Tuesday, April 24, 2012

Is Green Mountain Coffee’s Inventory a Toxic Brew?

Does Green Mountain Coffee Roasters (NASDAQ: GMCR) have a problem managing its inventory levels or is the company inflating its inventories to overstate its reported profits as alleged in a class action lawsuit against the company? The Securities and Exchange Commission is investigating Green Mountain Coffee's accounting practices.

Decreasing inventory turnover

Over the last two fiscal years, Green Mountain Coffee’s inventory turnover substantially decreased to 3.74 turns per year in the fiscal year ended September 24, 2011 compared to 4.72 turns per year in the previous fiscal year ended September 25, 2010. It took the company an average of 97.69 days to sell its inventory in fiscal year 2011 company compared to 77.36 days to sell its inventory in fiscal year 2010. In other words, it took about 22 days longer for the company sell its inventory in fiscal year 2011 than in fiscal year 2010.

The above consolidated numbers appear to mask the full extent of Green Mountain Coffee’s declining inventory turnover issues. We need to remove the effects of the Van Houtte acquisition made in December 2010 (during the first quarter of fiscal year ended September 24, 2011) to make an apples-to apples comparison with the previous fiscal year.

If we remove the effects of the Van Houtte acquisition, it took Green Mountain Coffee an average of 107.14 days to sell its inventory in fiscal year 2011. On an apples-to-apples basis, it took the company about 30 extra days to sell its inventory in fiscal year 2011 compared to fiscal year 2010. Therefore, it took 38% longer to sell its inventory in fiscal year 2011 after factoring out the effects of the acquisition. (Download my calculations here.)

Troubling decrease in first quarter fiscal year 2012 inventory turnover despite revenues that exceeded expectations

As of December 24, 2011 (end of first quarter of fiscal year 2012), Green Mountain Coffee reported that its inventory was $606.679 million compared to $269.132 million of inventory as of December 25, 2010 (end of first quarter of fiscal year 2011). Its revenues increased to $1.158 billion in the first quarter of the current fiscal year compared to $574.148 million of revenue in the previous fiscal year first quarter. Its cost of sales increased to $821.612 million in the first quarter compared to $430.548 million cost of sales in the previous fiscal year quarter.

Green Mountain Coffee's inventory increased 125.4% compared to both a 101.7% increase in revenues and a 90.9% increase in related cost of sales in the first quarter of fiscal year 2012. Therefore, inventory turnover continued to decline during the first quarter of fiscal year 2012 because reported inventory grew faster than revenues and cost of sales. (Source: 10-Q report for period ended December 24, 2011.)

On November 9, 2011, 46 days into the 91 day first quarter of fiscal year 2012, Green Mountain Coffee gave the following guidance:

Fiscal first quarter consolidated net sales growth of 85% to 90%.

Its first quarter fiscal year 2012 revenues exceeded its guidance by $67 million to $96 million. Based on Green Mountain Coffee's gross profit on revenues of 29.1% in the first quarter, it delivered an extra $48 million to $68 million of product, at cost, to meet demand above the company's expectations.

The company’s inventory growth exceeded both its actual and expected revenue growth. Inventory turnover should have been higher as the company pushed its product out the door faster to meet unexpected excessive demand during the remaining 45 days of the quarter. However, inventory turnover was lower in the first quarter of fiscal year 2012 compared to the first quarter of fiscal year 2011.

Green Mountain Coffee red flags similar to Crazy Eddie

A combination of excessive increases in inventory levels coupled with declining inventory turnover are generally considered to be a red flag for possible overstatements of inventory and earnings among forensic accountants.

For example, before the Crazy Eddie fraud was uncovered, independent analyst Thornton L. O’glove noted that its inventory levels were growing much faster than revenues. He was suspicious that Crazy Eddie was fraudulently inflating its inventories to overstate its profits. Unfortunately, most investors and other analysts ignored his concerns as Crazy Eddie's revenues and profits consistently beat Wall Street analysts' expectations. (Source: Wall Street Journal – By the Numbers: How One Analyst Scores Big by Finding the Dark Side, by Jeffrey A. Tannenbaum and Lee Berton, August 4, 1987).

Ultimately, O’glove was proven correct. Crazy Eddie was over-counting its inventory. It engaged in a massive fraud to overstate profits and fleece investors. Is Green Mountain Coffee another Crazy Eddie? The similarities between the two companies are troubling.

Written by,

Sam E. Antar

Recommended reading

Business Insider: Here's David Einhorn's Presentation That Absolutely Destroys Green Mountain Coffee by Eric Platt

The Long Short Trader: GAAP-uccino 1.5 Part IIa

Seeking Alpha: My Notes From The Green Mountain Class Action Lawsuit by Yaron Ron Reuven

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could. If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. I do not seek or want forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

I do not own any Green Mountain Coffee Roasters securities long or short.

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