- SodaStream International posted weak FY2013 guidance.
- A weak holiday season is not indicative of waning product demand.
- The industry's competitive landscape remains attractive.
- The market is overestimating competitive threats and is significantly undervaluing the company.
SodaStream International (NASDAQ:SODA) had already been trending down in the second half of 2013 as it struggled to allay a host of investor concerns. Then January's weak guidance came along adding fuel to the fire, and shares tumbled more than 26%.
Revenue guidance of $562M was roughly in line with estimates, but management, citing a "challenging" holiday season, said net income would only come in at 41.5M, roughly 20% below expectations. The substantial dip in gross margins gave new credence to concerns about product demand and the company's business model. Despite this miss in income, however, I believe SodaStream is substantially undervalued, and that this recent dip presents an attractive buying opportunity.
Discounting Does Not Imply Waning Demand for the Product
The reason the company missed expectations on the bottom line, but not the top line, is because a weak holiday season forced them to price their soda makers more aggressively. I would find this worrying if, and only if, this weakness came in the backdrop of strong holiday retail sales. This however, is not the case. While raw retail sales numbers were up 2.3 YoY, retailers got there by relying on aggressive discounting as well. Thus, the decline in gross margins we saw this past quarter is not indicative of weakening demand for the product, but could be a manifestation of overall weakness in holiday sales.
In any case, the revenue figure is far more relevant than earnings at this stage in the company's development. It's important to note that the margins on the soda makers were already paper thin, as they are sold almost at cost. SodaStream actually makes most of its profit from the sale of carbon dioxide refill canisters and flavored syrup, so the carbonators themselves are essentially annuities. Thus, it is crucial that the company keep unit sales up, which they were successful in doing this year.
Long Term Benefits from Appliance Manufacturer Tie-Ups
Both Samsung and Whirlpool (NYSE:WHR) have partnered with SodaStream to bring carbonation to their line of appliances. Samsung already brought some refrigerators equipped with SodaStream branded carbonators to market in 2013, though with questionable success. Retailers have marked the refrigerators down as much as 25%, which doesn't surprise me considering that the MSRP was almost a $1000 premium over comparable models. With discounting this aggressive, I would assume that the refrigerators were not selling as well as expected. Nonetheless, this arrangement certainly helps SodaStream with name recognition with no cost to them, and perhaps more successful products could come to fruition in the future.
Whirlpool intends to make its own line of home carbonators, similar to the ones that SodaStream already produces, and I have much higher expectations of this partnership. While nobody expected the Samsung refrigerators to generate meaningful volume, especially given their price, Whirlpool's appliances have the potential to significantly boost SodaStream's market share. Whirlpool's expertise with appliances and manufacturing facilities are far more extensive, which means that they could benefit from economies of scale that SodaStream has yet to attain. In addition, the Kitchen Aid brand name has greater brand recognition and a larger customer base, which could further expand SodaStream's market share.
Industry's Competitive Landscape Creates High Profit Potential
SodaStream currently monopolizes the home carbonation industry, but Green Mountain Coffee Roasters (NASDAQ:GMCR) announced they would enter the industry in late 2014 through a partnership with the Coca Cola Company (NYSE:KO). Nonetheless, I believe the competitive landscape remains attractive as it is characterized by high growth rates, and weal to moderate competitive forces. This enhances SodaStream's ability to generate above average returns for the foreseeable future.
Threat of New Entrants
I believe that the threat of new entrants into the industry is low. While barriers to entry are low for the carbonator device manufacturing segment, it is not the case for the high margin consumable's segment. Stringent government regulation, high startup costs, and fierce brand loyalty make it difficult for new firms to enter.
The underlying technology behind carbonating neither complex nor patentable, so it would be easy for new players to manufacture carbonating devices. However, brand equity is important in this industry which makes it difficult for younger or smaller firms to enter the market. Customers preferences will tend to lean towards appliances with more name recognition and reliability, especially since most consumer utility is derived from continued long term use of the product. Sodastream's and Green Mountain's large advertising expenditures and history will give them a leg up in this respect.
While established appliance manufacturers would not have a problem in this respect, they lack an incentive given that the margins on carbonator sales have been historically low. The majority of industry profits come from the sale of consumables, such as CO2 canisters and flavored syrup. The sales and distribution of carbon dioxide refill canisters are heavily regulated in most major markets, including the United States, and are classified as hazardous materials. This heavily restricts firms' ability to transport and handle these goods as they must be handled by hazmat certified entities.
As it stands now, Sodastream customers return depleted CO2 canisters to select retail locations, from where they are shipped to refill locations. To mimic such a setup would require extensive amounts of startup capital, a wide network of participating retailers, and a considerable amount of time. These factors present a significant barrier to entry as they materially affect even large firms, as evidenced by Green Mountain's delay in entering the industry.
Product differentiation also exists in the form of flavored syrup availability. In addition to providing the generic flavors, both major players have partnered with different firms to provide brand name syrups. Green Mountain, for instance, has partnered with Coke, and SodaStream has partnered with a variety of smaller brands such as Kool Aid and Country Time Lemonade. PepsiCo (NYSE:PEP) will likely partner with a firm in this industry, namely SodaStream, to remain competitive with the Coca Cola Company. It is possible PepsiCo will partner with another firm in the future, or never enter the market, both of which I find unlikely. Consequently, the industry will likely consolidate to two main firms, given that PepsiCo and the Coca Cola Company dominate the beverage market.
Threat of Substitute Goods
I evaluate the threat of substitute goods to be moderate. External competition from bottled beverages and water, the industry's main substitute goods, do indeed pose a risk to growth but not a substantial one. The declining demand for bottled soft drinks in developed markets appears to be attributable to two keys trends - increasing environmentally friendly behavior and health consciousness. The home carbonation industry is well poised to take advantage of these trends, which so far display no indication of reversing.
In addition, I believe perceived product differentiation between home carbonation products and traditional bottled soft drinks is high enough that the goods will not be near perfect substitutes. The per liter cost of SodaStream beverages are still greater than the cost of bottled soda, yet sales growth has been strong so far indicating that customers are willing to pay that premium.
Among the lower income demographic, however, the marginal rate of substitution between home carbonation and bottled soft drinks is likely lower because perceived product differentiation is lower. This demographic does not currently represent a significant portion of the industry's market share or growth, but could be important in the future given that it is the largest consumer of soda.
Supplier Bargaining Power
I rate the strength of supplier bargaining power as very high, but I believe this force is not nearly as relevant to firm performance as the other four. The industry uses several raw materials in production, the most important of which are aluminum, CO2, plastics and sugar. These inputs comprise the majority of COGS, but firms will have little pricing power given the low buyer concentration ratio within all of the supplier industries.
There are signs that the low margin carbonator manufacturing business is shifting to larger appliance manufacturers, such as Whirlpool and Samsung. If this trend holds, firms' sensitivity to polymer prices will decline. Aluminum prices are a more substantial concern as it is used in the manufacture of carbon dioxide tanks, one of the industry's main profit drivers. However, the industry's current business model involves customers recycling depleted canisters and receiving a full one at a discounted price. Thus, an increase in aluminum prices should not have any impact on income from repeat customers, only new ones.
In terms of consumables, the price of carbon dioxide is almost a nonissue as it is inexpensive and the supply is abundant. The margins on canisters sales would not decline materially if the price of carbon dioxide was to rise. Sugar prices would have a negligible effect on margins as well. For instance, the cost of sugar in a $10 bottle of flavored syrup is only 22.38 cents.
Buyer Bargaining Power
The strength of buyer bargaining power is moderate in this industry. Given the high initial costs of purchasing a carbonator, the industry's target market for the near future will be higher income households. Consequently, demand for consumables should be much more inelastic than with traditional soft drink bottlers because these products represent a smaller portion of the market's disposable income. This will give firms a greater ability to pass on costs to customers.
Customers would also be reluctant to substitute between different firms' products, namely those of SodaStream and Green Mountain, because of brand loyalty to offered flavors. Switching costs would also be high due to vendors striving to make their consumables incompatible with competing appliances. However, demand would likely be sensitive to a large price differential between consumables in the industry and traditional bottled soda because those goods are more substitutable.
Intensity of Competitive Rivalry
I expect that the intensity of competitive rivalry in the near future will be moderately low. Product differentiation is adequate enough that firms need not compete by lowering prices. Instead they can focus on improving their own brand equity, product portfolio, and manufacturing process.
The growth rate of the industry is high, and I expect it to remain so for some time. SodaStream currently estimates that its soda maker penetration in the United States, the largest market for carbonated soft drinks, is 1.1%. The penetration rate in markets with longer exposure to the product are as high as 25%, which would indicate that the potential for future growth is strong. Consequently, firms can grow without pulling customers away from competitors.
SodaStream International trades at a substantial discount to its industry peers. The chart below compares its valuation metrics to those of the S&P Consumer Discretionary index. SodaStream trades at a discount to the consumer discretionary index on both a forward earnings and book value basis, yet its estimated long term growth rate is more than double.
(click to enlarge)
The Bottom Line
To justify the market's current valuation, EPS growth will have to slow materially. It is possible that this could occur, but I find it unlikely given recent developments in SodaStream's position in the industry. I believe competitive forces in the industry are not as strong as the market seems to believe, and the steps SodaStream has taken to improve its business model will keep it growing for some time. Therefore, I recommend accumulating SodaStream.
Disclosure: I am long SODA. 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.