By Ilene and Scott of Sabrient, and special thanks to Sam Antar of White Collar Fraud.
Green Mountain Coffee Roasters (NASDAQ: GMCR) has been at the center of controversy lately over certain accounting errors, an informal SEC inquiry, the questionable timing of insider sales, and a lingering patent expiration. Originally, on September 28, 2010, Green Mountain announced it was notified by the Securites and Exchange Commission (SEC) of an informal inquiry concerning “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” At the same time, the company announced:
In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit. Management discovered that the gross margin percentage used to eliminate the inter-company markup resulted in a lower margin applied to the Keurig ending inventory balance effectively overstating consolidated inventory and understating cost of sales. Management determined that the accounting error arose during fiscal 2007 and analyzed the quantitative impact from that point forward to June 26, 2010.
As of June 26, 2010, there is a cumulative $7.6 million overstatement of pre-tax income. Net of tax, the cumulative error resulted in a $4.4 million overstatement of net income or a $0.03 cumulative impact on earnings per share.
Initially, the company brushed off those accounting errors as “immaterial.” However, after the market closed on Friday November 19, 2010, Green Mountain disclosed that its internal investigation discovered additional accounting errors:
- A $1.4 million overstatement of pre-tax income, cumulative over the restated periods, due to the under-accrual of certain marketing and customer incentive program expenses. The Company also has corrected the classification of certain of these amounts as reductions to net sales instead of selling and operating expenses. These programs include, but are not limited to, brewer mark-down support and funds for promotional and marketing activities. Management has determined that miscommunication between the sales and accounting departments resulted in expenses for certain of these programs being recorded in the wrong fiscal periods.
- A $1.0 million overstatement of pre-tax income, cumulative over the restated periods, due to changes in the timing and classification of the Company’s historical revenue recognition of royalties from third party licensed roasters. Because royalties were recognized upon shipment of K-Cups by roasters pursuant to the terms and conditions of the licensing agreements with these roasters, Keurig historically recognized these royalties at the time Keurig purchased the K-Cups from the licensed roasters and classified this royalty in net sales. Management has determined to recognize this royalty as a reduction to the carrying cost of the related inventory. The gross margin benefit of the royalty will then be realized upon the ultimate sale of the product to a third party customer. Due to the Company’s completed and, when consummated, pending acquisitions of third party licensed roasters, these purchases and the associated royalties have become less of a factor, since the post-acquisition royalties from these wholly-owned roasters are not included in the Company’s consolidated financial statements.
- An $800,000 overstatement of pre-tax income, cumulative over the restated periods, due to applying an incorrect standard cost to intercompany brewer inventory balances in consolidation. This error was identified during the preparation of the fiscal year 2010 financial statements and resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales.
- A $700,000 understatement of pre-tax income for the Specialty Coffee business unit, due primarily to a failure to reverse an accrual related to certain customer incentive programs in the second fiscal quarter of 2010. The over-accrual was not identified and corrected until the fourth fiscal quarter of 2010.
This time, the company announced that it will restate its financial reports to correct those errors. Apparently, in addition to the original $7.6 million in overstated pre-tax income, three overstatements totalling $3.2 million and one understatement of $0.7 million in pre-tax income were found, making a total overstatement of $10.1 million in pre-tax income.
In its press release, the company stated: "The adjustments necessary to correct the errors will have no effect on reported cash flow from operations, and are not expected to have a material impact on the balance sheet. The estimated impact of these items for the restatement periods is expected to reduce cumulative net income by approximately $6.1 – $6.5 million and cumulative diluted income per share by approximately $0.04 – $0.05 per share." Thus, compared to Green Mountain’s initial revision of revenue and earnings on September 28, 2010, the current estimates are for additional decreases of $2.5 million in pretax income, $1. 7 to $2.1 million in net income, an another reduction of $0.01 – $0.02 cumulative earnings per share. (Initial figures were $7.6 million overstated pre-tax income, $4.4 million overstatement of net income, and a $0.03 cumulative impact on earnings per share.)
Green Mountain also claimed that:
… these errors were discovered by management during the course of its preparation of the year-end financial statements and audit, as well as during the course of an internal investigation initiated by the audit committee of the Company’s board of directors in light of the previously disclosed inquiry by the staff of the Securities and Exchange Commission’s (“SEC”) Division of Enforcement.
We asked former white-collar criminal turned independent whistleblower, Sam Antar what he thought about Green Mountain’s latest SEC filing. According to Sam Antar:
The company did not disclose exactly when it discovered certain accounting errors while it was preparing for its year-end audit for the fiscal year ended September 25, 2010, We know that initially on September 28, 2010, the company disclosed an accounting error relating to intercompany margins. It also informed investors of the SEC inquiry. Did Green Mountain insiders suspect that an SEC inquiry was coming?
On November 19, 2010, Green Mountain disclosed even more accounting errors. I wonder if Green Mountain would have discovered those additional errors if it weren’t for the SEC inquiry.
Meanwhile, SEC filings show two insiders unloading large amounts of stock in starting in August 2010. Usually, companies prepare for their year-end audits months up to 60 days advance. In this case, Green Mountain’s fiscal year ended September 25, 2010. The SEC will probably want to know exactly when Green Mountain discovered its initial accounting error and what those insiders knew before they unloaded their shares. Usually when a public company gives less than transparent disclosures, such as omitting the date it discovered accounting errors, it has something to hide.
On September 28, 2010, Green Mountain erroneously claimed that its intercompany margin error was an “immaterial accounting error.” That error was in fact material under accounting rules, because the company was required to restate its financial reports to correct the error and other errors subsequently uncovered.
In addition, Green Mountain announced that none of the financial statement errors implicate misconduct with respect to the Company or its management or employees. I asked Sam how much weight the self-absolution carries. According to Sam Antar:
Crazy Eddie conducted a similar internal inquiry into its own wrongdoing back in the day and proclaimed itself clean. At the very least, it’s irresponsible for Green Mountain to make such an assertion when the SEC inquiry has not been completed. The SEC inquiry began on September 21 and if the SEC finds wrongdoing this statement will come back to haunt Green Mountain.
There are still many uncertainties surrounding GMCR including the SEC investigation, insider selling, and competition on the horizon. The admission of accounting errors does not change our opinion of GMCR and we have decided to remain short in our VIRTUAL Dark Horse Hedge portfolio.
