Green Mountain Coffee Roasters: Restructuring The Ghosts Of Acquisitions Past

Oct.21.13 | About: Keurig Green (GMCR)

Green Mountain Coffee's (NASDAQ:GMCR) announcement to shutter its production facility in Toronto reveals an increased pace of momentum in the company's restructuring efforts. We had previously discussed restructuring signals at GMCR that investors may want to keep an eye on going forward.

In a press release issued on September 5, 2013, the company announced it expects to cease production at its Toronto, Ontario facility by March 5, 2014 affecting a total of 120 production and production support employees, or approximately 2% of its total workforce, whose positions will be eliminated.

As we continue to grow, we also are assessing the effectiveness of our manufacturing, distribution, and logistics network across our U.S. and Canadian locations," said Brian P. Kelley, President and CEO of GMCR. "We have expanded the footprint of our Montreal facility more than 40% this fiscal year. After careful analysis of facility-specific operational costs and the Toronto facility's inability to expand to accommodate future growth, it was clear that consolidating our Canadian-based production to our Montréal facility is the right business decision to support our strong and growing presence in Canada.

GMCR expects a one-time pre-tax charge related to this action in its fourth quarter fiscal year 2013. It is also interesting to note that the company provided no figures as to the amount or range of the pending charge. However, the company expects the impact of the charge will be immaterial to its fiscal year 2013 results and did not update its previously issued financial outlook.

Lingering Questions About the Timothy's Acquisition: The Toronto facility was acquired by GMCR when they purchased the wholesale and roasting operations of Timothy's Coffee's of the World Inc. back in 2009 for $157 million. The acquisition was lauded by former chief operating officer of GMCR's specialty coffee business unit Scott McCreary as a "jumping off point to grow our business in Canada".

This acquisition will provide GMCR with a Canadian presence and a coffee roasting facility in Toronto. It will accelerate GMCR's geographic expansion," former Green Mountain Coffee Roasters CEO Lawrence Blanford said in written statement.

This is a bit ironic when you consider current CEO Kelley's comments regarding the assessment and effectiveness rationale for shutting down Toronto production all together. We also consider Mr. Kelley's view that the "Toronto facility's inability to expand to accommodate future growth" as a potential tactical attempt to imply that "future growth" has rendered the Toronto facility redundant.

Keep in mind; it was only four years ago that previous management believed the 40,000 square feet of manufacturing facility (included in the Timothy's deal) penciled-in to the growth story. Obviously, Mr. Kelley's operating perspective suggests otherwise.

Another interesting aspect to the planned closure of the Toronto production facility is its connection to a previous Securities Exchange Commission Division of Corporation Finance comment letter (and subsequent response by the company) regarding segment reporting in its 10-K report for the fiscal year ended September 24, 2011.

As mentioned earlier, the Toronto facility was included in the November 2009 Timothy's Coffee acquisition. In response to the S.E.C. request for clarification on Note 7 -Goodwill and Intangible Assets (page F-28 of 10-K), the Company states the following:

Timothy's was operated as a plant for the SCBU prior to the Company's acquisition in December 2010 of LJVH Holdings Inc. ("Van Houtte") (which is also located in Canada). Timothy's is shown separately in the segment managers package because it was acquired by the Company in November 2009 and included in the SCBU segment until September 24, 2011, when it was transferred to the CBU. Green Mountain Coffee Roasters and Timothy's share similar characteristics given that they each are in the business of sourcing and roasting coffee in various package forms, predominately K-Cup® packs, to sell to various customer channels (i.e., offices, in home channels such as supermarkets, club stores, mass merchandisers, and also consumer direct). The KBU operating segment is currently a reporting unit because it comprises only a single component. The KBU primarily sells brewers and accessories to retail department stores and mass merchandisers ("retailers"), club stores, consumer direct and offices as well as K-Cup® packs to retailers and consumer direct. Discrete financial information is currently available for each of these components and is regularly reviewed by the President of the applicable operating segment.

GMCR claimed Timothy´s unit averaged a 33% gross margin in the five quarters ending September 24, 2011. When a company sheds an operating asset only a few years after telling regulators it had a relevant economic characteristic, the change in the asset´s economic usefulness will need to be reconciled adequately.

More important, when a company makes changes to or combines aggregated components (within the operating segments) the method in which it is valued, (however subjectively) becomes the basis of the representation. As it pertains to Goodwill and Intangible Assets do the numbers provided by the company consider the guidance of FASB ASC paragraph 350-20-35-35 within reason?

Sam E. Antar, who runs the blog White Collar Fraud, put out a report in July 2012 which carefully examines the S.E.C. comment letter and the company´s response in greater detail.

Scissors, Axe or Chain Saw: Corporate restructurings are not exclusive to financially distressed or highly leveraged businesses. In many capital intensive industries for example, competition, input costs, underfunded pensions and a host of other potentially variable liabilities often find companies in perpetual restructuring mode. Cost-cutting and increased productivity will always be fashionable.

While improving operating leverage is a primary reason why Mr. Kelley is at the helm, his actions do indicate that house-cleaning may have stepped up a notch. Last March, GMCR announced a workforce reduction, with expectations of a Q2 2013 related pre-tax charge in the range of $600-650 thousand.

The question we have is how much of a charge should investors expect related to the Toronto facility? The absence of such information, suggests GMCR management is treading carefully, presumably to avoid shocking investors with additional potential surprises. It is also notable that the expected March 2014 Toronto closure coincides with expiration of the lease on the facility.

Previous management seemed confident the Toronto facility would play an important role in the company's future. Now, four years later, GMCR's current management is signaling a need to consolidate the Toronto production elsewhere.

Again, we believe Mr. Kelley will likely be chief architect for improving operational efficiencies at GMCR. The question is, will it be accomplished with scissors, an axe or chain-saw? We saw a two percent workforce reduction this past spring. Now, the company is planning to cease production in Toronto (expected to trim an additional two percent of GMCR's total workforce).

It is important for investors to realize that while GMCR was in hyper growth phase, previous management led investors to believe the company was capacity constrained. Remember, the company's CFO Fran Rathke only a year ago alluded to inventory builds seen in FQ3 2012 as likely the result of customers lowering their forward inventory coverage. The assumption being, that customers were more confident in the supply channel going into Q3 (given Rathke's belief that customers may have been more concerned about supply constraints in the previous Q2 and Q1 periods for FY2012).

Unfortunately, it was also Q3 2012 that management recognized a flawed forecast model, suggesting this may have been the cause of under-utilization of both labor and capacity during the similar Q3 period. (CFO Rathke's comments on the issue can be viewed at the link above). Here we are a year later as capacity is being consolidated and the workforce trimmed.

Slamming on the Brakes: We know revenue at GMCR has moderated from the heady quarterly growth rates of recent years. This current restructuring reminds us of what happens when you crash the company car. The driver(s), in this case prior management, were behind the wheel when growth was "rapid". Driving a car fast is one thing, but driving recklessly or blindly and getting paid well to do so is entirely different.

GMCR Revenue Quarterly YoY Growth Chart
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GMCR Revenue Quarterly YoY Growth data by YCharts

There is no irony lost on the fact previous senior management has left the company. However, their actions required bringing in new operating leadership to clean up the mess. This is not about coffee, brewers or leveraging the company's platform (did we hear soup?). Also notable is the company's recent announcement to open a retail Keurig® store slated for November 2013.

This restructuring is more about cleaning out the skeletons of previous management, rationalizing their serial acquisitions and making sense of the baggage left behind.

Rationalizing assets are seldom a simple nip-and-tuck event. Thus far, we have yet to see asset impairment charges for goodwill and intangible assets resulting from GMCR's previous acquisitions.

Although the trend of GMCR's goodwill and intangibles growth appear to have moderated since 2011, the devil is usually in the details. As of June 30, 2013, GMCR had $1.22B of reported goodwill and intangibles on the balance sheet. This is equivalent to one-third of total assets ($3.62B) and more than half of total long-term assets.

GMCR Goodwill and Intangibles Chart
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GMCR Goodwill and Intangibles data by YCharts

If anything, the Toronto news suggests that GMCR may still be in the very early innings of its restructuring efforts. More important, it reveals the "dismantling" of actions taken by previous management and at a time when reported revenue growth collapses from 95% to a more "normalized" growth rate between 15-20%.

Legacy of previous management: There is nothing wrong with double-digit revenue growth, but the senior management responsible for GMCR's parabolic growth have all unceremoniously slipped out the back door. In most cases with plumper wallets and as the growth-rocket experienced "gravidad".

It's easy to take credit for the ride up, but leaving the party when the punch bowl suddenly isn't brimming begs too many questions. Consider former CEO Larry Blanford's prepared comments during the Q4 2012 earnings call (Blanford's last as acting CEO):

Finally, well, this is my last conference call. I'd like to say thank you to the amazing GMCR employees across North America. GMCR is a place of high energy and passion for innovation with a culture of inclusiveness and giving back. I'm proud and humbled by what this organization has accomplished over the last five years.

During my time here, we have taken GMCR from being a modest participant in single serve to an architect of change in the category from several hundred millions of dollars of sales to several billions from less than a 1,000 employees to nearly 6,000, and from limited distribution to mass distribution of Keurig products with significant and very impressive merchandising and display. Five years ago, no one would have imagined this is possible.

Discussing my intent to retire earlier this year, one of my top priorities has been to ensure a seamless transition to the next-generation of leadership. I'm confident that in Brian Kelley, we have identified an ideal successor, one eminently capable of taking GMCR to the next level of its growth and opportunity of fostering the creativity and imagination manifesting itself daily in new product innovation and are continuing to inspire this amazing organization to accomplish feats others deem impossible.

Transitioning a company to the next-generation of leadership is often considered a positive, at least in theory. However, boasting to be an architect of change implies management's game plan was tactically and strategically sound. The manifestation of "modest participant" to market leader also suggests that the building blocks (via acquisitions) were and presumably remain essential to the company's future. Yet, when a growth story suddenly changes, the "architect's" blueprints should be scrutinized more closely.

Blurred Acquisition Accounting: We do believe that integration of GMCR's current operating infrastructure will likely result in further and potentially significant asset impairment charges, write downs and other harmful shareholder equity actions going forward.

Also, keep in mind that GMCR's previous acquisitions were financed with cash provided by secondary offerings and debt. For all practical purposes, they were bolt-on acquisitions and not organically funded with operating cash-flows.

Acquisitions are notoriously complex matters and often involve some ambiguity regarding materiality. A non-cash impairment charge may be "immaterial" to fiscal year results and cash-flow scenarios, but shareholder equity is reduced as a result of the impairment loss included in the income statement.

A more conservative accounting policy which would accurately reflect both the financial condition of a company and the quality of their earnings include: rapid write-off of fixed assets; writing-off impaired assets quickly; net income closely resembles cash-flow from operations.

Additionally, the relationship of goodwill and intangibles to total assets suggests that many of GMCR's deals came at a premium. In absolute terms, the $157 million paid for Timothy's may seem trifle when compared to GMCR's $9 billion market-cap. But, shuttering 40,000 square feet of production capacity says the risk of diminishing returns will have to be reconciled eventually.

The cost of the Timothy's acquisition in excess of the fair market value of assets acquired less liabilities assumed represents acquired goodwill of approximately $69.3 million. The acquisition provided the Company with a Canadian presence and manufacturing and distribution synergies, which provide the basis of goodwill recognized. Goodwill and intangible assets related to this acquisition are reported in the SCBU segment. The goodwill recognized is not deductible for tax purposes. (Page 60 of FY2012 10K)

Investment Risk: Investors should be prepared for further turbulence in GMCR's share price as the restructuring efforts continue to unfold. Thus far, we have observed very basic steps taken by the company to improve operating efficiencies. Any progress is better than no progress, but in barbershop parlance, these are trims.

The current multiple of 22 times earnings assumes revenue growth will justify the valuation going forward. However, it does not price in the potential for damage to shareholder equity resulting from ongoing restructuring events.

GMCR Return on Equity Chart
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GMCR Return on Equity data by YCharts

ROE has moderated significantly since 2008 while reported shareholder equity grew almost three times faster during the similar period of time. This by itself would be a glaring red flag considering the fact sales growth at GMCR has fallen dramatically in the past year.

GMCR bulls like to believe that even moderating "normalized" growth rates validate current share price valuations. Bulls also point out the perceived benefits of new strategic partnerships and platform integration as a catalyst for justifying multiples. And, a new management team led by CEO Bryan Kelley adds plausibility to the bullish viewpoints.

Obviously, we acknowledge new management and board configuration as valuable to the future success of GMCR. Yet, regardless of the future prospects and favorable gloss of recent headlines, GMCR is a company amidst a massive organizational, operational and cultural turnaround. While we would prefer to see a more expedited restructuring process, timelines are never precise nor outcomes certain.

What we do know is that previous management was unceremoniously shown the door and a new management team is responsible for proving to investors there is still some meat on the bones.

Although an incremental restructuring process may be comforting to shareholders (small cuts bleed less than a gaping wound), a prolonged restructuring could potentially result in cloudy "facts ascertainable".

GMCR Chart
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GMCR data by YCharts

GMCR's share price is well off of its summer mid-$80 highs, but the stock still looks expensive to the forward revenue and earnings guidance currently available. Further improvement in operating efficiency would be constructive to the future outlook, but the greater risk to GMCR shares we believe is in the rear-view. Anytime previously rapid growth (fueled primarily via acquisitions) stalls or moderates, the risk of asset impairment increases significantly.

Managerial opportunism does not necessarily qualify as a moral hazard, but reckless or uninformed decisions and actions do open the door to "collateral damage" for stakeholders. In the case of GMCR, previous management proudly relished in their achievements, only to tell investors last year that their crystal ball (forecast model) was flawed. Oops!

To think the departures of key senior executives and board members are a coincidence and easily explained as a fluid transition is extremely tough to swallow. For those with short memories the company deftly announced a very successful secondary offering within minutes of releasing their FQ2 2011 earnings report. To call timing of the secondary as "uncanny" may be too generous a term. Events leading to the offering included a robust dog and pony show and a FQ2 earnings beat which was 27% higher than consensus of the eleven analysts covering the name. The secondary also provided for insiders to sell more than 410,000 shares as part of the offering (see page S-4 of the prospectus supplement).

You cannot make these things up and prior management's acumen for raising capital is in sharp contrast to their seemingly operational ineptness. Ultimately, it's the erosion of confidence and the actions of previous management (less than one year after pounding the table about a rosy growth story) which should concern shareholders most.

It is unsettling enough that insider selling was rampant during the period of explosive growth (2010-2012). However, the fact most of the insiders have left the company within a very short period of time only heightens this concern.

More to the point, it casts further doubt to the legitimacy of reported sales and revenue growth in prior years. Earnings growth creates more value when it is rooted in activities that generate high returns on capital-such as the discovery of new customer segments for a company's products-rather than in activities with low returns on capital, such as many acquisitions when the goodwill paid is taken into account.

Recent headlines suggest GMCR management is heavily engaged in the discovery of new customer segments for its products. Innovation will always be a catalyst for future growth, but GMCR first needs to reconcile potentially messy adjustments of its previous acquisitions.

Perhaps GMCR can grow its way out of legacy issues, but the company is arguably walking a tight rope now. It's a balancing act between building for the future and cleaning up pricey acquisitions of the not so distant past. Future growth opportunities make for good press releases, but they will not be realized if the cart is before the horse.

GMCR is scheduled to report fiscal 2013 fourth quarter and full year results following close of market on Wednesday November 20, 2013. It bears mention that the 10K filed by the company for fiscal year 2013 will be required to include audited financial statements (Item number 8 of the 10K report).

Investors are encouraged to pay close attention to the footnotes accompanying the financial statements for clues to how management explains the restructuring initiatives undertaken this past year. Keep an eye on changes to fixed assets, amortization of identifiable intangibles and the allocations provided to the presentation and basis of goodwill.

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