Monday, April 26, 2010

GMCR: Why I Worry Little About the Patent Expiration

Update 9/28/2010: I have been getting a lot of hits today from a number of prominent asset managers after the SEC announced inquiry into GMCR's dealings with a "fulfillment vendor", most likely M Block and Sons. There have been allegation about channel stuffing for a while, as I note in the last paragraph, because a number of the short theses that I had seen question the relationship. This article has very little to do with the allegations: I refer to them only in the last paragraph+comments.

Original article. 

There is a lot of noise about the expiration of the k-cup patent protection in 2012, and its impact on Green Mountain Coffee Roasters (GMCR). Of all the possible problems with GMCR, this one is not a priority, in my view. (I have no position in GMCR but this can change at any time.)

Let's talk about patents first. Patents provide protection for inventions and are good for a certain number of years. Patent protection is crucial to human progress as it provides incentives for people and companies to go out and develop new things, as the inventors can reap the benefits of their efforts. There are certain industries in which patent protection is of paramount importance: pharmaceuticals for example. A patent-protected drug is a gold mine, de facto a monopoly. This is why one of the crucial metrics in valuing the large pharma companies is how many drugs they have that are coming off protection in the next few years. Patents are also important with tech companies and some industrials for the same reasons.

Enter GMCR. GMCR's spectacular performance is due to the success of its Keurig brewer system. The company sells the machines at cost, and then sells really expensive "k-cups" (vacuum-packed roasted ground coffee) that work with the machines. The company describes the model as "razor-razor blade". I prefer calling it a Trojan horse (but this is good from a shareholder perspective). A bit of history, the company did not invent Keurig. They had a relationship with them that culminated in GMCR acquiring Keurig a few years ago. Keurig had licensed out the production of the k-cups to several roasters, including GMCR. GMCR has been working at bringing the k-cup production under its roof by acquiring the licensees, most notably the pending DDRX deal. It has been dragging but once done, GMCR will have only one licensee outstanding, a private company up in Montreal. 

So the fear is that once the k-cup production patent expires in 2012, everyone will start making k-cups, suppressing GMCR's margins. I think that the importance of this expiration is overstated, and drawing parallels between a patent expiration event in pharma to this is misplaced. Here's why.

Look at the consumable products that you use in your daily life (including coffee) and think whether patent protection plays a major role. Are there cheaper cognacs than Hennessey? Sure. Do you drink them? No. Are there cheaper cigarettes than Marlboros? Sure. Are there cheaper chocolates than Lindt? Are there cheaper sodas than Coke? You get the picture. Very simply, you do not make consumption choices guided by price alone. What is the common thread in these examples?

Bingo. It's brands. None of the brands mentioned above are patent-protected and, yet, somehow, they are doing more than OK. This- in my view- means that it will be difficult for a non-major coffee brand to compete with GMCR for shelf space in the stores and for mindshare with the consumers. People who would buy a Keurig machine are already (1) higher income (paid $100+ for a machine vs. $10 Mr Coffee drip brewer), and (2) bought the machine precisely because they like good coffee. So I think that this eliminates the non-brand competition.

Now let's look at the potential major brand competition. What are the major coffee brands? Store: Folgers (SJM), Maxwell House (KFT), Taster's Choice (Nestle); Retail: Dunkin, Starbucks, Seattle's Best (also SBUX), Caribou (CBOU); Office: Flavia (Mars). There are a lot more brands at the regional and local level, however, to be a threat by 2012, the brand should have national visibility and distribution at this stage.

You may not know it, but Kraft, Sara Lee, Mars and Nestle have their own machine systems in existence for years: Tassimo, Senseo, Flavia and Nespresso, respectively. So the competition has been around for a long time. Of the major brands that I list above, Folgers (and related, like Millstone) and Caribou are aligned with Keurig, Starbucks is aligned with Sara Lee, and, obviously, the Kraft (Maxwell, Gevalia) and Nestle brands are with their own. This leaves only Dunkin out to the best of my knowledge. So, even with an expired patent, I do not see a major threat to the k-cup system from the branded competition either. Sara Lee is trying to do something like that with the Nespresso capsules in France but there they have major brand presence compared to the US.

Finally, you have the game theory bit. Even if you have a well-capitalized, popular brand enter the space, this does not mean that they will compete on price. If you look at instant coffee, for example, the only major new entrant (SBUX) is more expensive than Nestle, even though the margins are good. Players understand that competing on price simply shrinks the profit pool for the manufacturers. Further, an entry into the space by a well-known brand might even be beneficial to the wider adoption of the machines, which does help GMCR (a network effect of sorts).

So the patent expiration is not high on my worry list. If I were a GMCR shareholder, I would be a lot more worried about (1) compression of the earnings multiple, (2) dilution, (3) input costs, (4) integration issues, (5) the DDRX tender offer, (6) alleged channel stuffing, (7) the ongoing drop in average kcup usage per machine, (8) office market penetration, (9) growth/maturity issues, and so on. ***PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US

Saturday, April 17, 2010

Corporate Governance Malpractice Case Study: Kraft Foods

In the earlier article about Kraft, I discussed at length the potential benefits and dangers of the combination with Cadbury. To summarize, I was mildly positive on the transaction as it provides a diversification away from KFT's commodity business. Additionally, I provided some color on Kraft's subpar performance vs. its comps. Pershing Square/Ackman came out with a presentation saying a lot of the same things a few days later but with the view that one should be long KFT into the transaction. Today's missive is about Kraft's problematic corporate governance and its link to shareholder value destruction. I have no position in Kraft Foods but this can change at any time.

One of the "textbook" problems in governance is the so called "agency" problem. Many years ago, when most owners ran their businesses, they made sure that things were running for their benefit. As businesses got bigger and more complex, the owners saw fit to bring in professional managers to run things for them. This is today's equivalent of the shareholders and the managers. And the relationship gives a rise to the "agency" problem. The interests of the managers are not always aligned with the interests of the shareholders. If you are a manager, you want to do as little as possible for as much money as possible. The shareholder wants the exact opposite. Since it is impractical for the shareholders to supervise managers, shareholders elect a board to keep an eye on the managers, set goals, set comp, hire, fire, vote on major decisions and so on. The most powerful position on the board is the board chairman (but you already knew that). Obviously, a hallmark of good governance is the separation of the chairman and the CEO role. After all, the board is supposed the defend the shareholders' interests, and the chairman should be spearheading the effort.

Enter Kraft Foods. The company brought in Irene Rosenfeld, a professional manager, from Frito-Lay in June 2006. She also became chairman of the board in March of 2007, and if you do not think that the chairman role was a part of the initial deal, you should keep your money in an index fund. The chairman has strong influence in the selection process of other board members. Since Mrs. Rosenfeld's appointment as a CEO (remember the high likelihood of her chairmanship being a part of the deal), the following individuals have joined the board: Mr. Banga (1/07), Mrs. Hart (12/07), Mrs. Juliber (11/07), Mr. Ketchum (4/07), Mr. McDonald (1/10), Mr. Reynolds (12/07), Mr. von Boxmeer (1/10), Mr. Zarb (11/07).

You might be asking yourself, was there a "friends and family" discount for Kraft board memberships? It sure seems this way: only 3 board members pre-date Mrs. Rosenfeld (vs. 8 post-2006). One also wonders about issues like continuity. More interestingly, management's compensation is set by the compensation committee of the board. Who are the members of the comp committee? Well, those are Mr. Banga (Chair), Mrs. Juliber, Mr. Ketchum and Mrs. Wright. Three out of four are "Rosenfeld appointees," so to speak. Last year, Mrs. Juliber's seat was held by Mrs. Hart, another "Rosenfeld appointee."

The only non-Rosenfeld member is Mrs. Wright, who, according to the proxy materials, is qualified to serve on KFT's board, in part, because she is the CEO of Carver Bancorp ("CEO of a federal bank"). You might be forgiven if you have never heard of Carver: their market cap is $21 mm. Yes, that is twenty-one million dollars, 2,000 times smaller than KFT's. They have 9 branches. She is also on a few non-profit boards, including The Sesame Workshop. Oreo cookies, Cookie Monster. You get the picture.

A cynic might call this board composition "stacking the deck." There is no way they would get tough on management. But cynicism alone is not a good investment approach, so let's look at some numbers from Kraft's latest proxy. I am looking just at actual comp, not at the golden parachutes and other uncertain/potential provisions, nor am I looking at the pay % based on "adjusted" measures.

How has the board done in the past with defending the shareholders' interests by rewarding performance and aligning incentives?

Rosenfeld total comp for 2007: $13.5 mm; 2008: $18.7 mm; 2009: $26.3 mm

So, Mrs. Rosenfeld doubled her income between 2007 and 2009. Not bad at all, I wish I could do the same thing. Surely the shares must have done very well if what should be largely a fixed cost is so variable on the upside.

How did Kraft shareholders do during the same period?

Kraft Foods share price: Jan 1, 2007: $31.45 Dec 31, 2009: $26.92 (both adjusted for dividends received, looks much worse without, $35.61 in '07 to $27.18 in '09).

You can judge for yourself. Like they say, where are the shareholders' yachts? And the shareholders pay the board members $250- $270k per year for this.

The increase in the 2009 compensation was justified with "Ms. Rosenfeld’s leadership in executing on the formal bid for Cadbury in November 2009 and closing this complex deal in early 2010 as exceptional" (this quote is the #1 reason given).

My guess is that the board did not bother with the question "what if the deal is ultimately value-destructive and how are we going to measure it, and how are we going to adjust comp if the deal turns out to hurt shareholder value?"

But wait, there is more, just like in a Billy Mays infomercial. Note that the board describes the leadership as "exceptional". Is it? Here are some recent developments to keep in mind. Also remember that the deal was uncontested: there were no other bidders.

During the due diligence process, Kraft had missed a substantial pension liability with some of Cadbury's UK workers and ended up forcing 3,600 workers to opt out of the plan or to have a 3-year pay freeze. During the bidding process, Kraft also lied about not planning to close the Somerdale factory: KFT changed its mind post-takeover, based on unknown new production capacity in Poland (if I remember correctly). While this has not been reported widely in the US, the scandalous takeover the iconic British candy marker led to Parliament hearings (!) during which Kraft promised NO more job losses in the UK for the next two years. Further, the EU mandated that Kraft divest some product lines in some geographies.

Poooof! This is the sound of your mythical "synergies" disappearing. You could add paying 100% more than the 52-week low for Cadbury's stock. "Exceptional leadership" in deed.

Here's something else, from My Investing Notebook, Jamie Dimon of JPMorgan possibly takes a stab at Kraft in his latest shareholder letter: "We do not pay bonuses for completing a merger, which we regard as part of the job. When the merger has proved to be successful, compensation might go up." Cold.

So, is it any wonder that Buffett, KFT's largest shareholder, is upset? There might be more to his displeasure than just the use of KFT stock in the acquisition.

Monday, April 12, 2010

The Value of Counter-intuitive Thinking

 This article was a featured link on The Reformed Broker's Hot Links.

There is this anecdote about the Battle of Britain (if you slept through history class, this was largely an air operation). After every mission, the planes that came back would be inspected for bullet holes and subsequently repaired and strengthened in the areas that were hit. Makes sense, right? It did, until someone pointed out that the ground crews should be more concerned with the areas of the planes that did NOT have holes in them: the planes that were hit there simply never made it back... This is a fine example of counter-intuitive thinking.

Here are my not-so-fine thoughts on a number of policy and other initiatives that might benefit from some counter-intuitive thinking (that is, counter to what seems to be the mainstream view). As long-time readers know, I belong to the Garage Logic University school of thought, so pardon any inconsistencies with what your advanced econometrics professor told you.

As a country "we need":

(1) A "jobs" bill: no, we do not. It is scary, arrogant and delusional to think that "jobs" can be created by decree. Central planning has failed over and over again but apparently this is beyond the comprehension of many of our elected representatives. The government should ensure that there is a fertile soil, and let the collective efforts of the market participants decide what the next growth industries would be. What would have happened if Congress, years ago, had decided to protect jobs in the horse and buggy, abacus, whale oil, vinyl record and candle industries?

(2) A healthcare reform bill that expands "access": no, we do not. There is no problem with access: there are no waiting lists, that I know of. The problem is cost. Cost=price. This means that there are issues with supply and demand. The thing that passed does nothing to increase supply, and does nothing to decrease demand (not even the simplest things, such as a minimum mandatory out-of-pocket copays for any office visit, a cap on malpractice liability and transparent pricing). Oh, and don't forget, it uses 10 years of taxation for 6 years of spending to be "neutral". It would be laughable if it these clowns (one thinks that Guam will capsize if there is more US troops there) were not in a position of real power.

(3) To encourage consumer spending to "help" the economy: no, we do not. Higher consumption (along with higher taxation) hinder capital accumulation. Having more capital is a good thing, not a bad thing. An added bonus, the joy coming from an acquired object drops very quickly post-acquisition, we just get used to having the object, and we lose the option of spending the money on something else.

(4) To keep zero interest rates to "help" the economy: no, we don't. Everyone loves free money, but this discourages savings. The rebound in banking profits is simply the expropriation of value by the banks from the savers. Greenspan waited for way too long to raise rates in the '00s, and it surely seems to me that Zimbabwe Ben is repeating the same mistake. ZIRP, the last time around, also had other undesirable effects, such as high housing inflation in select markets and the now-infamous "reach for yield."

(5) To increase government spending to "help" the economy: no, we don't. To begin with, the government must take the money from its rightful owner, the earner, via taxation. I am not sure that bureaucrats spending other people's money can make better spending decisions vs. people who spend their own hard-earned money. Second, since we have a huge budget deficit, the increase in spending has to be borrowed. When you add the shocking lack of political will to do a real entitlement reform, we are creating "path dependent outcomes". Simply put, the financial mismanagement of the last and the present administrations has cut the number of options that will be available in the future.

(6) To subsidize "green energy": no, we don't. If a certain technology is not ready for the market, then may be it should not be in the market. Last time I checked, there were no rebates for people buying iPhone apps because it is such a cool new efficient technology, and, yet, there were billions downloaded. Why? Because it makes sense to download apps that make you more productive (for example). The sad truth is that neither solar nor wind can have utility-level reliability. Further, with 50% of the current energy coming from coal, that electric plug-in is not the zero-emission vehicle it is sold as. Finally, with solar panel and car battery efficiency dropping with age, exactly what are the recycling implication? Or there will be a "hybrid car battery recycling tax" levied on all drivers that dare not to buy a Prius (on top of the tax subsidy for purchase)?

(7) To pass "cap and trade" legislation: no, we don't. The man-made global warming has been exposed as the single largest science fraud of our times. Further, carbon dioxide is an essential part of the carbon cycle, this is the cycle of life. The creation of a "carbon credit" to trade is simply a transfer of value from the productive segments of society to the financier class. Personally, I am all for fuel efficiency and mass transit: a driving commute is largely unproductive time from an economic perspective, but personal views are not necessarily a good starting point for a larger policy.

(8) To help stem the foreclosure tide: no, we don't. If anything, foreclosures should be accelerated. Instead of throwing good money after bad, the government should cut its support of the housing market. This way the speculators will get flushed out, and the prudent participants will be rewarded. Further, as the market finds its ground, this will, shockingly, spur more investment. Finally, more foreclosures will actually enable the home-borrowers (not "owners" btw) to move to where the jobs are: the mobility of the US labor force has been severely constrained over the last two years because of the real estate problems.

(9) To pass comprehensive financial reforms legislation: no, we don't. I can see something dealing with the Too Big to Fail problem, but outside of that, we need actual enforcement of existing regulations (instead we have SEC staffers surfing porn all day, and getting reassigned, not fired!). To wit, the costliest problems have come from institutions that were already heavily regulated and, on top, were dealing with heavily regulated products, such as mortgages. The biggest blow-ups (Lehman, Bear, Merrill, Fannie, Freddie, AIG, Ambac+friends, Countrywide+friends) have led to virtually no persecutions or convictions: normally "professionals" are held to certain standards, and doctors/lawyers/dentists/architects are sued if they fail to meet them. I do not see the equivalent level of responsibility with financial "professionals" at all levels, from Frauddy N. Komish, a mortgage broker, to Trancheè M. Bonusky, the guy who knowingly stuffed the MBS with garbage, to Mr. Bonusky's bosses, who were in on the 'bezzle and then some (i.e. the repo 105 crowd).

So, there it is, 9 areas that can benefit, in my humble view, from a counter-intuitive look that goes beyond the knee-jerk, soundbite non-logic that seems to dominate. Criticism and your own examples are always welcome.

(PLUG: the author of Barbarian Capital blog is available for the right consumer- or inflation-focused analyst opportunity within the US)