08. November 2013 · Write a comment · Categories: News · Tags: , ,

Introduction

The beverage world is making constant movements, and the current macro-cycle in food is for more nutrition, more organic, and more natural foods. The beverage industry is no different. Soda has seen a drop in sale volumes for eight straight years and that drop was accelerated in 2013. The only place where soda sales are not dropping are in boutique, fancy sodas that use natural ingredients like cane sugar and lack preservatives. Mineral waters, teas, kombucha, and juices have filled this void. Enter – Reed’s (REED). Reed’s may be the answer beverage investors have been seeking against a tough backdrop for Coca-Cola (KO), PepsiCo (PEP), and others. REED produces popular non-GMO, natural sodas as well as the fast growing kombucha, and we believe that the company has potentially 50% upside in the next twelve months.

As we will show in this article, there is upside potential for REED from its cheap valuation in comparison to growth alone, but the company is also a perfect takeover candidate and is playing off the shifting trends in food consumption that will benefit them. The company’s initiative of kombucha production alone is reason to be excited about this company.

Considering the company’s discounted valuation to peers and better than industry average growth potential, we believe that this stock will move up in the near-term and mid-term. Since the craft beer explosion, REED may be onto the next biggest explosion in the beverage industry!

Business Overview

Reed’s is a beverage producer, but the company is much more than just that. The company compares themselves to a brewery that spends long periods of time brewing each batch with quality ingredients and intricate brewing process. The company has become the top-selling beverage in the natural foods industry with their iconic Reed’s Ginger Beer. Additionally, the company launched a line of kombucha called Culture Club. The company sells several other lines of sodas (Butterscotch beer, root beer, and sparkling juices). The company runs two production locations in Los Angeles and the East Coast. The company sells their branded beverages through distributors and to supermarket chains, natural foods grocers, and restaurants.

Industry Trends

One of the most exciting aspects of REED is that the company is part of a growing industry – natural foods. Within natural foods, REED is in an even more exciting portion – kombucha. We are looking at a company that is in one of the most exciting growth portions of the food industry. Let’s take a look at some of the trends in the industry:

· The organic food industry has grown 12% in 2013 and is expected to grow by the same rate in 2014

· The organic food industry is expected to grow from $67.2B in 2012 to $102.5B by 2016.

· Natural food industry is growing by low double-digits each year, and that number should continue to grow as it moves into the mainstream supermarkets.

· Kombucha industry has grown nearly 40% from 2012 to 2013, some say more.

· Kombucha industry is expecting to have $500M in sales in 2013.

The industry is very healthy for the expansion of natural foods and kombucha, and we can expect to continue to see 10-12% growth of natural foods over the next several years and 20-30% growth of kombucha over the next several years as well, which provides for a strong potential for Reeds moving forward.

Main Catalyst

For Reed’s, the catalyst for this company is fermented tea – kombucha. Most of the potential upside in shares comes from the opportunity that the company has in kombucha.

What is kombucha?

Kombucha is simple. It is fermented tea that has a carbonated taste with hints of alcohol. The company started selling kombucha under their Culture Club logo in 2012, and the upside is tremendous. The company sold 750K bottles in 2012 and expects to sell 7.5M in 2013. The company is seeing a lot of success at picking up distributors, and they have probably one of the brightest stars in the industry given their strong distribution network and established business lines already from their Reeds Ginger beverages. Being able to work with clientele that they already have and bring this high growth and wanted beverage into those locations is causing a lot of early success that we see continuing on a multi-year trend.

In the company’s latest quarter, they saw 75% increase in volumes for kombucha sales year/year, and the company is really just getting started a little over one year into the industry. In fact, the company is having so much success with the product that their current production appears unable to meet demand, and they are starting to look for some third party companies to help production. According to Nelson data, kombucha will grow 70% in 2013, and the main reason is that kombucha is making the move from the natural foods market to the mainstream market.

Some of the recent developments for the company suggest a similar action. In the past three months, the company has announced their Culture Club will be sold in 176 stores in the Midwest through Jewel-Osco stores, 81 stores in Wegmans, and 1000 stores of Kroger (KR). The company has gained access to 1500 stores in Q2 of 2013 and 1200 stores in Q3 of 2013. What is great is to see is that the company is also going into these new markets despite the fact that the company is new to the market. The current leader GT’s has been around for years, but REED is using their success with their other products to propel themselves into the kombucha industry and gain shelf space. Many of these companies are moving into kombucha for the first time and working with REED right off the bat.

Moving forward, the potential for kombucha trends are amazing. Two things are going to develop for REED – growth of kombucha and growth of the production capabilities of REED. The company spoke many times in their latest quarterly report of production issues causing them to not reach their maximum potential. They also mentioned that they are spending a lot of money to improve efficiencies. The kombucha is only produced in REED’s West Coast facility currently, but they are looking to expand it to their East Coast facility and move some simpler products out to allow for larger kombucha production. As the production issues become less intrusive, margins should grow as well as volumes.

What is perfect about kombucha is that it does not have the constraints of the rest of the beverage industry. Kombucha is more intensive to produce and costs more, but it is demanded year-round and more people want to drink it. Not something many beverage producers can say. That helps the company reach 30%+ gross margins for the product, but the company expects that this can move to 40%+. Margins are lower for REED overall though in comparison to competition.

How much growth is in kombucha?

The conservative side of our model projects around 20% CAGR through 2017, but if kombucha can make the move to the mainstream, it could stay around 30% for the next several years. The question for many would be trendiness. Is the drink just trendy? The answer is possibly. Yet, if it is trendy, that trend is just getting started given the amount of new companies that want to have kombucha for REED that aren’t just health food stores where it has already been popular for several years.

Secondary Catalyst

Margin expansion is another major catalyst for this company. The rest of the company – ginger beer, root beer, candies, and cola are all seeing growth more in line with the natural foods industry but still outperforming (20%+ in the last quarter). Margins, though, are much lower for REED despite that it sells a premium product. The company’s gross margins sit at just south of 30% in the trailing twelve months, which is much lower than the 60% of Coca-Cola and PepsiCo at 53%. Margins, though, are on the right trajectory. In the past ten years, the company’s gross margins have gone from 20% to 30%. Those margins should continue to expand moving forward.

Here is what the company is doing to help improve those margins that we believe can help to continue bring higher margins:

I look at gross margins, that’s kind of like can you cut the branch you still see the sap and the green, those are important things to see that the actual margins are doing very well. I think looking at the quarter from myself personally, knowing that we could have gotten closer to 11 million, knowing that we spent probably an extra $400,000 on promoting this above what we normally do in a key launch knowing private label hit me 400,000 harder than normally could do the onetime cost on the reserve for the private label.

And knowing that West Coast production is an up to 100,000 pieces a month and producing oil in the East Coast another $400,000 of additional shipping from the East to the West. So knowing that sales next year same time with growth with everything else going on with, I mean, personal promise plant will be running at full bore on the West Coast and the 100,000 cases to East Coast will have a backup. And we should be north of where we are now even producing just for this current quarter without any growth we should be able to do 1.2 million better in gross profit.

The company, though, seems to be in many ways maximizing their production at their facilities in some ways, and so the upside to margins may be limited until we see a move to build larger facilities. The fixed costs are also higher for REED than Coca-Cola and PepsiCo as the ingredients are of a higher quality and production process is much longer. Yet, the company is going to continue to see expansion as the company brings down their marketing costs and can see a larger growth of revenue to costs. In the pricing section below, we have provided our margin outlook that we see going from 30% in 2013 to 35% in 2017, which we believe is a very conservative estimate. With that estimate, we believe upside is still significant.

Competitive Landscape

The competitive landscape is not strong for the company overall. The major player is GT Kombucha, but REED is taking a different approach that will allow them to compete. Further, the pie is growing so much for kombucha that there is space for multiple players since the industry appears to be growing at a faster rate than production can meet currently. The company has recognized GT is the leader, and they believe that their relationship with the grocery stores gives them a competitive edge. As we can see from recent developments, that appears to be true. The company realizes it is #2 in kombucha, but given they are only 1.5 years in… they are making amazing strides.

Chris Reed, CEO, noted:

People want Kombucha but they don’t necessarily want who is Kombucha, because they are going, you know what, this would be the first time our customers are seeing Kombucha, we like your shelf life, we like the quality of your products and we are going to enter Kombucha, you know initially with you. They had big plans for Kombucha but they are definitely shifting from our original plan. I know that wasn’t your question.

Outside of kombucha, REED is #1 in the natural foods beverages with the top-selling sodas in natural food stores. The company sells its natural sodas in 13,000 stores and supermarkets with the top-selling root beer, Virgil’s and the top-selling cola with China Cola. With the industry growing, the pie continues to get larger and as the established leader in the industry, it will only get better for Reed’s.

The company, additionally, appears to actually be bucking the trend of other companies. As other soda companies are seeing contraction, REED is expanding. The fact that the company is seeing such growth and in areas where they are the top seller, the company appears to be a perfect buyout candidate. The company’s current valuations also suggest that potential is there. They are not overly expensive with a 2.5 price/sales and the company has an EV/revenue at about 2.7. The level that most look at for EV/revenue for potential buyouts is below 4.0, so the company is not going to take too much expense to pay off. For a large company like KO, PEP, or other beverage companies that want to take advantage of this trend, REED is a perfect candidate with little debt, solid production lines, and a great name that is growing.

Pricing/Valuation

In our pricing model, we came up with a $10 twelve-month price target for REED, which shows over 50% potential upside from current pricing. We used a conservative model that we believe takes into account margin expansion, kombucha growth, other branded lines’ growth, and an increasing tax scene as well as capital expenditure growth. Let’s breakdown the numbers:

Revenue – From 2013 to 2017, we see growth at $38M to $81M with a CAGR of just 23%. The company is growing well above these rates currently, and kombucha appears ready to explode over the next 1-2 years at a much higher rate. In our model, we saw around 30% growth in 2014 and 2015 with growth decreasing into 2016 and 2017 as comps become larger and kombucha likely sees its growth start to diminish.

Gross/operating margins – Margins should continue to expand. We believe costs of goods will stay fairly constant but gross margins will expand as the company produces more bottles for each production line and can likely start to see COGS-to-revenue decrease. SGA will start to take a smaller part as production increases and operating margins should expand at a faster rate than gross margin. We see no operating income in 2013 but it bouncing to $6M in 2014 up to $11M in 2017. The company has noted a lot of upfront costs hurt operating income in 2013 due to marketing and sales team growth.

Taxes – We foresee taxes increasing to around 20% by 2017 while they will stay minimal through 2013.

Shares – They are at 12.7M currently, and the company has signaled nothing about increasing or decreasing these levels.

CapEx/Depreciation – For now, we expect these will stay relatively in tandem and neutralize each other as far as cash flow. The company should see both rise as their production facilities depreciate and the company increases capex to likely acquire new facilities or do some share repurchasing.

All in all, when we use this data to price out the company for a five-year valuation, we come up with just north of $10. That number speaks volumes to the company’s potential, and we believe this model is fairly conservative especially since we use only a 10% growth model for the final year in 2017. Seeing this growth and value, it furthers our belief that REED is an excellent buyout candidate as well.

Risk/Variance

Overall, the most important risk or variance to our claim would be the trend of natural foods/kombucha dying out. The shift, though, has been so widespread and multi-year that it seems unlikely to reverse in the next two to three years. It is hard to imagine a scenario where natural foods start to lose popularity especially as medical costs rise, meat prices rise, and health concerns grow. The other potential snags in our argument is that the company has seen some overall production snafus since they went public, and those could continue to create a scenario where they do not meet expectations of their distributors that would cause them to lose potential business. Finally, the company could see major companies coming in with their own natural foods beverages that can compete with them. These companies will have significant more capital to work with and could create a negative situation.

Conclusion

In conclusion, the opportunity for REED is tremendous, and the market is likely missing this opportunity because the company is very small and unknown. Yet, as kombucha and natural sodas grow in popularity, so will REED. We see a very similar Hansens Natural to Monster (MNST) explosion potentially occurring for REED moving forward. The company still has a ways to go, but it will not take a major growth phase to power shares significantly higher.

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

Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.