Investors are getting roasted with JVA

As many coffee aficionados may know, Coffee Holding Co. (JVA)  has a vital interest in the success of Green Mountain Coffee Roasters (GMCR). As GMCR’s shares climbed the green mountain, the Sherpa of JVA has joined for the ride.  See JVA’s chart below.

However, we strongly believe that JVA’s shares are overpriced (P/E: 31x) and its business risks are High…Not a good Brew!   Below are our Top reasons to avoid these shares:

1.)  Coffee Holding Co. is a distributor.  Distributors trade at very low price-to-earnings and price-to-sales multiples.  By their very nature, distributors grow only as fast as the market.  Additional “growth” is usually attributed to rising prices (rather than true volume gains) or acquisitions.   JVA has done both, which has positively affected revenue growth.  Hence, its shares should receive no premium for that growth.  According to the latest data from research firm StudyLogic, Coffee demand in the U.S. rose just 2% during the 12 mos ended June’11.  Though, in fairness to JVA, this growth was driven by K-cup demand (Green Mtn.’s product).  The table below includes P/E ratios for several types of businesses.  The bar chart shows historical US coffee demand, which we estimate grew <2% yearly since 2000.  The last chart shows the sharp gains in coffee prices over the last year.

 Coffee Futures (KCU11)
2)  JVA is a complimentor to Green Mountain Coffee (GMCR).  However, this is not a case of “Wintel” aka Microsoft and Intel, in which both companies equally benefited.  First, GMCR benefits more so than JVA because a) it commands and controls its own K-Cup ecosystem.  However, JVA is simply a distributor with no proprietary technologies; no entry barriers.  JVA does not have a trade-pact with GMCR, meaning GMCR could drop the company at will (with no consequences).  Secondly, GMCR benefits because it is a manufacturer of the (proprietary) Keurig system, which entails significantly higher profit margins.

3). We believe GMCR may be using aggressive accounting.   The Securities & Exchange Commission continues to investigate GMCR’s accounting and internal controls.  This SEC inquiry was initially reported in GMCR’s Form 8-k link of September 28, 2010 and remains ongoing.  Further, the company noted in its 2010 Form 10-K annual report link (Item 9A – Controls and Procedures) that there are “material weaknesses in its internal controls related to financial reporting.”  Should any negative headline news occur, GMCR’s business would suffer, which could directly impact JVA’s business, as well as investor sentiment across the entire coffee industry.  As a background, readers may be interested in this author’s articles Dominic Lombardo and Sam Antar’s on GMCR.

4.)  JVA is aggressively trading in the coffee derivatives market, which the company states is used for hedging price volatility.  However, we note that a) a large portion of its (green) beans business cannot be hedged directly, thus creating cross-hedging risks, b) company is trading near-term options (which easily lose time-value),  c) the dollar amounts are large, including what has been mostly trading gains.  In good times, this creates the illusion of core profits.  

The Income Statements below are for FY’09, FY’10 and 2Q’11.  They include adjustments (i.e, hedging profits are taken out of reported numbers).  FY’09 adjusted numbers also exclude a non-recurring gain of $2.1mm.  This results in 36% and 73% lower EPS for FY’10 and FY’09, respectively.  2Q’11 adjustments resulted in 69% lower EPS.  Under the “% Change” column, is noted how the adjustments affect the Balance Sheet and Cash Flow Statements.

In bad times (i.e, when management makes “wrong-way” bets) reported earnings could decrease significantly (as in the most recent quarter, see below).

5).  Financial Leverage is increasing.  Debt/Capital rose from 14.6% during FY 10/2010 to 32.9% during the latest quarter (7/2011).  This percentage also includes margin loans from its derivatives broker.  See red highlighted below. Management recently (9/14/11) filed an S-3/A link in what is called a “Shelf” registration for a huge dollar amount of $100mm in Debt, Equity and other securities.

6). Shareholders have little say in JVA.  Brothers Andrew and David Gordon control the executive positions of the company including President, CEO, CFO, and COO.  The company has no “key-man” life insurance for either brother.  This is a family business with the extended family owning nearly 49% of JVA’s shares.

7).  Lack of Internal Controls:  Given the nature of the business (i.e., small, family-managed, lack of a Big 4 accounting firm) controls are somewhat deficient.  For example, JVA recently filed two amendments with the S.E.C.- the first was an amendment to the Form 10k annual report.  The second was far more serious, an 8-K essentially reporting that there was a leak of the firm’s recent quarterly earnings release (for July’11).  Consequently, it was necessary for the company to issue preliminary earnings.
Source: Coffee Holding Co, 8K, Aug. 30, 2011
8.) Numerous Conflicts-of-Interest.  A) One conflict this author has never seen is the linking of brokerage reports on JVA to its website (link).  Typically, companies tell investors which Street analysts are following it, letting investors attain the reports themselves. An example (Starbuck’s) is provided here.  B) Further, the company does (“arm’s length”) business with its 40% partner (Generation Coffee Company LLC).  Refer to Item 13 of Form 10-K/A for FY’10 for additional information.

C)  JVA director Daniel Dwyer, is a coffee trader at Rothfos Corporation- a coffee bean supplier.  Mr. Dwyer is also responsible for a large account between the two companies.  Refer to Item 13 of Form 10-K/A for FY’10 for more information.

We have not seen evidence JVA is using aggressive accounting or misusing its relationships.  We also believe the company is correctly accounting for its hedging program as per IAS 39.  However, they’re just too many risks (e.g., dependence on GMCR) to justify its high share price

Disclosure:  The author has no investment position in JVA (short or long). The author does not receive any monetary or implicit dollar benefit from this article.

SODASTREAM…Not your grandfather’s Green Mtn. Coffee

Since SodaStream’s November’10 IPO, several writers have highlighted the similarities between Green Mountain Coffee Roasters (GMCR) and SodaStream (SODA).  Indeed, they have similar *business models, but I believe the two companies should be differentiated. Years ago, GMCR was a shining example of a socially ideal, yet profitable company with heavy emphasis on Corporate Social Responsibility (“CSR”).  The firm was not only good to society and local community, but to its employees and investors as well.  (* Both companies use the razor-razorblade business model.)
A decade ago, GMCR was a small, earthy-granola company with good (but not stellar) growth flying under the radar of larger heavyweights  Now, GMCR itself is a big wig  ($11Bn market cap) that is on the cusp of competing with some of the most well managed companies – think Starbuck’s, Dunkin Doughnuts.  Ah, before I get criticized for saying Starbuck’s is a competitor (as there’s a big contract with GMCR) I suggest readers take a closer look at that contract’s (lack of) details…Press Release
SodaStream International Ltd is an Israeli company that makes and sells home beverage machines.  These portable machines typically make flavored sodas out of ordinary tap water, or just seltzer/sparkling water at the consumers’ preference.  In order to make a flavored drink such as a cola, SodaStream sells these products:
  1. Soda Makers (Beverage Machines):  to make the drinks
  2. CO2 refills: which make the drinks fizzy
  3. Flavored Syrups such as root beer, colas
  4. Bottles which the Soda Makers fill the soda into

SodaStream is not your grandfather’s Green Mtn. Coffee Roasters – it’s better than that!  How then….?

Key Difference # 1
Harking back a decade ago, GMCR was showing real earnings – more recent earnings are suspect.  It reported steady revenues and earnings growth, of which was organic (i.e., internal, without acquisitions).  Now,  I’m not quite sure what their earnings really are, or how rapidly the company is really growing given the huge acquisitions skewing reported growth.  For additional information, please refer to this website’s article on Green Mountain, which essentially alludes to the company’s deceptive practices of presenting earnings.

By comparing GMCR’s pro-forma revenues to reported revenues, one realizes that the company is growing slower than it’s reporting, and that this is attributed to acquisitions.  For example, during FY 1Q’11:

  • Proforma Revenue growth (+54%) was below reported revenue growth (+67%).  See table below for figures. 
  • Note: GMCR also focuses on Non-GAAP numbers when presenting to investors, of which excludes several items including cash litigation expenses.  These Non-GAAP earnings are significantly higher than reported earnings.

The tables below present GMCR’s proforma condensed income statements for FY 1Q’11 and 2Q’11 (including YTD).  The Securities and Exchange Commission’s Rule 210.11-02 requires that when making an acquisition that the acquiring company disclose what its condensed income statement would look like if the acquisition occurred at the beginning of a reporting period.  This helps investors distinguish between internal and external growth.

  • Oddly, the 1Q’11 numbers were substantially revised in 2Q’11,  without explanation.   We estimate that 1Q’11 EPS were boosted $0.12/share.  In other words, numbers aren’t adding up.  (This is calculated by comparing YTD earnings per share with the previous quarter).  All tables can be clicked to enlarge.
GMCR 1Q’11 Proforma earnings
GMCR 2Q’11 Proforma earnings, including year-to-date data.

Key Difference #2
SodaStream’s internal, or organic growth, is better than GMCR’s.  Other than an acquisition of assets from a bankrupt company in the Nordic region that got hit with the financial crises, all of SodaStream’s growth is internal.  For example, during FY 1Q’11, both operating income and adjusted EBITDA doubled while revenues grew 50% (all without acquisitions!). 

Note: company uses the Euro as a reporting currency.  Source: SodaStream

Key Difference #3
SodaStream’s financial statements are significantly more transparent compared to GMCR.  In order for analysts to accurately measure and forecast the company’s performance several key metrics are necessary including:

  • Unit sales of Keurig brewers
  • Coffee pricing
  • Unit sales of K-cups
During 1Q’11, GMCR’s management decided to stop disclosing K-cup data, leaving investors in the dark.

In this regard, SodaStream is excellent.  The company not only provides data points in its conference calls, but significant data about its business model is disclosed in its government filings.  This allows some comfort when analyzing trends, as SodaStream analysts have to reconcile two different businesses:

  • Soda Makers: aka, the razor
  • Consummables (CO2 bottles, flavors):  aka, the razor-blades
  • Note 1 below is a small distribution business of Brita filters and related products
Note: Soda Makers and Consumables data sourced from SodaStream

   In the above table, note that CO2 cylinders are also included under Soda Makers (first line) as the company typically includes one or two CO2 cylinders in its “Starter Kit” Soda-makers.  The Consumables line includes both the CO2 cylinders as well as Flavored Syrups, of which the company discloses in separate text.  Unit sales are also disclosed on a quarterly basis (not in the above table).

Key Difference #4
Market share, revenue and earnings potential are all greater for SodaStream than Green Mountain Coffee Roasters.  With an $11Bn market cap and nearly $2.5Bn in expected revenue for FY’11, the company is quickly reaching its asset-size capacity.  GMCR is expecting 82%-87% reported revenue growth for FY’11.  We are not saying that the potential is not there for GMCR, but with a U.S. market share of 35%-45% for household coffee makers (depending on whom you ask, or trust..) it will be difficult to continue rapidly gaining share.  At some point, GMCR will effectively become the market, and it’s growth will be limited by the LT growth of the home consumer coffee market.  This growth is likely to be 5%, according to Moody’s. 

It is difficult to ascertain the addressable market for GMCR, but it is likely below $9Bn (U.S. At-Home market).   This author has seen global numbers for single-serve coffee that were no higher than $4Bn.  However, NPD Group notes that GMCR has only 8-9% of the total number of U.S. coffee drinking households.  However, this percentage needs to be distinguished from the addressable market which we view as far smaller (see $ amounts above).

For comparison, SodaStream’s beverage market is slow-growing (see chart below) but the total market size is absolutely huge.  According to Datamonitor, the global off-premise soft drink and sparkling water market generated $216Bn and $34Bn respectively in 2009.

Note that SodaStream is a global company with products selling in 41 countries.  Given that SodaStream’s soda makers are unique products that some consumers will never buy, and given market control by Coca Cola, etc., market share potential (in % terms) is likely limited to 5%-15%.  So far, SodaStream’s highest penetration has been in Sweden where its share is 21%.

Taking a conservative share percentage of 6% yields an addressable market size of $15Bn (includes soda + sparkling water).  This compares with SODA’s FY’10 revenues of just $227.8MM (converted from Euros).  In global market share terms, this equates to just 1.5% of the addressable marekt.  It is difficult to ascertain SODA’s U.S. market share, it’s most important market.  However, management believes it is negligible (~ 0.25% of the total market). Hence, the potential for SodaStream is huge, so long as the company executes well.

Disclosure:  the author is long GMCR, SODA

Green Mountain Coffee: The Dr. Jekyll & Mr. Hyde of SRI

Like Robert Louis Stevenson’s  1886 novella entitled the The Strange Case of Dr. Jekyll and Mr. Hyde, Green Mountain Coffee Roasters has a split-personality.

Company Description:
Green Mountain Coffee Roasters (GMCR) is a specialty coffee company based in Waterbury, Vermont. The company roasts 100% Arabica coffees and offers over 100 different coffee selections, including certified organic, Fair Trade Certified, estate, and flavored coffees that sell under the company’s and Newman’s Own Organics brands.  In 2006, the company acquired Keurig, a manufacturer of single-cup (“K-Cups”) brewing systems.

Green Mountain Coffee Roasters is considered a benchmark for what a Socially Responsible company’s supposed to look like – a gentleman to society.  It is often highly ranked, sometimes #1 (2006, 2007) as a company with the most Corporate Social Responsibility (Source: CRO Magazine, 2006-2010)

What we have here appears to be two entirely different companies.  How can one justify an investment without being able to describe it!  Consequently, we are no longer recommending investing in GMCR  🙁

Looking at GMCR’s website, one sees how transparent the company is – the outstanding corporate citizen of Dr. Jekyll.  There is a detailed Code of Ethics and Mission Statement.  Corporate Governance information is clearly displayed and committees are fully disclosed to show that their members are independent (see below).  In fact, CSR is so important to the company, they’ve elevated it to a Committee headed by Chairman Bob Stiller.

The company’s stock has risen 1,340% plus during the last 5 years and earnings growth has been great. GMCR 5Y stock chart.

However, there’s a creepy, opaque face – the other side of the Green Mountain into the Black Forest, where the company’s financials have yet to see the light of day.  In fact, the forest is darkening.  Beginning 1Q’11, management said it was no longer supplying K-cup shipments.  And this begins my outline of several issues I have with the company’s financials/reporting.  Mr. Hyde is about to be revealed….

Background reading:
Readers are asked to be familiar with Green Mountain Coffee Roasters and recent earnings reports.  See Investor presentations and our previous story on and seekingalpha articles.  Also, the whitecollarfraud website has interesting forensic accounting.

Our growing list of Issues with GMCR…
  •  Shifting future expenses to the Current Period as a Special Charge
    • Acquisitions offer the company a perfect time to do such a ploy.
    • Examples include: acquisition-related expenses, amortization of intangibles.
    • You might be wondering, “Hey isn’t this a more conservative way of accounting?”  Well, the only problem is that earnings are then presented on a Non-GAAP basis (without the charges).  Further, such charges could be reversed in the future, boosting earnings.
  •  Presentation of Pro-Forma/Non-GAAP Results
    • Pro-forma numbers were traditionally used when a company acquired another.  Income statements, etc. would be shown as if the two companies were combined for a full year or more.  This allowed for “apple-to-apples” comps.
    • However, GMCR has successfully convinced analysts and investors to accept its pro-forma income statement. It’s then able to remove what it considers not part of recurring earnings.
    • For 1Q’11 this boosts GAAP  earnings/share from the reported $0.02 to $0.18/share, a huge difference !
    • While difficult to estimate, I believe certain items should not have been excluded from expenses included SEC inquiry expenses (as they most likely were cash) and amortization of intangibles.  See table below (Source: 1Q’11 Form 10Q for all financial data presented in this article):
  • The table below shows traditional use of Non-GAAP presentation (specifically Pro-Forma) reflecting the Van Houtte, Diedrich, and Timothy’s acquisitions.  Note these are unaudited numbers and subject to change.  Regardless, note that earnings were actually FLAT versus the year-ago period, implying internal growth is zero !

  •  Lack of Transparency as highlighted by the 1Q’11 stoppage of K-cup disclosures.  K-cup numbers are vital to analysts when making their projections.  The lack of K-cup numbers may compel analysts to become more dependent on GMCR’s projections, rather than their own.
    • There is evidence that 1Q’11  K-Cup shipments actually decelerated during the quarter compared to FY’10 (see below).
      • 1Q’11 K-Cups Shipped 1,016 million (up 56% Y/Y)
      •  FY’10 K-Cups Shipped 2,885 million (up 75% Y/Y)
      • Source:  Stifel Nicolaus analyst estimates
    •  High Level of Inter-Company Sales:
      • 36% of 1Q’11 revenue was attributed to sales to related business units (i.e, K-Cups/Keurig).
      • Such a high percentage leaves the company susceptible to manipulation by financial managers.
    • Management restated its revenue recognition policies three years in a row.
    • Revenues, income items were not discussed, or disclosed, in the 10Q report for the Diedrich acquisition.
      • Management said it couldn’t disclose the above data because Diedrich “migrated into the Company’s common information technology platform..and thus was impracticable to disclose..”
  • Rising Keurig brewer warranty costs resulting from quality control issues.  
    • Warranty costs are rising substantially faster than revenue growth.
    • This issue points to control issues at GMCR both from an operations point of view (as well as lack of financial controls (see next bullet).   The company is working on a new brewer system for 2012.  As such, warranty costs may remain high as the company works out the new brewer’s glitches.

  • Numerous misstatements point to lack of accounting control.  For example, the company had to issue an 8K (“Current report”) on 11/19/10 after the SEC began an investigation of the company’s financial policies.  It issued another 8K on 1/3/11 on a revenue mistake.  It later issue an NT 10K for a late-filing 10K disclosure.
    • The company’s 10K did mention (Item 9A- Controls and Procedures) that its “internal control over financial reporting was not effective.” 
  • Litigation issues tied to an SEC investigation.  The SEC investigation remains ongoing, though the company indicated its own internal investigation is “nearly complete” implying the SEC doesn’t have an issue w/ GMCR’s accounting w/  M. Block & Sons (GMCR’s fullfillment vendor, hmm… or is it a distributor?)
    • In a nutshell, we think if there’s a problem, it’s that GMCR’s stuffing the channel, by selling more K-Cups to M. Block than the distributor can actually sell to retail customers (stores).
    • For additional info, refer to Seeking Alpha editors: Ilene at Phil Stock World and Sam Antar.
  • Expiration of GMCR’s patents for its K-Cups will occur in September 2012.  Superficially, it appears its biological clock will time out by then.  In actuality, GMCR’s will extend its patent (like a drug company does) by creating a next generation brewer platform/technology.
    • Then the company will essentially force everyone to that new platform.  However, there’s one catch.   GMCR’s free cash flow, which is lousy (and that’s okay for a growth company) will remain lousy.   Typically as a growth company reaches maturity, free cash flow surges as it captures market share, and spends less on working capital.  However, the situation’s a bit different for Green Mountain Coffee Roasters.   Pray to God that the company’s new brewer platform is released by summer 2012, else competition (Starbucks) may roast them alive.
    • Consequently, I expect Capital Expenditures to reach $300MM by 2012.  Intensifying competition, and the associated higher potential marketing and warranty expenses will likely cap Free Cash Flow to under $10million/year.
    • Further, let’s just say that GMCR didn’t have a pending patent expiration.  The company still faces competition from companies that are bypassing the patented filters licensed by GMCR.  Just ask Wal-Mart – they’re selling “Walnut Grove” pods that fit into Keurig brewers, but not paying royalties! (Source: The Chicago Tribune: 2/12/11).
  • Negative Tangible Equity:  Stockholders Equity was $963MM as of 12/25/10.  Intangibles were $574MM and Goodwill was $769MM.  Should GMCR experience margin compression, these intangibles would be required to be written off.  
  • Insider Selling prior to the 11/19/10 SEC investigation was released.  See chart below:
Source: Fidelity Investments, government filings

In conclusion, we’d like to summarize our article by referring to Audit Integrity (AGR).  This firm independently rates several North American public companies.  Green Mountain Coffee Roasters was Average to Highly Rated until late 2010 when its AGR Score of 6 (“very aggressive”), indicated it had higher accounting and governance risk than 94% of companies rated by them.

Disclosure:  The author has a long position in GMCR, but is scaling down position.

      Green Mountain Coffee Roasters restates earnings. Can we trust its Social Responsibility Report ?

      Green Mountain Coffee Roasters announced that it restated its previous financials after the close on Friday, 11/19/2010. 

      On first glance, I was like everyone is, very excited by the resolution of this accounting problem.  The shares are soaring 10% in after-hours trading;  just $5 below their all-time high of $38.  Not too shabby for a high P/E company.

      However, on closer inspection, the accounting issues may actually be a bigger can of worms.  Press Release is troubling because:

      1. There were several restatements (albeit just a few pennies per share)
      2. These restatements were made over several quarters (and years)
      3. Worse of all,  they don’t even cover GMCR’s fullfillment vendor, M.Block & Sons

      Like Yogi Berra said, “it ain’t over ’till its over.”  The SEC investigation remains ongoing, though the company indicates its own internal investigation is “nearly complete” implying the SEC doesn’t have an issue w/ GMCR’s accounting w/  Block & Sons.  What is readily apparent though, – – this company’s got some major internal-control issues.  This is surprising for a company that is so Socially Responsible and into “ESG“.  Can we trust its Social Responsibility report ? link to GMCR’s CSR page

      However, a Moody’s analyst I spoke w/ a few weeks ago, mentioned that the key issue was likely with M. Block & Sons.  So something’s not making sense here.