Interface’s 3Q’11 EPS exposes sensitivity to Business Cycle

Interface (IFSIA) the company that invented “carpet tiles” and the notion of lifetime corporate sustainability, had lackluster earnings for the Third Quarter 2011.  The earnings report was even worse than 2Q’11 with another earnings miss large enough to get management’s attention (i.e., restructuring).  In the graphic below, note how earnings estimates trended lower:

Source: WSJ

Management’s tone during a conference call was flat & weak, as they were clearly saddened over Ray Anderson’s passing.  Ray Anderson was the carpet industry’s Steve Jobs.  He founded Interface, later shocking investors with his revolutionary 1994 speech on Sustainability.

Summary & Key Points:
  • Revenue growth slowed, +8.1% (to $273MM) down from 18% in 2Q’11, 13% in 1Q’11.
  • Operating income of $25MM.  This translated to 9.3% of sales, down from 9.8% in 2Q’11, and 11% the year earlier period.
  • Orders were $284MM, up 6.8% from a year ago.  Down sharply from 13% in 2Q’11. 
  • Cash Flow from Operations, at $31MM was a pleasant surprise, rising 63% from a year ago.  The large increase was mostly attributed to Deferred Income Taxes, rather than earnings, so the increase may be transient.
  • Book Value grew a decent 16%, likely surpassing cost of capital, especially debt costs (as the company refinanced bonds in January’11)
  • EPS was $0.19 vs the same a year ago.  Earnings were clean (negligible charges or non-cash gains/losses)
  • The flat EPS was victim to 2 factors we’ve discussed several times.  1) input cost pressures, and 2) slowing demand in Western Europe (and Australia/Japan).  Management, which already increased prices 3x this year, will not increase prices during 4Q’11.
Click image to enlarge
 
Restructuring:
Given the above, management’s proactively slimming its cost-structure in 4Q.  This will result in costs of $6.5MM to $8MM.  (Cash costs likely under $7MM for severance,etc.).  Management’s expecting profits to increase by $11MM/yearly and we expect these savings will be reaped in 2012.

Geographic & End Market notes: 
  • The German market continued to remain “robust” (see PMI Output chart on bottom).
  • Pockets of weakness in several mature markets including Japan, Australia and certain countries of Western Europe.
  • The new factory in China continues to ramp up well.  During quarter, added a second shift. This “scaling up” of production will allow the factory to become profitable for the first time next quarter (4Q’11).
  • The Commercial Office market is moderating, however, management believes this may just be a short-term phenomenon
Biggest Positive Surprise:
What we had once feared of draining management resources and costs, the Flor see link retail stores, are turning out to be successful.  Interface opened a new store in Dallas during 3Q’11 (5 stores total) and two additional stores will be opening by Nov/December.  Speaking of Steve Jobs, the stores are very cheek-looking and trendy.  In fact, the first one opened in the Hip SOHO area of NYC, just 2 blocks from Apple’s. 

 How are earnings affecting the stock price ?

  • Based on 9Mos numbers, Full Year 2011 EPS likely $0.65-$0.75 per share, yielding a Price-Earnings multiple of ~ 19x.
  • A high Beta (GoogleFinance) of 2.4x, a P/E of 19x, and high operating leverage continue indicating these are risky shares.
  • Though, IFSIA’s shares already partially-discounted the recent earnings reports as they had already declined from $20 to $12 between July’11 and Aug’11.



Euro-Crises is likely to be the “tail wagging” the stock price:

We believe IFSIA will remain sensitive to global economies.  Hence, we view the progression of the Euro-Crises as a key influencer of IFSIA’s shares.  As a reminder, IFSIA is a global company – over half its business is from overseas, including Asia, and Western Europe.
What’s the state of Global Economies?   We believe the Chinese economy is in a long-term (real-estate) bubble, the United States is stable (1-2% GDP growth) and the weakness in Europe will worsen.  Stubbornly high bond yields to PIGS countries (especially in key country Italy) indicate that the Eurozone bailout plan of October 27, 2011 will likely fall flat with investors.  Even if the bailout plan (which could run as high as EUR1 trillion) is successful, the EU must initiate an austerity plan.  This fiscal plan is likely to push the EU in recession and continue stemming demand for industrial/commercial products such as Interface’s floor carpet tile.  This informative graph from Markit Economics gives a telling story.  It not only shows the Eurozone PMI (purchasing managers index) but the discrepancy between Germany and the rest of Europe.  (On 11/2/11, the PMI declined to 47.1, a 27 month low.)
Disclosure:  the author is long IFSIA

Interface 2Q’11 Earnings analysis & opinion

Interface 2Q’11 Earnings: were on the mark.  However, they weren’t as good as previous quarters as they missed consensus earnings estimates.  Relative to peers, they were quite good.  However, business intelligence for the industry is pointing towards tough Euro-headwinds.

Interface earnings Highlights:
Investors are requested to view IFSIA’s earnings release link, as this article is a commentary of them, not a rehash. Highlights:

  • Revenues rose sharply, up 18% to $268MM
  • Orders grew 13%, and backlog continued to rise
  • Chinese plant, while not profitable, continues to ramp up.  It achieved breakeven performance during the month of June.
  • Operating Margins continued rising (from 9.5% last year to 9.8%)
  • EPS of $20 cents/share slightly missed analysts’ estimates.

    What we liked:
    Despite all the talk of a decelerating US economy and Euro-Crises, revenue was quite good, especially compared to competitors.  Margins continued rising, albeit at a slower pace than previous quarters.

    And not so much..
    IFSIA has been able to pass costs through to customers.  We think this is getting increasingly difficult.  Other than higher raw material costs, the company is also getting hit with continued Start-up costs in China, and its relatively new strategy of opening company stores.  These stores don’t comprise a large part of Interface’s overall costs, but the trend is there.   The company had 5 stores as of quarter’s end and several more are expected by YE.  Cash flow from operations was also weak, but likely short-term due to higher inventory (i.e, hoarding) ahead of price increases from its suppliers.  Also attributed to higher receivables and paying off its vendors more quickly.

    Conclusion:
    We believe the shares of Interface, which had performed quite well until the Euro-Crises reemerged, will be very sensitive to European and US economic activity (regardless of the company’s sound business operations).  Also, note the shares have a high Beta, hence higher volatility is to be expected.

    What to look for in 2012:
    As such, we expect Interface to issue a cautious outlook for the rest of this year and into 2012.  We believe there already is a Euro-Crises, and that it’s been with us for nearly 2 years now.  In our estimates, things could only get worse in Europe given political deadlocks, austerity measures and a stubbornly tight ECB (on the monetary side).  Traditionally Interface’s key drivers were 2, now they are three:

    1. Residential Construction
    2. Commercial Construction
    3. Europe

    On the domestic side, the US economy is also witnessing slower government growth, which should slow demand from that end-market.  We will expand on specific economic data points and charts in our upcoming 3Q’11 review.

    What’s happening on the Corporate Social Responsibility front:
    I’d like to highlight this “win-win” situation the company initiated during the quarter.  It essentially participated in a knitting program as it introduced a new floor tile that looks like yarn.

    The project produced a smashing number of squares, nearly 10,000 ! It also produced hats and other knitted garments.  This “Knit a Square” program was part of KasCare, a charity providing warm clothing to orphaned children with AIDS in South Africa.   See these links for additional info: knit-a-square.comknitting-for-charity.

    Background of the company:  

    Interface, Inc. is the world’s largest manufacturer of modular carpet, which it markets under the InterfaceFLOR, FLOR, and Bentley Prince Street brands.  Interface’s main goal, other than serving its investors, is to help make the world a better place via its widely heralded Sustainability program.

    Disclosure:  The author is long Interface.

    Ray Anderson: In Memoriam

    In Memoriam:
    Apologies for the tardiness of Interface’s earnings report, but Ray Anderson’s passing came out of left field to me, even more so than Steve Jobs’.  Ray died on August 8, 2011 after a 20-month battle with cancer.  Spent a few emotional nights tearing over the many tributes given to him during his memorial service.  If ANYONE doubted this man’s authenticity and sincerity in making the world a better place, I suggest this website: http://raycandersonblog.com/.   Below is what might be Ray’s last video, when he was receiving chemotherapy.

    Ray Anderson, who was born in Georgia, always talked about climbing the Mountain of Sustainability.  He said he wasn’t going to be around to see the other side of the mountain but was happy that we would.  Interestingly, another man from Georgia also had a vision of a “promised land” across the mountain-top; that man, of course was Doctor King.  Anderson and King were two different people, but Oh, in some ways, so much the same!

    Ray, you will be MISSED !

    On September 1, 2011, Ray left 62% of his total assets to his foundation, a trust fund devoted to environmental causes, with the remainder going to his family.

    SodaStream: Analysis

    SodaStream International Ltd. (SODA)
     SodaStream is an Israeli company that makes and sells home beverage machines.  These portable machines make flavored sodas out of ordinary tap water, or just seltzer/sparkling water.  In order to make a flavored drink, SodaStream sells these products:
       1. Soda Makers (Beverage Machines):  to make the drinks
       2. Carbonators (and CO2 refills): which make the drinks fizzy
       3. Flavored Syrups such as root beer, colas
       4. Bottles which the Soda Makers fill the soda into
    For those unfamiliar with how the SodaStream system works, please take a few minutes to view this company video:

    So what’s so special about SodaStream?
    We believe there’s a time and a place for everything.  Remember Apple’s Newton?  Well, the time and place (United States) are now ripe for SodaStream.  What we have here is a confluence of factos creating a whirlwind of demand for SODA.  They include:
    1.     A self-aware and knowledgeable American consumer
    2.     The Greening of America
    3.     A weak economic recovery creating more “do-it-yourself” consumers
    SODA’s products, for example, contain less sugar, its diet-versions don’t contain saccharin, and consumers can control the amount of flavorings that go into their drinks.  Or like most people do, they can simply drink club soda/seltzer with no sugar at all.  The company even sells an essence flavor that doesn’t contain sugar.  In 10/2009, the company introduced a Sodamaker made with 85% recycled materials.
    It is SodaStream’s job not just to manufacture soda machines but to educate the consumer that its products exist, show how they promote health & wellness, and help protect the environment (i.e, fewer disposable plastic bottles).
    According to the U.S. Natural Marketing Institute, the “Green”Consumer Market is over $500Bn globally and over $200Bn in the U.S., and growing at a CAGR of 15%.
    Overall assigned Rating:
     We believe SODA is a good SRI investment candidate.  Our rating is “7” (out of a possible 10).  This rating incorporates quantitative and qualitative factors, including the corporate, social and responsibility efforts.

    The Executive Summary below summarizes key investment factors/risks.  With the goal of maintaining objectivity, every investment is required to have a full list of Negatives, or if you will, “things we don’t like very much.”
     Note: Earnings estimate is diluted, on 20mm shares outstanding, reflecting the 4/2011 secondary share offering.  EPS converted at an exchange rate of $1.40/EURO.
    Share Data for SODA reveals a company with moderate to high-priced shares, as measured by the Price to Earnings (P/E) ratio.  The P/E ratio is high, but not huge on a PEG basis.
    Note that the company is global, but based in Israel.  So, it’s reporting currency is the Euro, but labor gets paid in Shekels.  However, we report EPS data in dollars, as the shares are traded on NASDAQ.
    Market Capitalization of <$2Bn categorize this as a Small-Cap investment, further increasing return potential, as well as risk.  Our overall investment rating is 7, reflecting strong business trends, but higher-than-average share price volatility.  Beta is 1.2x (co. went public in 11/10) however, we suspect it may actually be higher.
    Our FY’2011 EPS estimate is based on 33% revenue growth and 73% net income growth, both higher than management guidance (+30%, +60% respectively).
    Revenues for Fiscal Year 12’10 were €161mm, up from €105mm the prior year.  Over the last 3YR period, revenue and earnings have grown consistently with the exception of a “hiccup” in 2009 attributed to the Financial Crises.  Data above is on an adjusted basis, which excludes a management fee (to former majority owner Fortissimo Capital) as well as non-cash compensation.
    The Balance Sheet improved dramatically over the last year, as the company moved from an LBO to mainstream company.  Shareholders’ Equity is high and much of the company’s assets are in working capital.
    FY’10 Cash Flow was weak, after reporting two strong years.  SodaStream reported positive Free Cash Flow in FY’08 and FY’09, but FY’10 FCF declined dramatically due to rising accounts receivables and inventories.  We estimate A/R and Inv will be a $40-$50MM drag on yearly operating cash flow.
    SodaStream’s profitability is expected to rise based on simple trend analysis.  However, there are several short-term crosscurrents beneath the numbers readers should be aware of.  Management fees to Fortissimo Capital affected FY’10 reported profits, and this will no longer continue.
    Secondly, FY’11 operating margins will continue to be negatively affected by high Sales & Marketing Expenses, as management aggressively ramps-up business in the United States.
    Thirdly, we expect the denominator to increase (on Capital) as the company issues common shares.  There was a secondary common stock offering in April 2011, which will increase Equity over 25%, and decrease debt to negligible levels.  Management is expecting 2011 net income to rise 60%, however this may not translate to EPS growth given the dilution effect.

    Longer-term Profitability could rise sharply:

    SodaStream’s business model is such that longer term (2013-2014) profitability could increase dramatically from 2009 levels even as revenue growth slows.  By 2013, these factors may occur:
    ·      Selling & Marketing expenses could decline as consumer awareness increases.
    ·      The proportion of U.S. (i.e. “Americas”) revenue will increase dramatically.  U.S. consumers love getting their “sugar fixes”, and thus, use more syrups than their European counterparts.
    ·      A larger U.S. market will also benefit margins resulting from the distribution channel.  This is because management has chosen to distribute directly in the U.S.  Direct distribution has higher gross margins as the company typically sells its product at a discount to indirect distributors.
    ·      The slice of Soda Makers’ share of the revenue pie will decline, as a larger proportion of sales will be attributed to high-margin Carbonators (i.e., CO2 bottles).
    ·      Optimization of factory logistics, including the new factory being constructed will lower transportation costs.
    ·      Operating Leverage should help increase earnings at a more rapid clip compared to revenue growth.  This is because SodaStream has a fixed component to its cost structure as the company owns most of its factories.  Further, half of its General & Admin expenses are fixed in nature.
    ·      The dilution effect on EPS growth should decrease as the company becomes less dependent on external equity financing.
    ·      Note that the above increase in expected profitability is expected despite our view that Carbonator margins will decline as new competitors enter the market.
          
     Rather than reiterate the company’s statements, we highlight key data points and conference call comments:
    ·      Performance was much better than expected by both analysts and management.  So much so that SodaStream raised Revenue growth, from 25% to 30%.  The company sharply raised earnings growth from 40% to 60%.
    ·      SodaStream is experiencing rising raw materials costs especially for plastics (up 19%) and Sugar (up 14%) but so far has been able to pass through price increase to customers.
    ·      Profits were boosted by strong consumables growth.
    ·      Balance sheet debt declined to negligible levels.
    ·      Operating cash flow remained negative, due to higher inventories
    ·      The U.S. launch and ramp-up is performing better than expected.
    ·      Company will launch into the Japanese market by 4Q’11.
    ·      SodaStream will undergo a “big-box” retailer test this year
    Overall liquidity is not high, but sufficient.  SodaStream used a portion of its 4/11 secondary share offering to repay most of its debt.  A small bank line, cash, and minimal debt maturities support liquidity.  However, continued FCF deficit and higher (though transitory) capital expenditures for a new factory.
     Most indicators of leverage are very low (minimal).  Operating Leverage, while difficult to accurately measure precisely, appears high given the company’s ownership of fixed assets.
    SodaStream’s FY’10 P/E ratio presents a rich valuation.  FY’11’s is lower given the company ‘s rapid earnings growth.  The PEG ratio of 1.4x would have been lower were it not for a 36% increase in diluted shares outstanding.  In fact, we are forecasting a 70% increase in adjusted net income for FY’11.  The EPS estimate is also subject to the ebb and flow of exchange rates, which we are basing on last year’s $1.4/EUR.
    Other measures of valuation such as Price/Book Value, Price/Sales and Enterprise Value indicate SodaStream’s shares are fully valued.  We also examined various Discount Models.  Most indicated SodaStream’s shares were trading below calculated values (about 20% discount, on average).
    However, we conducted a Discount Model utilizing FCF, which yielded a share price under $60.  That calculated price is below the current trading price of SodaStream’s shares.  Note that our model used more aggressive growth rates and a lower WACC than typically utilized, and we still could not achieve higher than $60.
    This website utilizes CsrHub and Audit Integrity ratings given that they are a good standardizing and benchmarking tool for evaluating a corporation’s Corporate Social Responsibility efforts.  Unfortunately, neither firm (including others such as RiskMetrics) was able to provide ESG ratings.  This is attributed to the firm’s foreign (Israeli) incorporation and since its initial public offering was fairly recent (11/10).
    However, what we can do is offer our opinion of the company’s accounting policies and disclosures.  In both aspects, SodaStream appears above average.  Disclosures are good, in fact, they seem better than what we’ve seen from most companies.  This is likely attributed to its incorporation in Israel, which requires additional financial and operational disclosures.  For example, several balance sheet items are footnoted, and detailed further in the company’s Annual Report.
    In terms of the Environment, the company’s products are clearly beneficial compared to traditional methods of producing and distributing soda.  For example, the SodaStream method of producing soda eliminates the need for disposable plastic bottles (and cans).  Whilst true that both are recyclable, the fact is that only a small percentage actually gets recycled.  Further, the carbon footprint and pollution created from transporting bottled soda is mostly eliminated using the SodaStream approach.  We say “mostly” because it is true that its refillable CO2 containers do have to get transported to refilling stations.  Management though, is aware of this and is establishing these stations logistically to reduce transportation.
    SodaStream’s products also promote what’s commonly called Health & Wellness.”  It does this by using sugar instead of high fructose corn syrup, offering less sugar in its flavors, using less caffeine, less sodium, and using better versions of sugar-substitutes (i.e., Splenda instead of saccharin).  More recently, this author noticed SodaStream is now selling natural flavor essence, something very popular now in club soda.
    How could SodaStream make its CSR Reporting better?
    As seen from the above, SodaStream clearly has a healthy product and is environmentally friendly.  However, we offer a short-list of recommendations if the company wants to be a truly Socially Responsible company.  Essentially, the company should offer a CSR Report (perhaps integrated into its Annual Report initially).  This report should include key metrics on:
    ·      Environment:  Data (yearly) on energy consumption and use of fossil fuels.  Systematic programs that are used to reduce toxic emissions.
    ·      Social: Employee benefits, diversity programs, work/life balance, etc.  Metrics on factory safety. 
    ·      Suppliers:  Monitoring of labor standards at suppliers
    ·      Governments:  Policy to address controversies in countries that have weak labor records, etc.
    It is important that the CSR report not be a marketing piece about how great the company is.  This is why it should have specific goals, and specific measurements to achieve them.  It should also talk about “bad things” that happened to the company or its chief challenges.  Speaking of which, the last bullet is of particular importance, if not urgent, concern to SodaStream given that its main factories are located in the West Bank (Mishor Adumim) Israel.
    The West Bank was occupied by Israel during the Six-Day War in 1967 and the area is the subject of dispute between Israel and the Palestinian Authority.  With the exception of East Jerusalem and the former Israeli Jordanian no man’s land, the West Bank was not annexed by Israel but remained under Israeli military control.  Most of the residents are Arabs, although a large number of Israeli settlements have been built in the region since 1967.  There has recently been negative publicity against companies with facilities in the West Bank.  Several political groups have called for consumer boycotts of Israeli products (including SodaStream’s) originating from the West Bank.
    SodaStream participates in the carbonated soda drink (“CSD”) and sparkling water industry.  The industry is in the Maturity stage of its life cycle.  The CSD industry is marked by low growth, high penetration, moderate competition and low revenue cyclicality.  Industry revenues approximate $216Bn globally, according to Datamonitor.  The sparkling water industry (i.e., seltzer, club soda) is $34Bn globally and far more popular in Europe than in the States.  Both numbers exclude soda/sparkling water at restaurants.  According to Euromonitor, the U.S. had the highest per capita consumption of 118 liters in 2010, approximating $39Bn in sales.

     The CSD industry is experiencing flat growth, with most of it occurring in Emerging Markets.  Revenue growth is fairly lackluster in Europe given the troubled economies of Greece, Spain, Portugal and Ireland.  In the U.S., soft drink volumes had been growing in the low-single-digits in the ‘90s.  However, volumes turned negative during the Financial Crises and have not recovered to previous levels.  Name brand soda is also experiencing competition from white-label brands as well as niche drinks such as Energy and Sports Drinks (e.g. Hansen Natural).

    YTD 2011 has shown incremental improvement, due to higher marketing spend.  Companies have cited ongoing input cost pressures.  SodaStream noted in its conference call (1Q’11) that Aluminum prices were up 9%, Plastic (+19%) and Sugar (+14%).  Though, all participants have been able to recapture margins via higher pricing.
     
    According to industry expert and Harvard professor Michael Porter, an industry can be analyzed using a Five-Forces Model.  These forces determine how intense competition is within a particular industry.  Industries with low intensity, are considered attractive, as they are profitable.  Below we summarize these forces for the CSD industry.
    As readers will soon notice, the soda industry structure is quite strong and oligopolistic.  It is well protected and the threat of new entrants is low given high entry barriers and high promotional activity.  Consequently, we expect there will be some retaliation and an answer to SodaStream’s market share advances.
    click to enlarge
     A peer group comparison indicates that SodaStream is much smaller than its brand-name competitors (i.e., Coco-Cola, Dr. Pepper Snapple, PepsiCo).  Its (reported) profitability is also lower than most of its peers.  However, SODA’s forward Price/Earnings ratio is higher than its peer group.
    Management Summary:
    SodaStream’s management appears highly focused, forthright, and attentive.  In fact, they’re almost scientific about tactical market strategy.  CEO Daniel Birnbaum is not only qualified in education and business experience, but he is a great “front man” for showing off the company’s products.
    The existing management is fairly new, having been installed in conjunction with the acquisition and restructuring by Fortissimo Capital in March 2007.  While new, senior managers have had experience working at Nike, Proctor & Gamble, Pillsbury, Kraft and McDonald’s.
    SodaStream is now arming for battle at the home turf of the world’s most powerful soda companies.  However, management also brings with it best practices from years of operating and entering new global markets (41 countries as of 1Q’11).
    Management appears customer-centric, an important attribute in the Consumer Products industry.  Note that several (four) executives have non-technical, social-type skills that may be giving it an edge above competitors.  Mr. Tali Haim, for example, has a degree in Psychology and had been an organizational psychologist earlier in his career.  After all, this business is really about consumer behavior !
    Despite the 11/2010 IPO and 4/2011 secondary share offering, SodaStream insiders retain a significant ownership stake.  We consider this very important in aligning executive interests with those of investors.  As of 8/2011, insiders owned approximately 19% of SodaStream’s shares outstanding.  In addition, Fortissimo Capital (the firm that LBOed SodaStream) continued to own at least 11% of the company’s shares.
    Conclusion:
    SodaStream’s a great company with somewhat richly-priced shares.  Those interested in investing in the company are recommended to purchase on stock price retrenchments in the $50s area.
    Disclosure:  The author is long SODA.  This article is neither a recommendation to buy or sell shares in SODA.
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