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Executives

Suzanne DuLong - Investor Relations

Brian Kelley - President and Chief Executive Officer

Fran Rathke - Chief Financial Officer

Analysts

Bill Chappell - SunTrust

Bryan Spillane - Bank of America Merrill Lynch

Greg McKinley - Dougherty

Akshay Jagdale - KeyBanc

Matthew DiFrisco - Lazard

Jon Andersen - William Blair

Alton Stump - Longbow Research

Marc Riddick - Williams Capital

Mark Astrachan - Stifel Nicolaus

Scott Van Winkle - Canaccord Genuity

Tony Brenner - Roth Capital Partners

Green Mountain Coffee Roasters, Inc. (GMCR) F2Q 2013 Earnings Conference Call May 8, 2013 5:00 PM ET

Operator

Good afternoon, and welcome to Green Mountain Coffee Roasters Incorporated Fiscal 2013 Second Quarter Conference Call. Today’s call is being recorded. At this time, I would like to turn the conference over to the company’s Vice President of Investor Relations and Corporate Communications, Suzanne DuLong. Suzanne, please go ahead.

Suzanne DuLong

Thank you, Robert, and welcome, everyone. Today’s press release is available on our website at www.gmcr.com. We also have posted slides that summarize and supplement much of the information we will discuss on this call. Our Form 10-Q for the period is also available on our website.

On today’s call Brian Kelley, our President and CEO, will provide some brief introductory remarks. Fran Rathke, our CFO, will discuss aspects of the quarter’s financial results. Brian will then provide some additional commentary about the business and its opportunities. We’ll then open the call to questions from the sell side analysts.

Several members of our management team are with us for the Q&A session, including Michelle Stacy, T.J. Whalen, and John Whoriskey. To ensure we have the opportunity to address everyone’s questions during the time we have allotted for this call, we ask that you limit yourself to one question. We will revisit the queue for follow-up questions.

Finally, I will remind everyone that certain statements will be made today which are forward-looking within the meanings of 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 the 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 word “certain information.”

And now, I'll turn the call over to Brian Kelley.

Brian Kelley

Thanks, Suzanne, and good afternoon everyone. With steady and strong consumer adoption, our Keurig brewing system gives us the distinct advantage in the marketplace with significant untapped potential to change consumer behavior. Importantly, it positions us to continue generate strong growth in revenue, earnings, and cash flow. We consider our mid-teens revenue growth and 45% non-GAAP EPS growth strong operating performance. And it demonstrates the leverage inherent in our business model.

Our free cash flow was a very healthy $202 million for the quarter. And through the first half of the fiscal year, we have generated free cash flow of $456 million. We also announced some organizational changes filed in the Form 8-K today that we are confident it will better align us with our customers and the marketplace. In addition, we announced today a new long-term agreement with value partner, Starbucks. This agreement is for five years from signing this week, with an additional 5 years upon renewal, upon achieving mutually agreed upon volumes. This long term partnership is a big win for our shareholders, customers and consumers and is 100% consistent with our goals to drive long term revenue, margin and EPS growth. As we look at our business the two key drivers of the health of our system are the install base growth, and the single serve pack growth. Revenue of single serve packs grew 21% during the second quarter with unit growth up 26% and while brewer and accessory sales were down slightly more than we expected at minus 10% our retail sell through of Keurig system brewers increased by 13% in the quarter and we increased our unit share of brewers by 2.2 points. In addition we generated revenue growth in the mid-teens and nearly doubled our earnings, this is a clear indicator of the strength of our model.

As we expected our installed brewer base to increase by 25% to 30% by the end of this fiscal year. After Frances finishes her financial review, I’ll talk specifically to some of the themes we have identified on last quarter’s conference call including how are we evolving our technology platform, our goals for further operational improvement and our progress along four growth vectors. I will also provide some insight into our recent strategic review that we just completed. But before I do that my thanks to all of our employees whose hard work delivered these results. Let me now hand the call over to Frances to quarter’s financial results.

Fran Rathke

Thanks Brian and hello everyone. We reported total revenue of just over 1 billion for the quarter with our 14% growth driven by primarily by single serve pack sales. We noted last quarter that brewer net sales were likely to be down slightly over last year. When our licensed brewer partners are included total cared Keurig brewer unit shipments were down 9% for the quarter a bit lower than we expected. According to our internal estimates which include NPD data and retail customer reported information, consumer purchases or POS accrued brewer through our second quarter increased by 13% over the prior year period. Moving to a review of growth we saw a 590 basis point improvement to 41.3% of net sales versus 35.4% in the prior year period. This was largely due to lower green coffee cost, lower obsolescence expense, a product mix shift towards single serve packs and continued lower warranty expense due to improved brewer quality.

These positive impacts were partially offset by a $10.4 million pretax charge related to a loss on non-coffee purchase commitment. Today’s press release includes a table that outlines all the year changes and gross margin and I would ask that you look there for further details. Turning to operating expenses as indicated on our first quarter call Q2’s, SG&A expenses were up over the prior year period largely as a result of an additional 22 million of compensation bonus and related expenses. As a percentage of sales on an non-GAAP basis, SG&A was 19% in the second quarter compared to 17% in the prior year period.

Regarding cash our second quarter has historically been strong given the seasonal trend of selling brewers over the holidays and collecting cash for those sales. We were very pleased with our 202 million of free cash flow this quarter driven by strong operating performance and effective management of our balance sheet. Finally on our share repurchase program during the second quarter of fiscal 2013 we purchased roughly 608,000 shares of our common stock at an average price of $44.65 per share for approximately $27 million. These purchases bring our total shares repurchase since the fourth quarter of fiscal 2012 to roughly 8 million shares at an average price of $25.32 per share for a total of $202 million.

Turning to our outlook for the third quarter of 2013, we anticipate a total net sales increase in the range of 11% to 15% from the year ago period driven by continued single serve pack growth. We expect non-GAAP earnings per diluted share in a range of $0.71 to $0.78 excluding the non-GAAP items as noted in today’s press release. This represents a growth rate of 37% to 50% over last year’s $0.52 per share.

For the full fiscal year, we expect total net sales growth in the range of 11% to 14% over fiscal 2012. On a comparable basis, when excluding the 53rd week of fiscal year 2012 which contributed $90 million in net sales in our fourth quarter, our net sales guidance equates to a range of 14% to 17% growth for the year. In evaluating our guidance, it’s very important to understand the components of our revenue.

On a comparable basis, our expected fiscal 2013 revenue growth rate is being driven by a 20% increase in our core single-serve business, which includes single-serve packs, brewers and accessories offset by a 5% decline in our traditional coffee business comprised of bad coffee fractional packs and office coffee services. As the entire coffee category shift, the tiered single-serve continues, our traditional coffee business will likewise continue to be adversely impacted. The fiscal 2013 20% growth rate for our core single-serve business is very strong and is why we remain comfortable reiterating our long-term annual net sales growth outlook of 15% to 20%.

For the year, we are also reaffirming guidance that we expect our brewer unit shipment and POS growth to be in the mid single-digits. For the remainder of the year, we expect continued favorable green coffee cost, lower warranty expense, and lower labor and overhead manufacturing cost to contribute to better gross margins compared to 2012. We have increased our non-GAAP EPS estimate to a range of $3.05 to $3.15 per share representing growth of 27% to 31% over the prior year period. More importantly, on a comparable basis, our non-GAAP earnings per share guidance equates to growth in the range of 31% to 35%. This growth rate excludes the 53rd week of fiscal year 2012 which contributed $0.07 per share in our fourth quarter.

We are lowering our estimated capital investments to a range of $275 million to $325 million from our prior range of $350 million to $400 million. The reductions are driven from anticipated lower spend on single-serve pack packaging lines as a result of increasing efficiencies and are evolving brewer strategy, which Brian will speak to in his remarks. At the midpoint, our revised CapEx estimates represent approximately 7% of 2013 forecasted sales, down from 10% in 2012 and 11% in 2011. Finally, for the year, we are increasing our free cash flow estimates significantly to a range of $300 million to $400 million.

And now, I will turn the call back to Brian.

Brian Kelley

Thanks, Fran. GMCR and our portfolio of brands have recently experienced a number of key achievements. We received the prestigious Edison Award for innovation in consumer packaged goods beverage preparation category for our Keurig Vue brewer. Also Keurig was named Brand of the Year in the 2013 Harris Poll Equity Study in the coffeemaker category for the second year in a row. And third, GMCR was also recognized for our sustainability efforts receiving the 2013 Corporate Award from the Millennium Challenge Corporation, a U.S. foreign aid agency that works to reduce global poverty through economic growth. These external recognitions highlight the success of our strategy and the passion consumers continue to feel for their cared brewers in our family of beverage brands.

I mentioned last quarter that we are in the process of a complete and thorough review of our business strategies. Our review which is now completed let us to clarify three main objectives for our company. First, earn sustained growth through continuous innovation and passionate advocacy of our brands. Second, achieve operational excellence to delight consumers and customers. And third, develop our talent and culture to achieve our mission. We then defined the specific strategies will pursue to achieve each of these objectives and we made some organizational changes which we have filed in an 8-K today.

We had four objectives behind these organizational changes. First, to present a single phase to our customers and become their best partner by unifying our existing U.S. sales team for brewers and beverages. Second, we know that innovation is the life blood of our future growth, so to accelerate our speed of innovation and to strengthen our focus on discovery and pioneering ideas we established a unified technology and R&D group. Third, to strengthen the delivery of our operational effectiveness and generate productivity particularly in the areas of manufacturing, procurement, logistics and distribution we established a single global supply organization. Finally to achieve success across our four growth vectors new beverage categories, new brands, new technologies and new channels across a broad range of geographies. We have combined the marketing organization for brewers and beverages so that we market a system. We believe this is how we can accelerate the growth of the Keurig beverage system and continue to win.

We’re very confident in the organizations ability to quickly embrace the new structure and continue to deliver on our commitments. This new organization changes however report our financial results beginning with our third quarter 2013 reporting. We will report U.S., Canada and corporate segments. To enable straightforward year-over-year and quarter-over-quarter comparisons when we report Q3 we will provide three years of historically comparable data. Now moving on from the organization I will speak to our future brewer strategy, our operational improvements and what we believe are some exciting growth opportunities.

First on the brewer strategy, by the end of this fiscal year we will have between 16 million and 17 million Keurig brewers active in U.S. homes, that’s a growth rate of between 25% and 30% over last year and we would expect to see similar install base growth next year. We’re building a strong pipeline of powerful innovations that we expect to deliver across multiple channels and multiple geographies. We will obviously have more to talk about this as we get closer to launching these new platforms but let me spend a few minutes today to give you a sense of where we are headed directionally with our hot beverage platform.

Over the last several years we have learned just how successful our Keurig K-Cup platform is and just how devoted consumers are to it and the more than 30 powerful brands we have in the system. And we believe firmly the technology in our Keurig Vue brewer represents the best of our technology capable of producing the best beverages for Keurig consumers which is why we will bring consumers a new line of brewers with our best technologies that deliver the best of both Keurig K-Cup and Keurig Vue.

These brewer technologies will be capable of brewing both K-Cup packs and Vue packs. We will bring them to consumers in a range of price points that are at least comparable to today’s K-Cup and Vue brewers and we will be targeting brewers with these technologies to home, offices, and the food service customers. Our goal is to begin to roll these out towards the end of calendar 2014. We will also continue to pursue innovations both inside and outside of hot beverages. In the meantime we’re very excited about our near term plans for the Keurig K-Cup and the Keurig Vue platforms with new designs and powerful commercial support. Every experience our consumers have with Keurig should delight them. For some time now we have been pursuing interactive technologies that can deliver unique consumer benefits including the ability to customize beverages.

We’re moving forward to commercialize an interactive solution that assures a great consumer experience and we have plans to integrate it into our future Keurig brewers. We also believe we have significant growth opportunity in the away from home channel which to-date for us has consisted primarily of the office channel. The U.S. away from home business for hot beverages is a $10 billion wholesale opportunity that consists of food service which is 74% of that total, workplace which is 20% and travel, leisure and hospitality which is 6%.

We have a significant opportunity to increase all three of the sub-segments in this important channel. And today we estimate we are only in 10% of U.S. workplaces less than 5% of travel, leisure and hospitality locations and in less than 1% of the largest away from home businesses which is the food service sub-segment.

Last week, you saw an example of our early work in pursuing new growth in these channels with the announcement of our NSF foodservice certification. We believe the Keurig system brings substantial value to a large segment of these foodservice customers. First and foremost, we can reduce coffee waste. Since today, they brew coffee a gallon at a time in many cases. We can also improve the speed of preparation, the variety of brands and the freshness and consistency that they can offer to their customers. We are currently pursuing a number of opportunities in foodservice and we are confident that this represents a significant growth opportunity for us beginning in 2014.

Now, moving on to operations, we are focused squarely on operational effectiveness and efficiency and the reduction in our forecast CapEx illustrates the progress we believe is realistic even in the short-term, specifically, with regard to our efficiencies on our single-serve packaging lines. Here are some specific examples of how we are improving. We are improving the flow of coffee between roasting and grinding and this minimizes downtime in our packing lines. We are improving the way our plants plan and respond to downtime. We are better balancing our labor across plants to maximize efficiency. We are improving the scheduling our plants and delivering better customer service. We are examining every facet of logistics footprint to make it more efficient. And while we are still early in our efforts, we are excited about the improvements we have made and the opportunities that still exist. We expect these and other actions to generate efficiencies that we will use to improve returns and reinvest in the business and reinvest in our growth.

Before wrapping up our prepared remarks today, let’s talk about our very exciting announcement with Starbucks. In our discussions with (indiscernible) it became clear that we shared a vision for the single-serve opportunity in North America and globally, and we realized that we can unlock even more growth potential by working closely together and committing to a longer partnership. The agreement is for a minimum of five years and is a testament to the leadership of the Keurig brand in the single-serve category, the quality, the safety, and the expertise of our operations and the Keurig brewers’ platform power as a brand builder. It’s also a testament to the strength of Starbucks. We value them as a partner and respect the strength of their brand globally.

Without going into details, the economics of the deal are very attractive for us and for Starbucks. And as I said before, this is a big win for our shareholders, our customers, and our consumers. Finally, this agreement serves as an overwhelming validation of our model. We are confident that Keurig beverage system will continue to grow here in North America and around the world, and it will provide a significant ongoing opportunity for all our partners to grow with us in the fastest growing segment of the coffee business.

In conclusion, we are very excited about our future. We have multiple growth opportunities. We have significant operating leverage. We will keep a keen focus on cash flow and we look to continuously improve our returns on invested capital. We believe that over time, our business can produce gross and operating margins in line with the best CPG companies in the world. This means sustainably producing close to 40 points of gross margin and approaching 20 points of operating margin. Our goal is to continue to build a great global company for the long-term that can deliver for our consumers, our customers, partners, and our employees as well as our communities, and our shareholders. Thank you.

Operator, we will now take questions from the sell-side analysts.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) We will take our first question from Bill Chappell of SunTrust.

Bill Chappell - SunTrust

Good afternoon. Maybe starting up on the Starbucks partnership, can you give us a little more color in terms of, I guess, one does this supplant the prior relationship sort of the five-year start today? And then two, maybe kind of what’s your expectations are for international expansion, I mean, are we going to see Keurig machines in Starbucks stores around the world and how fast will that be, and how should we be looking at from that standpoint?

Brian Kelley

Thanks Bill. First, the agreement starts with the signing of it. So, here now, the second answer is that, as we look and develop our international plans, then we look at Starbucks current plans and their future plans will make the decision as to when we launch and where we launch. Most importantly, the partnership is powerful for North America. It will really continue to build our North American business. Now, there is no question we have opportunity outside of North America but this is a North America partnership today and we know it can get even stronger and we’re excited about that and the global growth will be on top of that but it's not just about global growth it's about North America growth and we know that when the system grows in any brand in the system grows with it. So, our job is to continue to grow the system and we think that this Starbucks deal they are obviously a very, very strong brand they do really well in our system. They are one of the 32 brands in the system and we can continue to make our system stronger with this deal.

Bill Chappell - SunTrust

Got it and then switching to gross margins I guess on your comment about getting to 40% sustainable and also looking at Green Coffee cost, you’re at 41 this quarter, so I know this is higher than average but just help us understand kind of the path to the sustainable 40% and then also did you see the full benefit of kind of lower green coffee cost yet with your hedges rolling off? Are we still yet to get there?

Brian Kelley

Well I will talk broadly about gross margin in the 40 points and then we will get into coffee costs, yes we had 41% gross margin this quarter but as you saw a significant portion of it is due to green coffee costs which won't be with us forever and they make go the other way at some point in the future too. That said we expect to continue to get those coffee costs as they are today through the rest of this year and if you look at other parts of the gross margin, our gross margin benefited this quarter because of the mix shift as we sold less brewers in fact less brewers than we did last year it let’s the portion pack overwhelm the gross margin intent (ph) which is terrific for our gross margins. So again power to model, we don’t want to have brewers go backward year-over-year and so we won't have brewers go backwards year-over-year typically and so we won't always have that benefit. So if you look at where we will move, we will continue to get mix that benefit us, we will continue to get operational effectiveness, we will continue to get, we hope quality improvement and continue to drive those things and those are the things that will move us from the mid-30s up to a sustainable 40 plus.

Fran Rathke

Just to clarify I think on the coffee cost, we had a sizeable benefit year-over-year this quarter, Q2, we’re going to continue to see that even better in Q3 and then kind of a similar range from Q3 to Q4.

Operator

And we will take our next question from Bryan Spillane from Bank of America Merrill Lynch.

Bryan Spillane - Bank of America Merrill Lynch

So just I will keep it at two questions, I guess there is a ton that we could ask but I guess the first question just in terms of the ambition to grow the away from home, can you just talk a little bit about kind of the infrastructure, the size of your I guess sales force you have today just how you do it today and what you would need to build in order to do it to have a bigger business there. Is it going to be hiring a sales force, is it easing third party to help you to get to those channels, just a little bit flush out a little bit more in terms of what have to be built in order to achieve a bigger away from home business.

Brian Kelley

Well thanks for the question, we first of all we know that the food service business in particular in away from home is a big opportunity for us. I mentioned we’ve virtually no penetration of it today and think about our single serve opportunity in food service customers. So if I give an example of a small, doesn’t matter the size of the chain it matters the size of the store in the prevalence the incident of coffee, a restaurant or a store that’s doing 10 to 20 cups a day is quite different than one that’s doing 100s of cups a day but that 10 to 20 cups a day that’s a really good business for us and a single serve opportunity like Keurig we can go in there and allow them to brewer a fresh cup of coffee every time with multiple brands and give the consumer some choice and they can deliver an excellent cup of coffee quickly to their customer. Today they have enormous ways and you can think of and I could mention lots of restaurants and chains that have that proposition today. They brew a number of cups, 10 cups of coffee a day in order to serve just a handful of cup of coffee, 10 to 20 cups of coffee but they do it to keep it fresh and so we can go and offer them a real proposition for them that’s both economical and great for their consumer.

Now, the infrastructure required to do that then it’s not that large versus what we have today. We have a sizable infrastructure in our away from home business today, but most of it is focused on the workplace. And that’s where we are most developed in the workplace today it’s where we started the business and we are really good at it. We will get very good at the foodservice business as well. We will bring in some new people. We will bring in some additional people, so that we can cover a broader range of the geographies. So, you will see us grow our infrastructure, but we have targeted and we know there is a number of customers that were actually in discussion with today. I can’t name them that we are excited about.

Bryan Spillane - Bank of America Merrill Lynch

But you’d envision having you are selling the product and also I guess having an organization that would service the machines the inevitable breakdowns or things that happen in the trading, but would you require that type of investment or would you envision that?

Brian Kelley

Yeah, we have series in a network of distributors today and John, you might want to comment some on it or TJ, but we have a network of distributors today and salespeople today who do all of that and that we cover it in workplace and we could very easily use that same network to cover it in our foodservice business as we gain new customers. So, the infrastructure isn’t going to be the challenge. The real challenge is making sure we have the right product and the right brands and that we go out and we aggressively sell it, which quite honestly we haven’t done. We focused on the workplace, which we know can get a lot of people excited about Keurig and then they go buy it at home. We have that same strategic capability here in restaurants, where we can watch them – the consumer can come in they can see the Keurig offering and maybe bring one to their home as well.

Bryan Spillane - Bank of America Merrill Lynch

Okay. And then just I guess the other bigger question related to that is just as it evolves, would it be neutral to your margins like would you expect this channel to be sort of equal to your average or better than or less than?

Brian Kelley

I don’t want to give you one way or the other. It shouldn’t be terribly different than what our margins are today. Away from home is a fairly comparable to our at home business today. And so I wouldn’t anticipate it being that much different. It’s quite different if you are going into the, what I would call, the traditional foodservice business as you know. The foodservice business, it can be very price competitive, and I know we will face some of that, but we have a very, very good proposition that we’ll bring to these customers and we don’t think we will see margin dilution on this.

Bryan Spillane - Bank of America Merrill Lynch

Okay. And then just one follow-up, just in the 10-Q that was filed this evening, there is a change that’s been made to, I guess the definition of a change in control, so it’s related to the change in control of severance benefit plan, can you just not sure exactly, I mean, I see what the definition is today, but why was it changed, how is it different from, what the I guess the pre-existing plan was?

Fran Rathke

Bryan, its Fran. The change you are referring to I would – it’s a very minor change and it’s for compliance with 409(a), which I don’t know if you guys, it’s a technical, there is no message or big change there.

Bryan Spillane - Bank of America Merrill Lynch

Okay, so nothing more to read into it than that.

Fran Rathke

No, correct.

Bryan Spillane - Bank of America Merrill Lynch

Okay, great. Thanks guys.

Brian Kelley

Sure. Thank you, Bryan.

Operator

And we will take our next question from Greg McKinley of Dougherty.

Greg McKinley - Dougherty

Yes, thank you. So, you had spoken about plans for really an integrated brewer platform here that utilizes both the K-Cups and the V packs, I am wondering if you can help us understand what that product might look and feel like to the consumer a little bit more. Will the beverages using the different portion packs essentially be capable of being producing the same beverages or will it depend on the form factor used in the brewer and maybe just talk with us strategically about the decision to align the brewer platform under one model and will it be branded as Keurig or how will we get to know that brand?

Brian Kelley

So, Greg let me talk about the strategy first and then there are some of the details we are not going to give obviously for competitive reasons. But we will talk a little bit about the strategy. The thing consumers want in our Keurig view technology is they love the great cup of coffee they get. They want more – they want the ability to have more choice. They want to have all of the brands available to them. And a lot of consumers who have Keurig K-Cup today they don’t want to give up the K-Cup, they love the K-Cup what having a machine and a brewer and a technology that can actually brew both gives us enormous flexibility from bringing new brands, better brands, new products, we can offer the kind of customization in choice that our consumers have told us they want and we have seen them actually use at home and so we don’t want to tell you too much more than that other than that we know that we know that consumers are passionate about Keurig and the most important thing they tell us about Vue is give us more choice and this allows us to get more choice for them because they love the cup of coffee that it brews for them. So quite honestly have a lot of flexibility with this by having a machine and line of machine and we’re not talking about what brand we call this we are not going to talk about other than it's going to be part of the Keurig system certainly.

We want to make sure that the consumer gets what they want. Also know that and recognize that the Vue cup gives us a different capability than the K-Cup does and so without again going into it you can imagine beverages that we can do in Vue cups that we couldn’t do in a K-Cup and it really gives us flexibility that’s why we are doing it and we’re very excited about it, it's going to take some time as I mentioned before we launch it and we have a lot of work to do to determine how we market it and we don’t want to talk much more about it.

Greg McKinley - Dougherty

And then you just commented on your brewer based growth expectation 25% to 30% for this year I think you indicated similar expectations or next year. Can you help us understand what type of wholesale shipments Green Mountain will have to deliver into the retail channel to support that? Thank you.

Brian Kelley

Well we said that we will have mid-single digit growth in brewers units this year, and we would expect similar to that next year and that gives us the 25% to 30% growth in the install base. And that’s very healthy growth for our install base and it's what builds the portion pack business and that’s what obviously is driving the leverage in our model.

Operator

And we will take our next question from Akshay Jagdale of KeyBanc.

Akshay Jagdale – KeyBanc

So first question is just playing devil’s advocate here on the slowdown in sort of sales growth and your guidance coming down for the full year. I know you maintained a full year your long term guidance but Brian just what gives you confidence that the long term guidance is the right guidance even though we have now seen almost three or four quarters of consecutive slowdown in your overall sales growth and your guidance for next quarter imply the further slowdown.

Brian Kelley

If you look at what Frances talked about and we will go into a little bit more, our business really has two components to it, it's got a traditional coffee business that today is a small and getting smaller portion of our business and that business is down 5% and it continues to get smaller and as that continues to shrink we have got a business in our core business, our single serve Keurig brewers and portion packs that we know we will grow out 20% this year and so those are the kind of numbers as that traditional coffee business gets to be a smaller and smaller impact on our number that’s how we give and we have the kind of confidence to talk about our long term growth strategy. I will stock there and see if there is any other question.

Akshay Jagdale – KeyBanc

Sure and just since we have two questions, the second one is just is related to your brewer technology and how you’re strategies is evolving there. Can you help me understand how that impacts your CapEx because I’m assuming now you don’t have to add all Vue new lines et cetera but how does that impact your CapEx and what do you think is a good ROI C-target for the company or (inaudible)?

Brian Kelley

Well you hit it right on the head in terms of what it does to our CapEx first of all because all of a sudden if you thought that the Vue cup had to replace the K-Cup then there is a lot of capital in front of us to have spent to get that Vue cup up to the size of our base that the K-Cup delivers today. And that’s not the kind of the thing we want. And so it just happens to be what the consumer wants as well. They want machines that can do both. And what that allows us to do is have both K lines and Vue lines and I think you have already seen that efficiency play into our CapEx forecast, you are going to continue to see that. In terms of ROIC, we are at roughly 15% today and we think we can do at least that and improve on that. Fran, would you comment additionally?

Fran Rathke

Yeah, I would just echo what Brian is saying. I mean, today at the end of the second quarter of ‘13, we are at a 15% return on invested capital coming off of a few years where investment spend behind the acquisitions we have done and the incremental CapEx to really ensure we were able to keep up with demand. And I think as we look at what we can do to improve efficiencies with our packaging lines. And as Brian pointed out, in our brewer strategy to ensure that we have a lot of flexibility on our portion packs, I think we will see we will be able to definitely see a pretty significant return on invested capital over this next few year period.

Akshay Jagdale - KeyBanc

Right. Can I just squeeze one more in, just on long-term sales growth again, I mean, just to confirm the initiatives that you are looking at away from home, international, and to some extent, the international portion of the Starbucks deal, would that be incremental to growth at some point or it’s supposed to sort of supplement what you have and your base business slows down over time, how should I think of those initiatives?

Brian Kelley

Well, we don’t see our base business slowing first of all. And but we don’t want to over commit beyond the 15 to 20 kind of long-term growth that we have talked about. And we look at the global growth, which by the way won’t happen. It doesn’t happen overnight as all of you know, it doesn’t happen quickly. That takes – it takes thinking, it takes strategizing, it takes planning and then a lot of execution. And they don’t grow quickly and each country is different and the competitors are different. So, these are long-term plays. Foodservice is the same way and away from home. We have got growth potential in channels, in brewers, in new technologies and geographies. We have got a variety of them and we’ll think big, we’ll start small, and then we will scale as quickly as we can, but it doesn’t mean that we are going to take up that long-term target, because we have those growth opportunities. We will continue to use – we will play them all.

Akshay Jagdale – KeyBanc

Thank you. I will get back in line.

Brian Kelley

Thanks Akshay.

Operator

And we will take our next question from Matthew DiFrisco of Lazard.

Matthew DiFrisco - Lazard

Thank you. I guess congratulations as well on a great quarter. I am just looking at some of the…

Brian Kelley

Thank you, Matt.

Matthew DiFrisco - Lazard

You are welcome. I wish I had a more interesting question, but like the timing of things when you can rollout I just see the opportunity out there that you have with Starbucks and some of their products. I wonder if you can give us some color on that as far as is there a – you mentioned some new names in there, things like (indiscernible), does this sort of accelerate some of those things or could we see – what would be the timing of seeing some of the relationship with Starbucks expanded beyond the current brands that are offered in the platform right now?

Brian Kelley

Well, I don’t want to give you too many specifics about that until we really formulate it and define it, but I will give you some indications. First and foremost, we have a number of global growth strategies and we are going to have to employ them all, country by country like Starbucks has growth strategies that differ country by country, so will ours have to be. And so we are going to have a number of partners, we are going to have number of means that we grow globally. Obviously, Starbucks is going to be a big one and we are really, really excited, I think you can tell about the Starbucks deal, and they are going to be a terrific partner and they already are.

When you look at the brands they have, the portfolio of brands Starbucks has it’s not just Starbucks, obviously that’s the power of brand that they have, but they have a lot of other emerging brands that are strong and you will likely see them first here in North America we hope before we can take them around the world. I also think the opportunity for us in the next 12 months, yeah, I suspect you will see something from us in the next 12 months of meaning as we begin to roll these out maybe sooner, but let us go to work together to figure that out before we commit to anything.

Matthew DiFrisco - Lazard

Okay. And then I guess just Fran as far as the basis point breakdown that you have given in the past one of the line items I noticed missing this time round, I was curious if it’s just in other and it’s less significant, but the Vue related impact as well as your lower sales returns, I would have thought that one of those would have still probably been still persistent in this or meaningful to be aggregated out. But is that consolidated into other?

Fran Rathke

Sure, Matt. The view wasn’t a significant amount this quarter so it's in other and I think in terms of sales returns we did overall have a slightly better rate of return than we did last year’s Q2 but it wasn’t as significant as what the warranty was this quarter so it was also another one that just netted into other. But I think last year or sequentially Q1 of last year had per-sales returns had a pretty significant rate and then some comp that last quarter if I take a rate of the expense the sales return provision divided into the brewer and accessory sales it dropped much more precipitously in a positive way from Q1 of last year to Q1 of this year and then we did have some improvement but not anything significant.

Matthew DiFrisco - Lazard

Understood. I thought there was something about accounting policy implied in that as far as what you needed on the return policy.

Fran Rathke

We did on sales returns it's very consistent methodology, we look at the last 12 months and we look by brewer model and by customer and we monitor rates and provide for those kind of levels of return.

Matthew DiFrisco - Lazard

Excellent and then just if you can give us a little bit of guidance on the G&A line it looked like I guess inline with some of those change overs as far as reallocation of resources at the corporate level that jumped up in your queue I think you break out over 22 million of that was salary related expenses but some of the other line items in there I guess the consulting expense, is that something that is done with or is that going to be recurring or should we start to see a little bit of a slower growth of the overall SG&A?

Fran Rathke

In terms of G&A as noted in our queue in the MD&A in terms of SG&A the main driver of the increase in G&A really is compensation salaries, bonus that type of stuff, we also this past quarter did incur as part of our expansive strategy work. We did have outside consulting firm helping us in those facilitation efforts. So that will drop off significantly as we move into Q3 and Q4.

Brian Kelley

So that’s part done, the other thing is to your question, you will see continuing improvement in our G&A growth rate. We want to spend money in R&D and marketing, we want to spend money where it matters, where we can create innovation and where we build brands and you will see a slower growth rate as we move forward certainly in 2014 on the rest of the G&A line.

Operator

And we will take our next question from Jon Andersen of William Blair.

Jon Andersen - William Blair

I just wanted to ask another question on the Starbucks, expanded Starbucks relationship. I understand you described that as powerful for North America clearly the five year term is a critical component, the increase from the range of brands and skews that you know will be made available on the system. Are there other things that this relationship will enhance and I’m thinking here around kind of the combined go to market strategy ways that Starbucks might support the system, they will try adoption that are different than what they have done over the last year, year and half.

Brian Kelley

Yes and in fact there are, things like selling Keurig brewers in Starbuck stores. Making the Keurig system available in more places, that’s the kind of thing that will be different and it is as much as anything validates and confirms the strength of our model, the consumer has been telling us this for quite a while with Keurig. This really validates it in many, many ways and so we obviously there is a number of benefits then they come with that. We have 32 plus wonderful partners in our system and this is actually good for all of our partners because anything that strengthens the system it strengthens the partners that are in it. You have heard in the last six month or so we bought more partners in, you are going to continue to see that happen. We are going to continue to offer to other store brands, great store brands that are out there. We want them in our system. We will make it available to come into our system, because they need great quality brands and we can provide it. So, there is a lot of benefits to this. In addition to what is on the face of it that I think you can probably see.

Jon Andersen - William Blair

That’s great color. Just a quick follow up on operating efficiencies, because I think, Brian you have done a lot over the last few months to kind of articulate some of the opportunities as you see them and again here today on the call. Is there any way you can give us a sense maybe kind of a high level roadmap for how we think about the timing of some of the benefits of these initiatives? Are we seeing that already in certain cases or is this kind of an 18 to 24 month timeline as those things become more impactful? Thanks.

Brian Kelley

Yeah, thanks. You are seeing them already, you saw them somewhat this quarter and you are going to see in each quarter going forward. A lot of that we are going to want to reinvest because we are going to want to take what we think of is anything that doesn’t add that value that the consumers waste, we are going to take it out and we are going to put it in the things that really grow our business. And so you saw some of it this quarter, you saw it in better quality, you saw it in efficiency at our manufacturing lines and plants in portion packs, you are going to continue to see that. We are making real progress. And I am really pleased and I know our team is with the progress they are making in the plants, with the focus on it. Our quality is excellent. It only gets better. And so that plus the improved operations in terms of running it in the plants are we are encouraged by it. I also tell you from a logistic standpoint, you haven’t seen a lot of that yet and you will. You will see some more savings as we get smarter and smarter at our logistics.

Today, we grew up as two separate logistics systems. We had a Keurig logistic system and we had a Green Mountain logistic system. We don’t need two logistics systems. We need one that can sell the system to our customers, and that’s the work in front of us over the next 12 to 18 months. And so those are the kind of things that you will see us do. On the procurement side, we had two procurement organizations. We don’t need two procurement organizations. We need one that can approach our suppliers and partner with them in a way that’s effective. We have what we think is one of the best coffee buying departments in the world. Our team are experts and they are deeply knowledgeable about coffee and deeply knowledgeable about the farmers who provide it, and the sustainability required to allow those farmers to continue to provide it. And so we are going to maintain that kind of excellence and as we merge them, things like typical MRO and indirect kinds of purchasing that a lot of companies would do we will need to do it in two places anymore, we can do it in one. And our suppliers like that as well.

Jon Andersen - William Blair

Thanks a lot. Congratulations on hitting the ground running here quickly.

Brian Kelley

Great, thanks.

Operator

And we will take our next question from Alton Stump of Longbow Research.

Alton Stump - Longbow Research

Thank you. Great job on the quarter first off (indiscernible) about. I guess I am trying to find something with the 5% negative pricing mix impact in K-Cups, is that in general a good number to use as you go out over next few quarters let’s say or because I guess is it more like on average 2%, 3% decline over the last couple quarters. So, was there something new this quarter that drove that down 5% number?

Fran Rathke

Alton, its Fran. I would say just to clarify the 5% or percentage points that we referred to that drove the volume of 26%, down to 21% dollar growth. That’s really not due to price decrease as much as mix shift primarily due to the large partner agreements where we manufacture the portion packs and they procure the coffee themselves, and we sell them at a lower average selling price than what the sort of mean of our business is at. So, it’s still very strong economic margin business, but it drives down our average selling price. So, that’s the reason for the 5 percentage point drop. In terms of a run rate or looking forward, I think we are starting to anniversary a lot of that business. Starbucks has been now with us over a year. Boulder is over two years on. But I think you probably should have a little bit in there. We just started Kirkland is another one although we are doing the Dunkin. So, I think you should probably factor in some mix shift negatively impacting our dollar growth.

Brian Kelley

And these are big brands and they are great brands and they are terrific additions to the system, and the brands are growing. So when you have 32 plus brands in the system, being able to perfectly predict that mix is not simple but we know as brands come in they then have to have that cycle that next year and a lot of these brands are great brands and had terrific starts and the system will continue to grow all of our partners have the ability to grow in the system, that’s the important thing. The mix is what’s driving it and not pricing. We continue to have a pricing market that’s good, one that we can add value and it's today we’re going to continue to do everything we can to see it continue that way.

Alton Stump - Longbow Research

Okay thank you. And then just one quick follow-up on the coffee cost front on (inaudible) as we are hedged exactly but if I look at that chart if there is an assumption that with our basis points then I said you got in the recent quarter that you get bigger and not smaller over the next couple of quarters as we roll into better hedged positions.

Frances Rathke

In terms of coffee, we typically tend to be forward purchase locked in the pricing for about really closer to nine months than six months, so I think what we’re going to see what we got in Q3 is we will continue to see some improvement or lower, a more pronounced improvement in margin due to coffee cost in Q3 and Q4 than we even did this quarter.

Operator

And we will take our next question from Marc Riddick of Williams Capital.

Marc Riddick - Williams Capital

Quick question on the lower obsolescence expense line that was mentioned. Now I recall last year that there was if any by I suppose maybe it was maybe hit with hot weather last year and cold weather this year maybe it might have been you guys if I recall the hot coco was an issue. I was wondering if that had something to do with the benefit of the lower obsolescence expense and maybe how we might think about that line going forward. Is there any opportunity to gain there?

Frances Rathke

You’re correct that last year in Q2 January to March we did experience in the North-East a very an unusually warm winter that did contribute to the fact that we bought too much raw ingredients on coco and that had some (inaudible) to it and then secondly we also manufactured based on earlier demand signals that our customers felt they were going to sell we had manufactured a certain amount of finished goods that became coding out, so we had obsolescence charge, this obsolescence expense for us significantly. We usually don’t have obsolescence of any degree here. So in about – what I remember last year of the charge last year more than 50% of the charge was totally tied to hot coco. Then so as we comped that this year that’s a favorable trend and then what happens was heading into Q3 if you go back in our quarterly disclosures we actually still had an obsolescence charge that was higher than normal in Q3 that was more tied to a little bit of softening demand just in general and then we didn’t have much of an obsolescence charge in Q4 and I think we have been managing we really managed down our portion packed inventory by Q4 last year, so you should not see any kind of significant obsolescence charge but it will be another benefit in Q3 and not Q4.

Marc Riddick - Williams Capital

And I was wondering getting to my second question I was wondering if the how things are going with Eight O'Clock coffee and the reason why bring that up specifically is and a sense that your lower priced I suppose authentic K-Cup offering which when you look on the shelves is really maybe the best on the ground competitor versus some of the lesser expensive competitors. So I was wondering if you can spend a little time talking about how that’s going? Thank you.

Brian Kelley

Yeah, TJ is going to take that one.

T.J. Whalen

Mark thanks. This is TJ. Yeah, you are exactly right, that was part of the intent we wanted to introduce a new consumer segment, new occasion opportunity. It also happens to hit a different price point in many of our brands. Fran spoke earlier about mix shift and the time it takes to cycle some of these new introductions. This is one of those things that is affecting the ASP and will be with us for a little while further as we have only fairly recently introduced it, but we did a great job building distribution. I think we have done a good job of getting it at the price point that we are looking forward to consumer. And frankly I think it’s been very helpful to us, and it’s given another reason for another group of consumers to be excited about the system.

Marc Riddick - Williams Capital

Do you believe that you are at whole distribution now on that?

T.J. Whalen

No, we still have ways to go.

Marc Riddick - Williams Capital

Okay, excellent. Thank you very much.

T.J. Whalen

The exciting part for us is that a brand like Eight O’Clock, and every time, we have these good brands, but they tend to be incremental in many cases. And if we are smart about how we continue to grow the business in the system, we are seeing these incremental particularly, we only have 13% households in it in the system today And so as we bring more brands, we join more households and it can grow, and it’s not a zero sum gain for the brands in our system. And I think most of the brands will tell you that.

Marc Riddick - Williams Capital

Excellent. Thank you very much.

Fran Rathke

Thanks.

T.J. Whalen

Thank you.

Operator

And we will take our next question from Mark Astrachan of Stifel Nicolaus.

Mark Astrachan - Stifel Nicolaus

Yeah, thanks and good afternoon everybody.

Brian Kelley

Hi Mark.

Mark Astrachan - Stifel Nicolaus

Does the change in revenue guidance in the second half of the year have anything to do with the change in Starbucks deal terms? And then sort of curious also on the second half guidance in terms of how you sort of bridge from much stronger low 20s sort of EBIT margin in the second quarter to a high teens EBIT margin at least by my math over the back half of the year?

Fran Rathke

Sure, Mark, this is Fran. In terms of the question about Starbucks impacting revenue guidance post this new agreement that has not had any material impact on, as we said, I think both Starbucks and our company feel very comfortable with the economics. And that is not impacting our revenue guidance. And then in terms of the overall earnings margin, as we said we are seeing our core single-serve business continue to grow at approximately what we expect to be up about 20% this year, and that includes single pack, the single-serve packs and the brewers. And we are continuing to see very strong cash flow margins and earnings. I mean, as you know, we took up our cash flow significantly. We took up our EPS considerably coming off of this quarter. And I think in terms of your question on any kind of decline in margins, I think overall there is a lot of volatility if you will in our business to try to predict and we are anticipating brewers in the back half to become a higher percentage of our sales mix and that drives down our overall margins. We still want to drive brewers. So, that’s a very important driver of our business, but I think that’s the main contributor to a slightly lower margin.

Mark Astrachan - Stifel Nicolaus

Okay. So, back on the Starbucks deal, is there a change in the economics between the previous deal and this deal? And then just one follow-up question given the (indiscernible) in looking at the scanner data, the unlicensed share of Keurig compatible coffee pods has increased in grocery to, by our math, low double-digits, could you maybe give us an update on how you see the 5% to 15% unlicensed share playing out over time please?

Brian Kelley

Let me first talk, we don’t talk about the specific deals that we do with our partners. And so I won’t comment on that. Again, the only thing I will say is that it’s a great deal for us and it’s a great deal for Starbucks. And it takes places over a long period of time and so just notice this is a – it’s a very, very good deal for us. The next question you asked is about if you look at unlicensed portion packs, the 5% to 15% that was originally given a year ago, I think we don’t know any better number than that at this point. We think it’s about 8% of our total system today. Could it grow a little bit? Yes. Could are we going to aggressively pursue brands that we want in the systems yes we will and brands that we want in our systems that want great quality. We want them to come to our system and so whether they are a terrific store brand, there is a number of great store brands out there that should be in our system. We don’t see why a brand wouldn’t want to be in our system and why they would want a full pod out there. So we look at it as 8% today, our best estimate and we don’t see why they wouldn’t come to us and so we will go and an aggressively pursue the brands that we think should be in our system.

Operator

And we will take our next question from Scott Van Winkle of Canaccord Genuity.

Scott Van Winkle - Canaccord Genuity

Most of my questions have been answered although I probably could think of a 100 more but I guess the one I would learn hear Brian you set the strategy now, you have kind of realigned and reorganized, how about the forecasting and the data and talking about being in 13 million households or household penetration and getting the 17 or 18 by the end of the year, how are you building those numbers and do you feel comfortable that you guys really have an handle on what the household penetration is either positive or negative relative to your expectations.

Brian Kelley

Here is how I would say it, you got to give us the right to get smarter and smarter and we are and every month we get smarted, every quarter we get smarter. I don’t know of many packaged goods companies or durable companies that know with precision in their install base and the capability we have today of estimating it is pretty good and it's not perfect, it's not perfect but it's good and it's getting better and so I think we’re going to get smarter and smarter at this. We have some other ways that we are approaching this the consumer study we do, the other checks we do to ensure that we have a good understanding. There is a margin for error on anything you do like this but we’re going to get better and we’re getting better at the data. So, I don’t want to overstate. I don’t think anybody I don’t think anybody here would want to overstate that our install base prediction is exact but we’re pretty confident that we’re definitely confident that as good as we today and I’m not sure that there is a better methodology out there than what we’re using, we’re going to try to find that better methodology though. So we’re committed to that.

I will stop there and see if we have more questions on that.

Scott Van Winkle - Canaccord Genuity

That’s good and then the other question and if you have mentioned in the prepared remarks I apologize for missing it but can you give us an idea of kind of where you feel about the channel coming out of Q2, you obviously gave us the heads up on in trailing sell through during Q2 on brewers just wondering what do you feel like at the end of March.

Brian Kelley

Frances do you want to talk where we think we’re in inventory and brewers?

Fran Rathke

Sure. And you’re talking about it sounds like Scott more in the brewer side.

Scott Van Winkle - Canaccord Genuity

At retail brewers obviously more specifically but would love to hear on K-Cups too.

Fran Rathke

Sure I think overall we believe that brewers are out in the trade, we came off of very overly high brewer inventories at the end of December, they worked them down quite a bit in this past quarter, We still think they are still some of the accounts have a little more than normal so I think there is still going to be some work down but I think overall we expect unit growth for the year to be in the our shipments to be in the mid-single digits inline with our overall POS, and then on single serve packs I think on we believe the overall trade is in a good position and so are we not excess.

John Whoriskey

They Scott this is John Whoriskey I will just speak to it quickly that going into Mother’s Day and through this next few weeks I think that will align our retail inventories to where they need to be and therefore going forward we would expect for the rest of the year that we’re going to be matching our POS movement with our shipments for pretty much for the rest of the year and our portion pack business is a very good inventory position at retail as well.

Scott Van Winkle - Canaccord Genuity

And John do you have anything special focused on what you always called it Mom, Dads & Grads, is it anything different that has been in the past?

John Whoriskey

Well I would tell you that we’re right in the amidst of it all and I think you’re probably seeing, we’re on TV, we’re demonstrating it in stores, we’re supporting both of our platforms actively, the retail support is again I think has been tremendous. So it's an important part of the year the spring season is important to us, spike in that seasonality.

Operator

And we will take our next question from Tony Brenner of Roth Capital Partners.

Tony Brenner - Roth Capital Partners

I would like to understand a little better the integrated brewers platform, right now Vue portion packs are about 25% of the Keurig line up. Are you implying Brian that won't be expanded further until there is a different platform?

Brian Kelley

I want to make sure I interrupt what you said to make sure I understand it correctly. It's not 25% of the volume but they are 25% of the assortment is that what you mean?

Tony Brenner - Roth Capital Partners

That’s correct.

Brian Kelley

Yeah so the assortment that Vue offers is about 25% of what K-Cup offers and that’s accurate. And so as we look at it one of the things we will do is we will have a strategy in terms of what goes in a Vue cup, what goes in a K-Cup, which ones are in those and which ones are in distinct in one or the other and lot of us are going to do with what taste we want to deliver, what brands and what benefits we want to deliver to the consumer. What the machine can do in terms of what the brewer can do to customize and really deliver the best cup of coffee. So I don’t want to go into more than that and say that it gives us enormous flexibility again to deliver the best thing for the customer and there will be some that are in multiple cups and some that are in just one.

Tony Brenner - Roth Capital Partners

And that platform would accommodate both Keurig portion packs and Vue packs or they will be completely designed of the portion pack?

Brian Kelley

They would support both current K-Cup and current Vue cups.

Tony Brenner - Roth Capital Partners

I see. Any idea of the timing of that?

Brian Kelley

Well we don’t really want to go into it on the call for obvious reasons competitive and otherwise but I think that we will get it out there when it's when we’re ready and when we have the whole plan and we are excited about it and our customers will be excited about it when we show them and we haven’t talked about anything in terms of how we brand it whether it's a high end line extension we did say that toward the end of 2014 that’s when we could start looking forward.

Tony Brenner - Roth Capital Partners

Okay and maybe you can discuss a little bit the reception of the low espresso platform and what’s your intentions are with respect to distribution and marketing of that?

Brian Kelley

We tested with one customer and it went very, very well. We’re now rolling it out to our specialty department store customers and so we have when I say high hopes it's on a smaller scale, it's not, this is not something that appeals to the 90% of households like our Keurig brewer can. This is something that is a premium system for espresso and espresso based beverages. We have very, very good consumer feedback. Michelle would you anything on retail?

Michelle Stacy

Well I think one of the things that the consumer has really responded very well to is the overall taste of the average and the fact that it really meets their expectations for wide espresso beverage but a cappuccino or latte should taste like and that’s giving us tremendous confidence in moving forward and expanding our distribution into more specialty retailers and we’re very excited about the continued growth of that system.

Tony Brenner - Roth Capital Partners

Will this be marketed to the holiday season?

Michelle Stacy

Absolutely we’re expanding our distribution for the holiday season into other specialty retailers.

Operator

And this does conclude today’s question and answer session. At this time I will turn the call back to Mr. Kelley for any closing remarks.

Brian Kelley

We thank you very much for your questions, for your interest, for your support and we look forward to seeing you again soon. Thank you.

Operator

And this does conclude today’s conference call. Once again we would like to thank everyone for your participation and have a wonderful day.

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