Tea-gate For Teavana Ahead of Earnings

Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Teavana Holdings (NYSE: TEA) is set to announce earnings on Monday Nov. 26. While the company has gotten a lot of press lately, in part as a result of its announced acquisition by Starbucks (NASDAQ: SBUX), the earnings release is of very little concern to investors.

Starbucks recently announced its intention to acquire Teavana for $620 million, placing a premium of over 50% on the stock’s price at the time of the announcement. Since the announcement, allegations of sub-standard quality standards have been leveled at the company, following by cross allegations of stock manipulation on short selling. While my ultimate conclusion is that there is simply too much intrigue surrounding the stock to own the shares at current levels, using the behavior of Teavana as an indicator for Starbucks is a reasonable approach.

The Controversy

Recently, Glaucus Research Group announced that despite claims made by Teavana in both its SEC filings and in other promotional material, the company’s teas were found to contain pesticides, in some cases higher than the levels allowed by either U.S. or European standards. If true, the discovery could cost the company significantly in terms of fines for false advertising and violation of securities laws. There has been no specific reaction by Starbucks, and without access to the full terms of the acquisition agreement, it is impossible to know how these allegations could ultimately impact the conclusion of the deal.

Teavana quickly responded to the allegations by offering the following:

Teavana’s teas undergo rigorous third-party testing on each batch of teas based on international food safety standards including European Union regulations, which are widely considered to be the most stringent in the world. Consistent with that, the Company has established internal procedures and comprehensive third party testing to ensure all tea is safe and within those guidelines. Teavana refutes the report’s conclusions. The group that published the report is a short-seller and may benefit financially from the allegations in the report. Teavana’s teas are safe and of the highest quality.

There seems to be little argument as to the status of Glaucus as a short seller of the stock; the research group also indicated that the acquisition of Teavana by Starbucks could be in jeopardy as a result of the findings.

Where this situation can be differentiated from most is that the positions of both sides are very clear and unequivocal; there are few conceivable outcomes that will not leave one of the two parties open to a significant level of liability and exposure to regulatory scrutiny. If the company has, in fact, used pesticides, it has filed false reports. If the claims of the Glaucus group are unsubstantiated, it will likely have to answer stock manipulation charges. The impact on the Starbucks acquisition will likely surface and is a critical element of the story.

The Stocks

Since the allegation was leveled by Glaucus, Teavana shares fell by over 5% during intraday trading, recovering to close down over 4% (see chart below). During that same period, Starbucks has continued higher. The most likely cause of this divergence is a belief that the news may cause the deal to fail, benefitting Starbucks and hurting Teavana. While it is likely too early to reach any conclusions, this story is likely to drive the performance of both stocks.

<img src="http://media.ycharts.com/charts/951d998abe64d66568963ba2e8c59409.png" />

TEA data by YCharts

The Trade

Ultimately, I believe that Teavana will weather this storm and conclude its deal with Starbucks. If a problem has been detected, it is likely that it will be corrected to the satisfaction of both parties. In the interim, the details of the deal could be impacted. Seeing how the tea industry develops under the guidance of Starbucks will be interesting, but it is too soon to dedicate capital to this trade. The swings that could be created by news items related to this story will likely be too severe to warrant the risk.

Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of Starbucks and Teavana Holdings and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Starbucks. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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