Teavana Holdings, Inc (NYSE: TEA) is a specialty retailer of premium loose-leaf tea and related merchandise. The company was founded in 1997, received venture investment in 2004 and went public just under a year ago, at the spectacularly bad time of mid-summer 2011. Today, the company is down around 16% from its initial trading levels, and it is the most heavily shorted stock in America, with 76.6% short interest.
This is interesting, because the company has only reported two quarters worth of data as a public company. These must have been atrocious quarters, right? Let’s take a look. Here are the headlines from its first quarter (second fiscal quarter) as a public company:
- Net sales increased by 36% to $31.3 million from $23.0 million in the second quarter of fiscal 2010.
- The Company opened 18 new stores compared to 10 new stores opened in the second quarter of fiscal 2010. The Company ended the quarter with 179 company-owned stores.
- Comparable store sales, including e-commerce, increased by 8.7%. Comparable store sales, excluding e-commerce, increased by 6.9%.
- Income from operations increased by 41% to $2.3 million from $1.7 million in the second quarter of fiscal 2010.
- Net income increased by 78% to $1.0 million, or $0.03 per diluted share from $0.6 million, or $0.02 per diluted share in the second quarter of fiscal 2010.
Here are the highlights from its second public quarter (third fiscal quarter):
- Net sales increased by 35% to $33.4 million from $24.7 million in the third quarter of fiscal 2010.
- The Company opened 17 new stores compared to 13 new stores opened in the third quarter of fiscal 2010. The Company ended the quarter with 196 company-owned stores.
- Comparable store sales, including e-commerce, increased by 8.5%. Comparable store sales, excluding e-commerce, increased by 6.0%.
- Income from operations increased by 26% to $1.6 million from $1.3 million in the third quarter of fiscal 2010.
- Net income increased to $0.9 million, or $0.02 per diluted share, from $0.3 million, or $0.01 per diluted share in the third quarter of fiscal 2010.
By any objective measure, these results are fantastic. Aggregate sales are up but more importantly comparable store sales are up too. New store growth is robust and there is no sign of market over saturation. Furthermore, these increased sales translated to increased profitability (in other words, the company isn’t sacrificing its margins in order to show top line growth). In fact, gross margins expanded over the period, meaning the company has been able to charge more on average for the same inputs as compared to its results prior to going public.
On one hand, the company appears to be performing quite well by any reasonable standard and the future looks quite rosy as well, with high growth potential in a largely untapped market with growing demand. On the other hand, a number of market participants believe the company is headed for decline and are putting their money behind a short bet. So what gives? Valuation.
TEA is one of the most overpriced companies in America. Its share price premium makes any results, even great results, pale in comparison. Consider this: the company is trading at a price to earnings of 62x and a price to book value of a whopping 16.6x. By any objective measurement, the company is overpriced relative to its actual (strong) performance by an astonishing amount, meaning that there is a large amount of expectations built into its current share price. Even after 76.6% short interest, the bulk of investors in TEA expects the company’s future growth to exceed its historical growth and by a significant amount.
High expectations are a dangerous thing. As investors purchase at today’s high valuations, they are expressing their expectation that future performance will exceed that which is implied in the current price. Eventually, even strong performance will not be enough to satisfy these expectations. At the same time, the company will find it more and more difficult to achieve objectively strong performance, as its previous performance will attract new competitors, and heightened competition is a surefire killer of excess returns. As returns normalize and growth slows, the market’s high expectations will be left unfulfilled and suddenly a P/E of 62x and a P/B of 16.6x looks quite foolish and the shorts look quite reasonable.
We’ve seen this happen to Netflix (NASDAQ: NFLX) and Green Mountain Coffee Roasters (NASDAQ: GMCR), and it is almost certainly going to happen to TEA. In fact, I would argue that TEA is more susceptible to competitive forces than say NFLX, due to the latter’s relatively stronger competitive moat which helps maintain strong growth and excess returns.
Recall that TEA is a retailer of specialty loose leaf teas and related products. Where is the competitive moat? I can tell you first hand that there are effectively zero barriers to entry; my wife and I created one of these businesses online in a weekend and, thanks to the beauty of the e-retailing business model, were profitable from the first order, ultimately capturing the local market. Total initial capital investment? Less than $500 in inventory. Teavana has retail locations which vastly increase the riskiness of the enterprise, as fixed costs such as rent, utilities and minimum staffing levels require far higher sales to reach breakeven than my e-business. That said, many entrepreneurs will jump into the brick & mortar market despite the capital costs. There is no shortage of people willing to chase each new food fad with b&m locations at a minimal up-front investment of $120,000 (think smoothies, frozen yogurt, and bubble tea to name a few). And this is ignoring the fact that it is even cheaper for existing b&m retailers to begin emphasizing premium loose leaf tea. In the end, the company will get hit on all sides, from new entrants both online and in physical form, and from existing retailers with their greater marketing budgets and already loyal customers. TEA has some first mover advantage, but that isn’t enough to meet the market’s implied expectations.
The lesson here is that investors need to consider not just performance on an absolute basis but rather on a relative basis as compared to implied future performance. Anyone can assess whether a company is doing well or poorly, but investing success requires identifying where the rest of the market is mistaken in its assessment of the company’s future performance. This is what makes investing so difficult! I would argue that, despite TEA’s strong performance to date, the economics of the industry will prevail and increased competition will ultimately lead to the shorts prevailing. As Michael Mauboussin discusses in More Than You Know, too many investors fail due to first-order thinking, when the real trick is to focus on the second-order.