Recently, SODA inked a deal with KFT, in which SODA will begin selling carbonated versions of some of Kraft’s beverage brands, including the Crystal Light and Country Time Lemonade brands. The stock immediately spiked around 10%, probably prompted a rush of short covering, of which I am a tiny part of. I covered because when a stock with a 50% short interest releases positive news, a short squeeze is a very real possibility. Again, I am reminded that shorting stocks is very much a timing game, much more so than being long. Still, I have no complaints, having a profit of around 10% overall from my SODA short because I shorted initially in the upper $40s, despite covering one-third of my position at a loss in the $60s.

My core thesis that SODA is a faddish niche product is, I believe, intact even in the face of the recent announcement. As far as I am concerned, anyone who wants fizzy versions of Crystal Light or Country Time Lemonade can simply add the Kraft powders to soda water instead of paying SODA’s markup as a middleman. It should be noted that SODA’s machine is simply an inconvenient and laborious way of generating carbonated water, easily available cheaply in ready-made form at any supermarket. Of more concern is the fact that Costco has started distributing Sodastream machines. This was of some concern to me, since I believe that the lack of places at which to exchange SODA’s carbon dioxide canisters is a major stumbling block in their bid to reach the mass market. But as far as I can tell, Costco is simply selling the machines and not exchanging the canisters.

In addition, there are some signs that SODA is being manipulated, likely by call writers. For the past several months now, SODA has reached a peak in price in the middle of the month, shortly before options expiration Friday, and then proceeded to decline towards the end of the month, only to begin the cycle again in a new month. Academic research has suggested that stock prices tend to be pinned at a point where the total value of options contracts (both calls and puts) is the lowest, a hypothesis dubbed the Max-Pain theory. Both large and small stocks can be subject to option manipulation; the common factor is avid interest among retail investors, who tend to buy lots of call options at rich premiums for these stocks. Since the major danger in this strategy is that the stock may skyrocket, causing massive losses to call writers, stocks with poor fundamentals are reasonably good candidates for this strategy.

As the stock has now declined to near reasonable prices, I have switched to a more opportunistic mode of trading this stock, shorting highs and then covering at the end of the month.

Disclosure : I have a short position in SODA.

A recent article in The Atlantic asks the interesting question : Why is there a single price for movie tickets? We have different prices for airplane tickets and Broadway shows; why don’t theater owners use different ticket prices to manage demand and keep their venues packed? The article points out that the single price system is not all bad for theater owners. Theaters keep their venues full by allotting an appropriate number of theaters to the movies, not by charging different prices. Flexible prices could lead price competition between theaters, to their collective detriment. It also increases policing costs, since people will be tempted to buy cheap tickets and sneak into expensive movies. However, the article fails to mention the main reason for the single price, that is, the market power of the distributors. The Big Six majors, namely Paramount, Warner Brothers, 20th Century Fox, Disney/Touchstone, Columbia/Tristar, and Universal Pictures, wield enormous clout in the movie business. By maintaining a single price regime, they keep the movie theaters dependent on the big budget films that only the majors have the financial muscle to pull off, and thereby are able to negotiate a bigger cut of the ticket prices. And allowing flexible prices could allow independent films to gain a foothold in the theaters, threatening their lucrative franchises.

A brief history of movies

To understand how this state of affairs came to be, it is instructive to briefly examine the history of the movie business. The movie technology matured in the early 1900s, with the first movies with soundtracks appearing in the 1920s, and the first color movies in the 1930s. The early movie industry was vertically integrated by necessity, since companies had to invent every aspect of the movie business, from making movies to distributing them. Cinemas showed only the films of the studios to which they belong, and actively avoided competing with each other by scheduling films so that they do not compete head on. Studios had a chokehold on the creative and acting talent, and films were low budget and generally of low quality. This state of affairs came to an end in the landmark anti-trust case United States v Paramount in 1948, which forced the studios to break up. The studios naturally chose the least profitable parts of their empires to divest, and spun off their production and cinema businesses. From then on, the movie business was split into 3 parts, The studios contracted out the actual movie making to independent production companies, and contracted with independent cinema owners to show the movies at the theaters. But they kept the most profitable part of the business for themselves, becoming movie distributors who market, finance and distribute films. More importantly, the oligopoly structure remained intact in the distribution division of the industry, forever allowing the middlemen to continue extracting large profits from the weaker arms of the business.

Why CKEC is better than DWA

Long-time readers of this blog will know that I am bullish on CKEC, while bearish on DWA. This is because DWA occupies the least attractive arm of the industry, the production arm. Making movies is intrinsically a creative business, and creative industries are usually highly fragmented (see the fashion and IT industries), because ideas can and do arise in outsiders all the time. Production companies own libraries of films, but take outsized risks in making those films, and must share the revenues with gatekeepers like the distributors and Netflix/Amazon. Even worse, the Internet has driven down the cost of everything it has touched (see journalistic content, stock photography, online shopping etc.), and promises to do the same to movies. So, the future does not look bright for this part of the business.

A more attractive part of the movie business is the cinema owner arm, where CKEC resides. It is more attractive now than in recent history because the cinema chains have just gone on a massive consolidation spree in the 1990s and 2000s, and now has significant market share. The only problem, of course, is that they took on massive debt to consolidate, and now may not survive the hangover. But if they live past this crisis, it is likely that this part of the business will gain significant power and be able to push back somewhat against the distributors.

The most attractive part is, of course, the distributors themselves. But many are subsidiaries of major media conglomerates, so a pure analysis is difficult. And they never got cheap enough during the financial crisis to become a value investment, which isn’t surprising considering that their oligopoly status has been recognized for decades.

Disclosure : I have a long position in CKEC.

In my search for undervalued companies, I came across differing opinions for the value of Dreamworks (DWA). On the one hand, a professional analyst has rated DWA a sell, citing an EPS of only around $1 vs a stock price of around $16. On the other hand, two apparently independent financial bloggers, Frogskiss and Whopperinvestments, have come out with bullish calls on DWA, citing the deep library of films not carried on the balance sheet as the main reason why DWA should not be trading at close to book value, but rather way above book value. A difference of opinion is a potential profit opportunity, so I decided to do a little digging of my own. I was rooting for the bloggers (since I am one myself), but at the end of my analysis, I concluded that the analyst’s take is probably closer to the mark. For those who are interested, I set out my thinking below.

On DWA’s hidden asset

Hidden assets are the bread and butter of value investors. Many companies accumulate assets that are critical to their businesses but not well reflected on the balance sheet. A common example is land, which is typically carried at cost on the balance sheet, which can be vastly lower than its current market price. Typically, these hidden assets become important sources of value when the main business is failing and earnings fall off dramatically, but only when these hidden assets can be put to more productive use in another company’s hands. For example, a failing retailer with a lot of land can sell the land for residential or other uses, or a telco with a shrinking user base can sell excess wireless spectrum to other growing telcos. It is not clear to me that this is the case with DWA.

DWA’s hidden asset is its off-balance-sheet library of films, which contain such franchise films as Shrek, Madagascar, and Kung Fu Panda. These films cost $100-150M each to make, and were written down to zero when the films are released. However, the question that arises is, if the library is so valuable, why is DWA deriving only $80M of annual earnings from its library of content plus the 2 films it releases at the box office annually. DWA should be the company best able to monetize its own film library. If DWA is not able to monetize the library effectively, does that not mean that the library is not as valuable as anticipated? It seems unlikely to me that another company will be better able to monetize the library. Furthermore, film libraries are depreciating assets. With every year that passes, films become less valuable as memories fade and more competing films are made. Few films achieve evergreen status and continually generate a stable level of cash flow. With each year that DWA fails to monetize its content, chances are that the film library becomes less valuable.

On historical business models of movie companies

In the past, movie companies made films and released them in theaters, and the films had only 2-3 months in which to recoup their cost and make a profit at the box office. Box office earnings were everything to a movie. Then came VHS tapes, which allowed movies to be viewed at home on the TV. This increased the value of a film library, but only moderately, because the tapes were relatively expensive to manufacture, and picture quality degrades with time since the magnetic data was labile. The breakthrough technology came with the invention of the DVD, which costs pennies to make but retails for tens of dollars. Since the optical data was non-labile, for the first time, it was possible for the retail customer to acquire their own permanent personal movie library. The DVD revolution was further amplified because it coincided with the advent of the large screen LCD TV, the era of cheap credit. DVD, and the home theater craze. DVD earnings surpassed box office takings, and even decades-old films began to make serious money.

Then Armageddon struck in the form of Netflix, which made a personal movie library unnecessary. DVD sales has already began to decline. At this time, it seems inevitable that the DVD is headed for the trash bin of history, and the future of movie delivery is likely to be internet-based streaming. Blue-ray, the last best hope of the movie industry, has largely proved to be a dud. In the post-DVD streaming age, what is the likely value of DWA’s film library? Almost certainly lower than in the DVD age. In the best case scenario, Amazon may prove to be a viable opponent to Netflix, giving movie companies the possibility of a bidding war for their content library. However, Netflix has recently been laid low through its own missteps, and recently had to issue shares at a low price to shore up its balance sheet, and so is unlikely to be in a position to make rich bids for content. And Amazon, known as the Walmart of internet retailing, is unlikely to overpay for content. While the business model for internet streaming is still in flux, the final model is likely to be similar to the current model for theater delivery, that is, content companies receive a share of the revenue for each movie-viewer. In this scenario, cash flow from the film library will dramatically decrease, because while a large number of people may buy a DVD on the possibility that they may one day view the movie, in practice a far smaller number of people actually view the movie.

And matters could be worse. It is possible that executives at production companies have been misled by DVD earnings to splurge on their movie budgets. Certainly, the steadily rising movie budgets, now costing nearly $100-150M over 2-4 years for an animated film, suggests this. In other words, companies may have overpaid for their movies, and inventory write-downs will be required in the future. Furthermore, the large capital outlay makes companies more conservative. If you look at the upcoming slate of movies from DWA, they consist mainly of rehashes of their existing franchises (Kung Fu Panda 3, Puss in Boots 3 etc.). This paradoxically reduces the chances of getting a blockbuster movie.

My valuation for DWA

I predict that box office earnings will once again comprise the vast majority of film income, with only a trickle of cash flow from post-release streaming. Box office receipts are notoriously fickle and difficult to predict, so the earnings of movie companies will be lower and more bumpy. This means that the PE multiplier accorded should be lower. The professional analyst in question (Tony Wible, who also had the courage and foresight to correctly call the NFLX meltdown) gives DWA a PE of 12, for a price target of $12. I am more pessimistic and am personally inclined to give it a PE of only 10, for a $10 price target. As of Dec 15 2011, DWA had a shocking 37.7% of its float short, suggesting that many short-sellers are also of a bearish view. While I currently do not have a position in DWA, I am actively considering shorting it and other movie companies. To be sure, this is a highly hazardous short, since a blockbuster movie release could easily set off a massive short squeeze, so if you are thinking also of shorting this stock, I urge extreme caution. This is not for the faint-hearted, and certainly should not comprise a large portion of your portfolio.

Hewlett Packard, that icon of American technology, is now trading at between 5-7 times earnings. This is cheap, extremely cheap, especially for a large cap. Will new CEO Meg Whitman be able to turn things around? Sadly, I believe that the answer is : no.

Whitman, of course, led another technological icon eBay from 1998-2008. I had analyzed eBay previously back when I had a position in the stock a couple of years ago, so I had learnt something about Whitman’s management style. In short, Whitman is a visionary CEO, good at making grand strategic moves, but not good at the nuts and bolts of operations. In terms of strategy, Whitman is actually a passable CEO. She acquired two companies during her eBay stint, Paypal and Skype. The former acquisition is widely regarded as a success, and the latter a failure. However, the thinking behind both acquisitions was sound. Paypal was certainly a natural fit for eBay, and Paypal usage was probably boosted by its association with eBay. Skype can also arguably be regarded as complementary to eBay. After all, trust is important in online auctions, and a person-to-person conversation can do a lot to alleviate trust issues. However, Whitman overlooked a key operational detail during the Skype acquisition. She left the Skype’s key intellectual property in the hands of a separate company owned by Skype’s founders. Eventually, this allowed the Skype founders to continually blackmail eBay for more money, turning a marginally expensive acquisition into an incredibly expensive one. The greedy behavior of Skype’s founders was viewed with such disgust by the eBay management team that they did all they could to prevent Skype’s success, never incorporating Skype features into the eBay marketplace. While Whitman was busy with these transformative acquisitions, eBay experienced enormous organic growth due largely to the natural monopoly characteristics of the online auction business model. However, this growth was largely unmonitored and unguided by management, and eBay was widely criticized for its sale of stolen and illegal goods, the prevalence of fraudulent buyers and sellers, the clunky user interface and the widespread use of bidding robots. My impression was that nothing rose to the attention of eBay management until it has become widely reported by the media and threatened to become a legal issue. Contrast this with other online companies which has experienced exponential growth (Netflix, Amazon, Blizzard), where management proactively solved issues and generally kept its users happy despite massive growth in user base. In contrast, Whitman’s management team was almost solely focused on growth, especially growth overseas and through acquisitions, with little regard to the amount of money spent on acquiring growth. Post-eBay, Whitman campaigned to become California’s governor in much the same style, focusing on grand gestures and new directions while throwing money around with abandon. Whitman’s campaign was not successful, but is one of the most profligate campaigns of all time, spending nearly $45 per vote.

Of course, both vision and operational excellence are required for a company’s success. Every Steve Jobs needs his Tim Cook. My preference is that the Chairman takes on the strategic role, while the CEO concentrates on operations, but having a visionary CEO and a good COO is also fine by me. But tellingly, HP’s management team has no chief operations officer. This was inconsequential under Mark Hurd, since Hurd is himself an ops guy, but Whitman definitely needs a COO. While Whitman is no doubt trying to come up with some new magical acquisition or strategy that will fix everything, the underlying business is falling apart. Businesses and consumers are choosing Dell and Lenovo instead of HP for fear that HP will stop being in the hardware business soon. And if customers don’t trust HP with their hardware, where HP is a solid brand, I don’t think they will flock to HP enterprise software offerings any time soon.

HP does not have a transient difficulty due to the business cycle or a one-time mistake. It has an underlying management problem, one which I don’t see getting fixed. It is human nature to believe in oneself; few people are able to proactively acknowledge their weaknesses and seek help, and this is doubly true for someone as prone to grandiosity as Whitman. Yes, HP is an American icon. But no thanks, I think I’ll give this icon a miss.

Disclosure : No position in HP.

What a difference a couple of months makes in the ease of finding value stocks! Now that we’re awash with stocks trading at cheap valuations, what kind of stocks should one invest in? I humbly suggest Target, a stock that I think will hold its ground even in a double dip recession coupled with inflation, and will really take off if the economy stages a recovery.

The “Target will be driven out of business by Walmart” meme

Target is a familiar name to most US residents. The second-largest general merchandise retailer in the US (with 1750 stores exclusively in the US) had poor comparable stores sales during the recession, while its competitor Walmart posted better comparables. This led to phrases like “new normal”, and worries that Target customers were flocking en masse to Walmart. When comparable stores sales at TGT rose only 0.9% in January 2011, below the average for most other retailers, investors’ worst fears were apparently confirmed, and the stock staged a rapid 25% decline to the $45-50 range. This decline was probably accelerated by Bill Ackman puking out shares after a failed campaign to get Target to monetize its real estate holdings.

Competent retail analysts are aware that Target and Walmart are not, in fact, in direct competition. The two companies have different business models. Walmart strives for scale and operational efficiency, stocking less SKUs and maximizing inventory turns, appealing to its price sensitive and utilitarian shoppers who know what they want and want to get it at the lowest price. Target’s business model is akin to Costco’s, selling high quality merchandise in a pleasant shopping environment at low margins, while making more profit from shoppers who make discretionary impulsive purchases while browsing the store. Target’s consumers have retrenched during the recession and are doing less discretionary shopping, leading to lower comparables, but are still shopping for the essentials, an area where Target’s and Walmart’s prices are much closer. Shopping turns out to be a surprisingly sticky activity. Target is not losing customers; rather, its customers are changing their shopping habits in the face of the tough economy. Target management is aware of customers’ cash flow problems, and has rolled out the REDcard credit card initiative, which gave customers a 5% discount for shopping at Target, to huge success. Target also has a very low cost base, owning most of its stores outright and therefore not having to pay leases. These factors have led to Target staying in the black throughout the recession despite poorer profitability. I believe that Target’s customers have already retrenched all that they can, and that sales at Target have reached their nadir. Walmart’s growth coincided with a flood of low-cost imports from China, a phenomenon that likely has run its course, given rampant cost inflation in China, and going forward, Walmart’s customers are likely to find more pricey products and a higher incentive to try out Target stores. Going forward, investors will also see that the declining situation at Target has stabilized. More recent data bear this out, with Target’s August 2011 comparables up 4.1%. It is important to note that even if comparable sales do not take off and stay at this depressed level, Target is nevertheless profitable.

Target’s excellent growth prospects

Target has yet to saturate its core domestic market. Walmart has some 3000-4000 stores in the US, while Target has a relatively paltry 1750 stores. Management expects that an expansion to 2500-3000 stores is reasonable in the US market.

Target has also rolled out the P-Fresh concept, selling fresh groceries in stores. This is not expected to add to margins, because groceries are a low margin product, but does result in a 6-7% bump in overall sales in stores where the concept has been rolled out. Presumably, when the market recovers, this will translate to additional shoppers who will contribute to high margin discretionary purchases. While rolling out the P-Fresh concept will cost an estimated $1.8B, the returns are sufficiently high that this will add to growth, especially in a market recovery.

In addition, Target has announced plans to expand into the Canadian market, where it already has high brand awareness from spillover US advertising despite no retail presence. It has recently purchased 220 Zeller’s retail locations for $1.8B, with its first Canadian stores slated for 2013.

Target’s many assets

Property. Target owns 1500 of its 1750 stores. This was the prize coveted by Bill Ackman when he acquired a large block of Target shares during the peak of the real estate bubble, and subsequently tried to force management to spin off the real estate holdings into a separate company and to lease back those stores, thereby “unlocking” value. The popping of the real estate bubble put a crimp in that plan. Now, the value that Ackman’s prize is Target’s competitive advantage, dramatically lowering its operating costs compared to competitors, and helping Target remain profitable in a downturn.

A near impregnable market niche. The moat around Target’s niche is demonstrated by the fact that Walmart once launched a campaign to take market share from Target, but the appearance of high cost products in their stores only caused dismay among its customers and a dilution of Walmart’s brand. The project was later unceremoniously canceled, and replaced with a new campaign to try to raise margins with Walmart’s existing customers. Target’s scale allows it to underprice all other competitors aside from Walmart, and allows it to test out new concepts in select regions before rolling them out to all stores.

Goodwill. Target has enormous brand awareness and goodwill among both customers and suppliers. Suppliers desperately need a retailer of scale aside from Walmart, which has been relentlessly squeezing them on costs, and therefore are more likely to give Target preferable pricing. Among customers, Target’s brand awareness is very high. Target shoppers know that while they will not get the absolute lowest prices, they will have a better shopping experience with a larger selection and good value.

Capable management. Target’s management is known for competence in retailing and financial conservatism. They put a lot of effort into making browsing a pleasurable experience for the shopper, while balancing the need to simultaneously provide a good value proposition. The REDcard and P-Fresh concepts are evidence that management is not resting on its laurels, and are constantly trying to find ways to increase comparables. In addition, Target management is financially conservative, rejected Ackman’s financial engineering ploy as a way to boost earnings, and generally taking a measured conservative approach to growth. While Walmart expanded aggressively into many international markets simultaneously during the boom, and had to retreat from several of those markets eventually, Target had stayed an exclusively US retailer, expanding slowly and preferring to acquire stores in cash rather than through debt. Management has only recently started to get aggressive about growing store count, taking advantage of the low costs to expand into Canada. TGT therefore has a lower debt-to-equity ratio than WMT, with long-term debt adding up to less than half of equity.

Summary of investment thesis

As a general merchandise retailer, Target is likely to be able to pass on inflation costs to its customers, and therefore serves as an inflation hedge. While currently experiencing depressed profitability, Target’s customers are expected to loosen the purse strings if the economy improves. Furthermore, Target’s current growth initiatives are also expected to bear fruit in a recovery economy. At a share price of $50, TGT has a market cap of $36B, or about 12x trailing free cash flow of about $3B, TGT is a stock with minimal downside but poised to explode on the upside with any recovery. Note that TGT has managed to grow the bottom line by nearly 10% annually through the recession, and sports a dividend of 2%.

The only fly in the ointment is that the huge success of the REDcard initially has resulted in credit card earnings making up a significant portion of the total revenues, as well as credit card receivables making up a large portion of the balance sheet. There is some concern that as a company without extensive experience in the credit card business, TGT may have mispriced its receivables. However, Target is expected to sell its receivables to a financial company in the future, a step which should bring in cash for its current expansion, as well as clear up any misgivings about the valuation by bringing in an independent set of eyes. This will also turn TGT into a pure play retailer once again, which would make it easier to analyze for retail analysts.

Disclosure : I have a long position in TGT.

Starved of yield in the bond and money markets, investors are now frantically bidding up any stock which can deliver growth in the recessionary climate. Sodastream’s stock is a beneficiary of this phenomenon, driven by its past success in Sweden and its impressive growth in the US. However, this is not the first time this particular fad has been rolled out, and chances are that the fad will fizzle even faster this time round, especially given the current economic turmoil in Europe.

Sodastream sells home fountain soda machines that pump carbon dioxide into water to make soda water, which can then be mixed with syrups to produce soft drinks. Incredibly, the basic machine first made its debut nearly a century ago in the 1900s in Europe. Sodastream, previously known as Soda-Club, reached its peak popularity in the 1970s and 1980s in the UK on the back of a successful marketing campaign centered around the slogan “Get busy with the fizzy”. But as the marketing stopped, sales faded. The company passed through the hands of several companies, finally being bought by Fortissimo Capital, a newly formed Israeli private equity firm, in 2007. At that time, Sodastream had revenue of around $100M, but was losing money.

What ingenious plan did Fortissimo come up with to save the company? Simply put, they resurrected a business model that had previously failed. The PE firm planned a revival based on marketing, and recruited a new CEO from Israel Nike to drive the new strategy. TV advertisements were rolled out in UK capitalizing on nostalgia, while in the US, promoters were stationed in retail stores to demonstrate the machines. The marketing predictably caused an uptick in sales, which was used as justification to IPO the company. The company emphasized its push into a new market with high per capita consumption of soda, the United States, as well as its razor-razor blade business model, making low margins on machines (35%), and high margins on syrup (55%) and carbon dioxide carbonators (90%), essentially explaining the current lack of cash flow by implying that the best is yet to come. Growth-hungry investors were hooked into a plausible story. Comparisons were made with Green Mountain Coffee Roasters (GMCR) by a certain disreputable TV stock promoter.

Why SODA is not GMCR

The “SODA is the next GMCR” meme has become a major bull theme among retail investors. However, if you go beyond the superficial product similarities and consider the business model, SODA looks extremely weak compared to GMCR.

Firstly, GMCR’s K-cups are patent protected. You cannot make a cup that fits into Keurig’s single cup coffee maker unless you pay licensing fees to GMCR. GMCR’s competitors have to come up with a completely alternative packaging (e.g. Tassimo T-discs) to fit a different coffee maker. SODA’s consumables are not patent protected, which makes SODA’s razor-razor blade business model very iffy. Soda syrups are widely available to restaurants and easily adapted for retail sales. In fact, it is relatively easy to make your own soda syrups. As for the carbon dioxide cylinders, SODA deliberately makes its carbonators with a non-standard refilling adaptor so that they cannot be filled with industry standard canisters. This has not prevented third party companies like VikingSoda (in Sweden) from reverse engineering the fittings and filling SODA’s carbonators. (SODA has sued VikingSoda, and initially won an injunction, but the injunction was overturned by higher courts, and it now appears legal for third parties to refill SODA carbonators in Sweden.) Another approach is to use third party carbon dioxide tanks for Sodastream machines, circumventing its carbonators altogether. These third party manufacturers will limit the margins that SODA can achieve on its consumables.

Secondly, coffee is an addictive beverage with a growing market in the developed countries. Many people consume coffee every day on a regular basis. Soft drink and carbonated drinks are occasional beverages with a market that is shrinking 1-3% annually in Sodastream’s key markets, US and Europe. Few people drink soda on a daily basis, or with any kind of regularity.

Thirdly, the savings of a K-cup is clear to the consumer. You pay $0.50-$1 for a K-cup, versus paying $3-6 for a high quality cup of coffee at a café. In X number of cups, you recoup the price of the coffee maker. The savings of the Sodastream system is much more amorphous. Most consumers can’t even tell you the price of a can of soda that they drink, for the simple reason that the price is so low that it is below the pain threshold for most people, and simply does not register. And calculating how much an equivalent serving from a Sodastream machine costs requires breaking out the calculator, or maybe an Excel spreadsheet. How much does that carbon dioxide cost again? And how much is three tablespoons of syrup? While it is arguable that Sodastream machines may be somewhat cheaper on a per liter basis (and I do mean arguable, because you would have to drink a lot to achieve minimal savings), cost per drink will simply not be a factor to anyone except math wonks.

Fourthly, GMCR saves time. You can skip a trip to the café in the morning. Keurig coffee makers are easy to use, involving minimal labor. You can make single cup coffee quickly in the privacy of your own home, comparable with the waiting time you spend at cafes. As the slogan “Get busy with the fizzy” suggests, Sodastream machines are laborious to operate and represent a net waste of time for most people. To carbonate water to the level that you find in cans, you have to charge the water with carbon dioxide 7-10 times, and then add syrup to that water to make soda. Soda is best made in small batches, because it loses its fizz rapidly. Compare this to the time taken to pick up a can, pull a tab, and pour. And when that carbonator runs out, you can’t pick one up on your weekly grocery shopping trip. You have to make a special visit to your nearest home appliance store like Bed Bath and Beyond or Crate and Barrel, to pick up a new canister.

In conclusion, while GMCR’s customers are primarily driven by economics and value, Sodastream’s customers are not likely to be value-oriented. Why would one buy a Sodastream machine then? Sodastream machines appeal to three groups of consumers. Firstly, there are novelty seekers who pick one up on impulse, and soon after relegate the machine to the attic to join the bread maker. These consumers realize belatedly that while in principle, making your own bread and soda promises all kinds of health and culinary benefits, in practice, the convenience of picking up bread and soda at the grocer wins out. Secondly, there are soda aficionados who want to make their own fountain soda with their own specialized recipes, and appreciate a machine that produce soda water to a defined fizziness in their own kitchen without having to lug club soda from the grocer. And thirdly, there are environmentalists who feel that using so much metal and energy to make and transport cans of soda is wasteful, and that it is one’s moral duty to endure some inconvenience to save the environment. This is the same type of personality who religiously recycle despite the inconvenience. To these last two groups of consumers, Sodastream machines present real value, and they are likely to form repeat customers. However, in the final analysis, Sodastream’s core customers are a niche segment of the population. SODA in no way approaches GMCR’s broad appeal to middle class thriftiness, and is simply a pale imitator.

Retailers face cumbersome logistics and murky legalities

Sodastream’s carbonators present an unusual logistical challenge to retail stores. Most retail stores are set up for one way sales of goods with limited returns, and almost never ship products back to warehouses. Unlike most goods, however, SODA’s carbonators must be refilled when empty, generating a huge volume of returned products on a one-for-one basis with sales. Sodastream contracts with UPS to ship and exchange carbonators at customer’s homes, but this service is expensive (UPS adds a hazmat fee both ways), and many customers would either have to leave their carbonators out and risk theft, or stay at home to wait for the UPS guy. Management realizes that shipping carbonators individually is expensive and inconvenient to the customer, and is trying to place the carbonators in as many retail locations as possible. Because the empty cylinders comprise a large portion of the value in the goods, the retailers must pay a deposit for the value of the cylinders, and then recover that deposit when customers return the empty cylinders. In addition to the additional financial outlay, the retailer must also re-educate staff to deal with the high level of returns associated with this one special product. If these reasons do not deter the retailer yet, the gas cylinders themselves are regulated as hazmat in the US, due to the risk of explosion when heated, and the risk of suffocation if leakage occurs in a closed room. It is illegal to simply pile the cylinders up in a closed room without sufficient ventilation, and transport of the cylinders must be in open vehicles with drivers educated about the dangers of the goods. All this adds to the cost of the logistics associated with this one special product. And furthermore, Sodastream machines are made in Israel-occupied Palestine, and stores which sell their machines are sometimes picketed by Palestine activists, who demand that they stop selling good illegally produced in Palestine.

Which retailers would be interested in selling Sodastream machines despite these logistical and legal issues? To date, it appears that Sodastream is most attractive to kitchen appliance retailers such as Bed Bath and Beyond, Crate and Barrel, and Williams Sonoma. These stores have low turnover but high margins, and impulse purchases of Sodastream machines add appreciably to the bottom line. In addition, the presence of Sodastream product demonstrators increases the time customers spend in the store, and customers coming in to exchange carbonators are probably incremental customers to these non-food retailers, with the possibility of additional impulse purchases while the customers are moving in the store. These stores are also staffed with moderately well trained employees who are able to deal with the inquiries associated with a novel and unusual product that require exchange of carbonators. Obviously, the difficulty of finding one of these retailers nearby to exchange carbonators diminishes the attractiveness of the Sodastream machines (and there are anecdotal reports that the carbonators are always out of stock at some stores, because the retailers are much more interested in selling the machines then in dealing with the carbonators). To achieve scale, Sodastream has to sell its carbonators in grocery stores. Most mainstream grocers, however, rely on high turnover low margin products. A high margin product that is labor intensive and has unusual logistics would be challenging to the typical minimum wage employee at these stores. The currently low turnover of the carbonators would also decrease the yield of their shelf space. Grocers would like to see higher volume associated with the carbonators before committing to selling them, which creates a kind of a chicken-and-egg problem. In my opinion, it is highly unlikely that you’ll see Sodastream carbonators appear at Walmart or Target anytime soon.

The experience of Sodastream in Sweden, in my opinion, is the exception that proves the rule. The remarkable near 20% market penetration of Sodastream in Sweden can be explained by several factors. Firstly, Swedes have relatively high incomes and are more environmentally conscious then residents of most other countries. Secondly, the retail sector of Sweden is highly concentrated, with the top 3 grocers taking 80-90% of market share. Food costs are higher than other EU countries, grocery margins are higher, employees are better trained, and there is no need to strive for maximal inventory turnover. Just convincing one of the major grocers to sell/exchange carbonators would be sufficient to place the carbonators near every resident in Sweden, accounting for the company’s relative success in that country. It is unclear whether this set of conditions exists in other countries, and whether this success is replicable elsewhere.

Valuation

The valuation of rapidly growing companies like GMCR and SODA is always a crapshoot. Minute changes in growth rates and periods cause huge changes in final valuation. My preferred method for valuation of growth companies is to project the final terminal market size/revenue and the final margins possible. I find that this method of valuation makes for a more rational basis for disagreements. Still, growth companies always present increased uncertainty, especially if the market is new or being created as the company grows. In this case, I don’t think there is a new market being created, but rather, the existing soft drink market is being shunted into a new method of consumption, so there is a somewhat increased certainty.

What are the sizes of the soft drink market in Europe and the US? Unfortunately, I could not find any publicly available information on this, and am forced to cobble together what I consider a reasonable size estimate based on Coca Cola’s public filings and recent estimates on its market share. In 2010, Coke reported selling 25.5B cases of soft drinks, 22% of that in US, and 16% of that in Europe. The market share of Coke in US and Europe are approximately 35% and 50% respectively. Therefore, the total size of the US soft drink market is some 16B cases (300M people each consuming 53 cases annually), and Europe’s market is around 8B cases (500M people each consuming 16 cases annually). If one considers that initial pre-2007 pre-marketing-blitz revenue as the likely final revenue derived from a certain volume of soda drinkers, then Sodastream will derive $100M of revenue from Europe, and $200M of revenue from US, for a total of $300M in revenue.

Of course, the above analysis simply assumes that marketing efforts of the current management simply has minimal long-term effects in Europe, and ramps US sales up to a level comparable with European steady state sales. Another approach to get at terminal revenue is to estimate the effectiveness of the marketing spend on revenue. In year 2010, each additional marketing dollar resulted in 2.5 dollars of incremental revenue. As of December 2010, the company has $75M of cash on hand, and it raised an additional $50M in the last round of share offering. I assume that all income from operations is used to fund working capital and additional general and administrative expenses for increased sales, and all cash on the balance sheet is used to fund additional marketing at the same 2.5 additional dollars of incremental revenue per dollar of marketing money. This will translate into $312M of additional revenue. The low end Sodastream machine retails for about $100, and it is reasonable to expect about $100 in annual consumable sales from a repeat customer. So assuming a 50% customer retention rate, after the initial spike in sales to $500-600M, half of the incremental sales will disappear, leaving revenue of $300-$450M.

What operating margin will SODA obtain from this revenue? Currently, SODA has an operating margin of around 10%. SODA management will undoubtedly argue that over time, product mix will shift to a better machine-to-consumable ratio resulting in higher margins. GMCR, a more mature company, has operating margins of around 17% (if you strip out patent settlement expenses). A traditional kitchen appliance manufacturer such as LCUT (maker of Cusinart toasters and other appliances) sports operating margins of around 6-7%. SODA has a weaker business model compared to GMCR, and a 15% final operating margin seems reasonably optimistic estimate. This will be reduced by around 20% for taxes, leading to a net margin of 12%.

Combining the revenue and net margin estimates gives terminal earnings of $35-55M. At its current stock price of $71, SODA has a market cap of $1.4B, or around 25-40 times terminal earnings. A more reasonable valuation will be something like 10-15 times earnings for a small cap company. The company IPOed at the low end of that range, at around $20 per share or a valuation of $360M, and has since rapidly doubled, and is close to quadrupling.

Counter-arguments

Once the lockup is over, insiders lost no time in halving their holdings in a secondary offering priced at around $40 per share, recognizing that the stock is richly valued. On the other side, buyers include mutual funds like Fidelity, which currently owns 13% of the stock (on par with Fortissimo), and probably a number of retail investors as well. More recently, the stock seems to be trading in sync with GMCR, both priced at around 100x trailing earnings and moving in tandem, suggesting that hedge funds employing statistical arbitrage strategies may also be in on the action.

In the short term, there is probably no danger of slowing growth until SODA hits the $300-400M revenue mark, which at current growth rates should be some time in 2012. But I initiated a SODA short position recently despite suspecting that evidence of slowing growth is probably one year away primarily as a hedge against the European crisis, which should adversely affect the USD-Euro exchange rate and put a dent in the 60% of SODA revenue derived from Europe. Currently, I am underwater on this position, but am still comfortable with my thesis. I will re-evaluate my thesis if SODA starts selling its carbonators in mainstream grocers (a precondition of widespread adoption), or if revenue crosses the $500M threshold (unlikely before 2013).

Disclosure : I have a short position in SODA

Recently, a flurry of articles have discussed the pricing of the LinkedIn IPO, whether the investment banks screwed up and underpriced the IPO, or whether the IPO was priced correctly. These articles have piquéd my interest, and after some research into IPO pricing, I believe that I have come up with a reasonable framework for shorting some IPO first day pops.

First, let me present some research. Clearly, reasonable people can differ in their valuations of an IPO. Equally clearly, there is a simple way to resolve this to the benefit of the company doing the IPO. Just let the people with the highest valuations buy into the IPO. In other words, hold a Dutch auction. Why then do nearly all companies seeking to go public do so via book-building by an investment bank? The answer is that obtaining the highest possible price for the stock is not what the company’s owners necessarily want. If you sell the stock to the highest bidders in the market, then by definition, the stock has nowhere to go but down in the short term. This is undesirable to IPO investors, and surprisingly, also to the company’s owners. Why? Because IPO investors look dimly upon owners cashing out a large percentage of their stock at IPO, and most investment banks insist that owners sell only a portion of their ownership, with the remaining shares subject to a lock-up period. Accordingly, IPOs usually offer only 5-20% of the total equity, with more than 80% of equity still in the hands of insiders after the IPO. If the owners intend to sell more of their shares in the future after the lock-up, they want to create upward momentum for the stock price, and so they underprice the stock to ensure that result. Investment banks spin this behavior as the owners looking for “high quality buy-and-hold” shareholders, and are willing to lowball the stock price to attract such shareholders. This is a variation of the signaling hypothesis behind IPO underpricing. In essence, it means that the company is telling investors that it will soon be so profitable the money raised in the IPO is immaterial. The main point of the IPO is to “diversify the shareholder base”.

Another way of looking at this problem is that there are 3 parties involved in an IPO : the new investors, the company, and the previous owners. The motivations of the investors and the company are clear. The investors want a low price, and the company a high price. The motivations of the owners are conflicted. To the extent that the owners intend to hold and manage the company for the long term, they will want to obtain as high a price as possible to bring more cash into the company’s coffers, and perhaps sell a small portion of their own holdings to achieve a higher standard of living and modest diversification of their wealth. To the extent that the owners want to entirely cash out of their company in the short term, they will want to sell as few shares as possible (often over the objections of the underwriting bank, whose fees are a percentage of the total sum raised) to the lowest bidders, thereby ensuring frenzied bidding for the limited float, and saving the highest bidders for themselves in the future. The degree of the initial underpricing is an indication of the willingness of the owners to screw the company, which is indicative of their views on holding the company for the long term. In other words, the higher the first day IPO pop, the more likely the company is fundamentally flawed.

Now, although numerous academic studies suggest that investing in companies at IPO leads to underperformance in the long run (notably Loughran and Ritter 1995), shorting ALL IPO first day pops is likely to be a dangerous strategy. Firstly, there are structural factors above and beyond the signaling that can account for the first day pop, such as small retail investors not being able to access IPOs and thereby being forced to buy at a higher price in the open market. For example, even the Google IPO, which was performed by Dutch auction with 31 underwriting banks to reach as wide an investor base as possible, popped 17% on the first day. Secondly, SOME IPOs actually work out spectacularly well in the long term. If you are short, say, Microsoft, Dell, Google, or Walmart on the day of their IPO and held that position for 10 years, you would be a very poor man indeed. In fact, some insiders may not even realize the full potential of their own company. Paul Allen, for example, has said in his biography that he would have cashed out of Microsoft early on when he fell out with Gates, had Gates only offered him a more reasonable price. The stinginess of Gates ended up saving Allen a huge fortune in the long run. That said, if even insiders fail to see a company’s potential, the market is likely to only slowly come round to the bright prospects, and there should be ample time to close a short position at a modest loss. Most IPOs of successful companies take years for their success to become apparent.

In summary, my new framework for shorting IPOs is to short if there is a greater than 50% pop on the first trading day, and holding the position for 6-9 months until the expiration of the lockup period. If the theory is correct, the stock should deteriorate appreciably once the lockup period expires and insider selling floods the market. Since most lockups last for 180 days, it would take some time for the decline to be fully baked in. My framework is supported by academic studies suggesting that highly underpriced IPOs are lower in quality, and that extreme pops lead to long term underperformance. The LNKD IPO fits these criteria, having popped more than 100% on the first day. If you had shorted LNKD on the first day, you would be sitting on a 20% gain at this time. However, by the time I have finished my research and thoughts on shorting IPOs, the margin of safety for LNKD has declined substantially and the window of opportunity has probably passed. However, I am looking forward to the IPO of Groupon, a company with numerous competitors whose insiders are selling. Time will tell whether I end up shorting Groupon.

I have recently started shorting stocks again, and this post is a summary of how my short positions have been doing. Because I just started shorting, I decided to go slow to see if any problems will come up. I have just 3 shorts, NOG, LFT and SODA, and together, they make up around 5% of my portfolio, or about the weight of a long position. NOG and LFT ideas are courtesy of John Hempton at the excellent Bronte Capital, and both have been doing quite well. I shorted NOG at $26 and covered at $20, for an approximately 20% gain. I shorted LFT at $20, and the stock is now suspended. Since Bronte Capital and Citron Research have both already covered LFT in great detail, and in any case the trading opportunity has passed, I do not intend go over LFT in detail. I expect that LFT will gap down dramatically once it resumes trading as a pink sheet, and then slowly trend down. Suffice to say that I am in no hurry to cover LFT, and will likely sit tight for a while. SODA is my only non-Hempton short, initiated at $53. I’ll write a full post on SODA soon, but basically, I think it’s a fad and the torrid growth will soon slow, which would make the stock at its current multiple dramatically overvalued.

I usually write about a stock idea about 1-2 weeks after I have finished acquiring a full position. I do my write-up on the weekend after I am fully invested, and then publish it several days later. I find that a brief delay of 1-2 weeks typically does not matter. More often than not, the stock price has actually declined, allowing my readers to get in at lower cost basis than me. Unfortunately, in this case, I’ve gotten slightly behind in my writing, and UFS has popped by slightly more than 10% in the meantime and is now at a 2 year high. Readers who object on principle to buying stocks making new highs will probably want to give the following article a miss, although I feel that UFS is still moderately undervalued and has room to run.

Business

Domtar (UFS) is the largest producer of uncoated free sheet paper in North America, used for writing/printing paper and in various envelopes and stationery. The market for paper is in secular decline, and the industry has been consolidating slowly over the years as the marginal players sell out to the largest producers, which themselves have been cutting production capacity. Domtar has a market share of around 35%, with International Paper second at 25%, and Boise third at 10%. UFS was formed in 2006 by the merger of Domtar Inc, then Canada’s largest paper company and the third largest producer of free sheet paper, with the paper production assets of Weyerhaeuser. Weyerhaeuser was eager to offload its various production assets in order to convert to a timberland REIT, and the asset sale was generally regarded to be at a reasonable price. This has resulted in Domtar currently carrying a modest debt load of $825M, largely offset by cash holdings of $604M.

Domtar has a dominant position in the industry. It is a low cost producer, which is a crucial advantage in a commodity industry. It also owns Ariva, the largest paper distributor in North America with a network of warehouses serving both Domtar and other paper producers. The recession has accelerated the elimination of higher cost paper mills from the US market, and the paper industry has gained pricing power. In 2010, Domtar’s gross margin leapt to 25% from the 15-20% historically achieved, and revenue actually increased 7% despite a 4% decrease in units shipped. I estimate that free cash flow for Domtar in 2010 was around $900M, which means that at the current market cap of $4.2B, the stock is going for 4.7 times cash flow.

Management strategy

The challenge for management is how to handle cash flows in the face of a commodity business in secular decline. Domtar’s strategy appears to be to completely halt investment in the declining capital intensive business, and direct cash flows to shareholders. The company has announced an increase in dividend, and accelerated and increased its share repurchases. Capital expenditures are on a downward trend, with management is cutting capacity gradually, in line with expected secular decline, estimated by management to be 4% annually.

Investor valuation

Why are investors giving a business that has enormous cash flow, minimal debt, and a shareholder-friendly management such a low valuation? A major psychological obstacle is, of course, the secular declining trend. Clearly, even with decreasing capacity and increasing pricing power, price increases cannot continue indefinitely, and at some point, free cash flow must again decrease. That said, paper use has been in slow decline for a long time now, and would probably bottom out at some point. I ran a discounted cash flow analysis with a 5% decline in cash flow for 10 years followed by a bottoming out, with discount rates of 5-10%, and arrived at cash flow multiples of 7-9.

Before 2010, UFS had an average cash flow of around $400M. The stock chart reflects that fact, with a tendency for the stock to sell off at $80, a market cap of around $3.2B, around 8 times $400M cash flow. Right now, I believe that investors are just getting used to the idea that with price increases, UFS will earn a higher cash flow in the future. My target is for a cash flow of $800M and a multiple of 7, for a price target of around $135.

Threats to pricing power

The key to the above valuation is the obviously the durability of the pricing power. Investors have reason to be skeptical. Previous closure of plants by International Paper in 2001 was met with new capacity, so there is fear that irrational actors in the industry may again expand capacity in the face of high paper prices. However, things are likely to be different this time around. After the financial crisis, banks are now actually hesitant to loan money, and I consider domestic expansion of capacity as highly unlikely, given that setting up a new paper mill is enormously expensive.

Internationally, however, the picture is different. Paper use in Asian countries is increasing rapidly, which has prompted several US companies to purchase paper mills in those countries. Some investors fear that surplus capacity from overseas may be dumped in the US, especially if there is a second global recession. However, I view it this scenario as a low probability event. While paper is a commodity, transportation costs make it expensive to ship paper to US from Asia or Latin America. In addition, North America climate and terrain are especially suitable for the growth of trees, and the US and Canada are traditionally net exporters of wood and wood products to Asia. It is thus more likely that countries overseas will be a new market for US and Canadian based paper producers rather than a competing supplier, although transportation costs will make US-based suppliers less competitive in those markets compared to domestic suppliers.

In summary, I think that the new higher cash flow of UFS is here to stay, and that the stock market is slowly pricing in that fact. Paper sales is in secular decline, and is modestly impacted by the business cycle, but on the whole, paper is still indispensable for many uses, and will likely to around for many more decades. Given the new oligopolistic structure of the North American paper industry, UFS should be able to direct the cash flow from this profitable declining business to shareholders for years to come.

Disclosure : I have a long position in UFS

HRB stock has taken a stumble recently after it was revealed that a group of bond investors are attempting to force HRB to repurchase subprime mortgages issued by its erstwhile subsidiary SCC during the housing boom. Estimates of $12B in losses to HRB, which is 2 to 3 times HRB’s market cap, have caused a sudden panic in the market, causing a nearly 10% decline in stock price.

First, it should be noted that this is not a new risk, and that HRB has disclosed for several years now the possibility of losses from mortgage repurchases. To date, HRB has reported about $740M in claims registered with SCC (with a principal balance of $33B), and has put aside $188M in reserve for repurchases. These numbers are vastly smaller than the $12B estimate that has been bandied about. As far as I can tell, the $12B appears to be an estimate of the TOTAL probable losses on SCC mortgages due to delinquency and foreclosure. The percentage of losses that are due to fraudulent underwriting is a fraction of the total, and the proportion would obviously vary from company to company. Estimates of the losses due to fraudulent underwriting (and therefore eligible for repurchases) range from 2-20% of the total losses on the portfolio. Furthermore, the group of bond investors is likely to own only a small proportion of the mortgages issued by SCC, and is unlikely to claim the entire $12B of losses.

Secondly, to date, most mortgage repurchases have been forced by Fannie Mae and Freddie Mac. These entities have taken a lot of losses from subprime mortgages, to the extent that a government bailout has been necessary, and they are seeking to minimize their losses however possible. They are also basically the only entities still insuring mortgages, and hence have enormous leverage against banks, which are under enormous pressure to repurchase the mortgages if they want to have an ongoing relationship with Fannie and Freddie and continue to stay in the mortgage business in the future. (And it should be noted that HRB no longer has a mortgage business and have to need to stay in the good graces of either mortgage investors or insurers.) In this situation, the repurchase litigation is often settled out of court. In the handful of other repurchase situations involving other private mortgage insurers and not Fannie or Freddie, most are now still in litigation, and not enough cases have been resolved to illustrate what the critical legal points are. The burden of proof for any wrongdoing will be on the prosecution, and there are ambiguity regarding key points, including whether litigation must be carried out on at the level of the individual loan or at the level of the entire portfolio, whether bond investors or bond insurers have the legal standing to sue, and what constitutes adequate wrongdoing to breach the warranty clauses. I am not a lawyer and am not sure how these points are likely to be resolved, but it is clear to me that any litigation will be protracted and span years, and is hardly a slam-dunk. Even today, several years past the height of the subprime crisis and with most shaky subprime mortgages already in default, surprisingly few repurchase cases involving non-Fannie/Freddie insurers have made it through the court system.

In summary, I think that the latest development is more a ploy by bond investors to apply pressure to HRB management through the court of public opinion, to do what they know will be difficult to accomplish in the legal system. The story will play out at glacial pace in the legal system, leaving more than adequate time for HRB to recapitalize and negotiate a settlement if necessary. My read on the recent stock movements is that investors with a short time horizon are taking their profits from the recent rapid rise in HRB stock, with long-term investors taking advantage of the recent dip to increase their positions. As for myself, I will be hanging on to my stock, as I believe that HRB is still substantially undervalued at these levels, and is an excellent defensive stock for these times.

Disclosure : I have a long position in HRB.