In our opinion one of the most damning pieces of evidence against Green Mountain Coffee Roasters Inc. (NASDAQ:GMCR) was released last week in a proposed amended class action lawsuit filed against GMCR by Horowitz. Since, I have not come across any fund managers or writers who have examined this aspect of GMCR, I thought I examine it. But before we get to that, some background on GMCR.
Most should be familiar with GMCR and their business. If not, here’s info from the 2011 GMCR 10-K:
Green Mountain Coffee Roasters, Inc. (“GMCR”) is a leader in the specialty coffee and coffee maker businesses. We roast high-quality Arabica bean coffees including single-origin, Fair Trade Certified TM , certified organic, flavored, limited edition and proprietary blends offered in K-Cup ® portion packs, whole bean and ground coffee selections, as well as other specialty beverages including tea, hot apple cider and hot cocoa also offered in K-Cup ® portion packs. We manufacture and sell the Keurig ® single-cup brewing system for use with K-Cup ® portion packs and are an emerging leader in sales of coffee makers and single-cup brewing systems. As of the end of our 2011 fiscal year, we had the top four best-selling coffee makers by dollar volume according to the NPD Group for consumer market research data. Under the Keurig ® brand name, we offer a variety of commercial and home use brewers for the Away From Home (“AFH”) channel and for the At Home (“AH”) channel that are differentiated by features and size.
Most should also be familiar with hedge fund manager David Einhorn’s presentation about some of the problems with GMCR, including issues regarding inventory and GMCR’s relationship with their fulfillment partner, MBlock & Sons, as well as the looming expiration of several key patents on GMCR’s K-Cup product.
Prior to Einhorn’s presentation, Sam Antar had blogged extensively about GMCR’s accounting problems and inability to file accurate financial reports with the SEC, among GMCR’s myriad of problems.
In fact, Antar’s blog was what first piqued our interest in GMCR as a short candidate. The big question in our mind was just how far the problems extended in the company. I whole heartedly agree with Einhorn that no matter how bad you think something, it’s always worse. Also, it would be naïve to think GMCR’s problems didn’t go deeper than just some outdated accounting systems and the pressure of fast growth. Before I put my hard-earned money or my clients’ hard-earned money on the line, I would want a little more evidence that the problems at GMCR are systemic. Call it a beyond a reasonable doubt versus a preponderance of evidence standard.
I believe that significant proof comes from the testimony of several confidential witnesses in the Horowitz class action suit. The witness testified that GMCR instituted a system of bonuses for employees that was based on making production numbers and that these bonuses sometimes made up to 50% of employees’ pay.
To understand why this bonus structure is so significant we have to understand how CEOs or other top management construct criminogenic environments in order to perpetrate fraud. For an explanation of how this is done I will be summarizing the work and testimony of one of the nation’s foremost criminology experts, William Black, Professor of criminology at the University of Missouri – Kansas City Law School and a former bank regulator during the S&L fraud crisis.
When top management embarks down a path of fraud they are faced with a dilemma. They need to get the entire organization to go along with them, but they can not overtly ask for the type of behavior they need. First, most top management is going to be smart enough not to want to get caught explicitly asking or encouraging employees to commit fraud. Management needs to preserve the plausible deniability excuse should they be caught. Second, most employees would balk if asked or told to explicitly commit fraudulent acts.
Instead, management usually institutes a pay structure that rewards the behavior they desire without explicitly telling employees to commit said behavior. When employees start cutting corners to meet the targets needed to secure bonuses, management makes it clear that the employees will be rewarded anyway and any transgressions will be overlooked. Those who complain are demoted, fired, or marginalized.
Both the S&L crisis and the recent subprime mortgage crisis, or Great Recession, or whatever name you choose to call it, are rife with examples of this type of control fraud. Wall Street’s appetite for mortgage securities was almost limitless, and mortgage lenders could barely keep up. Lenders instituted pay structures that rewarded origination volume and size without any thought to underwriting standards. Those who complained about the loosening of underwriting standards or the endemic fraud were silenced. Greed took over, and we know how it ended - with massive fraud.
If we were to suppose GMCR was systemically overstating revenue and sales, GMCR would need to institute a system whereby it encouraged employees to produce and ship to MBlock the maximum amount of units possible. If employees got up to 50% of their pay in the form of bonuses for production (not profit or returns on capital or even sales!) how long do you think it would take before GMCR began overproducing units and shipping them to MBlock? How many employees do you think would be motivated to say something about the overproduction if they were getting large bonuses based on said production?
By Ben Strubel of Strubel Investment Management
Disclosure: You should do your own research and due diligence before making any investment decision with respect to any of the securities mentioned herein. As of the publication date one or more of the following: Strubel Investment Management, our clients, our employees, and/or funds we advise are short GMCR and stand to realize significant gains in the event that the price of GMCR declines. Following the publication of this article we intend to continue transacting in GMCR and we may be long, short, or neutral any time after the date of publication. We undertake no obligation to update or supplement this article or disclose changes in our position in GMCR securities. Nothing in the article should be construed as investment advice or an offer to buy or sell any security.