Money management can be one of the most interesting careers in the world. At best it gives you lots of unstructured time to think about how the world really operates – and to make bets based on your hypotheses. You get to conduct uncontrolled but real time experiments in the social sciences.
But never forget this is social science – not physics – and a little dogmatism about your rules or positions can result in getting it spectacularly wrong.
This was one of the more interesting places I have got it wrong lately – and so I thought I would write it up. It was also a surprising case of getting it wrong – because despite the analysis being totally stuffed I managed to scrape a (small) profit out of the trade.
The case involved three coffee companies (Diedrich, Green Mountain and Peet’s Coffee). I will explain what these companies do later – and how they are involved – but first I want to digress a little on the oddity of American coffee chains.
Starbucks failure in Australia
As an Australian the success of Starbucks (or Peet’s in San Francisco) puzzles me. Australia is blessed with a plethora of interesting and sometimes quirky, often very stylish cafes. For those who are interested here is a photo of my local (Bronte) strip of coffee shops. They are better than any strip I know of in New York, SFO or Chicago. The coffee is better too – and that is widely commented on by visitors to our shores.
It’s not that Australia is even a particularly coffee addicted country. Per capital consumption is not huge by developed country standards and is lower than the United States. We just have a better coffee scene.
It puzzles me why. There are awful lot of things that the United States does (substantially) better than Australia so this is an oddity deserving some explanation.
American coffee chains (particularly Starbucks but also some of the donut variety) have tried to break in and mostly failed. Starbucks closed most of its stores last year after multi-million dollar losses. They couldn’t cope with the Australian competition. Which is odd because in most things the US is a far more competitive market than Australia – and US senior management tend to be more battle hardened than their Australian peers (see my piece on the use of American CEOs in the Australian context). Its just the competition in cafes is far more fierce here.
I would love to be corrected – but I think the reason has to do with our wage structure. American low-end wages are very low indeed whereas Australia has minimum wages at quite high levels. Hiring unskilled labour to run a coffee shop according to a formula (and devoid of in-store entrepreneurial talent) works in America but does not work in Australia. Also entrepreneurial talent in America has too many opportunities to waste itself in a coffee shop – whereas small-time competent entrepreneurs will open a small coffee shop in Australia. [Maybe one of the good things about America is that it uses entrepreneurial talent well.]
Anyway this leads me to believe that some businesses that look bullet proof (running simple chains of shops which sell an addictive and brand loyal product) might actually be more vulnerable to quite strange social and economic trends than you would think. Coffee shops look impregnable (and Peet’s typically trades with a 30 times price earnings ratio) but coffee shops can be beaten back by small entrepreneurial talent for reasons that are hard to articulate.
The Green Mountain Keurig Cup
Another thing that coffee shops are vulnerable to is easy-to-make-at-home quality coffee. Nescafe and other instant brands distribute a large amount of caffeine – as for that matter does the Coca-Cola company. But against a well made espresso (diluted with frothy milk to taste) it just can’t cut it. Our funds management business requires its morning coffee (which we buy from an excellent and entrepreneurial local cafe). That said – American coffee is just not that special – and perhaps is more vulnerable than you think.
One thing it is vulnerable to is the Keurig Cup (or K-cup). K-cups are a plastic and coffee device you put in a special espresso machine and it makes you – instantly and with minimum mess and fuss – a very good espresso with very few traps for the unwary. Its certainly a better drink than instant – and matches in quality a better cafe (though there are some tricks with milk frothing that the k-cup does not match).
K-cups are a truly amazing business. Once you have sold the machine you get to sell the cups (an addictive product no less) ad-infinitum with astonishingly fat margins. And you don’t need to rent expensive real estate to do it. This is like cigarettes – but with a growing market and without the litigation (and without actually killing your customers).
The first time I saw a k-cup was when a pretty young woman in a department store offered me a free coffee (brewed in a k-cup). I noticed the razor-and-blades business model and determined that I did not want to be a sucker to that machine. Alas – and to my endless shame as a stock picker – I did not even consider buying shares in the company which owned the k-cup business. After all as a stock-picker you would really want to be on the receiving end of a razor-and-blade business selling a new addictive product.
That company is Green Mountain Coffee Roasters – and – since I first saw the machine the stock is up over five thousand percent. A five thousand percent gain would – of course – somewhat have improved my finances and the finances of my clients...
The attraction of the k-cup business is not unnoticed by the market – Green Mountain trades at a PE ratio around fifty. Still that is less than one times earnings on the price it was when I first saw a k-cup.
The k-cup license holders and Diedrich Coffee
Four companies have licenses to produce and sell k-cups. Only one of those companies (Diedrich) is listed. A license to sell k-cups is a license to share to some extent in Green Mountain’s very rapid growth however the terms with which you share are unknown. As a default position I would expect that Green Mountain – the technology holder – would extract its pound-of-flesh for granting such a license and whilst a license holder might grow very fast you would not expect it to be outrageously profitable. However – as I said the terms of the license are unknown and have never been published. If Green Mountain – in the infancy of the k-cup business – gave out the licenses on stupid terms then owning one of the four licenses to produce k-cups would be getting most of the benefit of being Green Mountain – but without even the expense of subsidizing the espresso machines or of hiring the pretty-young-woman sales people to sell new espresso machines.
It seemed however unlikely to me that Green Mountain – who have a truly fantastic product – would ever have signed a contract with Diedrich – or anyone else for that matter – which was truly unfavourable. After all Green Mountain held the aces.
Moreover Diedrich has truly strange accounts. It was an unsuccessful owner of a coffee shop chain (Gloria Jeans) which they sold off and the balance sheet has about 50 million in accumulated losses. Sales were flying – but half those sales were back to Green Mountain (for whom they out manufactured product). Moreover the accounts were truly strange in other ways (it was for instance very difficult to get a handle on tax expense). There was a truly frightening article that appeared on Seeking Alpha which went through the accounts in great detail – and – if you took all the suggestions in that article at face value – then you would probably conclude that Diedrich was a fraud. (The Seeking Alpha article has since been removed.)
None of that stoped Diedrich being a truly explosive stock – indeed before I had even looked at the stock (and in about six months) it has gone from 21c to just over $30. You don’t need too many of them in your lifetime…
Now this move looked truly bizarre given (a) the fact that it did not even own the k-cup technology and (b) the bizarre accounting as outlined in the Seeking Alpha article.
I thought (possibly incorrectly) that Diedrich was probably a stock-promote rather than a business as per the suggestion in the Seeking Alpha article – but I did not bother to do any of the work to prove or disprove that case. That work came later.
The Seeking Alpha article was anonymous and hard to verify (as discussed below).
The danger of shorting frauds
The reason I did not do any of the work to confirm or deny the Seeking Alpha article was that shorting frauds (especially well publicised frauds) is possibly the most dangerous thing you can do on Wall Street. Take for example a fraudulent oil company in Africa – but one that really has some oil. The company has oil – so it can show flows to visiting analysts. It has pictures and local politicians are excited to hob-nob with the management. But there is no real way of telling whether they have 1 million barrels or 10 million barrels. They may have 3 million barrels (which would be valuable – but not earth shattering) but tell the market they have 20 million barrels. There really are very few ways to tell – and if they are determined they can exaggerate at will. Moreover suppose you have worked it out (or at least have suspicions) – it doesn’t help you. If someone is going to fake the existence of 17 million barrels of oil there is not much that stops them from faking the existence of 170 million barrels of oil. If you are short and they “announced” a 100 million barrels (or a few trillion cubic feet of gas) and the market believes them then you are stuffed. The stock could go for a monstrous run – and you will be forced to cover at a shocking loss.
The problem with shorting frauds is that there is nothing to keep the fraud grounded – and hence there is nothing to limit your losses. If you short a real company (say Dell) and Dell sells less computers than it anticipated it will tell the market. The stock will probably go down. If it sells more computers than anticipated at better margins the stock will go up. But it is vanishingly unlikely to sell ten times as many computers as anticipated. You can be short and whilst you might lose money if you are wrong you will not do serious damage. Frauds – because there is nothing to keep the claims grounded – can cost you an enormous amount as a short.
There was a possibility that Diedrich was a fraud – but it was a high-growth with a substantial short interest. There was simply no way that I was going to short it because the potential losses looked vast. Given that I did not bother to fact-check the Seeking Alpha article.
The rare safe time to short a fraud
There is only one time that it is relatively safe to short a fraud – and that is when a real company is suckered into buying it. That happens – and the cannon-example was when Mattel purchased The Learning Company.
The Learning Company (TLC) was (and remains) a children’s educational game software maker. It has real games and real sales. In that sense it was similar to my African oil company with a few million barrels. It however had accounts which were peculiar – and several short sellers were convinced it was mostly fraudulent. [I had never heard of the company so I cannot vouch for their views.]
Eventually Mattel purchased TLC. The purchase was made from weakness. Mattel used to have a great franchise in toys for young boys (think Matchbox cars). There is simply no way I could interest my nine year old in Matchbox cars anymore – not when they have a Playstation or a Wii. Boys toys were dead and computer games killed them.
Mattel was desperate to join the computer game revolution – and it paid a fortune for what really was a dodgy property. The losses were in the billions. Wikipedia tells the story quite well. It was one of the worst acquisitions ever on Wall Street – and not only did it cost Mattel over 3.5 billion (mostly in stock) but it revealed the underlying (and fundamentally incurable) weakness in Mattel’s business. It also cost the CEO (Jill Barad) her job. Jill made her career promoting and marketing Barbie dolls and her claim to fame was that she was brilliant – possibly amongst the best ever – at marketing bimbos. (A company insider once noted to me that that included herself.) Jill was however absolutely useless at assessing a computer game company. [Personally though I think she should have been kept on as CEO but limited to Barbie… She really did deserve that job and did it well.]
A short seller’s dream is when a real company – preferably one which is a little dopey and in an old industry (matchbox cars as compared to computer games) buys something hot, sexy and fundamentally dodgy.
Peet’s bids for Diedrich
I thought I had my own repeat of Mattel and The Learning Company. Peet’s – a well run but simple coffee chain around the Bay Area bid cash (debt funded) and stock to buy Diedrich. Ah – here it was – a simple company with a simple model – whose margins seemed to be declining (for reasons I have not fully identified) which bids for a well promoted company with massively complex (and potentially misleading) accounts.
To say I was excited is understating it. This is precisely the sort of thing that excites a short seller. At worst what would happen was that Peet’s – a company with less than 200 coffee shops (and owning only the brand and fittings) would have roughly 140 million debt and a business (Diedrich) that – depending on the contract with Green Mountain – might not be worth very much at all.
In the bad-case Peet’s stock – trading at 30 times earnings – could lose 80 percent of its value. [That was what happened to Mattel.]
So I did some work. I went back to the Seeking Alpha article and tried to verify every claim in it. Alas I could not. There were a few simple (and innocent) explanations for some of the red-flags highlighted in the Seeking Alpha article. However with respect to some of the claims in the article I had to acknowledge that the author had a point. He wasn’t right with respect to everything – but he was right on some points. Diedrich’s accounts were (and still are) pretty aggressively stated.
I shorted some Peet’s. Not a lot – but maybe a third of the final position I hoped to have. I intended to do a little more work (especially as the debt covenants were published). Besides – in the Mattel case there were many quarters as The Learning Company disaster unfolded. There were plenty of opportunities for a short seller in Mattel to test their thesis on the way down. This was a small position – but as it unfolded I hoped to make it a big position.
Now the observant will notice there is a missing detail. I still do not know the terms of the contract between Green Mountain and Diedrich. If the terms are highly favourable to Diedrich then shorting Diedrich (or the new owner of Diedrich) is spectacularly misguided. In that case Diedrich is just a cheap way into Green Mountain’s (fantastic) business.
Not knowing the terms of that contract was the key weakness in all of my analysis. And I knew it.
Peet’s had a conference call when they announced the purchase. They indicated that the terms of the contract were acceptable but they refused to detail what they were. Paraphrasing Mandy Rice Davies “well they would say that wouldn’t they”.
What I was looking for in future quarters (as a guide to increasing the position) was evidence that the Green Mountain contract was favourable to Green Mountain.
Well I was wrong
I started this by stating that most of the analysis was wrong. And it was – in a very specific way. My biggest concern was always the contract Green Mountain had with Diedrich. And only one party outside Diedrich knows that contract and understands its economics intimately. That is Green Mountain.
And they proved me wrong. Green Mountain overbid Peet’s for Diedrich - $30 per share – all cash.
Oops – now I know I am wrong. Green Mountain wants to bring that contract back in house. They want it in-house for about a quarter of a billion dollars in cash! Remember ultimately all that Diedrich has is a few tax losses, a small manufacturing facility for K-cups, a couple of second-rate coffee brands and THAT CONTRACT.
Peet’s overbid – bidding $32 a share ($20 in cash the rest in stock). Green Mountain upped its bid to $32 per share ($265 million) all cash. Remember this stock was trading earlier this year under 25 cents! This is one hell-of-a-valuable contract.
Needless to say events have shown I was wrong about Diedrich with respect to the only thing that mattered (the worth of the k-cup contract with Green Mountain). I covered my short and thanked luck that it was not (much) worse.
Of course this bidding war drove down the value of Peet’s stock. So I was wrong and made a small profit.
Money management – lucky or smart?
Given I was wrong I can hardly say I was smart. But Peet’s was not a bad candidate for a short. It has a very thin balance sheet (almost all profits have been used to buy back stock). It does not own the sites of its stores. It was paying cash so it was going to incur debt with only intangible assets (its brand really) to back that debt. And it had a 30 PE.
Given all of that I could be wrong in lots of ways but still make a profit.
But I should not get carried away. I was wrong – proven wrong – and the profit is nice but it shouldn’t be used to ignore the fact that my hypothesis was simply inconsistent with observation.
Back to scratching around (often fruitlessly) for things that might make money.