Investment thesis

Against the backdrop of the recent developments, it’s time to revisit DavidsTea (DTEA), nearly one year after my initial article about the company. Since then, the stock has had a rocky ride, rising from around 1.40 US$/share to a high of 2.30 US$/share within a month after the publication of my report, followed by disappointing earnings which caused the share price to fall back to previous levels. Then, just after the shares recovered from their all-time lows as a result of the COVID-19-induced store closures, management sent the stock almost back to these lows with its announced restructuring procedure. In my opinion, this step is by no means a forced insolvency triggered by its creditors but rather a smart way to bring all landlords to the table seeking the most favorable and sustainable solution for all stakeholders. This view is confirmed by the speed with which the company came to terms with its landlords and especially by management who stated twice that the current restructuring procedure will not have any impact on DavidsTea’s share structure. However, the initial collapse in share price of nearly 50% on this announcement demonstrates that the market expects a devastating dilution for existing shareholders as a consequence of the restructuring process – in stark contrast to management’s repeated statements. At a current market cap of US$23 million with no financial debt and a cash position of $37.6 million, almost all potentially bad news seems to be priced in the current share price. Any positive developments during the restructuring process could lead to a significant revaluation of the stock. In addition, its e-commerce and wholesale growth rates of 268% and 81% since the store closures clearly show that there is a business case for DavidsTea beyond its formerly large store network, probably even a much more profitable one. From a risk/reward point of view, I’m convinced that the stock offers a highly attractive investment opportunity at current levels.

All financial figures presented in this report are in C$ unless otherwise stated.

Setting the scene

On June 8, DavidsTea announced that it is implementing a restructuring plan under the Companies’ Creditors Arrangement Act (the “CCAA”) in order to accelerate its transition to an online retailer and wholesaler of tea and accessories. At the same time, the company applied for similar orders for its U.S. subsidiary under Chapter 15 of the United States Bankruptcy Code. As indicated in the last 10-K, it has already been in negotiations with its main landlords for some time. Management initiated this formal restructuring process to increase the pressure on these landlords pursuing the goal of reaching more favorable lease terms and, ultimately, terminate a significant number of the 222 leases. In my opinion, at this stage, a restructuring within a court-supervised process is necessary to ensure fair and equitable treatment for all stakeholders as this situation is a classic case where the issue of free-riders is prevalent.

In addition to the company’s already declining profitability and mounting losses, the COVID-19 pandemic has prevented DavidsTea from operating its main revenue stream, as all brick-and-mortar stores across Canada and the U.S. were forced to close in the middle of March 2020. Following this drastic measure, the company was forced to temporarily lay-off all of its 2,276 store employees as well as all non-essential head office staff. As of July 5, substantially all remaining 128 employees have been moved to a four-day workweek to manage the e-commerce and wholesale businesses as well as necessary back-office functions.

On the bright side, DavidsTea’s dismal operating performance over the last two years, clearly, underlines the need for change. The current COVID-19 crisis has increased the sense of urgency even more but, at the same time, provides an opportunity to accelerate the envisaged transition to a mostly e-commerce-driven sales approach. First evidence that this major strategy shift can, ultimately, succeed can be found in the exceptional performance of the e-commerce and wholesale business after the shutdown of all brick-and-mortar stores. For the period March 18 through May 30, e-commerce sales increased by over 268% and wholesale business grew by over 81% (compared to the same period last year). In the first quarter last year, combined e-commerce and wholesale penetration had been at around 16%. I think these figures underline the assumption that many of the company’s loyal customers have already shifted to buying its products online, reducing the need for DavidsTea to stick to its unique and expansive “in-store customer experience” concept any longer.

To get an impression of how dire the current financial situation actually is, the graph below has been prepared showing the quarterly development of the cash balance over the last three years (in fact, these are net cash figures as DavidsTea did not have any financial debt on the balance sheet for the last three years). As a side note, as there is virtually no financing cash flow over this period, the change in the quarterly cash balance represents the free cash flow generated in the respective quarter (operating cash flow less investing cash flow).

Source: Annual and quarterly financial statements of DavidsTea (2016-2019) and recent CCAA filing (own preparation)

As can be seen in the graph above, DavidsTea is subject to a very strong seasonality. Usually, the fourth quarter has to make up for the first three cash-burning quarters of the year. Another noteworthy observation relates to the increase in cash balance in 2019, reflecting a positive free cash flow of around $4 million in the last year. According to a recent company filing, DavidsTea had a cash position of $41 million (as of May 30) and $37.6 million (as of June 27). Comparing these figures with previous cash levels over the last two years, it should be noted that the current cash balance is twice as high as the cash position recorded at the end of Q3 2018 and also higher than what could be seen for most parts in 2019. However, it has to be taken into account that after the company was required to close all of its retail locations it has not paid rent for the months of April, May, June, and July so far. On the other hand, apart from smaller customary contractual purchasing agreements, DavidsTea’s only contractual financial obligations relate to long-term operating leasing contracts. As of July 2020, the company is confronted with claims by unsecured creditors of around $16.7 million (with no financial debt and a current cash balance of $37.6 million). The largest amounts in the list of creditors refer to classic working capital items, like salary or trade payables, which every company has.

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Taking all this into consideration, you might wonder why DavidsTea has even entered into this formal restructuring process. In my opinion, it’s definitely not a forced insolvency procedure due to an imminent cash crunch but rather the most feasible and only logical way to restructure the burdensome future lease obligations. Unlike being bankrupt – which is a legal status – a company may already be considered insolvent if the debtor faces a looming liquidity crisis or is in the proximity of insolvency – even if it is currently meeting its obligations as they become due. I think DavidsTea wisely took advantage of the current COVID-19 circumstances, stopped paying its current lease bills, and filed for insolvency protection. Seeking creditor protections is generally possible if the debtor anticipates that it will become unable to meet its obligations as they come due before the debtor could reasonably be expected to complete a restructuring of its outstanding obligations.

Settlement of future lease obligations

There are two principal statutory regimes in Canada by which an insolvent commercial tenant may attempt to reach a settlement with its creditors, in order to avoid bankruptcy and remain in business: the restructuring proceeding under the Bankruptcy and Insolvency Act (the “BIA”) and the already mentioned restructuring proceeding under the Companies’ Creditors Arrangement Act, of which the latter is typically used for larger and more complicated businesses. The purpose of the CCAA is to afford debtors the opportunity to arrange their business with a view to continuing operations. In this regard, the debtor may file a plan of arrangement to be considered and voted on by the creditors. Throughout the process, the debtor corporation maintains possession and control of its property and operations with a court-appointed monitor overseeing and reporting on matters to the court. Like the BIA, the CCAA has various provisions that allow debtors to deal with their leases in a manner that may be inconsistent with the terms of the written lease agreement and the wishes of the landlord. For example, after the evaluation of each lease agreement, the tenant has to determine if it intends to (1) disclaim the lease; (2) retain the premises for the whole or any portion of the unexpired term; or (3) assign the lease.

On July 9, only one day after DavidsTea initiated the CCAA proceeding, the company already made use of this provision and announced the closure of 82 out of the 182 Canadian and the exit of all 42 U.S. stores to focus on its expanding successful e-commerce business. For the remaining 100 stores, management is currently in negotiations with landlords about more favorable lease terms. When it posted this encouraging news, the stock rose more than 30% on substantial volume in post-market trade to around 1.25 US$/share. This reaction looked very similar to the spike in the share price at the beginning of June when the first signs of a possible strategy shift became visible. Unfortunately, the print did not reveal any terms on which the future lease obligations will be settled, which might also be a reason why the short-lived rally faded the next day.

On July 30, DavidsTea announced that it successfully disclaimed lease contracts for another 82 Canadian stores, leaving the company with only 18 stores after the restructuring procedure. These best-performing stores are expected to be reopened by the end of August 2020 under more favorable lease terms, complementing its growing online and wholesale business model. As a result of this drastic downsizing of its brick-and-mortar retail network, nearly all of the formerly 2,300 store employees will be, ultimately, laid off over the next weeks. I expect the company to keep barely 200 store employees on its future payroll, thereof approx. 90% part-time employees.

Pursuant to section 32 (7) of the CCAA, a landlord will have a provable claim for unsecured damages in the CCAA proceeding, if its lease is disclaimed. In a proposal proceeding under the BIA, there is a specific formula that is set out to quantify landlords’ claims. The BIA proposal formula permits a landlord to file a claim for the lesser of (i) the aggregate of the rent for the first year following the date on which the disclaimer became effective and 15 percent of the rent for the remainder of the term of the lease after that year; and (ii) three years’ rent. Unfortunately, the CCAA does not stipulate how a landlord’s claim for repudiated leases is to be calculated. Debtors have, however, tried to import the formula in their CCAA proceedings.

In order to quantify landlords’ claims in DavidsTea’s CCAA proceeding and for the lack of better alternatives, I tried to estimate the hypothetical settlement payments based on the BAI formula combined with own assumptions about the company’s future lease obligations. Starting with these contractual obligations, the maturity table as of Feb 1, 2020, looks as follows:

Source: Annual financial statement of DavidsTea (2019)

Based on information from the most recent 10-K about property size and lease renewal date for its headquarters, distribution center, and store network combined with some rough estimates about the respective rental cost per square foot, I split last year’s lease payments as follows:

Source: Annual financial statement of DavidsTea (2019) and own calculations

Given these assumptions, I tried to strip out the assumed lease obligations for the headquarters and the distribution center to arrive at a maturity table only considering store leases. According to my calculations, future lease obligations relating to the store network amount to approx. $100 million. Assuming the proportion of disclaimed lease contracts equals the ratio of exited stores to total stores (as announced on July 9 and July 30, 2020), relief from current lease obligations would amount to $92.5 million.

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Applying the BAI formula on the basis of the assumed ratio of disclaimed to remaining lease contracts, we would arrive at values between $28.1 million and $50.2 million. As the BAI provision stipulates the lower of the both amounts, landlords’ claims resulting from the terminated leases could be settled for an amount of $28.1 million.

Source: Own calculations

Based on these assumptions, the lease payments for the next twelve months, taking the already announced store closures and assumed related disclaimed lease contracts into consideration, could look as follows:

Source: Own calculations

It should be noted that these assumed total lease expenses of around $5.6 million do not account for the renegotiated more favorable terms for the retained leases.

In summary, as of the writing of this report, neither the concrete proposal for a potential settlement payment nor the better lease terms are known to the public.

Funding landlords’ claims

Basically, the most appropriate source of financing highly depends upon the amount which has to be funded. Apart from asset-based lending or mezzanine financing, there are three options the settlement payment could be funded:

  1. Deferred cash settlement: This most advantageous financing alternative can be viewed as a debt instrument that could be structured to be superior to the remaining contractual lease obligations and backed by collateral, e.g. inventory. A big asset in the negotiations with the landlords is that DavidsTea has no financial debt on its books so far which means the company has some leeway and is not subject to any covenants like pari passu or negative pledge clauses.
  2. Cash settlement: Apart from the deferred cash settlement, this funding option would be the second most beneficial for current shareholders. With a current cash balance of $37.6 million, the feasibility highly depends upon the agreed settlement amount. For amounts north of $25 million, a full cash settlement is rather unlikely.
  3. Capital increase: I believe a classic debt-to-equity swap with its current landlords is highly unlikely. Theoretically, there is a higher likelihood that a distressed private equity investor takes a stake in DavidsTea and funds the potential landlords’ claims by this means. In this context, however, it’s noteworthy to mention that the management does not expect to dilute any of its current shareholders during the restructuring process.

On July 8, DavidsTea stated in the first filing concerning the formal restructuring under the CCAA proceeding:

The Company will work to complete its restructuring in a timely fashion, better positioned for long-term growth. The Company does not expect to issue any shares in the restructuring process or that the restructuring will have any impact on its share structure.

On July 16, a few days after it decided to terminate a significant portion of its leases, the company once again stated in an official filing:

At the request of Nasdaq, DavidsTea also confirms that it will not issue any new shares or create any new classes of stock in its restructuring under the CCAA and that the restructuring will not have an impact on DavidsTea’s share structure.

It’s really hard to evaluate from outside-in if these both statements will be proven right in the end. But if the management can keep its promises, the stock is dirt cheap at current levels with tremendous upside potential. I am rather in the camp to place my trust for two reasons: first, there was no need to create such high expectations which the management will be measured against and second, DavidsTea, particularly Herschel Segal, has a track record for being conservative when it comes to managing shareholders’ expectation. In my opinion, it hints at the fact that management entered the restructuring proceeding already with a pre-packaged plan on how to deal with its main landlords. Please bear in mind that the current interim CEO and chairman, Herschel Segal, still owns 46% of the company which should ensure that shareholders’ and management’s interests should be aligned.

In the quarterly earnings press release on July 31, the company once again clarified how it intends to settle the creditors’ claims:

Furthermore, in light of implementing the Restructuring Plan, the Company expects to use cash on hand to pay for professional fees and dividend resulting from the plan of arrangement that will be presented to creditors.

Taking all these statements into account, current shareholders can be pretty confident at this point in time that DavidsTea will emerge from this restructuring process without suffering any dilution or incurring any financial debt. In light of this new information, my above estimates might be very conservative.

DavidsTea 2.0

Finally, I want to dare to envision a financial outlook for the company’s next twelve months (NTM) performance. Even though DavidsTea intends to re-open its 18 best-performing retained flagship stores in August, my financial model conservatively focuses only on its e-commerce and wholesale sales channels, given the current uncertainty around COVID-19. To be coherent with my sales assumptions, only expenses assumed to be necessary to operate the newly envisaged e-commerce and wholesale business model (e.g. lease expenses relating to the headquarters and distribution center) are taken into account for the purpose of these financial projections.

To validate my projections for the next twelve months, the below abbreviated P&L statement has been prepared which provides a very granular view on the (adjusted) financial performance of the last three years. As these figures will provide the starting point for my NTM estimates, the historical performance has been adjusted by certain extraordinary and non-recurring items. Due to the admittedly difficult task to make projections during these unprecedented volatile times, the NTM sales forecast contains two cases. The bear case assumes no sales growth from existing customers and the conversion of one-third of 2019 brick-and-mortar sales from the segments Tea and Tea Accessories, i.e. every third store customer will buy his products online during this pandemic. In my view, this is a very conservative assumption against the background of DavidsTea’s loyal customers which tend to be repeat buyers rather than one-time purchasers. The bull case just extrapolates the growth rates which have been achieved in the e-commerce and wholesale business since all stores have been closed in mid-March. In particular, the projected increase in the wholesale business of around 80% y-o-y does not look that ambitious, given the strong expansion from 450 to 2,500 Loblaw stores in Q4 of last year. In my opinion, there are no obvious reasons why DavidsTea shouldn’t be able to maintain these growth rates in both sales channels for the rest of the year.

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Backed by some back-of-the-envelope calculations, I project an increase in the cost of sales margin by more than 15% percentage points to 60%, reflecting substantially higher fulfillment, packaging, and freight expenses, the lower margin wholesale business, as well as the loss of the presumably higher gross margin segment Food & Beverages.

The most significant change can presumably be seen in the personnel expense category in the next quarterly report. According to the most recent filings, DavidsTea is currently operating with 128 active employees as of July 5 with almost 2,300 store employees being on temporary leave compared to more than 2,500 employees as of February 1, 2020. As a result of the above-mentioned store closures, nearly all of its store employees will ultimately be laid off within the next couple of weeks. Interestingly enough, this minimal staff (having a four-day week) is able to ensure this exceptional recent e-commerce and wholesale growth and to manage general finance and administration functions. For the purpose of this exercise, I take a conservative stance assuming roughly the same headcount in supporting SG&A functions as before. Despite DavidsTea’s brand name and resulting loyal customer base, marketing expenses are expected to increase by $0.7 million to $8 million over the next twelve months, driven by a presumably higher online advertisement budget (e.g. Google Ads), whereas the P&L item store supplies are projected to be zero as no brick-and-mortar sales are assumed. Other SG&A, probably mainly fixed cost, is expected to decrease by a quarter as a result of general cost-cutting initiatives. Based on my outlined assumptions for 2019, the annual rental expenses for headquarters & distribution center have been estimated to be around $4.2 million and kept flat over the observation period, i.e. possibly more favorable future lease terms have not been taken into account.

Source: Annual financial statements of DavidsTea (2017-2019), company presentation of DavidsTea (July 2019) and own projections

Even in my very conservative sales scenario, the company’s leaner set-up as a result of the store network restructuring should provide the foundation to generate break-even results on an adjusted EBITDA level for the next twelve months. However, in my bull case scenario, DavidsTea should be capable to achieve an adjusted EBITDA of around $20 million in the first year following its transition to an e-commerce and wholesale business model.

As stated above, owed to the current uncertainty around COVID-19, the performance of the 18 most-profitable stores, which DavidsTea intends to retain, have not been included in my financial model. Based on some rough estimates, total annual sales of these stores should range between $12 million and $18 million under normal circumstances. Backed by some back-of-the-envelope calculations, these stores should add an incremental annual EBITDA after store lease expenses between $1 million and $4 million. Since the new lease terms will give the company termination rights at the end of 2020 and an option to extend the leases, it’s fair to assume that these 18 flagship stores all located in major Canadian shopping malls can only be accretive to the above estimated NTM EBITDA of DavidsTea’s e-commerce and wholesale business.

Valuation considerations

Admittedly, it’s very hard to put a price tag on a company currently undergoing a formal restructuring process which is why I won’t perform a valuation analysis. However, I believe that the stock provides a highly attractive – asymmetric – risk-reward profile at current levels, given

  • the proactively initiated restructuring process is led by the interim-CEO who owns nearly half of the equity in the company;
  • a reasonable chance to succeed with an e-commerce and wholesale only approach, thanks to its loyal followership built up through a cost-intensive sales & marketing strategy over the last years; and
  • a current market cap of around US$23 million with no financial debt and a cash pile of $37.6 million, seemingly financially prepared to cope with the current restructuring process.

From a pure quantitative valuation point of view, a leading branded beverage retailer with a strong e-commerce platform and decent growth potential can easily command an EV/EBITDA multiple of 10 in today’s markets. Given the company only achieves the midpoint of my EBITDA estimate $10 million (not taking the incremental EBITDA from its brick-and-mortar stores into consideration), DavidsTea could warrant an enterprise value of $100 million. Assuming the settlement claims eat up the majority of its current cash balance, this would give the stock a fair value of around 3US$/share, a potential upside of nearly 250% from current levels. In my view, if management can demonstrate that it is successfully executing its new online-driven strategy, substantially higher valuations are possible.

Conclusion

In summary, DavidsTea’s destiny will be dependent on (i) the compromise it can reach with the landlords as well as (ii) how critical the company’s unique-in-store concept has been for keeping existing and attracting new customers in the past. Since the company reported twice that the restructuring will not have an impact on its share structure and intends to settle landlords’ claims with its cash on hand, I’m quite confident that they have already been making progress and will come to terms with its landlords. In regards to the envisaged transition to an e-commerce business model, I think even the management team was a bit surprised itself about an achieved growth rate of 268% in the e-commerce business since the forced store closures. In a nutshell, I believe DavidsTea provides a very attractive investment opportunity for investors willing to take some risk in return for some significant upside potential.

Disclosure: I am/we are long DTEA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.



Via SeekingAlpha.com