Selling Short: Green Mountains Case Study Analysis

1. Critically review the short sales activity from a market efficiency perspective.

Ans 1
In Short sales , investor is not an owner, thus he borrows stocks from another investor to
sell it and later with the hope that price will fall when he decides to buy the shares. During
the transaction seller borrows from lender and promises to return it back on future date ,
during this time the dividend is paid to lender from sellers own pocket. If prediction goes
right, it earns them profit. But in prevailing bearish market short sales are a reason to blame
because it exacerbates already declining market and thus regulators have to make tight
rules on short selling

Short selling effect on market efficiency :

1. Helps in increasing liquidity : Short selling increases liquidity by increasing more
volumes above normal level and also helps with lower volatility in market

2. Short selling helps in improving price discovery : In a normal situation, supply and
demand leads to prices moving up an down , until buyers and sellers agree on a
price. If one side has more demand or supply, the price shifts bring balance. While
short selling, the sellers add pressure and bring more amount of supply which might
force prices to lower side. If there is little buying on other side, the stock price falls,
thus short selling helps in discovering approx lower price. Similarly short sellers while
buying can increase pressure to shoot prices up.

3. Also in illiquid market, short selling can help to stir up market activity.

4. Short selling helps the market to strengthen by revealing which companies’ prices
are very high, thus we get to know over valued firms.

2. As an Independent Financial Consultant, present a note on the Green Mountain’s present

and future business prospects.
Ans 2 .
Green Mountain coffee roasters which was founded in 1981 who started by initially roasting
and distributing coffee to restaurants and supermarkets. It’s major business then was sales
of wholesale coffee. Over the years Green mountain gained interest in ‘K cups’ single serve
coffee of Keurig brewing system machines. Green mountain then acquired this company
later on for $15mn + $104 mn

Presently Green mountain has evolved it’s business model and selling K cups at
comparatively high price and are earning attractive profit margins. They have patented K-
cup design and are earning by licensing K-cup manufacturing technology. It has retailers like
Tully’s, Timothy , Van Houtte etc thus having a strong market presence. The revenues is
continuously growing currently with 57 percent increase from 2006 to 2010. The return on
-invested capital is almost 16.3% .With 7-9 million brewing machines installed, and a
potential to install 21 million brewing machines which is one third of the market, its
financials actually looks good. But the CEO and top officials have reported that their sales
have been constrained because of inadequate production capacity, the demand is stretching
their ability to supply. But they are planning for additional capacity which will help in sales
to grow quickly and additional infrastructure investments were to be made in 2012.
Additional sales would result in adding famous brands like Star bucks and Dunkin Donuts

According to case the future prospects of Green mountain coffee roasters are as follows :
1. With 50% of addressable market already penetrated there’s low addressable market
left to capture hence revenue growth will likely decline

2. Coffee made by KCups is almost ten times expensive than traditional drip brewer,
the machines were also 3 times expensive than similar brewing machines. Thus I will
limit to high end market only.

3. It is expected because of higher price, private label coffee will capture 20 percent of
market share of K Cup, thus reduction of another 20 percent of opportunity in
addressable market . Strum foods are making Filter less K cup and are planning to
enter after expiry of patents of GMCR

4. Since patents are expiring in September 2012, others would be able to manufacture
and sell K cups without any fees being paid, and thus will also break the monoply
However GMCR is claiming they have few more technologies up in there sleeves and
will soon get more patents for new technologies

5. Sales recognized by GMCR would continue to be high as new retail outlets are being
added, but the end customer purchases won’t be that high, thus creating a bull-whip
effect
The above reasons and many ex employees complaining about Unusual inventory handling
and accounting, weak financial controls and expired inventory, the future prospects of the
company does not look great.

3. The Bull and Bear cases presented for Green Mountain. Conduct a critical assessment of
these two views. Support your answer with necessary quantitative analysis
Ans 3.
For Green mountain coffee roasters there are two views presented in this case which are
The Bull case and the Bear case. The Bear case has been presented by Greenlight capital.
The Bull case obviously shows the positive side of Green mountain coffee roasters where as
Bear case portrays the negative side of the Green mountain coffee roasters company. GMCR
founded in 1981 started it’s business with majorly selling wholesale coffee. Over the years it
decided to sell K cups coffee for Keurig Brewing System machines. First they invested only
$15 million with 42% ownership but later on acquiring the entire ownership of the company
for $104mn. Later it patented it’s K cup brewing machine and with higher pricing was
gaining attractive profits. Let’s look at the two different cases mentioned above.

The Bull Case :

 Bullish investors portrayed Green mountain coffee roasters as high growth business
in early stages. The bullish investors believed it to capture one third of the market
which was 64 million. Hence 21 million brewing machines to be sold.

 There is huge demand for the Keurig Brewing System machines and with increasing
the production capacity and infrastructure investment will lead to increasing sales
and will help luring big players like Starbucks and Dunkin Donuts

 An optimistic estimate for long term EPS was calculated, which was around $8 -$10
per share. Jim Cramer a prominent investor described the company as ETF on rapid
growing single cup serve market.

 Bullish investors also said that they will reduce the risk of competition by bringing all
brands together under them, also investors said their competition is protected by
the fact that they are host of patents because they were continuously improving
their technology

 K cup had become standard format for single serve coffee. Though it was expensive
than traditional coffee machines, but still far less expensive than Starbucks and
Dunkin Donut. K- cup was premium priced high end coffee.
The Bear Case :

 In the bear case, green light capital had estimated long term EPS potential as $3.47,
which in bull case was $8-$10
 The K cup coffee price was very high almost 10 times as much as coffee made with
tradition drip brewer. The brewing machines were also 3 times pricy than the drip
brew machines. Thus this high price meant limited market opportunity, only in high
end market.
 With 50 % of total addressable market already penetrated, its revenue growth was
soon going to decline
 Greenlight capital estimated low earnings because of less average daily cups per
machine, the private label coffee was set to penetrate K cup market and GMCR
was set to loose 20 % market opportunity. Many private label companies like Strum
foods would like to penetrate the market after patent is over in 2012.
 The Profit per K cup was also less, 0.12$ per cup . Non Green mountain K cups were
growing faster than Green mountain’s K Cup thus decline in trend in profit per cup.
Also because of patent getting over, the monopoly will break

Looking at both cases, Bear case representation by Green light capital seems more
favourable as
 Bull case claimed that GMCR is very good technologically and will lure other brands
to continue partner with them but other companies were able to find alternatives
like filter less K cup coffee with much less capital investment
 The K cup and the brewing machine of GMCR was very expensive which made it
premium product and thus limiting it’s market to high end market only
 Since it has penetrated 50 % of addressable market already, thus leading to low
future sales and thus low EPS was predicted and thus less profit margins.
 The sales were recognized on the basis of retailers outlets and distributions and not
on end customer purchase hence creating a bull whip effect. Thus the company was
over valued
 Profits and losses were calculated on the basis of expectations and hence there was
problem in the accounting. The bear case also portrays example of unusual auditing
where they used to show less inventory and sometimes keeping expired inventory,
which showed the real picture of the company, thus leading to fall in the revenue
significantly.
 4. Present a note on the financial misconduct at Green Mountain, if any and its impact on
the valuations. What control measures you would suggest to prevent the financial
misconduct?

Ans 4 .
There were lot of financial misconduct at Green mountain like :
1. Revenue recognition issues
2. Weak financial controls
3. Unusual inventory handling and accounting
4. Expired inventory

One of the most important was revenue recognition issues where the company had sold 1.3
mn brewing machines, 300,00 units more than expectations, thus proving that business was
not as strong as report. As new retail outlets were added , sales of retailers shelves and
distributors were recognized in GCMR’s revenue. Thus more revenue recognized by GCMR
rather than considering end customer purchases. GMCR also improperly recognized
revenue on 150 truckloads, they were also not able to gather proper paper work , including
purchase orders and product shipment authorizations, no payment was ever made for this
shipment. This order was also not listed on production forecast schedule. It nearly recorded
revenue between $7.5mn - $15 mn. Thus increasing the enterprise value of the company
and during that period stock value did suddenly shoot up.
The second problem was irregularities present during external audit, they would remove
product and pre load trailer trucks to ship to retailers because there was no room on the
floor. The warehouse was partially cleared before the audit leaving inventory to only 50% of
the actual. Inventory was loaded on trucks which was hiding in docks and was never
counted and after the audit it was simply moved back to the ware house. Before audit false
orders were created and after audit, it was again restocked.
The company used substandard IT system, important work like inventory management were
done in excel sheet which was changed later. Suggestions to new technology were not
entertained in the organization. Green mountain’s accounting department used temporary
workers like college interns instead of recruiting full time accountants. If theyasked too
many questions, the employee were sometimes fired too.
Also it was very unethical of them to keep expired inventory in their warehouse. Channel
checks also identified expired coffee and significant amount of retail products with short
shelf life. Atleast one third space of warehouse was occupied by expired coffee.
The Control measures to be taken to preven financial misconduct are :
 Recruiting designated accountants : The company should recruit full time
accountants and not rely on interns because they will not give accurate reports. They
should hire atleast 3-4 permanent accountants

 Regulations for auditing books : Books should be maintained properly and be

checked regularly, also non scheduled audits should be held to prevent any
misconduct in terms of inventory management thus helping in detecting frauds.

 Restricting access : The company should restrict access to sensitive data and reports
like financial , accounting data and inventory management so as to handle frauds
efficiently.

 Introducing Stringent policies : The company should introduce stringent guidelines

for the employees which would help them to prevent such misconducts already
happening in the organization. Everyone should be trained with the guidelines and
strict measures to be taken for those who misconduct guidelines. This will bring
more transparency in the handling of inventory

 Investing in IT system : Investing in IT software to regulate operations, inventory and

restricting access only to higher management so as no changes can be made in later
stages. Proper monitoring of orders will be done in new IT system to avoid false
orders.

5. What will be your recommendation to Dirks to take a short position in Green Mountain
stock?
Ans 5.
It’s mentioned in the case that if Dirks shorted the shares, he would have lost 270% in the
transaction as the price grew from 52-day low on 16 Dec. 2010 to 52-week high on 20 Sept.
If further this price continues to grow then there is no reason to short this particular stock as
it wont help you in making profits .
  Estimated Revenues were high was because the factors among like increase in
distribution, unpenetrated market, less risk of competition

 Addressable Market size of 21 Million is already half penetrated with 10 million of

installed units in 2011. But because of financial misconducts like revenue
recognition issues, as disclosed in the latter part of case, that 1.3 MN units were sold
in June 2011 but there was no purchase order received for the same and neither that
was on production schedule

 The revenue growth to be halted and set to decline because of already penetrated
market and other competitions penetrating market by using less capital investment

 The stock prices shooted high and the enterprise value of the company was also
quoted high but all this came with the fact that it conducted certain malpractices in
inventory management, creating false orders and including sales to retailer’s shelves
and distribution centres rather than end customer purchase

 EPS calculation by bearish side was taken as 1.2 based on actual attachment rate in
exhibit 6. Thus, the projected EPS came out to be much lower

 Private label market also posed a threat to the company

 Attachment rate was also high, which means lower number of machines being
installed
Thus we recommend Dirks to short the stock because with competitions left and right
coming and many of the malpractices and misconducts being caught, the company is
expected to make less revenue and thus lower profit margins, which will eventually lead to
fall in price. Hence now is the time to sell at higher price and later buy at lower price, to
reap profits.