Investors “gotz issues” with SodaStream

Ah SodaStream (SODA)…At a recent investor conference, CEO Daniel Birnbaum’s sidekick Yonah Lloyd (of corporate communications) did his usual “speal” about a product he’s truly excited about.

As most know by now, SodaStream’s (SODA’s) machines allow consumers to make sparkling water and customized sodas using ordinary tap water. This time around, Yonah highlighted the big and immediate 2,900 store roll-out at Wal-Mart. He also mentioned new products, and there are always new products from this nifty company. You know…patent-pending “snap & lock” mechanisms, the LED “Fiz chip”, and “sodacaps” ala Keurig – also patent-pending. SodaStream would like everyone and their grandpops making Soda-pops.

Daniel Birnbaum and Yonah Lloyd typically ask the audience to raise their hands if they know SODA’s product, then later give real-time demonstrations and tastings for the thirsting crowd. Yonah also highlighted last quarter’s great earnings. During a later 1Q’12 call, revenues and earnings were revised upward. Despite all the optimism, some investors are shorting SODA, in fact 10 million shares worth, which equates to 56% of their float, (2nd highest on Wall Street).
Investors having “issues” with Sodastream are concerned about:

  1. whether the Euro-Crises will affect its business
  2. bypassing the company’s CO2 refill bottles via by utilizing large CO2 tanks or from “white label” CO2 brands
  3. the “home-made” soda phenomenon seems faddish
  4. high marketing spend and working capital which is causing negative cash flow

Those investors that do own the stock, talk about how enjoyable the sodamakers are to use, and the company’s rapid earnings growth. So then, who’ll be right in this tug-of-war? For that, we visit the issues below:

Euro-Crises: I believe that the Euro-Crises will eventually “catch-up” with the company, though less so than most global companies given that its product is a “value proposition” and due to its low exposure to Europe’s sick periphery countries. As recently as 1Q’12, management said European “traction was good” in particular the new French market, as well as Switzerland, Germany,and the Nordics. (Note: as this article was being written, Moody’s lowered Germany’s credit outlook to negative.)

Bypassing CO2 refills: Some investors are bearish on the company because the CO2 refills can be bypassed using two methods. First, consumers can simply go on the Internet and find ways of making their own soda using conventional (and huge) CO2 tanks. While true, this is unlikely to happen for several reasons including safety, ease-of-use, space issues, etc.
There’s also the risk of “white label” brands, meaning an outside company can produce its own CO2 containers that are exactly the same specifications as SodaStream’s. I believe there is some credence to this in certain parts of the world, but not in the U.S. (which will be the largest market within five years). U.S. law is more favorable towards corporations and also note that SodaStream’s CO2 refills are protected by U.S. patents. In March 2012, the Swedish Competition Authority (SCA) terminated its investigation of SodaStream’s CO2 business. If SODA lost that case, it would have had to allow other third-party refillers. And that judgement could have been used as a template for cases in other countries.

Home Sodamaking seems like a Fad: Some say that SodaStream’s products are just a craze driven by the Healthy Foods Movement. Seems to me these accusations are a fad! First of all, fads take time to gain momentum. But by this time, investors could have sold the shares, as most investors keep their shares for just a few months (see chart below). This makes the fad argument illogical.

   Investors’ Average Holding Period
Source: NYSE Fact Book

Negative Cash Flow issue: I created a free cash flow (FCF) discount model. The model answers the last investor issue (that the company’s bleeding cash). The company does have negative cash flow in 2011, however, this is projected to turn positive this year. In fact, management expects positive cash flow as soon as the next reported quarter (2Q’12).
I used a WACC (weighted average cost of capital) of 11.3%, which is a blended mix of the cost of debt and equity. I believe SodaStream’s WACC should be at least 11% given the shares’ volatility. (High volatility, or Beta is associated with higher costs of equity.)

Year 1-5 free cash flows are projected to grow at a 35% rate, slowing to 3% longer term. After discounting FCF, I attained a calculated price of $74.60/share for a 49% discount to the current share price. Values were converted at an exchange rate of $1.30/EUR.

As readers may have concluded, I believe they’re focusing on the wrong issues. SodaStream releases earnings on August 8th, and I believe investors should focus on these questions:
1) Does SodaStream still feel somewhat immune to the Euro-Crises?
2) How effective has the Fx hedging program been (especially for the Euro)?
3) What is the attrition (i.e., churn) rate for the U.S. market?
4) How is management addressing the West Bank (Israel/Palestine) issue?

SODA’s Sizzling Earnings Stream

SodaStream manufactures machines that allow users to make sparkling water, and customized soda using ordinary tap water.  For background information, please refer to this website’s SodaStream archive.
SODA’s earnings-stream has been good. However, as many readers noted, SodaStream’s shares just can’t get their act together. Who’s selling & Why ?  I don’t know, but I don’t think it’s just short-sellers because they’ve already effectively sold much of the float short.

It appears long-term investors don’t feel comfortable holding shares given uncertainty over:
– the product being a “fad”
– the unfolding Euro-Crises
– its “bleeding” cash flow

    Those investors that do own shares tout about the product as if it’s the next best thing since sliced bread. While I agree, I believe forecasts need to be supported with data (see “Points” below). These Points are derived from a working Financial Model. Feel free to utilize the Model, but do source Socially Responsible Investing. (Note: financial figures are in Euros.)

    Point 1:
    Changing product mix, from SodaMakers towards Consumables will increase gross profit margins (GPM) and affect the Revenue Mix. SodaStream’s Razor/Razor-blade business model benefits significantly as the business matures.  Initially, SODA’s goal is to increase household penetration by getting Sodamakers into everyone’s hands. However, Sodamaker gross profit margins are low (about 30-33%).  Little of that flows to the “bottom line” as marketing expenses are high.  Though, once household penetration reaches key levels, the company will refocus to retaining existing customers and marketing consumables (e.g., Flavors and CO2 refills).  I estimate that flavor GPM are over 50% and CO2 refills are over 75%. Thus, changing product mix will significantly increase SodaStream’s profitability (e.g., EBIT margins).  (Note: Management’s EBIT margin goal for established markets (e.g., Switzerland) is 25%.)

    The chart below shows adjusted EBIT (excludes share-based compensation).  Forecast 2016 adj. EBIT margin is estimated at 18.2%.

    Point 2:
    Marketing costs, notably, Advertising & Promotion (A&P) costs will decline as a percentage of revenues as the company’s products become nationally recognized.  Since 2010, an undue amount of dollars have been spent on educating the American consumer.  I estimate that 16% of revenues are spent on A&P, with nearly 60% of that going to the U.S.!  This will decline by 2014 as consumer awareness reaches critical mass.

    Point 3:
    The bottom-line will grow faster than the top-line as the company benefits from certain fixed operating costs.  Without being specific, management has said that nearly half of its General & Administrative costs are fixed (source: 4Q’10 conference call).  In the Financial Model, I identified these costs as “Note 2.” The full benefit won’t occur until after 2015. Items with some fixed costs include:

    • Distribution costs
    • Depreciation and Amortization expenses
    • Communication & support
    • Rent & Building Maintenance

      Point 4:
      As geographic mix shifts to the Americas (the U.S., etc…) profitability will rise.  This is because the average global consumer utilizes 4 Syrups and 3 CO2 Refills yearly.  However, U.S. consumers use up to 8 Syrups and 4 CO2 Refills.  Consumables have significantly higher gross profit margins than Sodamakers. Also, the Americas distribution method is more profitable given that it’s Direct and homogeneous.

      Sources: SodaStream:  SEC Form 10-Q and S1 Report

      Point 5:
      As the company (and its distributors, retailers) ride the “learning curve” and as “economies-of-scale” ramp, cash flow from operations should surge.  This can be seen in the model where better working-capital management (e.g., faster inventory turns, shorter accounts receivables days) reduces the drag on cash flow. The table below shows both Cash Flow before and net of changes in Working Capital.

      So just how “Sizzling” will SODA’s earnings be?
      The focus of this article was to quantify the hidden earnings potential of SodaStream, which cannot be readily seen on superficial analyses.  My earnings estimates and Price/Earnings ratio are shown below.  (Note: EPS assumes a constant $1.30/EUR Fx rate and 21mm shares outstanding.  Current share price: ~ $38.)

      SODA’s shares are undervalued given that I forecast 37% EPS growth in 2012E and a five year CAGR of 29%.  This compares with a P/E of 17.3x for 2012E. 

      Disclosure: The author is long SODA, with an expected holding period of five years.

       

      SodaStream: Drink this Tonic instead of worrying about Competition

      Last June, rumors swirled that SodaStream was about to face a head-on collision with the globe’s most powerful beverage company, Coca-Cola Inc.  Upon further investigation, it appears these rumors were false.  These particular ones were broadcast via Twitter.  But there will be more… The Coke rumor alluded to a similar type machine from Coca-Cola, when in fact, it’s just a commercial soda machine used by restaurants.   Please read Firstadopter.com’s and Seeking Alpha’s article for additional information link.

      However, the question is not if, but when…And what will be the implications of competition. In my experience, new competition will be a good thing for SodaStream, especially if the competition is from a well-known brand.   (Coke is considered the highest rated brand in the world.)

      More recently (October 2011) rumors have turned into real competition.  But, not from the Big 3 soda companies.  Instead, a small publicly-owned company called Primowater introduced a product called Primoflavorstation.  Several Bloggers including commentators to seekingalpha.com imply this is a small, inexperienced, scrappy company.  Small…well that’s true, inexperienced…not at all!
      Primowater’s already innovated before with its well known Blue Rhino propane exchange program at 29,000 retail locations. (It was later sold in 2004 to a large gas company).  For this upcoming holiday season, the company is retailing two carbonating machines, one will be single serve, the other will be nearly identical to SodaStream’s.  What I don’t understand and challenge readers to question is, How can such a small company introduce such a machine when 1) SODA has patents for this and 2) the Single-Serve does not seem viable from a cost perspective?  Well, for one thing, Primo Water Corporation is currently a money-losing business (earnings release & forecast).  Secondly, the Soda business was recently purchased for just $13 million, so it may be weakly patented,  infringing on SODA’s patents or it may be an inferior product.  Hence, Primo is not viewed as a viable competitor in my view.

      SodaStream (SODA) Background:

      SodaStream is a historic company with roots dating back to 1903.  The company uses the razor-razorblade business model used by HP and Lexmark printers for example.  SODA makes some money by selling home beverage makers, but the bulk of its profits come from selling “razors” (i.e, carbon-dioxide bottles, flavored syrups).  Readers may wish to view this fairly objective online video review of the company’s products.

      Regardless, my business experience leads me to believe that SodaStream would Benefit during the short-to-intermediate term if the Big 3 (e.g. Coke) entered the personal soda-maker market.   This is attributed to:

      • Increased consumer awareness that would be generated.
      • Entrance of a large, well respected company would legitimize the new market segment.
      • The entrance of such a large, and adroit company such as Coca-Cola may prevent a host of potential competitors from entering the market.  This would likely create an Oligopoly with few large competitors and moderate-to-high profit margins (SodaStream’s LT operating profit margin goal is 25%).
      • Home beverage making is considered environmentally-friendly (no need for PET bottles).  Consumers may find Coke’s marketing strategy of selling both bottles and home beverage systems inauthentic.

        Based on (Harvard University’s) Michael Porter’s framework for competition, we believe SodaStream would utilize two strategies concurrently:

        1. Cost Leadership:  SodaStream says its cheaper for consumers to use their system rather than purchasing soda bottles.  (Though, we believe savings may not be substantial, link)
        2. Differentiation: SodaStream markets itself to consumers that consider themselves socially and environmentally responsible.  Their flavors also have no high-fructose corn-syrup (using sugar instead) and; are thus, also marketed to health-conscious consumers. Also, the company is retailing several high-end models.

        SodaStream is an efficient user of Technology which it leveraged to break into “new” markets (particularly in the United States).   Going forward, it is expected that the company will introduce new products (single-serving, under-the-sink machines).  These innovations will likely rate high under a competitive analysis.  Please review Porter’s writings for additional information.   Porter’s 5-Forces model is summarized below:

        Case Study:  Research in Motion (RIMM) versus Apple (APPL)

        Well then…How about a recent example?  On 6/17/11,  RIMM’s stock declined over 21% on news that competition with Apple (another huge brand name company) is hurting both top-line and bottom line growth.

        The point is that even in the fast-paced telecom/tech industry, it took Apple two years to break the backbone of Research in Motion.  Apple’s iphone was released on June 29, 2007.  However, RIMM’s stock price moved from $56 before the release of the iPhone to $66.5 after the phone’s release.  It then rose 157% peaking over $144 (Chart) a year after the iPhone was released.  Note that RIMM’s gains might have been higher were it not for the Financial Crises.

                                              RIMM Stock Chart:  Click chart to enlarge
        RIMM stock price after the intro of the Apple iPhone 6/07.  Source: GoogleFinance

        RIMM didn’t feel the negative consequences of the iPhone until mid-2009. The chart below shows the percentage moves in Apple shares versus RIMM.   For perspective, RIMM’s North American market share declined from the low 40s% level in 2007 (50% peak in ’08) to 15% this year.  More recently, RIMM has begun suffering from iPhone displacement in Emerging Markets (a previously strong area for RIMM).

        Source: GoogleFinance

        The difference with the above APPL/RIMM case and a SODA/Coke case is that SODA is both the innovator and the “first-mover.”  Therefore, it will take time for potential entrants to play “catch-up” with SodaStream.

        For example, upon first glance, barriers-to-entry appear low as direct competitors do exist globally.  However, not only is SodaStream protected by patents (a portion expire this year) but more importantly, the distribution network required to support SODA’s customers is extensive and would take years for most competitors to duplicate.  Distribution networks (both to sell the machines and via “reverse logistics” to exchange the empty CO2 bottles) and Execution are Sodastream’s key entry barriers to competitors – not the patents!

        CONCLUSION:
        Should SodaStream face new competition, we view this as a net positive for the short-to-intermediate term.

        Disclosure: the author is long SODA.