Non-recurring gains mask earnings decay; insiders now dumping at inflated prices
In response to the wild ride in the share price of JVA over the last four months (up 650% from trough to peak), the GeoTeam decided to take a closer look. After careful research, we have concluded that the company is dangerously overvalued at current prices. The stock appears to have rallied as a result of what we suspect were unnoticed and consider to be non-operating items in its fiscal 2011 quarterly earnings reports. These items may have created the appearance of strong earnings growth when in fact it seems apparent that core earnings are decaying. The following summarizes our obs.
Regarding earnings comparisons...
The stock surged in response to its 2Q 2011 earnings press release in which the company reported apparent strong net income growth of 47% from the previous year's same quarter.
To the contrary, for the same time period, if we remove the gains from the company's earnings, as would be appropriate for unpredictable non-recurring items, the earnings actually declined year over year by 37%. Repeat: they declined.
Regarding the use of options and futures contracts...
In their press releases, we believe that management failed to effectively communicate to the market that the net income growth in both quarters was essentially entirely a result of gains made through the purchase and sale of options and futures contracts to manage the purchase of coffee.
In FY2008 and 2Q 2008, when JVA reported huge losses that created the (false) appearance of a rapidly decaying business, the company very clearly communicated to investors in its earnings press releases that the losses resulted specifically from non-recurring losses on options and futures contracts. To quote the FY2008 earnings press release:
We had a net loss of ($2,597,294), or ($0.47) per share (basic and diluted) for the year ended October 31, 2008 compared to net income of $937,316 or $.17 per share (basic and diluted) for the year ended October 31, 2007. The decrease in net income primarily reflects hedging losses when the price of coffee surged to a ten year high and subsequently collapsed during February and October 2008.
Now that the company has found itself in the reverse situation, with options and futures contracts leading to non-recurring profits that have created the (false) appearance of attractive earnings growth, the company has decided to say nothing in its earnings press releases, paving the way for the stock to rally on hype and hot air. We find this lack of clarity and consistency in press release disclosure to be both opportunistic and troubling. Shame on management.
Regarding insider selling...
Even more troubling is the fact that management is now capitalizing on the stock’s questionable price surge by dumping shares as the stock has rallied. On July 11th, the CEO sold $3.37MM worth of shares in the open market at prices ranging from $23.01 to $25.81.
As if that weren’t enough, on the same day, the Vice President sold another $3.36MM worth of shares.
Regarding coffee prices...
Coffee prices are currently tapering off of an all-time 30 year high. Unless investors think that coffee prices are going to infinity, then these gains are non-recurring.
If we apply an extremely generous P/E multiple of 30 to JVA’s trailing 12-month taxed operating EPS of 0.217 (excluding gains from purchases and sales of options and futures contracts, and applying a 36% tax rate), JVA's fair value would be $6.50. Given that...
- the company’s year over year recurring earnings growth is negative,
- management appears to be inconsistent in terms of what it emphasizes in press releases, and
- most importantly, insiders are dumping their shares on the open market,
...we think a lower P/E may be appropriate. We believe that analyst fiscal (ending October) 2012 EPS growth estimates of less than 10% further support our lower P/E assumption. Note that on July 21, 2011 the stock closed at $21.26. We believe that the market will eventually share our conclusions. As for those traders and investors who appear to have bought into this name on a misunderstanding, it could be a very painful move down.
Investors should note that JVA has a small float and should expect high volatility in the company's shares as market dynamics play out.
Please see our full update.
Disclosure: I am short JVA.