Description

Summary

You don’t often get the chance to buy a fast-growing branded consumer products company at a steep discount. I think you currently have that opportunity with REED.

Reed’s is a micro-cap branded natural sodas company known for its ginger ales. The company has grown ~15% annually for a decade. More importantly, REED has a new kombucha product that only hit shelves in November, but in some natural foods stores is already outselling the entire legacy Reed’s product portfolio. Despite this incredible early success, REED stock currently trades at a discount to a my estimate of the value of JUST the legacy natural soda business (~$5 per share), leaving negative value for kombucha, a product which could conceivably outgrow the entire existing Reed’s portfolio within three to five years. I believe REED should be worth $8-12 three years from now, offering a 2-3x return.

Product Overview & Kombucha

Reed’s has three product lines:

Branded Natural Sodas are Reed’s core business. In 2012 they accounted for approximately $25 million of the company’s $30 million of revenue. The primary brands are Reed’s, which sells all-natural ginger beers in a variety of flavors, and Virgil’s, which sells natural root beer and other ‘traditional’ natural soda flavors. Reed’s natural soda revenues have been growing ~15% organically for about a decade. This growth has been driven by word-of-mouth promotion and small but continual distribution gains; Reed’s has never had a national advertising budget due to ongoing losses. The company’s brands are big in natural foods and have thoroughly penetrated that channel at this point (~2/3 of revenue—natural foods distributors are 50% of revenue and Whole Foods and Sprouts combined are another 10-15%), but national grocery remains a significant growth opportunity, especially once the company begins to advertise nationally (more on this later). This business continues to grow at an attractive rate, January 2013 was the strongest month in Reed's sodas' history despite the winter being a seasonally weak period for sodas. The Reed’s natural sodas generate 30-35% gross margins.

Private Label Natural Sodas are a new but fast-growing part of Reed’s product line. In 2012, private label products generated approximately $5 million of revenue for the company, up from nil in 2009. The company has used its proficiency as a brewer and specialty beverage producer to manufacture hard-to-produce beverages such as sparkling cider and all-natural root beers and other sodas.  Most private label manufacturers (Cott, for instance) aren’t set up to make these kinds of beverages. Reed’s private label revenues will remain small but should continue to grow over time as private label acceptance continues to grow and Reed’s expands its private label customer relationships. Reed’s private label products also generate 30-35% gross margins.

Kombucha is Reed’s newest product line. Kombucha itself is a probiotic fermented (< 0.5% ABV) tea beverage that has become extraordinarily popular in health foods circles, but remains somewhat unknown outside them. Kombucha sales have taken off like a rocket ship. Despite kombucha’s relative obscurity, the North American market for it has grown from nothing in 2004 to a ~$370 million industry (27% y/y growth) in 2012, based on retail sales. The kombucha category reportedly accounts for 1% of Whole Foods revenue but just one tenth of 1% of its floor space.

The #1 kombucha company is Millennium Products, a private L.A.-based company with two brands, GT’s and Synergy, which together control somewhere between 75% and 85% of the market. In most stores these two brands typically occupy at least 50% of the kombucha shelf space, and on a sales per-inch basis they greatly outsell the various regional brands that usually sit on the shelves below them. There is no other established national kombucha brand, and larger beverage companies have shied away from kombucha, for two reasons. First, the production and distribution process is much more complex than for soft drinks because the product is fermented and active. Second, past issues with alcohol content (covered in the risks) caused a couple of players, most notably Coca-Cola’s HonestTea, to drop out of the market. Today I believe Millennium’s wholesale revenues are approximately $200 million, and its sales at the retail level are approximately to $300 million. For what it’s worth, I have heard a rumor--which I cannot remotely confirm--that Nestle made a bid of a “a few hundred million” for Millennium a few years ago, when Millennium was generating $70 million of revenue (so 3-4x sales).

Chris Reed, the company’s founder and 30% owner, decided to enter the kombucha market after seeing how popular home-brewed kombucha had become with its own employees/brewers. The company had a couple of traits that made it a logical kombucha producer. First, it had the proficiency to make kombucha because its ginger and root beers are actually brewed beverages. Second, the company already had a national footprint and credibility with retailers and distributors thanks to its ginger brews (and in some cases Virgil’s sodas), which are available nationwide at stores like Trader Joe’s, Whole Foods, Safeway, Kroger’s, and Sprouts. The company is especially well-regarded in the natural foods channel, which is the launching point for kombucha. Reed’s also has a close relationship with UNFI, a 30% customer and the largest natural foods distributor in the country. Reed’s is a “preferred” supplier to UNFI, which means that UNFI will automatically add new Reed’s products to its catalog, and will also cooperate with Reed’s on some individual marketing efforts, such a national promotional events and videos like this: www.youtube.com/watch?v=H8Dfy9gjKLg

So when Chris saw how popular kombucha was becoming with his own employees he quickly took steps to develop and roll out a Reed’s kombucha product line. The hard launch commenced November 1^st, and sixty days later the product was selling at a $2.5 million revenue run-rate with no advertising and just four SKUs. The company has just announced that it is doubling the product line to eight flavor SKUs, and using a new label that will improve the visibility of the bottles when they’re stocked in unlit coolers.

Distribution of the kombucha product is still in its infancy. Small natural foods chains adopted the product early on, but Reed’s kombucha is not yet stocked nationwide by any large chains. Whole Foods, for instance, presently stocks it in about 60 of the 300+ Whole Foods locations. Why? Reed’s kombucha has been approved by the Whole Food’s corporate division, but the stores buy regionally (there are 11 U.S. regions), so Reed’s must sell to each region individually, which takes time. Reed’s already has agreements that will nearly double the number of Whole Foods locations that carry its Kombucha, but the product won’t actually hit those new shelves until refreshes happen in April and May. This sales process has been mirrored with other chains.

So the roll-out has gone more slowly than the company hoped—at the end of 2012 Chris Reed thought the company might be able to sell $5-15 million of Kombucha in 2013, but now $5 million, if that, is looking more realistic. Why isn’t this a disaster? Because once the Reed’s kombucha DOES get on the shelves, it is selling at a stunning rate. Some of the first natural foods stores to carry Reed’s kombucha have now reported back to the company that the company’s kombucha is generating as much revenue as all of Reed’s non-kombucha products combined. The figures vary (on the most recent conference call Reed’s said the biggest disparity was a store selling 2x as much kombucha, although conversely there was a store selling 1/3 as much kombucha) and we won’t know the exact numbers any time soon, but my guess is that in the natural foods channel, sales of kombucha can at least equal non-kombucha sales.If that happens, Reed’s kombucha will generate about $15-20 million of revenue—the same as Reed’s soda sales to the natural foods channel. This doesn’t seem crazy when you consider the following:

• On the last conference call, Chris Reed said he thought the company had $10-15 million of kombucha revenue in hand based on the stores that have already agreed to stock kombucha at some point and/or agreed to stock the new SKUs. That excludes the two thirds of Whole Foods locations that haven’t yet decided to carry Reed’s kombucha [sure of this?], as well as all Trader Joe’s locations, because TJ’s does not carry any kombucha.

• Reed’s is the only true national competitor to Millennium. High Country and Katalyst are two competing brands that have become more than regional, but neither has what I would call a strong national presence. High Country has been around since the earliest days of commercial kombucha (early 2000s), but was nonetheless projecting only $5 million of revenue in 2012.

• 15-20 million of kombucha sales equates to a 5-10% market share depending on how much the market as a whole grows. 5-10% market share doesn’t seem like much if Reed’s can become the clear #2 kombucha player. This is an important point. No brand ever keeps a market share as high as GT’s/Synergy’s share is right now. Consider these market shares for category leaders.

And so on. Nobody can monopolize the market forever. Millennium will not maintain 80% market share. MNST has become a $7.5 billion (3.2x sales) company by becoming a strong #2 in energy drinks and turning Red Bull’s monopoly into a duopoly. I think it is clear Reed’s has a great opportunity to become a viable #2—it is up to the company to seize opportunity.

It is also worth pointing out that at one 25-store chain, Reed’s top kombucha SKU is already selling at 1/3^rd the sales rate of Millennium’s top SKU. I don’t want to put too much value in this single data point given that Millennium has 3x as many SKUs, but I do think it is promising.

Margins & Profitability

On an EBIT basis, the company is about breakeven. Gross margins are 30% of sales, but so is overhead. There should be a lot of operating leverage going forward, as the company was operating at $7 million or so for about five years before ramping expenses up a bit this year in order to support the kombucha roll-out. I think it is reasonable for overhead to fall to 25% or so of sales within a few years.

The table below shows my rough estimate of the unit economics for Ginger Brew and kombucha. It is important to note that Reed’s has been running at a consolidated gross margin of 30%, rather than 37%, because the company’s facilities are currently only 50% utilized. The company reports idle capacity costs on its income statement, and in 2012 idle capacity costs were $1.9 million, or 6% of sales. Margins also suffered significantly in Q3 and Q4 due to production inefficiencies that occurred as the company honed its kombucha process.

Absorbing idle capacity costs with new kombucha sales while also transitioning toward a higher-margin product mix should make for a strong gross margin tailwind. In addition, the company has been selling most of its kombucha at sale prices to promote the roll-out. Eventually those promotions will expire, which will bring margins up further, as I’ve tried to show in the “normalized” column.

What is it Worth? And Margin of Safety

Traditionally transactions in the industry have happened at 2-3x sales, but in the case of Reed’s the right multiple is a little hard to figure. Reed’s generates lower-than-industry-average gross margins (most co’s are at about 50%), but on the other hand is growing more quickly than a lot of companies have slowed to GDP-rate growth and still sold for 2x. Ultimately I assume 2x for the legacy natural soda business. I think the Reed’s sodas could have quite a bit of growth left simply because the company has never advertised them nationally but will soon thanks to the additional gross profits that private label and kombucha are going to  generate. On the other hand though, as Reed’s natural soda revenues keep growing, generating the same rate of growth on a progressively larger revenue base will naturally become more challenging.

Every recent take-out of an established but still fast-growing natural beverage brand (FUZE, Naked Juice, Izze) has happened at about 3x sales, but unless Reed’s can improve its natural soda margins, I am more comfortable with 2x sales for the Reed’s soda business.

I give 3x to kombucha. I think this is a no-brainer. Reed’s kombucha has a fantastic growth outlook, and it should eventually approach 45-50% gross margins once introductory promotions roll off and the company improves its production processes. Big beverage companies have a long history of paying up to buy players in “new” beverage categories, whether we’re talking about VitaminWater (11x sales, #1 player), HonestTea (undisclosed, likely 3-4x sales, #3 player), ZICO (12x sales!, #2 player), or any of a number of other brands.

In the bear and base cases I give no value to the private label business on a sales basis. This business is profitable and growing but it exists largely to soak up Reed’s unused production capacity. I don’t know that it would have much value to an acquirer, and if Reed’s ends up selling enough kombucha to absorb the unused production capacity, the company might choose to wind the business down anyway.

The table below shows my various estimates for the value of the company, based both on EPS (fully taxes, although the company has $20 million of accumulated losses) and sales.

This is a growth investment but I still think there is a margin of safety at the current price. Let’s forget about kombucha and private label completely for a moment. At 2x $30 million of soda revenue in 2013, the branded soda business alone is worth $60 million, compared to a current market cap of $50 million. That means kombucha (and private label) have negative value, even though Kombucha will end up being the future of Reed’s if the company can become a well-established #2.

If Reed’s DOES become the established #2 kombucha producer, the upside is tremendous. Let’s say the overall kombucha market grows to $500 million (retail) by 2015, as some industry analysts are projecting. That would equate to $300-350 million of  wholesale revenue. If Reed’s captured a relatively low 10% of the market, its kombucha operations would arguably be worth about $90 million. Add in $75 million for a by-then-larger natural sodas business, and you’re looking at a $165 million market cap, versus $50 million today. If Reed’s can somehow capture a share in the 30%s, as most other #2s have managed to do….well, obviously this investment would be a great success in that scenario even if winning that much market share took 5-10 years.

Various Other Notes

-Chris Reed, the founder and CEO, owns 26% of the company. He is a bit of a wild man. He has chosen to self-finance the company as best as possible rather than sell a large stake to a strategic or financial partner. This has resulted in a steady sharecount increase over time. I think the increase will slow to a trickle going forward, as the company likely turned to the corner to consistent profitability in mid-2012 and should no longer need to support itself with equity.

-The company has about $20 million of accumulated losses, so it won’t pay taxes anytime soon.

-The company is basically unknown to the market. The stock is 8% owned by institutions, and is covered by just one (disinterested) analyst. The wild swings in the stock price despite the stable revenue trajectory suggest a lot of momentum and day trading in the stock.

-The company may have some untapped pricing power. It sells a case for $18-20 wholesale, which equates to $0.75-0.83 per bottle, and $3.00-3.32 per four pack. Trader Joe’s, a 10% customer, sells the four packs for $3.99, suggesting a gross margin of 20-30%. Any price increase by Reed’s would probably force Trader Joe’s to raise their retail price, something they probably wouldn’t be happy about—but it would still leave a decent margin for Reed’s grocery and natural foods customers, which typically sell the four packs for $4.99 or $5.99. This is purely my own conjecture and not based on anything someone from the company has said.

-It is also possible that the company can improve its cost structure a bit. As I’ve mentioned, the gross margins are below those of most competitors. Other than the idle capacity, the main reason for the lower margins is that Reed’s isn’t selling carbonated sugar water like most of its competitors are. The ingredients are real and the ginger brews have a lot of ginger in them, which is expensive, as well as spring water and real fruit juices rather than city tap water and high fructose corn syrup. I don’t think the company will compromise much on the ingredients, but based on talks with Chris I believe there could be some leeway to improve margins through more favorable production and purchasing agreements.

Risks

-The main risk to the thesis is that the company fails to seize the opportunity to become a strong #2 in kombucha. It has had one mis-step so far in the roll-out, using labels that were difficult to read and in some cases did not fit the bottles properly. The company has a history of success building a soda brand over time, but it has never attempted a product roll-out at the speed and scale it is attempting with kombucha.

-Kombucha is a fermented and perishable beverage with trace levels of alcohol. It must be refrigerated from production to consumption. If it isn’t, or if the kombucha is left in the bottle too long, the alcohol content can reach unacceptably high levels for a non-controlled substance. This happened in some instances in 2010 (before Reed’s entered the market) and a number of stores pulled all kombucha from their shelves temporarily. Hopefully this event put the fear of god in the kombucha producers and a reoccurrence is unlikely, but another such episode is still a possibility. Reed’s regularly sends its kombucha to an outside lab for testing for alcohol and other chemicals.

-The company is breakeven. It seems clear to me that Reed's will be profitable going forward, but there are still unseen risks to profitability. Chris will reinvest some of the gross profits in marketing, for instance.

Informative Links

http://www.nytimes.com/2010/03/25/fashion/25Tea.html

http://www.forbes.com/2009/09/23/gt-dave-honest-tea-cmo-network-kombucha.html

http://www.bevnet.com/news/2011/the-kombucha-crisis-one-year-later

http://www.time.com/time/specials/packages/article/0,28804,2094921_2094923_2108731-1,00.html

http://articles.latimes.com/2013/apr/08/business/la-fi-stock-spotlight-reeds-20130408

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