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

F1Q08 Earnings Call

January 31, 2008 8:30 am ET

Executives

Frances G. Rathke, Chief Financial Officer, Vice President, Secretary, Treasurer

Larry Blanford, President and Chief Executive Officer

Nick Lazaris, President of Keurig, Inc.

R. Scott McCreary, Chief Operating Officer

T.J. Whalen - Vice President of Marketing

Jon Wettstein - Vice President of Supply Chain

Analysts

Mitch Pinheiro - Janney Montgomery

Scott Van Winkle - Canaccord Adams

Mark Astrachan - Stifel Nicolaus

Nicole Miller - Piper Jaffray

[Rick Feron] - Credit Capital

Operator

Good day and welcome everyone, to the Green Mountain Coffee Roaster, Inc. Fiscal 2008 First Quarter Financial Results Conference Call.

At this time, for opening remarks and introductions, I would like to turn the call over to the Vice President and Chief Financial Officer, Ms. Frances Rathke.

Frances G. Rathke

I would like to thank all of you for joining us this morning for our First Quarter Conference Call. If you have not received the earnings press release, it is on our website at www.gmcr.com.

Before we begin, I want to remind everyone that certain statements will be made today that are forward-looking within the meaning of securities laws. Owing to the uncertainties of forward-looking statements, actual results could differ materially.

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

Larry Blanford

Thanks, Fran. Good morning, everyone. Joining us on the call today are Nick Lazaris, the President of our Keurig subsidiary and Scott McCreary, the Chief Operating Officer of our Green Mountain Coffee division. Fran will take us through the financials, and Nick and Scott will talk about their respective businesses. After these remarks, together with other members of our management team, we will be available to respond to your questions.

We are excited that we are off to such a great start this year with our first quarter results. As we predicted in our last conference call, the big story in our first quarter would be, and indeed was, Keurig Brewer sales are equivalent to the razors, in a Razor-Razor Blade opportunity. The robust growth rate of Keurig Brewers, up 166% overall during our first quarter, not only contributed meaningfully to our sales growth this past quarter, but also provides compelling benefits going forward as we anticipate it will drive continued sales growth of K-Cups to consumers’ homes and office environments.

As Fran will detail shortly, we continue to deliver strong sales and earnings growth. The bottom line is that Keurig continues to enhance our financial results and strengthen our market and brand development strategy, giving us a distinct competitive advantage. Also I believe, our corporate foundational principles which integrate corporate social responsibility, people, and financial success, further enhances our competitive advantage.

From the coffee farmer in a third-world country to the investor owning our stock, we’d like every GMCR constituent to benefit from their interaction with us. It is our purpose to have a positive impact on the world and the way the world views business. This may be a lofty goal, but it’s a big part of what motivates us at GMCR and distinguishes us in a highly competitive market where we compete for everything from sales opportunities to business partners and outstanding employees.

Looking forward, we are focused on continuing to deliver strong sales growth and to improving our margins for long-term sustainability and shareholder value. For 2008, we are raising our previous guidance and now expect to grow our top line by 40-45%, and increase our net income and earnings per share as much or slightly more, within a range of $0.72 to $0.77 per share.

And with that, I will turn the call over to Fran.

Frances G. Rathke

Thanks, Larry. I, too, am very pleased with our financial performance this past quarter. In the interest of time, I will repeat very little of the information contained in the press release we issued earlier today which is available on our website. I do, however, want to expand upon several key items in that release.

Net sales for our first quarter totaled $126.4 million, up 52% over last year. About two-thirds of our top line growth was due to very strong sales in our Keurig segment where dollar sales were up 115% over last year’s first quarter. The Green Mountain Coffee segment also achieved strong sales growth of 27% this past quarter with sales of K-Cups driving the majority of this growth. In a few minutes, Scott will talk more about the key elements behind this segment’s successful quarter.

Looking more closely for now at Keurig, a little over half of the increase in Keurig sales this past quarter was due to higher Brewer sales with shipments up an impressive 166%. The other half of the increase was due to higher K-Cup sales and royalty income from the sales of K-Cups.

The majority of the Keurig Brewer sales growth was due to strong sales of the At Home Keurig Brewers during the holiday season. This obviously bodes well for the anticipated future sales growth of K-Cups to support this increase in the installed base of Brewers.

Our gross profit for the first quarter of 2008 totaled $43.3 million or 34.2% of net sales, as compared to $31.7 million or 38% during last year’s first quarter. The decline in gross margin was largely due to the significant increase in sales of Keurig At Home Brewers as a percentage of total net sales which have lower gross margins than most of our other products.

Looking forward, this factor is seasonal as approximately three-quarters of Brewers sold into the retail channel over the past 12 months were sold during the last two quarters, which is the holiday season. In addition, our gross margin declined due to higher coffee costs; the sales mix shift towards K-Cups from other products; and higher manufacturing costs due the opening of our new K-Cup packaging facility during the first quarter.

In the first quarter of 2008, total company SG&A expenses improved as a percentage of sales to 29.1% from 31% in the prior year quarter. This improvement was achieved even though, as planned, the Keurig segment increased its selling and marketing expenses by 76%, as compared to the same quarter last year, to successfully drive sales of Keurig Single-Cup At Home Brewers during the holiday season.

Net income was $2.9 million in the first quarter of 2008, an increase of 20% over last year. Net income per diluted share was $0.12 in the first quarter of 2008, as compared to $0.10 in the first quarter of 2007, and was inline with our previous guidance of $0.10 to $0.14 per share. Overall, we are extremely pleased with our financial performance this past quarter.

Looking forward to our business outlook for our full-year and second quarter of 2008, please keep in mind that my remarks and the information contained in the press release are based on current expectations. These statements are forward-looking and do involve some very real uncertainty. Actual results may differ materially. The only updates we expect to make to you regarding our expectations and performance are on these routine quarterly conference calls, and in the related earnings press releases, and SEC filings.

As Larry has already noted, we are raising our guidance for both sales and earnings growth for this fiscal year. This increase is based upon the vitality of the Keurig and Green Mountain Coffee brands, the sales growth we achieved this past holiday season, and the higher installed base of Keurig Brewers underlying that growth.

At the same time, we, along with the rest of corporate America, are concerned about the possibility of an economic slowdown and the potential negative impact of such a slowdown on our sales. Keeping this caveat in mind, for the full fiscal year 2008, we now expect total consolidated net sales growth of 40-45%. Other key factors, including operating margin expectations, interest expense, CapEx, and annual depreciation amortization, are contained in today’s press release.

Incorporating these estimates, we anticipate fully diluted GAAP earnings per share will be in the range of $0.72 to $0.77, which is a similar to slightly higher rate of growth than our guidance for top line growth of 40-45%. And this includes the non-cash stock amortization expenses related to the identifiable intangibles estimated to reduce EPS by approximately $0.11 per share. The details of our second quarter expectations also are contained in today’s press release, so I will not repeat them here.

With regard to both full-year and second quarter expectations, I anticipate investors will be particularly focused on two items: one, our sales growth potential; and two, the impact of our gross margins on earnings growth potential. Regarding the first item, with all the speculation about a significant downturn in the economy, there is uncertainty about our growth prospects. That uncertainty is very real. That said, on balance, at this time our current analysis gives us enough confidence to go public with the increase and expectations that we have announced today.

Regarding gross margins, I just outline the primary factors impacting costs of goods. Opening the new K-Cup packaging facility was one of these factors responsible for roughly a tenth of the company-wide decline. Operating in our current environment of dramatic growth, and working to effectively meet that growth while planning to meet future demand, the balancing act is challenging at times and not without uncertainty.

On the other hand, I think you’ll agree that meeting very high growth is a nice challenge to have even as we focus on the cost containment part of that equation. In addition to adding manufacturing capacity, green coffee cost increases and the sales mix issues that have impacted our first quarter gross margin, some of which are specific to our first quarter holiday sales, and others which represent a new trend related to the tremendous success of the Keurig Single-Cup Brewer and K-Cups. Scott will be talking more in a few minutes about pricing as a part of our strategy to strengthen margin.

On balance, as we weigh the many factors and their impact on our sales growth and gross margin, combined with the continued anticipated SG&A leverage, we anticipate our second quarter and full-year operating margins will be where they were in fiscal 2007 or up to a full point better. As a result of these expectations, we believe we can grow earnings at least as much as sales in 2008, as I detailed a few minutes ago.

These obviously are all forward-looking statements and are based upon beliefs and assumptions that involve very real uncertainty and risk.

Now I’ll turn the call over to Nick. You’ll probably be pleased to hear that he will move beyond all this cautionary language to expand upon the reasons for our optimism about this fiscal year.

Nick Lazaris

Thanks, Fran, and good morning everyone, and as given our results and prospects, I can easily add plenty of optimism to this call. In addition to what Larry and Fran already have reported. Let me add a few more numbers to help you understand the business opportunity.

Shipments of 322,000 brewers this past quarter brought our total brewer shipments to 1.3 million, since we launched in 1998. A breakout of Away From Home Brewers shipped and At Home shipped is presented in a table on the last page of today’s press release. The installed base of brewers generated demand for K-Cup shipments of 230 million K-Cups by our roaster partners in the first fiscal quarter, 58% higher than comparable 13 week period in the prior year. In total our roasters have shipped almost 2.3 billion K-Cups on a life today basis.

If you’ll also see on the chart at the back of today’s press release, Green Mountain Coffee continues to be the leading Roaster representing well over half of all roaster K-Cup shipments for the first quarter.

Point-of-sale research performance by the NPD Group continues to show that Keurig was the market leader in dollar and unit share in the single-cup category at retail in the fourth calendar quarter of 2007. This data has Keurig with 59% dollar market share in the total single-cup category up from 28% in the prior year’s comparable quarter.

The NPD data also shows Keurig with 49% unit share in the single-cup category were just 21% in the prior year’s comparable quarter. Overall, we were pleased with the impact of our TV advertising spend of $3 million during the 2007 holiday season, which was reflected in our first fiscal quarter’s SG&A expense.

The campaign was a success on two levels. First, it helped us to secure better merchandizing space in retail stores and add space in catalogs across all markets. Second, it supported increase consumer awareness and interest in the target markets during the prime buying season between Thanksgiving and Christmas. Despite what you read about softening of consumer spending in general, post holiday year-to-year comp store brewer sales through this January continue to show strong year-to-year growth.

We believe there our continued success is partly a function of our more affluent target customers. I’d also add that some of our customers feel that Keurig saves them money as well as time, versus stopping at a coffee shop. In fact our survey show that this is one of the most distinct changes in coffee consumption behavior of people who convert to a Keurig system.

Our retail store count at calendar year-end was about 10,000 retail outlets from brewers and K-Cups in the United States and Canada, and we expect this continue to grow in calendar 2008. However, most of brewer sales growth in 2008 will continue to come from increasing rates of brewer unit sales per store rather than by adding new stores.

With the every increasing installed base of Keurig brewers and customer knowledge of K-Cup availability in retail stores, we continue to see a very strong growth in our K-Cup sales at retail. This K-Cup availability is convenient for consumers and provides our retail partners with substantial incremental sales and profits beyond brewer sales.

In addition to our success in the AT Home consumer market we continue to grow rapidly and the away from home office coffee market, where we believe we are the leading single-cup system in terms of brewer unit shipments. Our small, medium, and large office brewers were all redesigned and introduced in the last 24 months. These new products have helped our distributors continue to gain distribution.

In September, we launched our model B130 brewer for the away from home hotel in room brewing market, where we believe there are 5 million coffee makers. During the first fiscal quarter we shipped about 13,000 B130 brewers. Today we believe that together with the September shipments, we have about 14,000 brewers in hotel rooms in seven chains including Loews, Intercontinental Hotels Group, LXR, and Swiss Hotel, as well as several independent hotels.

We expect to make substantial progress in this channel during fiscal 2008. The hotel room brewer is an excellent and economical demonstration device and we are optimistic about its impact on our over all business market.

In summary, we continue to be pleased that Keurig contributes meaningfully to the success of our Green Mountain enterprise. In addition, to building Keurig’s brand at the leading Gourmet single-cup system, we’ll continue to help build national awareness, of the Green Mountain brand as well.

I’m pleased now to turn the call over to Scott McCreary, COO of Green Mountain Coffee segment.

R. Scott McCreary

We grew sales for the Green Mountain Coffee segment by 27% this past quarter. Certainly impressive in today’s market environment unless you’re following the comments of some one who just grew their segment sales by 115%. All kidding aside, the synergies between the two businesses are evident in both our numbers, such as Green Mountain Coffee’s 60% increase in K-Cup shipments. Our Office Coffee Services, or OCS, consumer direct, and the reseller channels were the main beneficiaries of the strong K-Cup sales, as you’ll see in the chart near the back of today’s press release.

We are now also seeing strong K-Cup sales in our supermarket channel where we are testing placement of Brewers and K-Cups in over 1000 locations. Based on our positive results, a key focus for us this year will be to expand K-Cup distribution into more supermarkets.

Consumer direct K-Cup sales increased 113%, supported by continued growth in our Café EXPRESS continuity program. Q1 Café EXPRESS membership grew by about 80% versus last year. We currently have over 75,000 active members, about three-quarters of who are buying K-Cups. We grew K-Cup sales in the OCS channel by 41% as we continue to partner with Keurig and new and existing distributors to expand Away From Home Brewer placements.

This past quarter we delivered growth in every channel. Those channels less impacted by K-Cups such as, C stores and food service, are more than holding their own. Feel free to ask me more about them as well OCS during Q&A.

Key to delivering our K-Cup growth was the investment we made last year in high-speed production lines and a new plant in Essex, Vermont. Last year we installed five new K-Cup lines, which doubled our annual capacity to 800 million K-Cups.

Our teams worked hard through the fall to meet increasing demand and they’re doing a great job. Seven more production lines are on order and will be installed this year to support the anticipated growth through fiscal 2009. As this production comes on-line we intend to leverage the overhead investment we’ve made in Essex and improve gross margin.

While we are striving to achieve production efficiencies in our K-Cup manufacturing, we’re also taking the steps to ensure that we have the capacity necessary for the rapidly growing single-cup business, and as Fran said, this is a balancing act.

On the upside, there are opportunities to gain additional distribution efficiencies and support our growth by having production and distribution in other region of the country. Work has begun to identify potential sites to add to our existing capacity. The initial focus is on K-Cup production, and we should be in a position to say more about this by next quarter.

New products and approaches are also key to our success. For our grocery channel, we launched a new line of single-origin coffees to build excitement and sales for a selection of our existing coffees, sourced directly from a particular area, farm, or state and known for their high quality and unique taste. Four of the single-origin coffees are Fair Trade Certified and all of them invite consumers to feel a direct connection with the farmers. With this line we introduced our new look and 10-ounce packaging which will be expanded to our other coffees in fiscal 2008.

Our line of Newman’s Own Organics coffee has also had a makeover. New packaging and a new flavor, vanilla-caramel, have lead to double-digit increases in sales year-over-year. Overall, sales of our Fair Trade Certified and Fair Trade Certified organic coffees continue to increase in the supermarket channel with both existing and new customers.

We have continued to reinforce our K-Cup leadership by adding new selections. We are the only roaster to have a Hot Cocoa K-Cup which was very successful this past quarter. Recently we introduced seven new coffee and tea K-Cups. The new coffees include Double-Black Diamond, our darkest coffee ever, Dark Magic Decaf, Hazelnut Dark Roast, and Half-Caf, a medium roast with all the flavor, but half the caffeine.

For the most part, Green Mountain Coffee has not increased prices since March 2005, almost three years ago. As we see continued high coffee prices, and our sales mix shifts to more K-Cups, we’re revaluating pricing as part of our effort to improve margins. Looking forward we’re focused on continuing to deliver strong sales growth and improve our margins so that it translates into even stronger earnings growth.

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

Larry Blanford

Thanks, Scott. Fran, Nick, Scott and I are joined today by T.J. Whalen, Vice President of Marketing, and Jon Wettstein, Vice President of Supply Chain. We would all be glad to respond to your questions. We will now start the question queue.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mitch Pinheiro - Janney Montgomery.

Mitch Pinheiro - Janney Montgomery

Hey, a couple of things I want to ask. In terms of, so your, Green Mountain’s share of the Keurig K-Cup sales is increasing. So, is that a function of a better execution on your part, are there is there slippage in the other brands?

T.J. Whalen

Our share within the system moves around a bit quarter-to-quarter depending on customer acquisition for us, as well as our other roaster partners. Products also impact that a bit, and I think what we saw in this past quarter was largely a function of cocoa being an aggressive new introduction for the system.

Mitch Pinheiro - Janney Montgomery

In terms of supermarket K-Cup sales, would there be slotting expense associated with that? And would you consider paying? I mean, Green Mountain has never, to my knowledge, endorsed the slotting philosophy?

R. Scott McCreary

Yes, our initial introduction in supermarkets has been with our core customer base that we’ve had, supported through our DSP program and we’ve been able to get in with our tower program, and getting shelf space without slotting. As we expand further, we are definitely considering slotting to get on the shelf into more stores and we will work that through account by account.

Mitch Pinheiro - Janney Montgomery

Is that something that is planned for fiscal ‘08 and in your updated guidance?

R. Scott McCreary

Yes.

Mitch Pinheiro - Janney Montgomery

In terms of pricing actions, you’re considering that. So you haven’t taken any pricing on bulk or bag coffee in the supermarkets. Is that what I understand?

R. Scott McCreary

Yes, that’s basically the case. We’ve done a little bit of realignment with some of our packaging so, for example, with the Newman’s Own we had a combination of 10-ounce and 12-ounce packages that have now been realigned to a common 10-ounce bag size. So with that, that line pricing was adjusted, but it wasn’t intended as a price increase, so, yes, since March of 2005.

Larry Blanford

Just on that point, we continue to monitor green coffee costs very carefully and track that, and certainly are evaluating the situation and also evaluating competitive moves. And we’ve not made a decision yet, but we are obviously monitoring it closely.

Mitch Pinheiro - Janney Montgomery

And then as it relates to your CapEx guidance, and also, Jon, I think you’re on the call, could you update us on where you are with your grinding capacity and as it relates also to what is involved in that CapEx budget increase?

Jon Wettstein

Thanks, Mitch. That figure, you’re obviously watching this closely. As far as grinding capacity, that is a particular bottleneck at the moment, and we have new equipment on order and being installed in the month of February. So we’ll be in good shape there. As far as overall capital expenses, it’s really driven by our readiness for this growth curve as we work to stay ahead, and have the right protection for the system as a whole.

Mitch Pinheiro - Janney Montgomery

Okay. So the CapEx increase is it on the Keurig end of the business or...

Jon Wettstein

Scott talked about the seven new machines. And that’s really what’s driving it, as well as minor enhancements in Essex and then the beginnings of our search for capacity beyond what we work with today.

Operator

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

Scott Van Winkle - Canaccord Adams

First, on the Brewers, what was the mix towards the lower price models versus the higher priced models? And my follow-up question is do you find that someone who steps in with a $99 model comes back and upgrades to a higher-end version? Have you seen any of that in your consumer research?

Nick Lazaris

I’d be glad to address those questions. As you know, we were the first in the market with a good, better, best structure relative to single-cup with $99, $149, and $199 price points. I would say that, in general, since we’ve had three price points, interestingly, the middle price point is the highest, not only in dollar volume, but in unit volume.

And your second question had to do with upgrading on Brewers. There may be some of that that happens, but I think, by and large, people are happy with the Brewers that they get. When they buy a second Brewer it might be for a vacation home or for a friend as a gift.

Scott Van Winkle - Canaccord Adams

And what about the, I apologize because I’m blanking on the name, that the very high-end version that was available at Williams-Sonoma? Did that product sell well?

Nick Lazaris

That product is the Breville product and as I think, you and others know, we have a licensing arrangement with Breville, so that they could introduce a high-end single-cup brewer that used Keurig technology. It was in Williams-Sonoma, as well as other upscale retailers. We don’t have the absolute details on the sell-through of that product since it is not ours. But, I would characterize it as having sold-through well based on the things that we’ve heard. It is at a $299 price point, $100 above our best price point of $199.

Scott Van Winkle - Canaccord Adams

And the stick-on on the Keurig side, it seems like there has been an acceleration in the OCS for replacements. Are we at a point now where a couple of years ago, it seemed like the OCS channel was kind of setting the stage for the home channel. Is it happening the other way now? Is the home channel driving the OCS channel?

Nick Lazaris

Well the beauty of our business model is each channel drives each other because ultimately, we’re marketing to the same consumer, the gourmet coffee and tea consumer, and they drink coffee and tea in the office, at home, and when they’re eating out.

As it relates to the growth that you can see in the numbers that we had in the schedule, I did point out in my remarks that about 13,000 of the Away From Home Brewers that we have in the table, relative to growth, were in the hotel segment which we don’t break out on that schedule that I provide.

Still, the net growth in Away From Home OCS is very strong. That’s been driven a lot by our small- and medium-sized brewers that we launched in the last two years allowing our distributors to go after smaller offices and believe me, there are lot more smaller offices than large ones.

Scott Van Winkle - Canaccord Adams

And moving over to Green Mountain, but also related to the K-Cup side, the continuity program, I missed it if you mentioned it. What are we seeing on the growth of the continuity program for K-Cups?

Larry Blanford

Hi, Scott, that part of our business is very strong. It’s a real effective proposition because of the convenience associated with it. I believe Scott mentioned in his comments that year-over-year Q1 continuity membership grew by about 80% and that we now have over 75,000 members in that program and about three-quarters of them, actually a little more, are buying K-Cups on regular intervals.

Scott Van Winkle - Canaccord Adams

And I think when you sign up for that you get some questions like how you found that about it. Is this all just word of mouth that’s driving this business now?

Larry Blanford

We do have an active referral program, but a lot of it frankly, comes from the retail Brewer penetration. So, as Keurig places a Brewer at, say, Linens-N-Things or Target, and a consumer finds that product there, they have a variety pack of coffee that they then can sample and they can make choices about what roasters to establish a relationship with. And we have both individual relationships for kind of individual purchases but also that continuity program. We find that a lot of our consumers migrate into that continuity program because it’s so convenient.

Scott Van Winkle - Canaccord Adams

And the last question is on share of Brewers. Obviously, you are clearly, you had the lead, now you are taking it over with a bigger margin. Is there a shakeout going on beneath you, as far as how many single-cup brewer manufacturers are really going to be around in a couple of years? Is it a two-horse race now?

Nick Lazaris

I would be glad to address that. I think, in earlier conference calls like this, we talked about the trends relative to single-cup. When single-cup launched at retail several years ago, it was in the form of pods and pod systems led by the Senseo system and the Home Café system.

And then came capsule systems. First Keurig joined, then by Tassimo and by FLAVIA. And what’s happened is, the pod systems continue to not resonate with the American consumer and capsule systems continue to grow. And the capsule systems are obviously the dominant type of single-cup at retail and almost can be thought about is our own segment, as we continue to grow relative to capsule systems.

Scott Van Winkle - Canaccord Adams

So, in general, you’re just talking capsule seems to be the winner. Is there one player out there that seems to be kind of keeping up with you? And what do you expect on those players in the pod side? Do we see a shift in how they operate or develop brewers?

Nick Lazaris

Well, I can only speculate relative to our competitors and their plans but, as it relates to capsule systems, our primary competitor is Tassimo at retail. And in the office coffee market it is FLAVIA.

As it relates to pod systems, the only pod system that, with any real traction anymore continues to be the Senseo system. And fundamentally, that’s a Sara Lee-Philips system that has done very well in Europe but hasn’t had the same attraction to consumers in the United States.

So Tassimo would be our primary competitor. I think everybody is aware that the Tassimo system was announced last year that they were moving their partnership from Braun to Bosch. And we expect them to continue to participate in the category, and we think that’s a good thing because we want to see this category continue to grow.

Operator

And our next question comes from Mark Astrachan - Stifel Nicolaus.

Mark Astrachan - Stifel Nicolaus

I guess that the first question on your SG&A line, it looks like you all got some pretty considerable leverage there based on, what I would guess would be, the closer alignment of the Keurig and the legacy Green Mountain businesses. I guess, first of all, is that true? And secondly, how sustainable do you think that is going forward?

Frances G. Rathke

In terms of the first quarter results, we did have a slight leverage. We went from 31% down to 29%. And in terms of the year, we’re anticipating that we would be a similar kind of leveraging this year, in terms of primarily seeing much stronger SG&A leverage from the Keurig segment where sales are growing so rapidly and the Razor-Razor Blade business model playing out where we don’t need to add anywhere near as much SG&A costs to drive that growth.

Mark Astrachan - Stifel Nicolaus

Okay, so in terms of thinking about that Keurig business going forward, if you look out over the next few quarters, next few years, as a percent of sales then you would expect, in the G&A component of that to stay constant then, basically if sales increase, so obviously the percent of sales would go down?

Frances G. Rathke

Yes, the percent of sales will go down with much smaller increases in the G&A, and, and selling and operating. We are going to be continuing to invest in R&D at Keurig which is included in the SG&A, but I think what we’ll see is, you know, much smaller growth in terms of the G&A and somewhat, the selling and operating.

Larry Blanford

Great, this is Larry Blanford, too, if I could just add to Fran’s comments. We will also be investing in the R&D side of coffee as well. Part of this elegant business model that we are fortunate to drive includes that driving the K-Cup for a Brewer per day numbers.

And one way we feel that we can improve that number going forward is to continue to bring forward to the marketplace attractive new K-Cup products. And we have actually, in the first quarter of this year, began to invest more aggressively in that initiative. And hopefully, in the next quarter or two, we’ll have some exciting announcements with respect to those new products.

Mark Astrachan - Stifel Nicolaus

And shifting over to the cost of sales, in terms of the increase there, I think you had mentioned that the Essex facility was about a 10th of the increase. So, the rest of that is raw coffee prices, cost of doing business, that sort of things; is that correct?

Frances G. Rathke

To your question, in terms of the buckets as to the decline in margin, about two-thirds of it is really this quarter, selling so many At Home Brewers where we don’t have the same kind of margin you see when we sell K-Cups or coffee products. That’s the big piece of it.

And then, sort of second tier issues are, coffee costs were about, approximately around $800,000 more coffee this quarter than last year, if we have the same kind of margin. And then, on the next one is really the shift again towards K-Cups. As we sell more K-Cups as a company, we have a slightly lower gross margin on K-Cups than we do on some other coffee products. And then a 10th or so is due to the Essex startup.

Mark Astrachan - Stifel Nicolaus

And then, shifting to, I guess, how you think about the Keurig business, I guess this question is more for Nick. When you talk about the saturation or terms of the increase your velocity of Brewers per store and you talk about not expanding the number of stores as much as you would like to increase that velocity, how do you think about your saturation at this point in terms of where you are and where you would like to go there ultimately? Like, how much more room is there within a smaller store base until you need to start expanding beyond that store base?

Nick Lazaris

Well, the store base, as I mentioned, is about 10,000. We continue to expect to see it grow but fundamentally, we are very early in the cycle relative to single-cup adaptation in the American marketplace. And so, I think what we are looking at, as I said, is an increase in the rate of sales in stores. Now fundamentally, when I am talking about the stores, I am talking about the retail stores that we sell the Keurig system into.

Now, in addition, over the next couple of years I think we are going to see some very nice expansion relative to Keurig’s presence, both with K-Cups and with Brewers in grocery, thanks to the Green Mountain coffee division sales and marketing efforts. But, fundamentally, NPD is looking at about 4% or 5 % current penetration of the American market. There are 110 million households.

It took a while for the drip coffee makers to take over from percolators, but they certainly did over a 20-year period to 95 % market share in the 1990s from when Joe Dimaggio was on television in the early 1970s promoting Mr. Coffee. So, we think the opportunity remains very large. We’re still at the early stages and we’re quite fortunate to be the market leader.

T.J. Whalen

Just to build on Nick’s comments relative to the grocery opportunity, so just this testing activity for us in this first quarter, within the single-cup category at grocery Green Mountain K-Cups has about an 18% share of the total grocery single-cup, single-serve market at grocery, just through that test. And our K-Cups have some of the highest dollar velocities within that category.

So, also coming back to Scott’s comment about slotting, while we have planned for higher than typical selling expense on these things, we’ve got tremendous story to tell behind that. And for grocers who are fundamentally looking at a pretty flat coffee category, this is one opportunity to really participate in something new, very exciting, and to be in early on a trend that’s going to have a major impact.

Mark Astrachan - Stifel Nicolaus

And then, just a final question. I’m not even sure how much you can talk about it, but I am curious from a McDonald’s standpoint, given all the press out there about their emphasis on expanding into a café-type system in their stores. Obviously, you’ve been successful in the Northeast with the Newman’s Own products. Is there any update that you can give there in terms of what your thoughts are, what McDonald’s thoughts may be?

T.J. Whalen

Yes, there certainly has been a lot of publicity about their efforts in coffee, a lot of speculation in terms of how that’s going to play out. What I can say is that we continue to be pleased with our performance in the Northeast. We believe that McDonald’s would also be pleased with our performance in the Northeast. We continue to be in discussions with their management in terms of how this whole effort is going to unfold, but we can’t talk about any specifics at this point in time.

Operator

Your next question comes from Nicole Miller - Piper Jaffray.

Nicole Miller - Piper Jaffray

Fran, the share count was a little lower in the first quarter than I expected. Could you help me reconcile that?

Frances G. Rathke

The stock ops, the shares you said?

Nicole Miller - Piper Jaffray

This is actual shares outstanding.

Frances G. Rathke

In terms of actual, I am not sure what was in your model.

Nicole Miller - Piper Jaffray

Okay. Well, it’s just being going up and then it went down, so.

Frances G. Rathke

You know what, Nicole, this is a quarter, so in the quarter we were at 25. Just looking at what my year-end number was. There was really no significant changes there. I can follow-up with you later on that, but I don’t think there’s anything material there.

Nicole Miller - Piper Jaffray

When might you and how could you take a royalty price increase?

Frances G. Rathke

In terms of the you’re talking about for the Keurig roaster community, that’s something we’re evaluating, considering as contractually we are able to raise prices based on the license agreements where there were terms and conditions that were tied to a CPI threshold over a number of years. And that has now been met so we are evaluating a royalty increase that would occur at the earliest, late this year.

Nicole Miller - Piper Jaffray

And can you remind us of what’s contracted on the green coffee side?

Larry Blanford

Nicole, your question again please, about how our horizon is?

Nicole Miller - Piper Jaffray

What’s locked in on commodities like for your green coffee needs? Is anything contracted or locked in? How forward?

Larry Blanford

Well, we’re certainly locked in forward and when we go out two to six months, and our real intent there is to be in pace with the coffee market and our ability to adjust pricing as the costs might change. So, that’s really our intent. We’re playing a defensive strategy when it comes to playing the coffee futures market.

Nicole Miller - Piper Jaffray

Okay, so that’s just sort of held steady at two to six months out?

Larry Blanford

Yes.

Nicole Miller - Piper Jaffray

Okay, thank you. And the final question, you talked, it was helpful to understand another plant coming on-line. Help me understand. I think it’s 12-month lead time. So, according to your calculations, when does that new plant have to be up and running?

R. Scott McCreary

Hi, Nicole, this is Scott. If we were to build a brand new plant, a 12-month estimate sounds about right. What we’re planning to do for our next site is build on this Essex model that we developed which is, find an existing building that meets our needs, provide the infrastructure to that building, and set it up as a manufacturing-only location for K-Cups and then bring in roasted coffee initially.

So, we’re working through an evaluation of possible sites and we would like, by the end of summer, to have a building ready for installation of packaging lines.

Operator

Your next question comes from Mitch Pinheiro - Janney Montgomery.

Mitch Pinheiro - Janney Montgomery

Hey, just a couple of follow-ups. Getting back to the supermarket, have you shown, is there any store door increases this quarter year-over-year?

T.J. Whalen

Yes, I’m looking at our overall ACV which correlates just to doors, but it’s is actually weighted based on volume, and we are up three points this year overall for our company. And so, we are about 31% of total ACV at this point, so ample room for growth.

Mitch Pinheiro - Janney Montgomery

I mean, you go into the supermarkets these days and there’s an awful lot of specialty coffee being sold. So, is there a way that you can tie bag, ground and whole bean coffee, with the supermarkets? If you take our K-Cups then you got to take our ground. Is that how it works?

T.J. Whalen

Well tying, contractually, it certainly isn’t something that we can do but certainly, we looked to stress the value and synergy between those product types. And we do think that there is some opportunity there as K-Cups take-off, perhaps in some new regions that retailers and consumers will get more familiar with our brands and we’ll be able to help expand our distribution there as well. So we view it as synergistic.

.

Larry Blanford

Mitch, this is Larry, just to add to T.J.’s comments. And what we do see are some trends in grocery where bulk coffee is declining in general. And, to the extent that we, with some of our major grocer accounts, have their bulk coffee business which takes up a fair amount of space, it gives us an opportunity to really rethink and help the grocer potentially optimize that space by potentially reducing some of the bulk coffee and using that space for K-Cups and Brewers. And so, we are actively looking at ways to improve the merchandising so that we gain the synergy that you are referring to.

Mitch Pinheiro - Janney Montgomery

So, one thing I did not see in the release, you used to, maybe it was there but I missed, you used to put out how you have done on a geographic basis. And, I was curious whether it’s here or whether you can just share with us, add some color, commentary. Could you back out the geographic expansion you’ve achieved just by having Keurig? Has the rest of your business followed in the wake of Keurig as you look at geographic expansion?

T.J. Whalen

I’m not sure exactly of the question, but consistent with some of our recent quarters, a lot of growth is coming outside of our core Northeast territory. And that’s an exciting sign for us. All regions for us are growing. Some of the more material increases for us are outside of our core territory, particularly in the South and the Midwest.

Mitch Pinheiro - Janney Montgomery

I was actually looking so, obviously, Keurig is growing nationally. I was curious whether, if you back out the impact of Keurig, the actual K-Cups, whether your sales were growing outside of your core regions, excluding the Keurig business. I don’t know if you can look at it that way but...

Larry Blanford

Let T.J. – he’s looking at some data there, but I am not sure. I mean, anecdotally there is some signs of that. I am not sure it’s hugely material at this point, but there is no question that going forward, Keurig is just a great trial machine as we’ve talked about. It is building brand awareness for Green Mountain in regions outside of our traditional area of strength.

One of the opportunities for us going forward is certainly to the point you’re making, is to leverage that brand-building in other channels. And we certainly are spending a fair amount of time talking about that and laying plans for that. I think it’s a little early yet in the curve. As Keurig continues to build and as our brand continues to build outside of the Northeast, those opportunities will increasingly unfold and our multi-channel strategy is positioned to take advantage of them.

Mitch Pinheiro - Janney Montgomery

Let me ask you two more questions concerning Brewer sales. This might be for Nick. First, Nick, you indicated that post-holiday Brewer sales were running at, I forget how you phrased that, but they were running, what did you say? Well, they seemed like they were running, you know, continue to show the same year-over-year increases. So from a modeling perspective, I mean, is it possible that you’d see 150% increase in Brewer sales year-over-year? Or is it going to slowdown?

Larry Blanford

Think of a quarter.

Nick Lazaris

I think that the first thing I should do is tell you the types of data I’m referring to. Certainly in the press release and consistently, we talk about NPD data. That’s third-party data where they are tracking a selection of retailers across the United States, many products etc., many levels of retailers. That’s the NPD data that we cite. It relates to point-of-sale information.

What I was referring to in January, was that we do get, from certain retail partners of ours, their weekly sales of Keurig products. So that we have our own sampling, if you will, of how Keurig continues to sell at point-of-sale, a kind of preview of what we are going to see when we see an NPD report.

And, what I wanted to emphasize and will repeat now, is that we’ve been very pleased with the continued rate of sell-through post holiday season. We saw a bit of this last year although last year we were troubled by some out of stock positions with retailers. But overall, the product continues to sell very well post-Christmas through January with this sampling of retailers who do report to us.

So we continue to be optimistic about the year. We are already talking to retailers about the next holiday season and retailers are feeling very good about the Keurig program in their stores because we drive great Brewer sales. And as I alluded to in my comments, the continuing revenue and profits from K-Cups sold in these retail stores is very important to them. So we feel secure with our retailers.

The consumers still like our product. They’re buying and are buying them even in these uncertain times. We see the same trends in our Keurig direct business, and I think in a way T.J. alluded to that with the greenmountain.com business as well. So the business is still moving forward and we’re feeling good about it.

Mitch Pinheiro - Janney Montgomery

Nick, it seemed like also, just anecdotally and through our channel check, it seemed like inventories, there were many fewer out of stocks this year versus last year. And I didn’t know if you could talk about how inventories, how you handled that and coming out of season is everything in good shape?

Nick Lazaris

Sure, Mitch. Thanks for asking. Last year at this time, we were very pleasantly surprised with a very strong sell-through in the holiday season and it left us very short on our own inventory to support replenishment with retailers. So, we not only took care of that last year, but even as early as last spring and summer, we were planning this year’s situation, so we wouldn’t be faced with the same thing again.

The net is that I reported, the retailers had terrific sell-through, but we built inventory, our own, to be able to deal with the replenishment orders. So we are in good inventory position relative to supporting both the retail and the Away From Home channels. And we have been working very aggressively with our supplier to make sure we are going to be set for what we think is a great holiday season at the end of this calendar year.

Mitch Pinheiro - Janney Montgomery

And final question relating to Brewer sales is you had a remarkable hour of selling Brewers on QVC, a remarkable first ten minutes. And is that something that we could see regularly or, if you could talk about the returns on that and how you view that type of selling channel?

Nick Lazaris

Well, as a channel, we think that’s a great channel and QVC has been a great partner. The Keurig system is all about a demonstration. And the best demonstration, of course, is in person or someone inserts the K-Cap in the Brewer, presses the button and gets a great cup of coffee and can taste it. But, pretty close to it is the demonstration on television. And we had had some brief segments on QVC earlier last calendar year that gave both QVC and Keurig their confidence that a major event could be very successful.

And, it’s public knowledge, if you were watching QVC, you would have seen the day that Keurig was the Today’s Special Value where the programs started at midnight. But after about two hours of running time of the programs that we were on, between midnight and 10:00 AM in the morning, 20,000 brewers were sold. You could see that ticking right on QVC, so that’s textbook information.

We were very pleased with that obviously. It sold out way before they thought it would. And, of course, that has led to continuing discussions with QVC about how to repeat that next holiday season. We did have a short segment on QVC this past weekend and did very well. It was a short segment but it does come back to demonstration. And so, the QVC, which is kind of like an infomercial, really shows it.

We think out TV ads were very supplemental to driving business during the holiday season, but we think QVC is a great partner. We think it’s great opportunity to do more with them, and support really, all of our retailers because that recognition and awareness that QVC builds yields QVC a lot of sales, but also raises awareness in the consumer’s mind when they are shopping at other retailers or on the internet. So, all the way around we think it’s very additive to our marketing program.

Operator

And we have time for one more question, and that question comes from [Rick Feron] - Credit Capital.

Rick [Feron] - Credit Capital

Yeah, just a couple of quick questions. As you talk about the royalty revenues, I know you alluded to the potential consideration of price increases towards the later half of the year. As you look out and as you are forecasting for the year, what is the pipeline for additional revenue, royalty revenue, coming from additional brands? Is that built into some other projections or is that, you kind of take it as it comes?

Frances G. Rathke

In terms of our projections, we estimate what we believe the installed base is, as well as the incremental installed base, as we estimate our Brewer shipment over the next few quarters. Then, in terms of estimating our K-Cup consumption, we really look to what the Brewer models are continuing to show, in terms of consumption patterns. And then, that’s how we sort of forecast our K-Cups.

We don’t really prioritize adding new roasters as driving the K-Cup demand, as much as really driving it through the Brewer base. We do continually look at our brand portfolio and evaluate whether adding new roasters makes a lot of sense, especially when we look at how fast we are moving into the regions and penetrating grocery. That’s something we definitely review and consider in terms of adding in new roasters.

Rick [Feron] - Credit Capital

And, Fran, can you talk just a little bit about, and maybe you don’t want to disclose this, but I’m curious what the gross margin benefit is through royalty revenue versus your traditional K-Cup sales without royalties?

Frances G. Rathke

In terms of royalty revenue that we report, all the revenue from the royalties in the Keurig segment sales numbers and that essentially is 100% gross margin, nice business to have. And then, in terms of K-Cups, it really depends on whether we’re selling to the OCS channel or a distributor partner versus when we sell off of the website. That’s where the primary difference is. So typically, we see ranges more like a 30% to as much as a high 50% margin. It depends on which channel the K-Cups are sold into.

Rick [Feron] - Credit Capital

The only other question I have relates to the restaurant channel and it sounded like, although I know you don’t want to be too specific and obviously, you don’t know where McDonald’s is at this point. But you have a sense that the relationship is going well. Is there an opportunity in other restaurant channels? And, any more light you can shed on McDonald’s that you are comfortable shedding on it would be helpful.

T.J. Whalen

I will say, so, if you look at the sales table in the press release you’ll see that we posted a 5.8% increase in food service sales. I’ll say that that increase comes primarily from customers outside of McDonald’s and a lot of that comes from our institutional food service business and customers like Sodexho. We continue to feel good about our opportunities in food service both indirect or institutional, as well as with direct food service partners.

And, we are seeing some nice growth from some long-term existing partners folks like Bruegger’s which we’re real pleased about. So, while I can’t offer you much specificity in terms of the relationship with McDonald’s, I will say that, we see continued opportunities for the Green Mountain Coffee brand outside of that particular customer as well.

Operator

And that concludes the question and answer session today. At this time, Mr. Larry Blanford, I will turn the conference back over to you for any additional or closing remarks.

Larry Blanford

Well, thanks, everyone. It’s been a pleasure to talk to you today about this quarter and our plans going forward. We really appreciate your interest in the company. And again, thanks for joining us.

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Source: Green Mountain Coffee Roaster, Inc. F1Q08 (Qtr End 12/31/07) Earnings Call Transcript
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