Canadian clothing store Reitmans (TSX:RET.A.CA) has effectively restructured its operations and its financials appear to be in outstanding shape. Reitmans underwent the Canadian Companies’ Creditors Arrangement Act [CCAA], which is the Canadian counterpart of Chapter 11, during the COVID-19 lockdowns, and as a result of the significant improvement in the company’s fundamentals, its share price has increased by almost 60x from the 2020 lows. My curiosity about other Canadian businesses that were subject to the CCAA during the COVID-19 lockdowns was piqued by the remarkable returns, and this led me to DAVIDsTEA (NASDAQ:DTEA). The two companies’ business restructurings share many parallels, but I believe that DAVIDsTEA erred by placing too much emphasis on internet sales. Simply put, it doesn’t seem to be a smart move for the tea retail industry, and I believe the company will either experience large stock dilution or will need to revisit the CCAA in the near future. Let’s recap.

An Overview of the Company’s Finances

In order to provide specialty branded tea products in welcoming locations with top-notch customer service, DAVIDsTEA opened its first location in Toronto in 2008. At the beginning of 2020, the business quickly expanded to become the biggest tea retail chain in North America, with a total of 231 locations and more than 2,500 employees. Yet, similar to Reitmans, revenue growth rates had already stagnated by that point. For the fiscal year that ended on February 1, 2020, DAVIDsTEA earned sales of C$196.4 million ($148 million), down from C$212.8 million ($164 million) a year earlier. Additionally, Reitmans reported a financial loss of C$87.4 million ($65.9 million) for the same period while C$35.4 million ($26.7 million) for FY20. This is because both companies were under pressure from rising rent prices.

In the middle of 2020, DAVIDsTEA had to turn to the CCAA, just like Reitmans had to at the same time, due to major financial losses and liquidity concerns brought on by retail outlets closing across Canada amid COVID-19 lockdowns. Reitmans shut down a fifth of its storefronts and is now shifting its focus to e-commerce; retail sales now account for more than 25% of its overall sales. Similar in concept, DAVIDsTEA chose to implement the change right now, closing all but 18 of its outlets, which are mostly located in the Ontario and Quebec regions. The tea merchant adopted a “digital first” approach and concentrated on improving the online customer experience by making their tea guides available online to offer a more personal and human experience. Also, DAVIDsTEA improved the features of its DAVI virtual assistant, which aids customers in shopping and finding new collections.

The switch to e-commerce initially appeared to be a success because, in Q2 FY21, e-commerce, and wholesale sales increased by 189.9% year over year, and the business reported profits from operations of C$4.1 million ($3.1 million).

Results for Q2 of Fiscal Year 21

Sales for the fourth quarter of the fiscal year 2020 were C$40.2 million ($30 million), with the 18 physical stores reopening in late August 2020. Of that sum, the e-commerce and wholesale division brought in C$35 million ($26.1 million), up 96% from the previous year.

Results for Q4 of Fiscal Year 21 

The financial performance of DAVIDsTEA has significantly declined as a result of Canadian tea customers returning to retail stores following the end of COVID-19 lockdowns. Sadly, this was the best it could get. At this point, the company’s course departs from Reitmans’ because the latter is still successful and seeing rising sales. You see, purchasing high-end tea may be seen as a social activity since clients want to interact with the employees, smell the different varieties, and discover new information about the tea leaves and their provenance. According to me, DAVIDsTEA used to be the tea equivalent of Starbucks (NASDAQ:SBUX), and the business model just fails when everything is moved online. It’s a very different product from clothes, where a number of firms have succeeded after switching to online sales, such as Lands’ End (NASDAQ:LE).

On February 2, DAVIDsTEA revealed that the midpoint of the range, or C$29 million ($21.5 million) – C$31 million ($23 million), implies a year-over-year fall of 25% in sales for Q4 FY23. The company claimed that it would pursue cost-cutting measures, including the temporary layoff of 15% of its head office workers and the cancellation of C$4 million ($3 million) in FY22 IT transformation investments. In light of this, pro-forma estimates for SG&A costs in FY23 range from C$8 ($5.9 million) to C$10 ($7.4 million), but I anticipate that a lack of investment would result in further sales declines, negating the impact of the cost-cutting efforts. In my opinion, DAVIDsTEA is once again in survival mode, and its future is bleak. The situation appears dire when examining the balance sheet because, as of October 29, 2022, cash was only C$16.1 million ($12 million). Contrary to Reitmans, DAVIDsTEA does not own substantial real estate assets that it may sell to bolster its balance sheet; for the first nine months of FY23, cash flows utilized for operating activities totaled C$6.6 million ($4.9 million). The DAVIDsTEA is likely to run out of cash soon, and the most likely outcomes after that include massive stock dilution or another restructuring of the company under CCAA. This depends on how quickly the business’s fundamentals improve. Investors would find both of these possibilities to be undesirable.

How do you play this, then? According to statistics from Fintel, the short borrow charge rate is 2.95% as of the time of writing, therefore short selling appears like a good choice. Only 0.14% of the float is short, and it takes less than a day to cover it. The only available call options have a $2.50 strike price, making hedging difficult.

Moreover, short selling could be risky because the share prices of microcap businesses occasionally rise for erroneous and unidentified causes. Many times in the last six months alone, this has already occurred here.

Conclusion

In my opinion, DAVIDsTEA’s switch to e-commerce was a bad move, and the business is currently experiencing financial difficulties once more. Revenue is falling as customers return to actual tea shops and money is quickly running out.

A minor short position looks feasible given the low short borrow fee rate. The share price has been erratic over the previous few months, and the lowest strike price for call options is $2.50. For risk-averse investors, it could be preferable, in my opinion, to steer clear of DAVIDsTEA stock.

Featured Image: Pexels @ Lucie Liz

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