Last October, David Einhorn, head of Greenlight Capital, a hedge fund famous for taking short positions in Lehman Brothers’ shares before Lehman failed, attacked Green Mountain Coffee Roasters’ in a presentation at an investors’ conference. It was a tour-de-force of financial analysis. Using only publicly available information, Einhorn made a strong case for unrealistic sales growth and overstated earnings.
Since then, things have only gotten worse for Green Mountain. The share price collapsed. Robert Stiller, the founder, was forced to sell shares to meet margin calls on $617 million in personal debt secured by his Green Mountain shares and had to resign the company’s chairmanship. The SEC continued with an investigation into the lack of disclosures about a key distributor.
And many of David Einhorn’s concerns remain. We’ve looked at one of the issues he raised: capitalizing operating costs. Here’s our own analysis, updated with the latest fiscal year data.
As Green Mountain reports it, sales have been growing at an striking rate, propelled by demand for its K-Cup coffee brewers and pods and by acquisitions.
After a dip in 2010, Green Mountain’s EBITDA margins expanded along with sales, peaking at nearly 18% in the fiscal year ending in September 2011.
One tactic companies use to understate expenses is to capitalize them. That is, they add current period operating costs to property, plant, and equipment — or some other asset with a life of more than a year — instead of treating them as cost of goods sold or selling, general, and administrative expenses. That spreads them out over a number of reporting periods as part of depreciation expense — or some form of amortization expense.
An increase in capitalized costs causes an increase in capital spending (“capex”). And Green Mountain’s improved profitability coincides with a big increase in capex.
Capex climbed from 6.1% of sales in 2009 to 10.7% in 2011. That may have been because the company needs to expand capacity to keep up with the growth in sales. But 10.7% seems high by Green Mountain’s past standards and in comparison with the company’ peers, whose average capex in 2011 was 4-6% of sales.
If we assume capex greater than 2009’s 6.1% of sales to be excessive, then Green Mountain may have capitalized expenses equal to 4.6% of sales in 2011. That’s $121.9 million in operating costs put on the balance sheet instead of run through the income statement (David Einhorn’s estimate of operating costs capitalized in 2011 was $103.1 million). Adjusted for these costs, reported EBITDA of $474 million falls to $352.1 million, the EBITDA margin falls from 17.9% to 13.3%, and debt to EBITDA increases from 1.2x to 1.7x.
So far there have been no serious credit consequences for Green Mountain. None of the rating agencies are considering a downgrade on Green Mountain’s $583 million in debt. The company hasn’t breached a covenant in any of it’s debt agreements.
But if these suspicions prove true and the company has to delay financial reports or restate its financial statements, that will almost certainly trigger covenant defaults. That, in turn, would lead to liquidity pressures and serious credit problems.
Of course, this is all just informed conjecture. But it’s grounds for caution, if not alarm. That’s because it’s reminiscent of another company with high growth, low costs, increasing capital outlays, and a chairman facing margin calls on his company shares — WorldCom.