Philip Morris Adds A Piece To The Smokefree Puzzle

Last week Philip Morris International announced it has agreed to buy Fertin Pharma from current owners EQT (70%) and the Bagger-Sørensen family (30%). The transaction value is roughly $820 million, for a price/sales multiple of somewhat over 5x, and an EV/EBITDA valuation of approximately 15x (using fy2020 financial data). Fertin Pharma started as a candy business in Denmark in the early 20th century, and subsequently expanded its operations into chewing gum and nicotine gum (1996). Its regular chewing gum brands, including Stimorol and V6, were sold to Cadbury Schweppes in 2001 and are nowadays part of Mondelez International. Since the branded candy exit, the company has focused its operations on developing products for oral delivery of nicotine, most prominently with nicotine gum, but has also developed know-how for delivering nicotine through lozenges, liquefiable tablets and pouches. Additionally, these delivery systems can also be deployed to deliver other active ingredients to the human body, such as vitamins, cannabinoids and caffeine.

Given the attractive market developments in recent years in such product categories as energy drinks, alternative nicotine products and cannibanoids, Fertin’s product portfolio fits well with PM’s stated goals of growing smokefree sales to 50% of total revenues and non-nicotine sales to at least $1 billion by 2025. Currently, Fertin operates primarily as a contract manufacturer for third parties, and not as a an important owner of branded products. Philip Morris is therefore buying the company for its technological and manufacturing capabilities, in my opinion primarily with regards to nicotine pouches. Nicotine pouches are the largest category in the modern oral nicotine (or MON) space and have shown very significant growth in recent years, particularly in North America and the Nordic and German-speaking regions of Europe. The outlook for these types of products is generally regarded as excellent due to their affordable nature, availability of flavors, ease of use and the dramatically lower health risk associated with their usage (when compared to cigarettes).

Even though PM is a clear frontrunner in smokefree nicotine products, which comprises heated tobacco, vapor and modern oral, the company is trailing its competitors in the latter category. Swedish Match and British American Tobacco have taken a clear lead in modern oral, while Altria has acquired Burger Sohne from Switzerland for its on! brand of nicotine pouches. Imperial Brands and Japan Tobacco are small players in this category, and are mostly competing with products launched by their existing Swedish snus subsidiaries (Skruf and Nordic Snus). PM’s acquisition of Fertin is meant to close the gap with its competitors in modern oral products, with Fertin adding the expertise and manufacturing capabilities to develop oral nicotine products while PM will likely assume responsibility for branding and marketing strategy. I believe the development and market introduction of a branded nicotine pouch product will likely be PM’s first priority after the acquisition closes. Longer term, Philip Morris may also explore possibilities for developing products with other active ingredients, as well as nicotine products with other delivery mechanisms. The deal makes a lot of sense from a strategic standpoint, at an acceptable price point, and since it is still early days in the modern oral category, PM is now in a better position to become a serious contender in this field.

(Disclosure: the author owns shares of British American Tobacco)

Altria and BAT: Will The FDA Go Menthol?

Yesterday the Wall Street Journal reported that the Biden administration is considering regulations targeting nicotine levels in cigarettes as well as menthol flavorings. With regards to nicotine, an addictive chemical present in tobacco smoke, the measure being considered is to only allow non-addictive levels of the substance in cigarettes. The potential measure with regards to menthol would be to ban it as a characterizing flavor in cigarettes, and possibly in other forms of tobacco as well. According to the report, the decisions regarding both initiatives have not been made yet. 

However, given the uncertainty created by the possibility of regulatory intervention, the market showed an adverse reaction in tobacco stocks like Altria. Regular observers of the tobacco industry can hardly be surprised by this development. The FDA, then under the leadership of commissioner Scott Gottlieb already announced similar intentions several years ago. The regulatory overhang has probably contributed to a significant discount in tobacco stocks since then. Therefore, this news report did not really deliver much of a surprise, but it does raise some questions. Namely;

  1. how likely are scenarios that either one, or both of these measures will be implemented? 
  1. how quickly will these policies be implemented if they are adopted? 
  1.  What will be the economic impact on the tobacco companies of both measures? 

Likelihood of menthol and nicotine regulation

Perhaps it is to be expected that the new administration, with a significantly more progressive agenda than the previous one, would like to move decisively on tobacco control. Regarding the possible implementation of menthol and nicotine content regulation, it should be noted that these ideas constitute very different tobacco control measures. Menthol regulation on the one hand is a tested tobacco control measure that has already been adopted in the European Union and Canada, while nicotine content regulation seems to be a more radical and untested approach. 

The rationale for menthol regulation is that it serves as a gateway for cigarette smoking by making the habit more palatable for new users, thereby fueling addiction and, by extension, long-term health damage. Removing mentholated cigarettes from the marketplace would presumably limit the uptake of smoking among youth, and might make it easier to quit for existing users. The fact that ethnic minorities are overrepresented as consumers of menthol cigarettes is an issue that has become more prominent over time, and has served as something of a rallying cause for minority advocacy groups in recent years. 

Given that menthol is an additive in tobacco products instead of a naturally occuring substance, the practical implementation of a ban would be relatively straightforward. A significant advantage with regards to implementing a menthol ban is that lessons can be drawn from experiences in the EU and Canada, who have already implemented such rules. If evidence can be presented from other countries that a menthol ban leads to a lower smoking rate, this clearly helps in building a public health benefit claim.

Nicotine content regulation on the other hand is a largely untested control measure, as it has not been implemented on a significant scale in other markets. Additionally, nicotine occurs naturally in tobacco leaves and a content rule would be far more intrusive and would likely require far more extensive cooperation from manufacturers in order to be implemented successfully. 

The rationale behind the possible introduction of non-addictive nicotine levels in cigarettes is that addiction to nicotine is the main reason why smokers continue to engage in behavior that causes severe long-term health problems in the majority of users. Taking the amount of nicotine in a cigarette down to non-addictive levels might raise the rate of success of smokers trying to quit, and might lower the risk of addiction in new users, or so the FDA thinks. The issue with this argument is that it is difficult to corroborate with data, because it is not at all clear how a lower level of nicotine would affect smokers’ behavior. For instance, it might lead smokers to smoke more cigarettes or inhale deeper, or it might lead them to different tobacco products, potentially even illicit ones. It would be hard to argue a public health benefit arising from such a rule if it may lead to more risky behavior in users.

Time-frame for implementation

The amount of time it might take for menthol and/or nicotine content regulation to be introduced in the marketplace is highly uncertain, and would depend to a significant extent on the regulatory path chosen to implement the new rules. I expect that the tobacco industry will try to challenge both a menthol and a nicotine content rule in court, something they did not do with regards to the recent tobacco-21 law.

Another unknown variable is the fact that the US senate has historically formed quite a formidable obstacle in the way of more restrictive tobacco laws. I presume that this is part of the reason why new tobacco restrictions in the US usually arise at the local level first. In the case of tobacco-21 measures, the adoption of federal legislation followed, rather than led, the implementation of more advanced age restrictions in many local jurisdictions. It is not entirely inconceivable that menthol regulation will follow a similar path, whereby a rising number of local jurisdictions where menthol sales are banned will at some point force the issue at the federal level.

In my opinion, both a menthol ban and a nicotine content rule would take several years at a minimum before they can be implemented in the marketplace. First, if new tobacco regulations are introduced as legislation, it is not at all a given that this bill would pass the US senate, where democrats currently possess only a razor-thin majority. Second, there is a significant chance that in case new rules are introduced by the FDA as part of its authority granted under existing legislation, these rules would likely be challenged in court.

Economic impact 

Regarding the economic impact of a menthol ban and a nicotine content rule, I would argue that a nicotine content rule would likely be more damaging to the tobacco industry’s long-term economic prospects. Of course a menthol ban would cause disruption in the US market, but in my opinion this would largely be a transitory issue. The US is the largest market for menthol cigarettes by far, estimated to constitute as much as a third of all cigarettes sold annually, but the dynamics of a ban are nevertheless likely to play out along the lines of what we have seen in Canada and the EU.

As we have seen in these markets, once menthol products disappear from the marketplace the addicts remain and usually switch their consumption to non-menthol cigarettes or other nicotine products. Some users will probably use the ban to try and quit completely. But because users overwhelmingly switch to other nicotine products, the impact of a menthol ban on tobacco companies usually comes down to a manageable event. After all, these companies are usually the ones that sell the alternatives as well. The most significant impact will therefore be related to changes in market share between different manufacturers, as well as differences arising from disparate profit contributions per product.

A nicotine content rule would in my opinion be far more disruptive to the tobacco industry because it potentially takes away or minimizes the addictive characteristics of the tobacco product in question. A tobacco product devoid of nicotine would probably experience a lot of problems in maintaining its marketplace relevance, given that it would no longer deliver the dopaminergic effects of nicotine to the brain. The delivery of nicotine to neuro-receptors in the brain and the pleasure effect it induces is the main reason why people find smoking enjoyable. Taking away or impairing this mechanism would probably severely disrupt the tobacco market over a prolonged period of time, the effects of which would only be ameliorated to the extent that consumers are offered satisfactory alternatives.

Despite this observation, a low-nicotine rule is unlikely to be the Holy Grail of tobacco control as some might like to conclude. First of all, it would be far more difficult to introduce successfully than a menthol ban would be, not in the least because manufacturers would have to be forced to materially alter a product they have marketed legally for many decades. Additionally, a low nicotine product landscape would likely leave many users with a nicotine addiction with few options to satisfy their craving. This might form an ideal breeding ground for an illegal market to arise in force, which would be an absolutely undesirable outcome.

For this last reason alone, I do not believe a low nicotine rule would be an effective tobacco control measure. A menthol ban on the other hand, would likely only temporarily cause disruptions in the US market but might deliver real health benefits to the extent it contributes to a lower smoking rate in the US population. It constitutes a more targeted and more reasonable measure than a nicotine content rule, is backed up by substantially more empirical evidence from similar measures taken elsewhere, and is therefore a substantially more likely candidate for successful introduction in the US than a low nicotine rule would be.

Disclosure: the author owns shares of British American Tobacco

Imperial Brands: A Weak Pulze

It has been quite an eventful year for tobacco purveyor Imperial Brands. Not only did Imperial cut its dividend for the first time ever as a public company, but it also saw a nearly complete overhaul of its senior leadership. Long-time CEO Alison Cooper has made way for Stefan Bomhard, formerly of Inchcape, and new appointments of a chief financial officer and a chief consumer officer were also recently made. 

In addition, the company has finally managed to close the long-awaited sale of its premium cigar business to a consortium of buyers from Asia. The sale of the premium cigar business was part of former management’s commitment to raise approximately £2 billion from asset sales, the proceeds of which were intended to strengthen the balance sheet and to put additional investment behind next generation products such as vaping devices and heated tobacco products.

The fact that the company fell substantially short of its divestment target is but a minor example of its failure to deliver on promises under former CEO Alison Cooper. When pressure from disgruntled investors started building a couple of years ago, there was little room for more disappointments. 

When the company’s US vaping sales were caught up in the fall-out from the EVALI uproar and the FDA’s subsequent crackdown on vaping products, Alison Cooper did not have enough credit left to ride out the storm. One week or so after the company warned on profit in the fall of 2019, the CEO’s departure was announced.

A man with a plan

More than a year later the company’s new CEO has recently presented a new strategy, which he believes will set Imperial Brands on the right track again. In my opinion, the new management team offered a very clear analysis of the company’s current shortcomings, which they primarily relate to its lack of a data-driven marketing approach, insufficient focus on key markets, and the distractions caused by next-generation products. As indicated in the presentation below, too many times in the past business decisions have been made without sufficient data to back them up, leading to subpar performance and significant market share losses in many markets.

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Key items detailing the new team’s assessment of past lackluster performance

Management’s analysis of Imperial’s business failures was followed by a detailed plan for how they will seek to improve the company’s marketing operations, and how this will gradually improve the company’s performance. The plan they shared was quite detailed and, as far as I can tell, it should be within the new management team’s capabilities to execute on it. Yet for me, the thoughts that lingered were not related to the plan on how to get the combustible business back on track, but rather the question of how the company intends to move forward with regard to next-gen products. And how difficult it will be for them to close the gap with its competitors.

If the world of tobacco was anything like it had been for decades, the plan management presented might well have met a more welcoming reception from investors. Instead, Imperial’s share price has languished near multi-year lows as investors were left to contemplate whether the new strategy will put the company back on track. In my opinion, navigating Imperial out of its troubled state and onto a more rewarding course will be a tough process for two reasons: 

  1. its development and commercialization of next-gen products is lagging significantly behind all of its major competitors
  2. turning the focus back to cigarettes and fine cut tobacco may deliver better economic results in the medium term, but goes against society’s decreasing acceptance of cigarette products

Regarding the first issue; Imperial Brands is so far behind the competition in next generation products that a significant consolidation of its efforts in vaping products has been deemed necessary by its new management. The leadership team under Mr. Bomhard intends to focus on a smaller number of vaping markets going forward, while keeping its oral nicotine products focused on markets with a preexisting habit of oral nicotine consumption. 

CEO Stefan Bomhard has referred to the  company’s blu vaping products as having previously been expanded too quickly, into too many markets, and without proper insights on consumer needs. The implication of this observation seems to be that these products are failing to gain significant traction in the marketplace, racking up substantial losses for Imperial, while lacking a clear path to profitability.

Retrenchment in next-gen may be the most obvious option available to the company, but admitting this has also highlighted Imperial’s NGP weakness. And while its larger competitors are racing to launch more new products into more markets, Imperial is proposing to move largely in the opposite direction. This  can only mean that the new management team has recognized how weak the hand is they are playing in these new categories. And although the decision might seem rational, the question investors should ask themselves is why they would want to join this management in playing a weak hand?

Imperial’s weak Pulze

Imperial’s heated tobacco product seems to be in even worse shape than its vaping products, where the company at least has a widely-recognized product in the market. Mr. Bomhard has referred to the heated tobacco product as showing promise, and having received too little prioritization under previous management. It is important to note that Imperial’s Pulze tobacco heater and accompanying tobacco sticks have barely put a dent into the Japanese market, which is currently the most important market for this type of product.

Compare this with Philip Morris’s IQOS product, which already has a presence in some 65 markets, or British American Tobacco’s Glo, which is currently present in 17 or so markets. When we add Japan Tobacco’s hnb product Ploom and KT&G’s lil, both of which currently have fairly limited but still meaningful geographic footprints, the inevitable conclusion is that Imperial is at best contending for a fourth or fifth place in this growing segment. 

Contending for fourth place is usually not a great position in any consumer product category but, given the unusual economic returns of the tobacco business, being a moderately sized contender has historically been a more than decently profitable position. It is not at all clear that this would be true for heated tobacco products as well. 

The amount of R&D dollars that Philip Morris has already spent on developing and commercializing IQOS strongly suggests that only those companies with significant market positions will be able to afford the expenditures that are required to develop and scale a successful heated tobacco device and still make a good return on investment. Aiming for fifth place, which in my opinion is really all Imperial can hope to achieve in this segment, is therefore a business strategy with a highly uncertain payoff.

Feeling blu

Imperial will likely withdraw its blu vaping products from certain countries where there is either poor demand for vaping products or blu currently holds a weak position. Instead of spreading its operations far and thin, as it did under Mrs. Cooper, from now on Imperial will focus on those markets that are already well-developed or show a very promising outlook. Consolidating its efforts on just a few important battlegrounds, such as North America and Northern Europe, seems sensible as these markets currently account for the overwhelming majority of vaping sales (outside of China). Gaining a strong market position in these markets will be key to building scale and a profitable business.

However, it is not a foregone conclusion that Imperial can turn its chances around, even if it is competing in a smaller number of markets. Imperial’s vaping products business is in particularly urgent need of improving its position in the US, a market where blu has long been an established player. In recent years the brand has lost a lot of ground to competitors Juul and Vuse though. Imperial’s pods-based vaping product MyBlu is estimated to currently hold a #4 position, at a very substantial distance to the dominant players. Stefan Bomhard has blamed the poor development of blu’s position in the US in part on insufficient retail support, and disruptions caused by the transition from Lorillard’s sales force, its previous owner, to ITG’s sales network (ITG is Imperial’s US subsidiary). 

The problem is that, even if Imperial increases sales support for blu and manages to increase its retail distribution, blu will likely still operate at a substantial disadvantage. Market leader Juul enjoys the benefits of its size in the market, and also has ties to the market leader in US cigarettes, Altria. Number 2 Vuse is owned by Reynolds, BAT’s US subsidiary, which occupies a strong number 2 position in US cigarettes, and benefits from its tobacco sales force. ITG on the other hand, has a weak number 3 position in US cigarettes, which means blu is unlikely to ever match its competitors’ strengths in distribution.

Another point of weakness is the fact that vaping is more of a scale business than conventional tobacco is. Just like heated tobacco devices, the amount of R&D expenditures involved in the development and marketing of vaping products is quite significant. The dominant players will increasingly benefit from their ability to charge large R&D and marketing expenditures against a much larger number of devices and refills sold, and will therefore benefit from having lower marginal product costs. Those savings can be put to productive use in regulatory compliance for instance, to an extent smaller competitors like blu simply cannot match.

Tobacco in an ESG world

While innovation is a very important driver of economic value (and value destruction) in any economic activity, the tobacco industry does not solely have an economic reason for innovating and trying to move beyond combustible products. It also has an increasingly urgent social acceptability problem with regards to its traditional business. The serious health consequences of tobacco consumption mean that tobacco stocks are increasingly avoided by investors looking for a financial as well as a social return on their capital. 

The rise of purpose-driven investment has been quite profound in recent years, in part because of increasing concerns over environmental impact, and is usually referred to as ESG (environment, social, governance) investing. With regards to tobacco companies this trend can be witnessed clearly in the increasing numbers of signatories to such initiatives as Tobacco Free Portfolios, which is a pledge institutions can sign to divest all tobacco-related investments from financial portfolios.

The decline in social acceptance has gone hand in hand with increasing regulation, thereby casting doubts over the tobacco industry’s future. While the industry has, from an economic standpoint, generally been quite effective in navigating these challenges, the risk of regulation has in recent years had quite a detrimental impact on public tobacco company valuations. The combination of decreasing social acceptance and increasing regulatory risk make the effort to develop products that are less harmful not just a matter of thriving in a competitive market, but also of earning a ‘license to operate’ from society. 

It is quite evident in today’s market that companies with rapidly increasing sales of ‘reduced-risk’ products, such as Swedish Match and Philip Morris International, are valued at substantially higher multiples of earnings than companies that have been slower to move in this direction. Imperial Brands unfortunately fits in with the latter group; fixing its conventional tobacco business may make perfect sense, but if society becomes even less forgiving towards its main business, it may not lead to an much improved share price at all.

Disclosure: the author owns shares of British American Tobacco.

Life Of Pie: A Closer Look At The Domino’s Pizza System

The Domino’s Pizza system is the second largest pizza franchise in the world, after YUM!’s Pizza Hut, with franchise-owner Domino’s Pizza Inc. (DPZ) reporting a systemwide restaurant count of 15,914 restaurants at fiscal year-end 2018.  Domino’s Pizza Inc. owns and operates just 390 corporate stores in the United States, with the balance made up of US franchised stores (5,486) and international franchised stores (10,038).

Pizza is a very well-liked food concept in many countries across the world, as it is usually the second or third most popular fast food after hamburgers and chicken, and the company has a smart and efficient business model. First of all, Domino’s Pizza operates the premier pizza delivery business and has fairly limited on-premise consumption, which means most of its stores are quite small and therefore not as expensive as restaurants offering full dining. Delivery is a point of differentiation and lowers the order threshold for the consumer. Ordering a pizza is the ultimate comfort food; having something you like to eat delivered to your doorstep, and for a very reasonable price.

Any pizza business has two potential points of strength; the pizza oven and the pizza dough. Most consumers do not have an oven capable of reaching the same high temperatures that a professional oven can. And since the best pizza is made from fresh dough being baked for a short amount of time on the bottom of a very hot oven, this gives pizza restaurants a clear quality advantage versus frozen pizza’s from the supermarket.

Fresh dough is another advantage: I learned to make pizza’s at home a couple years ago, by making my own dough and baking them on a plate in a microwave-oven. The taste advantage from using fresh dough are so significant that, even though my oven is not great, I have not eaten a frozen pizza from the supermarket ever since. Making fresh dough is also the hardest part about making a pizza; it is messy work and you have to plan your meals ahead in order for the dough to rise.

In other words, there is significant work involved which is why most people who want to eat pizza will not make one at home, but will either buy one in the supermarket and heat it up, order one from a delivery restaurant or go out to eat one. Since Domino’s is the most successful pizza delivery restaurant it is well-positioned for the second and third choices. I would argue its position as the foremost pizza delivery system has been strengthened by the rise of the smartphone, as it was one of the earliest restaurant chains with a mobile app designed to order pizza’s (it’s app was introduced over 10 years ago). This innovation has contributed to very strong same-store sales growth over the past couple years. The question is whether it can sustain this advantage with the rise of delivery aggregators.


The Franchise Model

To say the Domino’s model has delivered has delivered attractive returns is an understatement: Domino’s Pizza is valued at $11bn or so despite the fact that it owns just a couple hundred stores. This is made possible by the fact that the real money is made by franchising stores to independent owners, who pay a percentage of their revenues for the right to operate under the Domino’s name. So Domino’s receives slices of revenue generated by thousands of restaurants across the world,  which of course adds up to very significant amounts of money, all while employing minimal amounts of capital.


After struggling its first few years as a public company, Domino’s Pizza Inc.’s stock began a remarkable run around 2010-2011. The stock is up over 33-fold over the last decade.

The supply chain is also a significant money-maker, with the pizza dough and other ingredients generally delivered to restaurants from central manufacturing hubs, known as commissaries. The fact that making the dough centrally is more efficient also allows Domino’s to charge its franchise partners marked up prices for supplying this key ingredient. In fact, most of the ingredients required to make a pizza (flour, tomato sauce) are so inexpensive that the priciest part of a pizza is usually the cheese (followed by meat). The fact that pizza’s are made with reasonably priced ingredients allows all participants in the Domino’s value chain to make money, while still maintaining attractive price points for the consumer.

Outside the United States, the franchise concept works a little bit differently, with master franchise partners usually being assigned exclusive territories with the ability to run their own commissaries. Some of these franchise partners have become very successful companies in their right. Domino’s Pizza Enterprises (AU:DMP) for instance, originally from Australia, but currently also operating in New Zealand, Japan and parts of Europe, has grown into a sizeable enterprise of its own (stock chart below).

dmp uk

Domino’s Pizza Group (UK:DOM) is another big one, originally from the UK, but also active in Ireland and other parts of Europe (stock chart below). Both companies have been long term winners but have seen some of their gains being paired in recent years, presumably over valuation concerns now that growth has slowed down quite a bit. Another challenge has been the sometimes fraught relationships with franchisees, public scrutiny over working conditions and employee compensation at those same franchisees and the challenges met while expanding into new markets.

dom au

Jubilant FoodWorks meanwhile operates the Domino’s master franchise in India, while Alsea operates master franchises for Mexico, Colombia and Spain. And then there are dozens of private companies operating Domino’s master franchises for a single or a couple of countries.

In recent years, there has been increasing consolidation in the Domino’s system, with the most successful master franchisors expanding into other markets, either by negotiating with Domino’s Pizza Inc. for additional territories, or by buying a company already operating such a franchise. The main reason is usually to pursue additional avenues for growth after approaching maturity in their established markets. What I have found interesting is how much of a difference there can be with regards to the financial returns the Domino’s brand generates in different markets. Some markets like Australia are very lucrative for Domino’s while other markets have been very been difficult. The European market currently looks something like this… The countries left blank are territories for which I don’t have data about the operator, but a significant number of them do have Domino’s restaurants.


Map of European Domino’s system with white territories representing either unknown franchise owners or no Domino’s presence. Domino’s Pizza Group and Domino’s Pizza Enterprises jointly operate the Domino’s franchises in Germany and Luxembourg. I colored the different countries using a blank map found here.

Two of the companies operating in Eastern Europe secured a listing on the London Stock Exchange in 2010 and 2017 respectively, but they haven’t exactly delivered the attractive returns that their larger peers have. DP Poland (UK: DPP) operates the Domino’s brand in Poland, which failed  to take root in an earlier attempt in this market. The brand has been given a second chance by a different management and is currently at 69 or so stores in this market. DP Poland’s share price has been decimated over recent years due to lagging growth of its same-store sales, significant operating losses and other difficulties while trying to scale. The company has raised additional equity capital on multiple occasions, which has led to very significant dilution in its shares (stock chart below).


DP Eurasia (UK: DPEU) is a more recent listing and started out in Turkey but has expanded by acquiring the license for Russia too. This company appears to be performing quite well from an operations point of view and has about 724 stores currently (year end 2018). DP Eurasia’s stock has been held back by currency volatility, the Turkish Lira especially but the Russian Ruble as well.

The company has sought to refinance its formerly euro-denominated debt with credit denominated in local currencies, mostly Rubles, in order to avoid having to sustain liabilities in hard currencies like the Euro with earnings in soft currencies like the Lira. Despite the fact that they’ve wisely managed to eradicate their hard currency debt, the company’s shares have still been hit by the depreciation of the Lira, which has significantly depressed the value of its GBP-dominated shares (stock chart below). The reason DP Eurasia has borrowed in Rubles instead of Lira is because commercial interest rates in Turkey are prohibitively expensive. DP Eurasia is profitable on an underyling basis (excluding items deemed non-recurring by its management).



Lessons Learned

I recently watched an investor day presentation by Australia’s Domino’s Pizza Enterprises and, as I shared on Twitter, I found it quite illuminating. For a Domino’s master franchise to be successful it is critically important to get to significant scale within a reasonable timeframe. This may seem like a bit of an open door but a lot of Domino’s operators have had to learn this lesson the hard way again and again. As DPE’s current CEO Don Meij stated in the presentation below, Domino’s Australia went bankrupt three times before finally achieving success on the fourth try. The reason why they failed the first three times is because they threw in the towel before reaching critical scale. It is easy to forget such humble beginnings in a market that is currently very profitable.

Another thing I learned was the fact that Australia is not a exceptionally big pizza market at all. Pizza is the third most popular fastfood in Australia, after hamburgers and fried chicken, while in a lot of other markets it is in second place after hamburgers. It is therefore possible to achieve success in markets where pizza consumption per capita is substantially lower than it is in the US for instance. It is also possible to struggle in markets where pizza consumption is high, like France, where Domino’s has also gone through a difficult period some years ago.

The key to operating a successful Domino’s master franchise is to have the Domino’s brand stand out against all the other pizza options that are available in the marketplace. In other words, the brand has to be put to work to generate demand, which can only be achieved with significant marketing spend. Tv is still quite important for Domino’s and generally requires a significant advertising budget. That budget has to be levered on a good number of restaurants in order to make sure the marketing expenses stay at a reasonable level per store.

Every new market that’s entered starts more or less from scratch, with limited consumer awareness and entrenched behavior that benefits the incumbents. This is why it is so difficult for a new Domino’s market to get to a scale that makes economic sense. Once you manage to reach that scale that the flywheel can start spinning, because at that point the business can self-generate its growth through reinvestment in marketing.

In the case of Domino’s Pizza Poland for example, it is clear that they have not managed to get there yet. They are currently just shy of 70 stores and they reckon they need at least 100 stores to get to positive company-wide EBITDA-margins. With an operation of this size it is essentially impossible to buy the appropriate share of voice through marketing channels like tv. This predicament is currently exacerbated by the high marketing spend from several delivery aggregators, including Pyszne and PizzaPortal, which are competing for the same customers.

This is a phenomenon that can be seen internationally; it appears that the entire Domino’s franchise has come under a bit of pressure from aggregators like Takeaway, Uber Eats, Grubhub and Doordash, which are oftentimes operating at a loss. Since the aggregators are providing access to technology platforms that many small operators would not be able to afford or operate on their own, they’ve essentially levelled the playing field for pizza restaurants again. In my opinion this has decreased Domino’s Pizza’s advantage in the mobile ordering space. Domino’s Pizza Inc.’s CEO conceded recently that the aggregators are indeed having an effect on their same store sales growth (item below). For now I have no strong conviction on Domino’s but it is a business with some fascinating developments.

Note: the stock charts are a little bit dated as there was some lag between starting the article and finishing it. I did not feel like making screenshots for all the stock charts again, so please be aware that the present day stock prices may differ from those displayed in the article.

Coca-Cola Consolidated: Why Did The Soda Pop?

What’s going on with Coca-Cola Consolidated (COKE), the bottling company formerly known as Coca-Cola Bottling Company Consolidated? I have asked myself this question more than a couple times the past few months as its stock has bubbled higher and higher, and then higher some more. At this point the company’s stock chart is starting to look quite extreme (as seen below). Having written two extensive analyses of the company for Seeking Alpha in 2015 and 2016, advocating the stock for purchase in anticipation of the company’s acquisition of additional bottling territories from The Coca-Cola Company (KO), I consider myself reasonably well acquainted with the company and its operations. Yet I struggle to find a rational explanation for the monster move in its stock.


Coca-Cola Consolidated’s stock chart: screenshot from yahoo! Finance.

This was a $130 stock back in June 2018, roughly eleven months ago, which makes for a 200% return within a year. That seems rather extreme for a North American bottling operation locked into the Coke system. Bottling soda pop in a mature market like the United States is not usually associated with high growth or high returns. So let’s take a look at the company’s income statement for fiscal year 2018 (below). Sales increased by 7.9% to $4.6 billion while income from operations dropped by 43% to $50 million. Close to 8% growth in sales is quite attractive, but close to half is related to territory expansions while the other half was fueled by organic sources such as higher prices.


Part of the company’s income statement for 2018 is included above: growth from the territory transactions that started in 2014 and continued during 2015-2017 has decelerated to high single digits, while margins remain under pressure.

As expected, the deceleration of sales growth continued in Q1 of fy2019, with growth of 3.6% on higher case volume of 0.2%. While margins improved somewhat the company’s operating margin came in at the measly low level of 1.8%, which is both historically and comparatively poor for a bottling company. In other words, the company’s operating performance has been reasonable but nowhere near good enough to support the current market valuation.

Market capitalization sits around $3.6bn at current prices, with another $1.1bn in net debt on the balance sheet, which makes for an EV of $4.7bn. That valuation is supported by $58mln in operating earnings, which I will admit have probably been held back by the company’s efforts to integrate the TCCC territories into its operations. I expect the company should be able to achieve an operating margin around 4-5% within a couple of years, which would bring operating profits back to $190-$230 million.

But even that may be a rather optimistic scenario. After all, the company has never disclosed how much margin is lost through the company’s obligation to pay sub-bottling fees to The Coca-Cola Company for the territories acquired in 2014-2017. It is therefore quite possible that the bottling margins on those territories are substantially lower than those it has achieved historically in its legacy operations. Either way, even if the company manages to achieve a 4-5% operating margin the current valuation implies a multiple of 20-24x operating earnings before taking its substantial debt into account. That is not a realistic valuation at all. So what is driving the current surge in the Coke’s stock?

I have offered the following theory on Twitter before but the continuation of this remarkable run has strenghtened my conviction. On January 1st 2019 the company legally changed its name to Coca-Cola Consolidated, from its previous name Coca-Cola Bottling Co. Consolidated. The company already traded under the ticker COKE but now also carries a name that aligns it even more closely to The Coca-Cola Company. In my opinion, instead of simplifying ‘our legal name and (..) reflect how we are already commonly known in the marketplace’, the name change has made things more confusing. Given that the remarkable rise in the company’s share price coincides with the name change on January 1st, my theory is that some people are actually buying the wrong stock. They’re looking for The Coca-Cola Company, which trades under the ticker KO, but end up buying Coca-Cola Consolidated, which trades under COKE. Some have called this idea far fetched but it is remarkable how often people mistakenly use the ticker COKE on Twitter or Stocktwits when they’re talking about the Coca-Cola Company. Most people barely seem to understand the difference between both companies. That may be understandable for the average consumer, but it’s a cardinal mistake for an investor. Below is an example of an investor confessing to buying the wrong stock.


Message found on Stocktwits from an investor confessing to buying the wrong stock.

Given the low free float of Coca-Cola Consolidated, which is closely held by certain members of the Harrison family, even a limited number of people making this mistake can distort the market dynamic in its stock and prevent rational prices from forming. Given the possibility of having a fair amount of irrational buyers and the low free float, I would advise against shorting this stock, even if it is in my opinion overvalued by roughly 100%. More and more money will have to flow into the stock to keep this rally going, but the question is if you can hold a short position when the market is this irrational in such an illiquid security.