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DAVIDs TEA: A Toxic Brew Of Sweet Promises Overpowered By Bitter Reality

A Canadian retailer with ambitious plans to take the U.S. market by storm, DTEA has adopted the same kind of strategy that almost bankrupted its co-founder's first company.

With its new Canadian stores cannibalizing sales at its older locations, DTEA has decided to bet its future on a risky U.S. expansion plan that could easily backfire.

Despite the weak performance of its U.S. stores to date, DTEA wants to open hundreds of new locations in “Class A” shopping malls all over the country.

That goal seems wildly optimistic, however, since a rival tea retailer – owned by the formidable Starbucks beverage chain – has already entered most of the country's high-end shopping malls.

Given the challenges that DTEA faces, company insiders might feel tempted to start unloading mountains of stock once a temporary “lockup” period expires just a few short weeks from now.

DAVIDs TEA (NASDAQ: DTEA) needs to wake up and smell the coffee. After exploding onto the Nasdaq as an overheated high flier - and promptly burning the investors who had just swallowed its story - DTEA should feel lucky if it can even sleep at all.

A Canadian retail chain that recently went public with a celebrated (if misguided) plan to take the U.S. market by storm, DTEA has lost half of the lofty valuation that it achieved just before the company issued its first quarterly report and blindsided the market with its ugly financial results. At this point, DTEA owes the public a whole lot more than a simple apology. If DTEA even hopes to redeem itself, the company needs to somehow prove that its growth strategy actually makes good business sense.

With so much evidence pointing in the opposite direction, however, DTEA could find that argument difficult to win (or even to defend). Not that the company seems particularly eager to debate the merits of its case right now. Blaming a so-called "quiet period" for its silence (the same excuse that the company provided a reporter barely a week AFTER it had just released its quarterly results), DTEA declined an invitation to answer questions for this story.

Who knows? Maybe DTEA decided to buy itself some extra time after realizing that it still needed to finish its homework. The company might as well save itself the trouble at this point. By the time that it reaches the end of this extensive report - or even the crucial section that undermines the centerpiece of its mall-based U.S. expansion plan - DTEA should feel nervous enough to think twice about betting its future on a risky growth strategy that seems like such a terrible idea.

Take a look at some of the most obvious warning signs that the company has somehow managed to overlook or (even worse) chosen to ignore.

* Trouble at home: DTEA obviously decided to take a big chance on the U.S. market for a reason. By now, DTEA has opened so many stores in its home country of Canada that it needed to look elsewhere for growth. Shortly after its IPO, in fact, DTEA suddenly revealed that - with its newly opened stores now stealing business away from its more established locations - same-store traffic in Canada had declined for the first time in its entire history.

"With 1Q15 traffic turning negative in Canada, management sees future SSS growth in the region driven by ticket gains, with a decline in ticket potentially putting into question DTEA's long-term low-mid single-digit SSS targets," JP Morgan cautioned when it initiated coverage of DTEA with a lukewarm neutral rating in spite of the generous underwriting fees that it had just collected for taking the company public. "Management has attributed traffic declines to cannibalization from new stores … Looking ahead, management sees this cannibalization to traffic continuing, with forward-looking SSS in Canada driven primarily by higher ticket (AND) traffic flat to down over time."

* Sticker shock: DTEA has relied on a handy - if ultimately unsustainable - trick to prevent its overall same-store sales from sliding into negative territory, too. While same-store traffic has remained essentially flat for the past six quarters in a row, its skimpy disclosures show, DTEA has tried to make up for those stagnant crowds by collecting more and more from the customers who do wander into its high-end retail stores. If not for the helpful boost provided by the steady rise in its average ticket price, DTEA would have seen its same-store sales inch up by less than 1% in 2014 and actually slide during the first half of the current year

No wonder DTEA seems reluctant to disclose the crucial traffic and ticket metrics that most retailers normally share as a matter of routine. As illustrated by the chart below (pieced together with the help of figures grudgingly supplied by DTEA only after the U.S. Securities and Exchange Commission repeatedly intervened), the company has plenty to hide.

Time Period

FY 2013

FY 2014

1Q 2015

2Q 2015

Ticket Growth

13.0%

10.2%

7.2%

6.9%

Traffic Growth

4.2%

0.9%

- 0.8%

0.0%

SSS Growth

17.8%

11.1%

6.3%

6.9%

* Ticket and traffic growth figures based upon disclosures supplied by DTEA in its regulatory filings, press releases and quarterly conference calls.

* Weak U.S. results: When DTEA decided to shift its focus from Canada to the U.S. - where it tends to spend more on its stores and receive far less in return - the company basically elected to sacrifice margins for growth and hope for the best. While its Canadian stores generate close to $1 million in revenue, on average, its U.S. stores muster barely half of that amount. Far less of that revenue drops to the bottom line, too. Since 2011, when DTEA first entered the U.S. market, the company has seen its gross margins steadily decline from 57% to less than 50% after opening just 27 of the 300 U.S. locations that it ultimately hopes to operate in spite of the heavy toll on its financial results.

Time Period

FY 2011

FY 2012

FY 2013

Q1 2014

Q2 2014

Q3 2014

Q4 2014

FY 2014

1Q 2014

2Q 2014

Canada Stores

68

91

108

109

111

121

130

130

136

138

U.S. Stores

2

14

16

17

19

22

24

24

25

27

Total Sales

$42M

$73.1M

$108M

$27.8M

$25M

$27M

$62M

$142M

$35.6M

$32.8M

Gross Profit

$24M

$40.9M

$59.8M

$16M

$13M

$14M

$35M

$77.7M

$19M

$16.1M

Gross Margin

57.1%

56.0%

55.3%

57.6%

52%

51.9%

56.5%

54.8%

53.4%

49.1%

* Calculations based upon figures supplied in DTEA filings and/or analyst models

"Our future growth depends, to a considerable extent, on our expansion efforts outside of Canada into the United States," DTEA explained in the registration statement that it filed shortly before the company went public. "In connection with our initial expansion efforts in the United States, we have experienced longer projected payback periods for our new stores. Although we are currently targeting cash-on-cash paybacks of approximately three years in the United States (compared to two years in Canada), we have not yet achieved this in any of our U.S. stores" to date.

Still waiting for DTEA to produce some tangible evidence that it can achieve its lofty goals, Goldman Sachs has chosen to remain on the sidelines (along with fellow underwriter JPMorgan) even after collecting lucrative investment banking fees from the company.

"Given the large DTEA opportunity depends on the U.S., U.S. expansion risk may warrant discounting the valuation and growth potential," Goldman Sachs explained when it initiated coverage of the company with a tepid...


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