Are Rising Inventories at Green Mountain a Bad Omen?

Despite growing earnings by more than 90% on a year-over-year basis, shares of Green Mountain Coffee Roasters(GMCR) plunged in late trades because that performance wasn't up to snuff in comparison to Wall Street's consensus view.

Interestingly, however, it was rising levels of inventory and capital spending that were the focus of Green Mountain's conference call with analysts after the results were released.

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And that, along with the earnings and revenue miss, is making hedge fund manager David Einhorn is looking awful prescient right now. At after-hours lows of below $44, Green Mountain shares are now down about 50% since Einhorn introduced his short of the stock at the Value Investing Congress in October. The famed founder of Greenlight Capital came close to accusing the company of accounting fraud during the presentation of his short thesis on the stock. On Wednesday's conference call, Green Mountain said it's "confident" that no accounting fraud has occurred. The questions from analysts about growing inventories seem to signal unease about both sales projections and the merit of capital spending increases. For Einhorn, ultra-bullish forward earnings estimates and an ongoing informal probe of revenue recognition by the Securities and Exchange Commission were enough to prompt him to reexamine the company, an exercise that yielded three major concerns: 1. The company is a "serial issuer of stock," according to Einhorn, allowing insiders to cash out $172 million worth of equity at an average price of nearly $90 a share.2. The company's capital spending "is growing much faster than the business, when the business should be growing faster than spending." In 2011, Green Mountain spent $290 million on the development of new K-Cup coffee packs and Keurig machines. Einhorn expects the company to spend another $740 million on capex in 2012.3. Einhorn's most damning concern was of accounting "shenanigans" in acquisitions. He argued that this was a reflection of a wider symptom in revenue recognition.

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In a supplement to its quarterly report on Wednesday, Green Mountain said about its revenue recognition policy, "The Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred and risk of loss has transferred to the customer, the selling price is fixed or determinable, and collectability is reasonably assured."

Green Mountain said it ended fiscal 2011 with finished goods inventory of $273.3 million, a 126% jump from 2010. The company explained the boost by saying, "half of the increase [was]due to K-Cup portion packs on hand and the other half due to Keurig Single Cup Brewers and accessories on hand," in a press statement. Overall, inventories rose over 150% to $672.2 million.

The company also reported its accounts receivable increased 80% year-over-year in the latest quarter to $310.3 million as of September's end -- signaling either a surge in demand or recognition of previous sales.On its conference call, Green Mountain said previous lower inventory levels caused it to be "essentially short in Q3 or Q4 in meeting orders... Going into 2011, we were capacity constrained." As a result of the boost in inventory, Green Mountain added, "We are now in a capacity situation that allows us to meet weekly demand."Green Mountain was founded in 1981 as a coffee wholesaler. The company transformed itself to a higher margin coffee machine and pod seller through its acquisition of a controlling stake in Keurig in 2002. With K-cups, the company can have thin profit margins in its coffee wholesaling and brewing machine businesses, while capturing high profit margins from the pods themselves. But Einhorn noted in his presentation that Green Mountain's K-cup patent is set to expire next September and as competitors enter the business, he estimates the company will only earn profits of 12 cents a pod and overall revenue of less than $1 billion -- much lower than bullish forecasts at roughly double that level. In fiiscal 2011, K-cup portion pack sales increased over 100% to $1.7 billion, 84% of overall net sales of $2.7 billion.No charges or formal allegations of accounting fraud at Green Mountain have been issued by any law enforcement or regulatory agency.

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