A couple of weeks ago, David Einhorn bashed Green Mountain Coffee Roasters (NASDAQ:GMCR) in a 110-slide presentation called “GAAP-uccino” at the Value Investing Conference, sending the company’s shares down. The stock opened at $91.66, and closed at $82.50 the day of his presentation. Over the next two weeks, the stock closed as low as $61.59, with the stock ending last week at $70.99.

The stock had been hovering between $100 and $110 a share in September, despite warnings by others that Green Mountain has been manipulating numbers and could become the target of a full-blown investigation by the Securities and Exchange Commission.  Sam Antar, the former CFO of massive fraud Crazy Eddie, has been critical about Green Mountain for some time. He has been vocal about the company’s disclosures, accounting irregularities, and GAAP violations.

History Speaks For Itself

For those who think these accusations are trumped up and just designed to grab some headlines, you need look no further than Green Mountain’s history of shoddy accounting. Not only is the accounting bad, GMCR can’t seem to keep their story straight about just how bad the accounting is.

On September 28, 2010, Green Mountain announced it had found an immaterial error affecting financial statements from 2007, 2008, and 2009. The error overstated net income in the cumulative amount of $4.4 million. A month-and-a-half later, on November 15, Green Mountain said “Whoopsie…. we found more errors and now it’s material and we are restating earnings back to 2007!”  The cumulative adjustments for fiscal years 2007 through 2009 reduced net income a total of $6.1 million to $6.5 million, or 4 cents to 5 cents a share.

Why can’t GMCR get its story straight? And why should we believe that the company hasn’t continued to fudge numbers (accidentally or on purpose)?

 Einhorn’s Criticism

A lot was said in David Einhorn’s presentation. Three areas of particular interest include criticism of:

• Core Business Of Green Mountain – Over the years, GMCR has gone from a wholesale coffee business, to a seller of the patented K-cups by Keurig. The current business model relies on selling the single-cup coffee brewers at or near cost, making its money on the relatively high-priced K-cup sales. (“Our financial performance is highly dependent upon the sales of K-Cup portion packs.”) As the K-cup sales go, so goes the business of GMCR.  But it appears to be a tenuous business going forward. Green Mountain sells a very high-priced coffee product compared to other options available to consumers. This might cause consumers to be attracted to lower cost alternatives.
• Overstatement of  Market and Earnings Potential – Green Mountain says that the target market of people who brew coffee at home is 64 million, and the company can capture 33% of that market. With 21 million homes consuming 2 K-cups per day, the company will have EBIT of $2.3 billion, based on $0.15 profit per K-cup. Einhorn says the true market for the GMCR products is much smaller and that the daily consumption of K-cups is smaller than GMCR estimates (and continuing to decline), and recalculates EBIT at $934 million.
• Patent Expiration – Green Mountain’s two patents on the K-cup expire in September 2012. At this time, competitors will be free to make a K-cup compatible product. It is expected that these knock-offs will be significantly cheaper than the K-cup, which will cut into GMCR’s product sales (which is where all the profits are).
  •  Green Mountain’s answer to this problem has been to buy companies that could become competitors.  This has been expensive and really doesn’t solve the problem long-term.
  • GMCR has also been entering into licensing deals with companies like Starbucks and Dunkin Donuts to prevent them from competing with Green Mountain, but these licensing deals significantly reduce GMCR’s profits.
  • A third solution is the development of a new brewing system with new patent protection, but it seems unlikely that consumers would abandon their old brewers (for which they will soon be able to get lower-priced products) in favor of a new brewer (for which they could only get higher-priced products form GMCR).

Other issues were raised by Einhorn, such as the relationship between Green Mountain and MBlock, an entity that fulfills a large portion of Green Mountains orders from retailers. Is this organization really separate from Green Mountain? Or does it act more like an extension of GMCR? The importance of this issue was highlighted earlier this year in a class action suit, which indicates that Green Mountain may not have an arms length relationship with MBlock and may use the entity to manipulate revenue and inventory.

It is important to note that this is not some vague allegation being made. The lawsuit gets specific, citing 150 truckloads of Green Mountain product shipped in the quarter ending in December 2009, representing $7.5 million to $15 million of revenue. It is alleged that documents supporting an actual sale of products were not found, and that large quantities of inventory were sitting in MBlock warehouses following the shipment.

If this is true, Green Mountain would be violating GAAP rules by recognizing revenue on this shipment. And the lawsuit alleges exactly that, saying that GMCR violated the accounting rules by recognizing revenue early on shipments to MBlock.

Einhorn states equivocally that there are problems:

The research shows that Green Mountain and MBlock are potentially engaged in a variety of shenanigans that appear designed to mislead auditors and to inflate financial results.

He says that workers also stated that there were lots of shipments between entities, transferring products back and forth multiple times as part of a “shell game.” Workers further said that inventory was moved around during external inventory audits, with “trucks to nowhere” filled with products to get them out of the warehouse. It is alleged that somewhere in the neighborhood of 50% of inventory was concealed, and more specifically, that a shipment of 500,000 brewers was processed as an order for QVC but the products were never ship and were put back in the warehouse after the audit.

This kind of stuff is exactly the type of bad behavior that indicates substantial risk within a company. This could be just the tip of the iceberg.

Rebuttal

In an interview with CNBC, Bill Chappell of SunTrust said that David Einhorn is wrong, and he lays out his criticism in a rebuttal to Einhorn’s presentation. He claims that some mistakes in Einhorn’s calculations of long-term EPS make the numbers better than Einhorn presented. SunTrust calculated $9.00, while Einhorn predicts $3.50. Chappell may be right in his criticism. But if he is, it means that  Einhorn’s numbers are less bad than the numbers from SunTrust. That doesn’t exactly instill confidence in GMCR.

And what about all the accounting shenanigans Einhorn points out? Chappell dismisses them by saying that the issue of the SEC inquiry is nearly a year old and Green Mountain made disclosures relative to it. He says the company had some problems, which are expected with growing companies, and that everything has been fixed. Chappell says that the inventory problem related to 2009, and that no such problems have been found in 2010 or 2011.

Are we really to believe that because no wrongdoing has been uncovered more recently, GMCR is squeaky clean? I’ve heard this incorrect argument made too many times. If the SEC doesn’t prosecute, everything must be fine. If a government agency doesn’t take action, no crime has been committed. If we haven’t heard about any bad acts, that must mean there aren’t any. That is just silly.

Chappell claims Einhorn is saying that because irregularities were discovered previously, there must be irregularities now. I think what Einhorn said was a little nuanced. The company has a history of problems, and there is no evidence that those problems (and future problems) aren’t still ongoing. Chappell claims there is no “mythical warehouse” holding hidden inventory. He can’t possibly know if there is excess inventory being hidden from auditors and regulators, and he is foolish for making such a statement.

The most naive statements from Chappell pertain to the auditors. He stated that the auditors “scrubbed” Green Mountain’s financials for 2008, 2009, and 2010, and that the auditors gave a “fairness opinion” on the 2010 10-k. All is well, right? Not necessarily so. While it is true that the auditors did audit those financial statements and did issue clean opinions, it does not mean that there is no fraud or impropriety.

The fact of the matter is that audits don’t find fraud. Audits have never been designed to detect fraud, which is why they find fraud so infrequently. It doesn’t take much effort to find plenty of financial statement frauds that went undetected by auditors for years.  Auditors do a very limited amount of testing on the financial statements, looking to see if the numbers add up and the accounting rules have been properly applied. They are not designed to find purposeful, concealed instances of fraud.  Please, Mr. Chappell, stop holding up audit reports as proof that there is not fraud.

The biggest disagreement with Einhorn seems to be about the future of Green Mountain Coffee Roasters.  Chappell states:

However we continue to believe that the GMCR story is still in its early stages and that the stock will be highly rewarding to investors from current levels.

This is in contrast with what Einhorn has demonstrated. Chappell says there’s still huge growth to be had (i.e. “early stages”), while Einhorn’s presentation shows that Green Mountain’s business is likely headed for trouble. How could the company possibly have huge growth ahead when its patent (the driver of its earnings) is going to expire soon? I don’t believe the company has made a case that it can continue to grow rapidly, even if it introduces a new brewer and a new patented cup.

Where Are the Auditors?

Chappell’s comments about the auditors make it a good time to discuss the auditors and their work. PricewaterhouseCoopers (PwC) audited the faulty financial statements from 2007, 2008, and 2009. They continued as the auditors of the 2010 financial statements and have been the auditors during fiscal 2011.

What kind of comfort should we feel about the fact that PwC is auditing the financial statements of GMCR?  The financials that Green Mountain restated (2007, 2008, 2009) were audited the first time around by Price waterhouse Coopers, who didn’t find the problems. PwC has proven that they can’t find material misstatements in the GMCR financial statements, so relying on their audits for anything does not appear to be too wise.

Further, Green Mountain has told investors that its accounting process and its numbers cannot be trusted:

As a result of the material weaknesses in internal control over financial reporting described above, management concluded that the Company’s internal control over financial reporting was not effective as of September 25, 2010 based on the criteria established in Internal Control—Integrated Framework issued by the COSO. Additionally, these material weaknesses could result in a misstatement of the aforementioned account balances or disclosures that would result in a material misstatement to the annual or interim consolidated financial statements that would not be prevented or detected.

This is no minor problem. Although the auditors should do extra work during the audit to more thoroughly test the financial statements (since GMCR has bad, unreliable accounting systems, policies, and procedures), no one knows whether they did that extra work, or what the extra work entailed. Chappell is crossing his fingers and hoping the auditors did the work.

Nonetheless, even with additional auditing work, there is still risk that the financial statements are misstated thanks to the lack of control Green Mountain has within the accounting system. Chappell wants us to pretend everything is fine because the auditors say it’s fine. But that’s not true. Bad internal controls are so risky that disclosure about ineffective controls is required, so that users of the financial statements will be warned.

The warning from the auditors:

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.

That’s right. The auditors are saying the financial statements might be wrong, even though they have audited the numbers.

Green Mountain’s House of Cards

A critical look at the GMCR balance sheet reveals the precarious financial position the company is in. Between the end of fiscal 2009 and the end of fiscal 2010, unrestricted cash became almost nonexistent. It went from almost $242 million on hand, to only $4.4 million on hand.

During the same time, current liabilities nearly doubled, going from $126 million to $238 million. Think about what this means for the operations and cash position. Green Mountain spent all its cash and almost doubled the current amounts owed to vendors and creditors. Adding insult to injury, long-term debt increased by 4.6 times during that period.

Yes, assets increased substantially between 2009 and 2010, due to significant acquisitions. However, nearly all of that increase is due to an increase in intangible assets and goodwill.  As the Grumpy Old Accountants have pointed out, intangibles are imaginary assets which carry a lot of risk. These assets related to brands that were purchased and customer relationships, and the costs related to these are amortized over 10 to 15 years. The value of these assets is subject to management’s judgment about what they’re worth, and obviously items like this are subject to manipulation.

Some of GMCR’s financial pressures eased in fiscal 2011, thanks to nearly $1 billion in proceeds from the issuance of additional shares of stock. But the company spent lots of money on acquisitions and added another $755 million to intangible assets.  Green Mountain manages to show profits and positive cash from operations, but when you look at how much money the company has spent to build up intangible assets, you have to wonder what the shareholders really own.

My take? Green Mountain is a house of cards. They’ve grown rapidly and have managed to turn a profit, but the financial position is precarious and the stockholders own lots of invisible assets. Even worse, Green Mountain has an apparent inability to report numbers correctly, and its auditors cannot be relied upon to detect the errors and irregularities.

Stupid Investors?

Even as Green Mountain announced it was restating earnings, lowering cumulative net income, the price of its stock rose. Despite numerous accounting irregularities, investors continued to buy up the stock of Green Mountain.

I suppose those who sell as the price keeps rising are smart. But the stupid investors will be the ones left holding the bag if and when the accounting problems are found to be an outright fraud on the investors. Who knows when that will happen, and why do all these investors think that they are the smart ones who will get out in time?

Critics of Einhorn are saying that he didn’t bring anything new to the table. All of these issues were known more than a year ago, and the company has performed well in spite of them. The stock price has kept rising, and they say Einhorn’s presentation is a hill of beans.

Some analysts are saying that the expiration of the GMCR patent on the K-Cup is actually a good thing.  They say that Green Mountain will profit from the increasing popularity of at-home brewing systems since they’re tops in the market.

It’s hard to see how the company can do better when there will be a substantial increase in competition for the product driving profits. Consumers will have more options for their K-cups, and even though GMCR has tried to head off this competition by agreements with certain brands, it’s hard to see how the company will still grow given an upcoming free-for-all with unbranded coffees.

It’s easy to dismiss short sellers as people with profit motive, who are just bashing successful companies to make a buck. But the flip side should then be equally as true…. company management has a profit motive, and is fabricating financial statements just to make a buck.

Do you really want to take a chance that Einhorn is wrong, especially when there are so many red flags at Green Mountain? We’re not talking about a couple of isloated issues. We’re talking about serious, repeated questions about the validity of the numbers, completeness of disclosures, sustainability of the business model, and integrity of management. Even if half of Einhorn’s criticisms are wrong, that still leaves the other half of very serious issues.

Disclosure: At the date and time of publication, I held no position in GMCR, either short or long.