Will the U.S. stock market improve on yesterday's record high to end the week? Not if this morning's action is any indication, with the benchmark S&P 500 and the narrower Dow Jones Industrial Average (DJINDICES: ^DJI ) down 0.36% and 0.65%, respectively, at 10:05 a.m. EDT on Friday.
Shares of SodaStream (NASDAQ: SODA ) are underperforming this morning as investors collect themselves following yesterday's 9.4% price "pop" on a report from Bloomberg News that the company is in talks with an investment firm to be taken private at around $40 per share. The prospect of a going-private transaction looks highly unlikely to me, and I'll walk you through two key aspects of SodaStream's business to explain why.
Business model and competitive advantage
SodaStream has a "razor/razor blade" business model, selling its customers low-margin soda-making machines (the razor) and consumables like the CO2 refills and syrups (razor blades), which are source of high-margin, recurring revenues. As Gillette proved, this can be a powerful, profitable model if you can establish a competitive moat around it (in Gillette's case, this rested largely on the power of its brand).
SodaStream has made some headway in establishing a brand that would protect its business, and it claims to be the world's leading manufacturer of home beverage carbonation systems, with the top market share in each of the 12 largest markets in which it operates (including the key U.S. market).
However, this market is beginning to attract the attention of other firms, some of which have a keen interest in controlling its development -- and massive means to try to do so. In May, Coca-Cola (NYSE: KO ) announced a plan to bring its stake in Keurig Green Mountain (NASDAQ: GMCR ) to 16%, becoming its largest shareholder. The investment cements a working partnership, with both companies working on the Keurig Cold single-up beverage system. Keurig will manufacture and distribute Coca-Cola branded pods to work with the machine. If you enjoy Coca-Cola, which would you rather have at home: a system with syrups developed by Coca-Cola or SodaStream's cola substitute?
In sum, SodaStream's competitive advantage is burgeoning, rather than established, and it now faces much greater competition. I believe this state would make a private-equity buyer, with a medium-term time horizon, a bit nervous.
While a large strategic investor like Coca-Cola or PepsiCo could buy SodaStream, a financial buyer would likely be looking at a leveraged transaction (i.e., using debt to finance the majority of the purchase price). The trouble with SodaStream is that it is still in its high-growth phase, which is not conducive to a leveraged buyout (LBO). Indeed, private-equity firms typically seek mature businesses that churn out generous, consistent cash flows in order to service the debt load in an LBO.
SodaStream's EBITDA (earnings before interest, taxes, depreciation and amortization -- a common measure of cashflow) has been rising steadily over the past several years, but it is relatively volatile from one quarter to the next. Furthermore, SodaStream's capital expenditures far exceed its depreciation and amortization, such that free cash flow has been negative for at least the past three years.
While capital expenditures are expected to slow in SodaStream's fiscal year 2015, I'd join Stifel Nicolaus analyst Jim Duffy in his assessment that "use of debt to finance the transaction is imprudent, particularly given the leverage to fund the total amount of the deal would put the debt to trailing EBITDA leverage ratio at greater than 9.0 [times]." That leverage ratio is not much lower than the 9.6 average enterprise value-to-EBITDA purchase multiple on LBOs in the first half, according to S&P Capital IQ (which multiple is itself near the record-high 9.7 multiple achieved at the height of the credit bubble in 2007).
The fizzy on SodaStream
SodaStream is an intriguing business with some attractive properties. However, I would caution investors against buying the shares as a bet on a takeover. Fundamentally oriented investors ought to analyze the company as a growth enterprise, not based on speculation of a takeover that looks unlikely to occur.
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