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Cal Poly Pomona 2014 CFA Institute Research Challenge Equity Research Report - Reed's Inc. (REED)

The report provides an analysis of Reed's Inc., a beverage company specializing in natural sodas and kombucha, and issues a hold recommendation with a target price of $8.33, reflecting a potential upside of 15.86% from its current price. Despite expected high growth driven by new distribution deals and demand for healthier products, the company faces significant risks, including management instability and poor liquidity ratios. The competitive landscape is challenging, as Reed must navigate a declining carbonated soft drink market while capitalizing on the rising demand for functional beverages.

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California State Polytechnic University, Pomona Student Research This report is published for educational purposes only by Students competing in the CFA Institute Research Challenge. Company: Reed’s Inc. 1     Source: FactSet, Yahoo Finance Source: FactSet Key Financial Ratios 2012 2013E 2014E P/S 2.15 3.04 2.65 D/E 1.48 2.04 2.36 ROE -12.8% -7.3% 11.0% ROA -3.8% -1.8% 2.4% EPS $-0.05 $0.00 $0.04 Source FactSet, Team Estimate Valuation DCF P/S Estimated Price $8.46 $8.19 Weights 50% 50% Target Price $8.33 Source: Team Estimate Market Data Price Jan 28 2014 $7.19 52 Wk Range $3.80 - $8.98 Avg Daily Volume (3 Month) 84,727 Beta 0.93 Shares Outstanding 12.88 M Shares Out - Diluted 13.5 M Market Cap $92.6 M Ownership % Insiders 33.4% Institutional 7.81% RECOMMENDATION: HOLD Exchange NYSE MKT Price (1/28/14) $7.19 Ticker Symbol REED 2014 Year-End Target Price $8.33 Sector Consumer Non- Durables Upside Potential 15.86% Industry Beverage: Non- Alcoholic Highlights We issue a HOLD recommendation for Reed’s, Inc. (REED) with a 2014 year-end target price of $8.33. This offers potential upside of 15.86% from the January 28th closing price of $7.19. REED shows signs of high growth with new distribution deals and increased demand for its products, but detrimental risk factors and weak margins have dampened the outlook on this up-and-coming firm in the beverage industry. High Growth Already Priced In? Changes in the tastes and preferences of the U.S. population towards healthier foods and beverages should drive sales growth in REED’s market segment. Because of this, we estimate high growth in the REED product lines, particularly in kombucha. REED is well positioned to capture kombucha growth with its competitive advantages over most other current producers. Although we predict high growth for REED, our recommendation is HOLD because our model suggests much of the firm’s growth is already being accounted for by its current market price. Financial Position Although we expect increases in sales and improvement in gross and net margins over time, poor liquidity ratios create additional short-term issues for the company. The Current Ratio was at 1.32 in 2012, but the Quick Ratio was only 0.50 because much of the Current Assets were tied up in inventory. Over the past 5 years, the average Quick Ratio has only been 1/3 of its peers. REED is more highly levered than its peers and will require debt financing to expand operations. In 2012, the D/E ratio was 1.48 vs. 5-year peer average of 0.69. Key Risks REED has several risks that may impede its future profitability. • The recent resignation of CFO Jim Linesch gives us serious concerns about the stability of management. We believe that there is potential for high growth in REED’s target market, but the firm will require a strong management team to effectively guide the company through its high growth phase and transition towards profitability.
CFA Institute Research Challenge 31 January 2014 2     Figure 1: REED Revenue Breakdown Source: REED Financial Statements Figure 2: REED Product Growth Projected Annual Growth Rates for REED Products Core Brand Sodas 15%-20% Kombucha 50-100% Private Labels 35-40% Source: Company Guidance • REED has struggled with production shortfalls and if these continue they may significantly limit the growth potential of the firm. • Concerns regarding corporate governance lead us to believe that the Board of Directors is not adequately reviewing and advising executive management. Business Description Reed’s, Inc. (REED) is an American beverage company that develops, produces, and sells top selling beverages in the natural premium beverage category. They offer 24 types of all natural non-alcoholic soft drinks and seven product lines that include Reed’s Ginger Brews, Virgil’s Root Beer and Cream Sodas, Dr. Better and Real Cola, Culture Club Kombucha, China Colas, Reed’s Ginger Chews, Reed’s Ginger Ice Creams and Sonoma Sparkler Sparkling Juices. REED also operates a growing private label business. REED products are sold in more than 14,000 gourmet and natural food stores, grocery stores, supermarket chains and specialty stores throughout the United States, and to a lesser degree, in Canada and Europe. Distribution channels for REED are national natural foods distributors and an increasing number of regional mainstream direct store delivery (DSD) distributors. Its customer base is served by about 10,500 natural and mainstream supermarkets. New product developments such as kombucha, expansion in distribution channels, and trade and consumer promotions are expected to fuel future sales growth. Core Natural Premium Sodas REED has been #1 in sales for natural soda since 1992. Their Ginger Brews and Virgil’s Sodas currently make up 80% of sales, while Culture Club Kombucha and private labels each account for 10%. The company’s non-alcoholic ginger sodas are brewed using fresh ginger, spices and fruits in a unique brewing process that sets REED apart from other commercial soft drink brands. Each 12-ounce bottle contains between 8 and 26 grams of fresh ginger. They use pure cane sugar as a sweetener, and color the drinks naturally from herbs, fruits, spices, roots and juices. REED does not use injection based carbonation or preservatives in their ginger beverages. Company guidance estimates its core soda brands will grow at 15-20% in 2014. Kombucha REED entered the kombucha market in fall 2012 with its Culture Club Kombucha line. Their existing national distribution and experience in natural beverages has given REED a competitive advantage in this segment. The Culture Club Kombucha line was introduced into 800 new retailers throughout the U.S. and into select Whole Foods Markets in 2012. In Culture Club Kombucha’s first year, 200,000 cases were sold, penetrating 50% of natural food stores. Although REED is currently #2 in kombucha sales nationally, GT’s Synergy Drinks controls most of the kombucha market share. As of 2013, REED accounts for only $5 million in sales in this $300 million category. The company plans on capturing more market share in this segment with its flavor innovations, signature branding, and new distribution deals. Company guidance suggests a growth rate of 50-100% for its kombucha products in 2014. Private Label Products REED started producing private label products in 2009. REED has seen increases in sales within this segment with sales of $200,000 in 2009 growing to $5.2 million in 2012. They now have 10 private label customers as opposed to four in 2012. Outlook for REED’s private label segment looks optimistic as revenues in the first half of 2013 increased by 50% compared to 2012. Company guidance suggests a growth rate of 35-40% for its private label products in 2014. Current Strategies: • Stimulate consumer demand and awareness for existing brands and products through promotions and advertising – REED will continue to aggressively promote and advertise its Culture Club Kombucha and core brands through non-traditional and alternative channels to attain high sales growth. • Increase direct sales relationships and expand market – Products are distributed through natural and specialty food stores, mainstream markets and warehouse clubs. In August 2013, REED announced a distribution agreement with Kroger Supermarkets, one of the largest grocery chains, to carry four flavors of kombucha in nearly 1000 locations. REED continues to expand its sales channels with recently reached agreements with Haggen Food & Pharmacy and Ingles Markets, Inc., to distribute kombucha throughout Washington, Oregon, and the Southeast United States. 79%   10%   10%   1%   REED'S INC. PRODUCT LINES-2013 REED  Core  Brands   Culture  Club  Kombucha   Private  Labels     Other  
CFA Institute Research Challenge 31 January 2014 3     Figure 3: U.S. Beverage Market Volume Source: Marketline Figure 4: U.S. CSD Consumption Source: Beverage Marketing Corp. Figure 5: Volume Change by Segment Source: Beverage Marketing Corp. • Expand their national distribution networks by adding regional direct store delivery (DSD) accounts – Recent expansions of REED DSD network has resulted in a 50% increase in sales from this channel in 2012. REED has continued to add DSD accounts in North America; its most recent agreement was reached in early 2014 with Manhattan Beer Distributors to distribute eight Culture Club Kombucha flavors in metropolitan New York. Industry Overview & Competitive Positioning Beverage Industry - Carbonated Soft Drinks (CSD) on the Decline Coca-Cola (KO), PepsiCo (PEP), and Dr. Pepper Snapple Group (DPS) represent 87% of the CSD market. These leading producers have invested heavily in advertising to drive brand loyalty and have purchased several minor market players. The beverage industry is considered a consumer staple, and historically the demand for products has been relatively inelastic. Although the beverage industry grew by 1% to 29.8 billion gallons sold in 2012, the carbonated beverages segment declined by 1.8% during the same period. According to BevNET magazine, CSD’s are expected to fall below 50% of the market for volume in 2017 and 50% of the market in revenue in 2018. This can be attributed to natural and healthier alternatives that have steadily gained market penetration in recent years. According to the Beverage Marketing Corporation, the alternative beverage category of the market was estimated to be approximately $34.4 billion in 2012, an 8.3% increase from 2011. Alternative beverages include energy drinks, bottled water, juices, sports drinks, ready-to-drink teas and coffee teas. Additionally, beverages containing probiotics are gaining recognition due to perceived health benefits. Increases in public awareness of sugar induced issues such as obesity and diabetes is expected to drive down carbonated beverage consumption further. Functional Beverage Resilience While the carbonated beverage sector is starting to decline, the functional sector is experiencing high growth. According to IBISWorld, over the next five years the beverage industry will see many state and local governments attempt to limit the sales of CSD’s due to growing health concerns. Health conscious consumers have been willing to spend on higher priced healthy options due to endorsements from medical experts on the importance of proper nutrition. Even though there is a declining trend in sales for CSD consumption, the functional beverage markets may hold an insulated position. Strong Growth Opportunities in Kombucha Kombucha signals the arrival of a new generation of functional beverages, utilizing ingredients with active constituents-carbs, caffeine, antioxidants, alcohol, various natural acids and beneficial yeasts and bacteria. Kombucha is the fastest growing segment in the $609 million functional juice and beverage category. Of that segment, REED ranks second in Kombucha with its current $5 million in sales in a $300 million category. Kombucha is gaining shelf spaces in healthy food stores and natural gourmet food stores. According to BevNET, Kombucha sales are expected to reach $500 million by 2015. High sales growth is beginning to attract the attention of the large players in the beverage industry. Overview of Competitors Dr. Pepper Snapple Group, Inc. (DPS) is the third largest soda business in the U.S. and Canada. IBISWorld reports that DPS accounts for a 14.8% market share in beverages. According to Nielsen’s 2012 retails sales, they make up 39.8% market share in flavored CSDs. The company continues to build and enhance their leading brands while developing premium value teas and juices. Currently, they hold the top ginger ale beverage and their Snapple brand leads in ready-to- drink tea. Monster Beverage Corporation has $1.9 billion sales in energy drinks, $110.2 million in non- carbonated beverages, and $31 million in carbonated beverages. Their direct store delivery segment generates 95% of 2012 revenues, up from 90% in 2008. They also have an agreement with Coca-Cola to distribute their products in 70 countries. Monster will continue to add new flavors and improve their products that compete in the functional beverage category. Their Hansen’s Brand Sodas have been the leading natural soda brand on the West Coast for over 30 years and currently have 6.9% market share in the functional drinks category. Like REED, Hansen’s sodas are sweetened with cane sugar, contains no preservatives, caffeine or artificial flavorings. They also offer organic natural sodas under their Blue Sky Products Brands. PepsiCo, Inc. is the #2 carbonated soft drink maker with a 41.7% market share in the functional drinks category and 30.3% market share as the largest non-alcoholic drink producer. They have plans to expand in healthy and premium priced products as well as products for aging consumer demographics. Pepsi operates in the natural soda segment through its subsidiaries, SOBE and -­‐4.0%   -­‐3.0%   -­‐2.0%   -­‐1.0%   0.0%   1.0%   2.0%    28,000.0      28,500.0      29,000.0      29,500.0      30,000.0      30,500.0     2007  2008  2009  2010  2011  2012   %  CHANGE   GALLONS  (IN  MILLIONS)     YEAR     U.S. Liquid Refreshment Beverage Market: Volume and growth Gallons  (in  millions)   %  change   0   10   20   30   40   50   Gallons     Years   U.S. Per Capita Consumption of CSDs -­‐10.0%   -­‐5.0%   0.0%   5.0%   10.0%   15.0%   20.0%   %  change  from  2011-­‐2012     Segments     U.S. Liquid Refreshment Beverage Market: Change in volume by segment Energy  drinks   Ready-­‐to-­‐drink  coffee   BoWled  water   Ready-­‐to-­‐drink  tea   Sports  drinks   Value-­‐added  water   Carbonated  so[  drinks   Fruit  beverages  
CFA Institute Research Challenge 31 January 2014 4     Figure 6: 2011 Packaged Beverage Sales Source: Nielsen Figure 7: U.S. Functional Beverage Forecast Source: Marketline Figure 8: U.S Functional Market Share Source: Marketline IZZE. SoBe started producing functional drinks in 1997, releasing products that contained exotic herbs, vitamins and minerals. IZZE was acquired in 2006 and its products mix carbonated spring water with 100% fruit juices. These beverages are primarily sold in the US, Canada, Caribbean and the South Pacific. The Coca-Cola Company is the #1 nonalcoholic beverage company, as well as one of the world's most recognizable brands. Coca Cola owns 16 “billion dollar brands”, including four of the top five soft drinks: Coca-Cola, Diet Coke, Fanta, and Sprite. Other top brands include Minute Maid, PowerAde, and Vitaminwater. With the world's largest beverage distribution system, the Coca- Cola Company reaches more than 200 countries. Coca-Cola operates in the natural beverage market through its subsidiary Odwalla. Odwalla, Inc. offers natural juices, juice drinks, fruit smoothies, garden organics, protein drinks, soy-based drinks, nutrition bars, smoothie refreshers, and superfoods. Jones Soda Co. markets and sells brightly colored sodas with wacky names and flavors. The soda maker’s beverages are sold in the US (75% of sales) and Canada where they are distributed through a network of more than 185 independent distributors. Outside the US they have distributors in the UK, Ireland and Australia. Sales have gone down 57% since 2007 to $17.4 million in 2011. The company has not recorded a profit in the last five years. GT’s Synergy Drinks is the industry leader of Kombucha drinks. In 2009, Americans bought more than a million bottles of GT’s Kombucha. Established in 1995, they have distribution channels all across 50 states. In 2008, their Kombucha drinks realized $66.1 million in sales. Investment Summary Conflicting Signals We issue a HOLD recommendation for Reeds, Inc. with a 2014 year-end target price of $8.33. This offers potential upside of 15.86% from January 28th closing price of $7.19. REED shows signs of high growth with its new distribution deals and increased demand for its products, but high levels of risk and weak margins weigh the firm down. Between January 2012 and December 2013, we saw REED take huge strides as it closed deal after deal with distribution companies throughout the US and Canada along with entering the kombucha market. With these newly added opportunities for growth, REED stock price soared by 611.71% during this time period. We believe that much of REED’s expected growth is already priced in and that there is not much room for additional gain. Valuation methods Our target price was estimated by assigning both our DCF valuation and relative valuation models a 50/50 weighting. We realize that for relative valuation, price to sales is limited to only looking into a company’s revenues. However, we accounted for this by applying a discount for REED poor net margin, among other factors. For this reason, we could not find a reason to apply more weighting to one valuation method over the other. Strong Outlook for Product Line With consumers becoming increasingly cognizant of their well being, demand for more healthy foods and beverages has gone up. REED, being the top seller of premium natural sodas, has positioned itself well to capitalize on this growth. On top of that, REED explores another growing market in functional beverages with his Culture Club Kombucha line. Since adding it in 2012, REED has already seen moderate success with its growth expected to exceed 50% in 2014. Financial Position Weak gross, operating, and net margins compared to the beverage industry average have resulted in negative earnings since REED went public in 2006. While we expect margins to improve, we do not currently see a mechanism to allow REED to operate at gross margins similar to its large competitors. REED has relatively high levels of debt and must take on more debt to expand. We expect it to be several years before REED generates enough cash flow to pay down debt and move towards a long-term sustainable capital structure. Our model suggests that the average D/E ratio for next 10 years to be 2.30. This is more than three times the peer group average 5-year D/E ratio of 0.69. Investment Risks REED is a high growth company that currently does not have any earnings, and therefore has many serious risks to future profitability. Given the high growth niche segment that REED operates in, it is difficult to estimate several key growth factors that drive the stock price. REED also has several operational and strategic risks, such as recent production shortages and a sudden change in executive management that may deter the firm’s future growth. These risks are further discussed in the Investment Risks section. 43.9%   14.5%   13.3%   10.8%   9.5%  5.9%   2.1%   %  DOLLAR  SALES  PACKAGED   BEVERAGES  (2011)   Carbonated  drinks   Alterna]ves  (energy  drinks,  etc.)   BoWled  water   Juice  drinks   Sports  drinks   Iced  tea  (ready-­‐to-­‐drink)   Other  
CFA Institute Research Challenge 31 January 2014 5     Figure 9: Team Criteria Recommendation Criteria Price Range Jan. 28, 2014 Price $7.19 20% Upside Price Above $8.63 BUY 10% Downside to 20% Upside Price $6.47- $8.63 HOLD 10% Downside Price Below $6.47 SELL Source: Team Estimates Figure 10: 2014E Target Price Source: Team Estimates Figure 11: Sales Growth Forecast Source: FactSet, Team Estimate Figure 12: Gross Margin Forecast Source; FactSet, Team Estimate Valuation DCF P/S Estimated Price $8.46 $8.19 Weights 50% 50% Target Price $8.33 Acquisition Premium While we view REED as a likely candidate for acquisition and that an acquisition premium may cause the price of REED to meet our BUY criteria, we do not believe that just the possibility of a future acquisition is enough to change our investment recommendation. Criteria We assign a BUY rating to a stock that exhibits a 20% or greater potential upside. While BUY ratings may typically be issued to a stock with 15% upside, we believe that small cap stocks are inherently more volatile and therefore require a higher return before issuing a buy. We assign a HOLD recommendation to a stock with less than 20% potential upside to a 10% potential downside. We assign a sell rating to a stock with potential downside greater than 10%. Valuation In order to arrive at a year-end 2014 target price for REED we used two valuation models; Discounted Cash Flows through a Free Cash Flow to Equity Model and Relative Valuation using Price/Sales Multiples. Free Cash Flow to Equity Model We evaluated REED using a 3-stage Discounted Cash Flow Analysis. A Free Cash Flow to Equity (FCFE) model was chosen because we expect REED to have a period of high growth and transition from being an unprofitable company to a profitable one. FCFE is a useful model for high growth companies as long as the capital structure does not drastically change over the forecasted period. Company guidance has suggested that the capital structure of REED should remain similar to current conditions for the near future, although new expansion would be financed by debt. We estimated free cash flows by forecasting the determinants of net income, CAPEX, and working capital. Determinants of Net Income include revenue growth, margin improvement, and expected interest payments based upon our estimated debt levels. Given these estimates we forecast the year-end target price for REED at $8.46 per share. Given a January 28, 2014 closing price of $7.19, this price would imply 18% potential upside (See Appendix 5). Sales Forecast Sales revenues were forecasted using a 3-stage growth model. In the first stage, REED sales growth was estimated at 25% for the next 5 years. 25% growth was derived from a combination of the FactSet future year estimated growth rates and REED historic growth. We believe this number to be reasonable given the growth rate of natural products within the beverage industry and REED’s strong competitive advantages in the natural foods segment. This growth is supported by our expected growth for the kombucha product over the next 10 years and REED’s position in this market. For years 2019-2022 our model assumes that the growth rate will decline by 5% each year. As REED revenues grow, the growth rate will naturally decline as market share in the natural foods segment matures. For years 2023 and on we used 3% as an average long-term growth rate to reflect historical long-term real growth in the US economy. Depreciation We assume that REED will continue to depreciate its assets similar to its rates in 2012 and 2011. In these years, depreciation was 22% and 19% of fixed assets, respectively. In our forecasted period depreciation ranges from 18-19% of fixed assets. Gross Margin Historically, REED gross margin has been much lower than its competitors. With the large beverage companies like Coca-Cola, Pepsi, Dr. Pepper Snapple and Monster each having a gross margin of over 50%, it makes REED historical gross margin average of 23.2% look small in comparison. Due to REED’s size and premium nature of its products, we do not see it being realistic for REED to reach margins of this level. However, REED has been able to improve that figure to 32% in its most recent earnings report due to increasing production efficiency and decreasing transportation costs. We expect to see gross margin steadily increase to 38% by 2023 driven by expected sales growth on REED branded products. Selling, General & Administrative (SG&A) Expense Growth Currently, SG&A expenses have held constant at 30% of sales during the years ending in 2011 and 2012. SG&A expenses had increased to 31.5% of sales through the first three quarters of 2013, but much of this increase is related to additional trade show and advertising expenditure due to a new product rollout. Company guidance has suggested that advertising will remain at similar levels for the near future, unless an extraordinary opportunity arises. Large companies in the industry, such as Coca-Cola and Pepsi typically have SG&A to sales ratios of 36-38%. This cost can be attributed to the higher level of advertising that mainstream manufacturers engage in. Monster, a comparable company in the energy drink submarket, operates at 25% SG&A to sales. We believe holding SG&A to sales at 30% is a reasonable estimate for REED. -10% 0% 10% 20% 30% 40% Sales Growth Actual Forecast 0.0% 10.0% 20.0% 30.0% 40.0% Gross Margin Actual Forecast
CFA Institute Research Challenge 31 January 2014 6     Figure 13: Financing Terms REED Financing   Rate Line of Credit Prime + 3.75% Term Loan Prime + 11.6% Term Loan shall not be below 14.85% Source: REED Financial Statements Figure 14: P/S REED vs. Peers Source: FactSet Figure 15: REED vs. Peer Key Numbers Reed vs. Peer Group 2008-2011 Reed Peers Net Margin -13% 14% Payout Ratio 0% 33.50% D/E 1.08 0.66 Beta 0.93 0.79 Source: FactSet Interest Expenses REED currently pays 7% on its $4.5 million dollar short term revolving line of credit and 14.85% on its long-term debt. Both of these rates are floating. We assume additional debt financing will be available at 14.85%. REED also has interest expenses resulting from its capital leases of property and equipment. REED uses a rate of 9.9% to account for its interest expense for its capital leases. Tax Advantage Due to previous losses, REED may be able to realize a carried loss of $5.3 million against projected earnings in 2014-2016. Our model assumes that this will result in no taxes due in 2014- 2016. Cost of Equity Cost of Equity was estimated at 7.65% by using CAPM model. For risk free rate, US 10 year Treasury bond rate of 3.04% from year-end 2013 was used. Market risk premium of 4.96% was used from Damodaran’s 2014 market premium forecast. Beta of .93 was used from FactSet estimate. A regression analysis was attempted to estimate beta against the S&P 500 (^GSPC), but the results were not considered useful as our regression coefficient of determination was 1.1%. We consider Damodaran and FactSet to be reliable sources for these estimates. Dividend Policy Company guidance suggests that REED will not pay any dividend on common stock for the foreseeable future. Our model assumes that no dividend will be paid in forecasted period. Capital Expenditures (CAPEX) During the one-on-one meeting that we had with REED management, it was suggested that the company would finance new expansion by issuing debt as opposed to diluting shareholders. We believe that the forecasted future debt levels of REED are reasonable given its high growth, and as the company becomes profitable it will be able to pay down debt. Balance Sheet For our model we have assumed that all assets and short-term liabilities will remain a constant percentage of sales. Multiples Valuation This model seeks to arrive at a valuation by comparing how similar companies are priced in the market. Peer Group Selection It is imperative to select a set of similar firms in order to obtain a more precise market-based valuation. However, REED is a very unique company in which it encompasses a small niche within the beverage industry. This makes it difficult to find companies that strongly resemble REED. Companies that we did find to be similar to REED were either private, subsidiaries of larger companies, or too small for analyst coverage. We declined to use these companies due to the difficulty in obtaining forward projections. For this reason, we chose its peer group to be its biggest competitors within the beverage industry. This list includes Coca-Cola, Dr. Pepper- Snapple, Pepsi, and Monster. What Multiples to Use? Due to REED being a company that has historically had negative earnings with a small book value, both its earnings multiples and book value multiples are unreliable. We felt it most appropriate to use the Price to Sales multiple given how the company resembles a start-up along with its historical poor earnings. The advantages of using this method include that it is much less volatile than earnings multiples and harder to manipulate through accounting methods. However, we are aware that this multiple has its limitations as it does not account for a company’s debt levels or cost structures and plan to account for these factors in our valuation. Price to Sales Multiple Historically, REED has been trading at a discount to its peers. Between the years of 2008 to 2011, the average P/S discount was 72.22%. There were several reasons for this: • Significantly smaller net margin due to negative profits (-13.0% avg. vs. 14.0% avg.) • Non-existent payout ratio as REED did not pay out dividends (0% avg. vs. 33.5% avg.) • Higher total debt to equity ratio (1.08 avg. vs. 0.66 avg.) • Greater amounts of systematic risk (0.93 vs. 0.79) 0   1   2   3   4   2008   2009   2010   2011   2012   2013   2014  E   Price to Sales Reed's,  Inc.   Peers  
CFA Institute Research Challenge 31 January 2014 7     Figure 16: Effects of CFO Resignation REED P/S discount after CFO announcement Price (1/27/2014) $6.82 # Shares (million) 13.5 Market Cap (1/27/2014) $92.07 2013E Sales (million) 37.75 Implied P/S 2.44 2013E Peers P/S multiple 3.24 Implied Discount 25% Source: FactSet, Team Estimates Figure 17: P/S Discount P/S Discount Sensitivity Analysis Applied Discount 2014E Price Potential Upside 40% $6.55 -8.8% 35% $7.10 -1.2% 30% $7.65 6.3% 25% $8.19 13.9% 20% $8.74 21.5% 15% $9.28 29.1% 10% $9.83 36.7% Source: Team Estimates Figure 18: Weighting Sensitivity Sensitivity of Weighting on Target Price DCF Weight Relative Weight Target Price 20% 80% $ 8.24 30% 70% $ 8.27 40% 60% $ 8.30 50% 50% $ 8.33 60% 40% $ 8.35 70% 30% $ 8.38 80% 20% $ 8.41 Source: Team Estimates Figure 19: Implications of Acquisition Acquisition Premium Premium Price Potential Upside 0% $8.33 15.86% 5% $8.75 21.65% 10% $9.16 27.44% 15% $9.58 33.23% 20% $10.00 39.03% 25% $10.41 44.82% 30% $10.83 50.61% Source: Team Estimates From 2012 onward, REED has been trading at a much smaller discount to its peers with an average discount of 15%. We believe that this is due to the following reasons: • Improving net margins (from -25.0% in 2008 to -1.7% in 2012) • Higher expected growth due to new distribution agreements, a new private label partnership with one of the largest supermarket chains in the country, and the addition of kombucha to its product line Although REED’s average D/E Ratio grew to 1.6 during this time period, we feel that the improvements in net margin and expected growth more than made up for this factor to justify a 15% discount. For our year-end projection, we forecast REED to sustain its high level of growth due to an increasing demand for kombucha and natural sodas. Also, we expect net margin to continue to improve as revenues grow. Based off these factors, we decided to apply a 15% discount to year- end 2014, similar to the average of the discounts in 2012 and 2013. However on January 21, 2014, it was announced that REED CFO of 5 years, Jim Linesch, was leaving the company. Given that the CFO had just bought over $200,000 worth of shares 19 days prior to this announcement, we can assume that this decision was very abrupt. This poses a red flag as there appears to be serious management problems within REED. We feel that this added risk warrants an additional 10% discount. This estimation of 10% was derived from using the following calculations: • Taking REED market cap by end of January 27, 2014 • Divide it by our 2013E sales forecast to get to an implied current P/S ratio for REED • Found the discount of this P/S in comparison to the 2013E average peer group P/S ratio The resulting discount of REED was 25%, 10% more than its average discount to its peers for the past 2 years. Since there was a large price change after the announcement of resignation, we believe that the market was applying this added discount based upon similar concerns about management. We also believe that continuing to use this 25% multiple discount for 2014 is appropriate. This would give us a 2014 year-end target price of $8.19. This implies potential upside of 13.9% relative to January 28th, 2014 close price of $7.19 (See Appendix 6). Weight of Models We obtained a final one-year target price by taking a weighted average of our DCF and relative valuations. We utilized equal weights for both our DCF and P/S model. We believe that both of our models are rigorous and appropriately consider the major factors in valuation of REED. We performed a sensitivity analysis to determine how the weighting of our models would change our target price and discovered that any changes in weighting would not result in a change of investment recommendation based upon our stated criteria. While it was difficult to find a strong comparable group for REED, we feel we have correctly applied an appropriate discount relative our chosen group. Combining our forecasts gives us a 2014 year-end target price of $8.33. Given a January 28 price of $7.19 this represents 15.9% potential upside (See Appendix 7). Additional Upside - Acquisition Premium Historical acquisition premiums in the beverage industry have been known to range from 25%- 30% above market price per share. In 2001, Odwalla, an American food product company that sells fruit juice, was acquired by The Coca-Cola Company for $18 million. The company was purchased at a premium of 28.9%. More recently Jim Beam was purchased for $16 billion by a Japanese company, Suntory Holdings Ltd. The company paid a 25% premium. Other acquisitions in the beverage industry include SoBe and Izze sparkling juices, all of which were acquired under the PepsiCo brand. Izze was purchased at an estimated price of $75 million and SoBe was acquired around $370 million for a 90 percent stake, about 12 times its EBITDA. With a market size of $92.6 million, REED’s relatively small size also makes the company a great acquisition target. Competitors such as the Coca-Cola Company and PepsiCo have the resources and ability to purchase a small-cap company. As ownership is concentrated amongst a few large shareholders, it is easier to gain majority approval and consensus in voting decisions. REED has developed a strong brand identity in the functional beverage and kombucha segment. This can lead to high growth potential in a fairly new and developing market. Industry leaders in the beverage market looking to differentiate into functional drinks would value the acquisition of REED to their business. As a small-cap company, REED may also not have the resources that many of the large competitors may have. Unlocking value in REED through expanded distribution networks, marketing, and additional capital could also provide grounds for the company to be acquired. Possible synergies would give large competitors incentive to acquire as well.
CFA Institute Research Challenge 31 January 2014 8     Figure 20: Net Income Forecast Source: FactSet, Team Estimates Figure 21: REED Gross Margin Forecast Gross Margin 2012 2013E Terminal REED 30% 31.5% 38% Peer Group 5-Year Avg. 56.09% Source: FactSet, Team Estimates Figure 22: REED Liquidity Ratios Source: FactSet Given this information, we believe REED is an attractive acquisition target, and could potentially have 15-30% additional upside from an acquisition premium. However, there are also several risks that may impede an acquisition or result in a lower premium. These risks are further discussed in our Investment Risks section. Financial Analysis Future Earnings While REED has reported negative net income in the past, it has been consistently improving these figures over the last 6 years. Between 2007 and 2012, REED went from net income of - $5.58 million to -$0.57 million. We expect earnings to increase as revenues rise because REED closely resembles a start-up company in its high growth stage. Due to a higher demand of natural sodas and kombucha, we do not anticipate sales growth slowing down in the near future. This will boost net income with 2014 expecting to be REED’s first year of positive earnings. Given our sales growth and margin forecasts we estimate that REED will grow from a current net margin of 0% to 1.93% in 2018, with earnings of $2.27 million. Sales Growth REED sales growth has been consistently over 15% for the time periods 2007 to 2012, which is well above the industry average of 1% for beverage companies. However, sales in 2009 had declined due to the effects of the U.S. recession. We believe these growth trends will continue at a high level because of favorable market trends for REED product lines, their position as a market leader in the natural sodas market, and their established national distribution network. This is reflected in the forecasted growth rates for years 2013-2018. We expect that REED’s growth in sales can be heavily attributed to their position in the kombucha market segment, the fastest growing product in functional beverages. Improving Gross Margin We believe the relatively low gross margin is the most important factor limiting REED’s earning power. In 2012 REED gross margin was 30.47%, which was well below the average of large beverage manufacturers. However, gross margin has increased from 15% in 2007 to 30% in 2012, and we expect this trend to continue. REED uses promotional allowances as a direct reduction in sales. Due to new product rollouts, higher allowances have lowered gross margin. There has been a history in kombucha production inefficiencies that hindered gross margin. Third quarter 2013 results show a gross margin of 32%, leading us to believe that these inefficiencies have been corrected. REED has invested heavily in expanding production capacity in its west coast plant. Capital expenditures totaled $507,000 in 2012 and $447,000 through the first nine months of 2013. These enhancements should decrease transportation costs because they reduce shipments from the east coast co-packing facility. Increases in branded product sales will improve gross margins in the forecasted period due to higher margins on branded as opposed to private label offerings. Their Culture Club Kombucha is expected to have the highest sales growth, and should improve branded sales. Beverage industry peers Coca-Cola, PepsiCo, Dr. Pepper Snapple and Monster have a gross margin of over 50%. This may not be realistic for REED given its size and premium nature of its products. Company executives suggested in the 2013 third quarter conference call that they would like to see gross margin being closer to 40%. We have forecasted a steady trend towards an estimate of 38% in the terminal stage of our valuation model. This estimate allows for realistic and attainable increases of 0.5% per year from 2014 to 2023 (See Appendix 16). Efficiency Ratios REED has a 5-year average Total Asset Turnover Ratio of 1.79 compared to peer group average of 0.92. This implies REED is managing its assets efficiently compared to the large beverage manufacturers. REED also has a higher Receivables Turnover and lower Payables Turnover compared to peer average. This demonstrates REED collects its receivables quicker and it takes longer to pay its suppliers than its peers. Balance Sheet & Financing REED 3 year average Debt/Equity Ratio was 0.46 prior to 2009. D/E Ratio increased to 0.93 in 2009 and has continued to increase in the following years reaching a forecasted high of 2.47 in 2015E. The high ratio is due in part to the fact that REED sold and concurrently entered into a long-term lease agreement of its two buildings and brewery equipment in 2009. The capital lease has the effect of increasing operating income while also increasing interest expense. The building and equipment were sold at $3,056,000 but were recorded as a long-term financing obligation. At the end of 2013, we estimated the remaining balance of that obligation to be $2,784,000. The company is expected to decrease that balance at the rate of 9.9% annually and this has been taken into account in the balance sheet under long-term financing (see Appendix 11). As of third quarter 2013, REED has long-term debt consisting of a $525,000 term loan at 11.6% -­‐10   -­‐5   0   5   10   Net Income In Millions Actual Forecast 0.00   1.00   2.00   3.00   Dec  '06   Dec  '07   Dec  '08   Dec  '09   Dec  '10   Dec  '11   Dec  '12   Ratio Analysis Current Ratio Quick Ratio Cash Ratio
CFA Institute Research Challenge 31 January 2014 9     Figure 23: Forecasted Ratios 2013 Forecasted Ratios Affecting Liquidity & Solvency REED 2013E 5 Year Peer Average Current Ratio 1.33 2.07 Quick Ratio 0.5 1.69 D/E Ratio 2.04 0.69 Source: FactSet, Team Estimates Figure 24: CFO Resignation on Stock Price Impact from Loss of Key Management Executive REED S&P 500 Jan. 21st Open price $8.32 $1,841 Jan. 27th Close price $6.82 $1,781 Percentage Change -18.03% -3.23% Source: FactSet plus prime. Interest shall not be below 14.85% per terms of the loan. REED has maintained a Current Ratio over 1, with it being 1.32 in year ending 2012. The forecasted Current Ratio remains above 1.32 (See Appendix 4). However, due to REED having more than 60% of its Current Assets in inventories, its Quick Ratio is 0.5 in 2012, which we project to remain relatively constant through the forecasted period. DuPont Analysis DuPont analysis was employed to examine how the return on equity was affected by the company’s operating efficiency, asset efficiency, and financial leverage. Due to operating losses from 2006 to 2012, the return on equity (ROE) has been negative. However we expect in subsequent years, there will be gradual improvement. In 2007, the return on equity was -76.67%, and by 2012, the ROE was drastically reduced to -12.78%. Through examination of the company's operating efficiency, profit margins have increased 40.76%, from -42.51% in 2007 to -1.75% in 2012. The Total Asset Turnover has also increased from 1.29 to 2.17 over the periods of 2007 to 2012, showing improvement in the company’s utilization of its resources. However REED capital structure shows that its financial leverage is increasing as the equity multiplier rises from 1.39 in 2007 to 3.37 in 2012. This implies an increase in debt to finance the company's operations over the years. The projections for 2013 continue to show signs of optimism for the firm. By 2014, projected profit margins and ROE are expected to be positive with profit margins reaching 1.05% and return on equity increasing to 11.02%. The DuPont analysis suggests that the profit margins are the most important driver for the firm’s return on equity. Thus we believe REED is showing positive signs of growth that are expected to continue into the future (See Appendix 15.) Investment Risks Operational Risk: Production Shortfall REED may not be able to produce at a level to support high sales growth. REED had issues with production shortages in 2012 and early 2013, and this led to CEO Chris Reed taking over plant management at the west coast facility. Continued issues from production shortages due to equipment error or inefficiencies in production process may harm sales growth and gross margin. Operational Risk: Increase in Supply Prices Costs in tangible goods sold was 63% of sales in 2012 and 2011. Cost of tangible goods sold includes raw materials, packaging, co-packing and repacking fees, inbound freight charges and certain internal transfers. Increases in these costs could lower gross margin and impact the current and future profitability of REED. However, we would expect that such increases may happen across the industry and affect REED competitors as well. Given its relatively small size, future supply price increases may affect REED more than its competitors, resulting in a lower gross margin. Operational Risk: Lack of Working Capital REED Current Ratio has trended downwards going from 2.41 in 2007 to 1.44 and 1.33 in 2011 and 2012 respectively. Their Current Ratio also trails the 5-year peer group average, 1.33 to 2.07. REED Quick Ratio has trended downwards over time, going from 0.96 in 2007 to 0.43 and 0.50 in 2011 and 2012 respectively. Their Quick Ratio also trails the 5-year peer group average, .50 to 1.69. These ratios signal it may have some challenges paying bills over time. REED currently has a D/E Ratio of 2.04, compared to peer group five year average of .69, and company guidance has suggested that new funding would come from new debt rather than equity financing. Lack of working capital may negatively affect REED’s ability to borrow. If revenue from product sales are inadequate, the firm may also have insufficient working capital to continue operations. In the long run, poor liquidity can result in the firm managing business instead of growing it. REED is also susceptible to changes in interest rates because of the floating rate on its current and long term debt. Given the historical low interest rates that have prevailed during the last few years, if interest rates go up, REED would have to incur higher interest expenses in order to service its debt. Operational Risk: Loss of Key Management Executive On January 21, 2014, REED announced that its CFO of 5 years, James Linesch, would be leaving the company at the end of the month and that the firm was seeking a replacement. It was not publicly stated as to what the reason was for his leaving, but with him gone it does leave a hole within management. Linesch has held several CFO positions with small publicly traded companies such as AdStar, Inc. (ADST), DynTek, Inc. (DYNE) and CompuMed, Inc. (CMPD). When he was appointed as the chief financial officer for REED, he brought with him valuable management experience in emerging public companies. Along with his normal duties of managing the company’s finances, Linesch was responsible for improving REED’s line of credit and cutting legal costs by at least 50%. CEO Chris Reed had even stated that Linesch had contributed to the “inspiration and technical ‘macgyvering’ that gave us the Reed’s Culture Club Kombucha.” Since he was brought on board, REED has seen a rise in stock price by almost 500%.
CFA Institute Research Challenge 31 January 2014 10     When the announcement came out that Linesch was stepping down from his position REED’s stock plummeted. Within the span of 5 trading days, the price had dropped 18% vs. 3.0% decline in the S&P 500. The fact that Linesch had bought over $200,000 of REED stock 19 days prior to the announcement suggests that this decision was very abrupt. Also, the fact that REED does not have a replacement already set in place further justifies our assumption. It comes into question as to what had caused the sudden departure as there was no explanation given as to why Linesch left. The uncertainty that this event creates adds additional risk to the company. With REED in a crucial period of high growth, it is vital to find an experienced replacement. Competition Risk: Major Competitors Enter Market If the natural beverage industry continues its growth, there will be a large incentive for the major beverage manufacturers Coca-Cola, Pepsi, Dr Pepper-Snapple, and Monster to enter the market. While we see REED as an ideal acquisition target for a larger firm, it is also possible for one of REED’s competitors to be acquired instead. Major firms may also start to operate their own premium natural lines. This could materially impact revenue and profitability, as they would be competing against a powerful firm with more established distribution channels. Strategic Risk: New Product Failure REED’s fastest growing product is expected to be its Culture Club Kombucha line. Expected growth of this line is 50%-100%, compared to 15-20% for REED core brands (according to company guidance). If Kombucha sales falter, overall sales growth may be dampened. Valuation Risk: Long Term Growth Rates REED intrinsic value was calculated by using a long-term growth rate of 3%, which was set to model typical long term U.S. Economic Growth. This growth factor can have significant impact on the valuation of REED, both in when the terminal value is calculated and with what long-term growth rate is used. A range of long term growth rates were modeled using sensitivity analysis to determine the effect on our one year target price (See Appendix 10). Valuation Risk: Intermediate Term Growth REED intermediate-term sales growth rates (IGR) were estimated by utilizing analyst consensus, recent performance, and expected growth in market and market share. We utilized an annualized growth rate of 25% over the next five years, which we believe to be the best estimate given current production and market conditions. If these estimates are overly optimistic it would have a huge impact on REED valuation, as REED requires high growth and growth in margins to become profitable. Given the difficulty in predicting the growth pattern of a new niche product in kombucha, these growth numbers may be understated and therefore undervalue the company. A range of IGR were modeled using sensitivity analysis to determine the effects of different growth rates on our 2014 year-end target price (See Appendix 8). Valuation Risk: Changes in Cost of Capital REED is a relatively young company with high growth and a high D/E Ratio. Due to these factors, REED currently has a high cost of capital compared to the beverage industry. We have assumed that this number will not drastically change over time. If there are changes in capital structure, inherent business risk, market risk premium, or risk free rate, cost of capital will change, and therefore our estimate of valuation may change substantially. Sensitivity analysis was performed to view the effects of different long term cost of capital rates on the one year target price (See Appendix 9). Valuation Risk: Acquisition Risk While visiting REED headquarters, Chris Reed discussed an expected exit strategy in the next 4 to 5 years, and hoped to receive an offer valuing the company at $200 million. With the 2013 year end market cap being $102.22 million, this is a 95.66% premium. The possibility that Chris Reed could turn away potentially good acquisition deals based on his unreasonable expectations could lead to a risk for investors. Also with Chris being the age of 56, the decision to sell the company could be greatly influenced by his desire to retire. As both Chris and his wife are on the board of directors, they have a very strong influence on what price the company could be purchased at. Due to Chris Reed’s possible personal motives, this could lead to a much smaller acquisition premium than shareholders would hope for. Issues Regarding Corporate Governance Insider stake ownership at REED represents 33.4% of the company’s float, making it greatly influenced by a few insiders. The Chairman of the board is CEO Chris Reed. His wife Judy Reed, Mark Harris, Daniel S.J. Muffoletto, and Michael Fischman also serve on the board of REED. Given the makeup of the board, we have concerns to how the board could objectively review management decisions. It appears that both Daniel Muffoletto and Michael Fischman have no shares in the company, and both are paid very little to serve on the board. Fischman is paid only $750 to serve on the board and in 2012 attended less than 75% of the meetings. Total lack of ownership and the minimal payments to directors for fulfilling their duties leads us to the
CFA Institute Research Challenge 31 January 2014 11     assumption that they serve on the board as a possible favor to Chris Reed. This does not provide sufficient motivation for the directors to adequately review and advise management. These current corporate governance standards also make it difficult to attract investment from institutional investors. Right now, REED has an institutional ownership of 6%, which significantly trails the industry average of 46%. The lack of corporate governance gives shareholders limited power in REED management decisions. This has led to a recent shareholder proxy initiative to change the board nomination process that ultimately failed due to insider opposition. A proposal to limit proxy review of executive compensation to 3 years from every year also passed with insider support. When shareholders have the ability to scrutinize a company’s corporate governance practices, they can help to identify areas of improvement. However this only happens if the board and management promote shareholders engagement and actively consider the interests of the shareholders they serve. It is important that the board and management listen to what their shareholders have to say and adjust their governance practices when warranted. Thus far the REED board has made no attempt to address these concerns over their corporate governance practices.
CFA Institute Research Challenge 31 January 2014 12     Appendix 1: Pro Forma Balance Sheet (All figures in Millions) Balance  Sheet   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Assets                                                           Cash  &  ST  Investments   1.08   0.71   1.16   1.46   1.82   2.28   2.85   3.56   4.45   5.34   6.15   6.76   7.10   7.31   Short-­‐Term  Receivables   1.30   1.63   1.96   2.47   3.08   3.85   4.82   6.02   7.52   9.03   10.38   11.42   11.99   12.35   Inventories   4.56   6.10   5.79   7.28   9.10   11.38   14.23   17.78   22.23   26.67   30.68   33.74   35.43   36.49   Other  Current  Assets   0.22   0.29   0.41   0.52   0.64   0.81   1.01   1.26   1.57   1.89   2.17   2.39   2.51   2.58   Total  Current  Assets   7.16   8.73   9.32   11.7   14.7   18.3   22.9   28.6   35.8   42.9   49.4   54.3   57.0   58.7   Net  Property,  Plant  &  Equipment   3.65   3.51   3.42   4.15   5.19   6.49   8.11   10.14   12.67   15.21   17.49   19.24   20.20   20.80   Intangible  Assets   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   Other  Assets   0.05   0.09   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Total  Assets   11.89   13.36   13.82   16.96   20.93   25.89   32.09   39.84   49.53   59.22   67.94   74.63   78.31   80.63   Liabilities  &  Shareholders'  Equity   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   ST  Debt  &  Current  Portion  LT  Debt   2.20   3.37   3.36   4.17   5.11   6.27   7.76   9.69   12.02   14.30   16.35   17.93   18.79   19.32   Accounts  Payable   2.91   2.42   3.37   4.24   5.30   6.62   8.28   10.35   12.94   15.53   17.85   19.64   20.62   21.24   Other  Current  Liabilities   0.21   0.28   0.31   0.39   0.49   0.61   0.76   0.95   1.19   1.43   1.64   1.81   1.90   1.95   Total  Current  Liabilities   5.32   6.07   7.04   8.80   10.90   13.51   16.80   20.99   26.15   31.25   35.85   39.37   41.30   42.52   Term  Loan           0.40   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   Long  Term  Financing  Obligation-­‐Net     2.208   2.164   2.083   1.980   1.853   1.674   1.477   1.349   1.248   1.156   1.081   1.015   Capital  Lease  equipment       0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   Additional  Financing               1.32   2.81   4.40   5.94   8.24   10.79   12.22   11.87   9.08   3.32   4.49   Long-­‐Term  Debt   2.41   2.98   2.71   4.10   5.52   7.00   8.42   10.53   12.89   14.19   13.74   10.86   5.03   6.13   Total  Liabilities   7.73   9.05   9.75   12.90   16.42   20.51   25.22   31.52   39.03   45.44   49.59   50.23   46.33   48.65   Preferred  Stock  (Carrying  Value)   1.32   1.27   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   Retained  Earnings   (18.88)   (19.89)   (20.46)   (20.46)   (19.95)   (19.00)   (17.43)   (15.90)   (13.63)   (10.26)   (5.58)   0.59     8.29     8.29     Capital  Surplus   21.70   22.92   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   Common  Equity   2.82   3.03   3.54   3.54   4.05   5.00   6.57   8.10   10.37   13.74   18.42   24.59   32.29   32.29   Total  Shareholders'  Equity   4.38   4.14   4.31   4.10   4.61   5.56   7.13   8.66   10.93   14.30   18.98   25.15   32.85   32.85   Liabilities  &  Shareholders'  Equity   11.87   13.35   13.85   16.96   20.93   25.89   32.09   39.84   49.53   59.22   67.94   74.63   78.31   80.63   Source:  Team  Estimates,  FactSet  
CFA Institute Research Challenge 31 January 2014 13     Appendix 2: Pro Forma Income Statement INCOME  STATEMENT   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Sales/Revenue   20.38     25.01     30.01     37.75     47.19     58.98     73.73     92.16     115.20     138.24     158.98     174.87     183.62     189.13            Sales  Growth  (%)   34%   23%   20%   26%   25%   25%   25%   25%   25%   20%   15%   10%   5%   3%   COGS  excluding  D&A   15.43     16.96     20.13     25.06     30.41     37.71     46.79     58.04     72.04     85.71     97.80     106.73     111.18     113.60     D  &  A  Expense   0.62     0.65     0.74     0.81     0.98     1.21     1.51     1.87     2.32     2.76     3.15     3.44     3.58     3.66     Gross  Income   4.34     7.41     9.14     11.88     15.79     20.05     25.44     32.26     40.84     49.77     58.03     64.70     68.86     71.87            Gross  Margin  (%)   21.3%   29.6%   30.5%   31.5%   33.5%   34.0%   34.5%   35.0%   35.5%   36.0%   36.5%   37.0%   37.5%   38.0%   SG&A  Expense   5.06     7.66     9.01     11.32     14.16     17.69     22.12     27.65     34.56     41.47     47.69     52.46     55.09     56.74     EBIT  (Operating  Income)   (0.72)   (0.25)   0.14     0.56     1.64     2.36     3.32     4.61     6.28     8.29     10.33     12.24     13.77     15.13            EBIT  Margin  (%)   -­‐3.6%   -­‐1.0%   0.5%   1.5%   3.5%   4.0%   4.5%   5.0%   5.5%   6.0%   6.5%   7.0%   7.5%   8.0%   EBITDA   (0.11)   0.40     0.87     1.36     2.62     3.57     4.82     6.48     8.60     11.05     13.48     15.68     17.35     18.79     Interest  on  Credit  Line           0.21     0.26     0.33     0.41     0.52     0.65     0.81     0.97     1.11     1.22     1.29     1.32     Interest  on  New  LT  debt         0.20   0.42   0.65   0.88   1.22   1.60   1.81   1.76   1.35   0.49   0.67   Interest  on  Term  Loan       0.18     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     Interest  on  Capital  Leases           0.16     0.18     0.18     0.16     0.18     0.26     0.29     0.26     0.25     0.23     0.21     0.20     Interest  Expense   0.59   0.69   0.66   0.85   1.14   1.44   1.79   2.34   2.91   3.26   3.33   3.01   2.20   2.40   Tax  Expense   0.00     0.00     0.00     0.00     (0.17)   (0.32)   (0.53)   (0.79)   (1.17)   (1.74)   (2.41)   (3.18)   (3.99)   (4.40)   Offset  from  Carried  Loss           0.17     0.32     0.53                     Average  Tax  Rate   0.0%   0.0%   0.0%   0.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.1%   34.2%   Preferred  Dividends   0.07     0.07     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     Net  Income  Available  To  Common   Equity   (1.38)   (1.01)   (0.57)   (0.30)   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62   8.37   Retained  Earnings               (0.30)   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62             Source:  Team  Estimates,  FactSet
CFA Institute Research Challenge 31 January 2014 14     Appendix 3: Statement of Cash Flows Statements  of  Cash  Flows   2013   2014   2015   2016   2017   2018   2019   2020   2021   2022   2023   Net  Profit   (0.30)   0.50     0.92     1.53     1.50     2.23     3.32     4.62     6.09     7.62     8.37     D&A   0.81     0.98     1.21     1.51     1.87     2.32     2.76     3.15     3.44     3.58     3.66     Changes  Receivables   (0.51)   (0.62)   (0.77)   (0.96)   (1.20)   (1.50)   (1.50)   (1.35)   (1.04)   (0.57)   (0.36)   Changes  Inventories   (1.49)   (1.82)   (2.28)   (2.85)   (3.56)   (4.45)   (4.45)   (4.00)   (3.07)   (1.69)   (1.06)   Changes  Other  Current  Assets   (0.11)   (0.13)   (0.16)   (0.20)   (0.25)   (0.31)   (0.31)   (0.28)   (0.22)   (0.12)   (0.08)   Changes  Current  Liabilities   1.76     2.10     2.61     3.30     4.19     5.16     5.11     4.60     3.52     1.93     1.21     Changes  in  NWC   (0.35)   (0.47)   (0.60)   (0.71)   (0.82)   (1.11)   (1.16)   (1.04)   (0.80)   (0.45)   (0.29)   Cash  Flows  From  Operations   0.16     1.01     1.53     2.32     2.54     3.44     4.93     6.73     8.73     10.75     11.75     CAPEX   -­‐1.54   -­‐2.02   -­‐2.51   -­‐3.13   -­‐3.90   -­‐4.85   -­‐5.29   -­‐5.43   -­‐5.19   -­‐4.54   -­‐4.26   Cash  Flows  From  Investments   -­‐1.54   -­‐2.02   -­‐2.51   -­‐3.13   -­‐3.90   -­‐4.85   -­‐5.29   -­‐5.43   -­‐5.19   -­‐4.54   -­‐4.26   Net  Debt   1.40   1.42   1.48   1.42   2.11   2.35   1.30   -­‐0.45   -­‐2.88   -­‐5.83   1.10   Dividends  Paid   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Cash  Flows  From  Financing   1.35   1.37   1.44   1.37   2.07   2.31   1.26   -­‐0.50   -­‐2.93   -­‐5.87   1.06   Net  Change  in  Cash   (0.02)   0.36     0.46     0.57     0.71     0.89     0.89     0.80     0.61     0.34     8.54     Beginning  Cash     1.46     1.82     2.28     2.85     3.56     4.45     5.34     6.15     6.76     7.10     End  Cash   1.46   1.82     2.28     2.85     3.56     4.45     5.34     6.15     6.76     7.10         Source:  Team  Estimates,  FactSet  
CFA Institute Research Challenge 31 January 2014 15     Appendix 4: Key Financial Ratios Key  Financial  Ratios   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Liquidity  Ratios                                                           Current  Ratio  (x)   1.35   1.44   1.32   1.33   1.34   1.36   1.36   1.36   1.37   1.37   1.38   1.38   1.38   1.38   Quick  Ratio  (x)   0.49   0.43   0.50   0.50   0.51   0.51   0.52   0.52   0.52   0.52   0.52   0.52   0.52   0.52   Cash  Ratio  (x)   0.20   0.12   0.16   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   Efficiency  Ratios                                                           Total  Asset  Turnover  (x)   1.71   1.87   2.17   2.23   2.25   2.28   2.30   2.31   2.33   2.33   2.34   2.34   2.34   2.35   Fixed  Asset  Turnover  (x)   5.58   7.13   8.77   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   NWC  Turnover  (x)   11.07   9.40   13.16   12.90   12.56   12.25   12.09   12.07   11.96   11.83   11.75   11.70   11.68   11.66   Receivables  Turnover  (x)   18.78   17.07   16.72   17.06   17.01   17.01   17.01   17.01   17.01   16.70   16.38   16.04   15.68   15.54   Days  if  Sales  Outstanding  (days)   19.44   21.38   21.83   21.40   21.46   21.46   21.46   21.46   21.46   21.85   22.29   22.76   23.27   23.49   Inventory  Turnover  (x)   4.31   3.30   3.51   3.96   3.83   3.80   3.77   3.74   3.72   3.62   3.52   3.42   3.32   3.26   Days  of  Inventory  On  Hand  (days)   84.65   110.49   104.01   92.24   95.28   96.04   96.77   97.52   98.20   100.87   103.68   106.71   110.00   111.94   Payables  Turnover  (x)   8.20   7.18   7.10   7.19   6.96   6.91   6.86   6.81   6.77   6.53   6.29   6.04   5.78   5.65   Number  of  Days  of  Payables  (days)   44.49   50.80   51.41   50.75   52.41   52.81   53.19   53.58   53.93   55.90   58.04   60.43   63.10   64.57   Cash  Conversion  Cycle  (days)   59.59   81.06   74.43   62.88   64.32   64.69   65.04   65.40   65.72   66.83   67.92   69.04   70.18   70.87   Profitability  Ratios                                                           Gross  Profit  Margin  (%)   21.28%   29.60%   30.47%   31.47%   33.47%   34.00%   34.50%   35.00%   35.45%   36.00%   36.50%   37.00%   37.50%   38.00%   EBIT  Margin  (%)   -­‐3.55%   -­‐1.00%   0.45%   1.47%   3.47%   4.00%   4.50%   5.00%   5.45%   6.00%   6.50%   7.00%   7.50%   8.00%   EBITDA  Margin  (%)   -­‐0.53%   1.61%   2.91%   3.61%   5.55%   6.06%   6.54%   7.03%   7.46%   8.00%   8.48%   8.97%   9.45%   9.93%   Net  Profit  Margin  (%)   -­‐6.43%   -­‐3.76%   -­‐1.75%   -­‐0.79%   1.05%   1.56%   2.08%   1.62%   1.93%   2.40%   2.91%   3.48%   4.15%   4.43%   ROA  (%)   -­‐11.02%   -­‐7.04%   -­‐3.79%   -­‐1.76%   2.37%   3.55%   4.77%   3.76%   4.49%   5.61%   6.80%   8.16%   9.73%   10.39%   ROE  (%)   -­‐31.64%   -­‐21.9%   -­‐12.8%   -­‐7.34%   11.02%   17.08%   22.31%   18.00%   21.20%   24.12%   25.17%   24.96%   23.83%   26.19%   SG&A/Sale  (%)   24.83%   30.60%   30.02%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   Solvency  Ratios                                                           Debt  Ratio  (%)   38.77%   47.53%   43.89%   48.79%   50.81%   51.27%   50.42%   50.75%   50.28%   48.11%   44.29%   38.57%   30.41%   31.57%   Debt  to  Equity  Ratio  (x)   1.11   1.48   1.48   2.04   2.36   2.47   2.36   2.43   2.37   2.07   1.64   1.18   0.74   0.80   Equity  Multiplier  (x)   2.87   3.11   3.37   4.18   4.64   4.81   4.67   4.79   4.72   4.30   3.70   3.06   2.45   2.52   Long  term  Debt  Ratio  (%)   20.27%   22.31%   19.57%   24.20%   26.38%   27.04%   26.24%   26.44%   26.01%   23.96%   20.22%   14.55%   6.42%   7.60%   Interest  Coverage  Ratio  (x)   -­‐1.24   -­‐0.36   0.21   0.65   1.43   1.64   1.86   1.97   2.16   2.55   3.10   4.07   6.25   6.30   Source:  Team  Estimates,  FactSet  
CFA Institute Research Challenge 31 January 2014 16     Appendix 5: DCF Valuation FREE  CASH  FLOW  EQUITY   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   NET  INCOME   -­‐0.05   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62   8.37   P  Dividend   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Net  Capex   0.73   1.04   1.30   1.62   2.03   2.53   2.53   2.28   1.75   0.96   0.61   Changes  In  NWC   -­‐0.35   -­‐0.47   -­‐0.60   -­‐0.71   -­‐0.82   -­‐1.11   -­‐1.16   -­‐1.04   -­‐0.80   -­‐0.45   -­‐0.29   Net  Debt   0.08   2.63   1.41   1.34   2.03   2.27   1.21   -­‐0.56   -­‐3.00   -­‐5.96   1.10   Debt  Ratio   0.74   0.78   0.79   0.78   0.78   0.78   0.76   0.72   0.66   0.58   0.59   FCFE   -­‐0.45   0.06   0.39   0.88   0.71   1.22   2.22   3.49   5.05   6.93   7.96   Terminal  Value                     176.38     Total  FCFE   -­‐0.18   0.33   0.73   1.29   1.20   1.88   2.96   4.24   5.74   183.75     Equity  Value   106.42   114.24         Number  of  shares   13.50   13.50         Share  Price   $7.88   $8.46                                       Model  Returns   2014  Price   8.46   Jan  28  2014  Price   7.19   Potential  Upside   18%   Net CAPEX = CAPEX - Depreciation Net Debt = New Debt Issued – Debt Paid Source:  Team  Estimates,  FactSet,  Damodaran  Market  Risk  Premiums CAPM           Risk  Free   3.04%   10  Year  Treasury  Note  12/31/2013   Market  Premium   4.96%   2014  Estimate   Beta   0.93   FactSet  Estimate   Cost  of  Equity   7.65%      
CFA Institute Research Challenge 31 January 2014 17     Appendix 6: Multiples Valuation Price/Sales   2008   2009   2010   2011   2012   2013   2014  E   Dr  Pepper  Snapple  Group,  Inc.   0.72x   1.31x   1.51x   1.48x   1.56x   1.66x   1.63x   Monster  Beverage  Corporation   3.16x   3.18x   3.73x   5.05x   4.69x   5.41x   5.10x   PepsiCo,  Inc.   2.03x   2.22x   1.82x   1.59x   1.65x   1.95x   1.91x   The  Coca-­‐Cola  Company   3.31x   4.27x   4.37x   3.48x   3.46x   3.94x   3.86x   Average   2.31x   2.74x   2.86x   2.90x   2.84x   3.24x   3.12x   Reed's,  Inc.   0.64x   0.87x   1.00x   0.48x   2.15x   3.04x    Discount   72.26%   68.28%   64.84%   83.49%   24.29%   6.33%    Discount  Average   72.22%   15.31%          Price/Sales   2014E   P/S  Peers  Median   3.12   Applied  discount   25%   Target  P/S   2.34   Sales  (millions)   $47.19     #  of  shares  outstanding  (millions)   13.5   Price  from  P/S   $8.19     Additional Explanations • For 2013, our multiples were based off of year-end 2013 market cap divided by the sum of YTD Q3 revenues and Q4 revenues of 2012. We did this because 2013 Q4 earnings reports have not come out yet for REED or its peers. However, we do not anticipate that this will be an issue as we assume that the multiples will not change very much after Q4 earnings reports come out.   Appendix 7: Weighting of Valuations Weighting  of  DCF  and  Multiples     Price  from  Relative  Valuation   $8.19     Weight  of  Relative  Valuation   50%   Price  from  DCF   $8.46     Weight  of  DCF   50%   Price  per  share  (end  of  2014)   $8.33     Price  per  share  (January  28,  2014)   $7.19     Potential  Upside   15.86%         Source:  Team  Estimates.  FactSet  
CFA Institute Research Challenge 31 January 2014 18     Appendix 8: Intermediate Sales Growth/Cost of Capital Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price   Cost  Of  Capital         12.96%   11.97%   10.98%   9.98%   8.99%   8.00%   7.65%   7.26%   6.76%   6.51%   6.02%   Intermediate   40%    $            5.89      $            6.78      $            7.90      $            9.36      $        11.32      $        14.10      $        15.36      $        17.06      $        19.70      $                21.30      $              25.31     Term   30%    $            3.99      $            4.60      $            5.36      $            6.35      $            7.69      $            9.58      $        10.43      $        11.59      $        13.38      $                14.47      $              17.20     Growth   25%    $            3.23      $            3.72      $            4.33      $            5.14      $            6.23      $            7.76      $            8.46      $            9.39      $        10.85      $                11.74      $              13.95     (2014-­‐2018)   23%    $            2.95      $            3.40      $            3.96      $            4.70      $            5.70      $            7.10      $            7.74      $            8.60      $            9.94      $                10.75      $              12.78       22%    $            2.82      $            3.24      $            3.79      $            4.49      $            5.44      $            6.79      $            7.40      $            8.22      $            9.50      $                10.27      $              12.22       20%    $            2.56      $            2.95      $            3.45      $            4.09      $            4.96      $            6.19      $            6.75      $            7.50      $            8.67      $                    9.37      $              11.15       19%    $            2.44      $            2.81      $            3.29      $            3.90      $            4.73      $            5.90      $            6.43      $            7.15      $            8.27      $                    8.94      $              10.64       18%    $            2.32      $            2.68      $            3.13      $            3.71      $            4.50      $            5.62      $            6.13      $            6.81      $            7.88      $                    8.52      $              10.14       15%    $            1.99      $            2.30      $            2.68      $            3.19      $            3.87      $            4.84      $            5.27      $            5.87      $            6.78      $                    7.34      $                  8.74       10%    $            1.50      $            1.74      $            2.03      $            2.42      $            2.95      $            3.69      $            4.03      $            4.49      $            5.19      $                    5.62      $                  6.70       5%    $            1.09      $            1.26      $            1.49      $            1.78      $            2.17      $            2.73      $            2.99      $            3.33      $            3.86      $                    4.19      $                  5.00       3%    $            0.94      $            1.10      $            1.29      $            1.55      $            1.90      $            2.39      $            2.62      $            2.92      $            3.39      $                    3.68      $                  4.40     This chart represents 2014E prices with a range of estimates of Intermediate Term Growth and a range of estimates of for Cost of Capital.   Source:  Team  Estimates  
CFA Institute Research Challenge 31 January 2014 19     Appendix 9: Long-Term Growth Rate/Long-Term Cost of Capital Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price   Long  Term  Cost  of  Capital       12.96%   11.97%   10.98%   9.98%   8.99%   8.00%   7.65%   7.26%   6.76%   6.51%   6.02%   Long     5%    $            5.49      $            6.10      $            6.91      $            8.05      $            9.74      $        12.56      $        14.05      $        16.30      $        20.56      $                23.73      $              34.72     Term   4.50%    $            5.23      $            5.76      $            6.46      $            7.41      $            8.78      $        10.92      $        11.99      $        13.54      $        16.24      $                18.09      $              23.61     Growth   4%    $            5.00      $            5.47      $            6.07      $            6.88      $            8.00      $            9.68      $        10.49      $        11.62      $        13.49      $                14.70      $              18.01     Rate   3.75%    $            4.89      $            5.33      $            5.90      $            6.64      $            7.67      $            9.17      $            9.88      $        10.86      $        12.45      $                13.46      $              16.14       3.50%    $            4.79      $            5.21      $            5.74      $            6.43      $            7.37      $            8.72      $            9.35      $        10.21      $        11.58      $                12.43      $              14.64       3.25%    $            4.69      $            5.09      $            5.58      $            6.23      $            7.09      $            8.32      $            8.88      $            9.64      $        10.83      $                11.56      $              13.41       3%    $            4.60      $            4.97      $            5.44      $            6.04      $            6.84      $            7.95      $            8.46      $            9.13      $        10.18      $                10.81      $              12.39       2.75%    $            4.51      $            4.87      $            5.31      $            5.87      $            6.61      $            7.63      $            8.08      $            8.68      $            9.61      $                10.16      $              11.52       2.50%    $            4.43      $            4.77      $            5.18      $            5.71      $            6.39      $            7.33      $            7.74      $            8.28      $            9.10      $                    9.59      $              10.77       2.25%    $            4.35      $            4.67      $            5.06      $            5.56      $            6.19      $            7.05      $            7.43      $            7.92      $            8.66      $                    9.09      $              10.13       2%    $            4.27      $            4.58      $            4.95      $            5.41      $            6.01      $            6.80      $            7.15      $            7.59      $            8.26      $                    8.64      $                  9.56       1.50%    $            4.13      $            4.41      $            4.74      $            5.16      $            5.68      $            6.36      $            6.65      $            7.02      $            7.57      $                    7.89      $                  8.62       1%    $            4.00      $            4.26      $            4.56      $            4.93      $            5.39      $            5.98      $            6.23      $            6.55      $            7.00      $                    7.27      $                  7.86     This chart represents 2014E prices with different estimates for Long Term Growth rates along with different estimates for cost of capital in the terminal scenario. Source:  Team  Estimates  
CFA Institute Research Challenge 31 January 2014 20     Appendix 10: Intermediate Term Growth/Long-Term Growth Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price     Long  Term  Growth           5%   4.50%   4%   3.75%   3.50%   3.25%   3%   2.75%   2.50%   2.25%   2%   1.50%   1%     40%    $        25.47      $        21.74      $        19.04      $        17.95      $        16.98      $        16.13      $        15.37      $        14.69      $        14.07      $                13.51      $              13.01      $        12.11      $        11.35     Intermediate   30%    $        17.31      $        14.77      $        12.93      $        12.19      $        11.54      $        10.96      $        10.44      $            9.98      $            9.56      $                    9.18      $                  8.83      $            8.22      $            7.70     Term   25%    $        14.06      $        11.99      $        10.49      $            9.89      $            9.36      $            8.88      $            8.46      $            8.08      $            7.74      $                    7.43      $                  7.15      $            6.65      $            6.23     Growth   23%    $        12.88      $        10.99      $            9.61      $            9.05      $            8.56      $            8.13      $            7.74      $            7.40      $            7.08      $                    6.80      $                  6.54      $            6.09      $            5.70     2014-­‐2018   22%    $        12.32      $        10.50      $            9.19      $            8.66      $            8.19      $            7.77      $            7.40      $            7.07      $            6.77      $                    6.50      $                  6.25      $            5.81      $            5.44       20%    $        11.25      $            9.59      $            8.38      $            7.90      $            7.47      $            7.09      $            6.75      $            6.45      $            6.17      $                    5.92      $                  5.70      $            5.30      $            4.96       19%    $        10.73      $            9.15      $            8.00      $            7.53      $            7.12      $            6.76      $            6.44      $            6.15      $            5.89      $                    5.65      $                  5.43      $            5.05      $            4.73       18%    $        10.23      $            8.72      $            7.62      $            7.18      $            6.79      $            6.44      $            6.13      $            5.86      $            5.61      $                    5.38      $                  5.17      $            4.81      $            4.50       15%    $            8.83      $            7.52      $            6.57      $            6.18      $            5.85      $            5.55      $            5.28      $            5.04      $            4.82      $                    4.63      $                  4.45      $            4.13      $            3.86       10%    $            6.78      $            5.77      $            5.03      $            4.73      $            4.47      $            4.24      $            4.03      $            3.85      $            3.68      $                    3.53      $                  3.39      $            3.14      $            2.94       5%    $            5.07      $            4.30      $            3.74      $            3.52      $            3.32      $            3.14      $            2.99      $            2.85      $            2.72      $                    2.60      $                  2.50      $            2.31      $            2.16       3%    $            4.47      $            3.79      $            3.29      $            3.09      $            2.91      $            2.76      $            2.62      $            2.49      $            2.38      $                    2.28      $                  2.19      $            2.02      $            1.88           This chart represents 2014E prices for different estimates of long and intermediate term sales growth.         Source:  Team  Estimates
CFA Institute Research Challenge 31 January 2014 21     Appendix 11: Capital Lease/Term Loan Payment Schedules Capital  Lease  Payment  Schedule       Term  Loan  Payment  Schedule   Year    Year  End  Balance   Payment     Year   Balance   Payment   2012   2,874,000         2012   575,000       2013                  2,784,000     90,000     2013   399,000   176,000   2014                  2,673,000     111,000     2014   195,000   204,000   2015                  2,539,000     134,000     2015   0   195,000   2016                  2,378,000     161,000    2017                  2,188,000     190,000    2018                  1,971,388                                  216,612      2019                  1,776,221                                  195,167      2020                  1,600,375                                  175,846      2021                  1,441,938                                  158,437      2022                  1,299,186                                  142,752      2023                  1,170,566                                  128,619                                               Source:  Team  Estimates  
CFA Institute Research Challenge 31 January 2014 22     Appendix 12: REED Porter Five Forces Analysis Barriers to Entry: Low-Medium ● Anyone may create new soft drinks as the only limitation is in patented flavors and brands ● Existing firms with large capital expenditures have economies of scale, direct supply and distribution channels set up ● Barriers are low with no consumer switching costs and zero capital requirements ● Prices are competitive and fluctuate slightly depending on location ● Major players have flavor identities giving them more recognition ● Major brands have positioned themselves in the main distribution channels including super markets, gas stations and restaurants ● Licenses, insurances, and FDA approval are required to produce and distribute products and cover potential lawsuits ● Existing firms have cost and performance advantage and are able experience economies of scale ● Bottling, distribution, and storage can be contracted out Intensity of Rivalry: High ● Costs for warehouse, trucks and labor may be substantial fixed costs ● Exiting the market may result in huge losses due to binding contracts, fixed costs and marketing costs ● Many beverage firms exists and are rolling out innovative products with trendy flavors ● Greater development and use of natural ingredients for health benefits ● Firms are focused on expanding their beverage portfolios ● Natural premium is growing and major firms have significant market share in CSDs, ready-to-drink teas, and energy drinks ● Equipment is firm specific and may be difficult to liquidate ● Customers would not incur high costs from switching from one player to another ● No need for significant customer-producer interaction since purchase products depend on tastes ● Market is a differentiated product oligopoly in promotional pricing and new brands ● Existence of well established distribution channels, relationships with suppliers, retailers, and brand value to customers ● Market shares in the industry are not more-or-less equally distributed among competitors. This is evident because there are three main firms that own approximately 87% of the industry, yet there are over 100 companies in the industry. Threat of Substitutes: High ● Substitutes do not have performance limitations or high prices ● Substitutes are not priced at a high enough cost where it would affect their use as a mainland product ● Customers would not incur costs in switching to substitutes as switching for a customer would be difference of cents. ● Substitutes such as water, ready-to-drink tea and coffee, sports drinks, and energy drinks exist ● Consumers are brand name loyal as they have consumed certain beverages as long as they can remember ● Players have a wide portfolio of products for consumers to choose from Bargaining Power of Buyers: High ● Soft drink market is the largest accounting for an annual sales of $60 billion ● Three firms control 89% of the United States soft drink sales ● Average American consumes over 56 gallons of soda a year ● Average soft drink costs under $2 which makes each individual purchase relatively immaterial ● All information such as nutrition facts and ingredients are listed on the label ● Manufacturing own soft drink is inconvenient considering how inexpensive the product is ● Customers are highly sensitive to the price of soft drinks and are willing to change brands if one becomes more costly ● Major players have developed significant brand loyalty ● Firms provide incentives to customers such as contests and admission discounts to theme parks enticing customers to choose a specific brand Bargaining Power of Suppliers: Low ● Inputs used to create products may by unique and extremely differentiated such as in formula, color, and flavor ● Product innovation is needed to satisfy consumer’s need for a variety of taste ● Firms can switch between suppliers very quickly and easily ● Suppliers to the industry are bottling equipment manufacturers and secondary packaging suppliers ● Surplus of suppliers exists that can provide same products ● Firms have power to select suppliers that do the best job at the best price ● Soft drink companies own a portion of their own supply companies enabling easy access to enter the supplier for the soft drink industry ● Suppliers main revenue come from delivering soft drink beverages and equipment for the firms directly to customers ● Soft drink main ingredients include carbonated water, spices, roots to name a few ● Suppliers are not concentrated or differentiated
CFA Institute Research Challenge 31 January 2014 23     Porter's  Five  Forces  Analysis   Rating   Barriers to Entry: Low-Medium 2   Intensity of Rivalry: High 5   Threat of Substitutes: High 5   Bargaining Power of Buyers: High 5   Bargaining Power of Suppliers: Low 1   Final  Rating:   3.6                     0   1   2   3   4   5   Barriers  to  Entry:  Low-­‐ Medium   Intensity  of  Rivalry:  High   Threat  of  SubsLtutes:   High   Bargaining  Power  of   Buyers:  High   Bargaining  Power  of   Suppliers:  Low   Porter's  Five  Forces  Analysis   Scale   Rating   High   5   Medium-­‐High   4   Medium   3   Low-­‐Medium   2   Low   1  
CFA Institute Research Challenge 31 January 2014 24     Appendix 13: Industry Five Forces Analysis 0   1   2   3   4   5   Buyer  Power   Supplier  Power   SubsLtute  New  Entrants   Degree  of  Rivalry   Force  Driving  CompeMMon  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011       0   1   2   3   4   5   Backwards  integraLon   Buyer  independence   Buyer  size   Financial  muscle   Low  Cost  switching  Oligosony  threat   Price  sensiLvity   Product  dispensability     Tendy  to  switch   Drivers  of  Buyer  Power  in  the     FuncMonal  Drinks  Market  in  the  U.S.,  2011   0   1   2   3   4   5   DifferenLated  input   Forward  integraLon   No  subsLtute  inputs   Oligopoly  threat  Player  dispensability   Player  independence   Supplier  size   Switching  costs   Drivers  of  Supplier  Power  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011    
CFA Institute Research Challenge 31 January 2014 25     Source:  Team  Estimates   0   1   2   3   4   5   UndifferenLated   Weak  brands   DistribuLon  accessible   LiYle  IP  involved   LiYle  regulaLon  Low  fixed  costs   Low  cost  switching   Market  Growth   Scale  unimportant   Suppliers  acessbile     Factors  Influencing  the  Likelihood  of  New   Entrants  in  the  FuncMonal  Drinks  Market   in  the  U.S.,  2011     0   1   2   3   4   5   Zero  sum  game   CompeLtor  size   Easy  to  expand   Hard  to  exit   Lack  of  diversity   Low  cost  switching  Low  fixed  costs   Number  of  players   Similarity  of  players   Storage  costs   UndifferenLated   product   Drivers  of  Degree  of  Rivalry  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011   0   1   2   3   4   5   Low  cost  switching   Beneficial  alternaLve    Cheap  alternaLve   Factors  Influencing  the  Threat  of   SubsMtutes  in  the  FuncMonal  Drinks   Market  in  the  U.S.,  2011  
CFA Institute Research Challenge 31 January 2014 26     APPENDIX 14: Price to Sales Multiple vs. Peer Group                                     Source:  FactSet   0.00x   1.00x   2.00x   3.00x   4.00x   5.00x   6.00x   2008   2009   2010   2011   2012   2013   2014  E   CompeLtor:  Price  to  Sales  MulLplier   Dr.  Pepper  Snapple  Group,  Inc.   Monster  Beverage  CorporaLon   PepsiCo,  Inc.   The  Coca-­‐Cola  Company   Reed's,  Inc.   Average  
CFA Institute Research Challenge 31 January 2014 27     APPENDIX 15: DuPont Analysis Source:  FactSet,  Team  Estimate DuPont Analysis 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E Equity Multiplier 1.39 2.30 2.28 2.87 3.11 3.37 4.18 4.64 4.81 4.67 4.79 4.72 4.30 3.70 3.06 2.45 2.52 Profit Margin -42.5% -25.0% -16.9% -6.4% -3.8% -1.7% -0.8% 1.1% 1.6% 2.1% 1.6% 1.9% 2.4% 2.9% 3.5% 4.1% 4.4% TAT 1.29 1.68 1.52 1.71 1.87 2.17 2.23 2.25 2.28 2.30 2.31 2.33 2.33 2.34 2.34 2.34 2.35 ROA -55.0% -41.9% -25.6% -11.0% -7.0% -3.8% -1.8% 2.4% 3.6% 4.8% 3.8% 4.5% 5.6% 6.8% 8.2% 9.7% 10.4% ROE -76.7% -96.3% -58.6% -31.6% -21.9% -12.8% -7.3% 11.0% 17.1% 22.3% 18.0% 21.2% 24.1% 25.2% 25.0% 23.8% 26.2%
CFA Institute Research Challenge 31 January 2014 28     DuPont Analysis Cont.                           Source:  FactSet,  Team  Estimates     Return  On  Equity   -­‐7.3%  11.0%  17.1%   22.3%  18.0%  21.2%   24.1%  25.2%  25.0%   23.8%  26.2%   Return  On  Assets   -­‐1.8%  2.4%  3.6%   7.8%  3.8%  4.5%   5.6%  6.8%  8.2%   9.7%  10.4%   Profit  Margin   -­‐0.8%  1.1%  1.6%   2.1%  1.6%  1.9%   2.4%  2.9%  3.5%   4.1%  4.4%     Asset  Turnover   2.23  2.25  2.28   2.30  2.31  2.33   2.33  2.34  2.34   2.34  2.35   Equity  MulKplier   4.8  4.64  4.81   4.67  4.79  4.72   4.30  3.70  3.06   2.45  2.52   Legend  (Years) '13   '14   '15 '16   '17   '18 '19   '20   '21 '22   '23
CFA Institute Research Challenge 31 January 2014 29     APPENDIX 16: Margin & Sales Forecasts -­‐5%   0%   5%   10%   15%   20%   25%   30%   35%   40%   Annual  Sales  Growth   Sales  Growth   Actual   Forecast   0.0%   5.0%   10.0%   15.0%   20.0%   25.0%   30.0%   35.0%   40.0%   Gross  Margin   Gross  Margin   Actual   Forecast  
CFA Institute Research Challenge 31 January 2014 30     Source:  FactSet,  Team  Estimates   -­‐50%   -­‐40%   -­‐30%   -­‐20%   -­‐10%   0%   10%   20%   OperaKng  Margin   OperaKng  Margin   Actual   Forecast   -­‐50.0%   -­‐40.0%   -­‐30.0%   -­‐20.0%   -­‐10.0%   0.0%   10.0%   Net  Margin   Net  Margin   Actual   Forecast  

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Cal Poly Pomona 2014 CFA Institute Research Challenge Equity Research Report - Reed's Inc. (REED)

  • 1.
    California State PolytechnicUniversity, Pomona Student Research This report is published for educational purposes only by Students competing in the CFA Institute Research Challenge. Company: Reed’s Inc. 1     Source: FactSet, Yahoo Finance Source: FactSet Key Financial Ratios 2012 2013E 2014E P/S 2.15 3.04 2.65 D/E 1.48 2.04 2.36 ROE -12.8% -7.3% 11.0% ROA -3.8% -1.8% 2.4% EPS $-0.05 $0.00 $0.04 Source FactSet, Team Estimate Valuation DCF P/S Estimated Price $8.46 $8.19 Weights 50% 50% Target Price $8.33 Source: Team Estimate Market Data Price Jan 28 2014 $7.19 52 Wk Range $3.80 - $8.98 Avg Daily Volume (3 Month) 84,727 Beta 0.93 Shares Outstanding 12.88 M Shares Out - Diluted 13.5 M Market Cap $92.6 M Ownership % Insiders 33.4% Institutional 7.81% RECOMMENDATION: HOLD Exchange NYSE MKT Price (1/28/14) $7.19 Ticker Symbol REED 2014 Year-End Target Price $8.33 Sector Consumer Non- Durables Upside Potential 15.86% Industry Beverage: Non- Alcoholic Highlights We issue a HOLD recommendation for Reed’s, Inc. (REED) with a 2014 year-end target price of $8.33. This offers potential upside of 15.86% from the January 28th closing price of $7.19. REED shows signs of high growth with new distribution deals and increased demand for its products, but detrimental risk factors and weak margins have dampened the outlook on this up-and-coming firm in the beverage industry. High Growth Already Priced In? Changes in the tastes and preferences of the U.S. population towards healthier foods and beverages should drive sales growth in REED’s market segment. Because of this, we estimate high growth in the REED product lines, particularly in kombucha. REED is well positioned to capture kombucha growth with its competitive advantages over most other current producers. Although we predict high growth for REED, our recommendation is HOLD because our model suggests much of the firm’s growth is already being accounted for by its current market price. Financial Position Although we expect increases in sales and improvement in gross and net margins over time, poor liquidity ratios create additional short-term issues for the company. The Current Ratio was at 1.32 in 2012, but the Quick Ratio was only 0.50 because much of the Current Assets were tied up in inventory. Over the past 5 years, the average Quick Ratio has only been 1/3 of its peers. REED is more highly levered than its peers and will require debt financing to expand operations. In 2012, the D/E ratio was 1.48 vs. 5-year peer average of 0.69. Key Risks REED has several risks that may impede its future profitability. • The recent resignation of CFO Jim Linesch gives us serious concerns about the stability of management. We believe that there is potential for high growth in REED’s target market, but the firm will require a strong management team to effectively guide the company through its high growth phase and transition towards profitability.
  • 2.
    CFA Institute ResearchChallenge 31 January 2014 2     Figure 1: REED Revenue Breakdown Source: REED Financial Statements Figure 2: REED Product Growth Projected Annual Growth Rates for REED Products Core Brand Sodas 15%-20% Kombucha 50-100% Private Labels 35-40% Source: Company Guidance • REED has struggled with production shortfalls and if these continue they may significantly limit the growth potential of the firm. • Concerns regarding corporate governance lead us to believe that the Board of Directors is not adequately reviewing and advising executive management. Business Description Reed’s, Inc. (REED) is an American beverage company that develops, produces, and sells top selling beverages in the natural premium beverage category. They offer 24 types of all natural non-alcoholic soft drinks and seven product lines that include Reed’s Ginger Brews, Virgil’s Root Beer and Cream Sodas, Dr. Better and Real Cola, Culture Club Kombucha, China Colas, Reed’s Ginger Chews, Reed’s Ginger Ice Creams and Sonoma Sparkler Sparkling Juices. REED also operates a growing private label business. REED products are sold in more than 14,000 gourmet and natural food stores, grocery stores, supermarket chains and specialty stores throughout the United States, and to a lesser degree, in Canada and Europe. Distribution channels for REED are national natural foods distributors and an increasing number of regional mainstream direct store delivery (DSD) distributors. Its customer base is served by about 10,500 natural and mainstream supermarkets. New product developments such as kombucha, expansion in distribution channels, and trade and consumer promotions are expected to fuel future sales growth. Core Natural Premium Sodas REED has been #1 in sales for natural soda since 1992. Their Ginger Brews and Virgil’s Sodas currently make up 80% of sales, while Culture Club Kombucha and private labels each account for 10%. The company’s non-alcoholic ginger sodas are brewed using fresh ginger, spices and fruits in a unique brewing process that sets REED apart from other commercial soft drink brands. Each 12-ounce bottle contains between 8 and 26 grams of fresh ginger. They use pure cane sugar as a sweetener, and color the drinks naturally from herbs, fruits, spices, roots and juices. REED does not use injection based carbonation or preservatives in their ginger beverages. Company guidance estimates its core soda brands will grow at 15-20% in 2014. Kombucha REED entered the kombucha market in fall 2012 with its Culture Club Kombucha line. Their existing national distribution and experience in natural beverages has given REED a competitive advantage in this segment. The Culture Club Kombucha line was introduced into 800 new retailers throughout the U.S. and into select Whole Foods Markets in 2012. In Culture Club Kombucha’s first year, 200,000 cases were sold, penetrating 50% of natural food stores. Although REED is currently #2 in kombucha sales nationally, GT’s Synergy Drinks controls most of the kombucha market share. As of 2013, REED accounts for only $5 million in sales in this $300 million category. The company plans on capturing more market share in this segment with its flavor innovations, signature branding, and new distribution deals. Company guidance suggests a growth rate of 50-100% for its kombucha products in 2014. Private Label Products REED started producing private label products in 2009. REED has seen increases in sales within this segment with sales of $200,000 in 2009 growing to $5.2 million in 2012. They now have 10 private label customers as opposed to four in 2012. Outlook for REED’s private label segment looks optimistic as revenues in the first half of 2013 increased by 50% compared to 2012. Company guidance suggests a growth rate of 35-40% for its private label products in 2014. Current Strategies: • Stimulate consumer demand and awareness for existing brands and products through promotions and advertising – REED will continue to aggressively promote and advertise its Culture Club Kombucha and core brands through non-traditional and alternative channels to attain high sales growth. • Increase direct sales relationships and expand market – Products are distributed through natural and specialty food stores, mainstream markets and warehouse clubs. In August 2013, REED announced a distribution agreement with Kroger Supermarkets, one of the largest grocery chains, to carry four flavors of kombucha in nearly 1000 locations. REED continues to expand its sales channels with recently reached agreements with Haggen Food & Pharmacy and Ingles Markets, Inc., to distribute kombucha throughout Washington, Oregon, and the Southeast United States. 79%   10%   10%   1%   REED'S INC. PRODUCT LINES-2013 REED  Core  Brands   Culture  Club  Kombucha   Private  Labels     Other  
  • 3.
    CFA Institute ResearchChallenge 31 January 2014 3     Figure 3: U.S. Beverage Market Volume Source: Marketline Figure 4: U.S. CSD Consumption Source: Beverage Marketing Corp. Figure 5: Volume Change by Segment Source: Beverage Marketing Corp. • Expand their national distribution networks by adding regional direct store delivery (DSD) accounts – Recent expansions of REED DSD network has resulted in a 50% increase in sales from this channel in 2012. REED has continued to add DSD accounts in North America; its most recent agreement was reached in early 2014 with Manhattan Beer Distributors to distribute eight Culture Club Kombucha flavors in metropolitan New York. Industry Overview & Competitive Positioning Beverage Industry - Carbonated Soft Drinks (CSD) on the Decline Coca-Cola (KO), PepsiCo (PEP), and Dr. Pepper Snapple Group (DPS) represent 87% of the CSD market. These leading producers have invested heavily in advertising to drive brand loyalty and have purchased several minor market players. The beverage industry is considered a consumer staple, and historically the demand for products has been relatively inelastic. Although the beverage industry grew by 1% to 29.8 billion gallons sold in 2012, the carbonated beverages segment declined by 1.8% during the same period. According to BevNET magazine, CSD’s are expected to fall below 50% of the market for volume in 2017 and 50% of the market in revenue in 2018. This can be attributed to natural and healthier alternatives that have steadily gained market penetration in recent years. According to the Beverage Marketing Corporation, the alternative beverage category of the market was estimated to be approximately $34.4 billion in 2012, an 8.3% increase from 2011. Alternative beverages include energy drinks, bottled water, juices, sports drinks, ready-to-drink teas and coffee teas. Additionally, beverages containing probiotics are gaining recognition due to perceived health benefits. Increases in public awareness of sugar induced issues such as obesity and diabetes is expected to drive down carbonated beverage consumption further. Functional Beverage Resilience While the carbonated beverage sector is starting to decline, the functional sector is experiencing high growth. According to IBISWorld, over the next five years the beverage industry will see many state and local governments attempt to limit the sales of CSD’s due to growing health concerns. Health conscious consumers have been willing to spend on higher priced healthy options due to endorsements from medical experts on the importance of proper nutrition. Even though there is a declining trend in sales for CSD consumption, the functional beverage markets may hold an insulated position. Strong Growth Opportunities in Kombucha Kombucha signals the arrival of a new generation of functional beverages, utilizing ingredients with active constituents-carbs, caffeine, antioxidants, alcohol, various natural acids and beneficial yeasts and bacteria. Kombucha is the fastest growing segment in the $609 million functional juice and beverage category. Of that segment, REED ranks second in Kombucha with its current $5 million in sales in a $300 million category. Kombucha is gaining shelf spaces in healthy food stores and natural gourmet food stores. According to BevNET, Kombucha sales are expected to reach $500 million by 2015. High sales growth is beginning to attract the attention of the large players in the beverage industry. Overview of Competitors Dr. Pepper Snapple Group, Inc. (DPS) is the third largest soda business in the U.S. and Canada. IBISWorld reports that DPS accounts for a 14.8% market share in beverages. According to Nielsen’s 2012 retails sales, they make up 39.8% market share in flavored CSDs. The company continues to build and enhance their leading brands while developing premium value teas and juices. Currently, they hold the top ginger ale beverage and their Snapple brand leads in ready-to- drink tea. Monster Beverage Corporation has $1.9 billion sales in energy drinks, $110.2 million in non- carbonated beverages, and $31 million in carbonated beverages. Their direct store delivery segment generates 95% of 2012 revenues, up from 90% in 2008. They also have an agreement with Coca-Cola to distribute their products in 70 countries. Monster will continue to add new flavors and improve their products that compete in the functional beverage category. Their Hansen’s Brand Sodas have been the leading natural soda brand on the West Coast for over 30 years and currently have 6.9% market share in the functional drinks category. Like REED, Hansen’s sodas are sweetened with cane sugar, contains no preservatives, caffeine or artificial flavorings. They also offer organic natural sodas under their Blue Sky Products Brands. PepsiCo, Inc. is the #2 carbonated soft drink maker with a 41.7% market share in the functional drinks category and 30.3% market share as the largest non-alcoholic drink producer. They have plans to expand in healthy and premium priced products as well as products for aging consumer demographics. Pepsi operates in the natural soda segment through its subsidiaries, SOBE and -­‐4.0%   -­‐3.0%   -­‐2.0%   -­‐1.0%   0.0%   1.0%   2.0%    28,000.0      28,500.0      29,000.0      29,500.0      30,000.0      30,500.0     2007  2008  2009  2010  2011  2012   %  CHANGE   GALLONS  (IN  MILLIONS)     YEAR     U.S. Liquid Refreshment Beverage Market: Volume and growth Gallons  (in  millions)   %  change   0   10   20   30   40   50   Gallons     Years   U.S. Per Capita Consumption of CSDs -­‐10.0%   -­‐5.0%   0.0%   5.0%   10.0%   15.0%   20.0%   %  change  from  2011-­‐2012     Segments     U.S. Liquid Refreshment Beverage Market: Change in volume by segment Energy  drinks   Ready-­‐to-­‐drink  coffee   BoWled  water   Ready-­‐to-­‐drink  tea   Sports  drinks   Value-­‐added  water   Carbonated  so[  drinks   Fruit  beverages  
  • 4.
    CFA Institute ResearchChallenge 31 January 2014 4     Figure 6: 2011 Packaged Beverage Sales Source: Nielsen Figure 7: U.S. Functional Beverage Forecast Source: Marketline Figure 8: U.S Functional Market Share Source: Marketline IZZE. SoBe started producing functional drinks in 1997, releasing products that contained exotic herbs, vitamins and minerals. IZZE was acquired in 2006 and its products mix carbonated spring water with 100% fruit juices. These beverages are primarily sold in the US, Canada, Caribbean and the South Pacific. The Coca-Cola Company is the #1 nonalcoholic beverage company, as well as one of the world's most recognizable brands. Coca Cola owns 16 “billion dollar brands”, including four of the top five soft drinks: Coca-Cola, Diet Coke, Fanta, and Sprite. Other top brands include Minute Maid, PowerAde, and Vitaminwater. With the world's largest beverage distribution system, the Coca- Cola Company reaches more than 200 countries. Coca-Cola operates in the natural beverage market through its subsidiary Odwalla. Odwalla, Inc. offers natural juices, juice drinks, fruit smoothies, garden organics, protein drinks, soy-based drinks, nutrition bars, smoothie refreshers, and superfoods. Jones Soda Co. markets and sells brightly colored sodas with wacky names and flavors. The soda maker’s beverages are sold in the US (75% of sales) and Canada where they are distributed through a network of more than 185 independent distributors. Outside the US they have distributors in the UK, Ireland and Australia. Sales have gone down 57% since 2007 to $17.4 million in 2011. The company has not recorded a profit in the last five years. GT’s Synergy Drinks is the industry leader of Kombucha drinks. In 2009, Americans bought more than a million bottles of GT’s Kombucha. Established in 1995, they have distribution channels all across 50 states. In 2008, their Kombucha drinks realized $66.1 million in sales. Investment Summary Conflicting Signals We issue a HOLD recommendation for Reeds, Inc. with a 2014 year-end target price of $8.33. This offers potential upside of 15.86% from January 28th closing price of $7.19. REED shows signs of high growth with its new distribution deals and increased demand for its products, but high levels of risk and weak margins weigh the firm down. Between January 2012 and December 2013, we saw REED take huge strides as it closed deal after deal with distribution companies throughout the US and Canada along with entering the kombucha market. With these newly added opportunities for growth, REED stock price soared by 611.71% during this time period. We believe that much of REED’s expected growth is already priced in and that there is not much room for additional gain. Valuation methods Our target price was estimated by assigning both our DCF valuation and relative valuation models a 50/50 weighting. We realize that for relative valuation, price to sales is limited to only looking into a company’s revenues. However, we accounted for this by applying a discount for REED poor net margin, among other factors. For this reason, we could not find a reason to apply more weighting to one valuation method over the other. Strong Outlook for Product Line With consumers becoming increasingly cognizant of their well being, demand for more healthy foods and beverages has gone up. REED, being the top seller of premium natural sodas, has positioned itself well to capitalize on this growth. On top of that, REED explores another growing market in functional beverages with his Culture Club Kombucha line. Since adding it in 2012, REED has already seen moderate success with its growth expected to exceed 50% in 2014. Financial Position Weak gross, operating, and net margins compared to the beverage industry average have resulted in negative earnings since REED went public in 2006. While we expect margins to improve, we do not currently see a mechanism to allow REED to operate at gross margins similar to its large competitors. REED has relatively high levels of debt and must take on more debt to expand. We expect it to be several years before REED generates enough cash flow to pay down debt and move towards a long-term sustainable capital structure. Our model suggests that the average D/E ratio for next 10 years to be 2.30. This is more than three times the peer group average 5-year D/E ratio of 0.69. Investment Risks REED is a high growth company that currently does not have any earnings, and therefore has many serious risks to future profitability. Given the high growth niche segment that REED operates in, it is difficult to estimate several key growth factors that drive the stock price. REED also has several operational and strategic risks, such as recent production shortages and a sudden change in executive management that may deter the firm’s future growth. These risks are further discussed in the Investment Risks section. 43.9%   14.5%   13.3%   10.8%   9.5%  5.9%   2.1%   %  DOLLAR  SALES  PACKAGED   BEVERAGES  (2011)   Carbonated  drinks   Alterna]ves  (energy  drinks,  etc.)   BoWled  water   Juice  drinks   Sports  drinks   Iced  tea  (ready-­‐to-­‐drink)   Other  
  • 5.
    CFA Institute ResearchChallenge 31 January 2014 5     Figure 9: Team Criteria Recommendation Criteria Price Range Jan. 28, 2014 Price $7.19 20% Upside Price Above $8.63 BUY 10% Downside to 20% Upside Price $6.47- $8.63 HOLD 10% Downside Price Below $6.47 SELL Source: Team Estimates Figure 10: 2014E Target Price Source: Team Estimates Figure 11: Sales Growth Forecast Source: FactSet, Team Estimate Figure 12: Gross Margin Forecast Source; FactSet, Team Estimate Valuation DCF P/S Estimated Price $8.46 $8.19 Weights 50% 50% Target Price $8.33 Acquisition Premium While we view REED as a likely candidate for acquisition and that an acquisition premium may cause the price of REED to meet our BUY criteria, we do not believe that just the possibility of a future acquisition is enough to change our investment recommendation. Criteria We assign a BUY rating to a stock that exhibits a 20% or greater potential upside. While BUY ratings may typically be issued to a stock with 15% upside, we believe that small cap stocks are inherently more volatile and therefore require a higher return before issuing a buy. We assign a HOLD recommendation to a stock with less than 20% potential upside to a 10% potential downside. We assign a sell rating to a stock with potential downside greater than 10%. Valuation In order to arrive at a year-end 2014 target price for REED we used two valuation models; Discounted Cash Flows through a Free Cash Flow to Equity Model and Relative Valuation using Price/Sales Multiples. Free Cash Flow to Equity Model We evaluated REED using a 3-stage Discounted Cash Flow Analysis. A Free Cash Flow to Equity (FCFE) model was chosen because we expect REED to have a period of high growth and transition from being an unprofitable company to a profitable one. FCFE is a useful model for high growth companies as long as the capital structure does not drastically change over the forecasted period. Company guidance has suggested that the capital structure of REED should remain similar to current conditions for the near future, although new expansion would be financed by debt. We estimated free cash flows by forecasting the determinants of net income, CAPEX, and working capital. Determinants of Net Income include revenue growth, margin improvement, and expected interest payments based upon our estimated debt levels. Given these estimates we forecast the year-end target price for REED at $8.46 per share. Given a January 28, 2014 closing price of $7.19, this price would imply 18% potential upside (See Appendix 5). Sales Forecast Sales revenues were forecasted using a 3-stage growth model. In the first stage, REED sales growth was estimated at 25% for the next 5 years. 25% growth was derived from a combination of the FactSet future year estimated growth rates and REED historic growth. We believe this number to be reasonable given the growth rate of natural products within the beverage industry and REED’s strong competitive advantages in the natural foods segment. This growth is supported by our expected growth for the kombucha product over the next 10 years and REED’s position in this market. For years 2019-2022 our model assumes that the growth rate will decline by 5% each year. As REED revenues grow, the growth rate will naturally decline as market share in the natural foods segment matures. For years 2023 and on we used 3% as an average long-term growth rate to reflect historical long-term real growth in the US economy. Depreciation We assume that REED will continue to depreciate its assets similar to its rates in 2012 and 2011. In these years, depreciation was 22% and 19% of fixed assets, respectively. In our forecasted period depreciation ranges from 18-19% of fixed assets. Gross Margin Historically, REED gross margin has been much lower than its competitors. With the large beverage companies like Coca-Cola, Pepsi, Dr. Pepper Snapple and Monster each having a gross margin of over 50%, it makes REED historical gross margin average of 23.2% look small in comparison. Due to REED’s size and premium nature of its products, we do not see it being realistic for REED to reach margins of this level. However, REED has been able to improve that figure to 32% in its most recent earnings report due to increasing production efficiency and decreasing transportation costs. We expect to see gross margin steadily increase to 38% by 2023 driven by expected sales growth on REED branded products. Selling, General & Administrative (SG&A) Expense Growth Currently, SG&A expenses have held constant at 30% of sales during the years ending in 2011 and 2012. SG&A expenses had increased to 31.5% of sales through the first three quarters of 2013, but much of this increase is related to additional trade show and advertising expenditure due to a new product rollout. Company guidance has suggested that advertising will remain at similar levels for the near future, unless an extraordinary opportunity arises. Large companies in the industry, such as Coca-Cola and Pepsi typically have SG&A to sales ratios of 36-38%. This cost can be attributed to the higher level of advertising that mainstream manufacturers engage in. Monster, a comparable company in the energy drink submarket, operates at 25% SG&A to sales. We believe holding SG&A to sales at 30% is a reasonable estimate for REED. -10% 0% 10% 20% 30% 40% Sales Growth Actual Forecast 0.0% 10.0% 20.0% 30.0% 40.0% Gross Margin Actual Forecast
  • 6.
    CFA Institute ResearchChallenge 31 January 2014 6     Figure 13: Financing Terms REED Financing   Rate Line of Credit Prime + 3.75% Term Loan Prime + 11.6% Term Loan shall not be below 14.85% Source: REED Financial Statements Figure 14: P/S REED vs. Peers Source: FactSet Figure 15: REED vs. Peer Key Numbers Reed vs. Peer Group 2008-2011 Reed Peers Net Margin -13% 14% Payout Ratio 0% 33.50% D/E 1.08 0.66 Beta 0.93 0.79 Source: FactSet Interest Expenses REED currently pays 7% on its $4.5 million dollar short term revolving line of credit and 14.85% on its long-term debt. Both of these rates are floating. We assume additional debt financing will be available at 14.85%. REED also has interest expenses resulting from its capital leases of property and equipment. REED uses a rate of 9.9% to account for its interest expense for its capital leases. Tax Advantage Due to previous losses, REED may be able to realize a carried loss of $5.3 million against projected earnings in 2014-2016. Our model assumes that this will result in no taxes due in 2014- 2016. Cost of Equity Cost of Equity was estimated at 7.65% by using CAPM model. For risk free rate, US 10 year Treasury bond rate of 3.04% from year-end 2013 was used. Market risk premium of 4.96% was used from Damodaran’s 2014 market premium forecast. Beta of .93 was used from FactSet estimate. A regression analysis was attempted to estimate beta against the S&P 500 (^GSPC), but the results were not considered useful as our regression coefficient of determination was 1.1%. We consider Damodaran and FactSet to be reliable sources for these estimates. Dividend Policy Company guidance suggests that REED will not pay any dividend on common stock for the foreseeable future. Our model assumes that no dividend will be paid in forecasted period. Capital Expenditures (CAPEX) During the one-on-one meeting that we had with REED management, it was suggested that the company would finance new expansion by issuing debt as opposed to diluting shareholders. We believe that the forecasted future debt levels of REED are reasonable given its high growth, and as the company becomes profitable it will be able to pay down debt. Balance Sheet For our model we have assumed that all assets and short-term liabilities will remain a constant percentage of sales. Multiples Valuation This model seeks to arrive at a valuation by comparing how similar companies are priced in the market. Peer Group Selection It is imperative to select a set of similar firms in order to obtain a more precise market-based valuation. However, REED is a very unique company in which it encompasses a small niche within the beverage industry. This makes it difficult to find companies that strongly resemble REED. Companies that we did find to be similar to REED were either private, subsidiaries of larger companies, or too small for analyst coverage. We declined to use these companies due to the difficulty in obtaining forward projections. For this reason, we chose its peer group to be its biggest competitors within the beverage industry. This list includes Coca-Cola, Dr. Pepper- Snapple, Pepsi, and Monster. What Multiples to Use? Due to REED being a company that has historically had negative earnings with a small book value, both its earnings multiples and book value multiples are unreliable. We felt it most appropriate to use the Price to Sales multiple given how the company resembles a start-up along with its historical poor earnings. The advantages of using this method include that it is much less volatile than earnings multiples and harder to manipulate through accounting methods. However, we are aware that this multiple has its limitations as it does not account for a company’s debt levels or cost structures and plan to account for these factors in our valuation. Price to Sales Multiple Historically, REED has been trading at a discount to its peers. Between the years of 2008 to 2011, the average P/S discount was 72.22%. There were several reasons for this: • Significantly smaller net margin due to negative profits (-13.0% avg. vs. 14.0% avg.) • Non-existent payout ratio as REED did not pay out dividends (0% avg. vs. 33.5% avg.) • Higher total debt to equity ratio (1.08 avg. vs. 0.66 avg.) • Greater amounts of systematic risk (0.93 vs. 0.79) 0   1   2   3   4   2008   2009   2010   2011   2012   2013   2014  E   Price to Sales Reed's,  Inc.   Peers  
  • 7.
    CFA Institute ResearchChallenge 31 January 2014 7     Figure 16: Effects of CFO Resignation REED P/S discount after CFO announcement Price (1/27/2014) $6.82 # Shares (million) 13.5 Market Cap (1/27/2014) $92.07 2013E Sales (million) 37.75 Implied P/S 2.44 2013E Peers P/S multiple 3.24 Implied Discount 25% Source: FactSet, Team Estimates Figure 17: P/S Discount P/S Discount Sensitivity Analysis Applied Discount 2014E Price Potential Upside 40% $6.55 -8.8% 35% $7.10 -1.2% 30% $7.65 6.3% 25% $8.19 13.9% 20% $8.74 21.5% 15% $9.28 29.1% 10% $9.83 36.7% Source: Team Estimates Figure 18: Weighting Sensitivity Sensitivity of Weighting on Target Price DCF Weight Relative Weight Target Price 20% 80% $ 8.24 30% 70% $ 8.27 40% 60% $ 8.30 50% 50% $ 8.33 60% 40% $ 8.35 70% 30% $ 8.38 80% 20% $ 8.41 Source: Team Estimates Figure 19: Implications of Acquisition Acquisition Premium Premium Price Potential Upside 0% $8.33 15.86% 5% $8.75 21.65% 10% $9.16 27.44% 15% $9.58 33.23% 20% $10.00 39.03% 25% $10.41 44.82% 30% $10.83 50.61% Source: Team Estimates From 2012 onward, REED has been trading at a much smaller discount to its peers with an average discount of 15%. We believe that this is due to the following reasons: • Improving net margins (from -25.0% in 2008 to -1.7% in 2012) • Higher expected growth due to new distribution agreements, a new private label partnership with one of the largest supermarket chains in the country, and the addition of kombucha to its product line Although REED’s average D/E Ratio grew to 1.6 during this time period, we feel that the improvements in net margin and expected growth more than made up for this factor to justify a 15% discount. For our year-end projection, we forecast REED to sustain its high level of growth due to an increasing demand for kombucha and natural sodas. Also, we expect net margin to continue to improve as revenues grow. Based off these factors, we decided to apply a 15% discount to year- end 2014, similar to the average of the discounts in 2012 and 2013. However on January 21, 2014, it was announced that REED CFO of 5 years, Jim Linesch, was leaving the company. Given that the CFO had just bought over $200,000 worth of shares 19 days prior to this announcement, we can assume that this decision was very abrupt. This poses a red flag as there appears to be serious management problems within REED. We feel that this added risk warrants an additional 10% discount. This estimation of 10% was derived from using the following calculations: • Taking REED market cap by end of January 27, 2014 • Divide it by our 2013E sales forecast to get to an implied current P/S ratio for REED • Found the discount of this P/S in comparison to the 2013E average peer group P/S ratio The resulting discount of REED was 25%, 10% more than its average discount to its peers for the past 2 years. Since there was a large price change after the announcement of resignation, we believe that the market was applying this added discount based upon similar concerns about management. We also believe that continuing to use this 25% multiple discount for 2014 is appropriate. This would give us a 2014 year-end target price of $8.19. This implies potential upside of 13.9% relative to January 28th, 2014 close price of $7.19 (See Appendix 6). Weight of Models We obtained a final one-year target price by taking a weighted average of our DCF and relative valuations. We utilized equal weights for both our DCF and P/S model. We believe that both of our models are rigorous and appropriately consider the major factors in valuation of REED. We performed a sensitivity analysis to determine how the weighting of our models would change our target price and discovered that any changes in weighting would not result in a change of investment recommendation based upon our stated criteria. While it was difficult to find a strong comparable group for REED, we feel we have correctly applied an appropriate discount relative our chosen group. Combining our forecasts gives us a 2014 year-end target price of $8.33. Given a January 28 price of $7.19 this represents 15.9% potential upside (See Appendix 7). Additional Upside - Acquisition Premium Historical acquisition premiums in the beverage industry have been known to range from 25%- 30% above market price per share. In 2001, Odwalla, an American food product company that sells fruit juice, was acquired by The Coca-Cola Company for $18 million. The company was purchased at a premium of 28.9%. More recently Jim Beam was purchased for $16 billion by a Japanese company, Suntory Holdings Ltd. The company paid a 25% premium. Other acquisitions in the beverage industry include SoBe and Izze sparkling juices, all of which were acquired under the PepsiCo brand. Izze was purchased at an estimated price of $75 million and SoBe was acquired around $370 million for a 90 percent stake, about 12 times its EBITDA. With a market size of $92.6 million, REED’s relatively small size also makes the company a great acquisition target. Competitors such as the Coca-Cola Company and PepsiCo have the resources and ability to purchase a small-cap company. As ownership is concentrated amongst a few large shareholders, it is easier to gain majority approval and consensus in voting decisions. REED has developed a strong brand identity in the functional beverage and kombucha segment. This can lead to high growth potential in a fairly new and developing market. Industry leaders in the beverage market looking to differentiate into functional drinks would value the acquisition of REED to their business. As a small-cap company, REED may also not have the resources that many of the large competitors may have. Unlocking value in REED through expanded distribution networks, marketing, and additional capital could also provide grounds for the company to be acquired. Possible synergies would give large competitors incentive to acquire as well.
  • 8.
    CFA Institute ResearchChallenge 31 January 2014 8     Figure 20: Net Income Forecast Source: FactSet, Team Estimates Figure 21: REED Gross Margin Forecast Gross Margin 2012 2013E Terminal REED 30% 31.5% 38% Peer Group 5-Year Avg. 56.09% Source: FactSet, Team Estimates Figure 22: REED Liquidity Ratios Source: FactSet Given this information, we believe REED is an attractive acquisition target, and could potentially have 15-30% additional upside from an acquisition premium. However, there are also several risks that may impede an acquisition or result in a lower premium. These risks are further discussed in our Investment Risks section. Financial Analysis Future Earnings While REED has reported negative net income in the past, it has been consistently improving these figures over the last 6 years. Between 2007 and 2012, REED went from net income of - $5.58 million to -$0.57 million. We expect earnings to increase as revenues rise because REED closely resembles a start-up company in its high growth stage. Due to a higher demand of natural sodas and kombucha, we do not anticipate sales growth slowing down in the near future. This will boost net income with 2014 expecting to be REED’s first year of positive earnings. Given our sales growth and margin forecasts we estimate that REED will grow from a current net margin of 0% to 1.93% in 2018, with earnings of $2.27 million. Sales Growth REED sales growth has been consistently over 15% for the time periods 2007 to 2012, which is well above the industry average of 1% for beverage companies. However, sales in 2009 had declined due to the effects of the U.S. recession. We believe these growth trends will continue at a high level because of favorable market trends for REED product lines, their position as a market leader in the natural sodas market, and their established national distribution network. This is reflected in the forecasted growth rates for years 2013-2018. We expect that REED’s growth in sales can be heavily attributed to their position in the kombucha market segment, the fastest growing product in functional beverages. Improving Gross Margin We believe the relatively low gross margin is the most important factor limiting REED’s earning power. In 2012 REED gross margin was 30.47%, which was well below the average of large beverage manufacturers. However, gross margin has increased from 15% in 2007 to 30% in 2012, and we expect this trend to continue. REED uses promotional allowances as a direct reduction in sales. Due to new product rollouts, higher allowances have lowered gross margin. There has been a history in kombucha production inefficiencies that hindered gross margin. Third quarter 2013 results show a gross margin of 32%, leading us to believe that these inefficiencies have been corrected. REED has invested heavily in expanding production capacity in its west coast plant. Capital expenditures totaled $507,000 in 2012 and $447,000 through the first nine months of 2013. These enhancements should decrease transportation costs because they reduce shipments from the east coast co-packing facility. Increases in branded product sales will improve gross margins in the forecasted period due to higher margins on branded as opposed to private label offerings. Their Culture Club Kombucha is expected to have the highest sales growth, and should improve branded sales. Beverage industry peers Coca-Cola, PepsiCo, Dr. Pepper Snapple and Monster have a gross margin of over 50%. This may not be realistic for REED given its size and premium nature of its products. Company executives suggested in the 2013 third quarter conference call that they would like to see gross margin being closer to 40%. We have forecasted a steady trend towards an estimate of 38% in the terminal stage of our valuation model. This estimate allows for realistic and attainable increases of 0.5% per year from 2014 to 2023 (See Appendix 16). Efficiency Ratios REED has a 5-year average Total Asset Turnover Ratio of 1.79 compared to peer group average of 0.92. This implies REED is managing its assets efficiently compared to the large beverage manufacturers. REED also has a higher Receivables Turnover and lower Payables Turnover compared to peer average. This demonstrates REED collects its receivables quicker and it takes longer to pay its suppliers than its peers. Balance Sheet & Financing REED 3 year average Debt/Equity Ratio was 0.46 prior to 2009. D/E Ratio increased to 0.93 in 2009 and has continued to increase in the following years reaching a forecasted high of 2.47 in 2015E. The high ratio is due in part to the fact that REED sold and concurrently entered into a long-term lease agreement of its two buildings and brewery equipment in 2009. The capital lease has the effect of increasing operating income while also increasing interest expense. The building and equipment were sold at $3,056,000 but were recorded as a long-term financing obligation. At the end of 2013, we estimated the remaining balance of that obligation to be $2,784,000. The company is expected to decrease that balance at the rate of 9.9% annually and this has been taken into account in the balance sheet under long-term financing (see Appendix 11). As of third quarter 2013, REED has long-term debt consisting of a $525,000 term loan at 11.6% -­‐10   -­‐5   0   5   10   Net Income In Millions Actual Forecast 0.00   1.00   2.00   3.00   Dec  '06   Dec  '07   Dec  '08   Dec  '09   Dec  '10   Dec  '11   Dec  '12   Ratio Analysis Current Ratio Quick Ratio Cash Ratio
  • 9.
    CFA Institute ResearchChallenge 31 January 2014 9     Figure 23: Forecasted Ratios 2013 Forecasted Ratios Affecting Liquidity & Solvency REED 2013E 5 Year Peer Average Current Ratio 1.33 2.07 Quick Ratio 0.5 1.69 D/E Ratio 2.04 0.69 Source: FactSet, Team Estimates Figure 24: CFO Resignation on Stock Price Impact from Loss of Key Management Executive REED S&P 500 Jan. 21st Open price $8.32 $1,841 Jan. 27th Close price $6.82 $1,781 Percentage Change -18.03% -3.23% Source: FactSet plus prime. Interest shall not be below 14.85% per terms of the loan. REED has maintained a Current Ratio over 1, with it being 1.32 in year ending 2012. The forecasted Current Ratio remains above 1.32 (See Appendix 4). However, due to REED having more than 60% of its Current Assets in inventories, its Quick Ratio is 0.5 in 2012, which we project to remain relatively constant through the forecasted period. DuPont Analysis DuPont analysis was employed to examine how the return on equity was affected by the company’s operating efficiency, asset efficiency, and financial leverage. Due to operating losses from 2006 to 2012, the return on equity (ROE) has been negative. However we expect in subsequent years, there will be gradual improvement. In 2007, the return on equity was -76.67%, and by 2012, the ROE was drastically reduced to -12.78%. Through examination of the company's operating efficiency, profit margins have increased 40.76%, from -42.51% in 2007 to -1.75% in 2012. The Total Asset Turnover has also increased from 1.29 to 2.17 over the periods of 2007 to 2012, showing improvement in the company’s utilization of its resources. However REED capital structure shows that its financial leverage is increasing as the equity multiplier rises from 1.39 in 2007 to 3.37 in 2012. This implies an increase in debt to finance the company's operations over the years. The projections for 2013 continue to show signs of optimism for the firm. By 2014, projected profit margins and ROE are expected to be positive with profit margins reaching 1.05% and return on equity increasing to 11.02%. The DuPont analysis suggests that the profit margins are the most important driver for the firm’s return on equity. Thus we believe REED is showing positive signs of growth that are expected to continue into the future (See Appendix 15.) Investment Risks Operational Risk: Production Shortfall REED may not be able to produce at a level to support high sales growth. REED had issues with production shortages in 2012 and early 2013, and this led to CEO Chris Reed taking over plant management at the west coast facility. Continued issues from production shortages due to equipment error or inefficiencies in production process may harm sales growth and gross margin. Operational Risk: Increase in Supply Prices Costs in tangible goods sold was 63% of sales in 2012 and 2011. Cost of tangible goods sold includes raw materials, packaging, co-packing and repacking fees, inbound freight charges and certain internal transfers. Increases in these costs could lower gross margin and impact the current and future profitability of REED. However, we would expect that such increases may happen across the industry and affect REED competitors as well. Given its relatively small size, future supply price increases may affect REED more than its competitors, resulting in a lower gross margin. Operational Risk: Lack of Working Capital REED Current Ratio has trended downwards going from 2.41 in 2007 to 1.44 and 1.33 in 2011 and 2012 respectively. Their Current Ratio also trails the 5-year peer group average, 1.33 to 2.07. REED Quick Ratio has trended downwards over time, going from 0.96 in 2007 to 0.43 and 0.50 in 2011 and 2012 respectively. Their Quick Ratio also trails the 5-year peer group average, .50 to 1.69. These ratios signal it may have some challenges paying bills over time. REED currently has a D/E Ratio of 2.04, compared to peer group five year average of .69, and company guidance has suggested that new funding would come from new debt rather than equity financing. Lack of working capital may negatively affect REED’s ability to borrow. If revenue from product sales are inadequate, the firm may also have insufficient working capital to continue operations. In the long run, poor liquidity can result in the firm managing business instead of growing it. REED is also susceptible to changes in interest rates because of the floating rate on its current and long term debt. Given the historical low interest rates that have prevailed during the last few years, if interest rates go up, REED would have to incur higher interest expenses in order to service its debt. Operational Risk: Loss of Key Management Executive On January 21, 2014, REED announced that its CFO of 5 years, James Linesch, would be leaving the company at the end of the month and that the firm was seeking a replacement. It was not publicly stated as to what the reason was for his leaving, but with him gone it does leave a hole within management. Linesch has held several CFO positions with small publicly traded companies such as AdStar, Inc. (ADST), DynTek, Inc. (DYNE) and CompuMed, Inc. (CMPD). When he was appointed as the chief financial officer for REED, he brought with him valuable management experience in emerging public companies. Along with his normal duties of managing the company’s finances, Linesch was responsible for improving REED’s line of credit and cutting legal costs by at least 50%. CEO Chris Reed had even stated that Linesch had contributed to the “inspiration and technical ‘macgyvering’ that gave us the Reed’s Culture Club Kombucha.” Since he was brought on board, REED has seen a rise in stock price by almost 500%.
  • 10.
    CFA Institute ResearchChallenge 31 January 2014 10     When the announcement came out that Linesch was stepping down from his position REED’s stock plummeted. Within the span of 5 trading days, the price had dropped 18% vs. 3.0% decline in the S&P 500. The fact that Linesch had bought over $200,000 of REED stock 19 days prior to the announcement suggests that this decision was very abrupt. Also, the fact that REED does not have a replacement already set in place further justifies our assumption. It comes into question as to what had caused the sudden departure as there was no explanation given as to why Linesch left. The uncertainty that this event creates adds additional risk to the company. With REED in a crucial period of high growth, it is vital to find an experienced replacement. Competition Risk: Major Competitors Enter Market If the natural beverage industry continues its growth, there will be a large incentive for the major beverage manufacturers Coca-Cola, Pepsi, Dr Pepper-Snapple, and Monster to enter the market. While we see REED as an ideal acquisition target for a larger firm, it is also possible for one of REED’s competitors to be acquired instead. Major firms may also start to operate their own premium natural lines. This could materially impact revenue and profitability, as they would be competing against a powerful firm with more established distribution channels. Strategic Risk: New Product Failure REED’s fastest growing product is expected to be its Culture Club Kombucha line. Expected growth of this line is 50%-100%, compared to 15-20% for REED core brands (according to company guidance). If Kombucha sales falter, overall sales growth may be dampened. Valuation Risk: Long Term Growth Rates REED intrinsic value was calculated by using a long-term growth rate of 3%, which was set to model typical long term U.S. Economic Growth. This growth factor can have significant impact on the valuation of REED, both in when the terminal value is calculated and with what long-term growth rate is used. A range of long term growth rates were modeled using sensitivity analysis to determine the effect on our one year target price (See Appendix 10). Valuation Risk: Intermediate Term Growth REED intermediate-term sales growth rates (IGR) were estimated by utilizing analyst consensus, recent performance, and expected growth in market and market share. We utilized an annualized growth rate of 25% over the next five years, which we believe to be the best estimate given current production and market conditions. If these estimates are overly optimistic it would have a huge impact on REED valuation, as REED requires high growth and growth in margins to become profitable. Given the difficulty in predicting the growth pattern of a new niche product in kombucha, these growth numbers may be understated and therefore undervalue the company. A range of IGR were modeled using sensitivity analysis to determine the effects of different growth rates on our 2014 year-end target price (See Appendix 8). Valuation Risk: Changes in Cost of Capital REED is a relatively young company with high growth and a high D/E Ratio. Due to these factors, REED currently has a high cost of capital compared to the beverage industry. We have assumed that this number will not drastically change over time. If there are changes in capital structure, inherent business risk, market risk premium, or risk free rate, cost of capital will change, and therefore our estimate of valuation may change substantially. Sensitivity analysis was performed to view the effects of different long term cost of capital rates on the one year target price (See Appendix 9). Valuation Risk: Acquisition Risk While visiting REED headquarters, Chris Reed discussed an expected exit strategy in the next 4 to 5 years, and hoped to receive an offer valuing the company at $200 million. With the 2013 year end market cap being $102.22 million, this is a 95.66% premium. The possibility that Chris Reed could turn away potentially good acquisition deals based on his unreasonable expectations could lead to a risk for investors. Also with Chris being the age of 56, the decision to sell the company could be greatly influenced by his desire to retire. As both Chris and his wife are on the board of directors, they have a very strong influence on what price the company could be purchased at. Due to Chris Reed’s possible personal motives, this could lead to a much smaller acquisition premium than shareholders would hope for. Issues Regarding Corporate Governance Insider stake ownership at REED represents 33.4% of the company’s float, making it greatly influenced by a few insiders. The Chairman of the board is CEO Chris Reed. His wife Judy Reed, Mark Harris, Daniel S.J. Muffoletto, and Michael Fischman also serve on the board of REED. Given the makeup of the board, we have concerns to how the board could objectively review management decisions. It appears that both Daniel Muffoletto and Michael Fischman have no shares in the company, and both are paid very little to serve on the board. Fischman is paid only $750 to serve on the board and in 2012 attended less than 75% of the meetings. Total lack of ownership and the minimal payments to directors for fulfilling their duties leads us to the
  • 11.
    CFA Institute ResearchChallenge 31 January 2014 11     assumption that they serve on the board as a possible favor to Chris Reed. This does not provide sufficient motivation for the directors to adequately review and advise management. These current corporate governance standards also make it difficult to attract investment from institutional investors. Right now, REED has an institutional ownership of 6%, which significantly trails the industry average of 46%. The lack of corporate governance gives shareholders limited power in REED management decisions. This has led to a recent shareholder proxy initiative to change the board nomination process that ultimately failed due to insider opposition. A proposal to limit proxy review of executive compensation to 3 years from every year also passed with insider support. When shareholders have the ability to scrutinize a company’s corporate governance practices, they can help to identify areas of improvement. However this only happens if the board and management promote shareholders engagement and actively consider the interests of the shareholders they serve. It is important that the board and management listen to what their shareholders have to say and adjust their governance practices when warranted. Thus far the REED board has made no attempt to address these concerns over their corporate governance practices.
  • 12.
    CFA Institute ResearchChallenge 31 January 2014 12     Appendix 1: Pro Forma Balance Sheet (All figures in Millions) Balance  Sheet   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Assets                                                           Cash  &  ST  Investments   1.08   0.71   1.16   1.46   1.82   2.28   2.85   3.56   4.45   5.34   6.15   6.76   7.10   7.31   Short-­‐Term  Receivables   1.30   1.63   1.96   2.47   3.08   3.85   4.82   6.02   7.52   9.03   10.38   11.42   11.99   12.35   Inventories   4.56   6.10   5.79   7.28   9.10   11.38   14.23   17.78   22.23   26.67   30.68   33.74   35.43   36.49   Other  Current  Assets   0.22   0.29   0.41   0.52   0.64   0.81   1.01   1.26   1.57   1.89   2.17   2.39   2.51   2.58   Total  Current  Assets   7.16   8.73   9.32   11.7   14.7   18.3   22.9   28.6   35.8   42.9   49.4   54.3   57.0   58.7   Net  Property,  Plant  &  Equipment   3.65   3.51   3.42   4.15   5.19   6.49   8.11   10.14   12.67   15.21   17.49   19.24   20.20   20.80   Intangible  Assets   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   1.03   Other  Assets   0.05   0.09   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Total  Assets   11.89   13.36   13.82   16.96   20.93   25.89   32.09   39.84   49.53   59.22   67.94   74.63   78.31   80.63   Liabilities  &  Shareholders'  Equity   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   ST  Debt  &  Current  Portion  LT  Debt   2.20   3.37   3.36   4.17   5.11   6.27   7.76   9.69   12.02   14.30   16.35   17.93   18.79   19.32   Accounts  Payable   2.91   2.42   3.37   4.24   5.30   6.62   8.28   10.35   12.94   15.53   17.85   19.64   20.62   21.24   Other  Current  Liabilities   0.21   0.28   0.31   0.39   0.49   0.61   0.76   0.95   1.19   1.43   1.64   1.81   1.90   1.95   Total  Current  Liabilities   5.32   6.07   7.04   8.80   10.90   13.51   16.80   20.99   26.15   31.25   35.85   39.37   41.30   42.52   Term  Loan           0.40   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   0.525   Long  Term  Financing  Obligation-­‐Net     2.208   2.164   2.083   1.980   1.853   1.674   1.477   1.349   1.248   1.156   1.081   1.015   Capital  Lease  equipment       0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   0.10   Additional  Financing               1.32   2.81   4.40   5.94   8.24   10.79   12.22   11.87   9.08   3.32   4.49   Long-­‐Term  Debt   2.41   2.98   2.71   4.10   5.52   7.00   8.42   10.53   12.89   14.19   13.74   10.86   5.03   6.13   Total  Liabilities   7.73   9.05   9.75   12.90   16.42   20.51   25.22   31.52   39.03   45.44   49.59   50.23   46.33   48.65   Preferred  Stock  (Carrying  Value)   1.32   1.27   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   0.56   Retained  Earnings   (18.88)   (19.89)   (20.46)   (20.46)   (19.95)   (19.00)   (17.43)   (15.90)   (13.63)   (10.26)   (5.58)   0.59     8.29     8.29     Capital  Surplus   21.70   22.92   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   24.00   Common  Equity   2.82   3.03   3.54   3.54   4.05   5.00   6.57   8.10   10.37   13.74   18.42   24.59   32.29   32.29   Total  Shareholders'  Equity   4.38   4.14   4.31   4.10   4.61   5.56   7.13   8.66   10.93   14.30   18.98   25.15   32.85   32.85   Liabilities  &  Shareholders'  Equity   11.87   13.35   13.85   16.96   20.93   25.89   32.09   39.84   49.53   59.22   67.94   74.63   78.31   80.63   Source:  Team  Estimates,  FactSet  
  • 13.
    CFA Institute ResearchChallenge 31 January 2014 13     Appendix 2: Pro Forma Income Statement INCOME  STATEMENT   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Sales/Revenue   20.38     25.01     30.01     37.75     47.19     58.98     73.73     92.16     115.20     138.24     158.98     174.87     183.62     189.13            Sales  Growth  (%)   34%   23%   20%   26%   25%   25%   25%   25%   25%   20%   15%   10%   5%   3%   COGS  excluding  D&A   15.43     16.96     20.13     25.06     30.41     37.71     46.79     58.04     72.04     85.71     97.80     106.73     111.18     113.60     D  &  A  Expense   0.62     0.65     0.74     0.81     0.98     1.21     1.51     1.87     2.32     2.76     3.15     3.44     3.58     3.66     Gross  Income   4.34     7.41     9.14     11.88     15.79     20.05     25.44     32.26     40.84     49.77     58.03     64.70     68.86     71.87            Gross  Margin  (%)   21.3%   29.6%   30.5%   31.5%   33.5%   34.0%   34.5%   35.0%   35.5%   36.0%   36.5%   37.0%   37.5%   38.0%   SG&A  Expense   5.06     7.66     9.01     11.32     14.16     17.69     22.12     27.65     34.56     41.47     47.69     52.46     55.09     56.74     EBIT  (Operating  Income)   (0.72)   (0.25)   0.14     0.56     1.64     2.36     3.32     4.61     6.28     8.29     10.33     12.24     13.77     15.13            EBIT  Margin  (%)   -­‐3.6%   -­‐1.0%   0.5%   1.5%   3.5%   4.0%   4.5%   5.0%   5.5%   6.0%   6.5%   7.0%   7.5%   8.0%   EBITDA   (0.11)   0.40     0.87     1.36     2.62     3.57     4.82     6.48     8.60     11.05     13.48     15.68     17.35     18.79     Interest  on  Credit  Line           0.21     0.26     0.33     0.41     0.52     0.65     0.81     0.97     1.11     1.22     1.29     1.32     Interest  on  New  LT  debt         0.20   0.42   0.65   0.88   1.22   1.60   1.81   1.76   1.35   0.49   0.67   Interest  on  Term  Loan       0.18     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     0.21     Interest  on  Capital  Leases           0.16     0.18     0.18     0.16     0.18     0.26     0.29     0.26     0.25     0.23     0.21     0.20     Interest  Expense   0.59   0.69   0.66   0.85   1.14   1.44   1.79   2.34   2.91   3.26   3.33   3.01   2.20   2.40   Tax  Expense   0.00     0.00     0.00     0.00     (0.17)   (0.32)   (0.53)   (0.79)   (1.17)   (1.74)   (2.41)   (3.18)   (3.99)   (4.40)   Offset  from  Carried  Loss           0.17     0.32     0.53                     Average  Tax  Rate   0.0%   0.0%   0.0%   0.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.0%   34.1%   34.2%   Preferred  Dividends   0.07     0.07     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     0.05     Net  Income  Available  To  Common   Equity   (1.38)   (1.01)   (0.57)   (0.30)   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62   8.37   Retained  Earnings               (0.30)   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62             Source:  Team  Estimates,  FactSet
  • 14.
    CFA Institute ResearchChallenge 31 January 2014 14     Appendix 3: Statement of Cash Flows Statements  of  Cash  Flows   2013   2014   2015   2016   2017   2018   2019   2020   2021   2022   2023   Net  Profit   (0.30)   0.50     0.92     1.53     1.50     2.23     3.32     4.62     6.09     7.62     8.37     D&A   0.81     0.98     1.21     1.51     1.87     2.32     2.76     3.15     3.44     3.58     3.66     Changes  Receivables   (0.51)   (0.62)   (0.77)   (0.96)   (1.20)   (1.50)   (1.50)   (1.35)   (1.04)   (0.57)   (0.36)   Changes  Inventories   (1.49)   (1.82)   (2.28)   (2.85)   (3.56)   (4.45)   (4.45)   (4.00)   (3.07)   (1.69)   (1.06)   Changes  Other  Current  Assets   (0.11)   (0.13)   (0.16)   (0.20)   (0.25)   (0.31)   (0.31)   (0.28)   (0.22)   (0.12)   (0.08)   Changes  Current  Liabilities   1.76     2.10     2.61     3.30     4.19     5.16     5.11     4.60     3.52     1.93     1.21     Changes  in  NWC   (0.35)   (0.47)   (0.60)   (0.71)   (0.82)   (1.11)   (1.16)   (1.04)   (0.80)   (0.45)   (0.29)   Cash  Flows  From  Operations   0.16     1.01     1.53     2.32     2.54     3.44     4.93     6.73     8.73     10.75     11.75     CAPEX   -­‐1.54   -­‐2.02   -­‐2.51   -­‐3.13   -­‐3.90   -­‐4.85   -­‐5.29   -­‐5.43   -­‐5.19   -­‐4.54   -­‐4.26   Cash  Flows  From  Investments   -­‐1.54   -­‐2.02   -­‐2.51   -­‐3.13   -­‐3.90   -­‐4.85   -­‐5.29   -­‐5.43   -­‐5.19   -­‐4.54   -­‐4.26   Net  Debt   1.40   1.42   1.48   1.42   2.11   2.35   1.30   -­‐0.45   -­‐2.88   -­‐5.83   1.10   Dividends  Paid   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Cash  Flows  From  Financing   1.35   1.37   1.44   1.37   2.07   2.31   1.26   -­‐0.50   -­‐2.93   -­‐5.87   1.06   Net  Change  in  Cash   (0.02)   0.36     0.46     0.57     0.71     0.89     0.89     0.80     0.61     0.34     8.54     Beginning  Cash     1.46     1.82     2.28     2.85     3.56     4.45     5.34     6.15     6.76     7.10     End  Cash   1.46   1.82     2.28     2.85     3.56     4.45     5.34     6.15     6.76     7.10         Source:  Team  Estimates,  FactSet  
  • 15.
    CFA Institute ResearchChallenge 31 January 2014 15     Appendix 4: Key Financial Ratios Key  Financial  Ratios   2010   2011   2012   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   Liquidity  Ratios                                                           Current  Ratio  (x)   1.35   1.44   1.32   1.33   1.34   1.36   1.36   1.36   1.37   1.37   1.38   1.38   1.38   1.38   Quick  Ratio  (x)   0.49   0.43   0.50   0.50   0.51   0.51   0.52   0.52   0.52   0.52   0.52   0.52   0.52   0.52   Cash  Ratio  (x)   0.20   0.12   0.16   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   0.17   Efficiency  Ratios                                                           Total  Asset  Turnover  (x)   1.71   1.87   2.17   2.23   2.25   2.28   2.30   2.31   2.33   2.33   2.34   2.34   2.34   2.35   Fixed  Asset  Turnover  (x)   5.58   7.13   8.77   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   9.09   NWC  Turnover  (x)   11.07   9.40   13.16   12.90   12.56   12.25   12.09   12.07   11.96   11.83   11.75   11.70   11.68   11.66   Receivables  Turnover  (x)   18.78   17.07   16.72   17.06   17.01   17.01   17.01   17.01   17.01   16.70   16.38   16.04   15.68   15.54   Days  if  Sales  Outstanding  (days)   19.44   21.38   21.83   21.40   21.46   21.46   21.46   21.46   21.46   21.85   22.29   22.76   23.27   23.49   Inventory  Turnover  (x)   4.31   3.30   3.51   3.96   3.83   3.80   3.77   3.74   3.72   3.62   3.52   3.42   3.32   3.26   Days  of  Inventory  On  Hand  (days)   84.65   110.49   104.01   92.24   95.28   96.04   96.77   97.52   98.20   100.87   103.68   106.71   110.00   111.94   Payables  Turnover  (x)   8.20   7.18   7.10   7.19   6.96   6.91   6.86   6.81   6.77   6.53   6.29   6.04   5.78   5.65   Number  of  Days  of  Payables  (days)   44.49   50.80   51.41   50.75   52.41   52.81   53.19   53.58   53.93   55.90   58.04   60.43   63.10   64.57   Cash  Conversion  Cycle  (days)   59.59   81.06   74.43   62.88   64.32   64.69   65.04   65.40   65.72   66.83   67.92   69.04   70.18   70.87   Profitability  Ratios                                                           Gross  Profit  Margin  (%)   21.28%   29.60%   30.47%   31.47%   33.47%   34.00%   34.50%   35.00%   35.45%   36.00%   36.50%   37.00%   37.50%   38.00%   EBIT  Margin  (%)   -­‐3.55%   -­‐1.00%   0.45%   1.47%   3.47%   4.00%   4.50%   5.00%   5.45%   6.00%   6.50%   7.00%   7.50%   8.00%   EBITDA  Margin  (%)   -­‐0.53%   1.61%   2.91%   3.61%   5.55%   6.06%   6.54%   7.03%   7.46%   8.00%   8.48%   8.97%   9.45%   9.93%   Net  Profit  Margin  (%)   -­‐6.43%   -­‐3.76%   -­‐1.75%   -­‐0.79%   1.05%   1.56%   2.08%   1.62%   1.93%   2.40%   2.91%   3.48%   4.15%   4.43%   ROA  (%)   -­‐11.02%   -­‐7.04%   -­‐3.79%   -­‐1.76%   2.37%   3.55%   4.77%   3.76%   4.49%   5.61%   6.80%   8.16%   9.73%   10.39%   ROE  (%)   -­‐31.64%   -­‐21.9%   -­‐12.8%   -­‐7.34%   11.02%   17.08%   22.31%   18.00%   21.20%   24.12%   25.17%   24.96%   23.83%   26.19%   SG&A/Sale  (%)   24.83%   30.60%   30.02%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   30.00%   Solvency  Ratios                                                           Debt  Ratio  (%)   38.77%   47.53%   43.89%   48.79%   50.81%   51.27%   50.42%   50.75%   50.28%   48.11%   44.29%   38.57%   30.41%   31.57%   Debt  to  Equity  Ratio  (x)   1.11   1.48   1.48   2.04   2.36   2.47   2.36   2.43   2.37   2.07   1.64   1.18   0.74   0.80   Equity  Multiplier  (x)   2.87   3.11   3.37   4.18   4.64   4.81   4.67   4.79   4.72   4.30   3.70   3.06   2.45   2.52   Long  term  Debt  Ratio  (%)   20.27%   22.31%   19.57%   24.20%   26.38%   27.04%   26.24%   26.44%   26.01%   23.96%   20.22%   14.55%   6.42%   7.60%   Interest  Coverage  Ratio  (x)   -­‐1.24   -­‐0.36   0.21   0.65   1.43   1.64   1.86   1.97   2.16   2.55   3.10   4.07   6.25   6.30   Source:  Team  Estimates,  FactSet  
  • 16.
    CFA Institute ResearchChallenge 31 January 2014 16     Appendix 5: DCF Valuation FREE  CASH  FLOW  EQUITY   2013E   2014E   2015E   2016E   2017E   2018E   2019E   2020E   2021E   2022E   2023E   NET  INCOME   -­‐0.05   0.50   0.92   1.53   1.50   2.23   3.32   4.62   6.09   7.62   8.37   P  Dividend   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   0.05   Net  Capex   0.73   1.04   1.30   1.62   2.03   2.53   2.53   2.28   1.75   0.96   0.61   Changes  In  NWC   -­‐0.35   -­‐0.47   -­‐0.60   -­‐0.71   -­‐0.82   -­‐1.11   -­‐1.16   -­‐1.04   -­‐0.80   -­‐0.45   -­‐0.29   Net  Debt   0.08   2.63   1.41   1.34   2.03   2.27   1.21   -­‐0.56   -­‐3.00   -­‐5.96   1.10   Debt  Ratio   0.74   0.78   0.79   0.78   0.78   0.78   0.76   0.72   0.66   0.58   0.59   FCFE   -­‐0.45   0.06   0.39   0.88   0.71   1.22   2.22   3.49   5.05   6.93   7.96   Terminal  Value                     176.38     Total  FCFE   -­‐0.18   0.33   0.73   1.29   1.20   1.88   2.96   4.24   5.74   183.75     Equity  Value   106.42   114.24         Number  of  shares   13.50   13.50         Share  Price   $7.88   $8.46                                       Model  Returns   2014  Price   8.46   Jan  28  2014  Price   7.19   Potential  Upside   18%   Net CAPEX = CAPEX - Depreciation Net Debt = New Debt Issued – Debt Paid Source:  Team  Estimates,  FactSet,  Damodaran  Market  Risk  Premiums CAPM           Risk  Free   3.04%   10  Year  Treasury  Note  12/31/2013   Market  Premium   4.96%   2014  Estimate   Beta   0.93   FactSet  Estimate   Cost  of  Equity   7.65%      
  • 17.
    CFA Institute ResearchChallenge 31 January 2014 17     Appendix 6: Multiples Valuation Price/Sales   2008   2009   2010   2011   2012   2013   2014  E   Dr  Pepper  Snapple  Group,  Inc.   0.72x   1.31x   1.51x   1.48x   1.56x   1.66x   1.63x   Monster  Beverage  Corporation   3.16x   3.18x   3.73x   5.05x   4.69x   5.41x   5.10x   PepsiCo,  Inc.   2.03x   2.22x   1.82x   1.59x   1.65x   1.95x   1.91x   The  Coca-­‐Cola  Company   3.31x   4.27x   4.37x   3.48x   3.46x   3.94x   3.86x   Average   2.31x   2.74x   2.86x   2.90x   2.84x   3.24x   3.12x   Reed's,  Inc.   0.64x   0.87x   1.00x   0.48x   2.15x   3.04x    Discount   72.26%   68.28%   64.84%   83.49%   24.29%   6.33%    Discount  Average   72.22%   15.31%          Price/Sales   2014E   P/S  Peers  Median   3.12   Applied  discount   25%   Target  P/S   2.34   Sales  (millions)   $47.19     #  of  shares  outstanding  (millions)   13.5   Price  from  P/S   $8.19     Additional Explanations • For 2013, our multiples were based off of year-end 2013 market cap divided by the sum of YTD Q3 revenues and Q4 revenues of 2012. We did this because 2013 Q4 earnings reports have not come out yet for REED or its peers. However, we do not anticipate that this will be an issue as we assume that the multiples will not change very much after Q4 earnings reports come out.   Appendix 7: Weighting of Valuations Weighting  of  DCF  and  Multiples     Price  from  Relative  Valuation   $8.19     Weight  of  Relative  Valuation   50%   Price  from  DCF   $8.46     Weight  of  DCF   50%   Price  per  share  (end  of  2014)   $8.33     Price  per  share  (January  28,  2014)   $7.19     Potential  Upside   15.86%         Source:  Team  Estimates.  FactSet  
  • 18.
    CFA Institute ResearchChallenge 31 January 2014 18     Appendix 8: Intermediate Sales Growth/Cost of Capital Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price   Cost  Of  Capital         12.96%   11.97%   10.98%   9.98%   8.99%   8.00%   7.65%   7.26%   6.76%   6.51%   6.02%   Intermediate   40%    $            5.89      $            6.78      $            7.90      $            9.36      $        11.32      $        14.10      $        15.36      $        17.06      $        19.70      $                21.30      $              25.31     Term   30%    $            3.99      $            4.60      $            5.36      $            6.35      $            7.69      $            9.58      $        10.43      $        11.59      $        13.38      $                14.47      $              17.20     Growth   25%    $            3.23      $            3.72      $            4.33      $            5.14      $            6.23      $            7.76      $            8.46      $            9.39      $        10.85      $                11.74      $              13.95     (2014-­‐2018)   23%    $            2.95      $            3.40      $            3.96      $            4.70      $            5.70      $            7.10      $            7.74      $            8.60      $            9.94      $                10.75      $              12.78       22%    $            2.82      $            3.24      $            3.79      $            4.49      $            5.44      $            6.79      $            7.40      $            8.22      $            9.50      $                10.27      $              12.22       20%    $            2.56      $            2.95      $            3.45      $            4.09      $            4.96      $            6.19      $            6.75      $            7.50      $            8.67      $                    9.37      $              11.15       19%    $            2.44      $            2.81      $            3.29      $            3.90      $            4.73      $            5.90      $            6.43      $            7.15      $            8.27      $                    8.94      $              10.64       18%    $            2.32      $            2.68      $            3.13      $            3.71      $            4.50      $            5.62      $            6.13      $            6.81      $            7.88      $                    8.52      $              10.14       15%    $            1.99      $            2.30      $            2.68      $            3.19      $            3.87      $            4.84      $            5.27      $            5.87      $            6.78      $                    7.34      $                  8.74       10%    $            1.50      $            1.74      $            2.03      $            2.42      $            2.95      $            3.69      $            4.03      $            4.49      $            5.19      $                    5.62      $                  6.70       5%    $            1.09      $            1.26      $            1.49      $            1.78      $            2.17      $            2.73      $            2.99      $            3.33      $            3.86      $                    4.19      $                  5.00       3%    $            0.94      $            1.10      $            1.29      $            1.55      $            1.90      $            2.39      $            2.62      $            2.92      $            3.39      $                    3.68      $                  4.40     This chart represents 2014E prices with a range of estimates of Intermediate Term Growth and a range of estimates of for Cost of Capital.   Source:  Team  Estimates  
  • 19.
    CFA Institute ResearchChallenge 31 January 2014 19     Appendix 9: Long-Term Growth Rate/Long-Term Cost of Capital Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price   Long  Term  Cost  of  Capital       12.96%   11.97%   10.98%   9.98%   8.99%   8.00%   7.65%   7.26%   6.76%   6.51%   6.02%   Long     5%    $            5.49      $            6.10      $            6.91      $            8.05      $            9.74      $        12.56      $        14.05      $        16.30      $        20.56      $                23.73      $              34.72     Term   4.50%    $            5.23      $            5.76      $            6.46      $            7.41      $            8.78      $        10.92      $        11.99      $        13.54      $        16.24      $                18.09      $              23.61     Growth   4%    $            5.00      $            5.47      $            6.07      $            6.88      $            8.00      $            9.68      $        10.49      $        11.62      $        13.49      $                14.70      $              18.01     Rate   3.75%    $            4.89      $            5.33      $            5.90      $            6.64      $            7.67      $            9.17      $            9.88      $        10.86      $        12.45      $                13.46      $              16.14       3.50%    $            4.79      $            5.21      $            5.74      $            6.43      $            7.37      $            8.72      $            9.35      $        10.21      $        11.58      $                12.43      $              14.64       3.25%    $            4.69      $            5.09      $            5.58      $            6.23      $            7.09      $            8.32      $            8.88      $            9.64      $        10.83      $                11.56      $              13.41       3%    $            4.60      $            4.97      $            5.44      $            6.04      $            6.84      $            7.95      $            8.46      $            9.13      $        10.18      $                10.81      $              12.39       2.75%    $            4.51      $            4.87      $            5.31      $            5.87      $            6.61      $            7.63      $            8.08      $            8.68      $            9.61      $                10.16      $              11.52       2.50%    $            4.43      $            4.77      $            5.18      $            5.71      $            6.39      $            7.33      $            7.74      $            8.28      $            9.10      $                    9.59      $              10.77       2.25%    $            4.35      $            4.67      $            5.06      $            5.56      $            6.19      $            7.05      $            7.43      $            7.92      $            8.66      $                    9.09      $              10.13       2%    $            4.27      $            4.58      $            4.95      $            5.41      $            6.01      $            6.80      $            7.15      $            7.59      $            8.26      $                    8.64      $                  9.56       1.50%    $            4.13      $            4.41      $            4.74      $            5.16      $            5.68      $            6.36      $            6.65      $            7.02      $            7.57      $                    7.89      $                  8.62       1%    $            4.00      $            4.26      $            4.56      $            4.93      $            5.39      $            5.98      $            6.23      $            6.55      $            7.00      $                    7.27      $                  7.86     This chart represents 2014E prices with different estimates for Long Term Growth rates along with different estimates for cost of capital in the terminal scenario. Source:  Team  Estimates  
  • 20.
    CFA Institute ResearchChallenge 31 January 2014 20     Appendix 10: Intermediate Term Growth/Long-Term Growth Sensitivity Analysis 10%  Below  Jan  28  Price   Above  Jan  28  Price   20%  Above  Jan  28  Price     Long  Term  Growth           5%   4.50%   4%   3.75%   3.50%   3.25%   3%   2.75%   2.50%   2.25%   2%   1.50%   1%     40%    $        25.47      $        21.74      $        19.04      $        17.95      $        16.98      $        16.13      $        15.37      $        14.69      $        14.07      $                13.51      $              13.01      $        12.11      $        11.35     Intermediate   30%    $        17.31      $        14.77      $        12.93      $        12.19      $        11.54      $        10.96      $        10.44      $            9.98      $            9.56      $                    9.18      $                  8.83      $            8.22      $            7.70     Term   25%    $        14.06      $        11.99      $        10.49      $            9.89      $            9.36      $            8.88      $            8.46      $            8.08      $            7.74      $                    7.43      $                  7.15      $            6.65      $            6.23     Growth   23%    $        12.88      $        10.99      $            9.61      $            9.05      $            8.56      $            8.13      $            7.74      $            7.40      $            7.08      $                    6.80      $                  6.54      $            6.09      $            5.70     2014-­‐2018   22%    $        12.32      $        10.50      $            9.19      $            8.66      $            8.19      $            7.77      $            7.40      $            7.07      $            6.77      $                    6.50      $                  6.25      $            5.81      $            5.44       20%    $        11.25      $            9.59      $            8.38      $            7.90      $            7.47      $            7.09      $            6.75      $            6.45      $            6.17      $                    5.92      $                  5.70      $            5.30      $            4.96       19%    $        10.73      $            9.15      $            8.00      $            7.53      $            7.12      $            6.76      $            6.44      $            6.15      $            5.89      $                    5.65      $                  5.43      $            5.05      $            4.73       18%    $        10.23      $            8.72      $            7.62      $            7.18      $            6.79      $            6.44      $            6.13      $            5.86      $            5.61      $                    5.38      $                  5.17      $            4.81      $            4.50       15%    $            8.83      $            7.52      $            6.57      $            6.18      $            5.85      $            5.55      $            5.28      $            5.04      $            4.82      $                    4.63      $                  4.45      $            4.13      $            3.86       10%    $            6.78      $            5.77      $            5.03      $            4.73      $            4.47      $            4.24      $            4.03      $            3.85      $            3.68      $                    3.53      $                  3.39      $            3.14      $            2.94       5%    $            5.07      $            4.30      $            3.74      $            3.52      $            3.32      $            3.14      $            2.99      $            2.85      $            2.72      $                    2.60      $                  2.50      $            2.31      $            2.16       3%    $            4.47      $            3.79      $            3.29      $            3.09      $            2.91      $            2.76      $            2.62      $            2.49      $            2.38      $                    2.28      $                  2.19      $            2.02      $            1.88           This chart represents 2014E prices for different estimates of long and intermediate term sales growth.         Source:  Team  Estimates
  • 21.
    CFA Institute ResearchChallenge 31 January 2014 21     Appendix 11: Capital Lease/Term Loan Payment Schedules Capital  Lease  Payment  Schedule       Term  Loan  Payment  Schedule   Year    Year  End  Balance   Payment     Year   Balance   Payment   2012   2,874,000         2012   575,000       2013                  2,784,000     90,000     2013   399,000   176,000   2014                  2,673,000     111,000     2014   195,000   204,000   2015                  2,539,000     134,000     2015   0   195,000   2016                  2,378,000     161,000    2017                  2,188,000     190,000    2018                  1,971,388                                  216,612      2019                  1,776,221                                  195,167      2020                  1,600,375                                  175,846      2021                  1,441,938                                  158,437      2022                  1,299,186                                  142,752      2023                  1,170,566                                  128,619                                               Source:  Team  Estimates  
  • 22.
    CFA Institute ResearchChallenge 31 January 2014 22     Appendix 12: REED Porter Five Forces Analysis Barriers to Entry: Low-Medium ● Anyone may create new soft drinks as the only limitation is in patented flavors and brands ● Existing firms with large capital expenditures have economies of scale, direct supply and distribution channels set up ● Barriers are low with no consumer switching costs and zero capital requirements ● Prices are competitive and fluctuate slightly depending on location ● Major players have flavor identities giving them more recognition ● Major brands have positioned themselves in the main distribution channels including super markets, gas stations and restaurants ● Licenses, insurances, and FDA approval are required to produce and distribute products and cover potential lawsuits ● Existing firms have cost and performance advantage and are able experience economies of scale ● Bottling, distribution, and storage can be contracted out Intensity of Rivalry: High ● Costs for warehouse, trucks and labor may be substantial fixed costs ● Exiting the market may result in huge losses due to binding contracts, fixed costs and marketing costs ● Many beverage firms exists and are rolling out innovative products with trendy flavors ● Greater development and use of natural ingredients for health benefits ● Firms are focused on expanding their beverage portfolios ● Natural premium is growing and major firms have significant market share in CSDs, ready-to-drink teas, and energy drinks ● Equipment is firm specific and may be difficult to liquidate ● Customers would not incur high costs from switching from one player to another ● No need for significant customer-producer interaction since purchase products depend on tastes ● Market is a differentiated product oligopoly in promotional pricing and new brands ● Existence of well established distribution channels, relationships with suppliers, retailers, and brand value to customers ● Market shares in the industry are not more-or-less equally distributed among competitors. This is evident because there are three main firms that own approximately 87% of the industry, yet there are over 100 companies in the industry. Threat of Substitutes: High ● Substitutes do not have performance limitations or high prices ● Substitutes are not priced at a high enough cost where it would affect their use as a mainland product ● Customers would not incur costs in switching to substitutes as switching for a customer would be difference of cents. ● Substitutes such as water, ready-to-drink tea and coffee, sports drinks, and energy drinks exist ● Consumers are brand name loyal as they have consumed certain beverages as long as they can remember ● Players have a wide portfolio of products for consumers to choose from Bargaining Power of Buyers: High ● Soft drink market is the largest accounting for an annual sales of $60 billion ● Three firms control 89% of the United States soft drink sales ● Average American consumes over 56 gallons of soda a year ● Average soft drink costs under $2 which makes each individual purchase relatively immaterial ● All information such as nutrition facts and ingredients are listed on the label ● Manufacturing own soft drink is inconvenient considering how inexpensive the product is ● Customers are highly sensitive to the price of soft drinks and are willing to change brands if one becomes more costly ● Major players have developed significant brand loyalty ● Firms provide incentives to customers such as contests and admission discounts to theme parks enticing customers to choose a specific brand Bargaining Power of Suppliers: Low ● Inputs used to create products may by unique and extremely differentiated such as in formula, color, and flavor ● Product innovation is needed to satisfy consumer’s need for a variety of taste ● Firms can switch between suppliers very quickly and easily ● Suppliers to the industry are bottling equipment manufacturers and secondary packaging suppliers ● Surplus of suppliers exists that can provide same products ● Firms have power to select suppliers that do the best job at the best price ● Soft drink companies own a portion of their own supply companies enabling easy access to enter the supplier for the soft drink industry ● Suppliers main revenue come from delivering soft drink beverages and equipment for the firms directly to customers ● Soft drink main ingredients include carbonated water, spices, roots to name a few ● Suppliers are not concentrated or differentiated
  • 23.
    CFA Institute ResearchChallenge 31 January 2014 23     Porter's  Five  Forces  Analysis   Rating   Barriers to Entry: Low-Medium 2   Intensity of Rivalry: High 5   Threat of Substitutes: High 5   Bargaining Power of Buyers: High 5   Bargaining Power of Suppliers: Low 1   Final  Rating:   3.6                     0   1   2   3   4   5   Barriers  to  Entry:  Low-­‐ Medium   Intensity  of  Rivalry:  High   Threat  of  SubsLtutes:   High   Bargaining  Power  of   Buyers:  High   Bargaining  Power  of   Suppliers:  Low   Porter's  Five  Forces  Analysis   Scale   Rating   High   5   Medium-­‐High   4   Medium   3   Low-­‐Medium   2   Low   1  
  • 24.
    CFA Institute ResearchChallenge 31 January 2014 24     Appendix 13: Industry Five Forces Analysis 0   1   2   3   4   5   Buyer  Power   Supplier  Power   SubsLtute  New  Entrants   Degree  of  Rivalry   Force  Driving  CompeMMon  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011       0   1   2   3   4   5   Backwards  integraLon   Buyer  independence   Buyer  size   Financial  muscle   Low  Cost  switching  Oligosony  threat   Price  sensiLvity   Product  dispensability     Tendy  to  switch   Drivers  of  Buyer  Power  in  the     FuncMonal  Drinks  Market  in  the  U.S.,  2011   0   1   2   3   4   5   DifferenLated  input   Forward  integraLon   No  subsLtute  inputs   Oligopoly  threat  Player  dispensability   Player  independence   Supplier  size   Switching  costs   Drivers  of  Supplier  Power  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011    
  • 25.
    CFA Institute ResearchChallenge 31 January 2014 25     Source:  Team  Estimates   0   1   2   3   4   5   UndifferenLated   Weak  brands   DistribuLon  accessible   LiYle  IP  involved   LiYle  regulaLon  Low  fixed  costs   Low  cost  switching   Market  Growth   Scale  unimportant   Suppliers  acessbile     Factors  Influencing  the  Likelihood  of  New   Entrants  in  the  FuncMonal  Drinks  Market   in  the  U.S.,  2011     0   1   2   3   4   5   Zero  sum  game   CompeLtor  size   Easy  to  expand   Hard  to  exit   Lack  of  diversity   Low  cost  switching  Low  fixed  costs   Number  of  players   Similarity  of  players   Storage  costs   UndifferenLated   product   Drivers  of  Degree  of  Rivalry  in  the   FuncMonal  Drinks  Market  in  the  U.S.,  2011   0   1   2   3   4   5   Low  cost  switching   Beneficial  alternaLve    Cheap  alternaLve   Factors  Influencing  the  Threat  of   SubsMtutes  in  the  FuncMonal  Drinks   Market  in  the  U.S.,  2011  
  • 26.
    CFA Institute ResearchChallenge 31 January 2014 26     APPENDIX 14: Price to Sales Multiple vs. Peer Group                                     Source:  FactSet   0.00x   1.00x   2.00x   3.00x   4.00x   5.00x   6.00x   2008   2009   2010   2011   2012   2013   2014  E   CompeLtor:  Price  to  Sales  MulLplier   Dr.  Pepper  Snapple  Group,  Inc.   Monster  Beverage  CorporaLon   PepsiCo,  Inc.   The  Coca-­‐Cola  Company   Reed's,  Inc.   Average  
  • 27.
    CFA Institute ResearchChallenge 31 January 2014 27     APPENDIX 15: DuPont Analysis Source:  FactSet,  Team  Estimate DuPont Analysis 2007 2008 2009 2010 2011 2012 2013E 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E Equity Multiplier 1.39 2.30 2.28 2.87 3.11 3.37 4.18 4.64 4.81 4.67 4.79 4.72 4.30 3.70 3.06 2.45 2.52 Profit Margin -42.5% -25.0% -16.9% -6.4% -3.8% -1.7% -0.8% 1.1% 1.6% 2.1% 1.6% 1.9% 2.4% 2.9% 3.5% 4.1% 4.4% TAT 1.29 1.68 1.52 1.71 1.87 2.17 2.23 2.25 2.28 2.30 2.31 2.33 2.33 2.34 2.34 2.34 2.35 ROA -55.0% -41.9% -25.6% -11.0% -7.0% -3.8% -1.8% 2.4% 3.6% 4.8% 3.8% 4.5% 5.6% 6.8% 8.2% 9.7% 10.4% ROE -76.7% -96.3% -58.6% -31.6% -21.9% -12.8% -7.3% 11.0% 17.1% 22.3% 18.0% 21.2% 24.1% 25.2% 25.0% 23.8% 26.2%
  • 28.
    CFA Institute ResearchChallenge 31 January 2014 28     DuPont Analysis Cont.                           Source:  FactSet,  Team  Estimates     Return  On  Equity   -­‐7.3%  11.0%  17.1%   22.3%  18.0%  21.2%   24.1%  25.2%  25.0%   23.8%  26.2%   Return  On  Assets   -­‐1.8%  2.4%  3.6%   7.8%  3.8%  4.5%   5.6%  6.8%  8.2%   9.7%  10.4%   Profit  Margin   -­‐0.8%  1.1%  1.6%   2.1%  1.6%  1.9%   2.4%  2.9%  3.5%   4.1%  4.4%     Asset  Turnover   2.23  2.25  2.28   2.30  2.31  2.33   2.33  2.34  2.34   2.34  2.35   Equity  MulKplier   4.8  4.64  4.81   4.67  4.79  4.72   4.30  3.70  3.06   2.45  2.52   Legend  (Years) '13   '14   '15 '16   '17   '18 '19   '20   '21 '22   '23
  • 29.
    CFA Institute ResearchChallenge 31 January 2014 29     APPENDIX 16: Margin & Sales Forecasts -­‐5%   0%   5%   10%   15%   20%   25%   30%   35%   40%   Annual  Sales  Growth   Sales  Growth   Actual   Forecast   0.0%   5.0%   10.0%   15.0%   20.0%   25.0%   30.0%   35.0%   40.0%   Gross  Margin   Gross  Margin   Actual   Forecast  
  • 30.
    CFA Institute ResearchChallenge 31 January 2014 30     Source:  FactSet,  Team  Estimates   -­‐50%   -­‐40%   -­‐30%   -­‐20%   -­‐10%   0%   10%   20%   OperaKng  Margin   OperaKng  Margin   Actual   Forecast   -­‐50.0%   -­‐40.0%   -­‐30.0%   -­‐20.0%   -­‐10.0%   0.0%   10.0%   Net  Margin   Net  Margin   Actual   Forecast