Reviewing Longbow Research's Downgrade Of SodaStream

Shares of SodaStream (SODA) have remained under pressure since its 3rd quarter 2013 earnings release which many investors found disappointing, because the company not only missed revenue guidance narrowly, but flavor syrups grew at a much slower pace than anticipated. Much of this slowdown in syrup sales was due to a rebalancing of inventories at key retailers in the U.S., while another portion of this anomaly in syrup sales growth was due to the disparity in distributor orders during the quarter. In this article update, we (Capital Ladder Advisory Group) will discuss the syrup sales going forward as well as look into the recent downgrade of SODA by Longbow Research.

Before moving forward, we would like to take the time to note that usually there is a constant mix of direct sales and distributor sales in most reporting quarters on year-over-year basis. However this 3rd quarter, and for which we used the term anomaly, distributor sales only accounted for roughly 20% of total sales vs. 31% of total sales in the 3rd quarter of 2012. The CEO of SodaStream outlined that this anomaly will likely result in a redistribution of orders into the 4th quarter of 2013 for which some of the results can already be viewed by investors through inventory builds in retailers around the globe, including Japan, Australia, Czech Republic, Romania and many more.

In the U.S., we have already demonstrated that retailers such as Wal-Mart (WMT) have also increased inventory dramatically on a year-over-year basis by adding a series of new flavor and bottle SKUs to their respective lineup of SodaStream products. Our previous article, "SodaStream and Wal-Mart Add SKUs" clearly identified this factual representation of product additions and new orders. In Q4, and just ahead of the holiday shopping season, Wal-Mart added 10 new SKUs, including several new flavor SKUs such as the "Happy Hour" flavors, Ocean Spray, Tonic and Diet Tonic. In our recent channel sales sell-through data, we have found that both Margarita and Pina Colada flavor syrups are selling at an above average rate of sale for a new product launch.

In spite of evidenced sell-in data suggesting strong flavor syrup sales, sentiment around SODA remains bearish, with short interest around 42%, which is not all that new to shares of SODA. Frankly speaking, short interest has remained about 35% for the last 2 years and has reached roughly 40% in the past 12 months on two occasions, indicating some big positions have been maintained by shorts over this time period. If one considers that over 90% of the float is held in concentrate by institutional investors, coupled with a high percentage of this composition held as short interest, the more appropriate analysis proves to conclude that it is highly improbable for a largely hyped "short squeeze" to take place in shares of SODA. The math and historical precedence simply aren't there, and arguing or contemplating otherwise would be nothing more than blatant disregard of these factual representations in the data and injecting hope into the overall short squeeze thesis which many find desirable.

I had a discussion with a top level investor at Covestor just the other day about the possibility of a short squeeze in which Eric Steiman and I debated the probability of such an occurrence ever taking place in shares of SODA. Eric Steiman was recently recognized for his strong investing and returns in 2013 at Covestor with his Undervalued Opportunities portfolio. When it comes to SODA, Eric and I agree that the company, the stock and its business are largely misunderstood by investors, and this has led to its consistently undervalued position in the market despite strong YOY results for SODA. However, where we have disagreed is on the probability of a short squeeze taking place in SODA. With that said, shares of SODA can still very much appreciate in value with nominal short covering (notice the difference in verbiage) coupled with nominal buying pressure as they have always done.

We understand that most retail investors don't apply the opportunity to pay for analysts' reports, as they can often be pricey with respect to their actual investment. With this in mind, we are taking the time to more broadly report on this particular offering from Longbow Research so that investors can be aware of what is compiled and analyzed in the report and why the analyst decided to downgrade shares of SODA. You will have to be the judge as to whether or not the downgrade was warranted.

On December 6th, Longbow Research concluded that shares of SODA should be downgraded to Neutral from Buy. In addition to the downgrade from the research firm, they removed their initial price target of $78 a share from view in favor of no defined price target. In order to put the new rating from Longbow Research into context, we must discover first its historical context from the firm. Longbow's Philip Terpolilli initiated coverage of SODA on August 21st this year with a Buy rating and a $79 price target, which implied that there was another 22% upside in shares from the share price on that particular day. Now let's take a look at the firm's price discovery analysis offered to investors as justification for their initial rating and price target: The analyst believes SodaStream

...has a plethora of growth opportunities over the next 18+ months that should drive better than expected top and bottom-line earnings growth.

In addition to pointing out items like the company's seemingly-solid recent launch of the Source soda maker and opportunities in international markets, the Longbow analyst believes SodaStream could eventually be taken over. the company reaches critical mass with its install base, the potential for either third party agreements with major soda brands or full takeout increases.

Terpolilli said the stock's recent dip away from 52-week highs

creates an attractive risk/reward scenario for SODA shares heading into the 2013 holiday season.

Now we won't go so far as to conclude that a partnership with a major beverage brand isn't possible or even likely over the long term, but we will take that perspective with regards to a takeover. As it pertains to a takeover by Dr Pepper (DPS), Coca-Cola (KO) or PepsiCo (PEP), this is highly improbable given the natural divergence in these respective business models as it relates to SodaStream's business model. SodaStream's business model doesn't, in any way shape or form, facilitate or compliment KO or PEP's business models with consideration being given toward the size and scope of said businesses. In fact, SodaStream's business model renders that of its competition in the carbonated soft drink market as antiquated and obsolete. For those reasons, among others, the likelihood of a takeover from such firms is highly improbable, and we offer it only a 15% chance of occurring based on the aforementioned reasons. Now let's talk potential partnerships.

The only major beverage company of the three CSDs that could possibly result in a partnership would be with Dr Pepper Snapple Group due to its dwarfed market share and youth compared to that of Coca-Cola and PepsiCo. In this specific case, Dr Pepper could witness greater revenue expansion and brand awareness through a partnership with SodaStream. At this time in the partnership discussion, it should be recognized that SodaStream has been expanding its Dr. Pete and Diet Dr. Pete flavor syrup internationally over the last 9 months to include distribution in the United Kingdom and most recently Australia. This is the first non-traditional cola flavor, most popular in the United States, to explore international opportunity and may be the "fly on the wall" indicating potential partnership opportunities in the future as both SodaStream looks to grow its licensed brand portfolio and Dr Pepper looks to grow internationally. Having said that, we do not currently see such a partnership opportunity taking place in the near future, nor do we see it as a necessary driver for SodaStream's future growth as many opportunities still exist around the world.

To more broadly reiterate, a buyout from any of the three aforementioned beverage providers is highly improbable, and investors would be better advised to consider a party outside of the United States as a likely suitor; one for which the business model is better suited and less disruptive to the current business model of that company. Remember, SodaStream's business is not just beverages but it is also small appliances and gas. If any of the aforementioned beverage providers above wanted to diversify their product offerings into the small appliance channel, they would have likely done so over the last 100 years or so. Additionally, we wouldn't pay much attention to the misunderstanding surrounding Coca-Cola CEO's comments at the recent Beverage Digest conference which express cold beverage platforms in the U.S. as an opportunity rather than an impediment to their business (only available via paid report from

Presently one would have to suspect that the CEO doesn't wish to express weakened demand in its CSD business from such platforms currently offered by SodaStream. Secondly and most importantly, why partner with the likes of SODA or Green Mountain Coffee Roasters (NASDAQ:GMCR) when the opportunity to manipulate these firm's businesses is there at full profit margins with a takeover. It simply makes very little logical sense. Bottom line remains, how does Coca-Cola stem the tide of decreasing sales in the CSD segment of its business by partnering with another firm for its flavor syrups and opening up its consumer to other flavor offerings from the competition while giving up some of its profits at the same time? No logic in this speculation, but I must admit that stranger things have happened.

As we move along with the most recent report from Longbow research, we discover some of the points of analysis as outlined by Philip Terpolilli in his Key Takeaways segment of the report.

Our December SodaStream Survey results, which covered the early portion of the key holiday selling season for soda makers, were mixed.

Demand was up materially y/y at Wal-Mart and Bed Bath & Beyond (NASDAQ:BBBY) owing to increased promotional support. More favorable placement as well as deep discount "mega pack" bundle soda maker kits at Wal-Mart accounted for the growth - excluding this special promotion our contacts noted demand was up only modestly on a y/y basis. Most BBBY contacts cited low-double digit y/y gains across SodaStream's soda maker portfolio.

Sodastream's Source soda maker was added at a majority of Costco (NASDAQ:COST) locations ahead of the holidays versus its absence during our late summer survey. However, promotional support was light at both Costco and Williams-Sonoma (NYSE:WSM) and demand suffered at both retailers as a result.

So let's analyze Mr. Terpollili's analysis with regards to his Key Takeaways. It should also be noted that his research is highly, if not all dependent upon, testimonial offerings from in-store personnel from participating retailers which he contacts and mentions in his report. I only reference this fact as it should be recognized that this offers an analyst a very limited sample size for which to compile and analyze data, therefore rendering the analysis somewhat speculative, similar to speculating upon a buyout opportunity, if you will.

Mr. Terpollili makes some sound observations, and for the most part we agree with his findings, but how to put the findings into context is where we diverge from the findings. First and foremost, the analyst notes that demand was up, albeit from increased promotional support and a deeply discounted Jet "Mega Pack". We believe what concerns Mr. Terpollili is the inclusion of more flavors and bottles in the Jet Mega Pack vs. the promotional inclusions last year. Couple these inclusions with a $25 gift card offering at Wal-Mart, and it does seem to significantly impact gross margins on the surface.

But let's eliminate the gift card from the equation, because you have to, as the gift card comes out of the retailer's bottom line in most cases. In a highly competitive retail environment, the retailers are discounting, promoting and offering incentives to drive foot traffic even if it means sacrificing their own profits today. With that said, let's turn our focus toward the Jet Mega Pack,which offers the consumer another extra bottle and 3 full flavor syrup bottles including two co-branded syrups. We're not going to shadow this product offering with speculative analysis that could prove that this particular product is margin neutral to SodaStream, because we simply can't decipher that possibility at this time.

However, what investors can decipher is the company's gross margin performance year-to-date vs. the company's goal for FY13 gross margins of 54%. Presently, the company has achieved gross margins in excess of the offered 54% gross margin guidance for the year, leaving the firm roughly 60-70 points of gross margin to play with in this quarter and still achieve their goal for the year. So while we share the discounting concern offered by Mr. Terpollili, we disagree with its analytical conclusions which don't offer any consideration toward year-to-date gross margin achievement.

Turning our attention to the analyst's citing regarding sales at Bed Bath & Beyond, Williams-Sonoma and Costco, we find that his contacts suggested low double digit sales at BBBY and demand suffering at both WSM and COST. Our channel sales data, which includes all BBBY store locations, show a somewhat different story across the entire product portfolio and roughly higher double digit gains for the soda maker category during the early holiday selling season. Given the competition, with Target (NYSE:TGT) and Wal-Mart both selling Jet Mega Packs which include a free gift card, this percentage increase from BBBY seems strong and fitting with modeled expectations from the retailer.

Moving to Costco and Williams-Sonoma, we don't disagree with this assessment, although if we put it into the most appropriate context, we discover the reasoning behind the waning demand from these two retailers. First and foremost, William-Sonoma has witnessed dwindling demand for SodaStream products since the established partnerships between SodaStream, Target and Wal-Mart for the CO2 spare and CO2 exchange program. Basically, with these two densely populated retailers around the country now performing the CO2 exchange program, consumers don't need to travel to the local mall and visit Williams-Sonoma to perform a CO2 exchange. We have seen this heavily expressed in the data over the last several quarters.

In addition to this relevant convenience to the consumer, SodaStream has predominately promoted and marketed the Source machine which, until recently, was not carried at Williams-Sonoma. As one can see through greater consideration of the historical product placement for SodaStream, it leaves no wonderment as to why demand has weakened YOY at Williams-Sonoma. Furthermore, we would also consider the addition of another 800 K-mart (SHLD) stores as conveniently, localized competition in the marketplace with Williams-Sonoma for CO2 revenues.

Costco is also witnessing competition for SodaStream products, as SodaStream has added BJ's Wholesale Club (NYSE:BJ) to its distribution chain this year. Additionally, if we consider that fewer demonstrations are taking place at Costco vs. last year, we would also draw the conclusion that demand has weakened at this retailer, but still remains up YOY from our channel sales data.

Now we move to the Demand portion of the Longbow Research piece.

Of the retailers we surveyed, SodaStream demand was most favorable at Bed Bath & Beyond, where SODA's product promotional activity was up materially y/y and SODA benefited from increasing consumer awareness and incremental shelf space.

Wal-Mart results were also up nicely y/y, but benefited from a deep discount for a "Mega pack" Jet soda maker starter kit bundle ($79) that included a $25 Wal-Mart gift card and a half dozen various flavors/accessories. Respondents sold through the bundle quickly over the weekend, but demand was mixed excluding this special promotion for normally carried soda makers (Source, Genesis, Jet, etc.).

Sodastream's Source maker was added at 70%+ of Costco locations ahead of the holidays (essentially no placement in August), but experienced mixed demand owing to limited promotional support and a lack of product scale (no flavors or other product sold).

Last, in flavors respondents at WMT and BBBY noted positive y/y demand trends in "core" flavors (Cola, Root Beer, etc.) but disappointing trends in third-party flavors (Ocean Spray, etc.)".

Mixed results were mentioned a couple times from the analyst with regards to demand, and those results only came from a limited sample size, so we really can't definitively put much worth in this aspect of the report unfortunately. However, we think it is safe to conclude that if the consumer was faced with a Mega Jet Pack which includes a $25 gift card and a regular Jet, Genesis or Source soda maker kit with no gift card, they will likely choose the Mega Jet Pack first, which is why those offerings sold more quickly. These Mega Packs were a limited time offering for which most retailers have no inventory presently and now we see a greater propensity of sales coming from the Jet and Source soda maker kits as should have been forecasted for the remainder of the holiday selling season.

With regards to the last point on demand and its respondents survey which suggests strong flavor syrup sales for "core" flavors (Cola, Root Beer, etc.) but disappointing trends in third-party flavors including Ocean Spray, this is where we see the largest proof of poor sample size data compilation. Additionally, Ocean Spray syrup flavors have only been on the market for less than 30 days, hardly enough time to draw conclusive demand indication. We are seeing "exactly" the opposite in demand for the Ocean Spray line of licensed syrups and will publish our real time channel sales data to validate the real demand for the product line to investors in our upcoming publication.

If investors want more immediate proof of Ocean Spray sales, try ordering them through SodaStream directly; one will find they are told to seek out a local retailer as they are currently out-of-stock through SodaStream's e-commerce site. Sample size data is very relevant when issuing conclusive analysis, and we feel that this point regarding sales of Ocean Spray syrups is definitively inaccurate and unsubstantiated at this time.

Below are some additional comments from the Longbow Research Report.

BBBY was the sole retailer carrying Cuisinart's competing at-home soda making system. Respondents cited disappointing demand trends for Cuisinart based on limited consumer awareness and promotional activity despite a more attractive $79 price point versus SodaStream. Most contacted locations noted carrying 40+ flavor offerings, up approximately ten flavors from a year earlier. Flavors typically ranged in price from $5-6, similar to Wal-Mart. Demand for flavors was up nicely according to a majority of contacts driven by the breadth of BBBY offerings.

SODA is currently trading at 16.7x our 2014 EPS estimate. This compares to the company's average forward earnings multiple since its late 2010 IPO of 22.9x, the ~31x average for GMCR over the last five years, and the 16-18x average range for the packaged food group. We view GMCR as the closest comparable peer due to its impressive top-line and earnings growth rates over the last five years and similar razor/razor blade at-home consumption model. On an EV/EBITDA basis, SODA is currently trading at 11.3x our FY14 estimate, compared to the company's average multiple of ~11x since its IPO.

Longer-term, we still view SodaStream's model optimistically domestically and think the company should benefit in 2014 from steadily increasing consumer awareness and material entrance into grocery retailers. Management expects to continue spending heavily on advertising (Super Bowl ad expected again in 2014) which should aid sales for both soda makers and consumables. Abroad, SODA has ongoing opportunities for international growth particularly in Western Europe (SODA's largest market at ~46% of sales) via increased household penetration and effective country-specific advertising. Also, the company's southern Israel manufacturing facility slated to come fully online in 2014 should help gross margin expansion over the next couple of years. Last, from a valuation perspective uncertainty surrounding the long term viability of SODA's razor/razor blade model domestically seems to be priced in. We would look to get more constructive on SODA pending a much stronger/weaker second-half holiday season for SodaStream domestically, increased visibility around future ACV wins domestically, and/or significant incremental third-party license agreements.

In conclusion, what we decipher from the Longbow Research report is that the analyst has only a few survey results from a few different retailers. Without conclusive data to support the analyst's reasoning for the downgrade, investors should probably seek greater information related to sales including NPD data. The most recent NPD data has somewhat negated the fears that sales were tracking to the low end of analysts' expectations as indicated in the Longbow Research Report.

Last week Monday, when NPD sales data for SodaStream were released, shares spiked over $4.00 per share due to the strength in sales being reported, thus negating much of the negative commentary within the Longbow Research report. In addition, this Monday's NPD data supports the the thesis offered above regarding the consumers propensity to purchase more Mega Jet kits than the normal packaged Jet kits based on the lower average selling price discovery in the data. But of course, we have to consider the totality of the data for the entire quarter before drawing conclusions. There is still a few weeks left in the quarter, so investors will have to monitor sales of SodaStream products through their local retailer.

Much like Longbow Research, we believe in the long-term investment thesis due to consistent revenue and earnings growth over the last 3 years and leading market position in the at-home carbonation industry. Barriers to entry in this category are extremely high, although competition would likely help in aiding the growth of the entire category, as it brings awareness to the category.

Disclosure: I am long SODA, BBBY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.