Anyone who has followed Green Mountain (GMCR), turned on CNBC at least once in the last couple of years, or simply browsed yahoo finance, knows that GMCR and its management have been party to a Class Action Lawsuit that has been nastier than most. What's more interesting is that most people, including shareholders, have not actually read the lawsuit complaint page by page. Having a short position in the stock, which I discussed in my first SA article last month, we spend each waking hour searching the world for more information about each of our investments.
Before I begin noting a few interesting points I found in the recent amended filing, and other relevant points, let me just say that I am not a big fan of the whole Class Action lawsuit system. It just reminds of the unethical Ambulance Chasers that were highlighted in the 1997 movie with Danny Devito and Matt Damon, The Rainmaker. I'm sure they have many nice things to say about my profession. Being in the investment business for the last 13 years, I have seen countless times where these lawyers gang up on any company that had a bad quarter or announcement that caused the stock to go down.
Many of the suits are frivolous and a horrendous attempt to take advantage of a flawed system. This flawed system allows these lawyers to scream foul to the shareholder world, while negotiating a settlement with the company--that coincidentally equals the maximum Errors & Omissions insurance coverage the company has--at the first chance they get. But once in a while, the lawyers actually find a case that has some real foundation, and is actually in needed by the shareholders.
We believe that the GMCR lawsuit is needed by the shareholders. Unfortunately, one thing most of the lawyers will never tell the "Class" is that most shareholders end up getting pennies on the dollars lost (since the money has to be shared with so many shareholders), while the real cut goes to the Law Firm.
Now that you know my feelings about the Class Action system, let's move onto the amended filing, and check out a few points from my notes:
Overproduction Of Inventory
One thing that is a common denominator with all of the witnesses is their allegations that GMCR overproduced inventory. My first noted question was "wouldn't this excess inventory go bad if not sold?" Confidential Witness 1 (CW1) not only confirms that the excess inventory was destroyed regularly, but also gave specifics as to how this expired coffee is disposed of. Some expired coffee is given to pig farmers for inclusion is silage, while other farmers would use the expired coffee to acidize their fields (Page 27-28). Confidential Witness 7 not only corroborates with CW1, but also adds the details that much of the expired coffee gets buried.
These are wonderful details many have heard already. Who cares? Well, the next question that this brings up is "what about all of that ($600 million worth) inventory that has been accumulated on GMCR's balance sheet?" I am no coffee connoisseur, so I had to do some homework about the lifespan of coffee. While some claim that green beans (raw) can last up to 2 years, they also say that roasted beans last only a few weeks, while ground coffee loses taste immediately. I guess it's not like the wine my wife and I had for dinner.
K-Cups on the other hand are sealed differently, and some can last up to 8 months according to some sources. Although they do lose flavor as time passes and can become more likely to go bad and grow mold, they can last longer.
Next question...since expiring coffee is a normal part of the business, wouldn't this also mean that the huge amount of coffee inventory on GMCR's balance sheet is also likely to be written down if it's not sold in time? This risk should be highlighted with more details on the risk section of GMCR's Annual Report. When it had only $100mm in inventory, it wasn't a detrimental risk. But now that the management has committed to carrying nearly $700mm in inventory, one can only assume that a material write-down is an inevitable possibility at some point in the future. I feel some bull hate mail coming my way for this point.
Page 26 of 64
Another section discusses that employees were given bonuses based on product produced rather than product sold. This flawed rewards system is like telling a trader that he/she will be rewarded for the number of trades they executed instead of total profits. What if they lost money on every trade? This type of reward system would obviously lead to bad behavior, thereby negative results for shareholders.
More interesting, this section confirms the story we heard from Einhorn about the bad inventory that played hide and seek. CW1 states that everyone knew when the auditors were coming because expired coffee would be loaded onto trucks that would then park and hide from the auditors several blocks away. This is just too outlandish to be completely made up. It may or may not be exaggerated, but I find it hard to believe that it's completely made up. The truth is sometimes stranger than fiction.
Suntrust and the LVJH Deal
On page 45, the topic is the GMCR purchase of LJVH in 2010, and the loan that followed. In order to purchase LJVH for $915 million, GMCR borrowed $1.35 billion (in 3 parts) from Merril Lynch and Suntrust Robinson Humphrey for approximately 5 year terms. That type of loan sounds kind of familiar to me (think 2008 real estate market collapse). Putting things in perspective, is it really surprising that Suntrust has been the uber bull on GMCR even when its opinion made no sense at all?
They're stuck owed hundreds of millions by GMCR, and are just trying to protect their investment (on top of the huge fees they generate from them). Suntrust is only going to get paid if GMCR stays in business, and has a stock that prospers, since they will need to issue more shares to raise capital.
This actually leads me to another point that you may have missed from GMCR's Annual Report. The Risk Factors discussed on page 13 specifically mention "our indebtedness could adversely affect our financial health and may limit our ability to use debt to fund future capital needs." Although this statement is not exactly something we've never heard before, we believe that it (along with other steps the company has taken recently) is trying to prepare the market to an equity offering in the near future. GMCR claims that they only pay approximately 2% on their debt(page 39 of Annual Report).
This couldn't be farther from the truth if you calculate all fees, such as approximately $58 million interest, $46 direct financing fees, $28.4 million deferred finance charges, $3.8 in buying interest rate swaps, and commitment fees on unused portion of debt. That last covenant makes their deals sound just wonderful. The total cost of GMCR debt coverage is closer to that of junk bonds, rather than US Treasury.
If GMCR doesn't turn into a cash flow positive company, their only way of paying off the maturing debt is with more shares. Granted, they have time since the bulk of the debt comes due in 2016. But one thing to consider is that although the details available are limited, these debt deals have some pretty strict leverage ratio and interest rate coverage ratio covenants that GMCR must comply with quarterly. They also have undisclosed (which GMCR calls customary) mandatory prepayment clauses. I hope these clauses are not as good as the "heck of a deal" they got on paying fees for money they don't borrow mentioned earlier.
Pages 55-57 discuss the amazing luck (and fortune) GMCR executives have when they decide to sell their stock. Specifically it discusses how Michelle Stacy sold GMCR stock a week before the SEC investigation was announced, and then retracted her Form 4 to say that her sales were part of a 10b5-1 plan, since those plans were specifically designed to alleviate issues arising from illegal insider trading. This 10b5-1 is a complete farce, and for more details than you can ever imagine about what transpired, click on the Michelle Stacy link (Sam Anatar's play by play).
What's more interesting to me is that Michelle Stacy is not the first or last insider to be so "lucky" with her timing. In fact, it seems like this is a trend within the company that is still going strong. GMCR founder, Robert Stiller, coincidentally sold $66,000,000 worth of stock less than 2 weeks before Starbucks (NASDAQ:SBUX) announced they're launching a competing single serve brewer, which led to a GMCR stock decline that would have cost Stiller a cool $20,000,000.
Even further evidence that this "luck" is systemic within GMCR and its associates, look no further than their brewing partner and former major shareholder, Luigi Lavazza S.p.A. As you'll see on page 43-44, on August 2010, the two companies signed a "multi year agreement" that included a major investment commitment by Lavazza for nearly 8.6 million shares, and a further 608,342 shares purchased on 5/11/11. The key word in this agreement that jumped at me was that it was a "multi year" agreement. This is because, although the two companies are still making brewers together, Lavazza decided that it could no longer commit all of that capital to the appreciated GMCR stock after only 17 months (less than multi).
Even luckier than Robert Stiller, Lavazza sold a significant portion of their stake just 9 days before the SBUX announcement, taking their stake below the 5% threshold that requires them to report each transaction. There's no way for us to know if they sold the rest the next day or even own any more shares. The best part was that their excuse for reneging on a multi-year commitment was the "European Crisis." It's amazing how the European crisis wasn't a factor at the heat of the actual crisis when they signed (and amended the deal) and made the investment.
This story sounds like a movie that took parts from the Godfather and combined them with the Enron movie, The Smartest Guys In The Room. It's amazing how the world can sometimes choose to ignore the one and only thing they shouldn't.
Disclosure: I am short GMCR.
Additional disclosure: By I, I am referring to our fund. Reuven Capital Investments LP has a short position in GMCR.