Description

INTRODUCTION

We have owned shares in Cott Corporation (COT) since late 2017, and our summary writeup on the opportunity is included below. The company reported Q4 2017 results this morning. They formally introduced FCF targets of ~$115MM in 2018 and ~$150MM in 2019. I would encourage anyone interested in this idea to listen to this morning’s call. The management team lays out a very clear vision for “New Cott” on important topics such as margins, capital allocation and consolidation, which we hope to hear more about at their investor day next week (March 8.)

Byronval and AtlanticD both posted COT to VIC in the past (June 2017 and February 2016, respectively), as it went thru different stages of its evolution. I would refer you to their work for more history on the company, and view this post as the third installment of the trilogy now that the business transformation is complete.

COMPANY DESCRIPTION:

For its first 60 years in existence, Cott was a co-packer and manufacturer of private label carbonated soft drinks (i.e. off-brand Coca-Cola for Wal-Mart.) The company began diversifying away from unbranded CSD and into home and office water delivery beginning in 2014. The business transformation was completed last month with the sale of the private label soft drink business to European beverage company Refresco for $1.25 billion (closed January 30, 2018.) Note that the company minimized/eliminated tax leakage by offsetting any long-term capital gains with NOLs already on the balance sheet.

The new Cott Corporation operates a highly recurring water, coffee, tea and better-for-you beverage delivery business that services ~1.5 million customer locations through a network of over 180 warehouse/distribution facilities and 2,200 routes that touch ~90% of U.S. households and offices.

SUMMARY FINANCIALS:

INVESTMENT THESIS:

Business Transformation:  With the divestiture of its “traditional” business, Cott goes from a…

• Mature, slow growing, commoditized business with high customer concentration risk (Walmart=16% sales), a tapped out balance sheet (4.8x leverage) and constant worries about input costs (aluminum, sugar, etc.) to a...

• Stable, highly recurring business with no customer concentration, 50% higher gross margins, and a more manageable leverage load (3.5x) that provides ample resources to roll up the highly fragmented water and coffee delivery space, both in the US and abroad.  

Size Matters: Route density is the most important factor in the profitability of an on premise delivery system. Cott is the largest player in the US in the both the home and office delivery (HOD – 31% share) and office coffee services (OCS – 3% share) markets. The European market is more fragmented than the US, and Cott holds the #1 and #2 market positions in HOD and OCD respectively. Geographic scale and route density provide Cott meaningful advantages in both procurement and delivery over smaller competitors. VAR suggests Cott and Nestle have significant technology and system advantages over smaller market participants as well.

Stable LSD Growth: Beverage consumption largely grows in line with GDP. However, new Cott is well-positioned to grow faster than the market as consumer preferences continue to shift away from soda and toward better-for-you options.

Pricing Power:  The company provides relatively inexpensive, convenience driven products. Customers prize reliable delivery of cumbersome, high weight-to-value bulk beverages and have proven willing to take small annual price increases rather than attempting to switch services (assuming there is one available.) The incentive for the office manager is to keep the pantry stocked, not worry about paying an extra $0.50 per 10 gallon jug of water. On a national scale, this is basically a duopoly with Cott and Nestle controlling 60%+ share.

Synergies and Margins: Freed from the carbonated soft drink business, management can focus on integrating recent acquisitions and capturing cost savings. Route optimization is a key component of this work as density of network should be a powerful driver of margin growth as new sales are layered on to a fixed cost base at high incremental margins.

Coffee Acquisition: In 2016, Cott moved to vertically integrate their coffee operations by purchasing S&D Coffee. The company roasts and blends coffees and teas for commercial customers. In and of itself, this is a pedestrian business with HSD EBITDA margins.

• The opportunity for Cott is that the existing commercial business provides baseload volumes to insure full utilization of facilities (key in operating a roasting facility.) Cott can then push thru additional volumes to sell to their delivery customers. Adding relatively small, lightweight coffee (grounds and pods) to a large, heavy, labor intensive water delivery is highly profitable. VAR suggests cross-selling coffee to an existing water customer creates 60% incremental EBITDA margins by leveraging single delivery point (vs. high-teens for water delivery alone.)

Consolidation Opportunity: While the top 2 players in the U.S. have ~60% share, the market is fairly fragmented thereafter. Cott can make acquisitions that fall broadly into 1 of 3 categories:

• Mom & Pop – There are literally hundreds of small operators in individual locales. VAR from formers was very clear that they can “buy on a Friday and have it consolidated by Monday” on any number of small acquisitions. Business brokers we spoke with indicated small players usually trade for ~5x EBITDA.
• Regional Players – Farmer Brothers, Culligan, Mother Parkers – scale players with geographic density. Meaningful synergies and route density improvement would drive $3 to $5 per share in value for Cott for each acquisition consummated.
• Nestle – The Nestle Ready Refresh business would be a homerun acquisition. While not formally for sale, VAR indicates that Nestle does NOT want to be in this business. VAR suggests they have been starving the water delivery business for capital in recent years. Of note, they recently announced plans to sell their US confectionery business, presumably in response to pressure from Third Point. Synergies would equate to a HSD percentage of sales and drive ~$10+ per share in value for Cott.

VARIANT PERCEPTIONS:

This is pretty simple. No one is really paying attention to the transformation story.

We polled 10 friends in acquaintances in the investment industry. To a person they replied something along the lines of “You mean the private label soft drink company that makes Wal-Mart branded Coke? Gross. Wait, it’s up quite a bit – is it a short?”

Inquire with the expert networks about contacts to speak to on Cott and you’ll receive an email entitled “Perspectives on the Private Label Soft Drink Market” that is filled with carbonated beverage specialists that know nothing about coffee, tea or water delivery.

The stock “looks” expensive on Bloomberg (48x 2018E EPS!) due to a combination of stale sellside numbers, a Q317 balance sheet that does not reflect the CSD sale to Refresco and the material delta between GAAP EPS and FCF per share.

We believe we have a differentiated view on go forward margins based on thorough examination of last 3 years of filings and earnings calls. Cott has yet to come out and give a comprehensive set of goals and targets in one place, but they have provided details intermittently. For example, they provided detailed thoughts on synergies and potential margins at S&D Coffee in a 2016 conference call, but have never discussed again.

CATALYST / PATH TO PROFITS:

Clean ex-CSD financials that highlight the growth, margins, FCF and pro forma balance sheet.

Small M&A will likely go unnoticed, but a larger deal for a regional or Nestle will be synergy-laden.

KEY RISKS:

Amazon: Delivering bulk beverages is a poor fit with what Amazon actually wants to do. Last mile for them is either handled by carriers (UPS, Fedex, USPS) or increasingly by participants in the sharing economy (i.e. a side gig.) The weight and size of large scale beverage delivery, the need for carefully planned route density, and having to pick up empty water jugs for return trip make this a business Amazon is unlikely to compete in. Of note, Cott is a delivery partner helping Amazon with last mile fulfillment for certain beverage ordered on their platform.

Recession: Products straddle the line of being staple and discretionary. Business contraction a clear negative for demand for Cott’s products. Smaller players would be hit harder and provide an opportunity for Cott to accelerate consolidation.  

Churn: Not hard to turn this service off (in a recession or otherwise.) Cott increases customer stickiness with equipment installation (water coolers, coffee makers.) Cross-selling coffee particularly increases demand – as one industry participants put it to us “your water cooler can be out for 5 days and you might here a few grumbles…no coffee for 5 hours and the office shuts down.”

M&A execution / integration: Always a risk of losing customers or fouling up an integration, but track record so far has been strong.

VALUATION:

We view COT as a low-risk, medium reward investment on a stand-alone basis, with potential for high return if they can executive large-scale M&A.

Downside to $14 (vs. ~$15 today) based on a very-low-to-no growth scenario, 7.5x EBITDA and a mid-to-high SD FCF yield.

Base case, standalone, reasonable execution with the company re-rating to 10x EBITDA (small discount to similar staple, route-based businesses) and a ~5% FCF yield yields ~45% upside to $22.

Upside case where Cott acts as industry consolidator and is recognized by market as high quality business services enterprise yields ~100%+ upside to low $30s.  

Catalyst

Investor day (March 8.)

Further clean financial reporting.