Tuesday, November 8, 2011

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!

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

    Disclosure: the author is long SODA.

    Friday, November 4, 2011

    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
    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

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