Dark Horse Hedge

Dark Horse Hedge is Rocking (2) & Options Time Again

Dark Horse Hedge is Rocking (2) & Options Time Again

By Scott at Sabrient and Ilene at Phil's Stock World 

My heater's broke and I'm so tired 
I need some fuel to build a fire (actually need something that cools heat down)
The girl next door (Tokyo), her lights are out, yeah
The landlord's gone, I'm down and out
It's cold gin (option) time again
You know it'll always win - KISS

The tragic developments in Japan took center stage this past week and our hearts go out to everyone in Japan, and everyone who is touched by this catastrophic event.  

Prior to the earthquake and tsunami, the VIRTUAL Dark Horse Hedge portfolio was positioned with a 70% Long / 30% Short tilt. We are now considering moving to a 50% / 50% balance. We will most likely do that, assuming no material change in the world events, by adding to our short positions next week.  In the meantime, we have two option positions which are expiring today and we wanted to add to the review we began last week.  (Click here for our first four long positions reviewed a week ago.)  

Options Expiration:

Radware Ltd (RDWR): On November 11, 2010 we added Radware (RDWR) to the virtual portfolio using Phil’s Buy/Write strategy.  At that time RDWR was trading at $33.39 and we added half the shares we wanted (100) and sold the March $35 2011 call and March $35 2011 put to complete the buy/write. On December 7, 2010 when the stock traded up to $40, we rolled the call out to the Jan $35 2012 call, which we sold for $9. We kept the March $35 2011 put we had already sold for $5.10.  The put (as 65-70% of options do) will expire worthless today yielding a $5.10 profit.  At this time, we believe it is prudent to hold the shares, currently trading at $35.56, and the Jan $35 2012 call.

Xyratex (XRTX): On December 20, 2010 we added Xyratex (XRTX) using the buy/write strategy and acquiring half the shares we wanted exposure to and selling March $15 calls and puts for a net $3.60.  XRTX is trading at $11.14 today on expiration day, so the call side will expire worthless ($1.80 profit) and the puts will be exercised - the other half position we were willing to own will be "put" to us at $15/share.  We still like XRTX going forward. It's trading at a p/e just north of 2 and a forward p/e of 4, and it's rated a Strong Buy by Sabrient.  For the time being, we will not recommend any options on XRTX. XRTX announces earnings on March 31, 2011.  

Review of Positions Continued

LONGS

Gamestop Corp. (GME) has been a favorite of ours since July 23, 2010.  In the case of GME, we are buying stock in a company with a 12% expected growth rate which is slowing down from a torrid 36% growth during the last 5 years.  GME is trading at a low p/e, only 8, in an industry that averages 15.  This theme of growth at a reasonable price (GARP) will come up again and again in the stocks we prefer to own in the virtual portfolio.  Since July 23, 2010 when we recommended the stock at $19.92 the underlying stock has only moved $.13 to close Friday at $20.05.  However, by using covered calls for September 2010 and January 2011, we have been able to reduce our cost basis to $16.76 while waiting for the stock to catch up to our expectations.  We are comfortable holding the stock (or buying it if we didn't already own it). 

Jabil Circuit Inc. (JBL) was added to our list of Longs in January 2011 using the buy/write strategy.  The reasons we liked JBL are still the same.  Analysts are raising estimates for 2011 and 2012, it has a 12% expected growth rate, and it is trading at 9 times earnings. The stock was $20.56 when we added it in January and it closed Friday at $21.79.  DHH used the June 17, 2011 $21 call and put to bring in $4.30 in premiums.  (We are most often sellers of premiums in the virtual Dark Horse Hedge portfolio because 65-70% of options expire worthless and we are happy to be the recipient of those premiums.)

SHORTS

Green Mountain Coffee (GMCR) has a decent product in the coffee market but the company is currently the subject of an informal SEC investigation and many class action lawsuits.  There are enough rumors about this company to fill 10 pages. White collar criminal Sam Antar, top manipulator of money and people, continues to write articles about the problems he sees in GMCR's accounting records. Go to Sam's blog here for more detailed analyses.  GMCR trades at a pricey 116 times earnings and we don't think it's valuation is supported by its fundamentals and the risks associated with it.

We think there is significant downside potential for GMCR trading $60.85.

Warning: We have been getting our virtual head handed to us by shorting GMCR so far, and we hope GMCR is not the stock upon which we learn the lesson "the market can stay irrational a lot longer than we can stay solvent"!  

Dark Horse Hedge is Rocking On

By Scott at Sabrient and Ilene 

Stand up and be counted

For what you are about to receive

We are the (primary) dealers

We'll give you everything you need (free money!)

Hail, Hail to the good times'

Cause rock has got the right of way

We ain't no legend, aint no cause

We're just livin for today (the Fed)

 

For those about to rock, we salute you - AC/DC

Dark Horse Hedge is Rocking On

With February and the most of earnings season passing, we decided to "stand up and be counted" with a summary article on the VIRTUAL Dark Horse Traders' Hedge (DHH) portfolio.  

Our mission has been to generate absolute returns through the use of a tilted Long/Short strategy that remains market neutral, but with a partial bias towards momentum (as defined by measuring the S&P 500 relative to its 50 and 200 day Moving Averages). We have been tilted to the long side since October 2010.  

Over the long term, reasons for using such a strategy include being positioned to take advantage of both bull and bear runs. As evidenced by the near zero returns of the market over the last 10 years, buy-and-hold strategies are majorly flawed. The market also teaches hard lessons to those who attempt to predict direction, and has forced many retail investors to reconsider their strategies after being pounded in 2001 and 2008.  

Alpha is a measure of a return over and above a benchmark index's return, and Beta is a measure of the portfolio's performance as it is correlated to movements of the market.  With DHH, we strive to optimize Alpha while minimizing Beta to protect our portfolio in up and down markets. Beta is reduced by holding both Long and Short positions and using a rules-based approach to determine which stocks have the best chacteristics to benefit when the market is rising, and conversely to determine which stocks are most apt to perform poorly when the market is falling. In other words, we want to be long stocks of the best companies and short stocks of the worst companies - we want to identify the "tails" of a market, index, sector or basket of stocks.

Once a portfolio of Long and Short stocks is established, then it is a matter of gaining the desired exposure using the available tools, such as Sabrient's ratings for publically traded companies.  DHH also uses option strategies in an attempt to leverage our capital, acquire stocks at discounts to current prices, and create income yield on positions that don't pay dividends.  Phil's buy/write strategies are ideal methods for achieving these goals. 

Since March 2009, the market has resembled a "hail, hail to the good times," with periods of irrational exhuberance fueled by QE1 and QE2 and a mindset of "living for today."  (Stock World Weekly presents the case that the current round of QE2 is inflating prices in everything from oil to food to stocks.)  Dissociated from the "wealth effect" of higher stock prices, most Americans are not feeling the recovery, even though for the past two years, the bulls have mostly "got the right of way." 

Currently, the DHH virtual portfolio is tilted 70% Long and 30% short.  In the past few weeks, the market has tested the 50 day Moving Average several times without giving way.  A move below the 50 day MA would prompt us to go back to 50/50 market neutral.

So, let's get to DHH's virtual positions and start by reviewing the 12 stocks DHH is holding long. 

Arrow Electronics, Inc. (ARW) is a provider of products, services and solutions to industrial and commercial users of electronic components and enterprise computing solutions. Arrow made Fortune's World's Most Admired Company list again last week.  Several analysts raised price targets on ARW in the last 30 days, as well as raising 2012 earnings.  Currently ARW is trading at a p/e of 8 and a forward 12 month p/e of 7. The 5 year projected growth rate is 14.5%, double the forward p/e and the industry trades at an average p/e of 17.5.  This profile fits in our Growth at a Reasonable Price (also known as GARP) category.  ARW options are not very liquid, but a buy/write strategy might be a good way to establish a new position nonetheless.  Entering a ARW with a buy/write strategy, and thereby reducing our cost basis, we could buy 100 shares of ARW (half our position) for approximately $39.20, sell 1 ARW Jun 2011 40 Call (ARW110618C00040000) for approximately $2.50 and sell 1 ARW Jun 2011 40 Put (ARW110618P00040000) for approximately $3.20. This would lower our cost basis by $5.70. 

Axis Capital Holdings (AXS), through its subsidiaries, provides various insurance and reinsurance products to insureds and reinsureds worldwide. It operates in two segments, Insurance and Reinsurance.  AXS beat the street expectations of $1.41 vs. $1.21 in its last earnings report and analysts have been raising earnings estimates for 2011 and 2012. It has a yearly growth rate of 15.5% and a forward p/e of only 8.5.  AXS also pays a 2.6% dividend.  We originally bought AXS in our virtual DHH portfolio on Sept. 9, 2010 for $31.86. AXS is currently trading at approximately $35.74. Its optons are very illiquid so we are not devising a buy/write strategy for this position. 

Gannet Communications Inc. (GCI) operates as a media and marketing solutions company in the United States and internationally. As a value stock (p/e of 7), it is a solid addition on the Long side, using Phil's buy/write strategy.  GCI is not a high growth company. We first added GCI to the virtual DHH portfolio on July 26, 2010 when the stock was at $14.52.  This stock gives a good example to how to use the buy/write strategy on a value stock that has little risk of a big move in either direction. DHH bought 1/2 of the exposure desired by buying the stock, and then sold a Jan $15 call for $2.25 and Jan $15 put for $1.75 (the put gives potential exposure to the other 1/2 position if the stock is under $15 at the time the put expires).  At expiration time, GCI had moved very little and the Jan $15 put was trading at $.49

The Jan $15 call expired worthless (as approximately 65-70% of option contracts do).  We bought back the $0.49 put rather than buying more stock for $15. With a realized gain or reduction to our cost basis of $3.51 ($2.25 + $1.75 - $.49), we effectively bought our shares of GCI for $11.01 ($14.52 - $3.51 = $11.01), a 24% discount.  

Holding onto our core virtual position, we sold an Apr $15 Call for $1.35 and sold an Apr $15 Put $.95 on Jan. 21, 2011.  Now that GCI has moved up to $16.26, if we were to enter GCI as a new position, we might buy 100 shares of GCI and sell 1 GCI Jul 2011 16 Call for approximately $1.75 (GCI110716C00016000) and sell 1 GCI Jul 2011 Put for approximately $1.50 (GCI110716P00016000). 

Ingram Mcro (IM) distributes information technology (IT) products and supply chain solutions worldwide. The company offers various IT products, including peripherals, systems, software, networking, and more.  It makes our list of Longs as a GARP stock.  The 5 year expected growth rate for IM is 15% and the stock is trading at a p/e of 9 in an industry that trades at an average of 15.  Analysts have been busy upping their estimates of quarterly and annual earnings for 2011 and 2012. 

We bought IM in the virtual DHH portfolio on July 26, 2010 at $16.81 along with GCI, and we used the buy/write strategy to enter the position.  IM is currently trading at approximately 19.94.  For those who don't already have a position in IM, a current buy/write strategy would be to buy 100 shares of IM, and then sell 1 IM Jun 2011 20 Call for $1.10 (IM110618C00020000) and sell 1 IM Jun 2011 Put for $1.10 (IM110618C00020000).  

Come back for part 2 later this week. 

Crazy Train Market: SKH and SCHS

Crazy Train Market: SKH and SCHS

By Scott Brown of Sabrient and Ilene

Heirs of a cold war 

That's what we've become 

Inheriting troubles I'm mentally numb 

Crazy, I just cannot bear 

I'm living with something that just isn't fair 

Mental wounds not healing 

Who and what's to blame 

I'm going off the rails on a crazy train – Ozzy Osborne                           

Two stocks in particular have given me (Scott) cause to turn to Ozzy in an attempt to put into song what I am feeling.  Monday started normally enough with Skilled Healthcare Group (SKH) reporting earnings.  SKH is in the top quartile of all stocks in Sabrient’s VCU rankings and a holding in Sabrient’s Investors’ Hedge (IH) portfolio, so I was particularly interest in the company's earnings and future guidance.    

 

Headlines from Reuters read “UPDATE 1-Skilled Healthcare Q4 profit beats Street estimates” which was no surprise given Sabrient's BUY rating and favorable research report.  Q4 was reported as +$.31 versus +$28 expectation and $220 million in sales versus $218 million expected. The CEO had positive comments on the quarter and year: "We are very pleased with our fourth quarter and 2010 operating results which I believe reflect the outstanding effort by our clinical and support teams in managing through the extraordinary changes in the Medicare program during the period.  I also continue to be impressed with the talent and passion of the individuals at our new hospice and home health agencies," noted Boyd Hendrickson, Chairman and Chief Executive Officer of Skilled Healthcare Group, Inc., "Consolidated revenue and adjusted earnings per share increased year-over-year in conjunction with the geographic expansion and revenue diversification from our hospice and home health care businesses, along with an increase in long-term care reimbursement rates."  

 

Additionally, analysts from Credit Suisse, Jeffries and Citigroup raised their price targets.  With this type news as the backdrop for the stock, SKH shareholders must have felt they were “living with something that just isn’t fair” as the stock tumbled -13% for the day.  “What's to blame?  I don’t know, but two days later SKH has fully recovered to close at $13.62, $0.17 higher than the close prior to the earnings release on Tuesday morning. In the meantime, SKH traded as low as $11.65 while “going off the rails on the crazy train.”  The two day swing aside, SKH appears to be a stock worthy of consideration using Phil's buy/write strategy. The industry trades at an average p/e of 18.12  and SKH has a forward p/e of 10.84 at today’s close.

 

Just as I was watching SKH “recover” from beating estimates and having analysts pile on with higher price targets, another stock came on my radar for opposite reasons.  School Specialty Inc. (SCHS) is in the bottom quartile of Sabrient’s VCU ranking and a SHORT in IH. So, again I was tuned in to the earnings, or lack thereof, on Thursday morning.  The headline news stated “School Specialty reports higher 3Q loss”.  The company didn’t guide higher for future quarters and just maintained its expectation of losing -$.30 to -$.60 for the year. The analysts weren’t too excited about 2012, as they have an average target of -$0.37 in losses on lower revenues than 2011.  But investors apparently were so enamored with the loss, expectations of more losses, and declining revenue, that they bid the stock up almost 20% on the day. “Maybe it’s not too late” and the next 48 hours will normalize the effects of this report, just as was the case (inverted) as SKH. 

 

Dark Horse Hedge is adding SCHS to its virtual portfolio as a new short position.  It is currently trading at $16.18.

 

Have we truly gone off the rails on a crazy train when what is good is bad and what is bad is good?  As I concluded writing this post, I see CNBC has a lead story titled, “What Will Kill a Bull Market? Good News”.

Rock and ROLL (those IM buy/writes)

Rock and ROLL (those IM buy/writes)

By Scott and Ilene at Dark Horse Hedge 

You’re looking fancy and I like your style
You drive us wild, we’ll drive you crazy

You show us everything you’ve got
Baby, baby that’s quite a lot
You drive us wild, we’ll drive you crazy
You keep on shoutin,

I wanna rock and ROLL all night – KISS

It is a wonderful season of the year and my personal favorite time of the month.  Next week is options expiration week, and we need to rock and ROLL our options another quarter, turning a quality stock into a nice yield in our VIRTUAL Dark Horse Hedge portfolio.  The DHH portfolio was created using a combination of Sabrient's research and Phil's Buy/Write strategies. 

On July 26, 2010 Dark Horse Hedge bought ½ position of Ingram Micro (IM) at $16.81 in its virtual portfolio.  We used Phil’s Buy/Write strategy to get into the position with a 15-20% discount as follows:

Sold the Dec $17.50 call at $1.60 - now trading at $1.00

Sold the Dec $17.50 put at $.90 - set to expire worthless

This reduced the net purchase price to $14.31. 

IM has been looking strong and we like its style -- earnings of $.41/share in the last 3 quarters. It's forecasting $.66 in the 4^th quarter.  IM is trading at $18.55 today and so we will let the Dec $17.50 put expire next week ($.90 profit) and buy back the Dec $17.50 call for approximately $1 ($0.60 profit).  Now we can roll our Buy/Write strategy to March and earn another $2.30 lowering our net cost basis in IM to $13.01. 

Buy to cover, IM Dec $17.50 call, next week at approximately $1

Sell: IM March $17.50 call, next week at approximately $1.65

Sell: IM March $17.50 put, next week at approximately $.65

Slow Murky Drip

Slow Murky Drip

By Ilene, with Sam Antar of White Collar Fraud

Yesterday, CNBC Senior Stock Commentator Herb Greenberg wrote a brief article on Green Mountain Coffee (NASDAQ: GMCR), pointing out that the language in its press release on Monday, December 6, 2010, has changed and, significantly, the company may have backed off its previous commitment to release its 10-K report by the December 9, 2010 due date.

Green Mountain’s Monday press release contained new language not found in previous press releases:

In conjunction with this announcement, GMCR will publish management's prepared remarks on its quarterly and annual results. These prepared remarks will be provided via a Current Report on Form 8-K and also posted under the events link in the Investor Relations section of the Company's website at www.GMCR.com. [emphasis added.]

Herb writes: 

Historically, Green Mountain has simply said that “management will review” results “and discuss future prospects” during a call that will last “about an hour."

Now it says that it will “publish management’s prepared remarks on its quarterly and annual results. These prepared remarks will be provided via a Current Report on Form 8-K. As a result of publishing prepared remarks in advance of the live call, the conference call will include only brief remarks by management followed by a question and answer session.”

Did I mention they said “prepared remarks?” The significance is this: the wording sounds very legal...

More significant, perhaps: Whither the 10-K? While the company mentions an 8-K, which is used to disseminate important information, there is no mention of the release of an annual 10-K.

Green Mountain’s 10-K report was due on November 24, 2010. On that same day, the company filed a Form 12b-25 with the SEC notifying it that Green Mountain will file its 10-K report 15 days late on December 9, 2010:

As described in the current report on Form 8-K dated November 19, 2010, the board of directors of Green Mountain Coffee Roasters, Inc. (the “Company”), based on the recommendation of the audit committee and in consultation with management, has concluded that, because of errors identified in the Company’s previously issued financial statements for the fiscal years ended September 29, 2007, September 27, 2008 and September 26, 2009 and the first three fiscal quarters of 2010, the Company will restate its previously issued financial statements, including the quarterly data for fiscal years 2009 and 2010 and its selected financial data for the relevant periods.

The restatement process has resulted in delays in obtaining and compiling the business and financial data necessary to complete the restatement and prepare the Company’s financial statements for the fiscal year ended September 25, 2010. However, the Company continues to expect to file its annual report on Form 10-K for the fiscal year ended September 25, 2010, including all restated financial statements, by no later than the fifteenth calendar day following the prescribed due date of November 24, 2010, or December 9, 2010. [emphasis added]

So Green Mountain which previously stated it was going to file the 10-K by December 9, 2010, may be backing out of that with some legalistic language that makes it unclear to the average reader.  Company press releases are usually checked and re-checked by attorneys before issuance, and changes in language are often done on purpose. The 8-K that it is preparing to file is not the same as the annual report, the 10-K, which is required.  Does this mean that the 10-K will be delayed again?

Is the company buying time with its press release rather than filing its 10-K?  The market doesn't seem to care as the stock rallied 7% yesterday. Maybe, it’s because investors think that Green Mountains problems with an SEC inquiry are over.

For example, yesterday, Michael Baron from the Street.com reported that:

Green Mountain shares jumped following the announcement of the restatement as the market fears of problems related to M.Block & Sons, the fulfillment vendor for most of the at-home orders of Green Mountain's Keurig business unit's single-cup business, proved unfounded. [emphasis added.] 

On November 19, 2010, Green Mountain claimed that its internal investigation found no wrongdoing in connection with recent restatements:

The internal investigation is nearly complete, and the Company continues to cooperate fully with the SEC. None of the financial statement errors implicate misconduct with respect to the Company or its management or employees. In addition, none of the financial statement errors are related to the Company’s relationship with M.Block & Sons, the fulfillment vendor through which the Company makes a majority of the at-home orders for the Keurig business unit’s single-cup business sold to retailers. [emphasis added.]

However, last week, convicted felon turned independent whistleblower Sam Antar noted in his blog that:

It is premature for Green Mountain to proclaim the absence of any wrongdoing while the SEC inquiry is still ongoing and it admits that its own internal investigation is not fully completed. The SEC inquiry began on September 20 and has not been concluded. That statement will come back to haunt Green Mountain if the SEC decides to conduct a formal investigation.

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.

I asked Sam Antar about Green Mountain's earnings call announcement and Herb Greenberg's recent comments. Antar replied:

It appears that Green Mountain's lawyers are being extra careful to choreograph and sanitize all information while the SEC inquiry continues. It sends the subtle signal that they are concerned about the SEC inquiry and that the company is far from being out of the woods.

My personal guess is that the SEC may start a formal investigation. With a formal investigation, the SEC can take testimony from witnesses such as Green Mountain's officers and employees of M. Block & Sons and subpoena documents from them.

Whether or not Green Mountain files its 10-K report on December 9, the SEC inquiry will continue to leave uncertainty for investors.  As for the 10-K, we'll see tomorrow. 

Green Mountain Coffee Roasters, Time to Spill the Beans?

Going through the SEC filing and press releases by Green Mountain Coffee Roasters led Sam Antar to ask Green Mountain Coffee Roasters, Time to Spill the Beans? Specific dates would make a good first step. - Ilene 

Courtesy of Sam Antar, White Collar Fraud

To truly exonerate itself after the discovery of certain material violations of Generally Accepted Accounting Principles (GAAP), Green Mountain Coffee Roasters (NASDAQ: GMCR) needs to come clean with investors and disclose exactly when it found certain accounting errors. In addition, Green Mountain needs to provide clearer and more transparent disclosures to investors about the Securities and Exchange Commission (SEC) inquiry and the discovery of those errors.

Timing of certain disclosures

On Monday, September 20, 2010, the SEC notified Green Mountain Coffee Roasters that it was conducting an informal inquiry and requested it voluntarily submit 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 with the SEC. In that same 8-K report, Green Mountain disclosed that it discovered an "immaterial accounting error" affecting financial reports issued from 2007 to 2010: 

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit. Management discovered that the gross margin percentage used to eliminate the inter-company markup resulted in a lower margin applied to the Keurig ending inventory balance effectively overstating consolidated inventory and understating cost of sales. Management determined that the accounting error arose during fiscal 2007 and analyzed the quantitative impact from that point forward to June 26, 2010.

As of June 26, 2010, there is a cumulative $7.6 million overstatement of pre-tax income. Net of tax, the cumulative error resulted in a $4.4 million overstatement of net income or a $0.03 cumulative impact on earnings per share.

After evaluating the quantitative and qualitative aspects of the error in accordance with applicable accounting literature, including Staff Accounting Bulletins published by the SEC, the Company, with the participation of the audit committee of the Board of Directors, has determined that the correction in the margin calculation represents a correction of an error in accordance with Accounting Standards Codification 250 Accounting Changes and Error Corrections, that the correction was not material to the fiscal years and the respective quarters ended 2007, 2008 and 2009 and that the Company anticipates that the correction will not be material to fiscal year 2010 and the respective quarters of fiscal 2010. As a result, the Company anticipates the cumulative amount of the accounting correction will be made in the quarter ended September 25, 2010. [Bold and italicized emphasis added.]

Green Mountain did not disclose exactly when it discovered the margin error but only that the margin error was discovered “In connection with the preparation of its financial results for its fourth fiscal quarter…..” Green Mountain’s fiscal year ended on September 25, 2010. Usually companies prepare for their year-end audits up to two months in advance.

Two scenarios

If Green Mountain had discovered the margin error before it was notified about the SEC inquiry, on September 20, 2010, why didn’t the company disclose the margin error to investors earlier, instead of waiting until it filed its 8-K report September 28, 2010?

If Green Mountain discovered the margin error after it was notified about the SEC inquiry, on September 20, 2010, why was the company able to find an accounting error within eight days or by September 28, 2010, when it didn't find the error during the previous fiscal years (2007 to 2010)? This scenario is possible, but it would be very coincidental.

The unknown timing of Green Mountain’s discovery of its margin error raises the question: did the company disclose the error to investors when it was discovered or did the company wait?

Green Mountain’s Common Stock Purchase Agreement with Luigi Lavazza S.p.A.

In that same September 28, 2010 8-K report, Green Mountain disclosed that it closed its Common Stock Purchase Agreement with Luigi Lavazza S.p.A. See below:

On September 28, 2010, Green Mountain Coffee Roasters, Inc., a Delaware corporation (the “Company”), completed a sale of 8,566,649 shares (the “Shares”) of its common stock, par value $0.10 per share (“Common Stock”), to Luigi Lavazza S.p.A., an Italian corporation (“Lavazza”), for an aggregate purchase price of $250,000,000. The sale of the Shares was effected pursuant to the Common Stock Purchase Agreement, dated as of August 10, 2010 (the “SPA”), by and between the Company and Lavazza. The execution of the SPA was previously reported by the Company in its Current Report on Form 8-K filed by the Company with the Securities and Exchange Commission (the “SEC”) on August 11, 2010, and the full text of the SPA was filed as Exhibit 10.1 thereto. 

In connection with the stock purchase agreement, Green Mountain provided certain warranties that the Company and its auditors have not identified and are not aware of:

(A) any significant deficiency or material weakness in the design or operation of internal control over financial reporting utilized by the Company; (B) any illegal act or fraud, that involves the Company’s management or other employees; or (C) any claim or allegation regarding any of the foregoing that would have a Material Adverse Effect. [Bold and italicized emphasis added.]

According to Statement of Auditing Standards No. 115:

.07 A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.

A material weakness in internal controls generally arises when accounting errors have a “reasonable possibility” of causing a company to restate its financial reports to correct those errors. A "significant deficiency" in internal controls arises when accounting errors are not material enough to cause a restatement of financial reports, but are instead corrected by making a cumulative adjustment to the latest period’s financial reports.

Initially, Green Mountain claimed that its margin error was “immaterial” and disclosed that it would correct that error by making a cumulative adjustment to its Q4 2010 financial reports, rather than restate its financial reports issued from 2007 to 2010. At the very least, that margin error appeared to result from a “significant deficiency” under auditing rules. It could be a breach of warranty under Green Mountain’s Common Stock Purchase Agreement with Luigi Lavazza, though Green Mountain never told investors that may have breached a key warranty under its agreement with Luigi Lavazza.

Green Mountain initially entered into its agreement to sell shares to Luigi Lavazza on August 10, 2010. On the following day, Green Mountain disclosed to investors that:

On August 10, 2010, Green Mountain Coffee Roasters, Inc., a Delaware corporation (“Green Mountain” or the “Company”), and Luigi Lavazza S.p.A., an Italian corporation (“Lavazza”), entered into a Common Stock Purchase Agreement (the “SPA”). Pursuant to the terms of the SPA, Lavazza has agreed to make a $250,000,000 investment (the “Investment”) in Green Mountain’s common stock, par value $0.10 per share (“Common Stock”), at a purchase price per share equal to the volume-weighted average price of the Common Stock for the 60 trading days before the closing of the Investment, less 7.5% (the “Shares”). [Bold and italicized emphasis added.]

Thus, Lavazza's "purchase price per share would be equal to the volume-weighted average price of the Common Stock for the 60 trading days before September 28, 2010, less 7.5% (the “Shares”).” If the share price were to have dropped prior to Sept. 28, it would be reflected in Lavazza's final purchase price.

Based on the agreed upon terms, Luigi Lavazza paid $250 million to purchase 8,566,649 shares, or an average price per share of $29.18 which was computed as follows:

$31.55 gross volume-weighted average price of the Common Stock less 7.5% discount or $2.37 equals $29.18.

On September 28, 2010, Green Mountain closed its Common Stock Purchase Agreement with Luigi Lavazza. Later that same day, after the stock market closed, the company finally disclosed the SEC inquiry and the discovery of the margin error to investors.

On September 29, 2010, Green Mountain stock dropped $5.95 per share to close at $31.06 per share, a 16.1% drop in market value that day in reaction to news of the SEC inquiry and accounting error. The stock continued to drop to $26.87 per share on October 11, 2010.

Green Mountain’s gross "volume-weighted average price" per share of stock in the sixty trading days prior to closing its Common Stock Purchase Agreement with Luigi Lavazza was about $31.55 per share. Apparently, if Green Mountain had waited to close the deal until after it disclosed news of the SEC inquiry and margin error, Luigi Lavazza would have paid less money per share to the company. This leads to the question: did Green Mountain purposely delay disclosure to investors of the SEC inquiry, the margin error, significant weaknesses in internal controls, and possible breaches of representations and warranties under its agreement with Luigi Lavazza?

Or did Green Mountain give early warning to Luigi Lavazza under the terms of their confidential agreement? (See Common Stock Purchase Agreement Section 7). In such case, did Luigi Lavazza not care about the probable negative impact on the stock price after the SEC inquiry and margin errors were disclosed to investors? And if so, why not?

More accounting errors discovered

Dark Horse Hedge - Super Rad, RDWR

By Scott and Ilene at Dark Horse Hedge - Super Rad, RDWR

All systems go
Soon the world will know
The fury of attack
Feel the wrath of 
The super rad super rad super rad
Su-per Rad!  - Aquabats

Scott came up with this song; it's hard to believe, but he managed to find a song to fit the post "Super Rad" and I won't say anything about "Super Bad," I'll leave that up to you. More from Scott...

We are feeling pretty super about Radware Technology (RDWR) after a 21% surge on Monday to $39.77.  The virtual Dark Horse Hedge (DHH) portfolio bought 100 shares of RDWR on November 11, 2010 at $33.39.  Using Phil's Buy/Write strategy, DHH sold 1 March 2011 $35 Call for $3.30 and 1 March 2011 Put $5.10, taking in a total of $8.40. 

One strategy at this point would be to sit still and keep the $8.40 option premium, and let the shares be called away at $35 for an additional $1.61 profit (total profit $8.40 plus $1.61 = $10.01)  But at DHH we “feel the wrath of the Super Rad” and would like to potentially enhance our return on RDWR given the suggested buyout price of $47.  Our virtual DHH portfolio will buy back the Mar 2011 $35 Call at the open, Tuesday, December 7, 2010 (at approximately $6.75) and sell the Jan 2012 $35 calls (approximately $9.25).  The added time element will be moot in a buyout as all positions would be settled at the time of acquisition.  The Put should expire worthless in this scenario so there is no need to do anything with it.  There is a rumor that HP may also be interested in acquiring RDWR which could cause a bidding war with Riverbend, if those rumors are indeed true.

Buy (back) RDWR Mar $35 call at the open, Tuesday, December 7, 2010

Sell RDWR Jan 2012 $35 call at the open, Tuesday, December 7, 2010   

Green Mountain Coffee Roasters: Gosh, We Ended Up Having Way More Accounting Errors Than We Thought « Going Concern: Accounting News for Accountants & CFOs

So naturally you shouldn’t rely on anything out there. Despite the discovery and disclosure of this massive fuckup and warnings from Sam Antar including some possible insider trading (it’s a theme today) and disclosure violations, an analyst at Bank of America Merrill Lynch thought it would be rad to upgrade the stock which has sent the price soaring. Why not, right?

In directly related news, anyone on the PwC audit team shouldn’t make any Thanksgiving plans.

Full article here Goingconcern.com

via ilene.typepad.com

GMCR: Despite End of Probe, Avoid Green Mountain Coffee Stock - Barrons.com

Although its accounting problems were not as severe as some investors had feared, Green Mountain faces numerous other obstacles that could hurt its stock price. Shares have more than quadrupled since the beginning of 2009, and are now trading at 30 times expected 2011 earnings. As we wrote when the SEC probe first surfaced ("SEC Probe Roasts Green Mountain Coffee"), investors who buy into Green Mountain now are taking on significant risk for an uncertain reward.

Certainly, Americans have a taste for high-end coffee, but competition in the space has increased significantly and consumers can get similar offerings to Green Mountain for less money.

Green Mountain's sales have boomed, jumping 64% in its most recent quarter on a year over year basis, primarily on the popularity of its Keurig single-serve coffee machines and packets. But expectations give the company little room for error. Analysts are projecting a 35% long-term growth rate.

Green Mountain isn't immune to the challenges that other coffee-makers are experiencing. Arabica coffee beans have been trading at 13-year highs, pinching coffee makers and sellers. The company also saw its inventories grow considerably in its most recent quarter on a year over year basis, and revenue growth has tapered off somewhat.

Full Baron's article here: online.barrons.com

Green Mountain Coffee Roaster: Sell or Celebrate?

By Ilene and Scott of Sabrient, and special thanks to Sam Antar of White Collar Fraud.

Green Mountain Coffee Roasters (NASDAQ: GMCR) has been at the center of controversy lately over certain accounting errors, an informal SEC inquiry, the questionable timing of insider sales, and a lingering patent expiration. Originally, on September 28, 2010, Green Mountain announced it was notified by the Securites and Exchange Commission (SEC) of an informal inquiry concerning “revenue recognition practices and the Company’s relationship with one of its fulfillment vendors.” At the same time, the company announced:

In connection with the preparation of its financial results for its fourth fiscal quarter, the Company’s management discovered an immaterial accounting error relating to the margin percentage it had been using to eliminate the inter-company markup in its K-Cup inventory balance residing at its Keurig business unit. Management discovered that the gross margin percentage used to eliminate the inter-company markup resulted in a lower margin applied to the Keurig ending inventory balance effectively overstating consolidated inventory and understating cost of sales. Management determined that the accounting error arose during fiscal 2007 and analyzed the quantitative impact from that point forward to June 26, 2010.

As of June 26, 2010, there is a cumulative $7.6 million overstatement of pre-tax income. Net of tax, the cumulative error resulted in a $4.4 million overstatement of net income or a $0.03 cumulative impact on earnings per share.

Initially, the company brushed off those accounting errors as “immaterial.” However, after the market closed on Friday November 19, 2010, Green Mountain disclosed that its internal investigation discovered additional accounting errors:

• A $1.4 million overstatement of pre-tax income, cumulative over the restated periods, due to the under-accrual of certain marketing and customer incentive program expenses. The Company also has corrected the classification of certain of these amounts as reductions to net sales instead of selling and operating expenses. These programs include, but are not limited to, brewer mark-down support and funds for promotional and marketing activities. Management has determined that miscommunication between the sales and accounting departments resulted in expenses for certain of these programs being recorded in the wrong fiscal periods.
• A $1.0 million overstatement of pre-tax income, cumulative over the restated periods, due to changes in the timing and classification of the Company’s historical revenue recognition of royalties from third party licensed roasters. Because royalties were recognized upon shipment of K-Cups by roasters pursuant to the terms and conditions of the licensing agreements with these roasters, Keurig historically recognized these royalties at the time Keurig purchased the K-Cups from the licensed roasters and classified this royalty in net sales. Management has determined to recognize this royalty as a reduction to the carrying cost of the related inventory. The gross margin benefit of the royalty will then be realized upon the ultimate sale of the product to a third party customer. Due to the Company’s completed and, when consummated, pending acquisitions of third party licensed roasters, these purchases and the associated royalties have become less of a factor, since the post-acquisition royalties from these wholly-owned roasters are not included in the Company’s consolidated financial statements.
• An $800,000 overstatement of pre-tax income, cumulative over the restated periods, due to applying an incorrect standard cost to intercompany brewer inventory balances in consolidation. This error was identified during the preparation of the fiscal year 2010 financial statements and resulted in an overstatement of the consolidated inventory and an understatement of the cost of sales.
• A $700,000 understatement of pre-tax income for the Specialty Coffee business unit, due primarily to a failure to reverse an accrual related to certain customer incentive programs in the second fiscal quarter of 2010. The over-accrual was not identified and corrected until the fourth fiscal quarter of 2010.

This time, the company announced that it will restate its financial reports to correct those errors. Apparently, in addition to the original $7.6 million in overstated pre-tax income, three overstatements totalling $3.2 million and one understatement of $0.7 million in pre-tax income were found, making a total overstatement of $10.1 million in pre-tax income.  

In its press release, the company stated: "The adjustments necessary to correct the errors will have no effect on reported cash flow from operations, and are not expected to have a material impact on the balance sheet. The estimated impact of these items for the restatement periods is expected to reduce cumulative net income by approximately $6.1 - $6.5 million and cumulative diluted income per share by approximately $0.04 - $0.05 per share." Thus, compared to Green Mountain's initial revision of revenue and earnings on September 28, 2010, the current estimates are for additional decreases of $2.5 million in pretax income, $1. 7 to $2.1 million in net income, an another reduction of $0.01 - $0.02 cumulative earnings per share. (Initial figures were $7.6 million overstated pre-tax income, $4.4 million overstatement of net income, and a $0.03 cumulative impact on earnings per share.)

Green Mountain also claimed that:

… these errors were discovered by management during the course of its preparation of the year-end financial statements and audit, as well as during the course of an internal investigation initiated by the audit committee of the Company’s board of directors in light of the previously disclosed inquiry by the staff of the Securities and Exchange Commission’s (“SEC”) Division of Enforcement.

We asked former white-collar criminal turned independent whistleblower, Sam Antar what he thought about Green Mountain's latest SEC filing. According to Sam Antar:

The company did not disclose exactly when it discovered certain accounting errors while it was preparing for its year-end audit for the fiscal year ended September 25, 2010, We know that initially on September 28, 2010, the company disclosed an accounting error relating to intercompany margins. It also informed investors of the SEC inquiry. Did Green Mountain insiders suspect that an SEC inquiry was coming?

On November 19, 2010, Green Mountain disclosed even more accounting errors. I wonder if Green Mountain would have discovered those additional errors if it weren’t for the SEC inquiry.

Meanwhile, SEC filings show two insiders unloading large amounts of stock in starting in August 2010. Usually, companies prepare for their year-end audits months up to 60 days advance. In this case, Green Mountain’s fiscal year ended September 25, 2010. The SEC will probably want to know exactly when Green Mountain discovered its initial accounting error and what those insiders knew before they unloaded their shares. Usually when a public company gives less than transparent disclosures, such as omitting the date it discovered accounting errors, it has something to hide.

On September 28, 2010, Green Mountain erroneously claimed that its intercompany margin error was an “immaterial accounting error.” That  error was in fact material under accounting rules, because the company was required to restate its financial reports to correct the error and other errors subsequently uncovered.

In addition, Green Mountain announced that none of the financial statement errors implicate misconduct with respect to the Company or its management or employees.  I asked Sam how much weight the self-absolution carries. According to Sam Antar:

Crazy Eddie conducted a similar internal inquiry into its own wrongdoing back in the day and proclaimed itself clean. At the very least, it’s irresponsible for Green Mountain to make such an assertion when the SEC inquiry has not been completed. The SEC inquiry began on September 21 and if the SEC finds wrongdoing this statement will come back to haunt Green Mountain.

There are still many uncertainties surrounding GMCR including the SEC investigation, insider selling, and competition on the horizon. The admission of accounting errors does not change our opinion of GMCR and we have decided to remain short in our VIRTUAL Dark Horse Hedge portfolio.