As part of the Valuentum process, we perform a discounted cash flow (DCF) valuation, a relative valuation versus industry peers, as well as an assessment of technical and momentum indicators for each firm in our coverage universe. For example, firms that are undervalued on both a DCF and on a relative valuation basis, and are also showing improvement in technical and momentum indicators score highly on our scale. We think this approach, which we distill into the Valuentum Buying Index, represents the best way to identify the most attractive stocks at the best time to buy. Take a quick view of this video (click here) on how we think about which investment strategy is best, and then come back to see how SodaStream (NASDAQ:SODA) stacks up on our process in this article.
Great, you're back. Now before we get started, and in the spirit of transparency, we wanted to show you how the Best Ideas Newsletter portfolio, our flagship product, has performed since inception, applying the Valuentum Buying Index rating system. We think it is important to understand how we use the Valuentum process. Not all highly-ranked firms are added to the portfolio, and not all firms that score poorly are entered. As with any portfolio, the management team has the final say on which firms enter and exit the portfolio. One wouldn't expect a value investor to own every single undervalued stock on the market, for example. We only add the cream of the crop of ideas to the portfolio.
Let's now dig in. SodaStream posts a VBI score of 3 on our scale, reflecting our 'undervalued' DCF assessment of the firm, its neutral relative valuation versus peers, and bearish technicals. You'll notice that while we think SodaStream is undervalued from a DCF standpoint, its relative value and technical considerations impact its score. If the company was attractive from a relative standpoint and from a technical/momentum standpoint, its score would be a 9 or a 10 on the Valuentum Buying Index. Companies that have registered a 9 or 10 in the past have performed very well.
For relative value purposes, we compare SodaStream to peers Coca-Cola (NYSE:KO), Dr. Pepper Snapple (NYSE:DPS), and PepsiCo (NYSE:PEP), though we note that any relative valuation assessment is imperfect. However, because many investors make decisions about a company's attractiveness on the basis of its price-to-earnings ratio relative to its own history, its peers/competitors, or to a market median/average, we pay close attention to the relative value approach. That said, a robust intrinsic value-derived fair value estimate forms the backbone of the methodology.
Our Report on SodaStream
• SodaStream earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 20.6% during the past three years.
• SodaStream manufactures home beverage carbonation systems, which enable consumers to transform ordinary tap water instantly into carbonated soft drinks and sparkling water.
• SodaStream faces several obstacles to success, including overcoming consumers' desire to purchase carbonated beverages (instead of making them at home) and the inconvenience of exchanging empty CO2 cylinders.
Speculative Upside Potential
Earlier in February, Coca-Cola announced that it is collaborating with Green Mountain (NASDAQ:GMCR) on the introduction of its brand portfolio for use in the Keurig Cold at-home beverage system. We think Coca-Cola taking a 10% equity stake in the coffee-machine innovator had a lot to do with inking the deal. Such a collaboration may force other beverage makers, including PepsiCo and Dr. Pepper, to enter this business line. Though we fall short of speculating that either PepsiCo or Dr. Pepper may take a leap at buying SodaStream, we're not completely ruling it out. Needless to say, Coca-Cola's agreement with Green Mountain has shaken up the beverage industry.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. SodaStream's 3-year historical return on invested capital (without goodwill) is 20.6%, which is above the estimate of its cost of capital of 11.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. SodaStream's free cash flow margin has averaged about -4.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively WEAK. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At SodaStream, cash flow from operations moved into positive territory from levels two years ago, as capital expenditures expanded significantly during this time period.
Our discounted cash flow model indicates that SodaStream's shares are worth between $42.00 - $68.00 each. The high end of this range implies that shares of Soda Stream are very cheap. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $55 per share represents a price-to-earnings (P/E) ratio of about 27.7 times last year's earnings and an implied EV/EBITDA multiple of about 19.8 times last year's EBITDA. We think this level and the high end of the range approximates what a buyout premium could entail. Our model reflects a compound annual revenue growth rate of 17.6% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 26.5%. Our model reflects a 5-year projected average operating margin of 10%, which is above SodaStream's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 7.5% for the next 15 years and 3% in perpetuity. For SodaStream, we use a 11.8% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $55 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for SodaStream. We think the firm is attractive below $42 per share (the green line), but quite expensive above $68 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate SodaStream's fair value at this point in time to be about $55 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of SodaStream's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $77 per share in Year 3 represents our existing fair value per share of $55 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.