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Ever since it began reporting record sales growth, Green Mountain Coffee Roasters (GMCR) has been dogged by questions about its inventory levels. The company has always maintained that it was building inventory to support future sales growth. In this article, however, I will show how statements made by Green Mountain's management in the past about inventory do not seem match the financial statements they filed with the SEC as well as certain disclosures about inventory contained in those documents.

Green Mountain completed the latest quarter, FY 2012 Q3, with $667M in inventory compared to $418M in FY 2011 Q3. It took Green Mountain an average of approximately 101 days to sell their inventory this quarter, compared to approximately 71 days during the same quarter last year.

Green Mountain's management had this to say about inventory levels and sales during FY 2011 Q4; that is, they explained how they felt about the levels of inventory the company had at the end of FY 2011 Q3 to meet expected demand in FY 2011 Q4.

The following quotes are taken from the FY 2011 Q4 earnings conference call transcript.

"The K-Cups I would - in terms of as we noted in our Q3 remarks we caught up in terms of our ability to feel confident that we could produce K-Cups on a week-to-week basis to meet the weekly demand. So, we were not essentially short if you will in Q3 or Q4 on meeting orders." [Frances Rathke, CFO, emphasis mine]

Ms. Rathke clearly states that they had no issue meeting orders in Q3 or Q4. That would imply that the company had adequate production capacity and inventory on hand to meet demand.

"So, I think, we're well stocked at this point for what we expect to be a very strong holiday season."
[John Whoriskey , VP and GM of Keurig's At Home Division, emphasis mine]

So there also does not seem to be an issue with brewer inventories, according to the executive in charge of the Keurig At Home Division.

"What we feel confident about is that within the estimates that we have provided that the capacity that we have been putting in place in fiscal '11 and what we are planning to put in place in fiscal '12 will support our demand projections for '12 and importantly, get us ready for holiday '12 or the first quarter of fiscal '13, as we still have a lot of initiatives that we're working on that we would expect to continue to increase demand in '13. So, we're in good shape." [Larry Blanford, President and CEO, emphasis mine]

Mr. Blanford, the CEO, states that the company's planned capacity additions will support its demand projections for 2012 and 2013. Remember this is FY 2011 Q4 and the planned production capacity was designed to meet sales expectations in FY 2012 of 60% to 65% growth from FY 2011, which would be net sales in the range of $4.24B to $4.37B. With adequate production capacity in place, there should be no need to expand inventory relative to sales. As of 2012 Q3 Green Mountain is projecting net sales of only $3.79B to $3.84B.

"…going into Q1 of fiscal year '11 we were capacity constrained and we had very low inventories and now we have caught up from our capacity standpoint and we've come into this fiscal year with inventories that we think are appropriate to support the growth of the business." [R. Scott McCreary, President, SCBU, emphasis mine]

Mr. McCreary, the executive in charge of SCBU, Green Mountain's largest division, states that the company's inventories and production capacity are sufficient to meet projected demand. Again, remember that expected demand has fallen since these statements were made.

Green Mountains inventory levels and expected FY 2011 Q4 sales at the end of FY 2011 Q3 are shown in the table below.

Green Mountain had $.55 in inventory at the end of FY 2011 Q3 for every dollar of expected sales for the next quarter. As we saw by management's comments at the end of FY 2011 Q4, there were no problems meeting sales.

Now we fast forward to the same quarter this year. The table below shows Green Mountain's inventory levels this year compared to last year as well as differences in expected sales.

(click to enlarge)

(Note: inventory component information is calculated from GMCR's inventory component disclosure slide from the August 14, 2012 Canaccord Genuity Conference supplemental slides and from the disclosure of inventory component growth from the FY 2012 Q3 supplemental slides. Calculations are approximate due to rounding.)

Despite stating in FY 2011 Q4 that they felt inventory levels were adequate, Green Mountain has now let inventory levels balloon up to approximately $.74 in inventory per dollar of next quarter's expected sales. Even more alarming is the fact that Green Mountain was forced to write down almost $24M of inventory so far this year. Additionally, it is worth noting that two component parts of inventory increased faster than sales (brewers and raw materials).

Green Mountain took the first charge for inventory obsolescence in FY 2012 Q2. From the FY 2012 Q2 10-Q:

"Gross profit for the second quarter of fiscal 2012 was $313.0 million, or 35.4% of net sales as compared to $242.9 million, or 37.5% of net sales, in the prior year period. Gross margin declined approximately (I) 290 basis points due to a combination of under-utilization of our current manufacturing base as a result of lower than expected K-Cup® pack demand and the resulting efforts to reduce K-Cup® pack inventories, which together increased average labor and overhead costs per K-Cup® pack, (ii) 170 basis points due to higher green coffee costs, (III) 150 basis points due to a higher write down of finished product and anticipated obsolescence of raw material inventory due to lower than anticipated sales of seasonal and certain coffee products, and (iv) 50 basis points due to an increase in warranty expense over the prior year quarter, which benefited from a program introduced to reduce the cost of the brewers used for warranty replacement. The decrease in gross margin was partially offset by a 390 basis point increase due to the net price realization from price increases taken in fiscal 2011 to offset higher green coffee and other input costs, and a 90 basis point increase due to a recovery under an agreement with a supplier for certain brewer warranty indemnification." [emphasis mine]

It's also interesting to note point which is that gross margins declined in part due to under-utilization of manufacturing equipment. This would seem to imply that Green Mountain could afford to reduce inventories because they now have spare manufacturing capacity. Instead, the company has strangely increased inventories despite the admission that they have spare capacity.

Green Mountain's FY 2012 Q3 10-Q shows more of the same.

"Gross profit for the third quarter of fiscal 2012 was $303.3 million, or 34.9% of net sales as compared to $264.1 million, or 36.8% of net sales, in the prior year period. Gross margin declined approximately 320 basis points due to under-utilization of our current manufacturing base as a result of lower than expected manufacturing through-put primarily due to lower K-Cup® pack demand and lower-than-planned production levels which increased average labor and overhead costs per K-Cup® pack, (ii) 120 basis points due to a higher write down of finished product and anticipated obsolescence of raw material inventory due to lower than anticipated sales of seasonal and certain coffee products, and 110 basis points due to the launch of our new Keurig® Vue® brewer platform that has a lower gross margin than the Keurig® K-Cup® brewer platform. The decrease in gross margin was partially offset by a 250 basis point increase due to net price realization primarily from price increases taken in fiscal 2011 to offset higher green coffee and other input costs that were experienced in fiscal 2011 and the first half of fiscal 2012, (ii) a 110 basis point increase due to a decrease in green coffee costs in the third quarter of fiscal 2012 compared to the prior year period, and a 60 basis point increase due to the decrease in warranty expense related to Keurig® Single Cup Brewers." [emphasis mine]

Again, it is worth focusing on point a 320 basis point decline in margins because of under-utilization of manufacturing capacity. This is a 30 basis point increase from FY 2012 Q2. Again, this raises the question: Why, with all of this unused manufacturing capacity, is Green Mountain continuing to build inventory? The inventory build has also continued despite the company being forced to write down another $10M (120 basis points times $869.194M in sales) of inventory.

What does management have to say about the inventory situation? Well, on the FY 2012 Q3 conference call the CFO, Ms. Rathke, tells investors the company will continue to build inventory:

"…and we continue to build the brewer inventory for the holiday"…we have -- it will be definitely building brewer inventory. We're pleased to see the portion pack number come down. I think we're all at good target levels now, so I don't think we're going to have a big sequential drop from where we stand now for portion packs by the end of September. So, I think I don't know exactly your model, but we've got the CapEx and then the brewer inventory is the primary driver…" [Rathke, emphasis mine]

There seems to be no inventory level high enough for the management of Green Mountain. We continue to have serious questions about Green Mountains inventory levels, fixed assets levels, and capital expenditures. Despite telling investors more than one year ago that inventory levels were fine, why does Green Mountain continue to build inventory far beyond what management previously defined as acceptable? And why does it build inventory to such a degree that the company is apparently having difficulty selling that inventory in a timely manner and is beginning to incur obsolescence charges?

Disclaimer: You should do your own research and due diligence before making any investment decision with respect to any of the securities mentioned herein. As of the publication date one or more of the following: Strubel Investment Management, our clients, our employees, and/or funds we advise are short GMCR and stand to realize significant gains in the event that the price of GMCR declines. Following the publication of this article we intend to continue transacting in GMCR and we may be long, short, or neutral any time after the date of publication. We undertake no obligation to update or supplement this article or disclose changes in our position in GMCR securities. Nothing in the article should be construed as investment advice or an offer to buy or sell any security.

Source: Green Mountain Coffee Roasters Management's Comments About Inventory Don't Add Up