Sealing the Lid on The Container Store’s growth

The Container Store (TCS) went public in November 2013.  Despite being founded in 1978, the company has a young culture and feeling. TCS is a specialty store of storage and organization products and is best known for its Elfa closet system. (See company history for additional background.)

I remember the first time I heard of The Container Store. I was looking for a small apartment and my realtors’ sales-ladies were raving about the company. So after I bought my studio I checked out the local store and fell under its spell. Even though I’m a non-shopper, I was very excited and walked around the store for hours. While it’s true that one can buy many of TCS’ products at a Target, Walmart, etc., I was there to purchase a closet system. The Container Store’s customer service is second-to-nothing. I wanted a closet system that was efficient, built-to-order, yet customizable for the next purchasers of my studio apartment. I bought two systems and have been happy ever since.

For years I kept TCS in the back of my mind hoping the company would go public.  When they IPOed in 2013, I was ready to purchase shares in a company that I admired. I generally don’t invest in Retailers given the industry’s over saturation and increasing internet penetration (i.e., competition). However, The Container Store, to me, was a one of a kind specialty retailer with a strong mission and culture, akin to a Whole Foods Markets or Starbucks. TCS founder Kip Tindell (who roomed with John Mackey at University of Texas) is a founding member of Conscious Capitalism which is a group of companies, academics etc…moving business towards an active conscious culture.

The Container Store is guided by a set of seven values-based Foundation Principles.  Several of these are focused on employees, of which receive intensive training (~ 260 hours first year training) and above-average benefits & compensation. In fact, TCS’s first and foremost stakeholder is not the investor, or even customer. It’s their employees – this is something I’ve never seen from ANY company, but which appealed to me as a Socially Responsible Investor.  It’s also surprising that a private-equity firm LBOed the company (2007) while retaining this “high-maintenance” cost-structure.

Industry Structure/Growth:
TCS’ sharp price decline (down 50% from its peak) drew my attention. I usually examine the Industry first because individual stocks tend to move in lockstep with their respective industry. The Container Store operates in SIC no. 5700 – typically called Home Furnishings.

Porter’s 5 Forces Model

These have been good times for the Home Furnishings industry thanks to ultra-low mortgage rates, improving economic growth, increasing housing turnover (i.e., existing home sales) and rising home prices. Higher prices allow consumers to take home-equity loans, of portion of which is partly used for renovations. Industry size is large (over $200bn) though Home Organization Products are estimated to approximate $9bn and are forecast to grow 3.5% annually through 2019, according to Freedonia Group.

Industry Structure, using Michael Porter’s 5 Forces model is above-average. The Container Store is the only specialty home organizer company, other competitors are long gone. Its highly trained (and expensive) sales force acts as an entry barrier to competitors. Bargaining power of suppliers is low as the company is vertically integrated via its ownership of Swedish-based Elfa Products. Bargaining power of TCS’ customer-base is lower than average.  Its customers are similar to those seen wandering the aisles of Whole Foods or buying Lululemon gear for their Pure-Yoga workout. These are 30-40ish, highly-educated, affluent, busy women.

Half-time report:
So, before reading on, let’s do a quick summary.  Here we have a cool company, that customers like and employees love. They’re the leader in their industry, which continues to grow. Industry Structure is above-average and TCS’ shares are now 50% off their peak. This must be the buy of a lifetime. Well, not so fast!

“Execution is Everything” – Jeff Bridges
While The Container Store looks great on paper, something’s up with its execution. TCS has just 70 stores and expects to grow square-footage by 12% annually until it reaches its 300 store goal. However, the company’s earnings reports look more like a company that’s reached maturity. Management believes that it’s good at finding locations for new stores and that new store growth will be its modus operandi. However, I believe such an approach is fraught with risks.

The company needs to get its existing-stores back onto a growth path in order to fund new-store startup costs. Existing (“Comp”) store growth, while negative, is worse upon closer inspection. TCS needs to 1) improve customer traffic especially new customers, 2) convert the traffic into higher average ticket prices* and 3) retain existing customers. (*Average ticket prices = total revenues/total transactions). The chart below shows The Container Store’s historical comp-store downtrend.

In the table below, you can see the latest Net sales attribution for the latest year (i.e., “fiscal 2014”). Comparable-store sales declined nearly $4mm, however this included about $4mm in online sales.  So in actuality, the bricks & mortar comp-sales decline was $8mm! A better metric is customer traffic, which the company gives in conference calls.  Using this metric, customer traffic declined four consecutive quarters. (In all fairness, 4Q’15’s decline was related to bad weather.)

Highly Leveraged Balance Sheet
The 2007 LBO loaded The Container Store with debt, which will be difficult to pay-down given the business model’s dependence on the (little) free cash flow to be used towards new stores and key initiatives (e.g., POP!). The Container Store’s revolving credit facility and term loan are rated B2/B (Moody’s/S&P) and are secured by all assets of the company. Normally high debt reduces a company’s cost of capital, since a higher proportion of capital costs would be attributed to debt (which is cheaper than equity).  However, at a certain point (intersect on chart), increasing levels of debt (“New Capital” on chart) increase the total Marginal cost of capital.  At that time, TCS’ share price will be more correlated with its credit risk as per the Merton model.

Growth Initiatives:
According to a Seeking Alpha transcript of the last earnings call, management will focus in three areas: 1) TCS Closets, 2) Contained Home, and 3) POP!  The company is placing most of its resources into TCS Closets which is a high-end offering, and which will include customer-financing as the average ticket is $10,000. Contained Home is an in-home design service (average ticket: $2,000). POP! is the company’s customer frequency and reward program. I believe these initiatives are a smart strategy given they take full advantage of TCS’ affluent/busy customer-demographic and leverage the company’s highly-trained employees. However, the programs will likely take a year before boosting comp-sales and profitability.

Discounted Cash Flow (DCF) model assumptions:
The Container Store’s wish list is for long-term Gross Margin above 60% (FY’15: 58.6%) and SG&A at 45% (FY’15: 47.7%). The SG&A percentage excludes another 1.1% pre-opening costs (see table below) which I believe should be included in SG&A. (For comparison, this compares with the industry average of approximately 22-25%.)

Together this could yield a 4% increase in EBIT margins in a best-case scenario. My 3-Stage DCF model also considers a best-case scenario of positive and rapidly growing Free-Cash-Flow (FCF) as well as a Weighted Average Cost of Capital (WACC) of 10%.  I calculated FCF by using the midpoint number between Adjusted EBITDA and operating cash flow.  (I usually use operating cash flow which is lower and less subject to manipulation.)

DCF model results:
After inputting the above best-case assumptions as well as a 3% terminal growth rate and net-debt of $310mm, the result was a share-price estimate of $10.42. There is also the probability the company may have a secondary equity offering of, for example, 5 million shares, which could reduce the forecast value by $1/share. The matrix below shows results after lowering assumptions for Growth and the Discount Rate (“WACC”). They are all trading substantially below the company’s current share price of ~ $17-18.

 Peer Valuation comparison:
Other measures of value tell a similar story. Price/Book value (~ 4x) and Price/Earnings (~ 52x forward) are not worth mentioning given its leveraged balance sheet and near-term earnings suppression.  The more useful metric is Enterprise Value(“EV”)/EBITDA. This metric values the company at a 30%-50% premium to the Median, depending on the time-period utilized. There are a few companies (e.g., Tuesday Morning) with high EV/EBITDA multiples but their earnings growth is supportive of the higher multiples.

Source: Data provided by Bloomberg LLC

So what’s an investor to do?
My goal wasn’t to berate The Container Store, but to show how great companies don’t always make good investments. While I admire the company’s culture and mission, it is in the midst of a risky transformation which will take a year to gain traction. I am hoping to be a buyer but not until comp-sales reinvigorate to the mid-single-digits.

Full Disclosure: The writer does not own shares of TCS as of July 6, 2015.

How I Screwed-up with SodaStream and Where do we go from here?

I‘ve always strived for self improvement.  A key foundation to self improvement is knowing yourself, including your weaknesses and devilish-side.  One should also strive to be authentic and honest not just to society, and family but to ourselves.

With that said, I want to tell my readers how I screwed-up investing in SodaStream (SODA).  As a writer and avid reader of Seeking Alpha, I’ve run into too many writers who are “know it alls” – you know what I’m talking about.  Even if one has humility, the problem is our view becomes biased once we take a position in an investment.  But in order to become a better person and investor, I believe we need to view our actions in a critical manner.

I discovered SodaStream back in 2011, soon after its IPO on the NASDAQ.  The company’s strong growth spurred its stock to more than double less than a year after going public.  This and an interesting story and business model also attracted the likes of Jim Cramer and the talking heads of Wall Street.

I was instantly attracted to the company because of its interesting and perhaps faddish product (the DIY Sodamaker).  But what closed the deal for me was its attractive business model, which was essentially the razor razor-blade one.  I had already made a successful investment in Keurig Green Moutain (GMCR).  Both companies used the simple, yet highly effective razor business model. So I figured that SodaStream too would benefit from that model’s strong operating leverage.

I have written several articles on SodaStream but the full analysis was published in summer of 2011. In it was listed several pros and cons (i.e., risks investing in the company).  I did identify most of the risks with the exception that U.S. traction could slip. And that’s exactly what happened. Either the company didn’t educate the U.S. market properly (which I indirectly bulleted as Business Execution Risk) or U.S. consumers weren’t ready for a better and healthier way of attaining soda.

I have always been a big believer of licensing technologies and partnering with other companies, especially if you’re trying to make a name for yourself.  However, this is much easier said than done.  SodaStream has made agreements to sell name brand syrups but never from the Big 3; and it didn’t partner with a big investor as Coke has done with Keurig Green Mountain on the next-generation cold-beverage maker. The key risks from my full analysis report (2011) are listed below (right side).

http://1.bp.blogspot.com/-8e2QhYGRGkw/Tj7snMLwxRI/AAAAAAAAAus/X4kkLJgIj9s/s1600/Executive+Summary.jpg

Investing in the markets, all markets, is a risky endeavor.  Don’t let anyone, especially professionals fool you! Even fixed-income investments are dangerous, especially ANYTHING yielding 3% over the 10YR treasury rate.  If fixed income is risky, you can imagine how much riskier small-caps investments are!  With that being said, I invested in SodaStream knowing it was a risky venture. Given that it was a new industry niche, there was little available information, especially information that could be verified by third parties. The company said that U.S. consumers used 2x more syrups than its mostly-European customers, according to a consultant it had hired. Unfortunately, I had little outside information verifying this.  Though, I understood the business, the company and what could go wrong, including some of the “known knowns etc” as Donald Rumsfeld famously stated.

If I knew the risks, one might ask “why did I screw up”?  Well, upon deeper analysis it’s now clear that I was overconfident from successfully investing in Keurig Green Mountain and had invested a larger amount than I should have.  (I believe one should invest very small amounts in small companies.)  That large investment skewed my thinking, and created an attachment to the company and its attractive story.

A friend once advised me that successful investing in a portfolio should employ Risk Management.  (Enterprise) Risk Management is typically known as something big banks do to reduce risk in their loan portfolio. However, I believe this is key in successfully monitoring new and especially existing investments.  Effective Risk Management doesn’t care how much you like the company or it’s story.  You stress the portfolio to determine how it would do under a downside scenario.  This doesn’t have to be complicated.  It could be as simple as keeping a market weight investment, or 5% investment for each name, and reducing the investment allocation of individual names depending on the size (revenues) of the company.  So for a portfolio with S&P 500 names and just one small-cap name, one would have 5% investments in the S&P names, and maybe just 2% in the small-cap. This is easier said than done, and is helped enormously by having a “committee” of two or more examining the portfolio to ensure you haven’t broken your own rules.

Returning to SodaStream, I saw the company was getting stretched and mentioned to several friends how its financials were breaking every rule that we had learned in the Certified Financial Analyst designation program. In fact, I was so concerned that I published an article entitled SodaStream’s slippery slope to Adulthood in January 2014.  I also wrote numerous comments on SODA’s Seeking Alpha page citing its bloated inventories, low cash, etc.  The shares had declined from nearly $75 midyear to $53 by year-end. I could have sold then but I didn’t.  It was too late.  I was emotionally attached to the company.  You may be thinking “ah this will never happen to me.”  Well, we’re human, we have feelings, and we make mistakes.  This happens to everyone. The ONLY thing you can do is be aware of the above and your actions.

So where does SodaStream go from here?
SODA’s shares are hovering at just $21, near their all-time low.  At first glance they look like a bargain as Enterprise Value to Sales are about 1.0x, and then there’s the periodic takeover rumors.  However, I believe their is way too much risk in this company.  Given that revenue growth is now negative in what was supposed to be a hot U.S. market, the likelihood is high that there will be an inventory, factory as well as service network (i.e, distributor) write-down.  The company announced Third Quarter 2014 earnings on 10/29/14 and much of the report leaves me pessimistic.  Inventories are rising as well as debt and cash flow.
However, the stronger operating cash flow is typical when revenue growth slows. Readers can click here for the press release.

It is doubtful that an acquirer would want to buy a company that’s in a turn-around stage. Once the company’s business regains traction I believe its prospects could brighten. The company will now be marketing itself as a health & wellness brand given that its syrups have better ingredients such as no high-fructose corn syrup (or asparteme), and less sugar than store-bought soda.

I hope readers have found my experience helpful and encourage all of you to write-down your rational for investments and in life decisions.  Have a great 2015 !

 

Is SodaStream an Irresponsible Corporate Citizen

courtesy of Jweekly.com

Over the last few months I received quite a bit of hate-mail regarding SodaStream’s inclusion in this website. There have been boycotts in its largest markets including Sweden and the United States, and more recently TIAA-CREF removed it from its Social investment portfolio.

Essentially the company presents itself as a socially responsible organization helping the world reduce soda bottle waste, as well as promoting health & wellness as its syrups don’t use high-fructose corn syrup.

However, at the same time, SodaStream’s main production site is in Mishor Edomin, the industrial park of Ma’aleh Adumim, an illegal Israeli settlement in the West Bank. The main arguments against SodaStream are then:

  1. its use of illegal land
  2. its mislabeling of origin
  3. treatment of workers

I believe the most important of these is actually the last.  Israel motivates companies like SODA to invest facilities in these illegal settlements with tax rebates, etc.  The positives are that jobs are created for people that desperately need them.

Unfortunately, it is not certain if Sodastream’s employees are treated fairly with Israeli citizens as they may be exploited as is done in Bangladesh. In fact, there are some workers in the Mishor Edomin facility that claim they are working in “slave labor” like conditions including 60 hour work-weeks.

We will watch this issue closely and revert back to our readers when we receive further clarity.

SodaStream’s Slippery Slope to Adulthood

Recently SodaStream (“SODA”) reported third quarter earnings ending Sept’13.  As many readers of this website are familiar with, SODA sells DIY soda that you can make at home. Its machines are used to “fizz” water or make soda but people are learning how to fizz most anything including wine.

The company yet again beat consensus earnings estimates but investors were rattled when:

  1. the company didn’t boost guidance
  2. it reported weak flavor sales (up just 7% y/y)
  3. and adjusted EPS rose just 3%

The chart below, courtesy of SodaStream, shows (in light purple) the slowing growth of Quarterly Flavor Unit Sales over the quarter.

Consequently, SODA shares declined to $52.50, and were off from their 52-week high of $77.8.  The high price was emphemeral as SODA’s shares were victim to undocumented takeover rumors during the Summer.

Click to enlarge: Source: GoogleFinance


Financial Highlights:
As you can see from the company’s financial highlights below, revenues grew a healthy 29%, boosted by strong (albeit lower margined) Soda Makers.  However, investors remain concerned over the 7% gain in Flavor Units, which is sharply lower than its historical growth. The anomaly appeared to occur in the United States, a region the company’s depending on for growth.

Management claims the disappointing Flavor growth was due to changes in inventories at its retailers (“sell-in”) compared to the actual sales from those retailers to end-customers (“sell-through”).  Management stated that sell-through growth, which can be obtained using a service called NPD, was higher than sell-in growth.

SodaStream: 3Q Financial Highlights

Something similar to the above occurred in 2011; however, what worries me is that the company’s Operating Cash Flow has taken a big hit in the process.  SODA is no longer in its “infancy” growth stage and should be growing cash more rapidly. However, this is not the case (see Nine-Month cash flow statement below).  Though, SodaStream did see higher Operating Cash Flow during the latest three month period.

Equally troubling is a sharp decline in cash since Dec’12.  As you can see below, cash & equivalents declined to just $39mm.  What you cannot see on this table is that the company took out $20mm from its bank line. Without that, Sept’13 cash would have been just $19mm.  Some observers note that the company is spending lots of money on a new cutting-edge production facility.  However, upon closer examination, it appears that weak working capital management is to blame.

Where things are going well…
On the positive side, SodaStream continues working closely with its retailer customer-base such as Wal-Mart.  In fact, some of the large increase in Inventories that negatively affected Operating Cash Flow may be attributed to a Christmas program at Wal-Mart.  Also, the company has linked with several name-brand companies to sell their flavors including Kraft, Countrytime, Crystal Light, V8, Cambell’s, etc… The latest is OceanSpray flavors which can now be “sparkled” with SodaStream.  See the video teaser.

I think one of the most exciting characteristics of SodaStream is its innovation, some of which operates “behind the scenes.” For example, this summer Samsung started selling a fancy refrigerator that dispenses sparkling water (powered by SodaStream).  The water (and soon soda) can easily be dispensed from the outside of the fridge door. A side benefit is that the fridge door is likely to be opened much less, saving electricity in the process.

Source: Samsung

Remember, SODA isn’t an ordinary company but an extraordinary company revolutionizing the way we make and drink soda.  In the process, less waste is produced and users consume significantly less sugar than conventional sodas.

As a reminder, SODA’s business model is the “Razor-Blade” one. As such, it is still in its early growth stage (but not infancy) in the U.S. while it is in the maturity stage in Europe. Consequently, SODA is still selling lots of low-margined (about 30% gross margin) Sodamakers in the States. However, as the company matures, a higher proportion of revenues will be attributed to CO2 bottles and Flavors. Some analysts believe that SodaStream’s gross profit margin may be approaching 90% on those CO2 bottles.

SodaStream hopes to become a billion dollar in sales company by 2016 with 56% gross margins and over 15% net margins. The key will be maintaining customers (which would lower Ad & Promotional expenses) whom will purchase the higher margined CO2 bottles and flavors.

Source: SodaStream presentation: Aug’13


Conclusion:

The “take-away” from SodaStream’s 3Q’13 earnings report isn’t that its business model may not be working but that cash flow will likely build-up slower than first thought. This will, in turn, lower projected share-price estimates if one uses the Discounted Free Cash Flow model to calculate the intrinsic value of SODA.

While we like SodaStream as a company and as an investment, it is always a good idea to objectively seek out pros and cons including largest risk factors for any potential investment.  Such thinking, we hope, will allow investors to make better long-term decisions.

Disclosure: the author is long SODA.