On The Perils Of Management Access & Straying From Process: Our Adventure With Jones Soda by Jordan S. Terry, Stone Street Advisors

Summary

  • We initially were skeptical about Jones Soda (JSDA) due to declining and generally weak financials, questionable strategy, and uncertainty surrounding its turnaround plan.
  • After the annual meeting and a one-on-one with the CEO (& CFO), we became convinced the company was in capable hands, and the turnaround would go well.
  • Turnarounds are hard, particularly for severely resource-constrained firms. We now believe Jones Soda should put itself up for sale rather than wait/hope for a small miracle.

Introduction

In late May 2013, we started working for a client who was interested in knowing what we thought about Jones Soda (OTCQB:JSDA). It was a bit of a treat to be able to work on a company whose products I had enjoyed so much during my more formative years, and it provided me the opportunity to do a lot of work that I don’t often get asked to do, some banking and activism stuff in addition to research.

Unfortunately, until very recently, I was bound by a non-disclosure agreement, which prevented me from sharing further analysis publicly. Now that I’m at liberty to write again, I want to discuss how we got the bullish call wrong in June 2013, what happened when we realized we were wrong, what we’ve learned in the process, and what we think about Jones Soda today.

I’ve tried to be brief, but since there’s a lot of relevant background information, this isn’t exactly a quick read. If all you care about is our current view on the company, you may skip to the last section, though you’ll be doing so at the expense of understanding the bigger picture.

A Good Analyst is a Skeptical Analyst

First off, for those unfamiliar with our firm, it’s important to note that we begin and conduct our research as skeptics first and foremost, no matter how excited we get over a growth story. To be clear, we are neither cynics nor permabears, far from it! Being a skeptic isn’t the same as being bearish; it means we seek to analyze firms without bias, positive or negative. This has allowed us to avoid many traps, both long and short, though we’ve certainly made some mistakes, and our take on Jones Soda was one of the worst.

So, why are we skeptics? Some, but not all of the reasons:

1. Most people err towards optimism rather than pessimism; virtually no one wants to talk about how a company is terminal, but almost everyone wants to talk about the next big thing.

2. Most investors are long and thus biased towards optimism.

3. Most analysts are directly or indirectly incentivized towards being bullish rather than bearish, leading many to downplay the risks and focus instead on the upside.

4. Management knows more about the company and its outlook than we do, and short of outright lying, will always paint their company in the best possible light.

Skepticism, then – the foundation of our research process – acts as a balance against the myriad bullish biases in the market.

A Skeptic Becomes a Believer: Takeaways from the Annual Meeting – May, 2013

Perhaps unsurprisingly, our initial analysis left me feeling pretty bearish. Revenues had collapsed, expenses were still too high (despite reductions), distribution too limited, and money tight. After a private meeting with the CEO, Jennifer Cue and CFO, Carrie Traner at the annual meeting, I left feeling pretty confident that the company was in capable hands and could turn it around with some common sense actions. On June 7th, I published an article on my erstwhile Forbes column explaining, at least in part, why we were bullish on the company.

As mentioned above, I walked into the annual meeting appropriately skeptical, with a legal pad of questions for management to address my many and myriad concerns. After the shareholder meeting and private discussion with the CEO/CFO, I left with a totally different opinion of the company and where it was headed than the one I’d walked in with.

Straying From Our Core Belief: Caveat Emptor

I have long held that “management access” is a slippery slope in the research game, though it is often touted as providing some sort of competitive advantage. We’ve generally been successful without the sort of management access some analysts are renowned for having, at least judging by the returns of our ideas and our hit rate. Due to Reg FD, executives can’t really tell you much they haven’t already said in a public forum, and if they do, they have to make that information public. They may provide some hints or answer your questions with some more candor/detail than on an earnings call, but I think these conversations are just as – if not more – likely to leave you with a biased view on the company rather than with additional, useful insight. Many will adamantly disagree with me here and/or dismiss my concerns for a number of reasons, but seldom, if ever, will an executive tell you the firm is doing or will be doing worse than expected. They have to be bullish on their own firms, so anything they say is naturally going to play-up the good and downplay the, shall we say, ungood.

Duh.

When it came to the meeting I had with Jones’ CEO and CFO, I violated my own philosophy of not taking management’s word at face value and allowed the experience to affect my judgment, instead of retaining a healthy dose of skepticism. Unfortunately, this was a lesson I’ve had to learn the hard way. This is not to say you can’t talk to management or buy what they’re selling; rather, you must take it with a proverbial grain of salt.

By mid-June, I realized that I’d given far too much credit to Jones’ management, but unfortunately, I couldn’t share any of my work publicly due to the aforementioned NDA with my client.

Step One is Admitting You Got it Wrong

On 6/19, I received an “out-of-office” reply to an email I sent the CFO with some questions, informing me that she’d be out on vacation until 7/22. The #2 person in a company elbow-deep in a turnaround takes a five and a half week vacation during prime selling season? Are you kidding me?!?!?

This, among a number of other issues, hit us square in the face, and we went back and reassessed everything we’d done thus far. I did receive an email from CEO Jennifer on 6/20 in response to my email to the CFO to set up a time to talk, which speaks highly of her; however, many of our questions/concerns remained unanswered/unaddressed.

As a result, I sent the following to the CEO on 7/11:

Jennifer,

To be very clear, the following is purely on behalf of myself and my company, so please do not attribute my comments in any way to *redacted* or *redacted*. These comments/questions are purely my own as an analyst (one of the very, very few who actually has looked in-depth at the company).

  • There was only 1 non-executive board member at the annual shareholders’ meeting, Mr. Kellogg if I recall, who co-owns Tutta-Bella Neapolitan Pizza per his bio on the Jones website. $40,000/year and the rest of the directors can’t even show up to the annual meeting? By the way, per the online menu of Mr. Kellogg’s restaurants, www.tuttabella.com/menu/, they do not sell any Jones Soda products. Et tu, Brute?
  • The board is too small, with too much power concentrated in the hands of the two (2) members on the compensation committee (per the committee charter on your website), which has wide-ranging power and influence over things a so-named committee should not. This seems like a major corporate governance issue so far as I can tell.
  • Why no reverse split consideration? How else do you change the shareholder base from largely many small retail holders to larger institutions, who can generally provide more stable long term equity capital until the company maybe returns to its former glory?
  • Why is Jones not in the biggest, most affluent, influential city in the country? This does not make any sense to me. Just the Whole Foods in Tribeca would sell more product than 100 flyover country retailers combined, and that’s just a tiny part of NYC/NYC metro (Long Island, Westchester, Connecticut, New Jersey).
  • Am I correct that Carrie (the CFO) took a month-long non-working vacation during prime selling season? I realize everyone needs a break so as not to burn out, but a month out of office during prime season from the #2 executive at the firm just boggles the mind, even if she’s checking emails and staying in-touch.
  • Cutting costs was necessary – I don’t think anyone can debate that – but I think management has overshot the mark to the point where it’s become detrimental, as evidenced by e.g. q/q revenue decrease, employees handling multiple & myriad tasks beyond their prime focus, etc.

I have several other comments, but these are a few major ones that really make me scratch my head. I realize that you are operating in a resource constrained environment but the above comments/questions are fair regardless, in my professional opinion.

Thank you and Regards,

Jordan S. Terry

Founder & Managing Director

Stone Street Advisors LLC

There was some follow-up between myself, Jennifer, and the two investors whose names are redacted, but ultimately I was not satisfied, nor was my client. We worked on putting together a take-private transaction to reduce public company costs, rework the board, recapitalize the company, and implement strategic change, though it never got off the ground, and isn’t particularly relevant, anyway.

Jones Soda stock rose significantly after we released our bullish report in June, and stayed well above the price on the day before publication through the end of the client engagement late in the summer of 2013. Unfortunately, I was still unable to share my thoughts due to the NDA, even though we had significantly changed our outlook weeks after the initial article. The stock gave back most of its gains in the fall, but held up through the end of November, after which it dropped about 30% with some pops along the way.

Apparently, other people started to realize the turnaround wasn’t going as well as they thought it was, too.

Jones Soda Today: Commendable Effort, but Too Little, Too Late

In December, I was contacted by a business journalist inquiring about my thoughts on the company today, and in January, I was contacted by yet another. For the first time in about 18 months, I took another look at Jones and was disappointed, to say the least.

What do I think of Jones now?

My response to the journalists’ inquires was as follows:

The company has increased distribution, but revenue is flat to down, receivables are up, payables are up, shareholders’ equity is down, and they’re running out of money. The problem is, while they may be in thousands of locations, it’s not like they’re getting a ton of product to each/any; the one/few products per retail outlet thing only works in convenience stores and delis, not in grocery/etc. With flat/lower SG&A, they’ve got more distribution points to serve with the same or fewer resources to serve them. This is a brand-focused business which requires significant advertising/promotion/marketing efforts, and Jones Soda just doesn’t have the resources, human or financial, to build up the brand, despite having a huge and loyal following. The direct channel could be better, but when you’re shipping soda, there are not so many people that are going to buy direct, not very often at least, no matter how much they like it.

All things considered, unless current investors are going to keep throwing more money at the problem, Jones Soda is on the fast lane for Chapter 11. The problem though, is the company doesn’t really have any debt to restructure, so the only option is that another company buys them out of bankruptcy. I think the JSDA brand alone is worth well more than the firm’s current market capitalization, so if their bankers/lawyers are even semi-competent, there should be multiple buyers lining up. Why aren’t there buyers now? Why pay $1 for what you can get tomorrow for $0.50 (or less)? If they had debt, you could see a distressed exchange, but, alas, no real debt besides the A/R facility, which I’m shocked isn’t at a much, much higher rate and didn’t basically give half the company away with an equity kicker (warrants, rights, etc). I’m not familiar with the lender, but they don’t seem to be in the business of owning companies.

There is a strong argument the company is worth more alive than dead (bankruptcy), but no one has stepped up to the plate as far as I know. If the stock goes low enough, I suppose someone could come forward, but it’s hard for a board to agree to “sell low,” as they have those pesky duties to shareholders, and in some circumstances are held to higher standards, particularly if a company is “in-play.”

Jones is stuck between a rock and a hard place; they need money to grow, but they don’t have any money and there’s a dwindling # of people willing to give them more money just to see the company survive another few quarters. Are there any catalysts? I suppose a decent sized distributor/retailer could jump on board, which could, in one fell swoop, double revenue, but if it hasn’t happened yet…

Considering the firm’s suboptimal financial position, I’d be a bit surprised if distributors/customers, particularly the ones that could move the needle, would invest in a distribution/retail partnership. There’s significant reason to worry Jones won’t be able to keep up its end of the bargain, so why risk it?

Ultimately, Jones Soda is a great brand, a great product, with loyal fans/customers, and there are some great people involved. The CEO has put a lot of her own money into the company to keep it afloat; if that’s not a sign of confidence, I don’t know what is! But, it is also a company that desperately needs to be rolled-up into a larger company with significantly greater resources in order to succeed. On a stand-alone basis, Chapter 11 seems almost unavoidable, though more unlikely turnarounds have happened, so you never know.

Buying/owning the stock is effectively buying/owning a long-dated, deep out of the money call option. Sure there’s voting rights, but with no institutional ownership, it’s basically impossible for current shareholders to exert any influence on the Board and/or Management. Even if they could, what are they going to do? Vote out the board? While that’d be a long time in coming (four of five non-executive directors have been on the board since at least 2008, and have seen the stock drop >85% on their watches!), it doesn’t address the fact that the company is holding on for dear life. Shareholders still need a savior of one flavor or another.

Later, I added (with numbers updated for my most recent estimates):

I should add or clarify that, in my opinion, management has done its best, though it’s just not enough. Look at the below chart. This is just back-of-the-envelope math using store data gathered from the website last October so it isn’t 100% conclusive, but should give us a pretty good idea of where things stand, especially combined with their SEC filings. They have a lot of stores, but aren’t selling a lot per store. Their break-even revenue (to come out with $0 pre-tax profit) is significantly higher than they have any realistic hope of achieving this year, next, or maybe even the year after that….even IF gross margin were somehow 30% instead of what I estimate will be 22% this year.

Put another way: Just to break-even (pre-tax!), they need to grow revenues 25% from my 2014 estimate if the company can somehow achieve a 30% gross margin. Back in the realm of reality, we’re looking at gross margins in the mid 20%’s, so if they can bring GM back up to 25% from an estimated 22% this year (23.8% in 2013), revenue needs to grow 50% just to break even!

Jones Soda

I very, very, very seldom advocate “selling low,” but this company – absent a miracle – can muddle-along another few quarters, at best, before they have to file for bankruptcy. All things considered, I think the board should put the company up for sale ASAP.

Why Sell?

Management should be commended for keeping the ship afloat the past few years after the myopic decisions of prior managers left the company in a precarious position. Unfortunately, to turn the company around, it needs resources which it just does not and probably won’t have unless they can land a major customer very, very soon. Absent that, the only other option to execute the turnaround on a stand-alone basis would be to secure a significant capital infusion, the size of which would see the investor owning a majority of the company. Instead of seeking a large investor and diluting current shareholders, the goal should be to sell to a strategic partner – a larger beverage company – which has the resources to monetize Jones Soda’s valuable assets. I think Jones is worth far more alive than “dead” i.e. in bankruptcy, so were I a shareholder, I’d implore the board to hire an investment bank and start shopping the company, sooner rather than later.

It’s suboptimal to sell low, but when the likely alternative is limping-along for a few more quarters, shareholders would be lucky to get something for the company, rather than less than that in bankruptcy, which I otherwise see as practically inevitable, even if they can keep selling more stock/warrants.

Crazier turnarounds have happened, though they are few and far between, so while I wouldn’t rule it out completely, investors should play the odds. I think the expected value (price*probability) in an acquisition is higher than the expected value using the hope & pray “strategy,” betting on a successful turnaround at some indeterminate point in the future. Investors may get a higher price if the company can turn it around, but it’s a big IF, which means the probability is so low, the EV is, as well.

As always,

CAVEAT EMPTOR