SodaStream Can Deliver As Much Fizz As Investors Need

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 |  About: SodaStream International (SODA), Includes: GMCR, KO, PEP
by: Marc Gerstein

SodaStream (NASDAQ:SODA), which sells do-it-yourself home soda-preparation gadgets and syrups, is one of those momentum stocks everybody loves to bash – or not. The company definitely does have its detractors, but as far as its being a momentum stock, we need to stop living in the past. The shares, above 70 for much of the summer, are now in the mid-30s. The momentum angle is done and gone. So let’s shove that baggage where it belongs -- into the closet.

Looking with fresh eyes, I estimate that if SODA shares can trade at 25 times earnings three- to five-years hence, the stock would be a buy if one believes the company can post an EPS growth rate of 21% or better over that time span.

The details of the method I use are spelled out in the Appendix below, which also includes an illustration of a spreadsheet template you can create in just a few minutes if you want to change assumptions and come up with your own growth target.

The P/E Assumption

When it comes to historical P/E analysis, SODA doesn’t give us much to work with because the stock has such a short trading history.

I’ll therefore have to rely on the closest comparable company I can find, Green Mountain Coffee Roasters (NASDAQ:GMCR). I know full well the GMCR-SODA analogy is imperfect. Actually, that’s always going to be the case when we work with comparables; all we’re looking for is a general frame of reference and GMCR, which brought fast single-serve coffee brewing with a wide variety of flavors into the household market, is sufficiently similar to SODA to suffice. From 2007 (the first full year of GMCR ‘s current business model, which came about via the 6/06 purchase of Keurig), through 2010, the company’s P/Es averaged 43.65, 42.99, 30.02, and 47.96 respectively. The stock now trades for 55.23 times estimated current-year EPS and 34.50 times the estimate of next year’s EPS.

I’m not prepared to assume a P/E that high for SODA because, as I’ll explain in the discussion of growth, I think the differences between the two companies work in favor of GMCR and against SODA. At present, SODA trades for 24.7 times estimated current-year EPS and 19.44 times the estimate of next year’s earnings. Given this, and in a general value-investor tendency to prefer conservatism, it’s tempting to lock in on an assumed P/E near 20. But there’s no prize awarded for being value-macho, always going for the lowest plausible assumption.

Right now, sentiment toward SODA is pretty bad, especially after Jim Cramer loudly jumped off the bandwagon. Although the company has been around in Europe, it really hasn’t had its first U.S. holiday season yet, and the idea of home-soda making needs more time to catch on. GMCR came into a well-established activity. We’ve been brewing coffee at home for eons; all GMCR had to do was sell consumers on the notion that it’s way is better. Before SODA gets to sell the merits of its products, it has step back and first persuade consumers that home soda-making is worthwhile in the first place.

I really think a P/E of 20 is too low for a company capable of generating the sort of EPS growth I think we can get from SODA over the next 3- to 5-years. As time passes and the development of a track record enables investors to substitute analysis of numbers for debate over stories and as sentiment settles, I think a P/E of 25 is likely to be more representative of what SODA will achieve. (If you disagree, create a spreadsheet template as shown in the Appendix and plug in your own assumption.)

The Target EPS Growth Rate

Based on an assumed future P/E of 25 and the other more mundane assumptions described in the Appendix (all of which you are free to change), I think SODA’s valuation would be fine if the company’s EPS can grow at or above an annual rate of 21% over the next three to five years.

Again, I’m going to use the GMCR experience as a starting point. The 2007 EPS growth rate isn’t too instructive since the base for comparison is 2006, which included Keurig for only half a year. From 2008 through 2010, the EPS growth rates were 63.5%, 140.1%, and 27.5%. Because EPS trends are apt to be distorted by unusuals, I’ll look, too, at the rates of sales growth which, from 2008 through 2010 were 44.2%, 59.6%, and 72.6%. Over the trailing 12 months the EPS and sales growth rates were 108.4% and 92.7% respectively.

Clearly, if SODA was identical to GMCR, the 21% growth-rate target would look like a slam dunk. But there are reasons why I prefer to assume SODA will not be that strong:

  1. As noted, home coffee brewing was well established before GMCR jumped in. That’s not so for SODA, which must convince most consumers to try it.
  2. Use of Keurig machines is pretty much in the no-brainer category. Assuming a user handles cream/milk and sweetener, if desired, as per his or her usual habit, there is no room for error in terms of the quality of the final cup of coffee. That’s not so for SODA, where the user has three opportunities to screw it up: filling to bottle with the proper amount of water, how much fizz gets added to the bottle (how long the button is pressed and how many times it’s pressed), and how precise the consumer is in measuring the syrup. Don’t get me wrong: You don’t need a PhD to work a SODA machine. I find it quite easy to consistently get good-quality soda. Just be aware, though, it is easier for a klutz to screw up with SODA than with GMCR.
  3. GMCR has many brands and flavors of coffee from which to choose. SODA has good flavor variety, but right now, the only brand is its own.
  4. Although high-maintenance gourmets can and will carp about anything, I think most people will agree that the quality of what you get in a cup from GMCR is the quality you expect based on the brand, the brew strength, and flavor you choose. Paul Newman coffee tastes like Paul Newman coffee. Timothy’s coffee tastes like Timothy’s coffee. Etc. It’s much easier to gripe about SODA flavors. In my opinion, they’re all fine and I’ve come to really love some of their unique flavors (like green tea apple strawberry), and I recall a Cramer article mentioning a taste test in which Herb Greenberg (the perma-bear who’d probably advocate shorting Mother Theresa) failed to differentiate between SODA’s cola flavor and that of one of the big two (I forget which one). But no matter what I or anybody says, SODA brand is not established and, hence, presents a ripe target for critics.

But don’t get too depressed. There are some positives here wherein SODA might have an edge.

  1. Consumers are now accustomed to variety when it comes to home coffee brewing. When it comes to home soda-making, this is new. Unless a consumer wants to break a back lugging lots of bottles, or run to the store every day, he/she is going to be drinking the same stuff a lot. The ease of using SODA to switch flavors frequently is a whole new, and fun thing.
  2. We may have just scratched the surface in terms of variety. SODA has opportunities to do more here and that could add an element of growth beyond that which the soft drink industry now offers.
  3. I’ve seen comments here and there that the big gorillas, Coca Cola (NYSE:KO) and Pepsi (NYSE:PEP), will squash SODA. Maybe they will. Or maybe they won’t. Bear in mind neither KO nor PEP produce soda, not a drop. They produce syrup. A lot gets sold to bottlers. A lot gets sold to institutional clients (restaurants, movie theaters, etc.). Can you imagine what would happen to SODA stock if at some point KO or PEP would decide to sell syrup retail . . . hint: you really, really would not want to be short SODA stock. I have no clue if this could ever happen. But bear in mind that unlike GMCR, where we pretty much know what we have, there’s room for pleasant wild cards if SODA catches on.

I’m not offering any of these positives as a basis for owning SODA. I’m just using them to support the notion that we ought not go overboard in assuming SODA will fall shy of GMCR. Assuming SODA can grow 21% per year, versus the incredible rates we’ve seen for GMCR, seems like a very ample haircut, especially since SODA is at a younger stage of its product lifecycle.

APPENDIX

This valuation framework will utilize some basic algebra to twist the usual considerations around such as to bring the key issues – the ones that will make or break your investment – to the forefront, rather than leave them buried as inputs to models that focus your attention on other issues. The main flip involves P/E and growth rate. Many value investors devote considerable attention to P/E, and not nearly as much to growth as is warranted. That’s backwards. If you devote substantial and careful thought to your growth assumptions, it becomes much easier to make sense of P/E.

Giving primacy to P/E often causes value investors to spend an inordinate amount of time focusing on companies that are mediocre or worse because those are the ones that tend to have low metrics. There’s nothing necessarily wrong with this; shares of mediocre companies can be great investments if obtained at prices that erroneously presumed the companies to be worse than they in fact were.

The problem is that value investors too often exclude great companies from consideration because those tend to have higher metrics. That makes as much sense as restricting one’s self to fast-food eateries because of a rule eliminating restaurant means priced above $10 from consideration. In life, we’re all willing to pay up if the meal we get (or car, or house, or suit, or wireless device etc.) is worth the higher price.

We can do likewise when valuing stocks. PEG (the ratio of P/E to growth) is one popular attempt to do this, but it’s often an unsatisfactory in practice: Aside from folklore, there really is no truly correct PEG threshold. And use of PEG often lulls investors into giving short shrift to the most important element; the credibility of the growth expectation plugged into the formula. (There’s no point in buying a stocks with a PEG of 0.90 is the assumed growth rate is twice as high as it ought to be).

The method used here does not end with a target price or a “proper” P/E. Price and P/E are inputs which can (and should) be changed often in the course of what-if analysis (at the bottom, you’ll find instructions for creating a simple Excel template). The goal is to calculate a REQUIRED rate of EPS growth, a target. This is the focus of company evaluation, the area to which you devote most of your attention. If, ultimately, you believe the company can meet or beat this target, you can buy. If not, avoid.

Here are the basic steps to this valuation approach:

  1. Start by determining how much of an annual return I’d want to achieve over the next four years (the mid-point of the 3- to 5-year time horizon typically cited by investors who like to think long term) through stock ownership. To organize my thoughts, I’m going to use the capital asset pricing model, which tells me that a required annual return should be the “risk free” interest rate plus an assumed equity-risk premium multiplied by a stock’s beta (the measure of volatility relative to a benchmark, the S&P 500 being the most popular one nowadays). For risk-free rate, I’m presently using the 10-year treasury rate, now about 2%. For equity risk premium, I had been using 4%, in line with a number long used by many theorists. But given that increased stock-market volatility may be here to stay, I decided to kick this up to 6%. For a stock with a beta of 1.00 (the proverbial “ordinary” stock), that would translate to a required annual return of 8%. This may sound disappointing at first glance, given that many dream of a stock that will double before dinner. But if you really think about, an 8% annual return over the next four years seems pretty appealing. Next, plug in the beta for the company you are considering. (Note: For SODA, I’m using 1.5, which is much higher than the 1.00-1.25 range we often saw for GMCR.) Finally, make any common-sense adjustments you think may be necessary! (I added an extra percentage point for SODA.)
  2. Next calculate your required four-year stock price. This isn’t a target price, a prediction of where you think the stock will trade. It’s a minimum threshold. If you don’t think the stock can actually trade at least that high four years hence (or sooner), you would not consider buying.
  3. Decide what P/E you think the market might award the stock four years hence. This is an important decision. Use the present P/E (based on estimated current-year or next-year EPS) as a starting point. Adjust it upward if you believe the company will be better going forward than it has been in the past. But more often than not, you’ll want to lower the number to accommodate possibly higher interest rates down the road, and the tendency of growth to decelerate over time.
  4. Now, we can calculate how much EPS the stock would need to generate four years hence to make all this work. We take the future price threshold of and divide by your projected P/E.
  5. Here, now, is the punch line: What sort of EPS growth rate must the company achieve? If you use Excel or a decent handheld calculator, you can get your answer in less than a minute. If you use Excel, you can copy the formula from the template below. If you use a good handheld calculator, your inputs are Future Value (from step 4), number of periods, which is 4, and present value (from any web site that presents consensus estimates).
  6. To help you assess the plausibility of the required EPS growth rate, look to the past as a starting point. Is the market expecting the company to do more than it had in the past? That might happen, but before you accept such an assumption, you really need to give it some thought. Value investors seeking a margin of safety are more likely to favor companies whose share prices seem reasonable even if earnings they don’t grow as quickly as in the past. Look, too, at revenue growth; earnings are primary, but the growth rates are more frequently distorted by unusual income-statement items, so examining revenue growth makes for a nice second-opinion. Consider, too, the Wall Street consensus long-term EPS growth rate projection. We’re not going to adopt the sell-side’s crystal ball, but this data-point can help you assess potential sentiment-based stock movements (i.e. a company that underperforms the growth expectation might see its shares struggle even if the expectation was unreasonably high).

If you’d like to build your own Excel template, you can copy the one presented here (click to enlarge image). (Information for the required inputs can easily be obtained from free web sites.)

Click to enlarge

Disclosure: I am long SODA.