Thursday, September 27, 2012

Green Mountain Coffee Roasters’ Growing Inventory Levels: Is It a Fumble or a Fraud?

Has Green Mountain Coffee Roasters (NASDAQ: GMCR) fumbled in managing its inventory or has it engaged in an inventory fraud to inflate earnings?

Background


As the criminal CFO of Crazy Eddie, I learned that the overstatement of inventory levels was the easiest way to inflate earnings. Auditors don't always supervise the counting of each and every physical inventory item to confirm their existence. Even if the auditors confirm the physical existence of all inventory items, they don't always trace how every single item arrived in a company's storage facilities. Therefore, the same inventory items can be moved from location to location and counted several times to inflate earnings.

In September 2010, the Securities and Exchange Commission started a probe of Green Mountain Coffee's revenue accounting practices. Shortly afterwards, a class action lawsuit was filed against the company alleging that it engaged in securities fraud by inflating its inventory numbers to overstate its reported earnings. According to the amended class action lawsuit, several confidential witnesses who worked for Green Mountain Coffee allege that it moved around its inventory from location to location without a document trail to overstate inventory counts and inflate earnings. For example, paragraph 79 of the amended complaint alleges that:

CW7 [confidential witness 7], a lower-level employee in the Company's shipping department in Knoxville Tennessee, who worked at the Company from August 2009 through August 2011, also witnessed GMCR improperly transferring product from one plant to the next for no apparent reason. [Bracketed information added for clarity.]

In October 2011, money manager David Einhorn slammed Green Mountain Coffee's and noted "odd material movements" of inventory to possibly confound its auditors.

If there is inventory growth that is higher than revenue growth over extended periods of time combined with declining inventory turnover trends, it is considered to be a red flag for the possible inflation of inventory numbers and overstatement of earnings. For example, before the Crazy Eddie fraud was uncovered, independent analyst Thornton L. O’glove noted that its inventory levels were growing much faster than revenues. He was suspicious that Crazy Eddie was fraudulently inflating its inventories to overstate its profits. Unfortunately, most investors and analysts ignored the red flags that he spotted. (Source: Wall Street Journal – By the Numbers: How One Analyst Scores Big by Finding the Dark Side, by Jeffrey A. Tannenbaum and Lee Berton, August 4, 1987).

Is Green Mountain Coffee another Crazy Eddie?

Green Mountain Coffee's inventory levels have grown much faster than its growth in revenues in the last seven quarters since the S.E.C started its probe. Therefore, Green Mountain Coffee's inventory turnover rate declined in each quarter reflecting longer periods of time to sell its products. A comparison of Green Mountain Coffee's financial reports reveal that ever larger amounts inventory on hand are required to sell relatively less products quarter-after-quarter and year-after-year. See the chart below comparing Green Mountain Coffee's reported revenue increases compared to its reported increases in inventories. (Click on the table image below to enlarge it.)


Likewise, Crazy Eddie's had a similar pattern of inventory increases that exceeded revenue increases over an extended period of time resulting in declining inventory turnover. It seemed like Crazy Eddie needed ever larger amounts of inventory to sell relatively less product. For example, in fiscal year 1987 Crazy Eddie's reported revenues increased 34% while its inventories increased 82% when compared to the previous fiscal year. Its reported inventories grew at more than twice the rate of reported revenues. In November 1987, new management ousted the Antar's from Crazy Eddie and discovered that most of the inventory on its books did not exist!

Similarly, Green Mountain Coffee's reported inventories grew at more than twice the rate of revenues in the last two quarters. In the most recent quarter ended June 23, 2012, its reported revenues grew 21% while its inventories grew 60% when compared to the previous fiscal year's comparable quarter. In the quarter ended March 24, 2012, Green Mountain Coffee's reported revenues grew 37% while its reported inventories grew 100% when compared to the previous fiscal year's comparable quarter.

Consistent decline in inventory turnover

In each the last seven quarters, Green Mountain Coffee's inventory turnover has decreased when each quarter’s numbers are compared to the same quarter of the previous fiscal year. For example, in the latest quarter ended June 23, 2012, it took Green Mountain Coffee an average of 102.04 days to sell its inventory compared to 72.12 days in the same quarter of the previous fiscal year. In the quarter ended June 26, 2010 it took Green Mountain Coffee an average of only 64.89 days to sell its inventory. (Click on table images below to enlarge them.)


Green Mountain Coffee has claimed that it stocked up on inventories in each quarter in order to meet anticipated customer demand. However, in each of the last seven quarters, Green Mountain Coffee's rate of inventory buildup exceeded its own estimates of anticipated revenues. When it beat its own revenue projections, its inventory turns should have increased because it ended the period with fewer inventories on hand than it had anticipated. However, Green Mountain Coffee's inventory turnover still decreased in those periods.

When Green Mountain Coffee failed to meet its revenue projections, inventory turnover understandably decreased because it had more inventory on hand than it had anticipated. However, even if it had made up for the shortfall in sales by selling more products and depleting more inventory to match its revenue projections, its inventory turnover rate still would have decreased. Therefore, Green Mountain Coffee's consistent decline in inventory turnover rates cannot be explained by its failure to meet revenue projections. In any case, its inventory buildup appears to defy rational explanation.

Inventory turnover declined even when Green Mountain Coffee beat minimum and maximum revenue expectations

In four of the last seven quarters, Green Mountain Coffee's reported revenues exceeded both the minimum and maximum guidance it gave to investors several weeks before the close of the quarter (see green highlighted areas in the table above). Inventory turnover should have been higher because the company pushed its product out the door faster to meet unexpected excessive demand from its customers. However, Green Mountain Coffee’s inventory turnover decreased, reflecting a longer time to sell its inventory despite reporting revenues that exceeded its minimum and maximum projections.

When Green Mountain Coffees sales fell below expectations, inventory turns would have still declined if it had met expectations

In two of the last seven quarters, Green Mountain Coffee failed to meet both its minimum and maximum revenue projections it gave investors just a few weeks before the end of each quarter. Therefore, a decline in inventory turns would be expected because it sold fewer products than it anticipated to its customers and had more inventory on hand than it anticipated at the end of the period. However, even if the company had matched its revenue projections by selling more merchandise, its inventory turnover would have still declined in those same quarters. The decline in inventory turnover cannot be explained by a failure to meet revenue expectations, (See red highlighted areas in the tables above and below).

For example, in the quarter ended March 24, 2012 Green Mountain Coffee’s reported revenues of $885.052 million were $54.052 million short of its minimum revenue expectation and $86.435 million short of its maximum revenue expectations. Green Mountain Coffee reported a gross profit on revenues of 35.37% in that quarter. Therefore, the cost of product that it sold to customers was 64.63% of revenues.

To meet its minimum revenue projection, Green Mountain Coffee needed to sell an additional $54.052 million of products costing it approximately $34.934 million ($54.052 million multiplied by 64.63%). To meet its maximum revenue projection, Green Mountain Coffee needed to sell an additional $86.435 million of products costing it approximately $55.863 million ($86.435 million multiplied by 64.63%).

Even if Green Mountain Coffee had achieved its minimum revenue estimate for the quarter ended March 24, 2012, it would have still taken the company 88.0 days to sell its inventory compared to only 64.06 days in the previous fiscal year. If Green Mountain Coffee had met its maximum revenue estimate for that quarter, it would have still taken the company 83.55 days to sell its inventory compared to only 64.06 days in the previous fiscal year. (Click on the table image below to enlarge it.)


Latest quarter

In the latest quarter ended June 23, 2012, Green Mountain Coffee’s reported revenues exceeded its minimum revenue guidance, but fell short of its maximum revenue guidance. It took an average of 102.04 days to sell its inventory compared to only 72.12 days in the same third quarter of the previous fiscal year. Its revenues increased 21% while its inventory levels increased by 60%. The company had projected a revenue increase of 20% to 25% for the quarter. Even if it had met its maximum 25% increase in revenue projection, it still would have taken an average of 97.55 days to sell its inventory compared to 72.12 days in the previous fiscal year. See the yellow highlighted areas in the tables above and below:


During a conference call with investors, Green Mountain Coffee CFO Fran Rathke attempted to deflect criticism over inventory levels by explaining that it was stocking up on brewers far in advance of the holiday season:

Because of the time it takes to ship brewers to the US from our contract manufacturers in Asia, we must have on hand all of the brewers we expect to sell during holidays by early October to ensure availability on retailer shelves. It is this timing dynamic that necessitates that we begin building brewer inventory starting in Q3 toward anticipated demand.

Green Mountain Coffee reported that total inventory at the end of the quarter had jumped 60% to $667.0 million compared to only $417.5 million in the previous year's comparable quarter. The brewer and accessory portion of the total inventory increased 73% to $301.5 million compared to $174.2 million in the previous year's comparable quarter. However, the balance of the total inventory excluding brewers and accessories grew still grew at 50% over the previous year. As I detailed above, revenues for the quarter only increased by 21% over the previous year's comparable quarter. Brewer and accessory sales increased only 32%, single serve pack sales increased only 31%, and other sales categories declined when compared to the previous fiscal year. Therefore, inventory turnover decreased in every revenue category.

Portfolio manager Ben Strubel took issue with Rathke and noted that the purported buildup in brewer inventories ahead of the holiday season was much higher than the buildup in the previous year taking into account anticipated revenue projections by the company.

On June 6, 2012, Green Mountain CEO Larry Blanford told investors at a Piper Jaffray Consumer Conference:

…But should something like that happen we have a number of tactical responses, one of which could in fact be deciding to raise the price of the K-Cup brewing system.

It appears that both Rathke and Blanford were fibbing to investors. On Tuesday September 26, 2012, Green Mountain Coffee announced that it was offering $50 rebates for its brewers. Investor Daniel Yu noted in his blog that:

GMCR is offering up to a $50 rebate in Keurig brewers, after saying they might raise prices just a few months ago. Should Larry Blanford, CEO of GMCR/Keurig, change his middle name to ‘liar’? Larry Liar Blanford?

Apparently, Green Mountain Coffee had too many brewers on hand ahead of the holiday season and must now cut prices to move them, contrary to previous comments by Rathke and Blanford. Fibbing by management aside, still the question remains as to whether Green Mountain Coffee also inflated its inventory numbers to create fictitious profits. Green Mountain Coffee's inventory buildup does not appear to be solely the result of mismanagement. Its unusual growth in reported inventory levels could be the result of intentional inflation to overstate earnings as alleged in the class action lawsuit.

Was it a fumble or fraud?

No matter how you slice and dice it, Green Mountain Coffee’s troubling growth in inventory levels is not a single quarter fluke. As evidenced by the consistent decline in inventory turnover over the last seven quarters, the company continues to build excessive layers of inventory on top of previous excessive layers of inventory.

The S.E.C. is investigating whether Green Mountain Coffee’s excessive growth in inventory levels resulted from mismanagement or a fraud. However, I caution them that claiming incompetence is the last refuge of the white-collar criminal. Fraudsters know that stupidity is not a crime.

Was it a fumble or fraud? Maybe it is both.

Written by,

Sam E. Antar

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 as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. More recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud. I do not want or seek forgiveness for my vicious crimes from my victims. My past sins are unforgivable.

I do not own any Green Mountain Coffee Roasters securities long or short.

Monday, September 10, 2012

Lawsuit Filed Against ZAGG Alleges It Concealed Stock Pledges

Last Thursday, a lawsuit seeking class action status was filed against ZAGG (NASDAQ: ZAGG) Incorporated, certain members of its board of directors, and certain officers of the company. It alleges that they violated federal securities laws by improperly concealing certain stock pledges made by ZAGG’s former CEO and Chairman Robert J. Pedersen. Other law firms who specialize in bringing class action lawsuits have announced that they are contemplating filing complaints against ZAGG. (Download the complaint here).

ZAGG makes protective coverings for Apple's (NASDAQ: AAPL) iPhone and iPad and other devices. Big-box retailers such as Best Buy (NYSE: BBY) and Walmart (NYSE: WMT) carry ZAGG's product.

Background

On Friday August 17, 2012 ZAGG issued a press release saying that its co-founder Robert Pedersen resigned from his posts as CEO and Chairman. It did not mention any reason for his resignation. Later that day, Robert Pedersen was interviewed by the Salt Lake Tribune and it reported that “Pedersen said he resigned in order to focus on his family, his church and a family foundation.” In addition, Pedersen filed a Form 4 report with the Securities and Exchange Commission. It disclosed that he sold about 515,000 shares at an average price of $8.2214 per share to “meet margin calls” on August 14, just three days before he resigned. Pedersen’s sale of stock to meet a margin call was not mentioned in either the ZAGG press release or interview with the Salt Lake Tribune.

On Monday, August 20, 2012, my blog asked “if the timing of his sale of stock had anything to do with his resignation.” In addition, I pointed out that on December 21, 2011, Pedersen sold 345,200 shares at an average price of $7.5248 per share "to meet an immediate financial obligation." His Form 4 filing did not mention any margin call even though a margin call is an immediate financial obligation. I suspected that Pedersen’s December 2011 sale of stock was also due to a margin call and asked for an explanation in my blog. Furthermore, I reported that a proxy report filed by ZAGG on April 27, 2012 did not mention any pledges of stock by Pedersen. Public companies are required to disclose stock pledges by insiders in proxy reports. Separately, I contacted the Securities and Exchange Commission and asked them to look into this matter.

On Tuesday August 28, 2012, ZAGG held a conference call with investors. ZAGG President and Interim CEO Randy Hales finally admitted that Pedersen’s resignation was related to his margin calls. In addition, Hales admitted that Pedersen had a margin call in December 2011 as I had suspected:

…departure was entirely related to the margin calls situation that started last December and unfortunately surfaced again two weeks ago.

On that same day, Robert Pedersen filed a Form 4 report disclosing that on August 24 he sold another 1,250,061 shares and received $8.626 million in gross proceeds to satisfy all of his remaining margin obligations. Despite the margin call issue that led to Pedersen's resignation, ZAGG plans to hire him for one year as an executive consultant.

After the conference call, I asked, "If Pedersen had stock pledges in December 2011 that were still outstanding in August 2012, why weren't they disclosed in ZAGG's April 2012 proxy report as required under S.E.C. rules?"

Class action lawsuit

Robert Pedersen
The class action lawsuit alleges that ZAGG, certain members of its Board of Directors, and certain officers knew that Pedersen had undisclosed stock pledges and margin calls going back to December 2011, but covered them up. According to the complaint:

3. Unbeknownst to the Company's shareholders, a "margin call situation" involving Robert G. Pedersen... began in December 2011, whereby Pedersen borrowed substantial amounts of monies, putting up his Zagg shares as collateral. Although Defendant Pedersen ultimately resigned his post as the Company's Chief Executive Officer ("CEO') due to the "margin call situation," investors were not informed that Defendant Pedersen had pledged his stock until after his resignation over eight months later.

4. On December 21, 2011, Defendant Pedersen sold nearly $2.6 million worth of Zagg stock. However, at that time, shareholders were only informed that Pedersen sold the stock to "meet an immediate financial obligation." In truth, the December 23 stock sale was made to meet a margin call. Moreover, further undisclosed to investors, Pedersen had more than a million additional shares posted as collateral, which were subject to margin calls. Realizing that Pederson had recklessly put his CEO position at risk at the expense of investors, the Company began a succession plan beginning in December 2011 to remove Pedersen as CEO, and to appoint Hales as his successor. This accession plan was purposely hid from investors.

Furthermore, the complaint alleges that the defendant’s violated federal securities law by not disclosing Pedersen's stock pledges in the April 27, 2012 proxy report (paragraph 6). In addition, it alleges that former CEO Robert Pedersen and current CFO Brandon O’Brien signed "materially false and/or misleading" Sarbanes-Oxley certifications (paragraph 34 to 40).

According to the Salt Lake Tribune:

Jeff Jones, attorney for Zagg, said Friday that "the claims are without any factual or legal basis, and the company will defend them very vigorously."

ZAGG will probably try to get the complaint dismissed. If the lawsuit survives a motion to dismiss, its officers and directors could face potentially embarrassing pre-trial deposition testimony. Defending a class action lawsuit can be a very costly affair. Even if ZAGG has a current directors and officers' liability insurance policy, it could face more costly coverage in the future. If such litigation moves forward, it could take up a lot of management's attention that could be better used to run the business. I personally believe that if ZAGG and Pedersen had been more transparent about the stock pledges early on, they could have saved themselves a lot of trouble.

Written by:

Sam E. Antar

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 as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. More recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud. I do not want or seek forgiveness from my victims for my vicious crimes. My past sins are unforgivable.

I do not own any ZAGG securities long or short.

Real Estate Investor Who Fled Country Now Seeks to Raise $1 Billion in IPO

United Realty Trust Incorporated is seeking up to $1 billion of capital from investors in an initial public offering (IPO). Deep inside the prospectus on pages 89 and 90 is a startling disclosure about Eli Verschleiser, its President and member of its Board of Directors:

At the age of 17, while a high school student, Eli was subpoenaed to appear before a federal grand jury inquiring into the fraudulent activities of a group of individuals he knew. Eli exercised his Fifth Amendment rights and continued to do so after being given “use immunity.” Eli appeared before a federal judge who directed him to reappear. He did not reappear and, instead, moved overseas, where he remained for several years. While overseas, a federal indictment was unsealed naming over 20 individuals in connection with fraudulent activities, including Eli. Approximately two years later, his family contacted an attorney to help him return to the country. He eventually pleaded guilty to one count of failure to appear, a misdemeanor. He received one-year probation and 100 hours of community service as a sentence. The charges against him related to the fraudulent activities were dismissed.

The disclosure does not call Eli Verschleiser a fugitive. Did Verschleiser conveniently move overseas after being directed to “reappear” in front a federal judge? Where did he go? Who were the characters that he was involved with? Why did he wait over two years before returning to America? As of the time of this publication, his biography on the company's website makes no mention of the above incident.


Eli Verschleiser
A blind pool offering or a blind trust offering?

United Realty Trust’s effort to raise capital is known as a “blind pool offering” since it does not own any properties and has not yet identified any properties for investment. The "sponsor" of the offering is United Realty Advisor Holdings LLC. It is directly and indirectly controlled by Eli Verschleiser and Jacob Frydman. The sponsor indirectly controls United Realty Advisors LP which is the "advisor" and is responsible for managing day-to-day operations and identifying property for investment.

According to the prospectus, a couple of Frydman's entities went bust:

In February 2004, Mr. Frydman was chief executive officer of the general partner, and a 1% owner, of two entities which, while engaged in separate land development transactions, each filed petitions for relief under Chapter 11 of the United States Bankruptcy Code.

The prospectus cautions that:

We and our advisor have no operating history, we have no established financing sources, our sponsor has no experience operating a public REIT, and the performance of the prior real estate investment programs of the principals of our sponsor may not be indicative of our future results.

Furthermore, the prospectus warned that:

You may be more likely to sustain a loss on your investment because our sponsor does not have as strong an economic incentive to avoid losses as does a sponsor that has made significant equity investments in its company.

Instead of calling it a blind pool offering, maybe it should be called a blind trust offering?

Closing comment

Eli Verschleiser has "no experience operating a public REIT." He should understand that it is normal for him to be the subject of extra public scrutiny if he plans to take United Realty Trust Public. He shouldn’t hide behind nuanced language buried deep inside of a prospectus. The way that I learned to deal with my past transgressions is to be completely upfront about them. Hopefully, Verschleiser has learned from his youthful errors.

Written by:

Sam E. Antar

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 as an independent whistleblower. I teach white-collar crime classes for various government entities, professional organizations, businesses, and colleges and universities. More recently, I've helped the AICPA Fraud Task Force develop better methods for detecting fraud. I do not want or seek forgiveness from my victims for my vicious crimes. My past sins are unforgivable.

I no financial relationship with United Realty Trust Inc. or any of its affiliates.