Should SodaStream look East ?

In a recent Wall Street Journal article link the paper quotes Coke CEO Kent’s plans to spend $4Bn over the next three years to expand bottling plants, marketing, etc. in China.

For now, SodaStream’s concentrating in the United States (i.e., the Americas).  And for good reason.  Whether you call it a secular trend, or just a fad, no one can deny that SODA’s Americas’ growth is fantastic.

Source: SodaStream, Socially Responsible Investing

So then, everything must be Hunky-Dory at SodaStream.  Or No ?

SodaStream shares lost their fizz after they beat the Street’s estimates for 2Q’11.  Which makes me ponder what would have happened if they DIDN’T beat the Street!  CEO Daniel Birnbaum later (8/18/11) appeared at a mini roadshow speaking with Jim Cramer, but the damage was already done (see stock chart).

Source: GoogleFinance

Several analysts and Seeking Alpha members were disappointed that SodaStream didn’t raise its 2011 guidance.  After all, at this rate, revenue growth would implicitly be expected to slow down to c.20%.

The lack of color in this outlook picture is surely reason for pause.  So, what’s going on in Western Europe ?  Well, according to Birnbaum, everything’s Kosher.  He basically said:

  • Indicators of Americas and Europe are fine
  • In fact, Europe will benefit if its economy slows, as it’s a value proposition

Whoa, whoa, whoa.. REALLY…?

  • To me, SodaStream’s still a consumer discretionary product, in fact, Birnbaum doesn’t want to market it as a value-product.  The deal is, you can’t say that it’s a higher-valued/differentiated item (see company presentations) then later say it’ll sell well because it has a strong value proposition.  In fact, in my earlier analysis, I proved that SodaStream does not significantly reduce soda costs.  See SA article Should SodaStream go Single?
  • More evidence that weakness in Europe will effect SodaStream’s business comes from Linda Montag and Yasmina Serghii-Douvin of Moody’s.  They expect European soda demand to remain lethargic, especially in the ever-expanding countries with troubles (e.g., Greece, Spain, Portugal, Italy).  As proof, they give the example of Greece’s 2010 slowdown (one of the first) which significantly reduced soda volumes at Coca-Cola Hellenic Bottling Co.
  • Recall that SODA’s Western European revenues declined in 2009 attributed to significant business and inventory management problems at one of its Nordic distributors.  A portion of the problems were directly related to the Financial Crises.
  • SODA would also be hurt if the EURO, which has held up remarkably well in the $1.40/EUR area, declines.

Despite all the talk about the hot Americas/U.S. business, the fact is that much of SodaStream’s revenues still come out of Western Europe (see chart below).

Source: SodaStream, Socially Responsible Investing

Also note that given the geographic proximity and close economic ties, Eastern Europe will undoubtedly be affected by a slowdown in Western Europe.  So where does that leave SodaStream?

So then, maybe SodaStream should be looking East !

Going back to my opening comments, maybe, just maybe, SodaStream should focus its energies on the East.  Wait, wait, you say that “SODA’s already in Asia.”  And to that I respond, not really….

Yes, the company is doing a small amount of business in Asia-Pacific (see above chart).  However, drilling-down it appears nearly all of it is actually in Australia and New Zealand.  Should we really call those Anglo-Saxons examples of what it means to be Asian?

Instead, I suggest SodaStream delve into China and Japan.  Japan’s consumer-profile is somewhat similar to Europe and the U.S., and we all know they love robots and other gadgets.  In fact, management did mention their intention to enter the Japanese market by this year’s end.   Also, I strongly believe that SODA should enter the Chinese market, especially since Coke and Pepsi are already educating its consumers.  Besides, the trajectory of soda consumption is salivating.  See chart courtesy the WSJ.

Of course, entering China and Japan has its own share of problems.  Birnbaum, cited difficulties with language, regulations and advertising contracts in Japan.

In China, the largest issue will be protection of intellectual property rights and lack of full control of local entities.  Remember…those CO2 carbonators SodaStream “sells” to you actually come with a license agreement, which effectively empowers SodaStream to collect 70-80% gross margins.

I welcome constructive comments and criticisms.  So long as we’re listening with open minds, I believe we will all benefit from them.

Disclosure:  the author is long SODA

Investors are Look’n Thru a Rose-Colored Mosaic

On July 31st, I saw that share prices of Potash nutrient companies (e.g., Agrium (AGU), Potash Corp (POT), Intrepid Potash (IPI)) had taken double-digit falls on news that Uralkali was walking away from the BPC cartel.


Mosaic Corp. (MOS) in particular caught my eye because as a socially responsible investor I had seen the company on several SRI lists (e.g., Corp Responsibility Magazine’s list). And besides, the contrarian-side of me couldn’t wait to jump on MOS shares.

So I set out gathering data on the fertilizer market, feeling very bullish on Mosaic before even having a stab at the documents. Part of any good due-diligence, of course, is reading what SA authors are saying. However, several seem to be looking at MOS with rose-colored glasses. I now feel it necessary to “set things straight” on Mosaic. This article is a rebuttal of their logic.

They say: Several writers noted Mosaic’s low 10x price/earnings ratio.
I say: I believe this number’s deceiving and based on trailing earnings. Going forward, Potash prices could decline as low as $280/metric ton, according to Goldman Sachs. The lower prices are indicative of the constant oversupply condition of the industry and change in industry structure towards higher production. Lower Phosphate prices, in turn, boost the P/E ratio as the earnings denominator declines. I prefer to think of a P/E as expected earnings growth. So a P/E of 10 would infer 10% growth for the next year. I believe a 15% decline is more likely. Several sell-side analysts (who are typically bullish) expect EPS to decline from $4.08 in FY’13 to about $3.50 next year. (Note: EPS may be higher if the company repurchases shares at year-end.)
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They say: Some investors think Mosaic is protected by its large phosphate business.
I say: Over 60% of Mosaic’s earnings are from its smaller Potash business and, secondly, the Law of Substitution will suppress phosphate prices. While the two nutrients are indeed different, farmers tend to buy higher volumes of whatever’s cheapest at the time.

They say: There is a secular upward demand trend for fertilizer from Emerging Markets, especially the BRICs.
I say: This trend is not new and is already baked into prices. Further, weak currencies (attributed to the Fed tapering), falling subsidies and slowing population growth will reduce Emerging Market demand. While anecdotal evidence says that China’s population is growing rapidly, in fact, its population is expected to grow just 1% annually.

Data from the US Census
Yearly Chart of the Indian Rupee

They Say: One SA writer said, “Uralkali failed to substantiate plans to increase supply.”
I say: Uralkali expects to ship over 10 million tons (MT) of potash in 2013 and their stated capacity is 13mt. Further, it has already secured an agreement with China. In fact, China recently purchased a 12.5% stake in Uralkali to secure supplies.

They say: A SA writer said that Uralkali’s management won’t have time to increase production because it will be distracted with legal battles related to its arrested CEO.
I say: I believe that legal issues will be handled by the company’s legal team. A CEO’s duties are to set a company’s strategy, mission and build its culture.

They say: Another SA writer believes the cartel will resume soon.
I say: I believe this is doubtful because Uralkali’s CEO has been jailed (now under house arrest) and he’s supported by Uralkali’s Board of Directors. There is also the risk that the other side of the cartel, via North America’s Canpotex, could also break up. Further, do you really think the Chinese favor higher potash prices?

What’s working for Mosaic?
I think the best thing going for Mosaic is its management. It’s an offspring from one of the most successful private/family businesses. As such, cash and liquidity are high and I expect a large share-repurchase program. Expect a press release on the share repurchase amount soon as the company will no longer be restricted from buying-back shares after November 26th. What distinguishes the company from other miners is its progress in corporate social responsibility. Though the company’s mines remain a work-in-progress, Mosaic is a leader in governance and reporting. In 2011, Mosaic became a founding member of the Global Reporting Initiative. In 2012, it became a signatory in the United Nations Global Compact (deals with Labor issues).

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A friend once told me that good portfolio management is actually good risk management in disguise. And given that the S&P 500 is so elevated (as well as its P/E) it makes sense to trim your gainers and buy into a small MOS position. Then wait and see how the Potash market unfolds.

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.


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