|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|
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.
|Entry||03/27/2012 10:44 AM|
Intriguing idea. Thanks for the write-up.
On an unlevered basis, I get $115-120mm of FCF. So, I get 9.5-10x unlevered FCF for a company that might be "good" but is certainly not great and has medium-to-long term growth prospects in the 0-3% range. Not horrible but not super attractive.
However, the margin expansion would change everything, increasing unlevered FCF by 50%. So help me understand the details of input costs and their ability to pass them through.
Is the price they are paid by customers (Walmart, etc.) locked in for the year or longer? You state that there were some midyear surcharges, so it seems they had some ability to pass through increased costs midyear. Why can't they pass these cost increases through regularly? I do not understand why it would matter if there is a futures market. It sounds like if there was a futures market for PET resin or apple juice, they would simply lock in a price that is higher than the price they could pass through anyway. Clearly, everyone has known about the higher PET resin and apple juice prices for some time, but they are not expecting margins to bounce back in 2012. In other words, it sounds like even if PET resin and apple juice prices remain exactly where they are for say three years, COT will not be able to pass them through fully. This is not an issue of whether futures markets exist.
Another way to ask same question: If all prices remain at same level they paid (either spot or futures) in 2011 through 2014, what are their gross margin percentage in 2012,13, and 14?
This is a very different dynamic than, say, Gap Stores inability to pass through increased cotton prices to consumers. In the Cott scenario, there may not be futures on PET resin or apple juice, but they are commodity products and pricing is transparent and consistent. And so all other producers should be facing similar cost increases.
If input prices fell rather than rose from historical norms, I am very sure that Walmart and others would be very aware of that. Would they demand price decreases to share in the windfall? In other words, is Cott simply short an option? Heads Walmart wins. Tails Cott loses.
|Subject||RE: Margin Questions|
|Entry||03/29/2012 09:21 AM|
Straw, thanks for the thoughtful questions.
In general, the prices are set between COT and the retailers once a year, typically between November and February. This is the standard in the industry, for COT and for large branded players such as Coke and Pepsi. It is at this point where COT will negotiate price increases to adjust for any major changes in the commodity levels versus the prior year. Typically, these prices stay in place for the remainder of the year. At this point, COT will have already been able to fix a majority of its prices for aluminum (the largest input) and corn, due to the robust futures markets that exist. Prices for PET and fruit juice, where no futures markets exist, leave COT more exposed to fluctuations that may occur. In 2011, due to the rapid and relatively unprecedented rise in PET prices, COT was able to modify this somewhat and go back to customers with a round of price increases to make up part of the difference. They also were able to put in place price adjustment mechanisms, whereby if PET prices escalated past a certain range, the retailer would bear some of the cost via further formulaic increases.
In general, COT loses in the short-term when there is a rapid escalation in raw material prices, as occurred in 2011. Margin recovery can only be made ‘after-the-fact’ through the next year’s price increases. Conversely, COT gains in the short-term should there be a rapid decrease in raw material prices. In the long-term, COT is aiming for gross margins in the 15-16% range.
The company achieved this range in both 2009 and 2010. In 2011, gross margins dropped from 14.8% to 11.8%. This was almost entirely due to the significant and unexpected rise in PET resin and, to a lesser extent, Apple Juice Concentrate. Here is some basic math to illustrate this point. Going into the year the cost of PET was approximately 12% of revenues. During the early part of 2011, PET rose quickly and dramatically, by approximately 40% from its late 2010 levels. COT was able to go back to customers and pass through price increases for roughly half of this amount. Thus the impact to gross margin was approximately [.12 x .4 x .5] = 2.4% or $55 million.
So COT is currently working its way back from a short-term gross margin deficit. Entering into price discussions for 2012, COT was able to pass through price increases to recoup some, but not all of this margin loss. Here are the ways in which we see this playing out:
(1) Base Case: PET and juice prices stay flat at their current elevated levels. This should allow COT to regain a small chunk of margin each year via annual price increases. This is likely in the range of 1-2% per annum, and thus COT regains its target margin range by 2013-14.
(2) Bull Case: PET and juice prices revert back to ranges that are more consistent with their long-term historical norms. This will result in a more rapid return to COT’s target gross margin range.
(3) Bear Case: PET and juice prices continue to deteriorate somewhat, both well outside of their historical ranges. Through its regular annual price increases, COT is able to ‘tread water’ at these low gross margin levels of approximately 12%. As you point out, even with this outcome, the valuation is interesting, if not overwhelming. We are a bit more bullish, as even with $100 million of cash flow (used to pay down debt) and no EV/EBITDA multiple expansion, the equity should still appreciate nicely.
|Subject||RE: RE: Margin Questions|
|Entry||03/29/2012 10:13 AM|
Thanks for the reply. It is helpful. Given that prices are set in the winter and there is no futures market to hedge, I now understand why sudden increase (or decrease) in PET/apple juice during the year would affect the profit directly. I am not sure why they were able to add some surcharges though -- was that in the 2011 contract or was that out of the goodness of the heart of their customers?
Either way, I do not understand why this would continue past 2011. With everyone knowing that PET/apple juice is higher, why can't they pass it through for 2012. In other words, why would they expect lower margins again in 2012? It would seem to me that if they could truly pass through their expectations, they would set the prices so that the expectation was for stable margins. Margins may end up being higher or lower, but the expectation when the contract was signed would be the same year after year. Note this has nothing to do with "making up" for last year's low profits.
If margins remain low past 2011, then I can only assume that the new contracts continue to use the "normal historical" PET/apple juice price, not the actual one at present. And if that is the case, then a large part of your bet is that PET/apple juice prices will mean revert, not that they can pass it through. This is a much less promising story to me.
Also, on a related note, while there is no futures market for PET resin, are you sure they cannot contract a year's supply and lock in prices? Correct me if I am wrong, but the PET resin market is a large commodity market with a fair degree of transparency, etc. I have several calls into folks in the industry, and I will let you know what I hear.
I have seen many of these input cost stories. Sometimes they are temporary dips until contracts renew as you seem to suggest COT is. Sometimes they are mean-reverting bets--if so, why should PET/apple juice revert back. Sometimes they are because the company has no moat against its customers and they are always on the losing side of the move. Tecumsah Products is a good example of this. They have been blaming commodity prices for years. The fact is that they simply should not be in business and should sell their brand and terminate their operations. Commodity prices are a red herring.
|Subject||RE: RE: RE: Margin Questions|
|Entry||03/30/2012 02:55 PM|
Once again, you have asked some reasonable questions. Our answers are based on numerous conversations we have had with beverage buyers at major retailers, the leading PET industry consultants, multiple actors in the juice markets, and input from COT. Here are some replies to your questions:
I am not sure why they were able to add some surcharges though -- was that in the 2011 contract or was that out of the goodness of the heart of their customers?
Question #1: COT was able to add some surcharges in 2011 because both sides recognized the highly unusual and extreme nature of the PET price shift. COT is a valuable supplier to the retailers, and sometimes reasonable parties can agree to shift contracts when circumstances change like this. I would not call this ‘out of the goodness of their heart’ necessarily (by the retailer), but a rational decision made to ensure the stability of their long term partnership relationship. Furthermore, their competitors (both Coke and Pepsi as well as other private label providers) also raised prices as a result of PET price inflation, providing support for this action.
Either way, I do not understand why this would continue past 2011. With everyone knowing that PET/apple juice is higher, why can't they pass it through for 2012. In other words, why would they expect lower margins again in 2012? It would seem to me that if they could truly pass through their expectations, they would set the prices so that the expectation was for stable margins.
Question #2: There is a lot of complexity in the concern you bring up here. The simple answer is that Cott pricing and margin is influenced by a number of factors: input cost pricing, the need for Cott to maintain the appropriate (35%-40%) price discount to brands, the need for Cott to compete effectively against other private label suppliers, volumes sold, etc. Cott is neither a price taker or price dictator but instead falls somewhere in between.
A couple of specifics though to consider:
1) They are passing through higher costs for 2012 as a result of PET/apple juice cost inflation. They’ve confirmed this and have forecasted sequential, quarterly gross margin improvement for the year.
2) In 2011 their conversations with customers focused on maintaining gross margindollars but not necessarily gross margin percentage. This particularly applies in the juice business. Again, prices for concentrate have jumped from approximately $6 per gallon in 2010 to $11 and more in 2011 (in 2012 they seem to be settling at around $10). So the cost goes up considerably. In conversations with customers, COT can easily explain its need to raise its price to maintain the same gross margin $ per case sold, but if you do the math, this results in a lower gross margin percentage. This contributed to the lower gross margins in 2011.
3) Prices have gone up dramatically – this has resulted in lower volumes. This is simply unavoidable supply/demand dynamics, and, in fact, across the industry, juice sales are down approximately 20% by volume. Lower volumes generally result in lower gross margins (fixed costs spread over a smaller volume). So this hurt margins a bit in 2011.
So unfortunately it’s not as simple as it perhaps is being thought of. The pricing mechanism is complex with a lot of influences, and the margin level is a function of a variety of factors as well. Overall though, the company does have pricing power to some degree because they are the largest and essentially only provider of private label beverages to national retailers. And they are raising prices in 2012, which will result in a more gradual reversion to the historical COT margin level that the company should be operating at. This of course assumes no additional raw material cost inflation.
Also, on a related note, while there is no futures market for PET resin, are you sure they cannot contract a year's supply and lock in prices?
Question #3: In theory they could but nobody in the industry does, according to the company. There would be significant costs to store such a large quantity of PET resin though. Furthermore, if PET resin prices dropped and their competitors (again mostly Coke and Pepsi) lowered price or increased marketing, it might put the company at a disadvantage. This is the dance that the company and the industry must play. Note that for 2012, COT does seem to have arranged to have locked down some reasonable portion of its 2012 PET supply/pricing.
A few points to make about the PET market; the PET market is complicated and a bit unusual. Suffice to say that we have spoken to many industry participants. I won’t go into the deep details here, but the basics are that there are three large producers of PET resin in North America (DAK, Indorama, M&G). There are two main ingredients that they all need to make the PET – PTA, and MEG. In the US, BP has a near-monopoly on PTA production. Because of this, they are required to sell product at the same price to all customers. It is a formulaic price that is dependent on the monthly pricing of paraxylene, which comes out of the aromatics stream of refined oil. As such, its hard for anyone to predict prices or commit to long-term pricing.
I have seen many of these input cost stories. Sometimes they are temporary dips until contracts renew as you seem to suggest COT is. Sometimes they are mean-reverting bets--if so, why should PET/apple juice revert back. Sometimes they are because the company has no moat against its customers and they are always on the losing side of themove. Tecumsah Products is a good example of this.
We want to be extremely clear that we are not relying on mean reversion of PET and/or apple concentrate for this stock to appreciate in value. Even at the current margin levels (which have certainly been caused by input cost shocks) the cash flow generated will present a nice return on the equity. Status quo on the commodities (at peak levels) should result in a gradual (1-2 year) return to target margins via incremental price increases. Should meaningful reversion to the mean occur in the key commodities, margins should follow, resulting in more rapid and extended upside for the COT equity.
And finally, we are not overly familiar with the Tecumsah story, but here we can definitively say that COT serves an important need for the retailers (private label CSD and juice) that simply cannot be provided by other credible parties. Eachbusiness line is duopolistic in nature (with CSDs closer to monopolistic) and the capital costs are such that the possibility of new entrants is remote.
|Subject||RE: RE: RE: RE: Margin Questions|
|Entry||03/30/2012 05:11 PM|
I talked to a (chemical) industry insider, and he confirmed that there is no way COTT could get long-term pricing on PET resin.
|Subject||RE: RE: RE: RE: Margin Questions|
|Entry||04/03/2012 09:40 PM|
thank you for the thorough answers to my questions. I like the idea. I think it will outperform significantly.
|Entry||06/18/2013 04:11 PM|
Do you still follow? Ugly quarter. But does it start to look interesting again below $8?
|Entry||07/01/2013 10:21 AM|
Thanks for the inquiry. We do still monitor the situation.
The biggest issue that has arisen since our original posting, of course, is the unexpected material reduction in private label CSD volumes over the past year. The latest retail data suggests that this trend is continuing. While COT does appear attractive at the current value, based on our best estimate future cash flows, we are okay to wait on the sidelines until we see some evidence of these macro headwinds receding.
|Subject||Pro-forma for DS Services deal trading at 4x FCF|
|Entry||11/10/2014 12:13 PM|
Basically a public LBO at this stage. While levered (4.5x ND/EBITDA) this seems manageable given the stability of the acquired business. Also, with carbonated soft drinks now less than 20% of portfolio, could be a catalyst for a re-rating.
|Subject||Re: Pro-forma for DS Services deal trading at 4x FCF|
|Entry||11/10/2014 12:46 PM|
How do you get to 4x FCF? Is that on the estimated 2018 numbers from slide 13?
|Subject||Anyone still following?|
|Entry||11/11/2015 02:59 PM|
Sold off hard post Q315 on slight miss and worries over UK.
Seems pretty cheap now considering they upped 2015 FCF guide to $114m ($1.03/share), an 11% yield. And they exepct to grow FCF at mid/high-teens next 3 years...that's nearly $1.50/share or 16% yield for 2017.
Know it's levered but base biz FCF stream is stable and DS is growing w/ lots of M&A upside.
Am I missing something here?