SODA : A bubbly short

Starved of yield in the bond and money markets, investors are now frantically bidding up any stock which can deliver growth in the recessionary climate. Sodastream’s stock is a beneficiary of this phenomenon, driven by its past success in Sweden and its impressive growth in the US. However, this is not the first time this particular fad has been rolled out, and chances are that the fad will fizzle even faster this time round, especially given the current economic turmoil in Europe.

Sodastream sells home fountain soda machines that pump carbon dioxide into water to make soda water, which can then be mixed with syrups to produce soft drinks. Incredibly, the basic machine first made its debut nearly a century ago in the 1900s in Europe. Sodastream, previously known as Soda-Club, reached its peak popularity in the 1970s and 1980s in the UK on the back of a successful marketing campaign centered around the slogan “Get busy with the fizzy”. But as the marketing stopped, sales faded. The company passed through the hands of several companies, finally being bought by Fortissimo Capital, a newly formed Israeli private equity firm, in 2007. At that time, Sodastream had revenue of around $100M, but was losing money.

What ingenious plan did Fortissimo come up with to save the company? Simply put, they resurrected a business model that had previously failed. The PE firm planned a revival based on marketing, and recruited a new CEO from Israel Nike to drive the new strategy. TV advertisements were rolled out in UK capitalizing on nostalgia, while in the US, promoters were stationed in retail stores to demonstrate the machines. The marketing predictably caused an uptick in sales, which was used as justification to IPO the company. The company emphasized its push into a new market with high per capita consumption of soda, the United States, as well as its razor-razor blade business model, making low margins on machines (35%), and high margins on syrup (55%) and carbon dioxide carbonators (90%), essentially explaining the current lack of cash flow by implying that the best is yet to come. Growth-hungry investors were hooked into a plausible story. Comparisons were made with Green Mountain Coffee Roasters (GMCR) by a certain disreputable TV stock promoter.

Why SODA is not GMCR

The “SODA is the next GMCR” meme has become a major bull theme among retail investors. However, if you go beyond the superficial product similarities and consider the business model, SODA looks extremely weak compared to GMCR.

Firstly, GMCR’s K-cups are patent protected. You cannot make a cup that fits into Keurig’s single cup coffee maker unless you pay licensing fees to GMCR. GMCR’s competitors have to come up with a completely alternative packaging (e.g. Tassimo T-discs) to fit a different coffee maker. SODA’s consumables are not patent protected, which makes SODA’s razor-razor blade business model very iffy. Soda syrups are widely available to restaurants and easily adapted for retail sales. In fact, it is relatively easy to make your own soda syrups. As for the carbon dioxide cylinders, SODA deliberately makes its carbonators with a non-standard refilling adaptor so that they cannot be filled with industry standard canisters. This has not prevented third party companies like VikingSoda (in Sweden) from reverse engineering the fittings and filling SODA’s carbonators. (SODA has sued VikingSoda, and initially won an injunction, but the injunction was overturned by higher courts, and it now appears legal for third parties to refill SODA carbonators in Sweden.) Another approach is to use third party carbon dioxide tanks for Sodastream machines, circumventing its carbonators altogether. These third party manufacturers will limit the margins that SODA can achieve on its consumables.

Secondly, coffee is an addictive beverage with a growing market in the developed countries. Many people consume coffee every day on a regular basis. Soft drink and carbonated drinks are occasional beverages with a market that is shrinking 1-3% annually in Sodastream’s key markets, US and Europe. Few people drink soda on a daily basis, or with any kind of regularity.

Thirdly, the savings of a K-cup is clear to the consumer. You pay $0.50-$1 for a K-cup, versus paying $3-6 for a high quality cup of coffee at a café. In X number of cups, you recoup the price of the coffee maker. The savings of the Sodastream system is much more amorphous. Most consumers can’t even tell you the price of a can of soda that they drink, for the simple reason that the price is so low that it is below the pain threshold for most people, and simply does not register. And calculating how much an equivalent serving from a Sodastream machine costs requires breaking out the calculator, or maybe an Excel spreadsheet. How much does that carbon dioxide cost again? And how much is three tablespoons of syrup? While it is arguable that Sodastream machines may be somewhat cheaper on a per liter basis (and I do mean arguable, because you would have to drink a lot to achieve minimal savings), cost per drink will simply not be a factor to anyone except math wonks.

Fourthly, GMCR saves time. You can skip a trip to the café in the morning. Keurig coffee makers are easy to use, involving minimal labor. You can make single cup coffee quickly in the privacy of your own home, comparable with the waiting time you spend at cafes. As the slogan “Get busy with the fizzy” suggests, Sodastream machines are laborious to operate and represent a net waste of time for most people. To carbonate water to the level that you find in cans, you have to charge the water with carbon dioxide 7-10 times, and then add syrup to that water to make soda. Soda is best made in small batches, because it loses its fizz rapidly. Compare this to the time taken to pick up a can, pull a tab, and pour. And when that carbonator runs out, you can’t pick one up on your weekly grocery shopping trip. You have to make a special visit to your nearest home appliance store like Bed Bath and Beyond or Crate and Barrel, to pick up a new canister.

In conclusion, while GMCR’s customers are primarily driven by economics and value, Sodastream’s customers are not likely to be value-oriented. Why would one buy a Sodastream machine then? Sodastream machines appeal to three groups of consumers. Firstly, there are novelty seekers who pick one up on impulse, and soon after relegate the machine to the attic to join the bread maker. These consumers realize belatedly that while in principle, making your own bread and soda promises all kinds of health and culinary benefits, in practice, the convenience of picking up bread and soda at the grocer wins out. Secondly, there are soda aficionados who want to make their own fountain soda with their own specialized recipes, and appreciate a machine that produce soda water to a defined fizziness in their own kitchen without having to lug club soda from the grocer. And thirdly, there are environmentalists who feel that using so much metal and energy to make and transport cans of soda is wasteful, and that it is one’s moral duty to endure some inconvenience to save the environment. This is the same type of personality who religiously recycle despite the inconvenience. To these last two groups of consumers, Sodastream machines present real value, and they are likely to form repeat customers. However, in the final analysis, Sodastream’s core customers are a niche segment of the population. SODA in no way approaches GMCR’s broad appeal to middle class thriftiness, and is simply a pale imitator.

Retailers face cumbersome logistics and murky legalities

Sodastream’s carbonators present an unusual logistical challenge to retail stores. Most retail stores are set up for one way sales of goods with limited returns, and almost never ship products back to warehouses. Unlike most goods, however, SODA’s carbonators must be refilled when empty, generating a huge volume of returned products on a one-for-one basis with sales. Sodastream contracts with UPS to ship and exchange carbonators at customer’s homes, but this service is expensive (UPS adds a hazmat fee both ways), and many customers would either have to leave their carbonators out and risk theft, or stay at home to wait for the UPS guy. Management realizes that shipping carbonators individually is expensive and inconvenient to the customer, and is trying to place the carbonators in as many retail locations as possible. Because the empty cylinders comprise a large portion of the value in the goods, the retailers must pay a deposit for the value of the cylinders, and then recover that deposit when customers return the empty cylinders. In addition to the additional financial outlay, the retailer must also re-educate staff to deal with the high level of returns associated with this one special product. If these reasons do not deter the retailer yet, the gas cylinders themselves are regulated as hazmat in the US, due to the risk of explosion when heated, and the risk of suffocation if leakage occurs in a closed room. It is illegal to simply pile the cylinders up in a closed room without sufficient ventilation, and transport of the cylinders must be in open vehicles with drivers educated about the dangers of the goods. All this adds to the cost of the logistics associated with this one special product. And furthermore, Sodastream machines are made in Israel-occupied Palestine, and stores which sell their machines are sometimes picketed by Palestine activists, who demand that they stop selling good illegally produced in Palestine.

Which retailers would be interested in selling Sodastream machines despite these logistical and legal issues? To date, it appears that Sodastream is most attractive to kitchen appliance retailers such as Bed Bath and Beyond, Crate and Barrel, and Williams Sonoma. These stores have low turnover but high margins, and impulse purchases of Sodastream machines add appreciably to the bottom line. In addition, the presence of Sodastream product demonstrators increases the time customers spend in the store, and customers coming in to exchange carbonators are probably incremental customers to these non-food retailers, with the possibility of additional impulse purchases while the customers are moving in the store. These stores are also staffed with moderately well trained employees who are able to deal with the inquiries associated with a novel and unusual product that require exchange of carbonators. Obviously, the difficulty of finding one of these retailers nearby to exchange carbonators diminishes the attractiveness of the Sodastream machines (and there are anecdotal reports that the carbonators are always out of stock at some stores, because the retailers are much more interested in selling the machines then in dealing with the carbonators). To achieve scale, Sodastream has to sell its carbonators in grocery stores. Most mainstream grocers, however, rely on high turnover low margin products. A high margin product that is labor intensive and has unusual logistics would be challenging to the typical minimum wage employee at these stores. The currently low turnover of the carbonators would also decrease the yield of their shelf space. Grocers would like to see higher volume associated with the carbonators before committing to selling them, which creates a kind of a chicken-and-egg problem. In my opinion, it is highly unlikely that you’ll see Sodastream carbonators appear at Walmart or Target anytime soon.

The experience of Sodastream in Sweden, in my opinion, is the exception that proves the rule. The remarkable near 20% market penetration of Sodastream in Sweden can be explained by several factors. Firstly, Swedes have relatively high incomes and are more environmentally conscious then residents of most other countries. Secondly, the retail sector of Sweden is highly concentrated, with the top 3 grocers taking 80-90% of market share. Food costs are higher than other EU countries, grocery margins are higher, employees are better trained, and there is no need to strive for maximal inventory turnover. Just convincing one of the major grocers to sell/exchange carbonators would be sufficient to place the carbonators near every resident in Sweden, accounting for the company’s relative success in that country. It is unclear whether this set of conditions exists in other countries, and whether this success is replicable elsewhere.

Valuation

The valuation of rapidly growing companies like GMCR and SODA is always a crapshoot. Minute changes in growth rates and periods cause huge changes in final valuation. My preferred method for valuation of growth companies is to project the final terminal market size/revenue and the final margins possible. I find that this method of valuation makes for a more rational basis for disagreements. Still, growth companies always present increased uncertainty, especially if the market is new or being created as the company grows. In this case, I don’t think there is a new market being created, but rather, the existing soft drink market is being shunted into a new method of consumption, so there is a somewhat increased certainty.

What are the sizes of the soft drink market in Europe and the US? Unfortunately, I could not find any publicly available information on this, and am forced to cobble together what I consider a reasonable size estimate based on Coca Cola’s public filings and recent estimates on its market share. In 2010, Coke reported selling 25.5B cases of soft drinks, 22% of that in US, and 16% of that in Europe. The market share of Coke in US and Europe are approximately 35% and 50% respectively. Therefore, the total size of the US soft drink market is some 16B cases (300M people each consuming 53 cases annually), and Europe’s market is around 8B cases (500M people each consuming 16 cases annually). If one considers that initial pre-2007 pre-marketing-blitz revenue as the likely final revenue derived from a certain volume of soda drinkers, then Sodastream will derive $100M of revenue from Europe, and $200M of revenue from US, for a total of $300M in revenue.

Of course, the above analysis simply assumes that marketing efforts of the current management simply has minimal long-term effects in Europe, and ramps US sales up to a level comparable with European steady state sales. Another approach to get at terminal revenue is to estimate the effectiveness of the marketing spend on revenue. In year 2010, each additional marketing dollar resulted in 2.5 dollars of incremental revenue. As of December 2010, the company has $75M of cash on hand, and it raised an additional $50M in the last round of share offering. I assume that all income from operations is used to fund working capital and additional general and administrative expenses for increased sales, and all cash on the balance sheet is used to fund additional marketing at the same 2.5 additional dollars of incremental revenue per dollar of marketing money. This will translate into $312M of additional revenue. The low end Sodastream machine retails for about $100, and it is reasonable to expect about $100 in annual consumable sales from a repeat customer. So assuming a 50% customer retention rate, after the initial spike in sales to $500-600M, half of the incremental sales will disappear, leaving revenue of $300-$450M.

What operating margin will SODA obtain from this revenue? Currently, SODA has an operating margin of around 10%. SODA management will undoubtedly argue that over time, product mix will shift to a better machine-to-consumable ratio resulting in higher margins. GMCR, a more mature company, has operating margins of around 17% (if you strip out patent settlement expenses). A traditional kitchen appliance manufacturer such as LCUT (maker of Cusinart toasters and other appliances) sports operating margins of around 6-7%. SODA has a weaker business model compared to GMCR, and a 15% final operating margin seems reasonably optimistic estimate. This will be reduced by around 20% for taxes, leading to a net margin of 12%.

Combining the revenue and net margin estimates gives terminal earnings of $35-55M. At its current stock price of $71, SODA has a market cap of $1.4B, or around 25-40 times terminal earnings. A more reasonable valuation will be something like 10-15 times earnings for a small cap company. The company IPOed at the low end of that range, at around $20 per share or a valuation of $360M, and has since rapidly doubled, and is close to quadrupling.

Counter-arguments

Once the lockup is over, insiders lost no time in halving their holdings in a secondary offering priced at around $40 per share, recognizing that the stock is richly valued. On the other side, buyers include mutual funds like Fidelity, which currently owns 13% of the stock (on par with Fortissimo), and probably a number of retail investors as well. More recently, the stock seems to be trading in sync with GMCR, both priced at around 100x trailing earnings and moving in tandem, suggesting that hedge funds employing statistical arbitrage strategies may also be in on the action.

In the short term, there is probably no danger of slowing growth until SODA hits the $300-400M revenue mark, which at current growth rates should be some time in 2012. But I initiated a SODA short position recently despite suspecting that evidence of slowing growth is probably one year away primarily as a hedge against the European crisis, which should adversely affect the USD-Euro exchange rate and put a dent in the 60% of SODA revenue derived from Europe. Currently, I am underwater on this position, but am still comfortable with my thesis. I will re-evaluate my thesis if SODA starts selling its carbonators in mainstream grocers (a precondition of widespread adoption), or if revenue crosses the $500M threshold (unlikely before 2013).

Disclosure : I have a short position in SODA