Monday, February 28, 2011

Is Green Mountain Coffee Going to Get Roasted by its Exes?

Last week, lawyers representing investors filed an amended class-action lawsuit against Green Mountain Coffee Roasters (NASDAQ: GMCR) and members of its management containing new allegations of wrongdoing based on information:
…obtained from confidential witnesses, including former Green Mountain Coffee Roasters, Inc. ("GMCR" or the "Company") and M.Block & Sons, Inc. ("MBlock") employees…. [Emphasis added.]
Note: Download the amended class-action complaint here.

The three exes

In law enforcement circles, there is a term known as the “three exes” for ex-lovers, ex-employees, and ex-business associates. In many cases, such informants provide crucial information to law enforcement agencies that investigate and prosecute white-collar crime. In this case, the amended complaint is based on detailed first-hand accounts of alleged wrongdoing by the company obtained from several ex-employees and ex-business associates who are identified as "confidential" witnesses such as CW 1, CW2, and CW 3. One such ex-employee identified as "CW 6" is a former Vice President of Operations for Green Mountain Coffee.

The amended complaint identifies various alleged schemes employed by Green Mountain Coffee to deliberately violate Generally Accepted Accounting Principles (GAAP) and prematurely recognize income on the shipment of products to M. Block, its primary fulfillment vendor.

CNBC Senior Stock Commentator Herb Greenberg wrote in his blog that:
My take: I generally ignore class action lawsuits, but they're hard to dismiss out of hand when they include allegations from multiple former employees.
Is M. Block a "black box" entity used to inflate earnings?

The complaint effectively describes M. Block, in what is known in fraud investigation circles, as a "black box entity" used by fraudsters to play shell games with inventory and inflate income. Back in the day at Crazy Eddie, we took advantage of our cozy relationship with certain third party entities and effectively used them as "black box entities" to help us inflate our earnings.

For example, the amended complaint alleges that:
64. Information provided by former GMCR and MBlock employees described the companies' relationship as one where GMCR dictated their business dealings and being something other than on an arms-length basis.
[Snip]
66. A former regional sales manager for GMCR from late 2008 until late 2010 ("CW2") stated that anyone at the Company would acknowledge that MBlock was, in essence, a captive company and would do as GMCR instructed. CW2 indicated that his/her current employer is careful in its dealings with MBlock because it is aware of the close relationship between GMCR and MBlock.
One of the alleged schemes detailed in the amended complaint involves the shipment 150 truck loads of merchandise to M. Block to inflate revenues in the quarter ended December 26, 2009:
70. CW1 indicated that GMCR improperly recognized revenue on 150 truck loads of product that was shipped to MBlock during the quarter ended December 26, 2009. This former GMCR manager stated that he/she and other Company employees, including the Company's global transportation manager, were unable to locate the requisite paperwork, including purchase orders, material requisition orders, or product shipment authorizations, traditionally used by GMCR to validate the sale.
71. Specifically, CW1 indicated that because there was no order for those products, no payment was ever made on the 150-truckload shipment. In addition, the order was not listed on the Company's production forecast schedule and employees who worked under CW1 not only saw the trucks go out, but visited MBlock and saw its warehouses filled to the rafters with K-Cups. CW1, who estimated that the value the revenue recognized on the foregoing improperly recorded transaction to be between $7.5 and $15 million dollars, indicated the following GMCR executives were aware of the shipment: Vice President of Operations Jonathan Wettstein (who regularly provided updates to CEO Blanford), SBCU President McCreary and Vice President of Finance Tina Bissonette.
72. As a result of the foregoing, GMCR violated GAAP's criteria of revenue recognition, which provides that the conditions for revenue recognition ordinarily are met when the seller's price to the buyer is substantially fixed or determinable at the date of sale; the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product; the buyer's obligation to the seller is not changed in the event of theft or physical destruction of the product; the buyer has economic substance apart from the seller; the seller does not have significant future performance obligations to the buyer; and the amount of future returns, if any, can be reasonably estimated. See, e.g., Accounting Standards Codification 605.
73. Consequently, GMCR violated its revenue recognition policy, as disclosed in the 2010 Form 10-K, when it prematurely recorded revenue on shipments of product to MBlock:
The Company recognizes revenue when the fulfillment entities ship the product based on the contractual shipping terms, which generally are upon product shipment, and when all other revenue recognition criteria are met. 
74. CW1 also indicated that GMCR had earlier changed the wording of its revenue recognition policy because the auditors had found discrepancies and senior management was thus aware that GMCR was accounting for revenue incorrectly.
75. In addition, a former regional sales director for Keurig between 2004 and the fall of 2010 ("CW 5"), indicated that distributors were unhappy with certain sales made to them by MBlock and that during a March 2010 sales conference call with regional directors, Keurig Vice Presidents Chris Stevens, Dan Cignarella and Dave Manly denied sales to distributors had been made by MBlock.
76. A former Vice President of Operations for GMCR during 2010 ("CW6"), stated that while the accounting department in Vermont told CW6 to book shipments to MBlock as a sale, the SEC [Securities and Exchange Commission] questioned the existence of an arms-length relationship between GMCR and MBlock. In fact, CW6 did not know if MBlock ever owned the products shipped to it. [Emphasis added.]
When did the Securities and Exchange Commission start investigating Green Mountain Coffee?

The amended complaint alleges that the company knew it was being investigated by the SEC months before it was disclosed to investors. On September 28, 2010, Green Mountain Coffee issued an 8-K report claiming that:
On September 20, 2010, the staff of the SEC’s Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information. Based on the request, the Company believes the focus of the inquiry concerns certain revenue recognition practices and the Company’s relationship with one of its fulfillment vendors. The Company, at the direction of the audit committee of the Company’s board of directors, is cooperating fully with the SEC staff’s inquiry. [Emphasis added.]
However, the amended complaint takes issue with Green Mountain Coffee's disclosure:
68. Moreover, although the September 28, 2010 Form 8-K indicates that, "[o]n September 20, 2010, the staff of the SEC's Division of Enforcement informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information," the above-noted former employee has stated that by no later than the first week of May 2010, he/she was contacted by Company employees who asked if he/she had been had been the whistleblower in an SEC investigation of GMCR.
69. Accordingly, Company employees contacted the confidential witness concerning an SEC investigation five months prior to the issuance of the September 28, 2010 Form 8-K, which disclosed that the SEC informed the Company that it was conducting an inquiry and made a request for a voluntary production of documents and information on September 20, 2010. [Emphasis added.]
From my experience at Crazy Eddie and later consulting work, I learned that the SEC usually communicates its concerns to targeted companies before sending an official notification of inquiry or investigation to them.

Alleged Illegal Insider Trading

Further, the amended complaint alleges that Michelle Stacy (President of Keurig operating segment) and Scott McCreary, (President Specialty Coffee Business Unit) engaged in illegal insider trading stemming from recent stock sales starting in August 2010:
7. Approximately one month earlier, both Stacy and Scott McCreary ("McCreary"), the President of GMCR's other business division, the Specialty Coffee Business Unit ("SCBU"), unloaded a total of 230,000 Company shares for proceeds of more than $7.5 million. These sales, which also occurred shortly before the Company's official announcement of an SEC inquiry, were made after the SEC's initial contact with GMCR. Prior to these sales, there had not been significant insider trading activity since June 2009.
In the weeks before Green Mountain Coffee claims it was notified about the SEC inquiry, Michelle Stacy and Scott McCreary simultaneously exercised options and sold large amounts of shares. On August 13, 2010, Michelle Stacy exercised 30,000 options at $6.20 per share and simultaneously sold those shares at $30.95 per share for gross proceeds of $928,500. On August 18, 2010, Scott McCreary exercised 200,000 options and $1.47 per share and simultaneously sold his shares at $33.08 per share for gross proceeds of $6.616 million. On September 13, 2010 Michelle Stacy exercised another 5,000 options at $6.20 per share and sold those shares at $35.40 for gross proceeds of $177,000.

On September 20, 2010, Green Mountain Coffee claimed that it was notified by the SEC of an informal inquiry concerning its “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” On September 21, 2010, Michelle Stacy exercised 5,000 options and immediately sold her shares at $37 per share.

On September 28, 2010, Green Mountain Coffee disclosed the SEC inquiry to investors. In addition, the company disclosed that it discovered an "immaterial accounting error" involving its K-Cup margin percentages which resulted in a $7.6 million cumulative overstatement of pre-tax income in financial reports issued from 2007 to June 26, 2010. The company’s disclosure was vague about when it discovered K-Cup margin error:
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.
In my blog, interviews by fellow Seeking Alpha contributor Ilene (here and here), and in a televised interview on WCAX TV Vermont, I expressed my concern about the possibility of illegal insider trading by Michelle Stacy and Scott McCreary based on the timing of their stock sales.

Michelle Stacy sold her shares a day after Green Mountain Coffee claimed it was notified by the SEC of its inquiry but seven days before that inquiry was disclosed to investors. Green Mountain Coffee did not disclose exactly when it initially discovered its K-Cup margin error. Usually weaknesses in internal controls that cause accounting errors are discovered months or weeks in advance of the disclosure of such errors to investors.

On October 28, 2010, Stacy belatedly filed amended Form 4 reports and claimed that her September 13 and September 21 sales of stock were "affected pursuant to a Rule 10b5-1 trading plan" established on August 13, 2010.  A Rule 10b5-1 trading plan provides certain safe harbors which help executives defend against potential allegations of illegal insider-trading by removing their discretion to decide when their stock is bought or sold.

The amended complaint took issue with the timing of Michelle Stacy and Scott McCreary's stock sales:
103. Prior to these sales, there had not been significant insider trading activity since June 2009. Not only did both division presidents sell the majority of their shares, but Stacy did so the day after the SEC's information request and one week before GMCR made the SEC inquiry public.
104. Even worse, in October 2010, Stacy amended her Form 4s for the August and September sales, claiming that she forgot to include in the original Form 4s that the sales were made pursuant to a Rule 10b5-1 trading plan adopted on August 13, 2010. Not only did the Company fail to inform the SEC of the plan on the day it was adopted, but it failed to disclose the plan when Stacy's Form 4 for the $928,500 sale was filed a mere four days after its adoption.
In a follow up blog post, I noted that:
If a corporate executive already has nonpublic knowledge of certain adverse events such as undisclosed weaknesses in internal controls, accounting errors, or an SEC inquiry, a 10b5-1 plan cannot provide a safe harbor against illegal insider trading allegations.
As detailed above, the amended class-action complaint alleges that Green Mountain Coffee executives knew that it was being investigated by the SEC months as early as May 2010, which was about 90 days before Michelle Stacy and Scott McCreary sold their stock and before Stacy claims she set up a 10b5-1 trading plan.

According to the SEC:
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.
If the class-action lawyers or the SEC can prove that Michelle Stacy or Scott McCreary knew about any material weaknesses in internal controls involving financial reporting, any material accounting errors, or an impending or actual SEC investigation and then sold their stock before it was disclosed to investors, they could be successfully prosecuted for illegal insider trading. The class-action lawyers and the SEC do not have to prove that Michelle Stacy or Scott McCreary knew of and participated in any alleged schemes to improperly inflate revenues and income to successfully prosecute them for illegal insider trading.

Closing comments

The amended complaint cites reporting by me and fellow Seeking Alpha contributor Jason Merriam:
GMCR's accounting practices have also garnered attention from the financial press. For example, in a February 13, 2011 Seeking Alpha article entitled "Green Mountain Coffee: Only Thing Brewing Is Trouble," author Jason Merriam, noted "[t]he accounting practices at Green Mountain Coffee Roasters (GMCR) are not baffling ... they are downright ludicrous." Similarly, on February 15,2011, Sam Antar began his Seeking Alpha article, entitled "More Mucky Disclosures For Green Mountain Coffee Roasters," with the following sentence: "Just about every time I examine financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I find new troubling accounting practices and financial disclosures. [Emphasis added.]
In my Seeking Alpha article, I detailed how starting in the quarter ended December 25, 2009 Green Mountain Coffee restated its segment numbers without disclosing it to investors months before it announced the SEC inquiry and certain accounting errors. The company's restatement of segment numbers may indicate that it was aware of material weaknesses in internal controls over in its financial reporting as far back as 2009.

In another blog post, I questioned whether Green Mountain Coffee correctly determined that its K-Cup margin error was an "immaterial accounting error" when it was initially disclosed on September 28, 2010. My analysis showed that the K-Cup margin error caused Green Mountain Coffee to overstate profits and beat analysts' consensus earnings expectations in the quarter ended March 27, 2010. According the SEC Staff Accounting Bulletin No. 99, Green Mountain should have considered its K-Cup margin error as a material accounting error on September 28, 2010 and it should have immediately disclosed to investors that it was going to restate its financial reports from 2007 to 2010 to correct that error.

Instead, Green Mountain Coffee waited until November 19, 2010 to inform investors that it was going to restate its financial reports when it disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income. These errors plus the K-Cup margin error resulted in a total overstatement of $10.1 million in pre-tax income. This time, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

In addition, the company claimed that its own internal investigation cleared it of misconduct. I told Ilene, fellow Seeking Alpha contributor and editor at Phil's Stock World:
In any case, I am naturally suspicious of self-proclaimed absences of wrongdoing without thorough outside independent examination. Back in the old days at Crazy Eddie, we conducted a similar internal inquiry with help from our auditors into certain allegations of wrongdoing involving a supplier and proclaimed ourselves clean… Management and auditors have little incentive to report their own foul-ups.
To date, Green Mountain Coffee has not specifically disclosed details of who conducted the internal investigation, how it was conducted, or why the company missed certain red flags. For all we know, it could be the janitor who conducted the company's internal investigation.

In my last blog post, I wrote an open letter to Green Mountain Coffee's Chief Financial Officer Frances G. Rathke questioning unusual numbers reported for its Timothy's Coffee subsidiary. I questioned how the company missed a 75% overstatement of revenues for Timothy's Coffee in the quarter ended December 26, 2009 and how the subsidiary was able to report income before taxes in excess of revenues in the quarter ended June 26, 2010. So far, Rathke has not responded to me.

I've been able to identify financial reporting irregularities from just reading and analyzing Green Mountain Coffee's financial reports. However, the class-action lawyers and the SEC have the power to subpoena witnesses and compel the production of internal documents from Green Mountain Coffee and M. Block to get at the bottom of what happened.

Last quarter, Green Mountain Coffee disclosed that it spent about $6 million on "legal and accounting expenses related to the SEC inquiry, the Company’s internal investigation and pending litigation." I don't see any quick resolution of legal issues facing Green Mountain Coffee and the company should expect to spend significantly more money dealing with these issues in future periods. Back on October 21, 2010, I warned Green Mountain Coffee that "Your lawyers will defend you to your very last dollar."

Written by:

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.

Wednesday, February 16, 2011

A Question for the CFO of Green Mountain Coffee Roasters

To Green Mountain Chief Financial Officer Frances G. Rathke:

On September 20, 2010, the Securities and Exchange Commission (SEC) started an informal investigation of the Green Mountain Coffee Roasters (NASDAQ: GMCR). Since that time, I’ve written several blog posts critically examining Green Mountain’s compliance with certain accounting and disclosure rules.

This time, I have a question. How was Green Mountain Coffee Roasters able to report income before taxes in its Timothy’s Coffee of the World Inc. subsidiary that exceeded revenues in the thirteen-weeks ended June 26, 2010? While I wait for an answer from you, please let me explain to my readers why I am asking the question. You may listen in, too.

My question is based on the following computations

On November 13, 2009, Green Mountain acquired Timothy’s Coffee of the World and its operations were integrated into the company’s SCBU segment. In the quarter ended December 26, 2009 10-Q report, Green Mountain reported the following financial results for Timothy’s:
For the thirteen-weeks ended December 26, 2009, Timothy’s contributed approximately $7,141,000 in revenue and $902,000 of income before taxes.
In the quarter ended March 27, 2010 10-Q report, Green Mountain reported the following year-to-date financial results for Timothy’s:
For the twenty-six weeks ended March 27, 2010, Timothy’s contributed approximately $26,288,000 in revenue and $5,422,000 of income before taxes.
Therefore, Timothy’s revenues were $19,147,000 and income before taxes was $4,520,000 for the thirteen-weeks ended March 27, 2010 (Timothy’s revenue and income before taxes for the twenty-six weeks ended March 27, 2010 minus its revenue and income before taxes for the thirteen-weeks ended December 26, 2009).

How Timothy’s income before taxes exceeded revenues during the thirteen-weeks ended June 26, 2010

In the quarter ended June 26, 2010 10-Q report, Green Mountain reported the following year-to-date financial results for Timothy’s:
For the thirty-nine weeks ended June 26, 2010, Timothy’s contributed approximately $28,586,000 in revenue and $10,112,000 of income before taxes.
Therefore, Timothy’s revenues were $2,298,000 and income before taxes was $4,690,000 for the thirteen-weeks ended June 26, 2010. (Timothy’s revenue and income before taxes for the thirty-nine weeks ended June 26, 2010 minus its revenue and income before taxes for the twenty-six weeks ended March 27, 2010.)

In other words, income before taxes exceeded revenues by $2,392,000 for the thirteen-weeks ended June 26, 2010. How can that happen?

I will present three scenarios below. First, let’s discuss some basic accounting.

How is income before taxes computed?

Income before taxes is computed by starting with revenues and deducting operating expenses to compute operating income. Non-operating income is added to operating income to compute income before taxes. Non-operating losses and interest expense are deducted from operating income to compute income before taxes.

Scenario 1: Good for Green Mountain

Under this scenario, the reason that Timothy’s income before taxes exceeded revenues during the thirteen-weeks ended June 26, 2010 is due to it having non-operating income. Green Mountain did not specifically disclose any non-operating items for Timothy’s. However, on a consolidated basis, non-operating income was only $27,000 for the thirteen-weeks ended June 26, 2010, nowhere near $2,392,000. It is still possible that Timothy’s had over $2 million of non-operating income, but only if such income was offset by non-operating losses in other subsidiaries.

However, any non-operating income from Green Mountain’s Timothy’s subsidiary cannot come from investment income. According to the company’s 10-Q report for the quarter ended June 26, 2010, Timothy’s financial results are included as part of its SCBU segment. The company disclosed that:
Expenses not specifically related to either operating segment are shown separately as “Corporate”. Corporate expenses are comprised mainly of the compensation and other related expenses of certain of the Company’s senior executive officers and other selected employees who perform duties related to our entire enterprise. Corporate expenses also include interest expense, certain corporate legal and acquisition-related expenses and compensation of the board of directors. In addition, fiscal 2009 corporate expenses are offset by $17,000,000 of proceeds received from a litigation settlement with Kraft. Corporate assets include cash and short-term investments. [Emphasis added.]
If “Corporate expenses also include interest expense” and Corporate assets include cash and short-term investments”, then likewise investment income should be a corporate expense, too. Therefore, Timothy’s non-operating income would have had to result from non-operating income which is not investment income, such as gains on the disposal of assets. It's possible, though I personally don't think that it's likely.

Scenario 2: Not good for Green Mountain

If Timothy’s did not have any non-operating income, the $2,392,000 excess of income before taxes over revenues for the thirteen-weeks ended June 26, 2010, could have resulted from understating revenues in that quarter.

On September 28, 2010, Green Mountain disclosed that the SEC started an informal inquiry into its accounting practices eight days earlier. On that same day, the company reported an accounting error involving its K-Cup margin percentages. On November 19, 2010, Green Mountain disclosed four new accounting errors. On that date, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

Even if we assume that those accounting errors which were corrected by Green Mountain also corrected an overstatement of Timothy's revenues in the thirteen-weeks ended June 26, 2010, why didn't the company find that revenue overstatement earlier? When operating income that exceeds revenues, it is certainly a major red flag for close scrutiny by management and its auditors.

Scenario 3: Very bad for Green Mountain

If Timothy's did not have any non-operating income and its revenues were correctly reported, the $2,392,000 excess of income before taxes over revenues for the thirteen-weeks ended June 26, 2010 could only come from its operating expenses. However, in this case, operating expenses would have increased operating income, rather than reducing it, because operating expenses would have exceeded revenues by $2,392,000 for the thirteen-weeks ended June 26, 2010.

In other words, Timothy’s would have had negative operating expenses for that quarter. Negative operating expenses are normally caused by an adjustment to the current period’s operating expenses, because of an error in a previous reporting period. Therefore, Green Mountain may have been aware of material weaknesses in internal controls as early as June 2010 and not on November 19, 2010 when it first admitted to such problems.

In addition, none of the errors reported by Green Mountain involved any adjustment to operating expenses for the thirteen-weeks ended June 26, 2010. Therefore, there may be another undisclosed accounting error for Green Mountain to report to investors.

Missing a major overstatement of Timothy’s revenues and income back in 2009

In any case, Green Mountain missed a major overstatement of revenues and income before taxes in its Timothy’s subsidiary for the thirteen-weeks ended December 26, 2009 (the first quarter it was integrated into the company's operations).

In the quarter ended December 26, 2009 10-Q report, Green Mountain reported the following financial results for Timothy’s:
For the thirteen-weeks ended December 26, 2009, Timothy’s contributed approximately $7,141,000 in revenue and $902,000 of income before taxes.
In the quarter ended December 25, 2010 10-Q report, Green Mountain reported the following revised financial results for Timothy’s in 2009:
For the thirteen weeks ended December 26, 2009, the Timothy’s acquisition resulted in an additional $4.1 million of revenue and $0.0 million of income before income taxes.
Therefore, Green Mountain overstated revenues for Timothy’s by about $3 million and income before taxes by $900,000 in its 2009 10-Q report. How could Green Mountain miss a 75% overstatement in revenues in a single subsidiary? It's a very big error in a small subsidiary. The revenue overstatement should not have been hard to find.

Closing comment for Frances G. Rathke

If you respond to my question, I will post your answer in my blog. If you find additonal time, please respond to my blog post questioning your compliance with SEC Staff Accounting Bulletin No. 99 on materiality and my last blog post questioning your segment reporting and compliance with SEC Regulation G.

I hope you had a happy Valentine's day and I truly love reading Green Mountain's financial disclosures.

Very truly yours,

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.

Sunday, February 13, 2011

Green Mountain Coffee Roasters: Murky Financial Disclosures

Updated

Just about every time, I examine financial reports issued by Green Mountain Coffee Roasters (NASDAQ: GMCR), I find new troubling accounting practices and financial disclosures. For example, in my last blog post I questioned whether the company correctly considered a certain accounting error as an "immaterial accounting error" when it was originally reported to investors. In this blog post, I will examine Green Mountain's segment reporting and non-GAAP financial presentations and raise questions whether they properly comply applicable accounting and SEC disclosure rules. In addition, I will discuss other new reporting errors disclosed by Green Mountain in its latest 10-Q report.

Last Saturday, fellow Seeking Alpha contributor Jason Merriam noted in his article that, "The accounting practices at Green Mountain Coffee Roasters (GMCR) are not baffling...they are downright ludicrous." I think Green Mountain's financial disclosures are both baffling and ludicrous.


Background

On September 20, 2010, the SEC notified Green Mountain Coffee Roasters that it was conducting an informal inquiry. It requested information concerning “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” Eight days later, on September 28, 2010, Green Mountain surprised investors by disclosing news of the SEC inquiry in an 8-K filing.

In that 8-K report, Green Mountain also disclosed that it discovered an "immaterial accounting error" involving its K-Cup margin percentages which resulted in a $7.6 million cumulative overstatement of pre-tax income in financial reports issued from 2007 to June 26, 2010. Since Green Mountain determined that its K-Cup margin error was immaterial under accounting rules, it disclosed that it was going to correct that error by making a one-time cumulative adjustment to earnings in the latest quarter.

On November 19, 2010, Green Mountain disclosed three new overstatements totaling $3.2 million pre-tax income and one new understatement of $0.7 million in pre-tax income. These errors plus the K-Cup margin error resulted in a total overstatement of $10.1 million in pre-tax income. This time, the company said it would restate its financial reports issued from 2007 to 2010 to correct its errors.

In my last blog post, I questioned whether Green Mountain correctly determined that its K-Cup margin error was an "immaterial accounting error" when it was initially disclosed on September 28, 2010. Under SEC Staff Accounting Bulletin No. 99, an individual accounting error that overstates profits and causes a company to beat analysts' consensus earnings expectations for any reporting period should be considered a material accounting error.

My analysis showed that the K-Cup margin error caused Green Mountain to overstate profits and beat analysts' consensus earnings expectations in the quarter ended March 27, 2010. Therefore, Green Mountain should have considered its K-Cup margin error as a material accounting error on September 28, 2010 and it should have immediately disclosed to investors that it was going to restate its financial reports from 2007 to 2010 to correct that error. Instead, Green Mountain waited until November 19, 2010 to inform investors that it was going to restate its financial reports.

Below, I will examine certain other financial disclosures by Green Mountain and raise questions whether the company properly complied with GAAP and other applicable SEC disclosure rules.


Restating segment numbers without disclosing it

I compared Green Mountain’s segment reporting in its Q1, Q2, and Q3 2010 10-Q reports with the previously year’s corresponding 10-Q reports and found certain inconsistencies in amounts reported for income before taxes, total assets, and depreciation and amortization. For example, in its Q3 2009 10-Q report, Green Mountain originally reported the following selected segment information for the 39 weeks ended June 27, 2009:


In its Q3 2010 10-Q report, Green Mountain reported different segment numbers for the same period ending June 27, 2009:


In its Q3 2009 10-Q, Green Mountain reported that “Income before taxes” for the Keurig segment was $29.725 million for the “Thirty-nine weeks ended June 27, 2009.” However, in the Q3 2010 10-Q, Green Mountain reported that “Income before taxes” for the Keurig segment was $26.116 million for the same “Thirty-nine weeks ended  June 27, 2009” or $3.609 million less income than previously reported.  Apparently, Green Mountain revised its earnings for its Keurig segment by shifting $3.609 depreciation and amortization expense from Corporate and reallocated it to its Keurig segment.

SCBU and Keurig segment total assets

In the Q3 2009 10-Q, Green Mountain reported “total assets” of $412.413 million for its SCBU segment, $112.857 million for its Keurig segment, and $99.565 million for Corporate  as of June 27, 2009. However, in its Q3 2010 10-Q, Green Mountain reported “total assets” of $236.181 million for its SCBU segment, $240.859 million for its Keurig segment, and $14.936 million for Corporate as of June 27, 2009.

Changes in computing profits and assets for segments

In its Q3 2009 10-Q, Green Mountain disclosed that:
Corporate expenses also include interest expense, amortization of identifiable intangibles related to the acquisition of Keurig, as well as certain corporate legal expenses and compensation of the board of directors. All of the Company’s goodwill for the Keurig business unit and intangible assets related to the Keurig business unit are included in Corporate assets. [Emphasis added.]
However, in its Q3 2010 10-Q Green Mountain disclosed that:
Corporate expenses also include interest expense, certain corporate legal and acquisition-related expenses and compensation of the board of directors. In addition, fiscal 2009 corporate expenses are offset by $17,000,000 of proceeds received from a litigation settlement with Kraft. Corporate assets include cash and short-term investments.
Goodwill and intangibles related to the Frontier Natural Products Co-op, Tully’s, Timothy’s and Diedrich acquisitions are included in the SCBU reporting unit of the Company. Goodwill and intangibles related to Green Mountain Coffee Roasters, Inc.’s acquisition of Keurig are included in the Keurig reporting unit of the Company. [Emphasis added]
According to Green Mountain's Q3 2009 10-Q report, its "Corporate expenses" included “amortization of identifiable intangibles related to the acquisition of Keurig.” According to Green Mountain's Q3 2010 10-Q report, those same expenses were apparently “included in the Keurig reporting unit of the Company” instead of being considered as "Corporate expenses." In 2009, Green Mountain considered goodwill and intangible assets related to the Keurig as part of "Corporate assets." In 2010, those same goodwill and intangible assets were no longer "Corporate assets" but were included in the Keurig segment's balance sheet.

The re-allocation of goodwill and intangible assets seems to be the reason behind Green Mountain’s revision of its reported income before taxes for the thirty-nine weeks ended June 27, 2009 for its Keurig segment from $26.116 million in its Q3 2009 10-Q report to $29.725 million for the same period in its Q3 2010 10-Q report. In addition, the re-allocation of goodwill and intangible assets seems to explain why Keurig’s total assets as of June 27, 2009 was revised upward from $112.857 million in its Q3 2009 10-Q report to $240.859 million in its Q3 2010 10-Q report for the same June 27, 2009 date.

Green Mountain’s murky financial disclosures do not seem to explain why the company made downward revisions of its total assets for its SCBU segment as of June 27, 2009 from $412.413 million in its Q3 2009 10-Q report to $236.181 million in its Q3 2010 10-Q report.

Did Green Mountain comply with segment reporting rules under GAAP?

According to Statement of Financial Reporting Standards No. 131 (SFAS No. 131):
31. An enterprise shall provide an explanation of the measurements of segment profit or loss and segment assets for each reportable segment. At a minimum, an enterprise shall disclose the following…. d. The nature of any changes from prior periods in the measurement methods used to determine reported segment profit or loss and the effect, if any, of those changes on the measure of segment profit or loss.
However, Green Mountain made no reference to any change in its "measurement methods" used to determine profit and losses for its segments from 2009 to 2010. The company did not disclose that it revised 2009 earnings for its Keurig segment. As detailed above, Green Mountain revised its income before taxes for the thirty-nine weeks ended June 27, 2009 for its Keurig segment from $26.116 million in its Q3 2009 10-Q report to $29.725 million for the same period in its Q3 2010 10-Q report. According to SFAS No. 131, Green Mountain Coffee should have disclosed that it changed its computations for reporting profits for its Keurig segment. The company effectively restated its segment numbers without telling anyone.

Compensation issues

In its latest proxy statement Green Mountain disclosed that:
Our incentive compensation plans are typically based on corporate and business unit performance, measured by a range of objective and subjective criteria, and not solely on individual performance.
I was unable to determine from Green Mountain's financial disclosures if it made any compensation adjustments resulting from it revising profits for its Keurig segment for the thirty-nine weeks ended June 27, 2009.

Green Mountain’s Non-GAAP Disclosures

Over the last couple of years, I’ve identified many instances of public companies violating of Securities and Exchange Commission (SEC) Regulation G governing non-GAAP financial measures. In each case, those companies corrected their financial reports to properly comply with Regulation G after I notified them about their violations.  As I will detail below, Green Mountain needs to revise its presentation of non-GAAP net income to comply with SEC Regulation G.

For example, in its Q1 2011 10-Q report the Green Mountain presented the following reconciliation of its GAAP net income and non-GAAP net income:



According to Regulation G, Green Mountain's non-GAAP net income is required to be reconciled to its most directly comparable GAAP measure, which in this case is GAAP net income. Accordingly, Green Mountain showed how its non-GAAP net income did not include acquisition-related expenses, SEC inquiry expenses, and amortization of identifiable intangibles. However, according to SEC Regulation G Compliance & Disclosure Interpretations, Green Mountain cannot provide side-by-side reconciliations of GAAP and non-GAAP numbers in such a way that it presents a full non-GAAP income statement. See below:
Question 102.10
Question: Is it appropriate to present a full non-GAAP income statement for purposes of reconciling non-GAAP measures to the most directly comparable GAAP measures?
Answer: Generally, no. Presenting a full non-GAAP income statement may attach undue prominence to the non-GAAP information. [Jan. 11, 2010].
For example, NightHawk Radiology Holdings, Inc. made a similar reconciliation of GAAP and non-GAAP numbers and provided a full non-GAAP income statement in its 8-K report dated filed on February 17, 2010. See below:


On April 2, 2010, the SEC Division of Corporation Finance reviewed NightHawk Radiology Holdings 8-K report:
1. We note that you have presented an alternative income statement which excludes certain items recorded in your GAAP-basis Statements of Operations. This represents a full non-GAAP income statement which does not appear to be consistent with Regulation G. Please confirm in future Exchange Act filings you will remove such presentation or tell us why you believe it is appropriate. For additional guidance, refer to Question 102.10 of the Compliance & Disclosure Interpretations regarding Non-GAAP Financial Measures.
On April 14, 2010, NightHawk Radiology Holdings responded to the SEC Division of Corporation Finance:
The Company confirms that it will remove from future filings the presentation referred to above in this Comment 1 and replace it with a reconciliation table that is consistent with the guidance provided in the Answer to Question 102.10 of the Compliance & Disclosure Interpretations regarding Non-GAAP Financial Measures.
On May 6, 2010, NighHawk Radiology Holdings issued its 10-Q report and made a proper reconciliation of its non-GAAP adjusted net income to GAAP net income in compliance with Regulation G:


This time, NighHawk Radiology Holdings reconciled its non-GAAP adjusted net income to GAAP net income without providing a full non-GAAP income statement. Green Mountain should do the same.

Continuing financial reporting problems

In its Q1 2011 10-Q report, Green Mountain disclosed that it made errors in its previously audited fiscal year-end consolidated statement of cash flows:
Revision to Fiscal 2010 Year-End Consolidated Statement of Cash Flows
In preparing the consolidated financial statements for the thirteen weeks ended December 25, 2010, management identified that certain amounts previously disclosed within the Consolidated Statement of Cash Flows for the fiscal year ended September 25, 2010 required reclassification. These misstatements had no effect on the Company’s cash and cash equivalents. Specifically, the supplemental disclosure of fixed asset purchases included in accounts payable and not disbursed was overstated by approximately $8.2 million. This resulted in an $8.2 million understatement on the capital expenditures for fixed assets line and net cash used for investing activities category for fiscal 2010 and a corresponding understatement of the change in accounts payable line and an overstatement of net cash used in operating activities. The Company will make this immaterial correction when the 2010 financial statements are next issued.
The company reported continuing material weaknesses in internal controls over financial reporting for its latest quarter:
Under the supervision of and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, the Company conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, as of December 25, 2010. Based on that evaluation and the material weaknesses referenced above, the Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures were not effective as of December 25, 2010. [Emphasis added].
Closing comment

In its Q1 2011 10-Q report, Green Mountain disclosed that it was spent about $6 million on "legal and accounting expenses related to the SEC inquiry, the Company’s internal investigation and pending litigation" or approximately $46,000 per week during the quarter. According to Green Mountain's latest proxy statement, the combined annual base salaries for fiscal 2010 of its top five executive officers are just $2.01 million. In other words, in a single quarter Green Mountain spent three times the annual base salaries of its five top executive officers on legal and accounting issues arising from its restatements of financial reports.

The company's Audit Committee and Board of Directors recommended that "shareholders ratify the Audit Committee’s appointment of PricewaterhouseCoopers LLP" as its auditors. From 2007 to Q3 2010, every single financial report issued by Green Mountain which was audited or reviewed by PricewaterhouseCoopers needed to be restated due to material accounting errors. To date, no member of Green Mountain's board, none of its executive officers and certainly not its auditors have been held accountable for any errors in financial reporting.

Written by:

Sam E. Antar

Recommended reading:

February 11, 2011: Dag Blog -"Crazy Eddie" Fraudster Sam Antar To Return To Crime - Thanks to Darrell Issa & Anti-Regulation Republicans by William K. Wolfrum

Disclosure

I am a convicted felon and a former CPA. As the criminal CFO of Crazy Eddie, I helped my cousin Eddie Antar and other members of his family mastermind one of the largest securities frauds uncovered during the 1980's. I committed my crimes in cold-blood for fun and profit, and simply because I could.

If it weren't for the heroic efforts of the FBI, SEC, Postal Inspector's Office, US Attorney's Office, and class action plaintiff's lawyers who investigated, prosecuted, and sued me, I would still be the criminal CFO of Crazy Eddie today.

There is a saying, "It takes one to know one." Today, I work very closely with the FBI, IRS, SEC, Justice Department, and other federal and state law enforcement agencies in training them to identify and catch white-collar criminals. Often, I refer cases to them. I teach about white-collar crime for professional organizations, businesses, and colleges and universities.

Recently, I exposed GAAP violations by Overstock.com which caused the company to restate its financial reports for the third time in three years. The SEC is now investigating Overstock.com and its CEO Patrick Byrne for securities law violations (Details here, here, and here).

I do not seek or want forgiveness for my vicious crimes from my victims. I plan on frying in hell with other white-collar criminals for a very long time.

I do not own any Green Mountain Coffee Roasters or Overstock.com securities long or short. My investigations of these companies are a freebie for securities regulators to get me into heaven, though I doubt I will ever get there. My past sins are unforgivable.