|Shares Out. (in M):||14||P/E||0||0|
|Market Cap (in $M):||69||P/FCF||0||0|
|Net Debt (in $M):||9||EBIT||0||0|
An investment in Reed’s, Inc. common stock (NYSE MKT: REED) at the current price of $4.75 per share is likely to provide investors with a very attractive return over the next two to three years. The company is on the cusp of a large breakthrough in profitability driven by a significant increase in its production capacity on both coasts. Specifically, the company’s upgrades to its Los Angeles production facility, which will triple its west coast production capabilities, and the addition of a second east coast co-packing partner will lead to much higher gross margins and much lower delivery and handling expenses. I believe the company’s operating margin is likely to increase from slightly negative in 2015 to over 4% and over 9% in 2016 and 2017, respectively. Importantly, this improvement is not driven by unrealistic revenue forecasts but by cutting “low hanging fruit” expenses within an inefficient supply chain.
Based in part on these developments, I believe Reed’s common stock is worth at least $10 per share today. Despite the company’s looming breakthrough in profitability, the stock has fallen from a recent high in June of $6.64 per share to $4.75 per share as of yesterday’s close – a drop of 28%. In particular, the second-quarter 2015 report that highlighted out-of-stock issues and higher than usual operating expenses – both temporary factors – disappointed investors. The short-term orientation of those who have been selling REED recently is creating a wonderful investment opportunity for long-term investors to make an abnormally high return.
Reed’s, while a small company overall, is the largest producer of natural/craft sodas in the U.S. The company is best known for its Reed’s Ginger Brew and Virgil’s natural soda lines (the “core brands”), which are sold throughout the natural supermarket channel and increasingly in mainstream supermarkets and other retail establishments. The company grew net sales from $13 million in 2007 to $43 million in 2014 – an 18.7% annual growth rate. During the financial crisis and Great Recession of 2008 and 2009, when most discretionary consumer purchases were plummeting, Reed’s revenues grew 17% and fell 0.6%, respectively, before rebounding 34.2% in 2010.
Reed’s was founded by its current CEO, Chris Reed, in 1987 and has grown gradually over the last 28 years. Mr. Reed is a remarkable entrepreneur who started the company from scratch with his own naturally brewed recipes, originally taking his ginger brew door-to-door to health food stores and delis in Venice Beach, California. Over the years, he has organically grown the company from nothing into a $40+ million revenue business. Mr. Reed currently owns about 25% of the company.
Reed’s strong demand growth for its products is a result of a combination of “same-store sales” growth at existing stores and continued distribution gains. The company’s core brands have full distribution within the roughly 3,000-store natural foods supermarket channel, which includes supermarkets like Whole Foods and Trader Joe’s. This channel is estimated to be growing at a low double-digit rate, and Reed’s distribution should continue to expand as these stores open. For example, Whole Foods currently has 424 stores in the U.S., plans to reach 500 stores in its fiscal 2017 year and sees demand for 1,200 stores in the U.S. longer term, plus additional stores in Canada. In addition, Reed’s core brands have distribution in over 12,000 of the roughly 36,000 mainstream U.S. supermarkets. The company is expanding in this channel as well. Mr. Reed believes 60% coverage or about 22,000 doors is a reasonable target over the long-term.
Historically, Reed’s incurred operating losses for a number of years and funded itself with periodic equity and debt raises. The company has not issued equity since 2010 as the business has danced around breakeven levels since 2011. Lately, the company has issued new debt to fund its capacity expansion project. The company currently appears highly leveraged relative to its recent earnings. Reed’s has $9.1 million of debt as of June 30th and took on another $1.5 million in the form of a 6-month bridge loan, which is intended to add flexibility while the company upgrades its L.A. plant and brings on a second east coast co-packing partner. This debt level is substantial for a business with negative $200k of EBITDA over the last 12 months. However, a significant portion of this debt has been incurred very recently to pay for the capacity expansion, which is intended to drive large improvements in profitability starting in 2016. Further, the company’s earnings over the last year would have been higher had it not been preparing for the upgrades and paying for several one-time expenses. Given the sharply higher EBITDA that should occur in 2016 and 2017, I believe the company’s debt level should appear relatively modest in the not-so-distant future.
In recent years, Reed’s biggest problem has been its inability to keep production up with demand growth. Long-term observers have witnessed inconsistent production volume and missed sales opportunities due to out-of-stock issues. In addition, the L.A. facility’s lack of automation and scale coupled with the generally inefficient supply chain has caused sustained profitability to be elusive. This is despite continued sales growth and annual sales approaching $50 million this year. All things considered, an inability to keep up with demand growth is the best type of problem to have because it is fixable. I believe that is about to occur.
I believe Reed’s is finally on the cusp of a large breakthrough in profitability.
Reed’s owned and operated L.A. plant has historically not produced enough volume to meet U.S. demand west of the Rockies. As a result, the company’s east coast co-packing partner has been producing and shipping finished cases from the east to the west, which has contributed to an inefficient cost structure. In addition, the lack of sufficient automation and scale at the L.A. plant has resulted in relatively high labor costs and relatively low gross margins. Both these factors should improve considerably over the next two years due to the impending startup of additional production on both coasts.
To help bring about these major changes, Mr. Reed has recently hired three new executives. Mark Beaton is the company’s new COO. Prior to joining Reed’s, Mr. Beaton was Vice President of Operations at Dr. Pepper Snapple Group. He has additional experience working in operations and supply chain roles at Cadbury Schweppes Bottling Group, Pepsi Bottling Group, and UPS. Bringing on a beverage industry executive with his level of experience at much larger companies was a major coup for Reed’s. In addition, Reed’s hired Daniel Miles as CFO (Pepsi Bottling, Miller Coors, Ernst & Young) and Mark Costa as Director of Operations (Coca-Cola Enterprises, Dr. Pepper Snapple). I believe this team is helping drive meaningful changes at Reed’s that will propel profitability and business growth higher in the coming years.
As of the second-quarter earnings call on August 13th, Reed’s had procured 90-95% of the new equipment required to complete the upgrades at its L.A. facility. In addition, the company recently brought on a second east coast co-packing partner that will allow the company to shut down its L.A. facility for a three week period (in October/November) during which the new equipment will be installed. During the August 13th call, Chris Reed said he hoped the second east coast co-packer would come online during the week of August 17th, but was confident it would be during August in any case.
Reed’s profitability should improve meaningfully from these plant upgrades.
First, Reed’s gross margins are poised to increase by at least 500 basis points over the next 12-18 months. The company’s cost of goods sold related to idle plant capacity (plant costs that are not allocated to the cost of the finished product) were $2.3 million or 5.2% of net sales in 2014. Through six months of 2015, these costs increased to $1.3 million or 5.9% of net sales as the company prepared for the upcoming upgrades by repairing key equipment, utilities, and plumbing and replenishing supplies. With increased automation, higher production volume, and lower labor costs, this expense line item should fall towards zero.
The company’s specific plan is to increase from 100 12-ounce bottles per minute for two shifts per day to 300 12-ounce bottles per minute for one shift per day. As the exhibit below shows, this implies a production increase of 50% out of the L.A. plant and the ability to triple production from prior levels by eventually bringing on a second shift.
As Exhibit 2 shows, the increased level of automation will allow the company to produce 50% more cases while cutting labor expenses in half (one shift instead of two). Mr. Reed has indicated labor costs should fall by $200,000 - $210,000 per month as a result of only running one shift, which amounts to $2.4 - $2.5 million per year. This approximates the vast majority of the idle capacity costs, which Mr. Reed believes will fall to zero over the next 12-18 months. That suggests gross margin should increase from about 30% to 35% solely from these plant upgrades. Mr. Reed actually believes gross margins will rise to the 37% - 38% range, although that may include the benefit of a potential price increase on Reed’s Ginger Brew. To be more conservative, I assume gross margin plateaus at 35%.
Second, bloated delivery and handling expenses should drop by 300 - 400 basis points as a percent of sales because higher west coast production will eliminate the need to ship finished cases from the east coast to the west. Eliminating this expensive cross-country shipping could save the company roughly $800,000 per year, according to an analysis by the company’s CFO. The company believes normalized delivery and handling is 8% - 9% of net sales pre-capacity expansion, and should approach 6% post-capacity expansion after east to west coast shipping is eliminated. I assume this expense falls to 9.1% of sales in 2016, 7.5% of sales in 2017, and 7.0% of sales in 2018 where it remains thereafter, although the company is shooting for 6.0% by the second-half of 2016.
Exhibit 4 shows the output of my earnings model for the next several years.
I value Reed’s common stock using a discounted cash flow model. I incorporate the earnings model in Exhibit 4, an LTM sales multiple of 2.5x in 2019, and a discount rate of 8%. These inputs result in an intrinsic value of $10.69 per share today, which is more than double the current share price. With the stock trading at a 56% discount to my appraisal, I believe a lot would have to go wrong in order to lose money permanently.
Further, there are three points of conservatism built into my model and valuation. First, gross margins max out at 35% despite Mr. Reed believing they should reach 37% - 38%. Second, delivery and handling expenses gradually fall to reach 7% of net sales in 2018 despite signs suggesting they could reach 6% of net sales by the second-half of 2016. Third, the 2.5x net sales multiple is below the mean and median multiples of historical beverage transactions and is well below the 3.9x net sales multiple General Mills paid for Annie’s, a recent and relevant transaction. While Annie’s is a food company, not a beverage company, it has similarities with Reed’s. The two companies sell natural/organic consumable products and had similar revenue growth and gross margin profiles at the time of the Annie’s acquisition. Please refer to Exhibit 5 for a comp table of relevant food and beverage transactions.
Long-Term Exit Plan
I believe Chris Reed will sell Reed’s to a larger beverage company at some point in the future. This is not pure speculation. He has stated this on several occasions in the past.
“We’re obviously concerned or sensitive to the Wall Street shareholder who is interested in seeing earnings and only values the company on earnings, but we kind of know that we’ll be valued by our revenues… and probably more on gross profit than anything, in any kind of an acquisition that will happen in five to seven years. And so that’s kind of the goal of the company, is to take the starting point that we finally reached here and start accelerating growth that way.” - Founder and CEO Chris Reed, 3/25/13
On whether Reed’s, Inc. is a takeover candidate or whether anyone has been “sniffing around lately”, Reed recently responded this way:
“They are sniffing around plenty. I do have open invitations from some of the larger companies that have befriended me over the years to show up in their boardroom and talk about an acquisition. We are the Coke of natural foods. It’s a very enviable place to be when Coke and sodas are not growing. We seem to be growing. So we’ve been approached by European entities and other people looking to acquire us and we generally say, ‘We just got to the starting line. My feet have been bound, my hands have been bound — I’m just about to start to do the serious stuff that I’ve wanted to do my whole life.’ I’ve got three to five years to really mature this thing up way past $100 MM, hopefully closer to $200 MM, and I just don’t want to preempt it and try to value it right now. But it’s not like I’m a majority shareholder — I’m a major one — but I can’t really stop things. But I basically would say to anyone ‘Please give us a chance to make this company look interesting to Wall Street.’” - Founder and CEO Chris Reed, 11/14/13
Exhibit 5 shows a comp table of relevant transactions.
There are obvious outliers in this table that should not be applied to Reed’s. For example, Reed’s would not command a double-digit sales multiple, nor would it deserve the 1.7x multiple Cadbury Schweppes paid for Nantucket Nectars. That transaction occurred during a depressed economy (2002) and the brand was not growing at the time. I believe the 2.5x multiple I use to value Reed’s should be conservative.
If Reed’s were to be acquired for 2.5x sales tomorrow, REED would be worth $7.75 per share – 63% higher than the current $4.75 share price. If Reed’s were to be acquired for the same 3.9x multiple that General Mills paid for Annie’s, REED would be worth $12.22 per share – 157% higher than the current share price. I do not expect the company to be acquired anytime soon, but I do expect that to occur eventually. In the meantime, I am happy to wait for an eventual acquisition while the company’s sales grow at attractive rates and profitability levels increase. The ultimate sale price will only be higher than today’s hypothetical takeout valuation with the passage of time and further business growth.
Why is Reed’s Mispriced?
Reed’s is a small company with a $65 million equity market capitalization and a float of around $50 million (excluding Mr. Reed’s stake). The stock is only investable for smaller funds and individual investors.
To find this investment thesis attractive, one must have a long-term perspective. One must focus on the company’s long-term progress and have confidence the share price will follow the business progress over time. For a variety of reasons, many market participants do not take this approach and generally have a short-term orientation. I believe this is particularly true among the smaller investors who could consider investing in Reed’s.
Reed’s has frustrated some investors with its repetitive production problems and supply chain issues. The company has overpromised and underdelievered in the past. Some observers have grown tired of waiting for the company to become sustainably profitable.
Reed’s debt levels are substantial relative to its trailing earnings. This would be concerning to those who are not aware of the large increase in profitability that should begin next year.
The overall stock market has declined by about 7% since mid-August. Many securities are sold regardless of their fundamentals during periods like this.
Generally, I do not require my investments to have catalysts. However, I believe Reed’s should appreciate substantially sometime during 2016 when market participants begin to appreciate the financial benefits of the capacity expansion project. I expect to see tangible benefits beginning with the second-quarter report in 2016. However, it is possible that market participants begin to appreciate these benefits in advance.
The company also filed an interesting 8-K on September 2nd. The filing outlined the additional $1.5 million term loan (“Term Loan B”), which requires interest-only payments for the first two months but will be fully amortizing via four monthly payments beginning in December. I believe this reflects the company’s confidence that it will be generating more cash by December as a result of the startup of the new equipment (and unwinding cash from working capital).
Reed’s is a small company that is currently operating at roughly breakeven profitability levels. The company has substantial debt relative to its current earnings. If another severe economic downturn were to occur soon, it could negatively impact the company. Given the imminent capacity expansion and increased profitability that should follow, and the company’s strong sales performance during the financial crisis, I believe I am being well-compensated for incurring this risk.
Founder and CEO Chris Reed is a naturally optimistic individual. He has stated very bullish expectations in the past that have not come to full fruition. That could occur again. However, I have more confidence with the current circumstances. Prior optimistic expectations involved explosive sales growth expectations for a brand new product line (Reed’s Culture Club Kombucha), which is inherently uncertain. My investment case for Reed’s is primarily based on the margin improvement that should come from the labor cost savings from running one shift instead of two and the elimination of cross-country shipping. I have more confidence in those cost savings strategies than I could be in very big sales growth expectations for a new product introduction.
Reed’s has disappointed investors before due to out-of-stock issues and other supply chain disruptions in the past. That could occur again. However, I believe the company’s historical supply chain problems are being fundamentally improved. The L.A. facility has plans to increase production by 50% and has the ability to add a second shift that would triple production from prior levels. In addition, Reed’s will likely bring on additional co-packing partners over time. These capacity expansions will allow the company to grow sales for quite some time without facing capacity constraints.
It is possible that new entrants into the natural/craft soda category could negatively impact the company’s sales growth. That has been true for a very long time, but Reed’s has continued to grow. I believe brand authenticity matters in this segment, such that large companies like Coca-Cola or PepsiCo could not enter the natural/organic category with much credibility or success. Doing so would also further highlight the unnatural/unorganic nature of their flagship brands.
Reed’s has benefited recently from a surge in popularity of the Moscow Mule mixed drink, which includes ginger beer as the mixer. It is possible the popularity of the Moscow Mule wanes, which would incrementally hurt sales growth of Reed’s Ginger Brew.
Reed’s is developing a fountain program for its beverages with the goal of placing it in restaurant chains. The company is currently bidding for the new fountain program at a large fast-casual chain. I believe this chain is Panera Bread. Mr. Reed has said winning this bid could represent $40 - $50 million of annual sales if successful. For context, that would double the company’s current annual sales. That would represent significant upside to my appraisal of Reed’s common stock, but it is prudent to consider this a long shot.
Reed’s gross margin has been negatively impacted recently by the mix shift towards its lower margin Reed’s Ginger Brew line and away from its higher margin Virgil’s line. Mr. Reed is considering a price increase on Reed’s Ginger Brew, which if successful would likely improve margins beyond my expectations. Reed’s 4-packs are generally $3.99 - $4.99 on the shelf and are often placed next to competing brands that cost $5.99, $6.99 and even $7.99 per 4-pack, so it is possible there is room to raise prices.
I believe an investment in Reed’s at $4.75 per share represents an unusually attractive investment opportunity. Reed’s has a strong and growing core business with long-lasting core brands that are well-entrenched in the natural foods channel and increasingly so in mainstream channels. The company has a good underlying business that benefits from strong demand growth, and the major inefficiencies in its supply chain that have held back substantial profitability are about to be corrected. Given Reed’s small equity market capitalization, very few sophisticated investors are paying attention, which partially explains why the opportunity exists.
Disclosure: The author’s fund is long REED. This is not a recommendation to buy or sell any security. All the information in this write-up may be completely wrong. Do your own research.
Margin expansion in 2016 and 2017 on top of continued revenue growth
Longer term, an acquisition of the company