Description

DAVIDsTEA is a broken growth story that IPOed at $19 in mid-2015 on the pitch of a now clearly premature US rollout.  At $6.85, I believe the shares are comfortably in value territory.

Similar in concept to Teavana, DTEA retails tea through 225 stores, of which 47 are in the US and the remainder are in Canada (~11% of the business is ecommerce).  The company has a clean balance sheet thanks to its IPO proceeds, with a US$177mm market cap against $25mm of cash, no debt (aside from store leases), and ~$15mm of seasonal inventory, which adds up to an adj. EV of ~$138mm.  CY16 revenues should be ~$165mm with a YE run-rate of ~$180mm.  More importantly, DTEA's underperforming US stores, recent execution issues, and some accounting charges are depressing reported earnings and cash flow metrics and obscuring a profitable and growing Canadian franchise.  Backing out the cash and seasonal inventory, I believe the market is charging ~12-15x NOPAT for a Canadian business growing in the teens and tossing in a roughly breakeven US operation for free with an embedded option on it either getting figured out or shut down.

Background

DTEA started in 2008 with a single store in Toronto opened by then-27 year old David Segal and his octogenarian cousin and Canadian retail magnate Herschel.  The company brought on Jevin Eagle (ex-Staples executive) as a professional CEO in 2012 after Highland Capital bought in and the business was starting to ramp ahead of an impending IPO.   Jevin left in 2014 in favor of current-but-soon-to-be-ex-CEO Sylvain Toutant (ex-GMCR Canada).  By the time of the offering, DTEA had 161 stores (136 Canada and 25 US) and pitched a trajectory of 30-40 openings a year to eventually get to 555+ (230 Canada and 325 US).  With a clearly cleaner, younger and more modern/colorful box, DTEA positioned itself as the Lululemon of tea (Chip Wilson invested alongside Highland) in a niche market where Teavana continues to be the only other banner with more than a few dozen locations.  

Of course, the pitch was just that.  Given materially lower AUVs, DTEA USA’s reported gross margins have consistently been 10%+ lower than margins in DTEA Canada.  The US business has failed to get to management’s target mature 4-wall EBITDA margin of 25%; I estimate it currently operates at close to EBITDA breakeven and at a slight pre-tax loss pre-corporate costs.  DTEA USA saw management turnover earlier in 2016, with Christine Bullen joining in May to run the operation.  Christine previously headed Lindt’s US retail/e-commerce business, which encompassed several dozen US stores including outlet and café formats.  

To make matters worse, DTEA had an email marketing transition mishap this fall that cost it ~$1mm in high margin e-commerce revenue, in October announced that Toutant would be gone at the end of the Jan FY (in four weeks) to be replaced by Christine on an interim basis, and during Q3 earnings guided the key holiday quarter comp down LSD including some softening in Canada v. previous trend of +MSD.  The company also took impairments on several US store leases, and is finally slowing down expansion beyond in-progress openings.  

Why Long

The long case comes down to valuation.  DTEA consolidated continues to generate positive operating income and is FCF breakeven including new store investments (capex + working capital).  I peg DTEA Canada at a low teens EBITDA margin even loading practically all corporate overhead onto that unit, which implies +/- CAD15mm in run-rate NOPAT based on the 178 stores in place.  My estimates imply fully-loaded IRRs on these Canadian stores in the mid-teens+ before e-commerce, which is a very attractive box that the company thinks it can build at least 50 more of.  At 17x plus ~$1.50/share in cash + seasonal inventory, I get to a fair value ex-USA of ~$9/share.  Pretty good in today’s market, but not world-beating.  If you believe my Canada number, the reverse sum of the parts says that the market is paying us $2/share or $55mm to hold DTEA USA – the same business that was used in 2015 to justify the IPO price.  

DTEA USA should be close to cash breakeven on a fully-loaded basis with 47 fully-built stores and a growing high margin e-commerce business.  Unlike two years ago, the board/Herschel is beginning to admit that there are some issues with the current store model.  If we assume that the existing stores remain cash breakeven and DTEA wastes money building 20 more breakeven units before finding religion, the value destroyed would be ~$0.40/share.  If the team figures out the go-forward model, valuing the unit at 2x CY16 revenue would add $1.30/share instead – we can pencil out scenarios where it’s worth more, and none of this is in the price.  

For reference, DTEA USA will exit CY16 at ~$33mm in run-rate revenue while Teavana achieved EBIT breakeven in 2007 at ~$35mm.  At 200+ stores and ~$200mm of run-rate revenue, Teavana was printing a high-teens operating margin (albeit at $900+sales/ft² v. ~$700 for DTEA) before it was acquired by Starbucks at ~3.5x sales).  The situation begs for an activist and/or buyout, but Herschel still owns half the business and has effective control.  I would note his age and that DTEA is the only other scaled chain in the North America loose leaf tea business, but admit to having no insight as to whether he would be a willing seller (or buyer) if a bid came in.

Other Concerns

DTEA USA's blue sky scenario will be difficult to achieve as tea drinking is ultimately not as pervasive in the US as in Canada, resulting in density issues.  Teavana also already has 350 stores, including many flags in easy high traffic A malls which should make it that much harder for DTEA to position itself.

Price and product.  DTEA and Teavana generate high gross margins on prices well above non-boutique-y local shops/wholesale/cost.  Between the two, Teavana appears to use more aggressive sales tactics to generate AUV while DTEA is more customer-friendly, but this to date has gotten reflected in their margins.  There are also occasional concerns about chemicals in the tea originating further up the supply chain, and some complaints about the companies mixing in lots of non-tea ingredients to create their unique blends, which conveniently also helps boost margins.

Catalyst

Better segment breakout.

More clarity (and better decision-making) around US strategy.

Getting through bad comps (or just stop building).

Transaction.