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

F2Q09 Earnings Call

April 29, 2009 5:00 pm ET

Executives

Francis Rathke – Chief Financial Officer

Lawrence Blanford – President, Chief Executive Officer

Michelle Stacy – President of Keurig

Scott McCreary – Chief Operating Officer

John Whoriskey – General Manager, Keurig

Jim Travis – Vice President Sales

T. J. Whalen – Vice President Marketing

Analysts

William Chappell – SunTrust

Alton Stump – Longbow Research

Mark Astrachan – Stifel Nicolaus

Jon Anderson – William Blair

Scott Van Winkle – Canaccord Adams

[Lana – Manchester Management]

Mitch Pinheiro – Janney, Montgomery Scott

Operator

Welcome to the Green Mountain Coffee's fiscal 2009 second quarter financial results conference. Please keep in mind that today's call is being recorded. At this time for opening remarks and introductions, I would like to turn the conference over to the Chief Financial Officer, Miss Fran Rathke.

Francis Rathke

Welcome everyone. If you have not received the earnings release it is on our website at www.gmcr.com. Also on our website are slides that summarize much of the information on this 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 the Securities laws. Owing to the uncertainties of forward-looking statements, our actual results may differ materially from anything projected in these forward-looking statements.

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 and 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'd like to turn the call over to our President and CEO, Larry Blanford.

Lawrence Blanford

Joining Fran and me with prepared remarks on this call today are Michelle Stacy, President of our Keurig business unit and Scott McCreary, Chief Operating Officer of our Specialty Coffee business unit. After our remarks, our management team will be available to respond to your questions.

It is exciting to be sharing with you today truly outstanding results for our second fiscal quarter both in terms of the financial measures and execution of key initiatives. This quarter continues a string of excellent performance, making it the eleventh consecutive quarter with overall top line growth of at least 39%.

Our earnings per share of $0.50 in the quarter increased an impressive 113% from last year. Also impressive were our second quarter sales which were up 60%. This growth was led by a 62% increase of total K-Cup portion packs shipped system wide by all Keurig licensed roasters.

Importantly, strong Keurig sales of 148% versus prior year bolster our confidence in our single serve razor blade business model. We believe these strong brewer sales are largely due to increasing consumer awareness of and interest in the convenience, quality and value represented by the Keurig single cup system.

Our success positions GMCR as the leader in the early revolution of how consumers in over 100 million North American households prepare and enjoy their coffee.

As I have stated previously, our overall strategic plan is to deliver strong sales growth and improve our operating earnings for long term sustainability and shareholder value. Our plan over the next few years is primarily about driving future system wide K-Cup portion pack growth at rates similar to those we have experienced recently.

To do so, we continue to work proactively on initiatives that we believe will enable us to succeed. Since the first quarter, we have executed three new and significant enabling initiatives. First, we completed the $40.3 million acquisition of the Tully's coffee brand and wholesale business on the last Friday of our second fiscal quarter.

This acquisition is a great strategic fit for GMCR as Tully's is a complimentary west coast brand known for its dark roasted coffees with packaged products already distributed in over 5,000 supermarket locations. Scott will be talking more about the integration process.

The addition of Tully's to the GMCR brands will help accelerate our geographic expansion with a national brand platform and distribution. We anticipate the addition of Tully's will provide an expanded and complimentary specialty coffee brand portfolio in all package types and will help the GMCR enterprise drive Keurig single cup system awareness and penetration throughout North America.

Second, we have begun distributing Keurig's gourmet single cup coffee brewers and patented K-Cup portion packs in over 3,000 Wal Mart stores in time for the gift giving spring season including Mother's Day, Father's Day and graduations.

Having Wal Mart, the nation's largest retailer as a GMCR customer continues to reinforce the growth of the Keurig brewing revolution going on across the country. We are vey excited to announce this news as Wal Mart significantly expands our growing list of locations where consumers can buy our Keurig brewers and line of coffees in K-Cup portion packs, including Green Mountain, Newman's Organics and Tully's specialty coffee brands.

And third, we launched a test market of Cafe Escapes, a new line of K-Cups focused on coffee house specialty beverages. We also just communicated to customers the planned early summer availability of Celestial Seasonings perfect iced tea in K-Cups where the tea is brewed over ice using the Keurig brewer.

Products such as these give us a clear opportunity to catch consumer interest, expand brewer sales and increase K-Cup usage per brewer per day.

Revisiting a fall initiative, the introduction of the Keurig Mini, we have learned from early consumer purchase and use date that about 75% of consumers use the Keurig Mini as their primary brewer with similar K-Cup consumption rates per day as our main line of at home brewers.

This insight is significant and the data is one of several factors leading us to increase our 2009 growth estimate for total K-Cup portion packs shipped system wide. We now estimate growth of 60% to 65% up from estimates of 53% to 63%.

In the near term, we see continued opportunity to increase our distribution of both cured brewers and K-Cups. As shown on Slide 12, the addition of Wal Mart now brings our retail locations to 16,800. Our goal over the next couple of years is to increase our number of retail locations to over 20,000 and our grocery store locations to over 15,000.

As we accomplish this goal, we will have gone a long way in strengthening our ability to take full advantage of the revolution of in home coffee preparation, going from percolators to drip to now, single cup brewing.

Against this backdrop, GMCR also continues to distinguish itself in a highly competitive market place by working to be a socially and environmentally responsible corporate citizen. Using financial incentives from the State of Vermont and a local utility, we are building a 100 kilowatt solar array on top of our distribution center in Waterbury as a clean energy demonstration project.

Last week, we also announced five year grants to four non profit organizations to support their climate change work in four specific areas; threats to coffee growing communities, transportation related to missions, building political will and empowering individual action. The grants are part of Changing Climate Change, our company wide initiative that also includes operational programs, employee incentives to reduce carbon emissions and the purchase of carbon offsets.

In summary, despite a challenging economy, GMCR delivered outstanding results in the second quarter following the strong holiday season in our first quarter. Looking forward, we are focused on continuing to deliver strong sales and EPS growth to ensure long term sustainability and shareholder value.

Due to our stronger than anticipated performance this past quarter and due to the completion of the Tully's acquisition, we are raising our fiscal 2009 top and bottom line estimates as Fran will detail.

Over the past three decades, GMCR's multi-channel distribution model has been invaluable in buffering the ups and downs of economic cycles. Indeed, this growth strategy combined with our excellent coffee quality, superior customer service and our commitment to both innovation and corporate social responsibility gives GMCR a distinct competitive advantage that is delivering value to coffee lovers, our stock holders and our employees.

Now I'd like to turn the call back over to Fran.

Frances Rathke

In the interests of time, I will keep my comments brief. I do however; want to expand upon several key items in our earnings press release issued earlier this afternoon.

Net sales for our second quarter totaled $193 million, up 60% over last year. Keurig's business unit net sales were up 97% to $120 million and the specialty coffee business unit net sales were up 40% to $113 million. Please look at Slides three through six for these and more financial highlights.

About half of the increase in Keurig business unit sales this past quarter was due to the 129% increase in K-Cup sales to retailers and from Keurig.com. The specialty coffee business units dollar sales growth was strongest in channels that benefit from sales from Keurig K-Cup portion packs.

The company's operating margin this quarter significantly improved to 11.7% from 9.6% during last years second quarter. The operating margin improvement was driven by the lower percent for SG&A. Our operating income increased 95% to $22.6 million.

Net income was up 118% and on a per diluted share basis, increased 113% to $0.50 per share in the second quarter of 2009 as compared to $0.23 in the second quarter of 2008. This was significantly above our previous estimates of $0.33 to $0.37 per share primarily as a result of much stronger than anticipated top line growth.

As we look toward the rest of fiscal 2009, we will need to increase our staffing and manufacturing overhead costs at our new Knoxville plant as well as invest in additional west coast capacity as part of our efforts to integrate Tully's into the specialty coffee business unit.

Our free cash flow was strong, $8 million this quarter. We ended the quarter with debt outstanding of $119 million; up from $90 million at December 27, 2008, reflecting the company's $40.3 million acquisition of Tully's wholesale business and brand on the last Friday of the quarter.

Looking forward, 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 risks and uncertainties including what we expect will be a difficult economic environment for some time to come.

As Larry has already noted, we are raising our estimates for both sales and earnings growth for this fiscal year. These higher expectations for the second half of the year and full year are a result of the stronger than anticipated performance in the first two quarters of fiscal 2009.

Full year fiscal 2009, we now expect total consolidated net sales growth of 58% to 61% including the Tully's acquisition estimated to add 3% to 4% of growth to our top line. We also anticipate that total K-Cup portion packs shipped system wide by all cured licensed roasters will increase in the range of 60% to 65% up from prior estimates of 53% to 63%.

We expect to achieve a consolidated operating margin in the range of 8.6% to 9.0% including $5.3 million or $0.12 per diluted share for non cash amortization expenses related to the identifiable intangibles of both the Keurig and Tully's acquisition, and excluding the pre tax $17 million Kraft litigation settlement that was recorded in the first quarter of fiscal 2009.

For the third and fourth quarters of 2009 as the company integrates Tully's into its specialty coffee business unit and invests in additional west coast capacity, we estimate that this acquisition will be slightly diluted to the company's operating margin and earnings per share.

As we head into fiscal 2010, we estimate the Tully's transaction will be neutral to slightly accretive for the first 12 months of ownership and accretive thereafter.

We anticipate fully diluted GAAP earnings per share in the range of $1.87 to $1.93 per share as detailed in our press release. Excluding the Kraft litigation settlement, we now expect fully diluted non-GAAP EPS in the range of $1.47 to $1.53 per share, up from prior estimates of $1.25 to $135 per share.

Now, for the third fiscal quarter of 2009 we expect total consolidated net sales growth of 61% to 66% including the Tully's acquisition estimated to add 7% of growth to our top line. Also for Q3, we anticipate an operating margin in the range of 9.4% to 9.9% including non cash amortization expenses for identifiable intangibles of $1.5 million.

The fiscal third quarter operating margin estimates decrease from this quarter's margin of 11.7%. This is due to two factors; increased investment in capacity at Knoxville in Seattle and integration costs related to Tully's wholesale business both of which contribute to anticipated cost of sales as a percentage of net sales.

We estimated that fully diluted GAAP earnings per share for the third quarter will be in the range of $0.38 to $0.40 per share including the non cash amortization expenses of $0.04 per share.

We have increased our estimated fiscal 2009 CapEx to be in the range of $55 million to $60 million from prior estimates of $50 million to $57 million primarily related to adding additional K-Cup packaging lines in our new Tennessee facility earlier than anticipated stemming from the higher K-Cup demand this past quarter.

Other key factors including interest expense, tax rate, annual depreciation and amortization are contained in today's press release.

With respect to fiscal 2010, we intend as we did last year, to provide a first range of estimates for both sales and earnings growth on our next earnings call. And now I would like to turn the call over to Michelle Stacy.

Michelle Stacy

Good afternoon everyone. I am very pleased with Keurig's 97% sales growth this past quarter. The increase was driven primarily by our continued success on cured brewers and K-Cups through the retail channel. We believe that the sales momentum we carried into Q2 was the result of a number of factors including pre Christmas advertising and ongoing retailer advertising support.

Strong consumer demand was also driven by increased in store displays and demonstrations as evidenced by the pictures on Slide 15. The strength of the sales momentum and the value of the product demonstrations were both evident during the QVC program that we ran in February. We sold over 44,000 Keurig Mini brewers during a 24 hour period. This was a very successful program that followed our record breaking Christmas program.

This quarter's 148% year over year increase in brewers sold, combined with a 62% increased in system wide K-Cup shipments results in a positive and synergistic group for the company. Retail chains, club stores and supermarkets are satisfying the K-Cup demand created by current consumers. This increased K-Cup demand and the incremental profit opportunities that it represents drives these channels to increase K-Cup distribution and shelf presence.

At the same time as consumers discover the Keurig brewer, and enjoy their first K-Cup either at a friend's home or in an away from home location, they want their own machine. As stores develop fixtures to merchandise K-Cup and brewers in prominent high traffic areas of the store, new consumers are discovering the Keurig system in more and more places which drives increased brand awareness and purchase interest, resulting in retailers leveraging increased brand awareness by adding additional brewers and K-Cup SKU's and more advertising and display support. And the loop continues.

As a result, our prospects for Q3 and Q4 remain very positive as we have strong retail programs planned for the spring gift giving season. Keurig continues to hold a strong leadership position among single cup brewers, but more importantly, is emerging as an increasing significant factor in the overall mainstream coffee maker market place as confirmed by MPD data.

As you will see on Slides 13 and 14, we continue to expand the total coffee maker category in both units and dollars year over year. Our dollar share was up 7.5 point from 6.8% in the year ago quarter to 14.3% this quarter and our unit share more than doubled rising from 2.3% in the prior year quarter to 5.8% this quarter.

These are significant gains. But it is perhaps more important to note that Keurig was the only major brand of coffee makers to post such gains. The total coffee makers sold at retail on a dollar basis, Keurig had the number one best selling coffee makers with three of our brewers in the top five. Clearly, Keurig is increasingly a significant player in coffer maker market place.

The away from home channel remains an important part of our growth strategy as well. Keurig brewers in offices and hotel rooms not only deliver significant revenue in K-Cup usage, they also drive our at home business because they demonstrate the Keurig system to new consumers. The use of Keurig business in offices continues to increase despite the downturn in the economy.

In summary, our second quarter was outstanding. The Keurig brand has significant momentum that we believe will propel increased household penetration over the upcoming months with the support of strong programs during the spring gift giving season.

Finally our distribution Wal Mart and our plan to continue expanding K-Cup distribution should increase our brand presence. We are confident that the Keurig system is here to stay and has a very promising future.

And now I will [audio break]

Scott McCreary

[audio break] on the west coast. The Tully's brand has a loyal and enthusiastic consumer following and we're excited about the opportunity to leverage the combined value of our brands and our manufacturing expertise to accelerate our growth in multiple channels, especially in the west.

Tully's production has already begun in Vermont and orders will start shipping to New England based supermarkets in May. Vermont manufacturing provides capacity to grow the Tully's business and reduces transportation costs as we make products closer to the customer.

We're in the process of identifying a new facility south of Seattle for roasting, packaging and distributing our coffee. Our investment in a new modern facility will create an efficient work place for employees and will support the anticipated growth of the Tully's business. We'll be able to provide more detail on the next call after site selection.

In addition to investing in our Seattle operations, we will also continue to significantly increase staffing, packaging and roasting capacity in our Knoxville location during the later half of this fiscal year in order to prepare to 2010 anticipated volume. We plan to expand our K-Cup production volume at Knoxville from approximately two million K-Cups a week today to over eight million K-Cups a week by this fall.

Turning back to channel sales, the new 12 count K-Cup package for supermarkets introduced last fall is now being sold in over 3,800 stores, up 90% from a year ago and the 80 count K-Cup package for club stores is being sold in 438 stores, up 158% from a year ago, making K-Cups more readily available to consumers.

IRI data for the food, drug and mass merchandiser category for the 12 weeks ending March 22, compared to a year ago, showed dollar sales up 57% for GMCR as a company compared to 5% for specialty coffees as a whole. This growth is being fueled by K-Cups, up 164% year over year in dollar sales.

Impressively while our K-Cups are only in about 18% of this category as tracked by IRI, we are the clear national leader in single cup sales.

I'm very pleased that we've been able to deliver profitable growth while investing in our future. We have balanced our focus on aggressive growth with an equal focus on margins and profit. Our investment in K-Cup capacity enables us to meet the strong sales order demand in Q2. Despite our very high sales growth, we were also successful at exceeding customer expectation, something that has always been a priority at Green Mountain Coffee and one of the way we distinguish ourselves in a very competitive market place.

Additionally, we are delivering productivity gains through continuous process improvement efforts. This is paying off with reduced scrub rates reducing our environmental impact and achieving a higher return on the capital we've invested in the packaging line. Our results this past quarter demonstrate better than words our success in focusing on profitable growth.

This is a very exciting time to be a GMCR as we leveraged the Keurig opportunity, the strength of our growing family of compelling brands and the synergy between our two business units to grow sales and earnings. It's truly a winning combination and made all the more gratifying because the success has been achieved in a socially responsible manner.

And now I'll turn the call back over to Larry.

Lawrence Blanford

Fran, Michelle, Scott and I are joined by John Whoriskey, General Manger of Keurig At Home business and Dave Manley, Vice President of Marketing, Keurig Direct and Away From Home. From our specialty coffee business unit, we have T. J. Whalen, Vice President of Marketing, Jim Travis, Vice President of Sales and [John Lipstein], Vice President of Supply Chain Operations.

We will now the question queue.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from William Chappell – SunTrust.

William Chappell – SunTrust

Digging right into the Wal Mart announcement, can you tell us was there any revenue from sell in from that relationship in the March quarter? Will that all come really in the June quarter?

Michelle Stacy

No, there was no revenue from Wal Mart during the second quarter. It is all going to start in the third quarter.

William Chappell – SunTrust

Just building out, would you expect this announcement to kind of accelerate the time of getting of K-Cups into other grocery stores? You would think that now the machines are going to be even more prevalent, it makes more sense for the other grocers to start carrying K-Cups.

Michelle Stacy

We certainly know that as we increase the presence of the brand, the consumer is going to see it in more places and that will continue to drive more accounts and more distribution of the brand so we certainly think that this will continue the momentum that the brand has.

Lawrence Blanford

Its part of that continuous cycle that reinforces itself that Michelle really spoke about in her prepared comments.

William Chappell – SunTrust

I'm just trying also to understand over the next couple of quarters the incremental spend on staffing or Tully's or how we should look at the dilution that that's going to put on numbers near term. Is there any way to quantify that or is it primarily staffing with Tully's only just being a few cents dilution.

Frances Rathke

In terms of guidance for Q3 and Q4, we provided the impact on top line in my remarks and then in terms of the lower operating margin and what we reported this quarter is out there. A portion of that on lower margin and EPS is due to the dilution from Tully's, and I'd say it's essentially a few cents or so in Q3 and then we've got also pressure as we said on the margin from the start up or continued start up and ramping of Knoxville and also getting Seattle going.

William Chappell – SunTrust

I was trying also to understand the hit. It sounds like its more on gross margin than it is on SG&A in terms of the next few quarters.

Frances Rathke

That's correct.

Operator

Your next question comes from Alton Stump – Longbow Research.

Alton Stump – Longbow Research

I think you talked quite a bit last quarter about the mini brewers and what the potential average for daily usage rate could be for those. If you could just give some color on what you're seeing so far with the daily average consumption of those Keurig Mini brewers.

Lawrence Blanford

In my prepared comments we did come back on that point since we promised we would do so and in our early consumer purchase and usage tracking, what we're seeing is approximately three-quarters of the Keurig Mini's are actually being bought as a primary brewer even though we have very carefully positioned it in the market really as a supplementary brewer, so about three-quarters.

For those that are being used as a primary brewer, we are seeing the usage rate per brewer per day very similar to what we would see in our mainline reservoir brewers. So very important, and very exciting and as I also indicated in my remarks, one of, not the only, but one of the factors leading us to increase our estimates for system wide portion pack sales this fiscal year.

Alton Stump – Longbow Research

You had some very impressive beats over the last quarter or two in particular, as you look out over the next few quarters from a competitive standpoint, are you seeing any competitors bulk up their attempt to the category because of your success or is anything changing on that front?

John Whoriskey

No, we really haven't seen any significant investment from the other key competitors that are in the category and we don't suspect that's really going to change and we don't anticipate any major announcements going forward into the holiday season this year.

Operator

Your next question comes from Mark Astrachan – Stifel Nicolaus.

Mark Astrachan – Stifel Nicolaus

Housekeeping on Wal Mart, I'm assuming the guidance for the remainder of the year does include the expectations for Wal Mart in it?

Frances Rathke

Yes the estimate we provided does include Wal Mart.

Mark Astrachan – Stifel Nicolaus

Keurig Mini as a percentage of total brewer sales, can you give that number in the quarter?

Lawrence Blanford

We do not break out our brewer sales by platform type. So all we can say is that we remain very positive and excited about the Keurig Mini and it continues to expand in distribution.

John Whoriskey

I would just add to Larry's comments that our number one, in fact the number one coffee maker in dollar sales this past quarter at retail was in fact special edition model and Model B-40 was the number three. So we are still seeing very, very strong sales from our over $100 price point products.

Lawrence Blanford

The special edition is the B-60 not the Keurig Mini.

John Whoriskey

Right. So we're seeing very strong growth across the whole product line, not just mini. This is not driven by just one model.

Mark Astrachan – Stifel Nicolaus

You had mentioned last quarter that the Keurig Mini was somewhere around 15% of sales. If you're not giving exact amounts is it fair to say that it's greater than that this quarter?

Frances Rathke

As Larry noted, we're not providing model by model data.

Mark Astrachan – Stifel Nicolaus

Shifting over to SG&A expenses, you had another quarter of pretty substantial leverage there. The G&A seems to be more just simply leveraging what you've got. On the selling and promotion side, are you comfortable with the level of investments that you're making going forward here?

Michelle Stacy

We're very comfortable with the level of investment that we have for this year and clearly it's been very successful for us. We saw an immediate bump after the media that we dropped in our Q1 prior to the Christmas season and we continue to see very strong results from our investment in advertising vehicles with our trade partners.

We would certainly expect as we move into future years that we would continue, the investment to continue to drive household and office penetration of our brewers.

Mark Astrachan – Stifel Nicolaus

In terms of thinking about how you discuss business planning with retail partners, what is typically their view of buy in by retailers of K-Cup packs versus brewers? In other words, in selling a brewer, what does a retailer typically want in total amount of K-Cups to compliment the brewer?

John Whoriskey

Clearly that is a function of the movement of that product and the success of the product in the store and certainly how they're going to merchandise and promote the system, and I think if you look in the slides that I presented to you when you're out visiting stores and retail outlets and so on, I think the presentation speaks for itself.

The presentation at retail of our brand has increased dramatically. The presence in the store in the front aisles and full page advertisements by retailers I think is indicative of the strength of this brand and the importance of this category as a growth engine and a profit opportunity for all our key retail partners and we see that to continue to accelerate as we go forward and start planning for Christmas 2009.

Lawrence Blanford

I might add, John was referencing slides, if you look at Slide 15, you'll see a couple of representative samples of merchandising, and I would also add to John's comment too, that to your question.

Each retailer goes to market a bit differently and each retailer with this opportunity is kind of staking out its own position. So they're all very supportive, but the number of varieties of K-Cups differ by retailer kind of depending upon how they're trying to position this within their overall assortment and their go to market strategy.

Mark Astrachan – Stifel Nicolaus

Could you describe the retailer response to the brewer price cuts that you took earlier in the quarter and the thought process there from the retailer perspective.

Michelle Stacy

When we realigned our brewer pricing, it was largely to ultimately expand the assortment of the brewers that the retailers were carrying and in fact much of the growth that we experienced this quarter included the expanded brewer distribution within our existing accounts. So we really are seeing retailers carrying additional brewers.

As we've moved into mainstream coffee makers, we're seeing all of our retailers looking towards putting multiple facings of our product in each of their stores. So the price realignment really enabled our retailers to carry a broader assortment of product in their stores and we got an immediate bump from that as we saw the 148% growth.

Operator

Your next question comes from Jon Anderson – William Blair.

Jon Anderson – William Blair

I wanted to start with the brewer unit growth, 120% year over year in the first quarter, 148% this quarter, Wal Mart coming on board, going forward should we be thinking about the brewer unit growth continuing on this accelerating path year over year during the second half of the fiscal?

Lawrence Blanford

We certainly are very confident about our overall business model and certainly are expanding distribution in supports brewer sales. What we have been though counseling everyone on is that in any given quarter, brewer sales can vary depending upon a number of things. We may be running out older models, running in newer models, etc.

What we really are focused on internally and what we have tried to help everyone following our company with is K-Cup demand. As the install base of brewers continues to grow, we can certainly predict if you will the K-Cup demand far better than we can brewer growth rate in any particular quarter. I think I would leave it at that at this point.

Jon Anderson – William Blair

In terms of the distribution for K-Cups in the grocery channel, I think you said earlier that you have kind of a longer term objective of going up to 15,000 groceries. Can you talk about the rate of expansion when you think about timing to get there, how long it may take you to get there?

Lawrence Blanford

In my prepared remarks, I indicated that we would expect to get over 20,000 retail locations which the way we talk about it is kind of non grocery and 15,000 grocery over about the next two years or so. That progress continues.

We just if you recall in the fall last year, after about a 12 or 15 month test market program in grocery, introduced a brewer for grocery in the nested 12 count K-Cup product designed to move more efficiently through grocery distribution. So really our expansion efforts started in earnest as we introduced that last August and September.

With that I'll turn to Jim Travis who might also want to comment on this.

Jim Travis

We are making good progress on the grocery front. There's a lot of work to do as Larry mentioned to get 15,000. We're in about 3,800 I think you heard from the remarks today. We expect or anticipate over the next couple of months to continue making great progress on that really on two fronts.

One is with growing grocery doors, but also growing the number of items that we offer grocery, so we're excited by that. Two years is an aggressive goal, but we're certainly targeting all of our brands as we look to expand nationally with Tully's and using Caribou in the mid west and of course we now have coffee in the east.

Scott McCreary

You may have heard in the prepared comments that Tully's is in 5,000 supermarkets today with their bagged items and while it's still a little too early to predict how quickly we'll roll K-Cups out, that's a great opportunity for us to work with those customers that already know the Tully's brand and are getting now to know about Keurig. So there is a great opportunity there and those 5,000 Tully's supermarkets are basically all incremental to the supermarkets that Green Mountain has today.

Jon Anderson – William Blair

On a broader, longer term, the strategy for K-Cup business, as you look out two, three years, do you see yourself wanting to own more of the brand or kind of expand the network of licensees? How are you thinking about that model evolving over the next several years?

Lawrence Blanford

From a strategic standpoint, we are very comfortable right now with our lineup of participating coffee brands; those that we own as an enterprise and those that are licensees and participating.

Having said that, we are always evaluating the strength of the variety of K-Cups that we have and the brands that we have in the system and how well those play geographically and across various types of retail formats.

So we will continue to evaluate it, but right now we are very comfortable in our current brand set and I think are making very significant progress as we indicated in our results today.

Operator

Your next question comes from Scott Van Winkle – Canaccord Adams.

Scott Van Winkle – Canaccord Adams

When you change the name of the segment reporting from specialty coffee to Green Mountain, I assume there was no change in allocation of revenue, just change of the name is that correct?

Frances Rathke

That's correct. Just to welcome in Tully's into the specialty coffee business unit.

Lawrence Blanford

We've become a multi brand family. We felt that we needed to broaden the umbrella if you will.

Frances Rathke

It's the same segment data. You can use it. Historically it will be apples to apples.

Scott Van Winkle – Canaccord Adams

I'm checking to make sure I have it right from the press release, when you talk about the Keurig business unit, you talk about half of the increase in Keurig's net sales this past quarter, and I'm quoting, "was due to a 129% increase in K-Cup sales to retailers". Is Keurig getting involved in the selling of K-Cups to retailers or is that just the volumes driving higher royalties and things?

John Whoriskey

When it comes to selling the Keurig system into the retailer market place which would include retail brands like Bed Bath and Beyond or Target Stores or a Macy's, that is Keurig revenue. That is a Keurig sales organization and marketing program behind that distribution. So when we talk about being in 17,000 retail stores, that is a Keurig revenue on our P&L as well as Keurig.com.

And just to be clear, the specialty coffee business unit though has the responsibility for K-Cups to supermarket and then also to our office coffee distributor market as well as club stores and GMCR.com.

Scott Van Winkle – Canaccord Adams

Are there any third party roasters that would handle the selling into a Target for example for K-Cups?

John Whoriskey

No. We are representing, Keurig is the representor of selling the system into the retail channels so all the brands in the system are represented in our product line as we present to our retail partners.

Scott Van Winkle – Canaccord Adams

On follow up on that question about getting the 12 count K-Cups into grocery, the number was 3,800 stores and then you gave a comparison to a year ago. Can you remind us what the end of December number was?

Frances Rathke

It is on Slide 12. The end of December '08 we were in 2,600 supermarket locations and now we're in 3,800.

Scott Van Winkle – Canaccord Adams

What's left for brewer distribution now that you're in Wal Mart?

John Whoriskey

There are other retail channels that are out there. We don't consider them primary like drug stores as an example, but they're selectively maybe opportunities. We are gradually expanding our distribution into the mass merchant channel now and we have Wal Mart. And then of course there are office superstores.

Scott Van Winkle – Canaccord Adams

You already have some distribution on the office superstores don't you?

John Whoriskey

Yes. We are gradually expanding that program as we learn. That channel from a standpoint of an at home business and not an office application. So we have been growing that distribution.

Scott Van Winkle – Canaccord Adams

When you're talking about the Celestial Seasonings iced tea, brewed over ice, is there something different that's done with the K-Cup? I would assume that one of the issues with doing ice coffee is that you'd need a really strong coffee coming out of the brewer so it's not diluted by the ice. Is there something and is there an ice coffee solution coming down the pike?

T. J. Whalen

The tea is very different. It's more specifically formulated for rapid dissolution and also if you will a heavier dosage to make sure that it doesn't get diluted. And then it's augmented with various sweetening agents so that when you press that button over a cup of ice, you get a fully prepared iced tea that is really a sweet beverage that is particularly appealing to alternate day parts and perhaps even some different regions of the country.

That is as far as we've gone thus far. We're looking forward to introducing these products later on in the summer and we'll see how that goes for us before we take any other subsequent steps with iced beverages.

Lawrence Blanford

T. J., you might just want to comment. We did sample this product at both Cafe Escapes and Perfect Iced Tea.

T. J. Whalen

For those that recall NAMA is a trade show where we speak to our office coffee service trade customers and as Larry said, we shared the Perfect Iced Tea formulas as well as the Cafe Escapes dairy based specialty coffee house beverages with that customer class and I personally felt that there's a pretty warm reception to these types of products.

Incidentally, we had test marketed the Cafe Escapes beverages on our web site at least a couple of varieties of them over the past few months. You may have had a chance to check them out. We found interestingly that consumers who bought them happened to increase their K-Cup usage perhaps finding some incremental opportunities for these beverages in their lifestyle and then when polled in terms of their satisfaction with their system, also found a higher level of satisfaction with the overall system because of the new level of utility that these beverages bring to their lifestyle.

So we're excited about the opportunity.

Operator

Your next question comes from [Lana – Manchester Management]

[Lana – Manchester Management]

I wondering on Wal Mart, you're inventory wasn't up that much. Should we assume, will all of that occur in the June quarter, the dropping into the 3,000 stores?

Frances Rathke

Yes you can assume that. We have shipped for the initial quantity to Wal Mart to the 3,000 stores in anticipation of Mothers Day support coming up this coming week, and we are ready and able to resupply Wal Mart as the movement continues.

[Lana – Manchester Management]

Can you give us a sense of what models they're taking and what sort of K-Cups they'll be stocking?

Frances Rathke

They are taking our Elite B-40 brewer that's priced at $99.96 at Wal Mart. That is the only brewer they're carrying and they have an assortment of K-Cups that consists of the Green Mountain, Tully's Paul Newman's, Gloria Jean brands.

[Lana – Manchester Management]

So all of your own brands, they'll be carrying. When you sell to Wal Mart, do you sell directly to Target and those stores? Do you go through a distributor? Will Wal Mart be any different?

John Whoriskey

We distribute to all of our retail partners out of our fulfillment partner.

[Lana – Manchester Management]

And Wal Mart will be the same?

John Whoriskey

Yes.

[Lana – Manchester Management]

So it's one partner who handles all of them.

John Whoriskey

Correct.

[Lana – Manchester Management]

Can we assume that the gross margin will not necessarily be impacted by Wal Mart as a customer versus having any other large store chain as a customer?

Frances Rathke

You are correct in assuming there would be no change on our margin.

[Lana – Manchester Management]

I keep wondering when I see that the brewers are packaged with some K-Cups in the box, how do you account for those? Are those included in the K-Cup count or are they not?

Frances Rathke

We apologize. We believe the local phone system is having some problems. Would you mind repeating your question?

[Lana – Manchester Management]

I just wanted to clarify. In my model I'm always trying to figure out the K-Cups that are bundled in with the brewers, how do you account for those when you talk about the K-Cups system wide. Are those included or not?

Michelle Stacy

When we do our modeling we do not include free K-Cups as part of our model. What we do is, we have a very good research that is done and we understand when a brewer is purchased it takes a certain amount of time before the consumer comes back into the market to purchase K-Cups and that is what we model our K-Cup projections that we give you.

[Lana – Manchester Management]

So the number that you give on the press release does not include the K-Cups that are bundled in with the brewers.

Michelle Stacy

Correct. It does not include free K-Cups bundled in with the brewers.

[Lana – Manchester Management]

The number of retail doors that you were in at the end of the quarter.

John Whoriskey

It was roughly 14,000 and with the Wal Mart add going into this quarter, this will be up by 3,000 to 17,000.

Operator

Your next question comes from Mitch Pinheiro – Janney, Montgomery Scott.

Mitch Pinheiro – Janney, Montgomery Scott

I understand that Wal Mart's been in the Keurig advertising spin in the circular for a couple of days now and I was wondering number one, that means you've shipped to Wal Mart by now, is that correct?

Michelle Stacy

That is correct. We did ship to Wal Mart in advance of the circular, yes.

Mitch Pinheiro – Janney, Montgomery Scott

Typically, do you anticipate Wal Mart, they typically hold two weeks of inventory in grocery, what would you expect brewer inventory to be?

John Whoriskey

I don't really think we would comment on that and I think right now based on the anticipated movement of the launch there with the advertising support that's in place, we're prepared to meet the demand and we'll have to see how the business moves forward. But we've got a lot of history with all of our other retail partners, so I think we pretty much understand where we're going to go and we're working very closely with them and planning the business.

Mitch Pinheiro – Janney, Montgomery Scott

Will there be a special display or will it be put onto the rack with the other 17 brewers?

John Whoriskey

We're going though the transition where on a promotional display and then we will go into the set following the Mother's Day launch.

Mitch Pinheiro – Janney, Montgomery Scott

Will you be in the power aisle with that or is it going to be in the regular appliance aisle?

John Whoriskey

We will definitely be in the modular with all the other coffee makers and as we work out plans for Christmas, we'll have to see what promotional opportunities exist.

Mitch Pinheiro – Janney, Montgomery Scott

In terms of the thought of going with the multi-pack as opposed to individual brands in boxes, is that something that's going to evolve as well?

John Whoriskey

I'm not sure I understand the question.

Mitch Pinheiro – Janney, Montgomery Scott

You've got the multi-pack box with the multi, a couple of the brands. If people want to buy just Gloria Jean's or just Green Mountain our just Newman's Own do you anticipate having a single brand packaging?

John Whoriskey

The program that is in Wal Mart is our retail 18 count pack, one brand in a box with the brands that we represent in a single SKU just like all of our other retailer partners. It's the same pack. It's not multiple brands in a box. It's one brand in each of those SKU's, very similar to all of our other retail partners.

Mitch Pinheiro – Janney, Montgomery Scott

What will they retail?

John Whoriskey

Very comparable to the prices for all of our 18 packs with all of our retail partners.

Mitch Pinheiro – Janney, Montgomery Scott

You said QVC you said 45,000 Mini's were sold. When was that?

Michelle Stacy

That was a February QVC program that we ran.

Mitch Pinheiro – Janney, Montgomery Scott

When it comes to gross margins can you talk about whether Green coffee helped or hurt margins in this quarter?

Scott McCreary

As we've been talking about our coffee buying strategy, we bought ahead and so much of the coffee we had for Q2 was at that higher price point so coffee did not help us in Q2 and that wasn't a driver behind the improved margins that you see.

Mitch Pinheiro – Janney, Montgomery Scott

With what we're hearing, Columbia coffee is up very strong and I was wondering how you're approaching your green coffee buying going forward.

[John Lipstein]

We bought out well into calendar 2010 for some of our needs. Price fixing goes as we've discussed before about the six month horizon to give us time to react to any pricing opportunities or issues if the market were to spike.

As far as the Columbian situation, we are well aware of the shortfall in total Columbian production this year and are weathering through that with some various modifications in what we buy and what we do. But all in all what that's doing is having an effect on driving differentials up.

So the C market will be down a little bit. Differentials will be up a little bit compensating for that so we can't count on taking the future potentially slightly lower prices coffee C priced based anyway as upside profit potential. There's certainly a higher differential cost coming.

Mitch Pinheiro – Janney, Montgomery Scott

Any issues with the swine flu in Mexico either impacting the ability to get coffee from South America northward or any Mexican sourcing issues there?

[John Lipstein]

Nothing so far.

Mitch Pinheiro – Janney, Montgomery Scott

In terms of K-Cup capacity where does that stand now and where do you expect to be by fiscal year end?

[John Lipstein]

We're in the range of equipment capacity and space to do about 1.4 billion cups annualized. We're headed to 1.8 to 2 billion cup annualized basis by the time we close the fiscal year.

Mitch Pinheiro – Janney, Montgomery Scott

And that will come from additional Knoxville and I guess some out of Tully's on the west coast?

[John Lipstein]

It will be a little bit more from Tully's on the west coast as we move the machine out there. It will be a solid amount from Essex and Waterbury and the largest contributor to increase output will be from Knoxville.

Mitch Pinheiro – Janney, Montgomery Scott

And how about in terms of roasting and grinding capacity, where do you stand with that relative to your needs?

[John Lipstein]

We're increasing our production from the machines we have here in Vermont and we've just contracted for installation of roasting and grinding and coffee storage equipment in Knoxville with [Scallari] Engineering, a company from Milan.

Mitch Pinheiro – Janney, Montgomery Scott

When do you expect that roasting in Knoxville.

[John Lipstein]

We expect to begin roasting this summer.

Lawrence Blanford

From where we were with all our roasting concentrated here in Waterbury, very soon by the end of the calendar year, really as we go into the fall, we'll have solid roasting operations in Knoxville and in Seattle, so we'll have three locations providing roasting capacity. So we do not perceive any capacity issues on the K-Cup side either with coffee and/or K-Cup packaging.

I might say also, we've just gone through, let me turn it to Scott for a minute. Scott, why don't you just comment on our ability to deal with the dramatic increase in January, February and March?

Scott McCreary

We are feeling great about our forward planning here on the machine capacity and with the machines already in place, it allows us to staff up as we need to and that really in combination with good planning, allowed us to deliver on profitability, but also really meet some significant spikes in consumer demand and customer demand.

And we did see during the quarter some weeks as high as 22 million K-Cups shipping out in a weeks time that we were able to meet with no issue. So we're feeling great about our preparation and as John said, we're preparing for machine capacity for the Green Mountain Coffee Roasters business of 1.8 to 2 billion for next fiscal year.

Again, that will be more machine capacity than we need but we want to be ready to support the whole system and if there issue, but then also ramp up our staff as we need it.

Mitch Pinheiro – Janney, Montgomery Scott

I missed about the dilution or the investment in Knoxville. When do you anticipate that happening? How does that flow through Q3 and Q4?

Frances Rathke

For Q3 and Q4, we've got the Tully's dilution ramping them up and integration of a couple cents next quarter and then we're also anticipating some more dilution in Q4. And then in terms of probably the bigger piece is ramping the production at Knoxville and also getting Seattle expanded.

So those two manufacturing pieces, that's the primary reason for the lower operating margin in Q3 and Q4 versus what we just reported for Q2.

Lawrence Blanford

I think it's important to note that while we take those kind of hits as we're bringing these plants up, within about 15 to 18 months, Essex was fully operational and at full capacity and basically driving the same cost as we had already established in Waterbury. So I think as you think about it, we take some early hits, but in 15 months or so after we open up new capacity, we're generally driving very good efficiencies.

Mitch Pinheiro – Janney, Montgomery Scott

Were office coffee brewer sales, how would you characterize those? Up, flat, down?

David Manley

I would say that first of all no doubt our office coffee business has been impacted by the recession. We have a lot of customers who are in the professional services industry, law firms, advertising agencies, investment firms, and they've been hard hit by the economy. I would say though that we are pleased that in the second quarter we were able to maintain a rate of installation about the same as a year ago, slightly below, but about the same as a year ago which is better than the first quarter.

So we're not seeing a strong rate of growth but we continue to increase our install base of brewers in office coffee.

Mitch Pinheiro – Janney, Montgomery Scott

Were K-Cups, you talked about the impact of professional services and all those other firms, are K-Cup sales, how would you characterize those sales?

Jim Travis

We are seeing similar softness as we see with brewers but business is good. We are still lapping last year and we're confident about the growth. We'd like to be a little more confident with the economy, but I think we're in pretty good shape and poised well for the future.

Mitch Pinheiro – Janney, Montgomery Scott

You talked about your coffee pounds obviously in the areas affected by K-Cups and Keurig, the strongest channels, but I was curious how your regular coffee business was doing in C stores, food service and grocery on the non K-Cup side.

Jim Travis

The C store business is also seeing some softness based on the economy, but it's still one of our core businesses and it's doing well. We've introduced red which is helping some of our C store branding. Food service continues to be strong. We've got some news this summer coming with some new items. I think it's going to be helpful for us and the grocery business, if you look at IRI, we're up on our package business in double digits.

Specialty coffee is up about 2%. So we're doing pretty well. It's probably not outstanding but given the economy in certain factors, we're doing pretty well.

Operator

That concludes our question and answer session for today. I'd like to turn the call back over to Larry Blanford for additional or closing remarks.

Lawrence Blanford

It's been a pleasure to talk to you about our performance and our plans going forward. We really appreciate your interest in our company and we want to thank you very much for joining us today.

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Source: Green Mountain Coffee Roasters, Inc. F2Q09 (Qtr End 3/29/09) Earnings Call Transcript
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