that this portion of Green Mountain’s sales should be about 2.7 billion, not 2.6 billion.
Still, even if we use the company’s figure of 2.7 billion, total sales in the United States would be 4.9 billion, or about 700 million K-Cups short of what the company has said. That’s a lot of extra K-Cups sitting in the channel.
Maybe I’m just being paranoid, but I’ve seen this kind of thing before: in many of the China frauds, companies were booking fake sales, resulting in fake profits. But that leads to a big problem for the companies: it’s hard to fake all the cash that should be in the bank as a result of the supposed profits. The solution? Fake/overpriced/fraudulent acquisitions and/or cap ex to reduce the cash (that was, of course, never there).
Now go back and read David Einhorn’s 110-slide presentation on GMCR at the Value Investing Congress on Oct. 17, 2011 (posted here:http://blogs.wsj.com/deals/2011/10/19/heres-the-einhorn-presentation-that-killed-green-mountain-shares) and look at the high-priced acquisitions on pages 50-53 and especially pages 68-72 on cap ex. Einhorn calculates that $431 million (58%) of GMCR’s cap ex is “unexplained” and concludes:
• Capital spending is growing much faster than the business
• Capital intensity should be getting more efficient as the company achieves scale
• The gap is so large and insufficiently explained that it raises questions about what is being capitalized and casts doubt on the business model
Einhorn gave an update on GMCR in his presentation at the Congress on Oct. 2, 2012. He didn’t release the slides, but here are some of my notes:
GMCR’s cap ex as a percentage of sales was 11.0% in 2011, 13.1% (est.) in 2012, and 9.2% (guidance) in 2013. Compare this to the 3.3% average in the food products industry, with a range of 1.0% to 6.3%.
GMCR’s cumulative cap ex from 2007-2012 was $1.043 billion and K-Cup shipments in 2012 were 7.1 billion. Divide these two and you get 14.7 cents of cap ex over six years for each K-Cup produced in 2012. Compare this to Einhorn’s analysis of a competitor, which spent 3.8 cents for each K-Cup produced (buying the same production equipment as GMCR). Again, MASSIVE unexplained cap ex.
Einhorn then turned to the production capacity that GMCR’s competitors were bringing online and estimated that they would have enough capacity to take 19% market share by the end of 2012 and 26% by the end of 2013.
Lastly, Einhorn showed that competitors were already selling K-Cups for 22-39% less than GMCR was, and highlighted price cuts GMCR had taken that would wipe out nearly all of its profit.
(Obviously these last two things haven’t occurred yet – but that doesn’t mean they won’t…)
Is GMCR committing massive accounting fraud? I don’t know – and I certainly can’t prove it – but there are a number of warning flags, so I sure can’t rule it out. The company could easily put a lot of these concerns to rest by providing some obvious disclosure – like number of K-Cups sold – but refuses to (despite providing highly granular disclosure on most other matters – see today’s 188-slide presentation today, for example), which makes me all the more suspicious…
The nice thing about GMCR as a short is that I think it’s a good one even if it’s accounting is clean because of its very high valuation (29x trailing EPS and 22x FYE 9/14 estimates (if you believe them)) combined with its patent loss a year ago, which is resulting in a ton of low-cost competition entering the market (see page 44-48 of Einhorn’s 2011 presentation and my notes from his 2012 presentation above).
It’s almost never pretty when a company with a monopoly market share and monopolistic pricing begins to face competition from low-cost generic producers (think what happens when a drug goes off patent) – but it can take some time for the competition to emerge and impact the monopolist’s financials, during which time the monopolist can give whatever guidance it wants (and you can be sure that Wall St. “analysts” won’t question the pie-in-the-sky guidance). Witness today’s analyst day…
4) Attached is Bill Ackman’s latest salvo against Herbalife. I’ve deliberately not engaged in this war and don’t intend to write or speak about it further because a) it’s such a war and b) I don’t need the brain damage, but I’m convinced that Ackman is right that it’s a pyramid scheme. It’s a very clever one, however, because there’s just enough of a legitimate business that anyone who’s predisposed to conclude that it’s legitimate (or just wants to stick it to Ackman – see Icahn, Carl) can easily find evidence that there are some real sales and consumption. But as Charlie Munger once famously said: “If you mix raisins and turds, they’re still turds.”
Of course it’s possible that HLF could be a pyramid scheme, but not be a good short. For the short to work, one or both of the following must happen:
a) There’s a slowdown in the number of new suckers/victims that are needed to enter the bottom of the pyramid each year to maintain it, perhaps because the truth about HLF becomes widely known or the law of large numbers catches up with HLF; and/or
b) Regulators/auditors must act to rein in HLF.
I think the latter is more likely, but I don’t think it’ll be a sudden thing – for example, how regulators shut down Fortune Hi-Tech Marketing (see:www.bloomberg.com/news/2013-01-28/direct-seller-fortune-hi-tech-marketing-accused-of-fraud-1-.html). Rather, I think it’s more likely to play out like the for-profit ed industry, where a combination of running out of suckers combined with more scrutiny and tighter regulation resulted in this stock chart of the past two years of ESI, APOL and CECO:
5) Last but not least, an old favorite short, InterOil (believe it or not, this one is still going on!). Here’s what I wrote in my Q2 letter:
InterOil
I believe InterOil is one of the largest promotions of all time – but unfortunately (so far) for anyone short the stock, it’s also one of the cleverest. The company, which has all sorts of associations with questionable characters (and pretty much every other red flag a short seller looks for), has been drilling for natural gas in Papua New Guinea for well over a decade and has repeatedly claimed to have found the mother lode – only to disappoint investors again and again (see Appendix B for a remarkable and telling series of unfulfilled promises from the company and its founding CEO, Phil Mulacek, dating back to 2007). One would think investors would finally wise up, but to date they haven’t, as the company currently sports a $3.4 billion market cap.
This valuation is based on the expectation that InterOil has discovered one of the world’s largest natural gas fields and that current negotiations with ExxonMobil will result in an extremely lucrative deal for InterOil. I think the odds of this are close to zero.
To be clear, nobody – not InterOil’s management nor any outsider – knows with certainty whether the company has a real resource discovery or not. This isn’t a fraud like Bre-X (for those of you with long memories) because there really is some gas in InterOil’s fields, which makes it almost impossible to disprove the company’s claims. Instead, one has to analyze geological reports, look at the track record of the company’s promises, examine the background of the key people, and then apply common sense.
Here are the key facts: after 15 years of drilling, InterOil still has no proven, probable or possible reserves (nothing but a “contingent resource estimate” by a company well paid by InterOil); its founding CEO unexpectedly quit recently (when was the last time this event was followed by great news?); the company continues to burn enormous amounts of cash; and after hyping a bidding war among multiple major oil companies, is currently only negotiating with one, ExxonMobil (think about who’s likely to have the upper hand in those negotiations…).
Here is my analysis of what InterOil told its investors in a presentation at its annual meeting on June 24th:
- · What the company said: “Monetizing sufficient resource to cover our share of infrastructure costs and fund exploration while retaining maximum upside for IOC equity interest.”
What I think it really means: ExxonMobil will take a huge amount of the upside from whatever InterOil might have in exchange for a small amount of money to cover InterOil’s ongoing “infrastructure costs and fund exploration.”
- · What the company said: “Post-negotiations, InterOil and Pacific LNG have clear path to resource monetization.”
What I think it really means: ExxonMobil only agrees to pay InterOil anything material if it’s actually discovered a major field.
