Thursday, January 22, 2015

Read's (Nasdaq - REED) -- Healthy Growth

Reed's (REED $5.50) is a specialty producer of soft drinks made from natural ingredients.  Ginger Brew was the company's original product and still represents 33% of sales.  It's a natural ginger ale that is brewed instead of relying on injection based carbonation.  Reed's has expanded the line with several derivative offerings over the years.  A variety of flavorings have been developed.  The company also offers a low calorie version employing stevia, a natural sweetener.  Virgil's Root Beer, acquired in 1999, now accounts for 33% of sales, as well.  That line also is manufactured from all natural ingredients, including a low calorie version using stevia.  A line of kombucha drinks was launched three years ago.  That's a fast growing category featuring fermented tea that is thought to contain health benefits in addition to refreshing taste.  Kombucha now contributes 10% of sales.  Reed's additionally makes specialty drinks under private label arrangements for supermarkets and other retail chains.  That segment is less predictable but now accounts for 15% of sales.  Other products, mainly candy, provides the remaining 10% of sales.

Sales have grown at a 21% annual rate for the last four years.  High sales and marketing costs have prevented profitability from expanding, though.  Product development expenses have remained elevated, too.  And production efficiency has been difficult to improve.  Reed's manufactures for the West Coast using its own facility in Los Angeles.  That operation also serves as a product development laboratory.  The company also makes third party offerings there, resulting in more short runs.  East Coast production is outsourced.

Several changes are underway to improve margins.  Capital equipment upgrades are being installed at the Los Angeles plant designed to triple the line speed.  That project will generate incremental benefits as each new piece of hardware is installed.  The entire upgrade is slated for completion by the end of the June quarter.  East Coast margins should improve, as well.  Until last year Reed's outsourcing partner replicated the company's brewing process, which led to errors and higher costs.  The company now does all the brewing in California and ships concentrate to the manufacturer, facilitating more consistent and lower cost production methods.  The use of concentrate also has opened the door to hiring conventional bottling plants.  Many of those facilities are experiencing excess capacity due to the decline in soda consumption.  Taste of the final product has not been impaired, moreover.  In fact, many people think the concentrate form tastes better.

Gross margins could widen by 4%-5% as the new Los Angeles system comes on line.  Further gains are possible as the East Coast relationships are restructured.  Sales and marketing efficiency is being improved, as well.  Reed's sells its products to supermarkets and health food stores.  The company relies on third parties for distribution.  Feedback has been incomplete and unreliable over the years, causing Reed's to err on the side of providing discounts and other customer benefits.  The company wanted to make sure sales growth remained intact.  Better reporting systems have been installed, though, which are allowing Reed's to target discounts more effectively.  Margins promise to improve as the company becomes more adept at that big data analysis.  Better information also should help Reed's expand existing accounts and penetrate new ones.

We estimate earnings will break solidly into the black in 2015.  Larger gains are possible in subsequent years as the full effect of the manufacturing and marketing improvements are realized.  Income could attain $.10 a share (fully taxed) this year and keep advancing to $.35 a share by 2016-2017.  Sales are poised to continue rising at a 15%-25% rate.  Reed's has penetrated just a fraction of the potential market, in terms of U.S. store count.  Existing stores may expand the number of offerings on their shelves.  Overall demand is expanding, moreover, as soda consumption falls.  Natural drinks are taking up much of the slack.  International potential is large and unexploited to date.  The soda market's malaise also may lead those producers to partner with Reed's as a way to reinforce their own growth rates.

Reed's carries a significant amount of debt.  In the past the company has issued convertibles and warrants to satisfy cash requirements when profitability stalled.  Setbacks in the future could create similar types of dilution.  If margins improve as anticipated cash flow should be sufficient to finance growth internally.  If that happens the stock's price-to-sales ratio could widen materially.  Reed's relatively small size is likely to keep margins below the industry norm as the company continues to grow.  Potential acquirers could strip out much of that overhead and marketing expense, though, creating a much lower PE ratio on a de facto basis.  Price-to-sales ("P-S") is a more relevant valuation metric at this stage.  In 2-3 years sales could reach $75 million.  Applying a P-S ratio of 4x suggests a target price of $20 a share, potential appreciation of 265% from the current quote.


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