DavidsTea: Growing Into Ready-to-Drink

Steeped in Struggles

DavidsTea’s stock has decreased in value by 87 per cent since its initial public offering in 2015. This significant drop in share value reflects a company which finds itself in a harsher environment than when it was founded in 2008 by David and Herschel Segal. In its early days, the Montreal-based tea retailer helped pioneer a consumer preference for specialty teas. Over the next nine years, DavidsTea would go on to open 236 stores across North America. However, since 2014, the company has been stuck with an unsustainable and unprofitable growth model—a reality that is still prevailing in 2018. To avoid further losses, DavidsTea must rethink how and what it sells.

DavidsTea currently derives the majority of its revenues from tea and tea accessory sales at its proprietary stores, which are located predominantly in malls. The company is heavily reliant on mall foot traffic, yet North American malls are gradually becoming obsolete due to movements from e-commerce giants such as Amazon. Large U.S. mall operators like Simon Property Group, General Growth Partners, and Taubman Centers experienced an average decline in foot traffic of approximately six per cent from 2016 to 2017, and this trend is expected to continue. Exacerbating the situation is the overall decline of the tea market. In Canada, the tea market has contracted by over six per cent over the last four years, with further declines projected. To combat the overall decrease in tea consumption, tea companies have been raising tea prices, with the average unit price for tea increasing by 1.2 per cent between 2016 and 2017.

Boiling Point

Faced with the reality of troubling external forces, DavidsTea might point to its past three-year average revenue growth of 21 per cent as a beacon of hope. However, closer inspection reveals that 2017’s revenue growth of 5.9 per cent was solely driven by opening new stores. Furthermore, same-store sales growth at DavidsTea have dropped dramatically from 13 per cent to the current negative 4.5 per cent over the past four years. Ultimately, it seems that DavidsTea is only able to have its revenues appear healthy by unsustainably opening new stores in order to outpace the decline in mall traffic and demand for tea. DavidsTea is not the only company to experience these revenue challenges; U.S.-based Teavana, acquired by Starbucks in 2012, also offers premium and specialty teas. Unable to attract new customers and grow same-store sales, Starbucks recently disclosed plans to shut down all 379 proprietary Teavana retail locations. To thrive in a way Teavana never did, DavidsTea must rethink its core market and offerings, with the ultimate goal of achieving revenue diversification.

Fermenting Diversification

To achieve revenue diversification, DavidsTea must find a way to reach new customers in a growing market while still leveraging the company’s core competencies. These aspects are embodied in the ready-to-drink (RTD) tea market, which had annual revenue growth of 4.8 per cent in 2017, partially fuelled by increased demand in the premium segment. The market size of RTD teas in the U.S. was $3.5 billion in 2016 alone, representing a significant opportunity for DavidsTea to diversify. Selling RTD products through new channels such as grocery and health stores will allow DavidsTea to shift its revenue model and access new customers who do not frequent the company’s proprietary stores. Having developed a reputation for premium teas, DavidsTea must now leverage its proven name in the RTD market where it can capture a larger customer base.

A key driver of growth in the premium RTD tea segment is a popular new beverage called kombucha. Much like tea, kombucha is an ancient Chinese beverage that comes in a wide array of flavours, made by fermenting sweet tea with a symbiotic culture of bacteria and yeast. When the beverage development is complete, kombucha is often sold in single bottles. The North American kombucha industry has grown at an exponential rate in recent years and is forecasted to continue growing at an average growth rate of 25.9 per cent per year until 2025. The most popular segment for kombucha purchases is in supermarkets, although the product is also commonly sold in health stores due its perceived health benefits. As the market has grown, consumers have been increasingly selecting products based on flavour and brand association. Although DavidsTea offers a single type of powdered Kombucha, it does not currently sell any bottled kombucha. DavidsTea also does not sell products outside of its proprietary stores, so distributing through third-party retailers provides the opportunity to diversify and hedge against external factors. As the first step in expanding its brand within the broader RTD market, DavidsTea should enter the kombucha space with its own bottled products.

Simple All Oolong

DavidsTea has a large tea portfolio, with many SKUs that could be fermented into kombucha for the development of product lines. However, the company has no experience in fermenting teas on a commercial scale, nor bottling and distributing beverage products to third-party retailers. Working with industrial processes that use biological agents requires companies to comply with strict government regulations, and there is little room for error. In light of these circumstances, DavidsTea should acquire a company that is able to provide the necessary expertise.

Acquisition Targets: The Right Matcha

There is no single company that DavidsTea could buy to achieve strong growth in North America. Instead, DavidsTea should consider acquiring a company in each country that has has a strong retail distribution system. In the U.S., there are hundreds of kombucha companies, but most of these companies are smaller local breweries. Using company sales of bottled kombucha to gauge distribution and manufacturing capacity, Asheville Kombucha Mamas, which sells kombucha under the name Buchi Kombucha, would be an ideal target. Headquartered in North Carolina, the company’s eight years of past experience has led to revenues of over $6.6 million in 2017. In the Canadian market, one of the largest kombucha manufacturers is RISE Kombucha. Headquartered in Montreal, the same city as DavidsTea, RISE achieved approximately $10 million in sales. Using the price to revenue multiple from PepsiCo’s 2016 acquisition of kombucha maker KeVita, it would cost DavidsTea approximately C$62 million to acquire RISE and Buchi. DavidsTea would likely have high interest rates on any debt they issue, and with C$37 million in cash on its balance sheet, the company should attempt a buyout partially through cash and partially through a share exchange.

DavidsTea can provide the target companies with support regarding scalability, distribution, and capacity to innovate. The former’s large balance sheet enables it to provide both companies with the dry powder they need to scale quickly. In addition, with tea being the primary ingredient in the production of kombucha, DavidsTea’s economies of scale would allow the kombucha companies to drive down overall production costs. Further economies of scale are driven by the combination of RISE and Buchi, which rely on many of the same inputs.

Beyond these size benefits, this combination would provide RISE and Buchi with a virtual monopoly within DavidsTea’s 236 retail locations. The acquisitions will also provide these fledgeling names with the backing of a premium well-recognized brand in the form of DavidsTea, a powerful differentiator on Canadian retail shelves. Furthermore, the target companies will gain access to DavidsTea’s plethora of innovative tea flavours.

Davids Tea Graph (Tea Industry)-01-01

The fermentation process of Kombucha leads to a vinegar taste that is commonly masked by the addition of other tea. Approximately 68 per cent of Kombucha consumers favour flavoured drinks over the unflavoured sour taste. While many flavoured Kombucha teas are available, certain teas are much better suited for fermentation and as flavour additives that improve the taste profile. With its team of world-travelling tea connoisseurs, DavidsTea has developed an unparalleled selection of 150 types of proprietary loose-leaf tea and has created a premier flavour profile across its offerings. With the company’s market-leading position in tea curation, DavidsTea is in a favourable position to develop Kombucha that balances bold flavour with the sweetness of carefully selected teas.

Davids vs Goliath

With the acquisition of a kombucha manufacturer, DavidsTea officially enters into the RTD beverage industry. At first glance, the competition within this market is daunting, with goliaths such as Unilever, Arizona Tea Beverages, and Nestle alone dominating 37.5 per cent of the industry. However, DavidsTea can flourish by continuing to target the affluent segment of customers. Underserved by larger market players, these consumers are already fleeing high-sugar soda products; per capita consumption in this market has decreased at an annualized 2.8 per cent from 2012 to 2017. Although companies like Unilever and PepsiCo are responding to this shift, DavidsTea already has a loyal consumer base and strong R&D capabilities it can capitalize on. With these strengths, DavidsTea has the unique opportunity of timing, entering the RTD market at a point where consumers desire more than what is available.

Despite acquiring two companies, DavidsTea would not be the biggest player in the kombucha market. GT’s Living Foods line of kombucha is estimated to have captured 50 per cent of the current U.S. kombucha market. Second to GT is Pepsi-backed KeVita, with an estimated 10 per cent of the market. The remaining 40 per cent of the market remains unconsolidated, split into a large number of regional producers. Upon performing both acquisitions, DavidsTea would immediately start with two per cent of the market. Given DavidsTea’s strong brand in Canada, existing network of stores, and market leading flavour selection, the company will supercharge kombucha growth, capturing new and existing customers alike.

New customer adoption will be driven by customers already familiar with DavidsTea who experience kombucha for the first time. DavidsTea can capture share from the other 40 per cent of the kombucha market with its best-in-class flavour profile and strong brand name. To reach a revenue contribution of 20 per cent within three years, implied growth rates are approximately 50 per cent. This compares to Kevita’s trailing three-year revenue CAGR of approximately 75 per cent at the time of its acquisition.

Keep on Growing

Ultimately, entering RTD tea would diversify DavidsTea’s revenues in multiple ways. The product will be sold through new channels like premium grocery and health stores in addition to existing DavidsTea stores, attracting new types of customers. According to consumers, the most significant difference between RTD tea beverages and loose-leaf tea is convenience. The current DavidsTea customer commits time to the loose-leaf brewing experience. RTD kombucha, on the other hand, caters to health-conscious customers who favour convenience. Due to the differences in underlying buyer motivations and product placement, cannibalization in-stores is expected to be minimal.

Gross margin estimates from small kombucha manufacturers are expected to be around 80 per cent, which compares to DavidsTea’s current gross margin of 50 per cent; any revenue cannibalization that does occur will increase DavidsTea’s overall gross margin. Incremental fixed costs associated with manufacturing kombucha are minimal in comparison to existing expenses associated with brick and mortar. Most importantly, decreased mall foot traffic and tea consumption would not impact DavidsTea’s RTD revenue stream distributed through non-DavidsTea locations. Instead, the new product line will increase overall margins and brand exposure which could convert convenience-oriented consumers to loose-leaf customers, positively impacting same-store sales. After only three years of pursuing the diversification strategy, kombucha sales would generate more than 20 per cent of DavidsTea’s current sales.

Having helped reshape the loose-leaf tea industry in Canada, DavidsTea can expand its influence into the RTD space with kombucha as its first foray into the market. After conquering the kombucha space, DavidsTea will be ready-to-diversify into the broader RTD market to grow its brand into a household name across the world.