Cott Corporation COT W
March 14, 2011 - 12:16am EST by
skimmer610
2011 2012
Price: 8.50 EPS $0.00 $0.74
Shares Out. (in M): 95 P/E 0.0x 11.5x
Market Cap (in $M): 803 P/FCF 0.0x 7.0x
Net Debt (in $M): 613 EBIT 0 143
TEV ($): 1,417 TEV/EBIT 0.0x 10.0x

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Description

 

COT:

COT is the largest manufacturer of private label carbonated soft drink and private label shelf-stable fruit juices.

At current levels Cott Corporation presents a compelling risk/reward profile. At ≈$8.50/share, COTT trades at 14%-15%% levered FCF yield. I believe that is too cheap for a business of COT's relatively fair quality and stability. A more reasonable 10x FCF multiple would imply a ≈$12+ share price over the next 6-12 months, implying a 40%+ return.  More significant upside will be a function of two factors: 1) continued stability in business operations; 2) substantial FCF generation enabling highly accretive deleveraging and eventual cash returns to shareholders. Again, given the relatively fair quality and stability of COT's business, I believe downside is limited so the risk/reward is quite attractive.

This is a fairly conventional long idea where I'd be hard pressed to identify the situational/structural angle for the mispricing. That said, I do believe the market is overly concerned about nearer term issues relating to commodity price increases, and the myopia is preventing proper evaluation of COT's long term strategic position and fundamental earnings power.

The crux of the thesis, therefore, is as follows: 1) COT is a better business than the market gives it credit for; 2) COT will prove capable of dealing with the extremely well telegraphed commodity cost headwinds it faces; 3) Solid FCF generation even in a stressed scenario enables meaningful accretion to equity as COT deleverages.

Business overview:

Cott dominates two business lines:

  • 1) Private Label Carbonated Soft Drink (CSDs) - this is COT's legacy business, and the company commands a ≈60% market share in the US. Of non-captive capacity (i.e. KR, SWY, and WINN all produce their own PL CSDs), COT's market share is ≈80%.
  • 2) Private Label Shelf Stable Juice - COT entered this business through the acquisition of Dunkirk, NY based Cliffstar in July 2010 (acquisition closed August 2010)

In addition to their US operations, COT has three other businesses:

  • 1) UK - substantial in revenue and profitable
  • 2) Mexico - small in revenue and currently loss making; COT is trying to get this business to breakeven
  • 3) RCI - this is basically a licensing business for COT's RC Cola syrup formula; very little capital required and nicely profitable, albeit quite small

I recommend perusing recent company presentations to gain additional detail about COT's operations.

A key assumption underlying my view on COT is that COT's business is better than a mediocre one. I won't go so far as to call it a great business - ultimately, this is a commodity like product manufacturing and distribution operation. However, based on extensive discussions with industry participants, I believe that both Cott and Cliffstar occupy integral positions in the private label landscape, and ones from which potential competitors would have an incredibly difficult time displacing Cott and Cliffstar. Simply, to the extent national retailers are committed to outsourced PL beverage categories, they essentially have no choice but to use COT.

Moreover, COT is regarded as a highly professional and reliable PL supplier, very important points of recognition. The feedback I received was universally positive in this regards - i.e. retailers like to work with COT.

COT has fundamentally refocused itself over the last two years: its leadership has never been stronger and the company's recent acquisition of Cliffstar has further solidified the company as the absolutely unrivaled leader in the PL beverage space.

On a secular basis, I believe the general trends remain pro-PL. I believe CSD's are likely in very slow secular decline (which will eventually stabilize), and shelf-stable juices are likely to exhibit GDP or population like growth. However, alterative drink categories (vitamin waters, energy drinks, teas, etc.) provide meaningful expansion opportunities.

If one accepts the view that COT is a fundamentally sound business with reasonable growth prospects, then <7x guided FCF appears to cheap for a consumer staples company - notwithstanding the moderate leverage and potential for commodity headwinds (discussed later).

Background on Key Issues:

In February 2009, COT's current CEO, Jerry Fowden, was appointed to the role. At the time of his appointment Cott stock stood at ≈$.80. Jerry had joined Cott in 2007 to lead their UK business. Based on COT's result in that region and based on discussions with industry participants, I believe he executed extremely well.

At the time Jerry became CEO, COT found itself facing significant business and financial risk as a result of mismanagement under previous CEO Brent Willis. Willis came to COT from InBev in May of 2006, and remained there until March of 2008. Under Willis, relationships with retailers became incredibly strained. Additionally, during his tenure COT began facing massive commodity headwinds which Willis had thoroughly unprepared the company for. More specifically, there were two primary mismanagement issues:

  • 1) Willis devoted excessive resources to growing COT's branded business. Besides being a poor decision in-and-of-itself, pursuing such a course weakened COT's relationships with retailers. Simply, a PL supplier that also sells branded products is perceived by retailers as having conflicted interests and not being entirely committed to the PL supplier / retail customer partnership.
  • 2) Willis implemented no commodity hedging strategies at a time when commodities were increasing dramatically in price. The lack of any hedging strategy severely underprepared the company to deal with rising input costs. Additionally, due to soured relationships with retail partners, COT was in a weak position to request price increases.

Under Willis, COT's gross margins stagnated (2007 vs. 2006) and then declined (2008 vs. 2007). More significantly, gross margins declined significantly.

Under Willis, COT's  relationship with WMT severely deteriorated. Background: in the early 1990's, COT came to the US with a plan to substantially increase US manufacturing capacity for PL CSDs. In order to justify building the plants, COT was able to convince WMT to grant it an exclusive contract for the entirety of WMT's PL CSD supply. Such a contract is essentially unheard of for WMT.

Willis was replaced in March of 2008 by interim CEO n March David Gibbons. In June of 2008, Gibbons outlined his plans to refocus COT's efforts on PL, to pursue cost reductions, and to repair damaged customer relationships. These changes were meant to address to the major failings of the company under Willis:

In January 2009, COT announced that WMT had decided to phase-out the exclusive supply agreement with COT. Per the phase out, WMT would be permitted to move up to one third of their supply in the first year following notification and two thirds in the second year following notification. The termination of the contract is effective on the third anniversary of the announcement.

As mentioned, present CEO Jerry Fowden joined Cott in 2007 to lead the company's UK business. In April of 2008, Fowden was appointed President of International, and in June of 2008 he was asked by David Gibbons to assist in rebuilding relationships with Cott's customers in the U.S., while also taking on leadership of the Canadian business.

Based on my discussion with industry participants, since taking the helm at COT, Fowden has completely rehabilitated the relationship with customers - most significantly WMT. Multiple sources have stated that the relationship between COT and WMT is stronger than it has ever been.

The reality is this: While COT's substantial reliance on WMT may appear disconcerting, so long as WMT is committed to the PL CSD space, it has no alternative but to rely essentially wholly on COT. A high level industry source I spoke with communicated to me the following:  when WMT cancelled their contract with COT, they came to this man and asked him to provide them with advisory on alternative sourcing. The man came back to WMT and told them that they had no alternative - no other supplier had the national capacity and distribution capabilities to service them.

In reality, the only viable competitor to COT is the national branded beverage producers such as KO, PEP, and DPS. However, all of those companies are highly reluctant to use even excess capacity for PL products, as doing so would depress overall margins. Additionally, that prospect has been rendered almost moot as a result of the vertical integration strategy PEP and KO have pursued (i.e. buying in their bottlers).

In addition to repairing customer relationship, Fowden has accomplished 3 other key items:

  • 1) Entirely refocused the company towards PL
  • 2) Implemented a comprehensive commodity hedging strategy
  • 3) Reduced all lineaments of SG&A related to Willis' push into branded products

Under Fowden, COT is a much more focused, lean, and stable company than it has ever been.

Financial Considerations and Valuations:

I believe there are two focal points of the bear thesis against COT:

  • 1) COT will prove unable to manage the headwinds posed by commodity cost increase
  • 2) Cliffstar will materially underperform expectations

Commodity Costs:

The primary risk to this investment is that unabated commodity price escalation cripples COT should the company prove unable to effectively hedge input cost increases and push through price increases.

Per the company, ≈80% of total COGS are variable in nature and 50%-60% of COGS are commodity driven.

The concern, therefore, is the following: assuming a certain level of commodity cost increase, COT will have to be able to push through potentially significant price increases in order to maintain gross margins at acceptable levels.  Per the analysis below, in order to maintain constant gross margin levels, for every 100 bps increase in commodity linked COGS, COT must increase prices by 46 bps:
Leagacy Cott - LTM        
Revenue  $      1,574.8  $      1,574.8  $      1,574.8  $      1,574.8
COGS  $      1,325.2      
Gross profit  $         249.6      
Gross margin 15.8%      
         
Percent of COGS tied to raw materials 55.0%      
COGS tied to raw materials  $         728.9  $         765.3  $         838.2  $         911.1
Aggregate increase in said COGS 0.0% 5.0% 15.0% 25.0%
         
Other COGS  $         596.3  $         596.3  $         596.3  $         596.3
Reduction in other COGS   0.0% 0.0% 0.0%
         
Total COGS  $      1,325.2  $      1,361.6  $      1,434.5  $      1,507.4
         
Gross profit at flat revenue  $         249.6  $         213.2  $         140.3  $           67.4
Gross margin at flat revenue 15.8% 13.5% 8.9% 4.3%
         
LTM gross profit  $         249.6  $         249.6  $         249.6  $         249.6
Revenue needed to attain LTM gross profit  $      1,574.8  $      1,611.2  $      1,684.1  $      1,757.0
Implied price increase required (at flat volumes) 0.0% 2.3% 6.9% 11.6%
Price increase / COGS increase NA 0.46x 0.46x 0.46x

 

The analysis above effectively sums up the bear case: input costs are bound to increase and COT will not prove able of pushing through sufficient price increases.

Why do I think the bear thesis is wrong?

First - I don't think commodity prices remain at these elevated levels. Especially as it applies to agricultural commodities such as corn, I think the spike has been largely due to inclement weather. But speaking more generally, I think commodities moderate and normalize a bit.

That said, we can't rely on that. So let's assume commodities don't normalize and remain at their elevated prices. Should that be the case, COT will be alright for the first nine months or so of 2011. They have hedges they put on at various times in 2010 to protect them from the increased prices. What happens thereafter? Ultimately, I believe that that COT will be able to push through pricing because the national brand companies will be in no better shape and will as well have to push through significant pricing. As is generally known, what matters for private label is not absolute price - it is price differential. Therefore, so long as the national brands lead with price increase, COT can follow.

The counterpoint is this: the national brands already have much higher gross margins than COT but much higher marketing expense; therefore, in a prolonged high commodity price environment, the national brands will not take pricing, accept lower gross margins, and reduce marketing spend in order to keep operating margins flat.

I don't think that happens. The national brands realize that maintaining gross margin is important and will push through pricing to do so. It might take them some time and it might not be linear - but based on my discussions with industry participants, I believe that the national brands will ultimately take the pricing necessary to maintain gross margin levels thereby enabling COT to do the same.

Cliffstar Acquisition:

COT announced the acquisition of Cliffstar on July 7, 2010. The transaction was structured as follows:

  • - $500mm in cash at closing
  • - $14mm of deferred consideration over 3 years
  • - Additional contingent earnout consideration of up to $55mm based on performance for the fiscal year ending January 1, 2011
  • - Additionally, COT benefited from a substantial cash tax benefit generated from the deduction of the step-up in tax basis resulting from the acquisition of Cliffstar's assets (i.e. increased D&A non-economic in nature). COT estimated the NPV of the tax benefit at ≈$75mm

Insofar as the tax benefit offset the deferred consideration contingent earnout, COT effectively paid ≈$500mm for Cliffstar.

COT headline states that it paid 4.9x Adjusted EBITDA for Cliffstar (inclusive of tax benefits and based on pro-forma run-rate synergies of $20mm) - implying adjusted EBITDA inclusive of synergies for COT of ≈$102mm, and exclusive of synergies ≈$80mm.

The $80mm number is probably on the high end.

If one takes a cursory look at Cliffstar's numbers since 2007, the sharp improvement in profitability which occurred in 2009 and 2010 is manifest. Based on my research I believe three factors contributed to that:

  • - In 2008, a professional CEO took the reigns over from the family head of the business - the new CEO stressed margins/profitability over revenues
  • - Collapsing commodity prices in late 2008 and 2009 dramatically benefited Cliffstar
  • - Cliffstar had certainly been preparing itself for a sale, and the company likely cut significantly into R&D programs as well as certain sales initiatives

In short, I think there is no question that the recent results of Cliffstar are misleading. Indeed, if one pushes the company on it, they will admit as much and concede that perhaps $15mm of LTM EBITDA is the result various non-sustainable benefits.

However, like the commodity issues, I believe the market is well aware of the supernormal profits Cliffstar earned in 2009 and 2010 and is not baking such results into COT's numbers going forward.

Valuation:

COT reported 4Q10 earnings in early March. The focus of the call - as expected - was the impact of commodity cost inflation on the business in 2011.

As it relates to COT's key commodities, management confirmed the following coverage for 2011:

  • - High fructose corn syrup - 100%
  • - Sugar - 100%
  • - Aluminum - 70%

Management highlighted that late in 2010 they went to retailers with price increases for 2011. Those price increases became effective in February/March of 2011 and were meant to cover the commodity price increases that had already occurred. However, COT in unable to hedge PET Resin, which continued to increase significantly from late 2010 through March 2011. Accordingly, the price increases negotiated with retailers did not account for the run in PET over the last three months. COT expects the impact from PET to be a ≈$25mm hit to EBTIDA.

Based on management's comments on the conference call and my follow up discussions with the company, I believe the following represents 2011 EBITDA guidance:

2011 EBITDA  
Prior 2010 EBITDA guidance / consensus  $            260.0
Less: weakness in CS                  (5.0)
Less: PET impact                (25.0)
Plus: incremental synergies                   5.0
Implied 2011 EBITDA guidance  $            235.0

 

I think it's notable that despite the implicit EBTIDA guide down, COT stock held after the earnings release and conference call. I believe that although the sell-side had not yet adjusted their numbers, the market was ahead of them.

Critically, the company indicated to me that $235mm in EBITDA represents a conservative view for 2011 and I think it represents a troughish number for the company considering the particularly difficult commodity environment COT is currently facing. Simply, the worse sort of commodity environment for a PL manufacturer is one in which prices rise very quickly. Selling prices cannot adjust and input prices immediately rise.

The analysis below indicates COT is current trading at 7.2x 2011 levered FCF - 6.5x based on actual cash taxes to be paid.

Share price  $              8.50    
Diluted shares outstanding                 94.5    
Market cap  $            803.3    
Cash & cash equivalents                 48.2    
Short-term borrowings                   7.9    
Current maturities of long-term debt                   6.0    
Long-term debt                605.5    
Deferred consideration for Cliffstar deal                 42.0    
Net debt  $            613.2    
Enterprise value  $         1,416.5    
       
2011E EBITDA  $            220.0  $            235.0  $            250.0
EV / EBITDA 6.4x 6.0x 5.7x
D&A  $              92.0  $             92.0  $             92.0
EBIT  $            128.0  $            143.0  $            158.0
Interest expense  $             (52.0)  $            (52.0)  $            (52.0)
EBT  $              76.0  $             91.0  $            106.0
Tax rate 23.0% 23.0% 23.0%
Net income  $              58.5  $             70.1  $             81.6
P / E 13.7x 11.5x 9.8x
CapEx  $             (50.0)  $            (50.0)  $            (50.0)
FCF  $            100.5  $            112.1  $            123.6
P / FCF 8.0x 7.2x 6.5x
FCF yield 12.5% 14.0% 15.4%
FCF at actual 2011 tax rate  $            108.0  $            123.0  $            138.0
P / FCF 7.4x 6.5x 5.8x
FCF yield 13.4% 15.3% 17.2%

  

I believe the analysis below is helpful for thinking about the risk/reward of an investment in COT assuming things get worse or better:

  • - Revenues: for both legacy Cott and legacy Cliffstar I have assumed revenue in line with LTM levels. I believe that is a substantially conservative assumption insofar as COT is currently pushing through meaningful price increase for both COT (2-3%) and Cliffstar (25%-30%)
  • - Gross margins: for both legacy Cott and legacy Cliffstar I have assumed that the high end of margins is in line with management guidance for margins. In other words, management has guided to 16%+ gross margins for both legacy Cott and Cliffstar; I've assumed high end margins of 16% for both legacy Cott and Cliffstar
  • - SG&A - on the conservative end of managements guidance and assuming $14mm in Phase 1 synergies
  • - D&A, interest expense, tax rate - all in line with management guidance. However, in reality, cash taxes will be meaningfully lower than GAAP taxes for the next few years (company expects ≈$10mm in cash taxes in 2011)
Legacy Cott      
Revenue  $         1,575.0  $         1,575.0  $         1,575.0
Gross margin 12.5% 14.0% 16.0%
Gross profit  $            196.9  $            220.5  $            252.0
       
Legacy CS      
Revenue  $            675.0  $            675.0  $            675.0
Gross margin 12.5% 14.0% 16.0%
Gross profit  $             84.4  $             94.5  $            108.0
       
SG&A expense - post Phase 1 synergies  $           (180.0)  $           (180.0)  $           (180.0)
EBIT  $            101.3  $            135.0  $            180.0
D&A  $             92.0  $             92.0  $             92.0
EBITDA  $            193.3  $            227.0  $            272.0
EV / EBITDA 7.3x 6.2x 5.2x
       
Interest expense  $            (52.0)  $            (52.0)  $            (52.0)
EBT  $             49.3  $             83.0  $            128.0
Tax rate 23.0% 23.0% 23.0%
Net income  $             37.9  $             63.9  $             98.6
P / E 21.2x 12.6x 8.1x
CapEx  $            (50.0)  $            (50.0)  $            (50.0)
FCF  $             79.9  $            105.9  $            140.6
P / FCF 10.1x 7.6x 5.7x

 Based on the analysis, I believe the market is pricing into COT zero volume and/or pricing growth and the high likelihood of margin degradation. Margin degradation relative to recent levels is likely in 2011. However, assuming a more stable commodity environment I believe that COT's 16% targeted gross margin level is achievable on a LT normalized basis.  Accordingly, it is not difficult to see how on a normalized basis COT is trading at a levered FCF yield approaching 20%.

Should gross margins indeed collapse in late 2011 or 2012 as a result of commodity inflation, I believe ≈12.5% is a sufficiently conservative scenario. Assuming no price increases to translate into higher revenue, 12.5% gross margins on LTM revenues implies ≈7.3x EBITDA and >10x levered FCF. Assuming the fundamental LT strategic position of COT remains strong, I don't think the market will view that valuation as either particularly expensive or cheap. Accordingly, I think the risk reward is attractive.

Catalyst

1) Continued stability in operations

2) Stabilization of input prices

3) Interest from financial or strategic acquirer

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    Description

     

    COT:

    COT is the largest manufacturer of private label carbonated soft drink and private label shelf-stable fruit juices.

    At current levels Cott Corporation presents a compelling risk/reward profile. At ≈$8.50/share, COTT trades at 14%-15%% levered FCF yield. I believe that is too cheap for a business of COT's relatively fair quality and stability. A more reasonable 10x FCF multiple would imply a ≈$12+ share price over the next 6-12 months, implying a 40%+ return.  More significant upside will be a function of two factors: 1) continued stability in business operations; 2) substantial FCF generation enabling highly accretive deleveraging and eventual cash returns to shareholders. Again, given the relatively fair quality and stability of COT's business, I believe downside is limited so the risk/reward is quite attractive.

    This is a fairly conventional long idea where I'd be hard pressed to identify the situational/structural angle for the mispricing. That said, I do believe the market is overly concerned about nearer term issues relating to commodity price increases, and the myopia is preventing proper evaluation of COT's long term strategic position and fundamental earnings power.

    The crux of the thesis, therefore, is as follows: 1) COT is a better business than the market gives it credit for; 2) COT will prove capable of dealing with the extremely well telegraphed commodity cost headwinds it faces; 3) Solid FCF generation even in a stressed scenario enables meaningful accretion to equity as COT deleverages.

    Business overview:

    Cott dominates two business lines:

    • 1) Private Label Carbonated Soft Drink (CSDs) - this is COT's legacy business, and the company commands a ≈60% market share in the US. Of non-captive capacity (i.e. KR, SWY, and WINN all produce their own PL CSDs), COT's market share is ≈80%.
    • 2) Private Label Shelf Stable Juice - COT entered this business through the acquisition of Dunkirk, NY based Cliffstar in July 2010 (acquisition closed August 2010)

    In addition to their US operations, COT has three other businesses:

    • 1) UK - substantial in revenue and profitable
    • 2) Mexico - small in revenue and currently loss making; COT is trying to get this business to breakeven
    • 3) RCI - this is basically a licensing business for COT's RC Cola syrup formula; very little capital required and nicely profitable, albeit quite small

    I recommend perusing recent company presentations to gain additional detail about COT's operations.

    A key assumption underlying my view on COT is that COT's business is better than a mediocre one. I won't go so far as to call it a great business - ultimately, this is a commodity like product manufacturing and distribution operation. However, based on extensive discussions with industry participants, I believe that both Cott and Cliffstar occupy integral positions in the private label landscape, and ones from which potential competitors would have an incredibly difficult time displacing Cott and Cliffstar. Simply, to the extent national retailers are committed to outsourced PL beverage categories, they essentially have no choice but to use COT.

    Moreover, COT is regarded as a highly professional and reliable PL supplier, very important points of recognition. The feedback I received was universally positive in this regards - i.e. retailers like to work with COT.

    COT has fundamentally refocused itself over the last two years: its leadership has never been stronger and the company's recent acquisition of Cliffstar has further solidified the company as the absolutely unrivaled leader in the PL beverage space.

    On a secular basis, I believe the general trends remain pro-PL. I believe CSD's are likely in very slow secular decline (which will eventually stabilize), and shelf-stable juices are likely to exhibit GDP or population like growth. However, alterative drink categories (vitamin waters, energy drinks, teas, etc.) provide meaningful expansion opportunities.

    If one accepts the view that COT is a fundamentally sound business with reasonable growth prospects, then <7x guided FCF appears to cheap for a consumer staples company - notwithstanding the moderate leverage and potential for commodity headwinds (discussed later).

    Background on Key Issues:

    In February 2009, COT's current CEO, Jerry Fowden, was appointed to the role. At the time of his appointment Cott stock stood at ≈$.80. Jerry had joined Cott in 2007 to lead their UK business. Based on COT's result in that region and based on discussions with industry participants, I believe he executed extremely well.

    At the time Jerry became CEO, COT found itself facing significant business and financial risk as a result of mismanagement under previous CEO Brent Willis. Willis came to COT from InBev in May of 2006, and remained there until March of 2008. Under Willis, relationships with retailers became incredibly strained. Additionally, during his tenure COT began facing massive commodity headwinds which Willis had thoroughly unprepared the company for. More specifically, there were two primary mismanagement issues:

    • 1) Willis devoted excessive resources to growing COT's branded business. Besides being a poor decision in-and-of-itself, pursuing such a course weakened COT's relationships with retailers. Simply, a PL supplier that also sells branded products is perceived by retailers as having conflicted interests and not being entirely committed to the PL supplier / retail customer partnership.
    • 2) Willis implemented no commodity hedging strategies at a time when commodities were increasing dramatically in price. The lack of any hedging strategy severely underprepared the company to deal with rising input costs. Additionally, due to soured relationships with retail partners, COT was in a weak position to request price increases.

    Under Willis, COT's gross margins stagnated (2007 vs. 2006) and then declined (2008 vs. 2007). More significantly, gross margins declined significantly.

    Under Willis, COT's  relationship with WMT severely deteriorated. Background: in the early 1990's, COT came to the US with a plan to substantially increase US manufacturing capacity for PL CSDs. In order to justify building the plants, COT was able to convince WMT to grant it an exclusive contract for the entirety of WMT's PL CSD supply. Such a contract is essentially unheard of for WMT.

    Willis was replaced in March of 2008 by interim CEO n March David Gibbons. In June of 2008, Gibbons outlined his plans to refocus COT's efforts on PL, to pursue cost reductions, and to repair damaged customer relationships. These changes were meant to address to the major failings of the company under Willis:

    In January 2009, COT announced that WMT had decided to phase-out the exclusive supply agreement with COT. Per the phase out, WMT would be permitted to move up to one third of their supply in the first year following notification and two thirds in the second year following notification. The termination of the contract is effective on the third anniversary of the announcement.

    As mentioned, present CEO Jerry Fowden joined Cott in 2007 to lead the company's UK business. In April of 2008, Fowden was appointed President of International, and in June of 2008 he was asked by David Gibbons to assist in rebuilding relationships with Cott's customers in the U.S., while also taking on leadership of the Canadian business.

    Based on my discussion with industry participants, since taking the helm at COT, Fowden has completely rehabilitated the relationship with customers - most significantly WMT. Multiple sources have stated that the relationship between COT and WMT is stronger than it has ever been.

    The reality is this: While COT's substantial reliance on WMT may appear disconcerting, so long as WMT is committed to the PL CSD space, it has no alternative but to rely essentially wholly on COT. A high level industry source I spoke with communicated to me the following:  when WMT cancelled their contract with COT, they came to this man and asked him to provide them with advisory on alternative sourcing. The man came back to WMT and told them that they had no alternative - no other supplier had the national capacity and distribution capabilities to service them.

    In reality, the only viable competitor to COT is the national branded beverage producers such as KO, PEP, and DPS. However, all of those companies are highly reluctant to use even excess capacity for PL products, as doing so would depress overall margins. Additionally, that prospect has been rendered almost moot as a result of the vertical integration strategy PEP and KO have pursued (i.e. buying in their bottlers).

    In addition to repairing customer relationship, Fowden has accomplished 3 other key items:

    • 1) Entirely refocused the company towards PL
    • 2) Implemented a comprehensive commodity hedging strategy
    • 3) Reduced all lineaments of SG&A related to Willis' push into branded products

    Under Fowden, COT is a much more focused, lean, and stable company than it has ever been.

    Financial Considerations and Valuations:

    I believe there are two focal points of the bear thesis against COT:

    • 1) COT will prove unable to manage the headwinds posed by commodity cost increase
    • 2) Cliffstar will materially underperform expectations

    Commodity Costs:

    The primary risk to this investment is that unabated commodity price escalation cripples COT should the company prove unable to effectively hedge input cost increases and push through price increases.

    Per the company, ≈80% of total COGS are variable in nature and 50%-60% of COGS are commodity driven.

    The concern, therefore, is the following: assuming a certain level of commodity cost increase, COT will have to be able to push through potentially significant price increases in order to maintain gross margins at acceptable levels.  Per the analysis below, in order to maintain constant gross margin levels, for every 100 bps increase in commodity linked COGS, COT must increase prices by 46 bps:
    Leagacy Cott - LTM        
    Revenue  $      1,574.8  $      1,574.8  $      1,574.8  $      1,574.8
    COGS  $      1,325.2      
    Gross profit  $         249.6      
    Gross margin 15.8%      
             
    Percent of COGS tied to raw materials 55.0%      
    COGS tied to raw materials  $         728.9  $         765.3  $         838.2  $         911.1
    Aggregate increase in said COGS 0.0% 5.0% 15.0% 25.0%
             
    Other COGS  $         596.3  $         596.3  $         596.3  $         596.3
    Reduction in other COGS   0.0% 0.0% 0.0%
             
    Total COGS  $      1,325.2  $      1,361.6  $      1,434.5  $      1,507.4
             
    Gross profit at flat revenue  $         249.6  $         213.2  $         140.3  $           67.4
    Gross margin at flat revenue 15.8% 13.5% 8.9% 4.3%
             
    LTM gross profit  $         249.6  $         249.6  $         249.6  $         249.6
    Revenue needed to attain LTM gross profit  $      1,574.8  $      1,611.2  $      1,684.1  $      1,757.0
    Implied price increase required (at flat volumes) 0.0% 2.3% 6.9% 11.6%
    Price increase / COGS increase NA 0.46x 0.46x 0.46x

     

    The analysis above effectively sums up the bear case: input costs are bound to increase and COT will not prove able of pushing through sufficient price increases.

    Why do I think the bear thesis is wrong?

    First - I don't think commodity prices remain at these elevated levels. Especially as it applies to agricultural commodities such as corn, I think the spike has been largely due to inclement weather. But speaking more generally, I think commodities moderate and normalize a bit.

    That said, we can't rely on that. So let's assume commodities don't normalize and remain at their elevated prices. Should that be the case, COT will be alright for the first nine months or so of 2011. They have hedges they put on at various times in 2010 to protect them from the increased prices. What happens thereafter? Ultimately, I believe that that COT will be able to push through pricing because the national brand companies will be in no better shape and will as well have to push through significant pricing. As is generally known, what matters for private label is not absolute price - it is price differential. Therefore, so long as the national brands lead with price increase, COT can follow.

    The counterpoint is this: the national brands already have much higher gross margins than COT but much higher marketing expense; therefore, in a prolonged high commodity price environment, the national brands will not take pricing, accept lower gross margins, and reduce marketing spend in order to keep operating margins flat.

    I don't think that happens. The national brands realize that maintaining gross margin is important and will push through pricing to do so. It might take them some time and it might not be linear - but based on my discussions with industry participants, I believe that the national brands will ultimately take the pricing necessary to maintain gross margin levels thereby enabling COT to do the same.

    Cliffstar Acquisition:

    COT announced the acquisition of Cliffstar on July 7, 2010. The transaction was structured as follows:

    Insofar as the tax benefit offset the deferred consideration contingent earnout, COT effectively paid ≈$500mm for Cliffstar.

    COT headline states that it paid 4.9x Adjusted EBITDA for Cliffstar (inclusive of tax benefits and based on pro-forma run-rate synergies of $20mm) - implying adjusted EBITDA inclusive of synergies for COT of ≈$102mm, and exclusive of synergies ≈$80mm.

    The $80mm number is probably on the high end.

    If one takes a cursory look at Cliffstar's numbers since 2007, the sharp improvement in profitability which occurred in 2009 and 2010 is manifest. Based on my research I believe three factors contributed to that:

    In short, I think there is no question that the recent results of Cliffstar are misleading. Indeed, if one pushes the company on it, they will admit as much and concede that perhaps $15mm of LTM EBITDA is the result various non-sustainable benefits.

    However, like the commodity issues, I believe the market is well aware of the supernormal profits Cliffstar earned in 2009 and 2010 and is not baking such results into COT's numbers going forward.

    Valuation:

    COT reported 4Q10 earnings in early March. The focus of the call - as expected - was the impact of commodity cost inflation on the business in 2011.

    As it relates to COT's key commodities, management confirmed the following coverage for 2011:

    Management highlighted that late in 2010 they went to retailers with price increases for 2011. Those price increases became effective in February/March of 2011 and were meant to cover the commodity price increases that had already occurred. However, COT in unable to hedge PET Resin, which continued to increase significantly from late 2010 through March 2011. Accordingly, the price increases negotiated with retailers did not account for the run in PET over the last three months. COT expects the impact from PET to be a ≈$25mm hit to EBTIDA.

    Based on management's comments on the conference call and my follow up discussions with the company, I believe the following represents 2011 EBITDA guidance:

    2011 EBITDA  
    Prior 2010 EBITDA guidance / consensus  $            260.0
    Less: weakness in CS                  (5.0)
    Less: PET impact                (25.0)
    Plus: incremental synergies                   5.0
    Implied 2011 EBITDA guidance  $            235.0

     

    I think it's notable that despite the implicit EBTIDA guide down, COT stock held after the earnings release and conference call. I believe that although the sell-side had not yet adjusted their numbers, the market was ahead of them.

    Critically, the company indicated to me that $235mm in EBITDA represents a conservative view for 2011 and I think it represents a troughish number for the company considering the particularly difficult commodity environment COT is currently facing. Simply, the worse sort of commodity environment for a PL manufacturer is one in which prices rise very quickly. Selling prices cannot adjust and input prices immediately rise.

    The analysis below indicates COT is current trading at 7.2x 2011 levered FCF - 6.5x based on actual cash taxes to be paid.

    Share price  $              8.50    
    Diluted shares outstanding                 94.5    
    Market cap  $            803.3    
    Cash & cash equivalents                 48.2    
    Short-term borrowings                   7.9    
    Current maturities of long-term debt                   6.0    
    Long-term debt                605.5    
    Deferred consideration for Cliffstar deal                 42.0    
    Net debt  $            613.2    
    Enterprise value  $         1,416.5    
           
    2011E EBITDA  $            220.0  $            235.0  $            250.0
    EV / EBITDA 6.4x 6.0x 5.7x
    D&A  $              92.0  $             92.0  $             92.0
    EBIT  $            128.0  $            143.0  $            158.0
    Interest expense  $             (52.0)  $            (52.0)  $            (52.0)
    EBT  $              76.0  $             91.0  $            106.0
    Tax rate 23.0% 23.0% 23.0%
    Net income  $              58.5  $             70.1  $             81.6
    P / E 13.7x 11.5x 9.8x
    CapEx  $             (50.0)  $            (50.0)  $            (50.0)
    FCF  $            100.5  $            112.1  $            123.6
    P / FCF 8.0x 7.2x 6.5x
    FCF yield 12.5% 14.0% 15.4%
    FCF at actual 2011 tax rate  $            108.0  $            123.0  $            138.0
    P / FCF 7.4x 6.5x 5.8x
    FCF yield 13.4% 15.3% 17.2%

      

    I believe the analysis below is helpful for thinking about the risk/reward of an investment in COT assuming things get worse or better:

    Legacy Cott      
    Revenue  $         1,575.0  $         1,575.0  $         1,575.0
    Gross margin 12.5% 14.0% 16.0%
    Gross profit  $            196.9  $            220.5  $            252.0
           
    Legacy CS      
    Revenue  $            675.0  $            675.0  $            675.0
    Gross margin 12.5% 14.0% 16.0%
    Gross profit  $             84.4  $             94.5  $            108.0
           
    SG&A expense - post Phase 1 synergies  $           (180.0)  $           (180.0)  $           (180.0)
    EBIT  $            101.3  $            135.0  $            180.0
    D&A  $             92.0  $             92.0  $             92.0
    EBITDA  $            193.3  $            227.0  $            272.0
    EV / EBITDA 7.3x 6.2x 5.2x
           
    Interest expense  $            (52.0)  $            (52.0)  $            (52.0)
    EBT  $             49.3  $             83.0  $            128.0
    Tax rate 23.0% 23.0% 23.0%
    Net income  $             37.9  $             63.9  $             98.6
    P / E 21.2x 12.6x 8.1x
    CapEx  $            (50.0)  $            (50.0)  $            (50.0)
    FCF  $             79.9  $            105.9  $            140.6
    P / FCF 10.1x 7.6x 5.7x

     Based on the analysis, I believe the market is pricing into COT zero volume and/or pricing growth and the high likelihood of margin degradation. Margin degradation relative to recent levels is likely in 2011. However, assuming a more stable commodity environment I believe that COT's 16% targeted gross margin level is achievable on a LT normalized basis.  Accordingly, it is not difficult to see how on a normalized basis COT is trading at a levered FCF yield approaching 20%.

    Should gross margins indeed collapse in late 2011 or 2012 as a result of commodity inflation, I believe ≈12.5% is a sufficiently conservative scenario. Assuming no price increases to translate into higher revenue, 12.5% gross margins on LTM revenues implies ≈7.3x EBITDA and >10x levered FCF. Assuming the fundamental LT strategic position of COT remains strong, I don't think the market will view that valuation as either particularly expensive or cheap. Accordingly, I think the risk reward is attractive.

    Catalyst

    1) Continued stability in operations

    2) Stabilization of input prices

    3) Interest from financial or strategic acquirer

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