|Shares Out. (in M):||95||P/E||16.7x||12.2x|
|Market Cap (in $M):||630||P/FCF||5.0x||7.5x|
|Net Debt (in $M):||505||EBIT||101||113|
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Cott Corporation is the leading and dominant producer of private label beverages in North America. It controls 60% of the market for private label carbonated soft drinks (CSD’s), and through its purchase of Cliffstar Corporation last year, controls over 50% of the market for private label juice. While low gross margin levels might, at first glance, suggest a commodity-like business, the company holds significant competitive advantages that will enable it to maintain or grow its market share and profitability. Cott is a classic “cash cow”, deleveraging story, where cash flow generation is used to pay down debt. This alone generates a return and protects on the downside, even with no multiple expansion. 2011 was a perfect illustration of this, despite unprecedented raw material headwinds, which caused significant gross margin compression. We believe gross margins have bottomed and for 2012 expect continued significant cash flow generation, pay down of debt, with a possible tailwind on raw material costs towards the end of the year/2013. This altogether presents a timely, low risk, high return investment opportunity.
Very Cheap Valuation
In 2011 the company generated $197 million of EBITDA implying a TTM Enterprise Value/EBITDA multiple of 5.7x. For 2012 we forecast a relatively flat EBITDA level of $205 million and FCF of $91 million, largely used to pay down debt (the company has explicitly stated their intention to do this). Thus with no change in multiple, the above dynamic implies a share price at the end of 2012 of $7.90 or a 21% return. Using similar logic, and a 2013 EBITDA and FCF forecast of $217 million and $112 million, implies a $9.78 share price at the end of 2013 or a 50% return. Note that while we are not modeling any multiple expansion, there is a reasonable argument for it:
Historical EBITDA Multiple Analysis:
The average EV/EBITDA multiple over the last 9 years is 8.2x – higher than the current 5.7x multiple that Cott trades for.
Comparable Trading Multiples:
|Dr Pepper Snapple||12/31/11||38.55||8,175||10,182||1,256||8.1x|
While there are no perfect publicly traded comparables, the universe above represents a snapshot of companies that have some commonality with Cott Corp. Coca-Cola, Dr Pepper Snapple and PepsiCorp are the three largest CSD branded competitors in the market and collectively control 85% of the CSD market (versus 6.5% for private label as a whole). Ralcorp and TreeHouse are both private label good manufacturers with a similar customer base. Perhaps the closest comparable is National Beverage, which is a private label beverage manufacturer and a direct competitor in the non-juice business. As the table shows, Cott trades at a significant discount to all companies in this universe.
Why This Is A Decent Business
Cott is the largest private label beverage company in the world. The company has over 500 brands that it provides to a who’s-who of large national and regional grocery, mass merchandise, drugstore, and convenience store chains. Its products include CSD’s, juice, water, energy-related drinks, ready-to-drink teas, etc. Note that while Cott dominates private label beverage, this segment of the market is still less than 20% of the overall beverage market and has been gaining market share every year, for the last 10 years. Within the CSD segment (Cott’s largest), private label only consists of 6.5% of the market with 85% of the market controlled by Coke, Pepsi and Dr. Pepper Snapple. Various key business attributes are highlighted below:
-Economies of Scale
Cott has 32 beverage processing facilities including 20 in the US, making it the only private label beverage company with a national footprint. As such, it is the only company capable of servicing large, national retailers. We conducted fairly extensive primary research to corroborate this point and walked away thoroughly convinced of this. A sampling of comments from our notes with industry executives is as follows:
-Former Head Beverage Buyer at Major Supermarket A, B: Everyone outside of Safeway and Kroeger (who do their own) use Cott – they have nowhere else to go… Ahold, Meijer, etc… All except Publix in Florida… which uses National Beverage… a few other smaller chains use National Beverage… but don’t know another major retailer that is using someone other than Cott…
-Former beverage executive, Major Supermarket: I am not sure there is anybody but Cott in the space… they are the ones we always looked to in doing private label stuff
-Senior Sourcing Manager, Major Supermarket: Does anyone have the national footprint to serve all of their needs other than Cott?... No
Walmart, Cott’s largest customer (31.6% of sales) is perhaps the best evidence of this fact. Skimmer610’s write-up of one year ago provides excellent background on Walmart but to summarize, in January 2009 WMT announced they were terminating their exclusive supply agreement with Cott for private label CSD’s. Under the phase out, Cott maintained exclusivity for only 2/3 and 1/3 of Walmart private label CSD supply in 2010 and 2011. Yet, over that time period the company has continued to supply 100% of Walmart’s private label CSD product and was awarded the National Collaboration Award by Walmart in August of 2011. Furthermore, as noted in the Skimmer write-up, upon termination of the contract in 2009, Walmart made a concerted effort to identify an alternative provider and was unsuccessful. We corroborate Skimmer’s work on this issue through our own conversations with industry insiders that had knowledge of this process:
-Former Head Beverage Buyer at Major Supermarket Chain A, B: during their difficult time with Cott… Walmart said hey where else can we go other than Cott… the only other one with any scale at all is National Beverages in Florida – they have 3 plants in the USA… Walmart said we will get brands (KO, PEP, DPS) to pack private label and they said no they won’t… brands don’t want to get into private label… much lower margin… Cott was really the only one that Walmart could work with… Walmart tried to get others to pack it… National Beverage wouldn’t do it at the price Walmart wanted – they had egg on their face and had to keep using Cott
Cott’s economies of scale make it an efficient operator in the ultracompetitive private label space where thin margins are commonplace. We believe it is the low cost supplier in the market. Cott has the highest sales/employee ratio in its universe:
The current management team appears strong. As discussed in Skimmer610’s write-up, current management phased-out of the ill-fated brand business that turned customers into competitors, and has exceeded its synergy targets associated with the Cliffstar acquisition. In Q3 2011 management reversed certain short-term bonuses and long-term incentive accruals to mitigate the effects of rising raw material prices in an effort to stay on target for 2011 FCF forecasts given at the beginning of the year. Lastly, management’s stated intention to use FCF to reduce debt is shareholder friendly and good capital structure policy.
Why This Is Cheap
Cott management has repeatedly stated that “the right gross margin for this business is in the 15% to 16% range” and yet in 2011, gross margins were 11.8% - a fairly significant divergence. The cause of this margin contraction has largely been an unprecedented rise in raw material inputs – specifically PET resin (a lightweight plastic used to bottle beverages) and apple juice concentrate.
Aluminum, PET resin, high fructose corn syrup, and fruit (primarily apple juice concentrate) are the four main raw material inputs that Cott requires, contributing approximately 20%, 15%, 10% and 10% to overall COGS, respectively. Each year the company sets pricing for its product in Q1, using an estimate for the cost of each raw material and a desired gross margin. Since the company is largely able to hedge its aluminum and corn exposure, it bears limited risk that gross margin will be effected by fluctuations in the prices for these elements. However, since a derivatives market does not exist for PET resin and apple juice concentrate, fluctuations in the price of these elements can hurt or help gross margins and indeed, this is what happened in 2011.
|PET Resin (cents/lb)||99.3||75.3||66.6||83.6||71.0||73.8||80.3|
|Apple Juice Conc. ($/gallon)||11.0||8.4||5.3||9.4||8.8||6.1||5.5|
PET resin and apple juice concentrate pricing levels reached abnormally high levels in 2011. And while the company was able to implement middle of the year surcharges to recover some of this cost inflation, it wasn’t able to fully recover these costs. This rise in cost was unexpected and caught the company, the industry and the analyst community off guard. Throughout the year, management continually revised up the economic impact from $25m in Q4 2010, to $30m in Q1 2011, to $45m in Q2 2011 and finally to $50m in Q3 2011. Given that the company did $197m of EBITDA in 2011, this incremental $50m of cost was quite significant. Said another way, on total sales of $2.3 billion, $50m of incremental cost reduced gross margins by 2.2% to 11.8% from an otherwise 14% level – a big impact.
How It Will All Shake Out
While the market for CSD’s is expected to slowly decline over the long term, private label’s share of this market continues to grow. The juice business is a steady, low growth business. These two businesses account for roughly 70% of sales and are fairly predictable albeit with quarterly fluctuations. Thus a large portion of Cott sales is derived from markets that should experience relative stability. The remaining 30% of sales is a largely a combination of high growth/margin energy drinks, teas, etc. and lower growth/margin water. We project 2012 sales growth of -1% versus consensus estimates of 3% growth; we are purposely conservative.
For 2012, the company has entered into fixed price contracts on 70% of its aluminum, all of its corn syrup, and “a large portion” of its fruit requirements. It has effectively concluded its negotiations with customers on price. Taking this into account and a forecast that PET resin might rise slightly, the company has stated it anticipates gross margins will see “some restoration in 2012” above the 11.8% level. PET resin price changes appear to be the major risk factor since pricing on most of the other inputs is largely locked in. A number of PET resin forecast services exist and we have spoken to most of them (CMAI, Chemical Data, PCI). While hard to predict with pinpoint accuracy, the general consensus is that PET resin prices will remain flat or rise slightly, with some fluctuations, throughout the year. This is consistent with Cott’s expectations. Given the above, we forecast a slight uptick of 40 bps in gross margins in 2012 to 12.2%, which is roughly consistent with street estimates.
Overall, our forecast of $205m of EBITDA is 3.6% higher than 2011 EBITDA levels. Essentially, things need to not deteriorate further in 2012 for our expectations to be met, and for value to be realized. A few pieces of current data suggest things are headed in the right direction:
1) Consulting firm IRI closely monitors the price differential between private label and branded beverages, and their relative market shares. Cott has stated that a healthy price differential is 35%-40%. When that price differential narrows, it suggests that brands are lowering price to capture volume. So far in 2012, private label appears to be in a healthy position; the differential currently sits at close to 40%, and private label market share has been strong throughout the year.
2) Trends on raw material pricing have also been favorable since the start of the year. Aluminum prices in Q1 2012 are approximately 10% less than in Q1 2011. Cott has some, albeit limited, exposure to aluminum having hedged 70% of its 2012 needs. While approximate at best, the latest USDA weekly apple processing report shows apple concentrate prices dropping to $10.50, which is now lower than the corresponding period in 2011. The latest PET resin data suggests that prices are roughly flat versus that of a year ago. PET resin pricing warrants close monitoring but it is helpful that additional capacity is expected towards the end of 2012 with the benefit potentially realizable in 2013.
Cott is not a sexy business by any stretch, but is a solid company that is a stable cash generator with a good management team steering the ship. There is some commodity risk although for 2012, much of that risk has been eliminated through hedging and furthermore, and prices on raw materials have trended in the right direction in 2012. With no multiple expansion and no growth in either revenue or EBITDA, a 20%+ IRR is clearly achievable.
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