Downside Risk To Teavana After Q2 Earnings

| About: Starbucks Corporation (SBUX)
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Teavana (TEA) released Q2 earnings on Tuesday, and there are a few worrying developments with the company. I see downside risk with the stock as a result of gross margin pressure and continued comp weakness.

Comp guidance lowered...

Management lowered total comp guidance for FY2012 and Q3 from mid-single digit to low-single digit. For comp upside surprise, Q4 would need a high-single digit total comp.

Repeat customers are mostly for the beverage, which is a low revenue contributor category...
Store comp was +0.6% in Q2, similar to Q1 at +0.1%. Beverage has been a major component to both repeat customers and traffic. Core customers have been trading up but it seems to have reversed in Q2.






Store comp (Ticket)






Store comp (Traffic)






Traffic reversal this quarter can be explained by beverage






Beverage contrib to total comps (traffic)






Beverage contrib to store comps (traffic)






It seems management is shifting its beverage mix to drive up traffic:

During the 2012 Q1 earnings call, management said beverage as a percentage of revenue would probably level off at 4% in the long run. And in Q2 earnings call, management became comfortable with a 6-7% beverage mix as most of the repeat traffic has been coming from beverage.

Gross margin will be under tremendous pressure in Q3

By the end of Q2, the Company converted 3 of the 46 Teaopia stores. The Teaopia inventory was sold at a significantly lower gross margin during the clear-out and management plans to convert the remaining 43 Teaopia stores in Q3. The discount pressure might surprise Q3 gross margin on the downside. Assuming same Q4 gross margin as 2011, management 2012 EPS guidance implies a similar 200bps gross margin decline in Q3 like Q2.

Management is showing inconsistency with the real estate mix for future store expansion:

During Q1, management targeted 50-50 mix between picking A-mall locations versus B-mall locations for new stores in 2012 and 2013. In Q2, when asked about new store openings, management acknowledged that a big proportion of unit growth will come from B malls going forward.

It was weather in Q1, now its internal management pipeline that contributes to comp. weakness:

Management blamed a warm winter and spring for the comp weakness in Q1. In Q2 earnings call, management commented they were unable to keep up the store general manager with the unit growth (59% or adding 105 stores to a base of 179 stores) since they promote from within.

The Company is expected to grow store at 60+ units/ year pace for the next year or two and expected to absorb and convert 43 Teaopia stores in Q3. Management is confident that this growing pain will be over by 2H. However, there are so many moving pieces that could easily make this growing pain into indigestion.

In summary, management seems to be shifting towards using the beverage category to drive traffic, pushing the mix from 4% up to 6-7%, fulfilling unit growth by expanding aggressively into B mall which might not have the demographics for high-end tea purchases and over-confident about their ability to digest the growing pain in one quarter. Consensus sees Teavana earning at $0.57 and $0.74 in '12 and '13. I see at least 5% downside risk to the EPS, as a result of gross margin pressure and continued comp weakness.

If management can't deliver improvement by digesting the 30% organic unit growth and 43 Teaopia stores in Q3, the stock has plenty of downside from EPS surprise and multiple de-rating.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in TEA over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.