree.

So we are doing that and positioning ourselves such that when the acquisition does close, we can be ready to go.

Bill Chappell, Jr. - SunTrust Robinson Humphrey

Just a follow up there, just trying to understand the timing of getting to new grocery accounts, is that typically a first of a new year type time frame? Is that when we should see additional stores flow in?

Jim Travis

We are looking for some early decisions, hopefully first part of the calendar year. We’re a little bit at the mercy of some of these large customers as we work around their cycles, but I would think beginning kind of in the March timeline by the time we get the products lined up in the way we’re thinking about Keurig in grocery and other package opportunities. By June, so between March and June of fiscal 09, we would certainly be looking at expanding very quickly.

Bill Chappell, Jr. - SunTrust Robinson Humphrey

Last on. On the tax rate, Fran, that was a little bit higher for 09 than I was expecting. Anything into that?

Frances Rathke

The reason it’s higher than what we had this year is right now we’re not positive that the R&D tax credit will be continued to be enacted by congress for the whole fiscal 09.

Operator

Next up we have a question from Nicole Miller Regan at Piper Jaffray.

Nicole Miller Regan - Piper Jaffray

I’m a little confused by the coffee costs. I would have thought the exact opposite. If you’re saying $1.45 for most of 09, I thought you guys had previously somewhere said you’re working towards $1.35 into the first fiscal quarter of 09. So then it seems like you’d have lower costs in the first half and higher in the back half.

R. Scott McCreary

Through the summer months, I’ll back up a little bit, through the spring, when we saw $1.60 and $1.70, our forward buying strategy did allow us to pause and not buy coffee during that time period, but we continued on about this six month forward buy strategy to give us time to read the market and see how it was going to attract. So in the summer months as the coffee was coming down into the $1.40’s, we did continue to buy and so that’s what we have bought out for Q1 and part of Q2. Then what I was referencing in terms of later in the year, right now we see the coffee market coming down and if that stays low like that, we’ll see some opportunities later in the year.

Nicole Miller Regan - Piper Jaffray

The CapEx, Fran, of $50 to $57 million, does that include Tully’s or not?

Frances Rathke

No it does not. Tully’s is $40 million. The CapEx, a significant amount of that is due to the planned expansion of the Tennessee facility getting roasting in there, getting additional packaging lines in. That’s the big ticket items and the range.

Larry Blanford

Nicole, that Tennessee facility is just really a fantastic facility and if I might just have Jon Wettstein comment on how quickly we’ve been able to get that up and running.

Jon Wettstein

Thanks, Larry. We were able to close on the property on August 1 and were in business producing after some equipment installation, infrastructure, and some hiring actually producing K-Cups at the end of September. So it was really a record for us in terms of getting all the elements of the start up moving. We’ll continue that to be ready for the volumes particularly as we head into fiscal year 2010, that plan will be the supply for the bulk of our growth going forward.

Nicole Miller Regan - Piper Jaffray

And how is that plant impacting margin?

Frances Rathke

For the quarter we just reported on, essentially it didn’t really impact the margin at all, because we were putting CapEx into it and it really wasn’t manufacturing when we had just started adding people there. So for 09 in our guidance, we do have a cost in the estimate that are bringing down the margin somewhat for the Green Mountain Coffee segment, because of the need to get it started, you know, start up the plan essentially in fiscal 09.

Larry Blanford

I think it’s important to note that we have really demonstrated I think tremendous capability at bringing our manufacturing facilities up quickly as Jon noted-and then driving them to where they are operating efficiently. So as an example, the Essex facility, we bought up about a year ago and I believe that as we look forward into new fiscal, the cost coming out of Essex will approach that of Waterbury. Is that correct, Jon?

Jon Wettstein

That sure is, Larry. We’ll see reductions as we produce close to the billion K-Cups in Vermont and then we’ll bring those techniques built around the spirit of continuous process improvement and incrementally adding capital as we grow the business so that we don’t find ourselves in a position where we had to make huge increments to support a lesser increase in sales.

Larry Blanford

So just a little over a year, the Essex facility is now producing competitively to Waterbury. I think it’s just a great tribute to all of our members of our team both at Waterbury and at Essex to make that happen and I have high expectations for our facility in Tennessee as well. By the way, that was also in my view just a great buy that we were able to pick that facility up, 334,000 square feet, doubling our overall manufacturing footprint for roughly $10.5 million dollars as we acquired it.

So really, one of those enabling moves I spoke of earlier, that’s really going to pay great dividends as we go forward.

Nicole Miller Regan - Piper Jaffray

Fran, the $17 million, that’s net of any lawyer or other fees?

Frances Rathke

The $17 million does not include the legal fees that we’ve incurred. Those are separate. We had taken those through the P&L and the $17 million is the amount we received as a settlement. The litigation expenses had been in the G&A line over the last quarter and then the $17 million comes into Q1 on a separate line, but essentially we don’t really have that much more in terms of any litigation expense in Q1.

Nicole Miller Regan - Piper Jaffray

And the coffee pounds by segment?

Frances Rathke

We do anticipate that we’re going to be providing just the total pound at the Green Mountain Coffee segment, not by those external channels, because so much of our business has really shifted to dollars of K-Cups and it’s not as significant, the pound.

Larry Blanford

If you add up our Keurig sales and that portion of the Green Mountain Coffee business unit sales of K-Cups, you start getting into the two-thirds to maybe 70% of our total sales that are in someway related to single serve and that clearly is driving the business. So pounds become less important.

Nicole Miller Regan - Piper Jaffray

My final question, I did not catch the comment about current trends. It was something about for some period of weeks, up 90% dollar or 100% units in current trends are the exact same thing? That just went too quickly for me. Can you go over that again?

John Whoriskey

What we are seeing are the trends that continue through the month of October and into November. So the 90% in dollars and 100% in units, it’s continuing into the month of October and first couple weeks in November.

Nicole Miller Regan - Piper Jaffray

And what was the 90%. What was the timeframe of that?

John Whoriskey

What we’re saying is the trends that we reported for the calendar quarter, those trends are continuing into the months of October and November, beyond the quarter we’re reporting to you.

Larry Blanford

John, you might want to just touch on the advertising campaign that’s supporting that.

John Whoriskey

We will add, thanks Larry, that we just started running our $6 million national advertising campaign as of last week and the primary focus of the campaign is to drive a win of the new way to brew coffee at home, which is the next revolution, which is what Keurig is all about, and being the category leader, we are out there generating and driving a win is now in addition to all the other things that you’ll see at retail. It’s all part and possible to really being the leader and driving the category.

Operator

We’ll take the question from Mark Astrachan - Stifel Nicolaus & Company, Inc.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

Just a clarification on the trends. Those are your actual sales or NPD data at retail?

John Whoriskey

We quoted our NPD results through the reporting quarter of the third calendar quarter and in addition to that we have weekly data from all our key retail partners that would mirror those results through the month of October and November.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

Sales at retail basically?

John Whoriskey

I would simply add that single serve and Keurig single serve since we are the dominant leader here, our trends have been the same all year long through this challenging market. The retail market has not been stellar performing all year, yet we have been that bright spot and that’s continuing to be the case, even as we head into this holiday season.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

In terms of brewer sales, can you tell us how many Keurig Minis you sold in the quarter of that 294,000 that was the at-home. I’m assuming the Keurig Mini is in the at-home segment?

Larry Blanford

As a matter of protecting our information from a competitive advantage standpoint, we don’t break out our brewer sales by specific platform, but I can say that the Keurig Mini, we have introduced it, is with only five or six key retailers. I’m looking at John here, and really in one sense a test for us. We wanted to introduce that brewer, really understand who is buying it, how they’re using it, what the consumption rate of K-Cup per brewer per day would be, and then think about how we continue to leverage that going forward.

What we can tell you is in the retailers that are carrying the product today, those sales are incremental to our core brewer lineup. We’re very excited about it.

John Whoriskey

I would just add, Mark, that today is not a significant share of the results that we’re talking about and don’t suspect that to be a significant share for the short-term. So we shouldn’t be thinking that $79 brewer is what Keurig is all about. Our number one selling product is $149 special edition product, which is the number two best-selling coffee maker of all coffee makers and we view that system, those higher price points, as being the driving product as we go forward and that’s how we’re positioning it and we should remember that’s the product we want on a kitchen counter. The mini brewer is a supplemental brewer that can be used in a dorm room, somebody’s desk in an office, etcetera. That’s how the product is positioned today and we’re watching that very closely to make sure that’s how we see it being used.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

Fran, from a Kraft litigation standpoint, how much are we going to see in the fiscal first quarter or is that basically done at this point?

Frances Rathke

The $17 million is going to be booked all in our fiscal Q1.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

I’m talking about your legal expenses.

Frances Rathke

We will have some legal expenses in the month of October as we work on the negotiations in wrapping that up, but then it will be essentially over.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

When did the expenses begin. I know you didn’t break out the actual amount of expenses before it became meaningful? When was approximate start date for that and what do you think you’ve spent in total?

Frances Rathke

For fiscal 2008, we spent around $3 to $3.3 million in the P&L for 08. I will have to go back and look at 07, but I don’t think it’s material. I think we filed suit in January of 07, which is our second quarter and I don’t think it was material.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

Finally, I think you had talked about doing a survey or reexamining what your views on the obsolescent rates were in the last quarter earnings call. Any updates on what your findings were?

John Whoriskey

Minimal expense.

Mark Astrachan - Stifel Nicolaus & Company, Inc.

In terms of what the obsolescence rate looks like on a go-forward basis. The usage rate per brewer?

John Whoriskey

We do twice a year survey to our install base all the way back to the first brewers that were sold to consumers to measure that falloff rate or obsolescence rate if you want to call it that and I would say that the most recent results that we have seen mirror what we assume in our modeling, which is a 10% falloff each year of use.

Frances Rathke

I think the 10% essentially is related to the lifecycle. As part of the survey work, in addition, is to your question about consumption patterns. John and his team do survey frequently and reach out to consumers to understand their consumption patterns and behavior and that continues to hold at the 2 to 2 and a half K-Cups a day on a home unit and about 10 to 15 on the away-from-home.

Dave Manly

I can tell you that we also survey our distributors and our end users for our away-from-home brewers. We’re constantly amazed that the utilization of our brewers is generally over 90%, even going back to the original brewers we shipped back in 1998 and as we look at each brewer in each platform and what are K-Cup expectations are per brewer, they hold up every time we survey. So there’s very little change as well in away-from-home.

Operator

We will move on to Scott Van Winkle at Canaccord Adams.

Scott Van Winkle - Canaccord Adams

Did I hear that you don’t expect any gross profit contribution from brewers in the quarter and I know it was low. I figured less than 10% last year. Is that consistent with what it has been historically, the lack of gross margin on brewers?

Frances Rathke

Yes, the at-home brewer margins typically have been low. I think during fiscal 08 they’ve come down a bit due to cost input. Primarily this quarter they were a little bit lower than what we had to the three quarters of fiscal 08 primarily as I said due to some of the key components in the brewers that have gone up like the seal on some of the components.

Larry Blanford

It’s very important obviously in our razor/razor blade model that we drive at-home brewers and we are attempting to maintain momentum at retail and we’ve been operating at some key price points that we feel are important and in addition wanted to carry those into the holiday season, which we are doing. The $99, the $149, and the $199 price points, and we think that’s very important.

To help offset those brewer margins, however, the Keurig team has done a great job of building an accessory business, which is throwing off some nice margin, which helps to offset some of the declining brewer margins as we’ve held prices on brewers and experienced some cost price increases on materials and parts.

Scott Van Winkle - Canaccord Adams

A question for John, talking about the Mini being incremental sales when it’s placed in a half dozen retailers, what happens to total sales when you got maybe four SKUs? I’ve obviously been in a lot of stores and some of these displays carry almost every product you have, like in Bloomingdales in particular. Is it additive, I mean when there’s four or five different products on the shelves there, keep compounding. I’m wondering if the shelf space is driving the sales more so than you would think.

John Whoriskey

I think it’s a combination of all those things, but as we analyze retail movement by retail or by product in that store, we are feeling today that that is incremental. Now as we add additional brewers going forward, will they always be at the same incremental rate? Maybe not. But again, it’s still early. We’ve only been out really for a few weeks with the product, but we are very pleased with what we’re seeing so far and we should also remember that the Mini again is a supplemental product. It is the second brewer to have in your vacation home or maybe your office desk and so on. So there are consumer current Keurig users that have one on the kitchen counter that are now going to have one in the second location.

So again, it’s very careful how the product is positioned and how it’s going to be used.

Larry Blanford

As we think about the brewer sales and K-Cup sales in addition to retail, which certainly is booming as John had indicated. We’ve got a very important introduction in supermarkets and I thought maybe Jim Travis could just quickly comment on that.

Jim Travis

The addition of brewers at grocery obviously is one of those things that we’re really excited about here. Having the brewers as well as the K-Cups to sell has really proven beyond my expectations personally to be something that customers are really interested. In fact, the majority of the customers we have, 2,600 grocery stores today. The majority of those stores have brewers also displayed in the stores with K-Cups and so as we go out and we start thinking about launching nationally with Tully’s and other brands supporting these brewer sales, it’s really a good story to tell new customers that these things work well together in grocery as well as the retail story.

Scott Van Winkle - Canaccord Adams

To that point, when I looked on the website after your announcement a couple of days ago, I saw a lot more west coast grocery store retailers than I expected and I’m wondering what brand leads? What coffee brand leads in those stores on the west coast when it’s doing a combination with brewers? Is it Newmans Own, something purchased by Green Mountain, or is it another brand?

Jim Travis

The west coast we got Luckies, we now have Meijer in the Midwest. Meijer has probably been the biggest in terms of the biggest name success, because they also took the brewer, but they are also stocking Caribou, which is a big Midwest brand. So we anticipate as we go out with Tully’s eventually in the west, which is already a great brand name in Safeway and Kroger on the west coast. Then we had the fill in of Newmans across the whole country, a well recognized grocery brand already in packaged coffee, and then we have Caribou to fill in the Midwest, especially in the upper Midwest and Chicago, Michigan, and Minnesota, we feel like we’ve really got a well-rounded brand offering, portfolio offering, to take to these grocery customers nationally and that’s really starting to get a lot more traction as we start talking to these more national customers.

Larry Blanford

Just to clarify, we have a bit different licensing arrangement with Caribou and the Green Mountain business unit represents the Caribou K-Cups to supermarket as well. So to Jim’s point, as we go national with a supermarket program, we basically have a four-brand set – Green Mountain Coffee, Newmans Own, we will have Tully’s after the acquisition closes, and Caribou. So it’s a real solid supermarket program with brewers and the new 12-count compact box, which was designed specifically for grocery shelves.

Scott Van Winkle - Canaccord Adams

Jim, what happens to bad coffee, under the same brand, when you put a brewer and K-Cups in it? Is it just incremental, because different customers buy that brewer, or the Green Mountain bag customers trading up to the brewer, which obviously would be a good thing?

Jim Travis

We’re seeing most of the growth obviously, the dollar growth in K-Cups, Scott. The interesting phenomena about bad coffee is we’re seeing the migration from bulk coffee to packaged coffee and we’re still seeing a very strong package coffee business really across the whole base. A lot of the consumers that may have purchased Folgers and Maxwell House in the past are maybe moving up into premium specialty coffee. It is a high switch category. Specialty coffee is a, you know, I’m not sure it’s loyal across the country. It’s certainly more loyal in the northeast for us, but then we have this whole another segment, single cup coffee, and we’re already 33% of the market share with only 10% of the ACV. So that’s the really encouraging part as we go out and talk to retailers today is building on the solid opportunity to move consumers up the ladder, if you will, from bulk to packaged and ultimately to single cup.

Larry Blanford

If I could have TJ maybe just add to that in terms of after the Tully’s acquisition closes, our thoughts, and then using that Tully’s brand not only in K-Cups, but packaged coffee east and west.

T.J. Whalen

So obviously what you’re hearing here is a regional mix approach that is tailored to the consumption preferences in those geographies. Coming back to your earlier question, so both in bag and K-Cups, we would expect Tully’s to lead in the west and Green Mountain to lead in the east and for Newmans Own Organic’s and Caribou to play appropriate roles in their respective regions. Beyond grocery, we expect to bring the Tully’s brand more fully into consumer direct. That’s an area where we had deep competencies and we’ve been honing those skills over many years here and we believe that we can do quite a bit with the continuity program that we have called Café Express, over 100,000 members in that program with a strong catalog business that supports both acquisition and retention. So you can envision those types of programs tailored geographically with a new portfolio of brands to deepen our penetration.

Scott Van Winkle - Canaccord Adams

It was mentioned, I think Jim just mentioned it again, that the 33% share of single cup coffee and grocery and 10% penetration. You know, I heard that in the prepared remarks and I didn’t quite understand, who has the two-thirds share? You have basically two-thirds share or more than that of brewers, but only one-third share of grocery. Who’s distributing a much higher percentage in grocery?

Jim Travis

The legacy distribution out there of pods is really the lion share of that, but it’s declining in double digits. The other smaller fraction of that is the Passimo business that primarily have through customers like Target. We’re not seeing a lot of Passimo at grocery and then of course our K-Cup growth in grocery is triple digits. It’s fast-paced growth. So we’re seeing this pie chart, this third, third, third. It’s really pods are the majority of it, a small slice of Passimo, and then this really fast-growing segment of Keurig K-Cups.

Scott Van Winkle - Canaccord Adams

One more question. There’s some comments in the prepared remarks about the office coffee channel. I’m wondering if you can give us any comments you’re hearing generally from office coffee distributors and cyclical exposure to the economy. You know, beyond just brewer sales, which might be affected by last year’s launches. I’m thinking more of the recurrent coffee sales into the office channel.

Dave Manly

The first thing I would say is we’re very pleased about the fiscal year we had where we shipped 57,000, with a 75% increase versus a year ago. Clearly though, as you look at the fourth quarter, we started to see some belt tightening out there in the marketplace and this belt tightening continues. I would say though that we are not seeing any Keurig brewers that are being removed from the offices or any reduction in K-Cup volume. In fact, we think that we’ll be able to grow our business going forward during the fiscal year 09. We have not budgeted 75% growth for our OCS business. We budged something less than that and we’re cautiously optimistic that we will continue to grow it. In fact, at the end of this month, we’ll be introducing a brand new brewer. We’re calling it the Office Pro Brewer, which is targeted against small offices that we’ll be marketing direct or with our distribution channel. We’ll be taking some of our own, you know, putting our hands in our own destiny.

So we’re excited about the OCS business, but clearly we are watching it closely, but we don’t see any major cut-backs at this time.

Operator

Ladies and gentlemen, thanks very much for your participation in the question-and-answer session. We have reached the time limit for Q&A. I would like to turn things back over to Larry Blanford for any additional or closing remarks today.

Lawrence Blanford

Well thank you very much, everyone. It’s really been a pleasure to talk to all of you today about our past quarter and year and our plans going forward. Remember, that the Keurig brewer can make the perfect holiday gift this year and now with the new Keurig Mini, it’s also a great gift for that special college student in your life, or perhaps a second brewer for your own home office. K-Cups make great stocking stuffers too. So pardon the commercial, but we are very enthusiastic about what we do.

So we appreciate your interest in the company and thank you for joining us.

Operator

Ladies and gentlemen, that will conclude the conference call. Thank you once more for your participation. Have a good day.

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Source: Green Mountain Coffee Roasters, Inc. F4Q08 (Qtr End 9/27/08) Earnings Call Transcript
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