I would like to introduce myself to the investment community of Seeking Alpha with a research article on DavidsTea (NASDAQ:DTEA) - a highly misunderstood story providing a very favorable investment opportunity from a risk/reward point of view. This article comprises five parts: 1) summary of the developments around DavidsTea over the last 18 months; 2) competitive environment; 3) analysis of the recent financial performance; 4) valuation and risk section; 5) outlook describing various potential catalysts for the short- and mid-term future. All financial numbers presented in this report are in C$ unless otherwise stated.
DavidsTea is a leading retailer of specialty tea, offering a differentiated selection of proprietary loose-leaf teas, pre-packaged teas, tea sachets, and tea-related gifts, accessories and food and beverages through 234 company-owned and operated retail stores in Canada and the United States, as well as through its e-commerce platform and recently established wholesale channel.
This in-depth review begins in December 2017 when DavidsTea issued a press release announcing that its Board of Directors has decided to initiate a process to explore a broad range of strategic alternatives to maximize shareholder value, potentially including a sale or other transactions. The Board of Directors also stated that they would select financial advisors to assist in this initiative, showing the seriousness of their intentions. In this press release, the company also announced the launch of a new, revamped e-commerce platform in early 2018 (market capitalization at Dec. 7, 2017: US$107 million). The ownership structure as of December 2017 has been as follows: co-founder of DavidsTea Herschel Segal - via his investment firm Rainy Day Investments - owned 46.0%, followed by (activist) investors Porchlight Equity Management with a stake of 12.8%, TDM Asset Management with 12.2%, and EdgePoint Investment Group owning 11.5% of the company.
On February 20, 2018, Herschel Segal informed the Board of Directors that he had decided to begin the process of exploring the possibility of taking the company private. In the letter, he stated that he intends to make an offer to buy out the minority shareholders or to present a proposal for an alternative strategic transaction by the end of April 2018 (market capitalization at Feb. 20, 2018: US$87 million).
On March 5, 2018, Segal announced his resignation from the Board of Directors with immediate effect, expressing disagreement with the Board’s response to his letter of February 20, 2018. According to the filing, apart from being deeply unsatisfied with the recent financial performance, he stated that the Board of Directors currently does not share a common vision regarding DavidsTea’s future and that he was “very disturbed by the reaction to the letter […] by the largest shareholder of the company”.
Based on this filing, it becomes apparent that Segal could not convince the three largest shareholders, owning more than 35% of the company at that time, to sell their shares at current price levels, even assuming a reasonable takeover premium (stock price at Mar 5, 2018: 3.45 US$/share). In the context of an average entry price between 7 and 8 US$/share for TDM Asset Management, I believe that is a reasonable conclusion. The other two main shareholders Porchlight Equity Management and EdgePoint Investment Group bought in at an even higher valuation based on my research. Thus, it should come as no surprise that an agreement about a buyout deal led by Segal could not be reached. Reading between the lines it has already become apparent at this point that Segal has fallen out with the other three large shareholders, which is why I believe the evaluation of strategic alternatives of the Board of Directors was also petering out. This conclusion is supported by various developments in the following months.
The next battle between the quarreled parties took place on the annual meeting on June 2018 when Segal won a proxy contest to wrestle control over DavidsTea. In his view, poor operational decisions and unproductive leadership by the current Board of Directors as well as management have greatly eroded shareholder value. As a result, he succeeded in convincing the majority of shareholders to elect his seven-director slate and vote out the incumbent board members.
In August 2018, the Board of Directors was (then again) renewed by the addition of Susan L. Burkman and Anne Darche. Burkman is a seasoned investment banking veteran who has successfully led equity, M&A and valuation transactions over $6 billion for Canadian companies across numerous industries over the last 35 years. The other appointment is definitely not less exciting. The marketing and consumer-trends specialist Darche, apart from other engagements, currently serves as a director of 48North Cannabis Corp, a company listed on the TSX Venture Exchange whose wholly-owned subsidiary is a licensed producer of medical cannabis in Canada. It is hard to believe that her cannabis background is a pure coincidence.
The last noteworthy personnel decision took place on November 2018 when Frank Zitella was appointed as new CFO replacing Howard Tafler who resigned in August 2018 to take a position at another company. Zitella has nearly 30 years of experience in finance, corporate taxation, and strategic planning and was most recently CFO of the publicly listed Loop Industries. In a nutshell, there has been quite a lot fluctuation at the senior level which definitely did not help the share price over the last year.
Apart from the battle for control of the company between the four large shareholders and key personnel changes resulting from this dispute, the cannabis optimism was the third major theme which determined the fate of DavidsTea in 2018. It all started in September when New Age Beverages (NBEV) saw a five-fold increase in value within less than a week based on cannabis-related buyout rumors. DavidsTea also got caught in this euphoria with investors envisioning that DavidsTea could also enter the cannabis market by selling CBD-infused tea or gummies through its broad network of stores in Canada. In one European country - The Netherlands - for example, cannabis has been legally sold in coffee shops for years.
On September 21, 2018, this craze reached its peak when the stock jumped approx. 60% to 5.35 US$/share in early trading. Around 14.5 million shares changed hands on this day alone, quite remarkably in the context of 26 million shares outstanding and the fact that Segal - owning 14.2 million shares - did not sell a single one. All three activist shareholders, sitting on large book losses but having finally lost the fight over DavidsTea, took the opportunity of the substantially increased trading volume provided on this day and in the following weeks to completely get rid of their shares. This massive supply overhang obviously depressed the stock price quite significantly.
On September 27, 2018, Segal said in a very insightful interview with a Canadian newspaper that he has been approached by six marijuana producers this summer regarding a potential collaboration. He replied back then that the timing was not right, but that he is closely observing the developments in this newly emerging field. He was quoted as saying "for the time being, it is too dangerous to try anything. But one can think about it and dream about it". He further stated in this article that these cannabis producers “have a lot of money, a lot of production capacity, and they are looking for open stores that are ready to sell [their] products”. […] If our customers want it [...]. We must observe. Our team must stay on the lookout. Let's remember that the sale of edible products containing cannabis is not legal for the moment”. But according to Segal, not only cannabis producers are looking to explore partnership projects with DavidsTea, but also players in the beverage industry like specialty coffee chains. The interview also briefly touched the still ongoing search for a new CEO. Apparently, he had already found a seasoned successor last year but the selected candidate did not go down well with some team members. Asked about his daughter Sarah, currently vice president of product development and innovation, he said she will not become the next CEO as she does not have enough experience and she does not want it either, thus, the search is continuing. Finally, he briefly outlined his strategy to simplify the product offering, i.e. he intends to reduce the number of units of individual products in stores by at least 40% and to put less emphasis on accessories (cups, brewers, etc.) due to the strong competition in this niche. He asked for another three or six months until his strategy shift should bear first fruits. Thus, we may already see the first positive results from these announced measures in the upcoming quarter. Now, let’s have a deeper look into the recent financial performance.
The market for tea products in Canada and the United States is highly fragmented which is why DavidsTea competes with a large number of relatively small independently owned tea retailers and several regional tea retailers, as well as retailers of grocery products.
In recent years, Teavana has been considered to be DavidsTea’s most notable competitor. In 2012, the company was bought by Starbucks (SBUX) for US$620 million, which made it its largest acquisition in history. In 2017, its tea was sold in about 380 Teavana stores. In addition, it has been the in-house tea brand at Starbucks vast store network across the United States and Canada. While there are similarities between the two, like the wall of tea, I believe that DavidsTea offers a differentiated consumer experience for a younger generation. The most obvious difference is in the store aesthetic, with DavidsTea stores being fresh, modern, and inviting versus Teavana’s traditional, ornate, and Asian-inspired design. Moreover, DavidsTea caters to a broad demographic skewed toward millennials while Teavana’s customer base skews toward upper-middle-income females. Furthermore, while DavidsTea operates a flexible real estate model, with a combination of mall, including lifestyle centers and outlets, and street locations, that helps build brand recognition and enable beverage sampling, Teavana’s stores are primarily located in high-traffic shopping malls.
In July 2017, Starbucks announced that it would close all 379 Teavana stores, including its 54 locations in Canada, by spring 2018 due to continuous underperformance of its proprietary retail locations. It will also no longer market its tea online but focus on selling its Teavana products in its numerous Starbucks stores. However, in December 2017, a federal judge forced Starbucks to keep 77 of its Teavana stores open and honor their leases. DavidsTea believed back then that it would particularly benefit at the 38 malls in Canada and 19 in the United States where it competes directly with Teavana. Even though there does not seem to be much overlap between the two competitors, DavidsTea should certainly be in a position to take advantage of the lessened competition in the future.
As a leading retailer of premium loose-leaf tea in Canada, I believe DavidsTea has an attractive market positioning. In my view, the following reasons contribute to a further strengthening of its competitive position:
Contrary to many specialty mall-based companies, I see minimal mark-down risk for DavidsTea given its long shelf life consumable products, e.g. its inventory of tea lasts up to two years. To back up this statement, I compared current prices of DavidsTea’s green tea offering with the price of the respective tea as of December 29, 2017. As expected, nearly every tea is currently being sold for exactly the same price as it had been 20 months ago, clearly indicating that there is no pricing pressure for DavidsTea. In addition, DavidsTea should benefit from current trends towards healthier lifestyles, especially among millennials who are increasingly willing to pay a premium for higher quality beverages.
Looking at the graph below, it becomes apparent that DavidsTea had pursued a very aggressive expansion strategy over the last couple of years. From 2012 to its peak in 2017, sales increased from $73 million to $224 million resulting in a compound annual growth rate of 25%. This development was also driven by a massive expansion in stores from 105 to 240 over the same period. Unfortunately, profitability - measured in unadjusted EBITDA - could not keep up with this pace and peaked in 2015 at around $22 million with a profit margin of 12%. Looking at today’s profitability levels, one could argue that all sales growth in the years after 2015 - resulting from further massive store expansion - was highly unprofitable, leading to a significant destruction of shareholder value. The continuously decreasing gross profit margins are mainly a result of increased occupancy costs driven by a higher mix of US stores which have less favorable unit economics in the first years than their Canadian counterparts. In this context, it is important to know that DavidsTea does not own its retail stores but rent them. Until the adoption of the new accounting standard IFRS 16 in the most recent quarter, lease expenses for the company’s retail stores had been part of its cost of goods sold (COGS). In my opinion, a large proportion of the erosion in gross profit margin can be attributed to the significant growth in US stores from 2015 onwards, which could not generate enough sales to earn a healthy contribution margin after accounting for their fixed lease expenses. According to Segal, the excessive US expansion, in particular, was one of the main reasons for DavidsTea’s worsening financial position.
Source: Financial statements of DavidsTea
Conservatively assuming 80% of the total lease expenses can be attributed to its retail stores, gross profit margin ex rental expenses would still be around 60% in 2018. This high gross profit margin suggests that DavidsTea is still able to charge a premium price due to its high brand attractiveness and superior customer service - its tea offering is still held in high esteem. If you follow DavidsTea on social media, like Facebook or Instagram, you will notice that it is still a highly relevant brand as comments and activity demonstrates. This shows the potential of this company if it succeeds in rightsizing its store count and further increasing the e-commerce business through its revamped website. With such high brand awareness combined with an easily transportable good, it clearly would make sense to have just a few flagship stores out there and sell the majority of its products through the online channel. I will get back to this point later in this report.
To get a better understanding of DavidsTea’s current financial performance, the last two years have been analyzed in more detail. After reaching record sales in 2017, the company suffered a decrease in sales of 5.0% in 2018. But not all parts of the business deteriorated to the same degree. The segment Tea only fell by 2% year-over-year, whereas the two substantially smaller segments Tea accessories and Food and Beverages experienced a decline in sales of around 10% and 16%, respectively. An even more interesting picture provides the geographical split. Even though two of the three closed stores in 2018 were located in the US (California and New York), US sales increased by 12% in 2018, simultaneously leading to a higher gross margin of 41.9% (vs. 39.6% in 2017). The development over the last three years clearly shows that the US business is on a positive trajectory to catch up with the gross profit margins of the Canadian one.
On the other hand, the e-commerce and wholesale channel saw a rise in sales of 20% in 2018. This significant increase can be mainly attributed to the recently revamped e-commerce platform, which was launched in early 2018 and represented a multi-million-dollar investment. In the fourth quarter of 2018, ending on February 2019, the e-commerce channel alone accounted for 16.9% of total sales. As the company continues to make substantial investments to elevate the overall user experience and enhance the omnichannel shopping experience of its customer base, we should expect the e-commerce platform to be one of the main drivers of future growth. The other major growth driver could be found in DavidsTea’s recent wholesale expansion. Since August 2018, its top-selling products are also available in 450 stores of Canada’s largest grocery chain Loblaw. As this cooperation has been a huge success so far DavidsTea announced in early May that it will significantly expand its business with Loblaw. Starting in the fall of 2019, its products will be available in additional 1,300 locations within the vast Loblaw retail network. In July 2019, DavidsTea announced the signing of additional distribution agreements with major Canadian grocery chains, expanding the availability of its tea sachets in the Canadian grocery isle (including Quebec) to an additional 1,250 new grocery stores, effective in the fall of 2019. This marks a further step towards a more balanced distribution strategy which should pave the way for more sustainable sales growth going forward.
The sales development over the last three years has also affected gross profit margins which fell from 50.2% in 2016 to 46.1% in 2018, mainly resulting from a shift in product mix and the deleveraging of fixed cost due to negative comparable sales. This clearly shows that the recent store expansion was carried out at the expense of operating profitability and that some stores are not capable to generate enough sales to support their fixed lease expenses. Management has already taken countermeasures and reduced store count from 240 to 234 (as of May 2019). As Segal publicly criticized the recent excessive store expansion, I expect management to continue to close unprofitable stores over the mid-term. Besides, management has already launched several cost reduction initiatives, e.g. tackling procurement costs, streamlining the range of formats and changing the composition of its tea sachets, and anticipates reaping the benefits in upcoming quarters.
SG&A decreased from $131.9 million to $125.7 million in 2018. But these figures are as misleading as the company’s disclosed result from operating activities which went from minus $24.7 million to minus $27.7 million as they both include several one-time expenses. The development of the unadjusted EBITDA, which went from $0.3 million to minus $9.6 million, provides us with a slightly better picture of the operating performance.
Source: Financial statements of DavidsTea
Instead, investors should focus on the adjusted EBITDA development as DavidsTea incurred several significant extraordinary and non-recurring expenses over the last two years. Adjusted EBITDA, which excludes among others any impact from executive separation costs, onerous contracts, costs related to the strategic review and proxy contest as well as costs of its terminated ERP project, decreased from $12.8 million to minus $1.3 million in 2018. I strongly believe that (retail) investors overlook the fact that even in the very disappointing year 2018 the company only generated a slightly negative EBITDA on a recurring basis.
As investors are most afraid about the cash burn rate of the company, we should turn to the cash flow statement next. In 2018, which marked the worst year in DavidsTea’s history, the company’s unadjusted funds from operations came in at minus $1.6 million (vs. $15.4 million in 2017). If you exclude the three main one-time items (executive separation costs, costs related to the strategic review and proxy contest as well as costs of its terminated ERP project), you would get adjusted funds from operations of $5.8 million in 2018. With an adjusted operating cash flow of minus $5.9 million and capital expenditures of $8.3 million, DavidsTea generated an adjusted free cash flow of minus $14.1 million. The significant increase in narrow net working capital of $6.3 million, mainly resulting from a substantial build-up of inventory from $24.5 million to $34.4 million, meaningfully contributed to the negative free cash flow in 2018 though. Going forward, I do not expect annual CapEx to be higher than $6 million, as DavidsTea has already made significant investments in its brick-and-mortar stores as well as in its e-commerce platform over the last three years.
Source: Financial statements of DavidsTea
With the new era of lease accounting, DavidsTea had to adopt the new standard IFRS 16 in its most recent quarter with the effect that operating lease payments will no longer be recognized within the cost of goods sold and general operating expenses, but capitalized initially followed by quarterly depreciation and interest expenses on the recognized right-of-use asset and lease liability. As the accounting treatment of lease payments does not have any impact on the valuation of the company (in theory), my analysis in the following will refer to the numbers excluding the impact of IFRS 16, i.e. accounting for operating leases of retail stores within COGS instead of treating the capitalized amount of operating lease payments as a debt-like item. This approach also increases the comparability with previous quarters in 2018, as DavidsTea elected not to restate last year’s figures retrospectively.
The first quarter of 2019 showed mixed results which underscored the fact that the implementation and consumer uptake of its new initiatives requires some lead time until they are observable in the financial statements. Total sales declined 3.3% y-o-y accompanied by the closure of 3 additional stores. Gross profit margin fell to 46.3% - a decrease of 3.3% from the prior year quarter - resulting from a shift in product mix and the deleveraging of fixed costs due to negative comparable store sales. As indicated by management, the benefits of lower procurement costs will improve margins only as older inventory is reduced and replenished with a lower cost of goods. Adjusted EBITDA in the most recent quarter amounted to minus $2.6 million compared to minus $0.4 million from the prior year quarter.
On the positive side, sales from the e-commerce and wholesale channels increased by over 9%, driven primarily by greater online adoption as well as by increased demand in its grocery distribution channel. The sales split by segment and geography provides some bright spots as well. Sales in the by far largest segment Tea is slightly up y-o-y, while Tea accessory sales were impacted by the seasonal transition period leading up to the fall. Apart from that, US business continues its positive trajectory with sales up 9% y-o-y. These developments clearly demonstrate that DavidsTea does not suffer a decline in popularity of its core product, and the so far lagging US activities have the potential to grow the business substantially without opening new stores.
Finally, we should turn our attention to the current balance sheet. As of May 4, 2019, DavidsTea has a net working capital balance of roughly $20 million, a cash balance of over $35 million and zero financial debt. That means DavidsTea currently trades just slightly above its net cash level, resulting in an enterprise value of less than $13 million as of August 16, 2019. How can such a low enterprise value be justified? There is just one rational explanation for such a phenomenon: that investors expect DavidsTea to dramatically accelerate its cash burn rate of last year until they are ultimately forced to file bankruptcy. Based on my in-depth analysis of the company, I would assign only a very small probability to this event. My assessment is based on the following four aspects: 1) substantial investments in its e-commerce platform and recent implementation of a clear wholesale strategy should fuel growth going forward, 2) streamlining of the product offering and partially reversing its excessive expansion strategy by closing unprofitable stores should lead to prior profitability levels, 3) CEO who also happens to own almost half of the company made it clear that he sees huge potential in the company (18 months ago he tried to make a buyout proposal to the minority shareholders at a price significantly above 3.50 US$/share), 4) several cannabis players have already shown interest in some kind of cooperation.
Unfortunately, there is currently no publicly listed beverage retailer with a comparable growth and margin profile which the current valuation of DavidsTea could be compared with. Its formerly listed competitor Teavana was acquired by Starbucks in 2012 at a valuation of 3.6x sales (EV/sales) and 16.2x EBITDA (EV/EBITDA). As a reference point, DavidsTea’s enterprise value (EV) is currently trading at around 0.06x last year’s sales (current EV equals $13 million, and last year's sales amount to $213 million). For comparison purposes, as Teavana, exactly like DavidsTea, did not own any real property but instead entered into operating lease arrangements, the recently capitalized lease obligations must not be taken into account in the calculation of the enterprise value.
As DavidsTea neither provides any guidance nor does it have any sell-side coverage at the moment - also one of the reasons for the disappointing stock price development - I have to refer to my own forecasts to value the company.
I believe there is a good chance that the recently taken measures to return to profitability, i.e. closing unprofitable stores, streamlining the product offering, cutting procurement costs, substantial investments in its e-commerce platform and tapping into the wholesale distribution channel, will start to bear fruit in the second half of this year. As a result of this, DavidsTea should be able to generate around $200 million in sales in 2020 (vs. $213 million in 2018) with an EBITDA margin of at least 5% (compared to 14% in 2015). Again, this profitability estimate accounts for lease expenses above EBITDA, mainly as part of COGS. Assigning this EBITDA of $10 million an appropriate multiple of 8, we would get an enterprise value of $80 million. Adding roughly $35 million in net cash, the fair equity value would be at around $115 million. Taking into account the current exchange rate and the number of shares outstanding, my first target price comes in at around 3.37 US$/share. As my projections refer to an EBITDA in 2020, you may want to discount this price target with an appropriate discount factor of 20% p.a. for a 6-month period, for example. In this case, we would arrive at my initial price target of at least 3.00 US$/share, an upside potential of more than 100% from current price levels.
Source: Own analysis
Key risks for DavidsTea include the following:
All these potential risks mentioned above are hardly deniable, but I believe these factors have already been priced in to a significant extent at the current price level. In my opinion, specifically, the current role of Segal has been a substantial drag on the recent stock price performance.
Finally, I would like to briefly summarize some possible catalysts having the potential to result in a significant revaluation of DavidsTea’s stock price. First, Segal made it clear from the beginning that he will only serve as CEO on an interim basis. Since he took over leadership in summer last year, the company has been looking for a new CEO, and the search is still ongoing. As mentioned above, they were already close to hiring a seasoned candidate last year, but he was apparently not well received by key personnel. In my opinion, any news about a new CEO replacing Segal would make the stock soar due to the substantially strengthened independence between the company’s executive board and its major shareholder subsequently.
Another related catalyst refers to the age and health condition of Herschel Segal. Being 88 years old, it is very possible that Segal will not be able to run the company much longer. In my opinion, any hints or rumors that Segal will be forced to step down and give up his CEO role would probably lead to a significant revaluation of the stock price as well. Such a development would also open up the possibility of the sale of his 46% stake in the company to an interested strategic investor. I believe there would be some strategic as well as financial investors interested in acquiring the company at these price levels, including the usual takeover premium. Unfortunately, no takeover attempt will have any chance to succeed without the approval of Segal. Minority shareholders should substantially benefit from such a potential stake sale as the capital market’s perceived missing independence between the current management team and the company’s major shareholder weighs heavily on the stock price and explains to a large part why the stock price currently trades significantly below its intrinsic value.
A third catalyst refers to the possibility that Segal could make another attempt at buying out the minority shareholders. Likelihood and prospects of success of such an attempt are difficult to assess. Due to the very high shareholder churn over the last months leading to a shareholder base mainly comprising short-term retail investors, I believe an offer between 2 and 2.50 US$/share, implying a premium of between 30% and 60%, would have a very good chance to succeed. Such an offer would still be around 50% lower than what he would have had to pay last year. Remember, in spring last year, Segal pursued his first takeover attempt when the stock was trading between 3.50 and 4.00 US$/share.
Finally, probably the most explosive but also most unpredictable catalyst: CBD-infused tea. As outlined above, in summer 2018, DavidsTea has already been approached by six cannabis producers regarding a potential collaboration. Reportedly, all expressions of interest have been rejected so far as it was viewed as too dangerous at the time. This perception may change rather sooner than later as Canada’s federal government has already stated that edibles containing cannabis and cannabis concentrates will become legal on or before October 17, 2019. So far, the sale of pot-infused foods, like cookies, brownies, and gummies, which account for a large share of the black market is still illegal. But this will change when the next phase of cannabis legalization takes effect on October 2019 along with a flood of new regulations.
In their conference call in May, they addressed one of their main problems, namely that DavidsTea is “currently skew[ed] overwhelmingly towards a female demographic, which represents over 80% of total sales”. To increase the popularity among the male demographic, they will embark several “initiatives to more directly capitalize on the wellness trend”. For example, it already offers powdered Kombucha tea which is well-known for its benefits for gut health, but it is also said to have a detoxifying effect and increase mental clarity. DavidsTea will try everything possible to make its brand even more relevant and expand its addressable markets. What a step towards wellness-related drinks can do for a stock price can easily be seen at the example of New Age Beverages.
In a nutshell, I believe the stock trades at a significant gap to its intrinsic value currently, even when taking into account the poor operating performance over the last 18 months and the fact that DavidsTea will probably be in a transition phase for the next two quarters.
If management succeeds in executing against its announced turnaround strategy, which emphasizes the following four priorities:
I believe we could see plenty of upside potential for the stock. In particular, the envisaged shift towards a more balanced mix between its three distribution channels (e-commerce and wholesale are estimated to account for around 40% of total sales in the future) would remove substantial pressure from DavidsTea with the comparatively high fixed cost structure of its brick-and-mortar business.
Apart from improving operating performance, any catalyst mentioned above may lead to a significant change in the investor appeal and result in a quick revaluation of the stock price. Thus, in my opinion, DavidsTea provides investors with a very compelling investment opportunity with some cannabis upside potential completely for free.
This article was written by
Disclosure: I am/we are long DTEA. 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.