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Green Mountain Coffee Inc. (NASDAQ:GMCR)

F2Q08 (Qtr End 03/29/08) Earnings Call

May 1, 2008 8:30 am ET

Executives

Frances Rathke - VP & CFO

Larry Blanford - President & CEO

Scott McCreary - COO

Nick Lazaris - President, Keurig, Inc.

T.J. Whalen - VP, Marketing

Jim Travis - VP, Sales

Jon Wettstein - VP, Supply Chain Operations

Analysts

Mark Astrachan - Stifel Nicolaus

Mitch Pinheiro - Janney Montgomery Scott

Scott Van Winkle - Canaccord Adams

Julie Welter - Piper Jaffray

Ted Goins - Salem Investment

Karthik Shrinivas - Geobine

Operator

Good day, everyone, and welcome to the Green Mountain Coffee fiscal 2008 second quarter financial results conference call. (Operator Instructions)

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

Frances Rathke

Thank you, Chris. I would like to thank all of you for joining us this morning for our second 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, and good morning, everyone. I'm pleased to report a very strong second quarter for Green Mountain Coffee Roasters. We generated earnings of $0.23 a share in the quarter, up 89% from last year. Second quarter sales were up 46% and our operating margin was up 110 basis points, to 9.6%. It was by all measures an outstanding quarter. Fran will be further highlighting our financials shortly.

I have been at GMCR for one year now, and I have said that a key factor in my joining the Company was the tremendous opportunity to help the organization realize our growth potential with our Green Mountain Coffee brand, the Keurig single-serve system and our passion for corporate social responsibility, which allows us to make a positive difference in the world. I continue to be excited about our performance and our potential.

In our second quarter, I am most proud of our two business segments, demonstrated operational capability to meet significant increases in demand. At Home Brewer unit sales were up 144% and Green Mountain K-Cups were up 68%, respectively, over the same quarter prior year.

Our ability to meet these increases, while providing excellent customer service demonstrates the scalability of both our brewer and K-Cup manufacturing and distribution operations. Also, these rates of growth are evidence that the razor blade model continues to work, and that the more machines we have in the marketplace the more K-Cups we will sell.

I also am proud that we are succeeding in a business environment with rising cost, including significant volatility in coffee prices. Both business segments did an exceptional job in actively managing their SG&A costs, which contributed to our strong profitability. The Green Mountain Coffee segment introduced new account planning tools for customers and initiated a related price increase, which is effective May the 5th.

Keurig intensified efforts to proactively plan with our retail accounts the remainder of our fiscal year and the important upcoming holiday season. Additionally, Keurig announced a royalty rate increase of $0.01 on all system-wide K-Cup portion packs effective August 1. The increase will support continued growth in advertising and market development of Keurig's single-cup gourmet brewing system. In this environment, we will closely monitor input costs and consumer spending patterns.

Because of initiatives taken in the second quarter, we are optimistic about our growth prospects and are increasing our fiscal year 2008 guidance for both top line growth and EPS.

We are optimistic about the long-term as well. I believe there is a true evolution underway in coffee making, with Keurig in the lead. First, there was percolated coffee. Then there was drip. Now there is single-cup brewing. Looking forward, how many people will buy a Keurig machine? Well, the possibilities are very exciting when you realize that 90 million US households have coffee makers and those households now have the opportunity to choose our single-serve system.

Today, no other single-cup coffee maker has such an established presence as Keurig in both the away-from-home and at-home markets. Keurig brewer technology and K-Cup portion packs together provide a fresh cup of specialty coffee tailored to your taste consistently from brew-to-brew.

For the future, we are working in the Green Mountain Coffee segment to produce even more varieties of coffees, teas and hot cocoas. At the same time, the Keurig segment continues to innovate with technology, creating new features consumers want in their single-cup brewers.

There are now three different Keurig brewer models for wholesale customers, a good, better, best selection for retail customers and a brand new model for hotels. In addition, Nick will be talking about another new model being introduced this fall into the retail channel. Looking forward, with our innovative focus we believe we can offer a single-cup brewer for potentially every coffee lover out there and very possibly create some new coffee lovers in the process.

Green Mountain Coffee has always believed that a fantastic cup of coffee is one of life's best affordable luxuries. The Keurig single-serve system now offers consumers the ability to manage their tighter budgets by brewing their own coffee at home easily and conveniently.

We also are finding that the Keurig brewer is a very popular gift item. As one example, an oral surgeon in Atlanta bought 39 Keurig brewers this past December, which he gave away as gifts to each of the dentists who had referred patients to him earlier in that year. So far, in terms of both anecdotal observations and the NPD data that Nick will be detailing, we believe our opportunities in the single-cup arena are sustainable and that we are early in the transition to single-cup brewing.

Before closing, I want to thank and congratulate Nick and the team he has put together for their drive and innovation in making all this happen. Nick and the Keurig team first introduced a machine into the office coffee services market 10 years ago. In about five years we became a leader in that channel and have maintained our position. In 2002 Keurig first launched into the at Home channel, and today that data indicates we have established a market-leading position there as well.

We feel the Keurig system is at the crest of a new wave in coffee brewing, with a very promising future. We see the market for Keurig machines and K-Cup portion packs continuing to grow as people choose a really great and convenient cup of coffee that they can brew themselves one cup at a time.

With Keurig, we also have a great mechanism to build Green Mountain Coffee brand awareness and then ultimately leverage our multi-channel approach across North America, further growing our business in traditional channels. We believe the data and our performance that we are sharing with you today are indicative of a very exciting opportunity.

On this, my one-year anniversary, I feel fortunate to have joined this passionate and committed organization, as we pursue financial success and work together to make a positive difference in the world.

And now, I will turn the call over to Fran to talk more about the numbers. Fran?

Frances 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 second quarter totaled $120.9 million, up 46% over last year. More than half of our top line growth was due to very strong sales in our Keurig segment. Revenues there were up 89% over last year's second quarter. The Green Mountain Coffee segment also achieved strong sales growth of 37% this past quarter, with sales of K-Cups driving the majority of this growth. In a few minutes, Scott McCreary will talk more about the key elements behind this segment's successful quarter.

Looking more closely for now at Keurig, half of the increase in Keurig sales this past quarter was due to higher K-Cup sales. This reflects the strong shipments and an increase in the installed base of Keurig brewers during the last holiday season. The other half of the increase was due to higher At Home Keurig brewer sales and royalty income from the sales of K-Cups.

Our gross profit for the second quarter of 2008 totaled $44.7 million, or 37% of net sales, as compared to $32.5 million or 39.2%, during last year's second 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.

In addition, higher green coffee and other commodity costs, the sales mix shift towards K-Cups from other products and higher manufacturing costs due to the continued capacity investment in our new Essex, Vermont packaging facility contributed to the decline in gross margin.

In the second quarter of 2008, total company SG&A expenses improved as a percentage of net sales to 27.4%, from 30.7% in the prior year quarter. This improvement was achieved even though, as planned, the company incurred litigation expenses of approximately $1 million, or $0.02 per share, this past quarter. These expenses were related to the patent infringement suit filed against Kraft.

The company's operating margin this quarter improved to 9.6%, from 8.5% during last year's second quarter. This was driven by the lower percent for SG&A. Net income was $6 million in the second quarter of 2008, an increase of 89% over last year. Net income per diluted share was $0.23 in the second quarter of 2008, as compared to $0.13 in the second quarter of 2007, and was in line with our previous guidance of $0.19 to $0.23 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 third 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 could 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.

We have raised our range of sales growth expectations for the year and are giving guidance on Q3 for the first time. We now anticipate revenue growth of 42% to 47%, up from previous guidance of 40% to 45% for the year.

With regard to both full year and third quarter expectations, we have included in our financial estimates the impact of higher coffee and other commodity costs, as well as the previously announced 8% to 12% price increases on our Green Mountain Coffee segment effective on May 5.

Consistent with the previously issued guidance, we have incorporated the August 1 royalty rate increase of $0.01, from approximately [$0.54] per K-Cup to [$0.64] on all system-wide K-Cup portion packs.

As we weigh these many factors and their impact on our sales growth and gross margin, combined with the continued anticipated SG&A leverage, we anticipate our third quarter and full year operating margins will be where they were in fiscal 2007 or up about 50 basis points, which would be a range of 8% to 8.5% for the year. We've been able to narrow this range from previous estimates at this halfway point in our fiscal year. As a result of these expectations, we believe we can grow earnings at a rate similar to slightly higher than sales in 2008.

For the full year fiscal 2008, we are increasing our guidance by $0.01 from previously provided guidance for EPS. Specifically, we are increasing our EPS guidance to $0.73 to $0.78 per share. It includes the non-cash stock amortization expenses related to the identifiable intangibles, estimated to reduce EPS by approximately $0.11 per share.

Other key factors, including interest expense, CapEx and annual depreciation amortization, are contained in today's press release. The details of our third quarter expectations also are contained in today's press release, so I will not repeat them here. 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 Scott McCreary, COO of the Green Mountain Coffee segment.

Scott McCreary

Thanks, Fran. Keurig's success and the synergy between the two businesses continue to drive growth for the Green Mountain Coffee segment. We grew net sales this past quarter by 37%, with K-Cup shipments up 68%. Multiple channels are benefiting, as we see growth in OCS, consumer direct, resellers, supermarkets and club stores.

The 1200 supermarket locations selling K-Cup portion packs have helped us increase our share of single-cup coffee in this channel from 17% in Q1 to 24% this past quarter. Our packaged coffee sales in supermarkets are also increasing, with Q2 growth of 17% following the relaunch of our Newman's Own Organics line and the launch of our new single-origin line of coffees in the fall of 2007.

The single-origin line has received outstanding quality scores from Coffee Review, with Kenyan Highland Cooperatives receiving a score of 96 and Tanzanian Gombe Reserve a 90. We increased Q2 shipments to club stores over 20% due to new distribution for our two-pound Newman's Own Organics coffee in Costco's Midwest Division.

Also for club stores, we developed an 80-count K-Cup package selling into BJ's and 65 Costco stores. This provides a complementary K-Cup offering to the brewers that Keurig sells in this channel.

Consumer direct K-Cup sales increased 87%, driven by continued growth in our Cafe EXPRESS membership. We now have over 84,000 members, with about 80% using Cafe EXPRESS for replenishment of K-Cups.

In order to meet our high growth, we have invested in K-Cup production lines and the new plant in Essex, Vermont. Since our last call, we installed two new lines, bringing us up to 17, and have five more lines on order to support anticipated growth through fiscal 2009.

As we expand sales to broader geographies we recognize the need to expand production and distribution capabilities. We've met with a number of communities and are evaluating different options in the South. We may open a Southern plant as soon as the end of this calendar year.

Our sales team has been meeting with customers to review the upcoming price increases. Overall, these discussions have been great opportunities to reinforce our commitment to helping our customers succeed, and they have gone well. It hasn't hurt that our customers also are seeing cost increases in other products, which has made our discussions a little easier.

We seem to be in the right place at the right time with our great coffee and the tremendous appeal and sales momentum of the Keurig machines and K-Cup portion packs. We are, of course, driving this strong growth with marketing, innovation and high levels of customer service. At the same time, we're constantly looking for ways to become more efficient as we grow, so that growth flows through to the bottom line. Our success in leveraging operating expenses on higher sales this past quarter demonstrates our commitment here.

And now I'm pleased to turn the call over to Nick Lazaris, President of the Company's Keurig segment.

Nick Lazaris

Thanks, Scott, and good morning, everyone. Keurig continues to deliver outstanding year-over-year sales and profit growth, and the prospects are bright for the upcoming holiday season. Our primary channel for brewer sales is the retail channel. We continue to be very pleased with not only the sell into retailers but also the sell-through to consumers. Our year-over-year unit sales growth continues to be very strong, and we have become important to our retail partners.

Our holiday 2008 planning meetings with retailers before, during and after the housewares show have reinforced that while there are general concerns about the economy and a slowdown in consumer spending, our retail partners expect it to be another strong season for Keurig. Many are enlarging their Keurig product offerings and improving their Keurig merchandising statements.

Retail point-of-sale data from the NPD Group continues to show that Keurig is the market leader in dollar and unit share in the single-cup category at retail. In the first calendar quarter of 2008, the NPD data had Keurig with a 61% dollar market share and a 49% unit share in the single-cup category.

Interestingly, our Model B60 ultra brewer was the second best-selling coffee maker in dollar sales in the United States across all retailers, and this includes all drip coffee makers at all price points.

The foundation of Keurig's success in the retail channel has been our leading edge single-cup brewing technology. It consistently delivers the taste profile that our gourmet consumers expect. In addition, we invested in upscale packaging and in-store demonstration programs before we added television advertising last year. On top of these marketing investments, we've benefited greatly from very satisfied Keurig users, who refer Keurig to their friends or buy them Keurig brewers as gifts.

Keurig gave notice for our licensed roasters that the per-K-Cup royalty would increase by $0.01 per K-Cup effective August 1, 2008. These funds will help support Keurig's increasing marketing spend, which drives our rapid growth, which in turn creates even more demand for K-Cups, which benefits all roasters. To this end, we are planning to double the size of our holiday TV advertising program in 2008, to $6 million, and convert it from a multi-market to a national advertising program.

This fall we will be introducing a new consumer brewer at a new, lower retail price point of $79. This brewer will be called the Keurig Mini, and is based on our fourth generation brewing technology that is used in our current hotel in-room brewer. The brewer will heat water and brew a cup of coffee, tea or hot coca in less than three minutes. It's smaller than our other At Home brewers, and it will be offered in black, white and red.

The Mini has targeted consumers who want a Keurig brewer for occasional use in home offices, small kitchens, recreational vehicles, dormitory rooms and so forth. This will be a fun product, and we even plan to offer a tote bag as an accessory for the brewer and K-Cups.

As we did last year with the hotel in-room brewer, we continue to develop and introduce brewer products that broaden our market channels and our consumer appeal. Our goal is to have the convenience and great taste of Keurig brew technology available to consumers whenever and wherever they have a desire for gourmet coffee.

As you know, I will be leaving Keurig this summer, after more than 11 years as Keurig's President. I'm very proud of the Keurig team and what we've been able to accomplish as we pioneered the development of the single-cup category successfully against some very powerful competitors. The Keurig senior management team is seasoned, energetic and decisive. As for me, I've accepted an appointment as an entrepreneur-in-residence at Harvard Business School for the 2008-2009 academic year and I am looking forward to doing some teaching and research as well as interacting with and mentoring MBA students.

Now I will turn the call back over to Larry.

Larry Blanford

Thanks, Nick. Fran, Scott, Nick and I are joined today by members of the Green Mountain Coffee segment, including T.J. Whalen, Vice President of Marketing; Jim Travis, Vice President of Sales; and Jon Wettstein, Vice President of Supply Chain Operations; and we would all be glad to respond to your questions.

We will now start the question queue.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Mark Astrachan of Stifel Nicolaus.

Mark Astrachan - Stifel Nicolaus

Hey, good morning, everyone.

Larry Blanford

Good morning, Mark.

Frances Rathke

Good morning, Mark.

Mark Astrachan - Stifel Nicolaus

I guess just a few questions here, no particular order. In terms of your expectations for the third and fourth quarters, what have you baked in there as far as legal expenses are concerned?

Frances Rathke

Mark, this is Fran. We have, as we mentioned, this past quarter we incurred $1 million related to the lawsuit. We anticipate a slightly lower amount in Q3 and possibly a similar size, given we are anticipating going into litigation and the trial date is set in October.

Mark Astrachan - Stifel Nicolaus

Okay, great. And then shifting over to the Keurig Mini. In terms of thinking about that, I guess one is, is that going to be launched -- I think I heard Nick correctly is that going to be launched this holiday season?

And then secondly, as far as margins are concerned, would the profile there be similar to other At Home brewers that you guys have?

Nick Lazaris

Yes, Mark. This is Nick. And the product will be introduced this fall to support the upcoming holiday season. We expect shipments to retailers somewhere in the August-September timeframe. And the margins on this brewer are similar to the other margins on our At Home brewers.

Mark Astrachan - Stifel Nicolaus

Great. And then final question is just relating to the competitor action. I guess in terms of your thoughts on what your leading competitor is doing out there from a single-cup standpoint, in particular Tassimo, how have you seen their focus and their promotion of these? Are Starbucks products impacting retailers' shelf presence, promotion activity, and the like? And have you seen anything from other competitors that you may think that they can start to get in there in terms of having incremental shelf presence at some of these retailers?

Nick Lazaris

This is Nick. At the recent housewares show, which is the number one trade show for this category for retailers to attend, and this was in March, Bosch was reintroducing the Tassimo brewer for the fall season. They have been our number one competitor, and so we certainly respect their power in the marketplace, et cetera.

But I will say that the retailers that we work with were very excited about Keurig. They were not giving up any space to any competitor, Tassimo included, for Keurig. And in fact, they were, as I said in my comments, increasing their assortments and in many cases improving the merchandising associated with the Keurig system. So I think what that says is we are clearly number one, we're respected and it's always good to have competition.

Mark Astrachan - Stifel Nicolaus

Nick, just to follow up on that, do you think then, if you think about it from a retailer's standpoint, will the amount of space given to single-cup brewers increase overall?

Nick Lazaris

Again, this is Nick commenting on that. I think that one of the things we heard at the housewares show that was powerful to us was that retailers are looking at a holiday season that isn't as bleak, as positive as it has been in the past. And therefore they have to be very careful where they place their open-to-buy dollars. And single-cup, and in particular Keurig, has just such a tremendous track record with these retailers they want to increase their investments in this category, because the probability of success is so much higher.

Mark Astrachan - Stifel Nicolaus

Great. That's all for my questions. Thanks everyone, and, Nick, congratulations on the appointment at HBS.

Nick Lazaris

Thank you, Mark.

Operator

We'll take our next question from Mitch Pinheiro of Janney Montgomery Scott.

Mitch Pinheiro - Janney Montgomery Scott

Hey, good morning.

Frances Rathke

Good morning.

Larry Blanford

Good morning, Nick.

Mitch Pinheiro - Janney Montgomery Scott

A couple of things. One, so looking at the increase in the royalty rate in August, I guess I heard that these incremental dollars will be used to continue to support investment in the brand and in R&D and other things, but is there a -- does this also support earnings growth, in terms of is all of this money going to be spent back, or should we be thinking about some of this falling to the bottom line?

Frances Rathke

Mitch, this is Fran. As you noted, the royalty rate increase takes effect really in the back half of fiscal '08 for us. So we factored that into our projections that we just gave out today.

In terms of fiscal '09, as Nick noted in his remarks, we are going to be increasing our advertising spend for this holiday season, which we believe is a good spend. We do anticipate the $0.01 royalty increase for fiscal '09 to help fund that, but also we believe it will also help improve our operating margin next year.

Mitch Pinheiro - Janney Montgomery Scott

Okay. Obviously when you look at a K-Cup, the packaging piece of it is probably more significant maybe than the coffee piece. And I was wondering if you could talk about what the sort of inflation rate on the packaging side of K-Cups would look like?

Scott McCreary

Hi, Mitch. This is Scott McCreary. We are seeing inflationary pressures on our packaging across all of our types. And, as you say correctly, packaging does comprise a higher percentage of our cost with regards to K-Cups. So we continue to negotiate with our suppliers with regards to the volume leverage that we can tie to our business and at the same time recognizing the pressures they're facing in terms of their raw material costs.

Mitch Pinheiro - Janney Montgomery Scott

Okay. And just a couple more and I'll leave the floor. How many -- could you update us on the hotel brewer placements, how many you're in now at the end of this quarter?

Nick Lazaris

Yes, Mitch. This is Nick. And through the end of the second fiscal quarter, we had shipped about 20,000 hotel brewers. And that in conjunction with the brewers that were shipped at the end of last fiscal year bring us to about 25,000 brewers. Now, of those 25,000, we estimate that somewhere between 18,000 and 20,000 of those brewers are now in hotels.

We, in terms of the number of hotels we're counting, as we get reports from our distributors, it's over 70. And the selling process, I might've mentioned in prior calls is a longer sales cycle where hotel chains tend to do some tests before they take on the Keurig brewer. But the reports we're getting back are very positive. We remain very excited about this, and we're right on track with our business plan.

Mitch Pinheiro - Janney Montgomery Scott

Okay. In terms of looking at your Fair Trade, 26% of your coffee pounds shipped were Fair Trade Certified and the organic. I think, if I recall, I don't have my number from last quarter in front of me, but it seems flattish. Is there anything that we can infer from that? Are the channels selling predominantly Fair Trade slowing, or is it just you're growing faster or just as fast in the other areas of your business?

T.J. Whalen

Hey, Mitch, this is T.J. Thank you. You're right, 26% is our Q2 Fair Trade percent, which was also the percent of our total pounds sold in Q2 of FY '07. So that percentage has maintained over the past year. One of the factors for that relates to our Wild Oats business, which has, I think you know, undergone a bit of transition, and so we're in the process of, of course, looking to expand distribution with our Fair Trade organic coffees in part through our single-origin line and Newman's Own Organics re-stage, which have both been successful, as Larry noted in his remarks.

Mitch Pinheiro - Janney Montgomery Scott

Okay. Thank you. And last question, just looking at some of your channels, the c-Store channel seemed to perform nicely last quarter, the channel is up about 8%. Are you seeing -- what should we, how should we think about the c-Store channel heading forward here? Are transactions going to hold up or with the obvious increase in gas prices and recessionary pressures, or do you see growth rates slowing down in your c-Store channel?

Jim Travis

Good morning, Mitch. This is Jim Travis. We continue to see nice growth with our existing customers. It's certainly not keeping up with our growth that we're seeing on Keurig, but it is consistent with what we'd expect for the channel, c-Stores. The rate of acquisition for us continues to be challenging across regions where we don't have the brand presence. But we've got a few interesting things kind of working right now in terms of tests. So those are contributing nicely to the c-Store business as well as our continued relationship with customers like Exxon Mobil and then our regional customers in the Northeast. So we still feel good about that business, and we're certainly focused on it, that's for sure.

Mitch Pinheiro - Janney Montgomery Scott

Okay. Thank you.

Frances Rathke

Thanks, Mitch.

Larry Blanford

Thank you, Mitch.

Operator

We'll take our next question from Scott Van Winkle, of Canaccord Adams.

Scott Van Winkle - Canaccord Adams

Hi, congratulations. A few questions. First, just a quickie, how much -- did you purchase any more green coffee out of the ordinary when the price was in that 150 to 170 range?

Jon Wettstein

Hi, Scott. This is Jon. Our hedging strategy has us working forward to keep our cost of goods sold known in the three to six-month time frame. So at times we'll be at the shorter end of that range and other times we'll be at the longer end. What I'd say where we are now is we're out more at the longer end, giving us a little more cost certainty as we work through the rest of this fiscal year and then well into the first half of fiscal year -- the first quarter of fiscal year '09.

Scott Van Winkle - Canaccord Adams

Yes. So, Jon, there was no like rush to run out and go a little longer in your purchasing when the price was rising? A lot of companies sometimes seem to get upside down in short-term spikes like that. I just was wondering if you'd had any issue like that.

Jon Wettstein

Scott, this is Jon again. There was a slight amount of that, I would say, but certainly no extreme, no major reaction. We continue to pick away particularly on dips as we move forward.

Scott Van Winkle - Canaccord Adams

Okay. And, Nick, also my congratulations as well on the appointment. A couple of questions on Keurig. One, so on the hotel side you have 5,000 brewers that you've shipped that aren't in place yet, roughly, in the hotel channel. Is there anything else like that, like when we try to forecast K-Cup consumption, should we assume that all brewers that you have sold are in place, assuming some time lag at retail? Or is there any other kind of block of brewers out there that you've sold that maybe aren't in place yet?

Nick Lazaris

Scott, this is Nick. And what I would say there as it relates to modeling K-Cup demand, which is a challenging thing, I think probably all of you all on the call realize, that the pipeline effect by channel varies. And so you can't assume that brewers start generating K-Cups as fast when you're in a hotel channel or retail channel as opposed to when you're selling direct. So each channel has its own profile. Generally we don't go into the particulars of how we set up our assumptions, but there are different profiles by channel.

In the hotel channel, we do have a major distributor that when they buy brewers they buy by truckload, and truckloads I think are about 1,300 brewers a truckload, and to keep the pipeline going. So they buy a little bit differently than an individual, again, going to keurig.com and buying a brewer.

Scott Van Winkle - Canaccord Adams

Okay. But, so there's been no change, though, in the average consumption by channel, K-Cups per day per brewer?

Nick Lazaris

When we look at the At Home side of our business, which I think is what you're focusing on, Scott, our view is that K-Cup consumption per day per brewers that are installed hasn't changed. We don't see anything that is noticeable one way or the other.

Scott Van Winkle - Canaccord Adams

Perfect. And a question on the royalty going up $0.01, I just wonder the impact on the third-party roasters, I assume there's going to be an increase in their wholesale price of the K-Cups to offset this $0.01.

And I have always worked under the assumption that, for example, a K-Cup coming out of Green Mountain in the wholesale channel might be $0.30, and you might have a 20% contribution margin. That's $0.06 per K-Cup, and the royalty is going to be $0.06 per K-Cup. I wonder does this have any impact on your ability to attract new incremental third-party roasters, which I would assume is going to be a benefit for Keurig in the long run? Are you making sure that there's enough profit to be made for those third-party roasters after they absorb a higher royalty?

Larry Blanford

This is Larry Blanford, Scott. I'll address that. Certainly all the factors you just referenced are taken into consideration as we are attempting to manage the business going forward. The royalty rate increase we think was appropriate and I think the first increase that Keurig has implemented in terms of royalty rate since they got rolling in this business. So with all of the various cost pressures and our desire to continue to drive brewers, as we've indicated, we thought that was appropriate. The pricing for Green Mountain in terms of K-Cups to the market, that price has been raised.

The Green Mountain Coffee division, as we manage our financials, we hold the Green Mountain Coffee business responsible for their financials, and a royalty rate increase to Green Mountain would look no different than to anyone else, and they've got to take that into account in their thinking and their pricing.

So our price increase that we announced that's in the market on K-Cups reflects that. I think obviously then the other roasters all have to make their own independent decisions about what they will do with pricing, whether they want to simply absorb the royalty rate increase or to pass it along to their customers.

Scott Van Winkle - Canaccord Adams

Okay. Thank you. And last question, probably for Nick, on the competitive front in Keurig, I'm a new owner of a Nespresso machine, and I'm wondering if there's been any effort by Nestle to leverage this espresso technology into traditional coffee in the US I certainly didn't see it at the housewares show. I'm just wondering if you've heard anything on that regard, because they seem to have a pretty good espresso one-cup business?

Nick Lazaris

Scott, again this is Nick. We certainly have a lot of respect for Nestle and Nespresso and what they've done over the last 20 years in the global marketplace relative to single-cup espresso. We've never viewed from a Keurig point of view Nespresso as a direct competitor, because the taste profile of espresso is so different from filtered coffee.

Nestle does have a very strong position in single-cup relative to Nespresso, and overseas they have introduced a less expensive espresso system called Dolce Gusto. It was launched, I believe, in Europe last year. But that's not a filtered coffee system.

Scott Van Winkle - Canaccord Adams

Okay. Great. Thank you very much.

Frances Rathke

Thanks, Scott.

Larry Blanford

Thanks, Scott.

Operator

We'll take our next question from Julie Welter, Piper Jaffray.

Julie Welter - Piper Jaffray

Hi, guys.

Frances Rathke

Hi, Julie.

Larry Blanford

Hi.

Julie Welter - Piper Jaffray

My first question is what is the capacity at the plant currently running at right now?

Scott McCreary

Hi, Julie, this is Scott. Currently we have what I call 12 equivalent high-speed lines installed. And what I mean by that is we have some slower speed lines and some medium speed lines, but at roughly 80 million K-Cups annually, that's close to 1 billion annual capacity that we have in place right now.

Julie Welter - Piper Jaffray

Okay.

Scott McCreary

And then, with five more lines scheduled to be installed through the rest of this fiscal year, that takes us close to 1.4 billion on an annual basis once those lines are fully staffed.

Julie Welter -Piper Jaffray

All right. And what is the Keurig international opportunity?

Nick Lazaris

This is Nick, Julie. And it always -- the first question is what is international Canada, I should say, has always been important to Keurig. Soon after we launched our office coffee business in the United States we moved to Canada.

And one of the things I really haven't talked much about on these calls is our growing interest in Canada at retail. We expect to be in about 1,000 retail stores this upcoming holiday season in Canada. We view it as a very positive market opportunity, and we certainly have two roasters that have very strong brands in Canada, as well.

Beyond that, we do have a joint venture with UCC, Ueshima Coffee Co., in Japan. And that joint venture has been in existence for about six years. We are the leading single-cup system in the office coffee market in Japan. And there is a home version of our brewer available in Japan too, although it's very early in the life cycle there. Through our joint venture with UCC, we have some very limited presence in other Asian countries, but this is generally an area that we're looking at.

However, I'd have to say that the market opportunity in the United States of America is so huge we should never let up our efforts to continue to develop this channel for what it can be long-term, in terms of single-cup, as Larry said, replacing drip coffee as the primary method for people to brew coffee at home.

Julie Welter - Piper Jaffray

All right. Thank you. That's very helpful. And then, what do you think the volume of K-Cups was that was pulled kind of into the second quarter versus the latter half of the year before these price increases?

Jim Travis

Hi, Julie. This is Jim Travis. We really haven't seen a whole lot. We were very specific in our letter that went out announcing the price increase, that we would really not allow any forward buys. And so we've managed that very carefully through our customer care center. And really we haven't seen that spike that you would expect. I think most of our customers have respected that and are just managing their inventories as needed.

Julie Welter- Piper Jaffray

Great. Thank you. And then my final question, any commentary on April trends to date?

Larry Blanford

Scott, do you want to speak to the coffee trends?

Scott McCreary

Yes, hi, Julie, just a quick picture here. We're feeling good about our April trends. Q3 for us can sometimes temper a little bit as the weather starts to warm up, but we're feeling good about the volumes continuing right on track with what we've projected, and the discussions with regards to the price increase have gone very well, and so as we put in our guidance, we feel good about those.

Julie Welter - Piper Jaffray

All right.

Nick Lazaris

Julie, this is Nick. From a Keurig point of view we're comfortable that April will be right on track for their business plan.

Julie Welter - Piper Jaffray

Great. Thank you so much. That's it for me.

Larry Blanford

Thank you, Julie.

Operator

(Operator Instructions) Our next question is from [Ted Goins of Salem Investment].

Ted Goins - Salem Investment

Good morning.

Larry Blanford

Good morning, Ted.

Ted Goins - Salem Investment

Nick, I've been a modest shareholder since 1999. Your efforts have been beneficial to people beyond just Massachusetts and Vermont, and so I thank you very, very much for your service, and I wish you nothing but the best in your future endeavors.

Larry Blanford

Thank you, Ted.

Ted Goins - Salem Investment

Thank you very much. I just have a few questions. When -- the October trial with Kraft, where will that take place?

Larry Blanford

Do you want to comment? The trial is in Delaware. The case was filed in Delaware in federal court, so the trial will take place in the state of Delaware.

Ted Goins - Salem Investment

And that's will that be an arbitration or a jury trial or --?

Larry Blanford

The case was filed in federal district court alleging that Kraft violated our intellectual property, specifically one patent that we have.

Ted Goins - Salem Investment

Yes. Okay. And the office coffee channel in the second quarter was down sequentially in its growth rate from the first quarter, but I see the reseller business was up dramatically. Is it your opinion that there might be some substitution from one channel to the other?

Jim Travis

Yes sir. Ted, this is Jim Travis. The pace of growth for OCS is still well within the range of what we expect. We've got, as we venture into new geographies, certainly the challenges are a little bit different for us as we compete with other roasters for that share. And, as we have announced, we have partnerships with Office Depot and other office superstores, which is interesting, and it's a different challenge for us.

So I think as you look at the year-over-year growth rates, I'd have a difficult time contrasting that with the growth in the retail side of the business. But I can tell you that we are very pleased with the growth we're seeing. The Northeast continues to exceed expectations in terms of what we thought the growth would be on K-Cups. Our challenges are just cementing our position outside of the Northeast, and I think we've got some pretty good plans to do that here in the future.

Scott McCreary

And to just build on that a little bit, this is Scott. I think the strong reseller channel growth is really being driven by brewer placements and brewer sales, and I don't see much tradeoff between the OCS channel and the retail reseller channel.

Ted Goins - Salem Investment

Okay. Thank you. And also, in the past, you've talked a little bit about the success of the K-Cups at the grocery store level in terms of it's top 10 and so forth. And I'm wondering -- I think I heard you say earlier there were 1,200 grocery stores carrying the K-Cups now, I'm wondering if you could offer some examples of the success of the K-Cups at the grocery store, as well.

T.J. Whalen

Hi, Ted, this is T.J. Thank you. Yes, we continue to be really excited about the opportunity for K-Cups in grocery, and we continue to believe that we have among the highest velocity single-cup items in that channel. Based on our testing, which has been fairly extensive with different grocery customers, we are planning to expand our efforts in grocery this upcoming fall, and you should see a stronger presence of K-Cups in that channel with club, as well, where we're also seeing a very nice level of success for us and our retail partners.

Larry Blanford

Ted, I might just add -- this is Larry Blanford -- that we really have viewed our grocery presence this last 12, 15 months as really an opportunity to learn. And I believe we have learned a great deal about what is required to be successful in grocery, both on the K-Cup side and brewer side. And those learnings have been brought back into new product forms that we will be taking to grocers here very shortly.

Ted Goins - Salem Investment Counselors

That's great to hear. And one last question, and I apologize for asking so many. I hate to ask this in front of you, Nick, but how are we doing with regards to finding someone to replace Nick? Can you update us on the status of your search?

Larry Blanford

Ted, this is Larry. I'll address that. Replacing Nick certainly is a challenge, because he's provided just tremendous leadership to Keurig and been a key member of the Green Mountain enterprise team, and we really, really appreciate all of his contributions.

But going forward, as Nick mentioned, first and foremost he's also created an outstanding team. And as we are in the transition here, we're going to be relying on that team to continue to move the ball forward, and I am very confident and I know Nick is very confident that they will do that. With respect to the search, Spencer Stuart was brought on board. They are well into the search. We have several internal candidates that we are evaluating.

We also are looking outside to make sure that at the end of the day we have the very, very best candidate that we can identify, given the importance of the Keurig business to the overall enterprise. So that process is underway, and we have -- I think another important point is that the Keurig team has been very much involved in the process, as well as certainly we have at the enterprise level and even at the board level, identifying the critical specifications and leadership qualities that we're looking for in that individual.

Ted Goins - Salem Investment Counselors

Thank you very much for your time this morning.

Frances Rathke

Thanks, Ted.

Operator

And we have a follow-up question from Mark Astrachan of Stifel Nicolaus.

Mark Astrachan - Stifel Nicolaus

Yes, hey, guys, again. Question on the amount of outlets that the Keurig machines and K-Cups are available in, have you -- I guess the question is, what number of stores are you looking at this holiday season? And just in general if you could break out the retailers that you're in or will be in by geography in terms of whether they're mostly in the Northeast and Mid-Atlantic or where else they are across the country that would be helpful.

Nick Lazaris

Mark, this is Nick. Last holiday season we were very proud and pleased that we were in about 10,000 retail stores across the country. We expect by this holiday season to be in excess of 12,000. And then I mentioned earlier on the call that we expect an additional presence in Canada of about 1,000 stores.

Now, when you ask about geographical distribution, probably I'd say that it reflects population in the United States, because when we partner with a national retailer, whether it be Bed Bath & Beyond, Costco, Macy's, et cetera, their stores are spread across the country as a function of population and, of course, income levels. And when we launch with those stores, we are in every store. They don't just say, Keurig in New England Bed Bath & Beyond stores. We are chain-wide.

So we have a very strong national presence. And, as I said earlier, the escalation and increase in our TV advertising program, particularly becoming a national advertising program, I think will further move Keurig forward relative to the single-cup category

Mark Astrachan - Stifel Nicolaus

Great. Thanks, Nick. And then one more follow-up, in terms of the amount of GMCR produced K-Cups, it looked like it went up as a percent of the overall amount of K-Cups sold in the quarter. Is this something that we should expect going forward? And, I guess, what led to that shift in the quarter a little bit?

T.J. Whalen

This is T.J., again. Part of that increase in share relative to the overall system does relate to the in-home channel, where we have a stronger tradition relative to some of the other roasters. Just to give you kind of a sense of how that's working for us, in Q2 of this year, we roughly doubled the percentage of our K-Cups rolling into that in-home channel, which this time a year ago was about 3% of the K-Cups we sold in Q2 of FY '07, and this Q2 is about 6.6% of our overall K-Cups.

So you're seeing an increased effort there by Green Mountain, which is relatively unique to the system and increasing some overall share position. And then I might add also the cocoa that Green Mountain has had in the system for a while now is something that is also relatively, or has been relatively unique to the system.

Mark Astrachan - Stifel Nicolaus

Great. Thank you.

Operator

Our next question comes from [Karthik Shrinivas], of [Geobine].

Karthik Shrinivas - Geobine

Good morning. I apologize if you addressed this earlier in the call, but I was wondering if you could give us a sense of what the channel inventories are like for Keurig At Home brewers at retail, and also if you have that number for K-Cups that would be helpful, and how you compute that, if you look at it on a backward-looking or a forward-looking basis? Thank you.

Nick Lazaris

This is Nick. And while occasionally we'll see particular retailers' inventory levels in reports they supply us, we pretty much are tracking sell-through with the reports they give us.

We do not try to track in particular inventories in channels. As I alluded to earlier, we do make assumptions in our K-Cup demand models, our internal models, but we don't comment on those in particular on these calls. Sorry I can't be more helpful.

Karthik Shrinivas - Geobine

Thank you.

Operator

And there are no other questions in the queue. I will turn the call back to our speakers for any closing remarks.

Larry Blanford

Well, it's certainly been a pleasure to talk to all of you today about this quarter and our plans and prospects. We very much appreciate your interest in the company, and thank you for joining us. Have a great day.

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Source: Green Mountain Coffee Inc. F2Q08 (Qtr. End 03/29/08) Earnings Call Transcript
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