Keurig Green Mountain's (GMCR) CEO Brian Kelley on Q2 2015 Results - Earnings Call Transcript

May 06, 2015 11:29 PM ETKeurig Green Mountain Inc (GMCR)
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Keurig Green Mountain Inc. (NASDAQ:GMCR) Q2 2015 Results Earnings Conference Call May 6, 2015 5:00 PM ET

Executives

Christie Bonner - IR

Brian Kelley - President and CEO

Fran Rathke - CFO

Analysts

Judy Hong - Goldman Sachs

Matthew Grainger - Morgan Stanley

Akshay Jagdale - KeyBanc Capital Markets

Steve Powers - UBS

Bryan Spillane - Bank of America

Bill Chappell - SunTrust

Caroline Levy - CLSA

Brian Holland - Consumer Edge Research

Operator

Good afternoon and welcome to the Keurig Green Mountain Fiscal 2015 Second Quarter Conference Call. Today's call is being recorded.

At this time, I would like to turn the call over to the company's Senior Director of Investor Relations, Christie Bonner. Christie, please go ahead.

Christie Bonner

Thank you, operator. Welcome, everyone. Today's press release is available on our website at www.keuriggreenmountain.com.

With me today are CEO, Brian Kelley, and CFO, Fran Rathke. We’ll lead off today's call with a review of our fiscal second quarter performance and fiscal 2015 outlook and then we'll move on to Q&A. In an effort to get to as many analyst questions as possible within the hour, we request you that you limit your questions to two.

I'll remind everyone that certain statements will be made today which are forward-looking statements within the meaning of securities laws. Given the uncertainties of forward-looking statements, our actual results may differ materially from anything projected in these forward-looking statements. We can give no assurance as to their accuracy and we assume no obligation to update them. For further information on risk and uncertainties, please read the company's SEC filings and the paragraph in today's press release that begins with the words, certain information.

And now, I'd like to turn the call over to Brian Kelley.

Brian Kelley

Thanks Christie, and good afternoon, everyone. While we are pleased to deliver earnings per share inline with our guidance for the second quarter, our topline performance was below our expectations. Total revenue was up 2% for the quarter versus a year ago and up 3% on a currency neutral basis, driven by 14% pod volume growth that was offset by lower brewer and accessory sales.

Fran will detail the year-over-year drivers of the quarter in her remarks, so I will spend my time focusing on what we are seeing in the marketplace as we continue through the Keurig 2.0 product transition.

I'll also detail the actions we’re taking and currently taking to position the hot platform for success ahead of the upcoming holiday season. Let me first address brewers.

With any new product introduction they are always challenges that are front end loaded and our transition to 2.0 was particularly complex. Point of sale results were not as strong as anticipated which led to higher levels of brew inventory of retail and on our balance sheet.

Some of this was due to consumer confusion around pod compatibility which we’ve mentioned in the past. Although we are seeing improvement as we transition more formally unlicensed brands into our manufacturing system.

Our second challenge has been the inability to address key entry level brewer price points. And third, customer feedback suggest we should reintroduce the My K-Cup accessory and enhance some brewer features.

Turning to pods, volume in the measured channels continues to be healthy at 17% total category growth in the quarter according to IRI. However, we saw weakness in several unmeasured channels including the specialty channels, digital and Dunkin' Donuts retail stores which reduced total system category growth to the low teens.

With respect to our owned brand volumes, we have experienced some share loss as we focused on innovation for partner brands as they were introduced into the system. Also our price gaps widened versus the competition.

There is one other element to note that affected our pod volume. In bringing Kraft into our system, we agreed to a multi-year transition plan for manufacturing. Today we manufacture only a portion of Kraft's pods and they recently launched McCafé, which we do not yet manufacture.

And while difficult to forecast with precision, we estimate that total Keurig system volume would have been a few 100 basis points higher if we were manufacturing the pods for all Kraft brands.

Having outlined where we stand, I'd now like to address our plan to get the brewer product transition behind us and how we will adapt to compete more effectively in the fast evolving competitive landscape within the pod category.

So let me start with brewers. First, the pricing of our 2.0 brewer portfolio has not allowed us to effectively participate in historically highest volume single serve segment, the $79 to $119 retail price point.

We did not have these offerings fully available in the first half of the year. We intend to address this issue with the digital launch of our K200 in May and it’s retail launch this summer.

We are also continuing to restock the MINI at retail and it’s return combined with the K200 launch will give us two strong offerings in this key price point range for the latter part of fiscal 2015 and for the upcoming holiday season.

Second, beginning in June of this year 2.0 brewer packaging will more prominently communicate the fact that the Keurig 2.0 brew is more than 500 varieties across more than 70 brands, including the top 10 brands. We expect this to help clear up the misperception the system only brew's Green Mountain or Keurig owned brands.

Third, we’re planning to reintroduce the My K-Cup accessory for the upcoming holiday season, which will allow consumers to once again brew any coffee they choose in their Keurig brewer.

Our new My K-Cup accessory were working Keurig 2.0 and importantly we’ll respond to the small but passionate number of consumers to express their strong desire to see it in the Keurig 2.0.

Finally, we’ll be making a number of brew enhancements for the holiday season including more sizes, additional temperature control capability, and easier hot water dispense feature and a continued evolution of the brew process. We expect these actions along with incremental promotional programs with our retail partners to bring our brew inventory down to more typical levels over the next several quarters.

Turning to pods. Transitioning a large number of unlicensed brands into our system over a short period of time has required a significant amount of effort by our beverage team. Now that a majority of that transition work is done, they are now fully focused on reinvigorating innovation across our own brands and we expect to see these products in the marketplace over the next several quarters.

Specifically we began shipping in February two new Green Mountain brand Donut varieties and are expanding our premium offering with the launch of Green Mountain organic, Green Mountain reserve and our Laughing Man brand all of which will begin shipping in the June, July timeframe.

We will also introduce numerous seasonal offerings in the fall under the Green Mountain coffee brand and the Donut Shop brand to drive incremental volume.

Finally our new packaging, which includes enhanced branding and graphics is rolling out across our portfolio of beverages over the next several quarters. Our new packaging is tested well with stronger purchase intent and shelf visibility scores.

Other initiatives to improve pod volumes include larger sizes with greater variety. Specifically we launched the new K-Mug line of coffees on Keurig.com in April, which will enable consumers to brew travel Mug sizes between 12 and 18 ounces.

We are launching four new varieties on keurig.com this fall, which will expand the K-Mug line to nine varieties. We will also continue to expand varieties in K-Carafe launching eight new varieties this spring and we expect to add additional K-Carafe partner brands this fall.

While the initiatives I described above on pods and brewers will address the current transition, they will require few quarters to take hold. Therefore we are revising our guidance to better reflect brewer sell through trends and their associated impact on the installed base.

It also factors in the pod share of shifts I referenced earlier as well as a slightly accelerated level of investment in Keurig Cold. One last operational issue that's not factored into our guidance is incremental productivity. As we move from a coffee company to a multi-category beverage company, it’s critical that organization become more efficient and effective.

To that end we’re reviewing all aspect of our operations over the next 60 to 90 days and believe we can make meaningful changes that will yield a better structure for our multi-system company. This should improve performance and allow us to fund important growth priorities.

Although we're not in a position today to discuss the plan, we will lay it out in a greater detail on our third quarter earnings call.

In summary, we have some work to do with the consumer to increase the adoption of our 2.0 platform and we expect to resolve these issues over the next several quarters.

As far as longer term, we remain very confident in our strategy and continue to see strong growth prospects for the Keurig hot system as U.S. single serve household penetration slowly moves closer to level seen in other countries, where single serve system adoption is more mature.

Combined with our forthcoming cold system launch which is on track for the fall of 2015, we expect to be the leading player in the growing trend to offer premium beverage systems at home.

I’ll now turn the call over to Fran to discuss the details of our second quarter and our guidance.

Fran Rathke

Thanks, Brian. For the second quarter we generated net sales of $1.1 billion up 2% versus the prior year quarter and up 3% excluding currency impacts. Core Keurig beverage system net sales increased 3% in the quarter and 4% excluding currency impacts.

As expected, brewer and accessory net sales declined 23%. Brewer volume declined 22% due not only to a difficult comparison in the prior year quarter, but high inventory levels at retail that negatively impacted shipments. Brewer net price realization declined by one percentage point and there were two percentage points of positive mix.

Pod revenue grew 7%. Volume increased 14% with one percentage point of pricing offset by seven percentage points of negative mix and a roughly one percentage point on favorable impact from currency.

Given the always competitive pod environment, we were not able to achieve the price realization we had expected. Pod volumes for the quarter came in below our expectations. This was due to softer than expected performance in certain channel such as specialty and digital along with Dunkin Donuts store sales performing below our expectations.

Pod volumes were also affected by lower installed base growth due to weaker brewer sales and somewhat higher than expected consumer price elasticity at retail.

In addition, the success of McCafé in the quarter had a larger than expected impact on volumes. In addition to volumes, mix was worse than expected driven by weakness in our digital channel that Brian referenced earlier, strong promotions by some of our partner brands and lower levels of innovation on our own brands.

If we breakdown results regionally, for the quarter our U.S. business had revenue growth of 3%, while our Canadian business declined 5%. Excluding the impact of currency the Canadian business grew 6% for the quarter.

Moving onto review of gross profit. For the quarter our gross margin declined to 80 basis points to 40.7% of net sales. This was largely driven by benefits from a shift in sales between brewers and pods versus the prior year and supply chain productivity offset by higher obsolescence, higher coffee cost and negative mix.

A major component of the higher obsolescence was a $10 million charge related to lower than anticipated sales of the Rivo brewer.

Turning to operating results. Non-GAAP SG&A increased by 8% in the quarter. As a percentage of sales non-GAAP SG&A increased by 100 basis points to 17.8% of sales as we continue to invest in R&D ahead of our Keurig Cold launch later this year and experienced higher expenses associated with information technology and supporting our call centers.

Our non-GAAP operating profit declined 5% for the quarter reflecting significant investment in our upcoming Keurig Cold platform and due to the $10 million Rivo obsolescence charge.

Our second quarter tax rate of 34.8% was favorable to our prior year period tax rate of 35.8%. Non-GAAP EPS of $1.3 came in at the midpoint of our guidance range. Non-GAAP EPS excluding dilution from 2014 equity transactions and foreign exchange was a $1.16.

The foreign exchange impact on EPS was a negative $0.05 and dilution was $0.08.

Turning to the balance sheet and free cash flow, during the second quarter, we spent approximately $624 million to repurchase shares from Lavazza and repurchased an additional $213 million of shares in the open market.

Our balance sheet remains strong with a net debt-to-EBITDA ratio of 0.4 times. We generated free cash flow of $133 million year-to-date which was below the prior year period. This was primarily due to high inventory levels and higher capital expenditures related to our new Keurig Cold launch.

Moving onto guidance, for the third quarter, we expect net sales to be flat to up low single digits and non-GAAP EPS of $0.75 to $0.80 per share, we expect our effective tax rate to be in the 32% to 32.5% range. We expect our third quarter revenue to be impacted by several factors.

Negative brewer shipment growth year-over-year as we continue to work through inventory levels as retail and lapped 13% shipment growth in the prior year. Hard volumes affected by continued conversion of formally unlicensed brands into the Keurig system, the launch of Dunkin' Donut K-Cup pods at retail.

Continuing negative mix and elasticity to higher pricing on our own brands. The net effect of these factors is pod revenue growth slightly higher than the second quarter. Finally, we expect foreign exchange to negatively impact total revenue growth by approximately two percentage points.

Our third quarter EPS guidance is impacted by the following factors. We expect brewers to be a smaller percentage of mix versus the prior year period which will positively impact margins year-over-year.

This will be offset by higher 2.0 brewer cost as compared to the 1.0 brewers. Pod mix is expected to negatively impact margins, commodities will be a greater headwind in Q3 on both the year-over-year basis and versus what we experienced in Q2.

We are lapping a significant logistics productivity benefit in the prior year, continued investment in Keurig Cold, we fully lapped the Coca-Cola equity transaction the second quarter and began to lap the Lavazza equity transaction mid third quarter.

Foreign exchange is expected to negatively impact EPS by approximately $0.02 and finally our guidance embeds the share repurchases that we have made year-to-date.

Now moving to our full year guidance, for fiscal 2015, we now expect flat to low single digit net sales relative to fiscal 2014, we are revising our non-GAAP EPS guidance to a mid-single digit decline.

Our EPS guidance embeds the share repurchases. Our revenue guidance reflects an approximately negative two percentage point impact from foreign exchange, a one point headwind due to lapping the benefit of retailer preordering ahead of the year end SAP implementation and the adverse impact from pod mix related to new brands entering the system.

The reduction in our full year revenue guidance takes into account second quarter results, lower brewer sales estimates for the balance of the year, lower pod revenue growth due to a slightly lower estimated growth rate in the installed base entire negative mix.

Please note that the prior year SAP benefit was entirely in the fourth quarter of fiscal 2014. With respect to gross margins, we will still see benefits from pod pricing and productivity as well as brewers compromising a smaller portion of our business versus prior year.

Headwinds include higher commodity cost, higher cost on the Keurig 2.0 brewer versus 1.0 and negative pod mix as we continue to transition formally unlicensed brand into the Keurig system.

With respect to coffee cost, we are now more than 95% locked for fiscal 2015 but if higher rates in fiscal 2014, coffee cost will be a headwind for the remainder of fiscal year 2015. We will continue to invest in our cold platform with our current guidance taking into account investments slightly above the high end of the previously mentioned range of $50 million to $100 million with acceleration in the back half of the year as we move closer to launch.

We anniversaried the Coca-Cola equity transaction dilution in the second quarter and began to anniversary the Lavazza equity transaction dilution in the third quarter which will positively impact EPS growth in the second half of the year.

And finally our non-GAAP EPS guidance includes a $0.14 negative impact from foreign exchange, a 34.5% to 35% tax rate and includes the impact of share repurchases. From a cash flow perspective, we expect free cash flow in the range of $120 million to $170 million and capital investment in the range of $425 million to $475 million.

Embedded in our capital investment guidance is North America hot platform investment within our previously mentioned 4% to 7% of revenue target with the remainder representing investment in new products and platforms.

With respect to fiscal year 2016, we will be providing our guidance as per our typical practice on our fourth quarter earnings call.

Now I’ll turn the call back to Mr. Brian to wrap up.

Brian Kelley

Thanks Fran. As you may have seen from our announcement today we’re very excited that Pete Leemputte will be joining us as our new Chief Financial Officer effective August 17 of this year 2015.

Pete has significant financial and operational experience working at a number of public companies most recently as the CFO of Mead Johnson. Given his 12 years as a public company CFO, I’m confident that he will bring valuable perspective to Keurig.

I would also like to thank Fran for her contribution to Keurig over the years, she will work with Pete through the summer to ensure a smooth transition and as agreed to stay with the company through the end of September in an advisory role.

In closing, we have an extraordinarily valuable asset in our Keurig brand, and we’re fortunate to have the finest beverage brand partners of any home beverage system in the world. Our current partnerships are strong and we continue to add new ones such as the New England Coffee and Louisiana Tea brands, and we expand current partner relationships such as the Dunkin' Donut retail launch.

We are taking decisive steps to position our hot system for success over the long-term and are excited to showcase Keurig Cold at next week’s investor event.

Finally, we remain confident in Keurig’s ability to maintain our leadership position in the growing trend to offer premium beverage systems across multiple beverage categories.

With that I would like to open up the line to questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question today comes from Judy Hong with Goldman Sachs.

Judy Hong

Thank you. Hi, everyone. So my first question is just really on the brewer sales trend which obviously is continuing to be negatively impacted by the transition issues. Brian I guess maybe just a little bit color on the point-of-sales trend for your overall brewer sales how much was it down in terms of the point-of-sales trend, how much was it MINI versus the core reservoir line? And then as you think about the inventory positioning, exiting the second quarter, can you give us some sense of how much is left to get back cleaned out and what is the margin impact as you think about cleaning that out over the next few quarters?

Brian Kelley

Thanks Judy. The shipments were in line overall with what we anticipated and what we expected. The POS was a bit worse, if we look at - if you ask the question which you did about the reservoir brewers, when you take away the MINI brewers and the view brewers it was down about 11%.

And that's about where the POS was for the quarter and so that was slightly worse than we had thought it would be and so when I look at that from that standpoint, that's where we were with the quarter in terms of POS.

As we look in the next two quarters, we know we will promote brewers in order to get the - move the inventory through and be ready for success in holiday season. And that was going to be really important to us particularly also as we launched the K200, we want to make sure that we're right in the thick of the price points that we need to be in with that K200 all the while we bring the MINI back and we continue to restock the MINI.

But it’s going to take us several quarters to work through this and that’s reflected in the guidance.

Judy Hong

Okay. And then maybe just in terms of third quarter guidance I guess, your EPS guidance certainly implies a much more significant decline year-over-year versus sort of what you're guiding in terms of sales guidance.

So I’m just trying to bridge in terms of your margin outlook, I know Fran you had called out some of the gross margins, headwinds and some of the offsets to that but what’s really the delta between Q2 and Q3 in terms of what sounds like much worse margin behavior in Q3 based on your EPS guidance.

Fran Rathke

Judy, this is Fran. I think what we’re seeing is much more of headwind on cost and I think on what we see is on - in Q3 we'll have brewer shipments higher than what you saw in Q2 but we’re going to have more of the mix of 2.0 brewers which on - we loose more money on the 2.0 brewers and the 1.0 so when you compare to the prior year as well as sequentially Q2, that’s one of the things.

And also higher cold investment were really at the point where we’re on - in a lot more of the preproduction cause of getting the plants up on the capsules – the plant up on the capsules, so that effecting us as well as a drag on EPS.

And also just continued on, we believe our estimates have more of a negative mix from the portion pack side in Q3 compared to Q2.

Judy Hong

Okay. Just a quick follow up on the cold spending going up to the high end or about the high end of your range. Can you just - how should we think about the numbers coming up there, is it related to just see under estimation of your initial thought on the launch or are you thinking maybe more optimistic about the launch and you want to spend more money to ramp up more quickly, just some color on what's driving to spending increases.

Brian Kelley

Judy, it's really more the ladder, we’re accelerating the spending to get ready for the launch. We want to have, in a launch like this, the single most important factors having the supply chain ready. Once the product is ready which it is, we have to have a supply chain that's ready and that for us means having brewer capacity and having pod capacity.

And so what we're reflecting is accelerating some of that spending to be even more prepared as we launch.

Judy Hong

Okay, got it. Thank you.

Fran Rathke

Thanks Judy.

Operator

And our next question comes from Matthew Grainger with Morgan Stanley.

Matthew Grainger

Hi, good evening everyone. So Brian first as organizationally there is a lot of different effort going into place right now, multiple brewer launches, pod innovation, this ongoing review of the business, does this in anyway stretch your ability that execute on the cold launch or in anyway change on the margin the timing of how quickly it could ramp up or when you expect shipment to be sort of ready to go.

Brian Kelley

Well, these transitions have been in plan for a long time and we have been actually doing them to enhance our ability to execute. So the reality is we’re very, very focused on two priorities and that is return the hot system to healthy growth rate, launch cold and continue to be as productive and efficient and effective as we can be as an organization.

So those are the three priorities in the company. Those are things that everybody is focused on and the enhancements we’re making in the organization will only enable us to better execute those three priorities.

So that’s what behind them and I’ll see if there is any other question for me from there Matt.

Matthew Grainger

Okay. And just, I assume we’ll talk about this next week, but from a timing standpoint around cold, is there any other color that you would add today from a shipment 10 point impact on brewer sales to full year?

Brian Kelley

No, I don't really going to discuss it today because we’re going to into much more depth obviously next week. And I think that will be a good time to get much more detail and answer all of the questions about cold.

Matthew Grainger

Okay, thanks Brian. And just follow up, just on the comments on the installed base growth as a result of lower brewer sale through. How you’re thinking now about installed base growth for the full year and does this in any way change sort of the midterm outlook and to what extent is that being lower this year, to perhaps a weaker market share trends as opposed to - just for GMCR Brewers or Keurig machines versus others and how much of it might be attributable to just lower penetration growth for single served brewers overall?

Brian Kelley

Yes, let me address that. I think, we haven’t changed one bit the long-term opportunity of 50 million plus households that we think we can target single served Keurig brewers in. I will say that if you look at this year and if you look at the growth rate, we think it’s probably in the 10% to 15% range.

We would have said - in the first quarter, we would have told you it’s probably at the high end of that. We probably say now it’s a lower to mid range of that and if you look at what's happening in total single served, the single-serve market, we think, is attractive as ever. The consumer has indicated no lack of interest in single serve. In fact, it continues to grow at a healthy rate.

So, we don’t see a change there. We’re still the leader. We’re still in a very, very good position and we see, in the future, short-term and mid-term and long-term very, very healthy growth for single-serve and for Keurig within it.

We know that a large portion of single served brewer sales occur below $100, and if you look in the first half, we didn’t have an offering at that price point. The MINI plus was not in the market and we didn’t have the K200 launched. Both of those will be coming. We’ll be ready in the market with those, which get us in the sweet spot of the price points for single served brewers.

And we have a number of other actions, which I outlined that we'll take to make sure we can continue to grow the install base.

Matthew Grainger

Okay, thanks. Thanks Brian and I would just say congratulations also to Pete, and look forward to speaking with you later.

Brian Kelley

I’ll pass along his thank you. Your congratulations. Thanks.

Operator

And moving on to Akshay Jagdale with KeyBanc Capital Markets.

Akshay Jagdale

Good evening. Brian can you - you gave a walkthrough of the Kraft impact in terms of the transition on your K-Cups, K-Cup volume. Can you give us an overall walkthrough of the overall share gains, so you’ve obviously in principle agreed with a bunch of brands to come on to the system. Where are we in that transition and what impact would that have had if you had all of them in the system today?

Brian Kelley

It’s a good question Akshay. We’ve converted and brought in and welcomed in more than 25 brands in the last year. And so we are - I do know that I could give you an exact percentage of how many were actually shipping, I don’t want to give you a percentage is not accurate there, Fran, if you had one, jump in, but we’re well on the way with most of them - we mentioned the Kraft brands were not producing at all of them and there are still a number of others that were not yet barely producing and so those are coming.

We think unlicensed is probably in the high single-digit range, probably in the middle of the high single digits somewhere and we continue to be aggressive in terms of welcoming other unlicensed in to maker sure we offer consumers the best brand in our system.

We also are very excited we mentioned the new ones that we won, which are both the riley food brands, the New England coffee and Louisiana and the expansion of Dunkin is another big, big addition to certainly to the system.

Akshay Jagdale

Okay. And then just on the hot platform, just on the brewer side. You talked about the lower price point being an issue. I was under the impression that - especially with MINI’s and your view on that, that with the lower attachment rate, perhaps the $100 price point consumer, the guy who is buying below $100 is not really the best consumer to have, right, in terms of the attachment rate and the annuity income that comes with it.

So, I’m a little bit surprised that the emphasis is so much on that price point. And then can you talk about their change on the marketing side. I think you hired a new person there and what was wrong with the messaging and what’s the plan going forward?

Brian Kelley

Sure, I’ll comment on both. If you look at the price points, you’re right Akshay that the MINI has a lower attachment rate because it doesn’t have a reservoir. And so you're accurate there. What we're excited about with the 200 is that it’s going to be at that promotionally $99 price point and it does have a reservoir.

It’s a smaller footprint, it’s a beautiful design, it’s modern, it’s progressive it looks terrific and we think it will do quite well. So it will have all the benefit of a reservoir brewer with 2.0 capability from K-Cup through mug and craft it will be able to do all of the SKUs we have as well, it has a full reservoir and it will be at an attractive price point.

So that we expect to have the same level of attachment that any other reservoir brewer would have.

On the marketing front, you asked the question, Mark Baines is a terrific ad, he's a very seasoned and capable marketer. He is not only helping in terms of positioning thoroughly the Keurig brand as we expand beyond coffee and we expand into cold beverages, he is really helping us well as we build our own brands in coffee, The Green Mountain brand, the Donut Shop brand, our Laughing Man brand, the Barista Prima the brands we have that do quite well in the marketplace Mark is helping us clarify and sharpen those.

Christie Bonner

I think the other key piece is we look at the 2.0 launch we did not communicate effectively as effectively as we could have been the variety that is in the machine and it there were many consumers who thought that it only brew Green Mountain brand or Keurig-owned brands and we didn’t get the message out effectively, we didn’t get it out quickly enough and we didn’t get it out broadly enough to dispel that rumor that was out there and dispel the confusion consumers had.

So Mark comes in with enormous experience and already is really helping, it will be an enormous advantage for cold as well as we launched cold and as we build that platform over time.

Akshay Jagdale

And just one last one on the non-license conversions, obviously the mixed impact is pretty significant on your P&L here. It’s hard to parse through what the EBIT or margin impact is and I’m sure that is going to be a question on that short spring. And so can you talk about I mean previously you said the system is agnostic to with its own brands or licensed brands or partner brands on the per unit economic.

Can you refresh your thoughts on that now that you’re sort of through this transition? Thanks.

Brian Kelley

Sure, Akshay. We historically have said that we were confident that they were fairly equal in terms of an operating profit standpoint, the pods were somewhat indifferent in terms of which pod sell, in terms of operating profit not revenue but operating profit.

All of the pods we have today in the system still has healthy margins but we can’t stay more that is it's exactly – they’re identical. Because they're not identical. They're not wildly significant but we do see differences and we know that, we recognized that and we expected that as we brought all of the licensed pods in.

And so we are reflecting it but again helping margins across the whole system and we have a very good business model, that is a strong model.

Akshay Jagdale

Thank you. I’ll pass it on.

Brian Kelley

Thanks Akshay.

Operator

And our next question will come from Steve Powers with UBS.

Steve Powers

Thanks. Hi everyone. So Brian just want to step back because a few weeks before the end of Q1 you gave a very upbeat address at the Beverage Digest Conference and then obviously Q1 disappointed. And then more than half way through this quarter you gave at least from my perspective a similarly upbeat address at Cagney, saying you were very, very confident 2.0 issues would be transitory and our platform and we'll get back on track at a timely manner.

And here we are with lower full year expectations and momentum in the marketplace that is still struggling to take hold, so I appreciate all the new initiatives that you laid out in the prepared remarks and many of them make good sense but I guess I’m just left with the lingering question of how we can truly have confidence that you’re giving yourself enough cushion in this new outlook given the recent execution? I mean how much of what you have laid out in those prepared remarks is new versus what you had planned as of January, February and what I guess even is your early expectation for 2016, is it too aggressive to think that we’re back on algorithm by then on your long-term algorithm or does that get pushed out to 2017 and beyond given continued 2.0 ramp issues and new cold investments?

Brian Kelley

We’re not coming off from long-term algorithm Steve, we’re not going to comment beyond 2015 but we’re not coming off the long-term algorithm for the company.

If you look at the year itself reflecting, certainly reflecting the first half of the year, the results in the first half of the year we want to make sure the guidance is realistic, it is achievable and it reflects the transition we are going through.

There is no inconsistency in the fact that the transition we talked about, last quarter is the same transition we’re talking about this quarter, we’re smarter now. We know what the transition elements need to be, some of the plans were in place, many of these are new because we have a clear indication both on brewers and pods of what is actually happening in the market and it is complex.

There is no question it is complex, it is not a simple process to transition like this, it is strategically critical that we do it and so that’s why we’re going through it and if we look at the lower pod volumes given that lower installed base, it really flows from there, when you don’t get the installed base particularly when you don’t get it in the holiday season which is when the brewer sell, you’re going to have the challenges, it’s very difficult to make it up in the rest of the year.

That said what got a bit worse was the price realization that price elasticity hit is competitive out there on pods, there is no question and if you look at the mix impacts we’ve had as all of these new brands come in and the mix impact we have is real.

So we think these the guidance's is realistic, we think it’s achievable and we’re committed to the action plan.

Steve Powers

Okay. I guess just two follow-ups and then I’ll pass it on but with your – from your consumer survey work during the since December, is there anything you mentioned that the price elasticity and that but is there anything in the – from what you’re seeing from the consumer that comes across to you as a key learning that has influenced your new thinking.

And then follow-up one, the follow-up number two would be just want to get underneath that digital weakness that you mentioned because you’ve been excited about digital in some of the subscription services that you’re offering and launching in recent months, so just little bit more elaboration there on where the weakness reside will be great, thanks.

Brian Kelley

Yes the consumer, the predominant message the consumer gave us, it differed between new users and current owners of Keurig. So the current owner of Keurig was obviously the one who had challenges with pod compatibility and that was the major issue.

There is really no way to go through a transition like this without going through those issues and so our plan has been and continues to be shortened the time that consumer feels that, that challenge and that pain.

And you do that by moving through the inventories quickly as you can and by bringing in, welcoming in as many of the unlicensed brands as you can but there is really no way to do this transition without going through some of that. So the first thing is making sure we are clearly, I mentioned earlier, we want to make sure that we are communicating very clearly that the variety is enormous more than any one household needs when you have over 500 varieties in 70 plus brands.

I would tell you the other thing we heard loud and clear from the consumer while very small percent of consumers, a very vocal and intense, passionate consumer who really wanted the my K-cup back, what we learned that it’s important the message and the signal that it sends, the ethos that it sends is that we want consumers to be able to brew every brand, any brand of coffee in their machine and bringing the my K-cup back allows that.

So we heard that loud and clear from the consumer. If you look at other learnings from the consumer, those would have been the two critical ones. Steve did you have another follow-up on that?

Steve Powers

Yes, that’s great, that’s great. Just little bit more color on where you saw the digital weakness would be great. Thanks.

Brian Kelley

Yes, the digital question is we are excited about some of the digital initiatives we have but the fundamental digital challenge that we face and have worked through and continue to work through is that the Green Mountain brand, the Green Mountain company and the Keurig company had two distinct websites, two completely different programs or pods, two completely different processes for the consumer to move through it.

And when we went to SAP and we went to the conversion of SAP we had to move to one system and that changed, it changed the consumer pattern of how to order because one of them had changed the way they went through it and that’s hard for consumers, when you change the digital path that they have to follow and the click stream that they have to follow in order to order pods, you’re going to lose some of that pod business and that’s what happened in digital it’s really that simple.

And so we’ve been in the process of each month and each with consumers both on Green Mountain's side in Keurig side now as one Keurig.com building up and improving those satisfaction ratings these consumers get more and more satisfied.

This is something by the way Mark Baynes, our new CMO is deeply into and deeply capable of really helping and managing and again there was there’s a transition on that that when you have two different methods of selling pods and brewers online and you convert to one you’re going to have some dissatisfied consumers as you and some bumps and hurdles you go through this.

And that’s what happened in digital we continue to be very excited about the digital business and about the things we can do online it’s a tremendous capability for us hope that gives a little more detail.

Steve Powers

That’s perfect. Thank you.

Brian Kelley

Okay.

Operator

And our next question comes from Bryan Spillane with Bank of America.

Bryan Spillane

Good afternoon everyone. Just couple of first question is just Fran the obsolescence charge you mentioned that there was $10 million related to the Rivo there was another additional obsolescence charge as well. Could you I think as could you just clarify what that was?

Fran Rathke

Sure and that’s in the gross margin table so there was other obsolescence expense in the quarter in addition to the Rivo and that is more along on the pod side and it’s typical lot of it tends to be on some of the more C skews the more the slower selling or the varieties that tend to be more seasonal is usually what happens.

And I think, because we came in on the lower end of our at the pod volume we expected it ended up on resulting in on a need to set up a charge for things like hot cocos and seasonal flavors.

Bryan Spillane

Okay that’s more of a seasonal cleanup we had something similar last year if I remember correct?

Fran Rathke

Yes.

Bryan Spillane

Okay and then just inventory is being up higher year-over-year is that just simply the backlog that the sell through hasn’t been as good and you’re building cold or just any color there on just inventory is going up?

Brian Kelley

It’s all right go ahead.

Fran Rathke

So on inventory I was just going in terms of cold just to help everybody on the line we at this point we’ve not we’re not manufacturing sellable capsules yet that’s so those are called we got the plans trying to scale and start manufacturing capsules so nothing is in inventory at this point.

So that’s hitting the P&L and SG&A as a preproduction cost. So in terms of the increase in inventories some it’s slightly brewers, but you’re talking year-over-year or sequential?

Bryan Spillane

Year-over-year.

Fran Rathke

Year-over-year hold on I’ve got it’s primarily Q2 we don’t typically have significant amount brewer sales so I think it’s primarily still the higher inventory level of brewers that we saw at the end of December.

And then I’m just looking at the data sorry of course impacts a slight amount but it’s mostly building the K200 through the launch.

Bryan Spillane

Got it, okay. And then just one last one I think if I can Brian. And sort of misunderstand I mean it seems like part of the sort of the sell through on brewer it’s just because you haven’t had the entry point in next price point brewers.

And was that always the plan to have this sort of point in this gap of time where there were just more premium brewers than now you’re as planned putting them back in the market.

Are you bringing them and sooner than you would is it coming in later just trying to understand you’re going to kind of how this phasing I guess versus what your original launch plan was?

Brian Kelley

Yes, the original launch plan quite honestly did not plan on not having the MINI in the market and so we anticipated having the MINI in the market when we launched 2.0 and that would have - that would be in that $89, $99 price point that that actually as you know didn’t happen.

And so when we launched 2.0 and the MINI action was in the market we didn’t have anything in the first half at the sub-$100 price point really even and so that’s the difference.

The plan then on the K200 as it got bigger and bigger in terms of appealed launch I think we originally had it slated for late April in terms of shift, it’s now May 11. So 10 or 12 days later, but we’re – that was the plan, the plan was to launch it in the spring after the launch of the rest of the 2.0 items but we didn’t originally anticipated not having that MINI and so we that’s exactly what happened, Bryan, as you think about that.

Bryan Spillane

Yes, that makes sense. And the MINI-not being in the market which is related to the recall, right. The recall from 1Q?

Brian Kelley

Correct.

Bryan Spillane

All right. Thank you.

Operator

And next will be Bill Chappell with SunTrust.

Bill Chappell

Thanks. Thanks for taking my questions. Just going back one thing maybe I just don’t understand on the bringing the My K-cup back, how does that exactly work and I mean is that precursor to maybe taking off some of the smart technology for future – do you feel the need to kind of reopen the system and that’s been one of the problems of the launch?

Brian Kelley

I mean another the system that we have was intended to be able to distinguish a K-cup from a K-carafe and a K-mug, and it works perfectly and it does that and it’s delivering exactly wanted and by the way that’s the first step in a series of improvements in steps that will make that give us the ability to identify and brew individual pods, the way they need to be brewed.

And so that’s the first step in the evolution and so a lot of effort went into this thought on My K-cup, so let me explain exactly what the My K-cup was and will be, what it was, was a terrific addition for the consumer wasn’t used a lot, it didn’t make a lot of volume, it didn’t but it was a nice.

For a consumer it was a nice element to have if they were given coffee as a gift, in bagged coffee, they could put the My K-cup in there and pour the coffee in from the bag that they perhaps didn’t have in a pod.

And so it was a nice convenient for a lot of our very, very loyal and heavy user. They didn't use it frequently, but they used it and importantly it gave them the ability to brew any brand they wanted.

And so when we took it away and we took it away because that particular My K-cup wasn’t going to work with a new system as the new system had to identify the pod versus a carafe, so we took the My K-cup away and quite honestly we’re wrong.

We missed, we didn’t – we underestimated, it’s the easiest way to say, we underestimated the passion that consumer had for this. And when we did it, and we realized it, we’re bringing it back because it was we missed it. We shouldn’t have taken it away, we did. We are bringing it back.

Bill Chappell

Okay. And then switching gears, and I'm sorry, I don't fully understand the accounting but on the as I look forward for the rest of the year and as you go live on cold, do you have I guess brewers sales in this year’s fourth quarter guidance and then would there be amortization of the accounting part? That's what I don't understand. More the CapEx you've spent, would amortization kick in, in the fourth quarter as you start shipping or is that more of a longer term moving into 2016?

Fran Rathke

Sure Bill, it’s Fran. I think what we do anticipate on in the Q4 to see sales of the cold appliance in our revenue and then the corresponding cost of that in the cost of goods sold in addition on as we are starting to manufacture salable capsules for the cold system that we would be selling most likely you would see on our digital, on our website in Q4. That’s when we would start on – you’d start seeing the cost, the depreciation underlined and the plant we’re doing the first salable product up in our Williston plant.

That’s when that will be more like a traditional cost of goods sold with the labor and overhead and the depreciation on the manufacturing equipment. So that would be in cost of goods sold and as I said right now we are starting up, we have lot of R&D people working on the cold product, the whole platform as well as getting a plant ready to start making finished goods that is all in SG&A right now.

So there will be sort of cost of goods sold in Q4, sales in Q4 and continued R&D and marketing expenses in Q4.

Bill Chappell

Okay. That’s great and just last one from me and I don’t know you will break this up, but look at the 14% pod number for the quarter in volume, is there any way to break that out of kind of what was newly licensed versus what was kind of not same-store sales, but what you had in the past?

Fran Rathke

Bill, we don’t break out specific brands and skews. As you know we have tremendous amount of variety so we don’t break that out.

Bill Chappell

Okay, thanks so much.

Brian Kelley

Thanks Bill.

Operator

And next will be Caroline Levy with CLSA.

Caroline Levy

Good evening, thanks so much. My question relates to guidance to the mid single digit earnings decline for the full year. I think I got that right and you gave us guidance on the third quarter. I am having a hard time getting to that without the fourth quarter margins being up quite a bit or being up at all, which would seem a very strong reversal and may be not, doesn’t make tremendous sense. You've got very difficult comparisons on volumes in your take ups in the fourth quarter, so can you just help us get to what mid single digits for the full year?

Fran Rathke

This is Fran Caroline. We've laid out guidance for Q3 and as we said we do have some headwinds in Q3 both pulling down gross margin and operating or EPS for Q3 compared to the prior year. And we would continue into Q4. We're not giving out actual gross margins for Q3, Q4, but we would continue to have we noted coffee costs sequentially as well as year-over-year higher in Q3 and Q4.

And not necessarily Q3 to Q4 could be similar cost structure, but then I think it's really the more 2.0 brewers compared to the prior year where with 1.0 brewers where they cost more in Q3 and Q4. And I think we've also talked just, we just mentioned we'd also have the Cold startup happening in Q4 in terms of gross margin impact where it is impacting SG&A in Q3. And I guess we've tried to provide you appropriate level of insight into your model.

Caroline Levy

So again just I'm clear, you do expect margins to be down in the fourth quarter as well or just, there won't be a major difference between those?

Fran Rathke

Caroline we don’t give out specific gross margin or operating margin, or SG&A margin, just overall EPS guidance.

Caroline Levy

Okay and we appreciate that very much, thanks. And again getting back to the K-cup if I might, does my K-cup is it not again on those questions I guess opening up sort of the questions to your partners that people can use other coffee in that and I'm not as familiar with the system as some people followed the stock for a really long time. But does it in anyway put you in conflict with your partners?

Brian Kelley

It doesn’t Caroline. Let me just explain. Years and years ago, a decade ago when we launched My K-cup, it was launched originally because when Keurig Green Mountain started it was just a handful of regional brands, small regional brand and the thought was put in My K-cup in there in case somebody had a brand because it did not have major brands at the time. And the thought was put in My K-cup in there to let consumers brew coffees that weren’t in the pod form factor. And it stayed and again, like I said earlier and it's been around for a decade, a long time more than a decade I think.

And if you look at that it's again a very, very small portion of the volume, but it's an important piece of the ethos to be able to brew any coffee brand you want. You know, part of what we have stood for is the ability to brew an enormous variety and that is the ultimate variety because if you have a coffee that doesn’t have the pod form factor, you don’t have it in your home, you can brew it in that way. And so, that allowed the consumer to say, okay I can bring a single serve brew into my home and use any coffee I want and that's why we're bringing it back. It's an important component. And no, it doesn’t have any impact on partners.

Caroline Levy

Okay thank you and then just finally on your management changes, you've got very seasoned CFO joining you, congratulations. And somebody in marketing joining you, who sounds very strong. Can you just update us on the technology and supply side any changes there would be helpful?

Brian Kelley

Sure we're very, very fortunate about a year ago we brought in Bob Ostryniec who our global Chief Supply Officer. Bob served in that role as the Global Chief Product Supply Officer for Heinz for quite a while for a number of years and he left Heinz and he joined us and we've been really fortunate to have a true leader and capable professional in that situation.

So, on the marketing front the product supply front Fran as she transitions we will have an excellent replacement for Fran and then we have Kevin Sullivan we have the benefit of bringing in Mark Choe. Mark is a very, very seasoned R&D specialist who actually has deep appliance experience with Whirlpool, managed over 1000 people in the R&D capability there. And prior to that in the auto industry many years with Ford Motor Company managing complex platforms.

What I really like about Mark is that he has a – he is an engineer's engineer with a deep consumer understanding. And so in our business it is transitioning consumer spec into technical spec that is really what matters. And we'll have the benefit of having both Kevin here working on technical initiatives and technology initiatives, but Mark will run the operation and it allows Kevin to down shift a bit and enjoy just the technology work.

Caroline Levy

Thank you, very much.

Brian Kelley

Okay, thank you.

Operator

And the next question will come from Brian Holland with Consumer Edge Research.

Brian Holland

Thanks, good evening. Brian you mentioned that you did expect pod economics to vary somewhat by partner as you add to the portfolio and some of the commentary predated your coming onboard, the longstanding view from the company was that the per pod profit would vary that much if at all. So I think if you would clarify, the fact that we're seeing any variance is that simply attributable to a change in the company's view with respect to including private label or has the competition you referenced influence any concessions on your end?

Brian Kelley

Well, first I would say Brian that it's really not by partner that the margin gets structured, it's by pod brand, by the brand because it's what you do for that individual brand and what role we play, whether we're purchasing coffee, whether we're roasting the coffee, grinding it, putting in a pot who sells it and that really differs by brand. In some ways it is linked to a partner, but in many cases it is by brand.

And so if you look at where we are today you really it's very difficult to bring in all of the more than 25 licensed brands we brought in, in the last year and expect to see the kind of consistency in margins is not dramatic inconsistency, but it's not what it used to historically be which is we, the company used to be able to say that it was somewhat actually indifferent to operating profit by pods regardless of which brand. And, but it wouldn't be accurate to say that anymore because there is a difference.

It's again it's not a dramatic difference and we have healthy profit across all brands in the system, but you when you look at the value chain and you look at the different things you do for a private label player or a small brand, a large nationally distributed, global brand and their capabilities you do very, very different things in some cases the margins may be slightly higher or slightly lower. So, it's more accurate now to say that while we have very, very healthy margins across the entire portfolio they are not identical.

Brian Holland

Got it and then just the follow up moving elsewhere, so I appreciate all the color with respect to what you've sort of learned from the consumer with the 2.0 rollout and commend you for being nimble to make the changes as you see fit to sort of reconcile any disconnect. I guess, what did you learn about the consumer in so far as what they did in the December quarter?

Meaning you had a base of consumers you were targeting, you were a little bit disappointed by the lack of sell-through, what did that consumer do in the December quarter? Did they buy another brewer are they deferring purchases? And I guess because you would think that if it takes maybe three years as the reasonable life of a coffeemaker, that if you didn’t get on this past December then maybe it takes a while before you have another shot at them. So I'm just wondering what your view is, and what the consumer did this past December quarter?

Brian Kelley

Yes, actually it's a really good question Brian and actually if you look at what they did it's not that they bought another single serve brewer. And it's really if they bought a coffee brewer at all and you can look you guys can see somebody can see NPD data, if it impacted coffee brewers in total, but it was not that they bought another single serve brewer. In essence what happens you've got a short window of opportunity in that six-week primary holiday season.

And if they don't buy the single serve brewers they buy another hot product. They may buy completely different category, a large percentage almost 40% of gifts during the holiday, you've got a lot things have a choice to do and so they may not instead I want to go out and buy different kind of coffee brewer. They may brought something else with the money for other gift.

So it’s all about hitting the right time with the right product at that holiday season.

Brian Holland

It’s a reasonable then to say that you think that to some extent and because there is gifting component obviously to this, maybe this gets - these consumers go back into the pool and maybe got a better chance with better messaging to get on this holiday.

Brian Kelley

Absolutely. That's our plan.

Brian Holland

Got it. Thank you.

Brian Kelley

Okay. Thanks Brian. I think we are finished with questions, and I'll just end by saying we look forward to seeing many of you next week as we launch. I'll mention again we're on track for the fall launch of the Keurig Cold. And we're very excited to see everybody next week and show you and you'll get to see it and taste it and experience it.

With that, thank you very much.

Operator

Thank you. And that does conclude today's conference. We do thank you for your participation today.

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