Sodastream: Looking At Long-Term Potential

After beating earnings expectations in each of the last five quarters, Sodastream's (NASDAQ:SODA) share price has declined each time, except for once (see table below).

This remarkable trend highlights that in the case of high growth small cap stocks, earnings today matter more than earnings tomorrow. I am surprised to see analyst reports focusing primarily on short-term sales numbers, rather than long-term growth expectations. In this article, I will highlight what I feel are the longer-term considerations that will make or break Sodastream.

Attrition rate and American growth

In the company's Q4 earnings call, CEO Daniel Birnbaum stated Sodastream is being actively used in 0.6% of Americans households. American cumulative attrition rates are approximately 40%, meaning that almost half of the people who buy Sodastream stop using it after three years. Though higher than the worldwide average, Birnbaum stressed that Americans that stick with it tend to spend more on consumables than an average consumer in other countries.

Birnbaum also stated that based on studies, American purchase intent is approximately 16%. If we assume that attrition rates remain constant, it would not seem unrealistic to expect the American active household user base to grow to 10%. If this were the case, holding all else equal, we should expect to see an annual EPS of over $6.

Whether or not these numbers and assumptions are perfect, or if such an expansion could be possible without large expenditures and possible share dilution, it is clear that Americans are interested in Sodastream and that the company's potential to become a household name should not be ruled out. In summary, Birnbaum shed light on the potential reach of the product, as also made investors aware of the less-than-stellar attrition rate.

Japan and the newer European markets

In the Q4 earnings call, Birnbaum provided insight into the Japanese launch. The news was very encouraging. Sodastream is already being sold in almost 200 premium department stores all over the country. The product is being endorsed by a few celebrities, and consumer awareness is 19%. Birnbaum stated this level of consumer awareness is "unbelievable", given the short amount of time Sodastream has been available in Japan. Birnbaum highlighted that the strongest single sales day in Sodastream history is now from a department store in Japan, which sold 170 machines in one day. He also highlighted that growth in newer European markets, like Britain and France, is accelerating.

New alternative and do-it-yourself refills

With little patent protection and easy to replicate technology, the competitive advantage that Sodastream enjoys is flimsy at best. This has become increasingly clear with the upcoming introduction of a countertop Esio Beverage System, the Primo (NASDAQ:PRMW) Flavorstation and more recently, the "Twist 'n Sparkle."

The Twist 'n Sparkle carbonates water the same way Sodastream does, but without a separate machine. Instead, the carbonator is a small "charger," that attaches to the bottle itself. (Check out the Twist n' Sparkle at The Twist 'n Sparkle sells for about $20. On top of the new competition, videos have begun flooding YouTube on how to refill your carbonator bottles at home. The videos range from using dry ice to buying a big carbonator and hose. Though these don't seem like they will be readily adopted by the average American consumer, it would not surprise me to see illegal carbonators enter the market if Sodastream continues to grow. The "razor-razor blade" business model won't be successful if the razor blade is easily duplicate or avoid.

A few other concerns

The decrease in share price following the Q4 earnings report has largely been attributed to weak machine sales. Management stated that this was a direct result from retailers purchasing holiday stock in Q3. It is not clear to me why management neglected to share this information with investors in Q3, as it would have certainly dampened the positive 68% earnings surprise.

In 2011, Sodastream reported an "unusual" expense of €4.2 million related to share based compensation from the IPO. By IFRS guidelines, over 50% of this expense should be reported in the first year after the grant, followed by a sharp reduction in the following years. In 2012, the share based compensation expense related to the IPO is approximately €1.6 million.

However, the 2012 guidance includes an "unusual" expense of €4.1 million related to share based compensation. This means that €2.5 million of this expense is related to grants in 2011. While this is certainly not a concern in itself, it raises questions as to why the share based expense should be considered unusual.

I believe the share based expense should be included in DCFs until it is truly shown to be unusual. This, in combination with management's failure to state that the Q3 earnings surprise was largely due to early retailer purchases, demonstrates that management actively tries to portray results in the most positive light, even if sometimes it is not the most accurate.

Birnbaum stated that grocery stores and drug stores would not roll-out in 2012. This limits any significant and surprising rollouts in 2012, the exception being a more complete full year deal with Costco. Birnbaum highlighted that the Costco holiday sales were a success and that it is currently in negotiations for a full time partnership.

In summary, there is a lot to love and a lot to hate when it comes to Sodastream. I reiterate my strategy of buying below $45 and selling as it approaches $48. This has been very successful this far.

The data is sourced from Yahoo Finance. The earnings report can be accessed here. The information and data is believed to be accurate, but no guarantees or representations are made.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.