My Trading Journal

August 13, 2015

6:00 pm (PST)

In my section on stocks, I talk about trading IPOs. I talk about the different reasons why IPOs are difficult to analyze, as well as the opportunities they present. One recent IPO is a great example of everything I talked about: David's Tea (DTEA)

Description

David's Tea is a company based in Canada which operates retail tea locations. It has 161 total locations with 136 in Canada and 25 in the United States as of mid-2015. All stores are company-owned. The fact that the company operates in the tea industry is notable for a couple of main reasons: first, tea is the 2nd most popular beverage in the world behind water; and second, the retail tea industry is very underdeveloped commercially. No company has an established national brand of retail tea stores, and David's Tea only has 25 locations in the U.S. So, this situation appears to be similar to past opportunities in that there is (1) a big market, and this big market is so-far (2) underdeveloped.

Tea Industry - Cautionary Notes

A few people have made a reference to David's Tea as being the "Next Starbucks". These comments are way too premature to be taken seriously at this point. Firstly, the tea market is not as commercially viable as the retail coffee market. I don't think the tea market in 2020 will be the same low-hanging fruit that coffee was in 2000. Secondly, Starbucks already has a tea brand called Teavana. So, the "Starbucks of tea" may very well be Starbucks. Additionally, management of David's Tea have so far given very restrained goals for store growth targets. Their targets represent a 200-300% target, but this is far from the 10,000 store count which would allow DTEA to be classified as a mega-growth story.

Technicals

The IPO was issued at $19 and traded past $27 on its first day. It peaked at $30 in its first week. It has fallen straight down since then and reached a low of about $12.50 today. It is down 60% in 2 months. You can see this in the chart below. For a profitable company that is growing very quickly, this is very attractive.

Fundamentals

The next question is: What is the stock worth? To start, let's look at the earnings estimates for this year and next year:

Source	FY '15	FY '16
MarketWatch	$0.30	$0.52
Zack's	$0.31	$0.61
WSJ	$0.30	$0.52

Here is a link detailing DTEA's recent financials - including 22 consecutive quarters of positive same-store growth, a 50% CAGR for revenue, and a 68% CAGR for EBITDA.

Given that earnings estimates are about $.30 and $0.55 for this year and next, and the revenue growth rate is about 30%, one could apply a P/E of 30 to those earnings and get a value of about $10. If I use next year's earnings level and assume the growth rate will generally be the same, then I come up with a value of $16.50 ($0.55 X 30). This is roughly a 22% return in 1 year.

Instead of using earnings, I could use cash flow (either free cash flow, or operating cash flow) and use cash flow ratios instead of P/E ratios. A couple of days ago, I found some cash flow predictions for DTEA (which I can't find right now), but the valuation based on cash flow was not any more attractive. Even though it is common for free cash flow (FCF) to be higher than earnings (and therefore allow a higher valuation), growing companies often have a lower FCF than EPS since they have to spend so much on capex in order to fund their growth. I would assume this is the case with DTEA.

Given that none of these valuations have been very attractive so far, It may help if we look at the numbers from a different viewpoint.

We could look at the year-over-year earnings growth of 83% and use that as a P/E ratio against this year earnings of $0.30. This gives us a value of $25, which is in-line with the highs of the stock over the past couple of months. This earnings growth rate is particularly aggressive since the company is coming off of a low base of earnings of only $0.30. This can inflate the growth rate since the additional earnings result in such a large percentage rise. This high growth rate will come down next year because it will have a higher base of earnings of $0.55. But this is fine because the lower P/E (based on the lower growth rate) will be offset by the higher earnings. If I were to value the stock a year from now, I could value it by multiplying the 2016 EPS of $0.61 X a proposed 2016 EPS growth rate of 40% (cutting the growth rate in half). After doing this, I get $25. So, after giving the stock a more-reasonable PE ratio, we get the same number roughly.

Targets: Value and Price

The value target is roughly $25 per share, as per the analysis above. As far as the price target goes, given the fact that the stock recently traded at $30, this means the market has valued the stock at this level before. It is not unreasonable then, to expect the market to value it again at this level a year from now, especially since the company will have another year of 30% growth under its belt. Normally, I wouldn't use the market's past trading level as a reliable indicator for the future, but for a high-growth company, it is uncommon for a stock to not reach its old highs. So, given a price target of $25-$30, this implies a 100% return or so in the near future.

Even if market conditions turn negative and the DTEA stock takes 2 years to hit its target, a 100% return in 2 years still represents a very attractive 41% compound annual growth rate. Furthermore, if the current negative investors' sentiment turns positive, additional returns in valuation expansion are very possible. Since there are fewer reliable high-growth consumer brand names for growth-oriented investors to be able to count on, it is common these days for growth stocks to go straight up for multiple years. It would not be surprising if DTEA stock becomes a growth darling in the future and turn into a 5-bagger in 3 years.

Random

Note 1: Some of their financials may be quoted in Canadian dollars so make sure you do a conversion to the US Dollar before analyzing their numbers.

Note 2: Fidelity has been shown to be a big buyer of DTEA stock recently. This is notable because Fidelity has traditionally been a large buyer of growth stocks, and sustained buying by Fidelity has been perceived by some investors as a reason for bullishness. Personally, I'm not a big believer in the strategy of tracking institutional cash flow in-and-out of individual stocks.

My Trading > My Trading Journal > August 13, 2015