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Short Case for Teavana, an Overvalued Specialty Retailer: Yale Report

May 10, 2012 | About:
We recommend shorting Teavana (TEA). Our best estimate of the fair value of Teavana is $8-$10 per share, indicating that the stock is currently overvalued. Our short case is based upon the following arguments:



· Teavana’s product faces a limited market in America because of the time-consuming process it takes to make loose leaf tea

· High-end specialty tea has a limited market, and growth in the tea industry will only partially be captured by Teavana.

· The competitive advantages that Teavana currently has can and will erode quickly over time

· Teavana’s same-store sales growth will rise at a lower rate than Wall Street expects. Teavana’s valuation is extremely high; downside risk for missing growth expectations is substantial

· Teavana has been counting on a recovering economy and new store openings for its sales growth. These assumptions will be tested in the quarters and years ahead

· Teavana’s margins will come under pressure

· Teavana’s cash flow yield will decline

Company Description[1]

Teavana was founded in 1997 by the current Chairman and CEO, Andrew Mack and his wife, Nancy Mack. The vision of the company is to introduce consumers to the global tea lifestyle. In 2004, Teavana partnered with the Parallel Investment Partners to obtain equity capital. The company had its Initial Public Offering on July 28, 2011.

Andrew Mack, founder and CEO of Teavana, owns 57%-58% of the outstanding common stock, while the fund advised by Parallel Investment Partners owns 19%-20%. Parallel Investment Partners is a sector-focused, middle-market private equity firm that is headquartered in Dallas, Texas.

· Business: Teavana is a retailer that specializes in selling premium loose leaf tea and tea-related merchandise. The company’s business strategy is to create a “Heaven of Tea” retail experience for their customers.

· Product Mix: Teavana’s tea selection consists of 20% single-estate teas, including white, green, oolong and black, and 80% blended teas.

· Merchandizing: At Teavana, the merchandising team is responsible for sourcing tea from tea gardens and brokers around the world. Teavana does not have much control over potential price fluctuations and quality variance of their suppliers. Teavana sources from over 100 vendors, with the two largest vendors accounting for 25% and 15% of their purchases, respectively. The merchandising team is also responsible for the creation of their tea blends. Teavana does not have any tea estates, blending operations or manufacturing facilities.

· Profitability Growth: Teavana increased its operating margin from 7.5% in FY 2008 to 18.8% in FY 2010. Management attributes the margin expansion to the shift in sales mix from tea-related merchandise towards higher margin loose leaf teas as the stores mature. However, the sales mix in 2010 was still 40% of merchandise and 56% of tea. This fact illustrates that Teavana still heavily relies on the sales of merchandise, which is not its core business and does not bring repeated sales as tea products do.

Company and Industry Analysis

Our negative outlook for Teavana is based on the following factors:

1. The fast-paced lifestyle of Americans does not mesh with the time-consuming process to prepare premium loose leaf tea:

American culture is fast-paced. The time and effort it takes to brew and drink loose leaf tea like Teavana sells goes against cultural norms. In addition, the more a customer purchases at one time, the longer it takes for that customer to consume the product and eventually consider replenishment.

Americans already have ample convenient tea offerings. The ready-to-drink market is saturated with traditional brands such as Lipton, Snapple, and Arizona Ice Tea as well as more recent entrants such as Honest Tea and The Republic of Tea.

Teavana stores are located in shopping malls that are relatively inaccessible for the busy upper/middle class consumers who are most likely to be health conscious and have the disposable income to purchase premium tea.

2. The tea industry may be growing, but Teavana will only capture a fraction of that growth:

The tea industry outlook is growing because consumers are becoming more aware of the health benefits of tea and are looking for alternatives to sugar-rich carbonated beverages. Though the tea industry will continue to experience growth, strong demand for ready-to-drink teas and beverages will somewhat restrict revenue growth for the loose leaf tea segment.[2] In addition, as some consumers switch to drinking tea, their first stop would naturally be brands that they are already familiar with such as Starbucks’ fresh-brewed tea or Lipton’s tea bags.

According to the Tea Association of the USA,[3]

· Iced Tea Consumption: Approximately 85% of tea consumed in America is iced.

· Tea Bags, Loose Leaf Tea & Iced Tea Mixes: In 2010, over 65% of the tea brewed in the United States was prepared using tea bags. Ready-to-drink and iced tea mix comprises about 25% of all tea prepared in the U.S., with instant and loose leaf tea accounting for the balance.



3. Teavana’s market position is very vulnerable:

The overall tea industry is highly concentrated with a few big players (Unilever, etc.). Four-fifths of the market is controlled by several sizeable firms, with the rest of the market full of smaller firms.[5] Therefore, one needs to determine if the major players such as Unilever would reap all the benefits of tea industry growth and leave little room for specialty stores such as Teavana. As Teavana grows, the capital expenditures for installing new store fixtures and paying store rent are likely to go up, while the start-up costs for specialty products for established players are relatively small.



FIGURE 1: Threat to Teavana’s Current Position

Below, we examine each of these external factors in more detail:

Low Barriers to Entry

Teavana is considered a first-mover in the fragmented specialty tea industry of the United States. The company’s vision is to be associated with “an East-Meets-West healthy living lifestyle.”[6] However, the Teavana brand is not well-known given the company’s lack of marketing and branding effort. We believe that the specialty tea industry has very low barriers to entry. A competitor with strong financial backing could easily emerge to threaten Teavana’s market position.

The low barriers to entry can be illustrated by several hypothetical situations. If Lipton sees the profit potential in the specialty tea market and decides to enter this space, the capital expenditures for Lipton to grow its store or shelf space footprint is much less than that for Teavana. Credit could be constrained for a relatively small firm like Teavana but is readily available for multinational companies like Unilever, which owns Lipton. Unilever also has better bargaining power over suppliers than Teavana.

Tazo Tea has already captured the large Starbucks customer base, including both regular patrons and occasional consumers. Starbucks or Tazo could credibly enter the specialty tea retail space, either heavily promoting tea sales in stores or starting a chain of retail stores (Starbucks, for instance, has already started a chain of smoothie stores). The threat to Teavana is significant because of the ease with which its competitors can more directly compete.

Margin squeeze from suppliers

The United States grows very little tea, so it is a major net importer of tea. Rising international labor costs could pressure retailers’ margins. A report from the United States Department of Labor states that only a very small amount of tea is grown commercially in the United States.[7] Therefore, the United States is among the world's major importers of tea.

See http://www.dol.gov/ilab/media/reports/iclp/sweat4/tea.htm

FIGURE 2: Tea Chain of Production and Distribution[8]

Rising international labor costs, along with uncertain economic factors for major tea exporting countries (China, Germany, Sri Lanka), exert tremendous pressure on retailers’ margins.

Customer base is weak

As of the end of fiscal year 2011, Teavana had 200 company-owned stores in the United States in at least 39 states and at least 18 franchised stores primarily in Mexico.[9] All the stores utilize a “consistent store model.” The stores have “wood fixtures, ceramic tiled floors, soft lighting and soothing Asian music.”[10] The sales associates are called “teaologists” who are trained to explain the stories behind the tea and tea-related merchandise. Management believes that the retail experience supports repeat visits and customer loyalty.

We believe that the vacuum of customer loyalty programs leaves Teavana’s customers open to competitors’ offerings which are substitutes to loose leaf tea products. The loose leaf tea market is already small, with regular tea-drinkers largely concentrated on estate tea consumption (Black, Green, Oolong and White). Estate tea is only 20% of Teavana’s tea selection.[11] Teavana is betting on converting non-regular tea-drinkers to consume their blended tea, which is 80% of their selection. In our view, this is a bold bet and does not look promising. In our opinion, blended tea is more of a fad than a sustainable trend.

Substitutes flourishing

As Teavana is catching the health movement in the United States, there are plenty of substitutes for loose leaf tea. The two obvious categories are juice drinks and ready-to-drink teas. Current popular ready-to-drink tea brands include Nestea, Lipton, Crystal Light teas, GOLD PEAK and Honest Tea.[12] Over the last ten years, ready-to-drink tea has grown by more than 15 times. In 2010, ready-to-drink sales were conservatively estimated at $3.30 billion. International expansion - Not a tailwind

Currently, Teavana has 16 franchise stores in Mexico.[13] However, the total franchise royalty income is not significant. Teavana is also looking to expand into other geographical areas such as the Middle East and Western Europe. Given the current economic condition in Western Europe and a deep-rooted local tea culture in Middle East, we do not expect these areas to provide strong revenue streams for Teavana in the near future.[14]

4. Teavana’s same store sales growth will come into greater question:

We believe that in the coming eight quarters, the revenues from existing and new store sales will disappoint Wall Street. This is because we anticipate Teavana’s high per-square-foot sales growth to slow down as Teavana reaches the 200 stores mark. (see exhibit further below; the blue dots represent other retailers).

Comparable store sales (including e-commerce) increased by 8.6% in Q4 FY 2012, the most recent quarter.[15] In recent years, Teavana has shown increases in average transaction sizes but not in the number of transactions. In FY 2010, transaction size increased 8.1% from $33 to $36. The number of transactions only increased 0.6%, though.[16] This fact suggests that the mature stores of Teavana have already reached the potential customer base within its geographic area and are thus not seeing significant growth in numbers of transactions in comparable store sales. Thus, the rapid sales growth (see below) may not be able to continue at the same pace.





Teavana will be saturating some of the same locations with additional stores, and the best locations have likely already been selected by Teavana. We expect that the current 8.6% growth of comparable store sales will significantly decrease as Teavana opens more stores. The stores are likely to cannibalize each other’s sales.

Teavana has also started to report some misleading comparable store sales numbers. Whereas in their offering documents they reported comparable physical store sales, in some of their recent quarterly releases they have instead started to focus on comparable same store sales, including e-commerce. This measure is not a true representation of comparable store sales, as e-commerce transactions obviously don’t belong in the measure of same store sales.



The differences in these numbers are illustrated in the chart below.

In addition to analyzing the comparable sales numbers, we heavily scrutinized the sales data in order to estimate how new stores are faring relative to old stores. In its comparable stores analysis, Teavana only includes stores that have been open for 15 months or more. Our analysis includes a number of assumptions, but the overall result strongly suggests that new stores are faring substantially worse than old stores. In Q3 FY2011, the last quarter for which we have detailed financial information, comparable store sales were about $177,000. Based upon our analysis (more detail in the appendix), we estimate that new stores had sales of about $143,000, significantly below comparable stores.



We understand why the company has focused more on providing percentage growth numbers of comparable store sales (including e-commerce) rather than per-store sales or comparable store sales excluding e-commerce. The company is able to “show” same-store sales growth right now as the comparable stores include better-performing stores and stores in better locations. As the underperforming new stores are added to the comparable store analysis, these numbers will come down. In addition, as the number of stores grows, the growth in e-commerce sales is spread over a larger denominator of stores, so comparable store growth including e-commerce will fall. We believe that Wall Street doesn’t fully appreciate the subtleties of the analysis provided by management. Earnings releases in the coming quarters will show slowing revenue growth in same store sales.

Some in the market has called into question Teavana’s ability to meet its sales numbers and maintain its valuation. We still believe that the valuation is too rich based upon our analysis (see the Valuation section), and that there is additional room for the stock price to fall in the coming quarters.

5. The short-to-medium term economic outlook for the U.S. is challenging:[17]

This fact is in large part due to the uncertainties that remain in the economy, These uncertainties mean that specialty retail stores like Teavana may be adversely and disproportionately impacted as a result.

Below are some current economic factors that highlight this gloomy prospect:

US economy growth remains anemic. While the US economy has now managed 10 consecutive quarters (through the fourth quarter of 2011) of positive gross domestic product (GDP) growth, real GDP growth for 2011 was only at 1.7%.

Employment market continues to be flat. Employment is the primary driver of consumer spending but there continues to be little improvement in the labor market as 2012 progresses. The recent drop in the national unemployment rate was primarily driven by a reduction in the labor force, not an increase in employed persons.

Public sector is under pressure to cut costs which doesn’t bode well for employment. Federal, state and local budgets are largely in the red, and among the solutions suggested to close these deficits are raising taxes and reducing spending; the latter includes layoffs of public sector employees. Either solution will be a drag on the economy.

Rising energy prices are going to hurt consumer confidence and change consumer behavior Energy costs are up approximately 20% over the past year, and wage increases in China and other countries are adding to the input costs of many raw goods. In addition, higher gas and food prices, worries about federal budget issues, and an uncertain regulatory and tax environment are all reasons why consumers are not feeling very confident.

6. Margins will be compressed in the future

Bull view: Gross margin improvement was a result of shift in sales mix

Teavana claims that the shift in sales mix from merchandise to tea helped to increase overall gross margins. However, by end of FY 2011, Merchandise still accounted for 40% of sales despite their effort to sell higher-margin loose leaf tea, a 2% change compared to 42% in FY 2010.[18] We believe the customers are just as interested in the merchandise as they were and the percentage change can easily be a result of the sales associates in the stores upselling to customers on their tea selection.

Teavana warned investors: “We forecast…first-year sales to be lower than we have historically experienced, and comparable store sales to grow at less than historical rates…We anticipate our profit margins will grow at less than our historical growth rate given that we have recently completed initiatives… that have driven significant margin gains that have already largely been realized.”[19]

7. The projected change in cash flow yield supports our hypothesis that in the short-term, Teavana’s stock price will drop as its cash flow declines:

Looking at the cash flow yield, we notice a decline in the short-term before it picks up followed by a steady decline in the long-term. Given the outlook of the economy and the fact that access to the credit market continues to be tight, Teavana will have to rely heavily on internally generated cash flow to finance investments into the business. With a declining cash flow yield, Teavana will have a tough time making those investments to meet its immediate growth goal, which will impact its stock price.

Furthermore, looking ahead we see a steady declining trend for Teavana’s cash flow yield. This is consistent with our hypothesis that in the long-term, erosions to Teavana’s competitive advantages and an increasing supplier squeeze on margins will adversely impact Teavana’s business.



Revenue Growth Estimates and Valuations Details

Sales Revenue Estimate

We estimated the sales growth of Teavana. Per company estimates, the company seeks to have about 500 stores by 2015, which is an ambitious goal from the current number of roughly 200 stores.[20] We assumed minimal net growth in stores after that. We then took the current sales per square foot (this number excludes e-commerce), and in our “aggressive” scenario, we assumed that growth would be flat. Finally, we assumed that e-commerce sales will climb over time to 10% of sales, per company estimates.[21] Our conservative growth estimate, shown in the appendix, has negative sales per square foot growth for the foreseeable future, as our analysis has suggested. We believe that we could be overestimating sales even in the conservative scenario, but have left the numbers as is for conservatism.

Valuation Results

The primary valuation methodology we employed in analyzing Teavana’s stock price is the Discounted Free Cashflow (DCF). We derived the pro forma free cash flow (FCF) using the following formula.

FCF to Capital
EBIT
EBIT * (1-t)
Plus: Depreciation
Less: Capex
Less: Change in NWC


Since Teavana doesn’t currently have any debt, we calculated Teavana’s cost of equity (10.69%) and used it as the weighted average cost of capital (WACC) when we discounted the cash flows. We assumed a long-term growth rate of 2%.



When building out the pro forma analysis we used historical averages to project the statements, and we derived a more aggressive scenario by increasing or decreasing the assumptions by 20% where appropriate.

Lastly, we also create a comparable companies analysis to see how that compares against our DCF valuation. The detailed comparable companies analysis is in the appendix.

We find that the appropriate price range is $8-$10.

In the appendix at the end of the report, you will be able to find

· Detailed DCF assumptions

· Snapshot of the valuation portion of the DCF model

· Detailed pro forma statements

· Snapshots of the comparable companies analysis

Risks to Our Thesis

1. Unexpected growth in the next eight quarters

2. Successful international expansion

3. Successful CPG launch

4. Teavana is purchased by a larger competitor

























[1] Sources for this section are: Teavana S-1; “Teavana Holdings, Inc. Share Price Reflects Future Growth; Initiating at Equal-weight”, Morgan Stanley Research North America. “Growth Is Our Cup Of TEA. Reiterating OW on TEA Shares Heading Into 2012”, Piper Jaffray.

[2] IBIS – Tea Production in the US: Market Research Report http://www.ibisworld.com/industry/default.aspx?indid=273

[3] Tea Association of the USA http://www.teausa.com/index.cfm/14655/tea-fact-sheet

[4] The Tea Association of the USA http://www.teausa.com/index.cfm/14655/tea-fact-sheet

[5] U.S. Department of Labor study http://www.dol.gov/ilab/media/reports/iclp/sweat4/tea.htm

[6] Teavana S-1 dated July 26, 2011.

[7] U.S. Department of Labor study http://www.dol.gov/ilab/media/reports/iclp/sweat4/tea.htm

[8] Chart is from U.S. Department of Labor study http://www.dol.gov/ilab/media/reports/iclp/sweat4/tea.htm

[9] Teavana 8-K filed March 28, 2012. Teavana 10-Q filed December 13, 2011.

[10] Teavana S-1 dated July 26, 2011.

[11] Teavana S-1 filed July 26, 2011

[12] American Beverage Association http://www.ameribev.org/minisites/products/

[13] Teavana 424B4 filed July 28, 2011. More recent numbers aren’t available.

[14] KeyBanc Capital Markets Inc. “Teavana Holdings Inc. Initiating Coverage with a BUY Rating: Steeping Growth”

[15] Teavana 8-K filed March 28, 2012.

[16] Teavana 424B4 filed July 28, 2011

[17] Data and analysis are from S&P NetAdvantage Report on the Specialty Retail Industry

[18] Teavana 424B4 filed July 28, 2011.

[19] Teavana 424B4 filed July 28, 2011.

[20] Teavana 424B4 filed July 28, 2011. Numerous analyst reports also cite this statistic.

[21] Teavana 424B4 filed July 28, 2011. Numerous analyst reports also cite this statistic.

[22] Teavana 8-K filed March 28, 2012. Teavana 10-Q filed December 13, 2011.

[23] All financial data for each individual companies are extracted from S&P Capital IQ

Rating: 3.2/5 (12 votes)

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