Description

While SODA is not the type of traditional low multiple value idea I would normally post on VIC, I am finding a dearth of traditional deep value type ideas with the market at all time highs.  SODA has been a long-term growth at a reasonable price (GARP) holding for me, and I continue to be impressed by management’s consistent execution across many geographies.  The company is early in its growth curve and is misunderstood and underappreciated by many investors, as evidenced by its high short interest.  While it is not dirt cheap, I think it is quite reasonably priced given its strong growth potential, and I think it can be a double from here over the next 3 years, despite strong recent performance.  I apologize for not getting this write up posted before the recently reported strong quarter.  While the stock is higher than it was prior to reporting, trends improved sequentially, which was quite impressive as the company had an extremely difficult year over year comparison, having entered Wal-mart in the second quarter of 2012.

Summary:

1. Long-term earnings growth potential:  topline is growing well over 20% and current earnings of around $3 are depressed because of:
   1. Marketing investments in new geographies where they are building general category awareness as well as a machine base to support the sales of high margin consumables in future years
   2. Internal manufacturing capacity constraints which will be resolved by the new plant in construction, allowing gross margins to rise
2. Goals (not guidance) for sales and margins imply $7-8 earnings in 2016 ($1 bn sales at a 17-20% operating margin, which implies a 22% CAGR)
3. High short interest because of the perception the business is a fad even though it has been in Northern Europe for many years, and consumables trends in the US only continue to improve
4. Optionality around a lot of new business initiatives (in-refrigerator sparkling water dispenser partnership, restaurant service business currently testing in Europe, various branded flavor partnership initiatives and other product initiatives such as energy and stevia, higher priced premium sodamaker models that are being introduced, etc.)
5. Trading around 22x 2013 earnings doesn’t seem cheap but it should grow its valuation over time given topline growth of 20%+ supported by US growth just under  100%.  The US has just hit an inflection point in profitability and the margins in the mature markets are way higher than those of the new markets.  Profitability is further suppressed currently by the entry into new markets such as Japan, Brazil, and Russia
6. European business has accelerated in the most recent quarter from mid-teens growth to over 20% growth, given strong country-specific marketing programs and retailer partnerships

Company Description:

The company makes its money selling sodamakers (razors) and replacement CO2 canisters and flavor/syrup bottles (razor blades).  While the company does not disclose the margins of the three main products, it is safe to assume that soda makers are the lowest and CO2 canisters are the highest.  My assumptions are that soda makers have around a 35% gross margin, flavors have around a 50% gross margin, and gas canisters have around an 85% gross margin.  The company is headquartered in Israel, makes all its machines in the West Bank, and produces flavors and fills CO2 canisters in Israel as well as a number of geographically distributed locations.  The company has a long history of operating in several Northern European countries, and in countries where they have been selling a long time, household penetration rates can be in the high single digits or even the double digits (Sweden is the highest penetration market at 25% of homes).  The company has thus far focused its marketing on environmentalism (less plastic canisters going into landfills) and convenience (no lugging heavy bottles from the store), although there is definitely a cost-saving angle as well as a health and wellness angle with several of their products (they use cane sugar and not high fructose corn syrup, their sodas contain 1/3 less sugar, and they are about to launch stevia-sweetened formulations).   The 5 trends they are consciously marketing to are listed as convenience, sustainability, health & wellness, value for the money, and personalization.

The company has often been compared with Green Mountain because of its similar razor/razor blade business model and category innovation.  Green Mountain has an advantage in that their product, coffee, tends to be consumed daily on a regular basis out of both routine and addiction.  Sodastream does have one unique advantage however in terms of a barrier to entry: the need for gas canister exchange programs with retailers.  While all retailers are set up to receive goods, they aren’t usually set up to take in goods and ship them back out.  So far there has been no indication of a retailer willing to set up a second, or alternative, on premises gas canister exchange program.

SodaStream currently sells in 45 countries, 21 directly, and 24 through a distributor.  In the countries where they sell directly, they have country-specific marketing and promotion strategies.  Global points of distribution are around 60,000, and the current sales breakdown is 45% Europe, 39% Americas, 9% Asia-Pacific, and 7% CEMA.  Management is great here.  They are a relatively small company to be managing in so many countries, and have been very creative in coming up with marketing strategies to expand their reach on a limited budget.  In a few years, they have gone from 0%  household penetration in the US to over 1%, despite spending in a year on marketing what industry heavyweights Coke and Pepsi spend in a day and a half.

The company is a relatively new entrant to the US, having entered the market in late 08.  The US market offers very great potential because of its size, but also because of its high per capita soda consumption, which provides the potential opportunity to sell more high margin flavor packs per installed machine than in Europe, where consumption of sparkling water is more prevalent relative to the consumption of soda.  In Europe, the sale of sodamakers is primarily in media marts, stores that sell small household appliances.  In the US, they went specialty initially in their launch – Williams Sonoma first, then Bed, Bath and Beyond – and then went broader as the product became more known, adding Macy’s, Staples, Target, Best Buy and Wal-Mart.  The next push will be to get consumables into the grocery channel, now that household penetration has just broken through the 1% level in the US.  Sales in the US have grown at a 113% CAGR since the 2008 entry.

                                                                US Sales               Retail Doors        CO2 Exchange Doors     

                                2008                       $ 7 mm                 325                         25                                          

                                2009                       $15 mm                1850                       500

                                2010                       $40 mm                3950                       2000

                                2011                       $86 mm                9500                       4000

                                2012                       $143 mm              15,000                   9500

Door growth will be slower in the US going forward, so future growth will depend more on productivity per door as the installed base gets used more, SKUs/door increase, and the installed base continuing to grow through continued awareness marketing (such as this year’s SuperBowl ad – the uncensored version of which has been watched almost 5 mm times on YouTube).  The grocery channel remains a relatively untapped area of door growth.  Over time, margins in the US should increase with scale as well as a higher mix of consumables.  There are currently around 1.5 mm households in the US actively using the product.  Advertising and promotion were 17% of sales in 2012, but a more normalized level when the recent country entries become more mature would be 13-15%.  There is also an opportunity to leverage the company wide selling expense line and G&A line by about 100-200 bp each.

Recently the company has experienced reignited growth in some of the markets where it has had a presence a long time.  The catalyst for this reacceleration of growth has been a combination of product innovation and investments in print and television advertising, and internet presence.  As an example, SodaStream has been in Germany 20 years, but grew 25% in 2012, and 31% in Q1 2013.  Despite strong recent growth and a money-saving value proposition to the consumer, concerns remain about the health of the European consumer, although the strong performance in Q2 should at least temporarily put those fears aside.

The company has recently partnered with CPG companies to offer well-known flavor brands, such as Crystal Light, CountryTime, and Kool Aid (with Kraft).  The Kraft partnership sold 1.2 mm units in its first 7 months in 2012, and they are planning for the business to triple in 2013.  Ocean Spray was recently announced as a partner.  So far no carbonated beverage company has agreed to partner with them, but it sounds like there have at least been some conversations with second tier brands.  There been speculation in the past couple of months about a possible tie up with Pepsi (either through an outright acquisition of the company or a deal to sell their syrups), but I put little stock in these rumors as it would not necessarily make sense for Coke or Pepsi to get into the home carbonation market as this time, given their agreements with their bottling partners.

Putting aside all the new products and ventures, increasing usage per capita will be the key to the company.  If each user were to make 1 sparkling drink/day, they would go through 15 syrups/year (assuming they were drinking soda) versus current consumption at 4 flavors per machine annually.  Gas usage would also double from 3 cylinders/year to 6.  Increasing consumption per cap will depend on flavor innovation, broad marketing, retailer partner/POS marketing, as well more direct marketing (they are just getting into CRM now).

The company has a number of new premium models with higher ASPs and greater ease of use and functionality in the pipeline, and there are also new flavor delivery systems that are in development that should increase ease of use.  Samsung has also partnered with Sodastream to offer a refrigerator that offers carbonated water from a unit in the door.  It is a high priced fridge ($3500), but over time, the technology should be introduced into lower priced models.  There is also a SodaStream Professional product being used and tested currently in 350 European restaurants.  In 75% of the restaurants, the units are sold.  In the other 25%, the units are leased with a service agreement.  There should be 1500 professional deployments by the end of the year.

In terms of history, the company was founded in 1903 and sold its first home sodamaker in 1955.  It was owned by Cadbury Schweppes from 1985, and later sold to the company’s Israeli distributor in 1998.  It was sold to private equity in 2007, and was IPOd on the NASDAQ in 2010.  Despite the perception this is a new company (since it only entered the US market in late 2008); the company has actually been around a long time in Europe and is well established there.

Valuation:

My estimate for 2014 earnings is $3.81 versus consensus $3.49 and a distribution of $3.21-$3.89.  Putting a 20 multiple on that gets you to $76.  20x seems reasonable as that is a little under the low 20s earnings growth rate and a discount to the 22x 2014 earnings that GMCR trades at.  GMCR is more mature thus has lower growth but probably less risk.  Another way to look at it would be if they can hit the low end of their 2016 goals of $7 (which I think they can), and trade at 16x (a lower, consumer products type multiple because more of the growth would be behind them), that implies $112 in 2016.  Discounted back at 10%, that would give you $84 today.  Discounted back at 12.5%, you would get $79 today.  If the company makes its numbers, I think there is a decent chance it overshoots the mid-high $70s given 1) short interest is still 40% of the float, 2) the scarcity of consumer stocks with 20%+ topline growth has led to most trading at 30x or more.

The balance sheet is clean with about $1 in net cash.

Risks:

• Risk the bears are right and it’s a fad and the installed base in the US starts gathering dust.  Their own surveys show that 71% of owners are using their machines 1-2 years later as of April 2013.  The same survey in June 2011 showed only 58% of owners using their machines after 1-2 years.  The trends in quarterly US flavor and CO2 sales reinforce the company’s assertions that attrition is not on the rise.
• Risk the bears are right and US revenue growth slows as door growth slows down.  However, in Q1, doors were up 67% and sell-through revenues were up 182%, so right now there is no sign of that happening.
• Decelerating growth from an unsustainable high level.  Since 2009 (the real launch in the US), revenue has grown at a 47% CAGR, leading to a net income CAGR of 71%.  It’s known that forward guidance only implies growth in the low 20s.  This would be expected as door growth slows and also as the mix overtime shifts from higher ASP, lower margin sodamakers to lower ASP, higher margin flavors and CO2 canisters.  Because it is known/forecasted, it shouldn’t be too much of a risk factor, but the vocal bear community will continue to point to decelerating growth.
• European macro – Europe is the largest market and the most profitable one, so sales declines there would have a high deleverage factor to the overall company (so far so good however)
• FX – while they do hedge currency, they are making a lot of money in non-USD
• Production in the West Bank opens them up to potential negative publicity from opponents of the current ruling party in Israel (although they pay one of the highest wages in the region, making jobs at their factory quite sought after)

Catalyst