We believe that Middleby (MIDD) is an attractive short idea at current levels. 

Company Overview

MIDD manufactures and sells a variety of foodservice equipment, food processing related equipment and premium residential kitchen equipment through over 100 brands.  The company operates through three segments 1) Commercial Foodservice (67% of revenue), 2) Residential (19% of revenue) and 3) Food Processing (14% of revenue).  Commercial Foodservice offers over sixty brands to all foodservice operators including quick-service restaurants, full-service restaurants, convenience stores, retail outlets, and hotels.  Residential sells and distributes a variety of premium brands including the iconic Viking brand.  Food Processing offers a variety of solutions (22 brands) for packaged foods manufacturers.  Key brands include Viking, TurboChef, Follett, Star, Blodgett, Pitco and Taylor.  The company serves a number of large restaurant chains, food processors and retailers as customers but no customer accounts for over 10% of revenue.  The end markets that MIDD operates in are competitive and fragmented.  In particular, the residential market is becoming more competitive with mid-tier brands offering more technology and features in order to be more competitive with MIDD’s more premium positioned brands.  61% of revenue is generated in the U.S. & Canada, 33% in Europe & the Middle East and the remainder in Asia and Latin America.  The company has been a serial acquirer under former CEO Selim Bassoul and current CEO Timothy Fitzgerald and has achieved mixed results with M&A. 

Summary

Many segments of the foodservice industry have been disrupted by COVID-19 and will likely be changed permanently.  MIDD has felt the impact of its struggling customers (particularly Commercial Foodservice) with organic revenue expected to decline 18% in 2020 and EPS is expected to decline 31%.  Despite the extraordinary challenges that face some of MIDD’s commercial foodservice end markets, MIDD shares trade at an all-time high and are up 20% over the past year, outperforming the S&P 500, which is up 16%.  MIDD strong performance is attributable to investor preference for “reopening” levered companies, strong demand in Residential with a favorable housing market, solid demand in Food Processing with high demand for packaged food and improving October demand trends in Commercial Foodservice.  We have a less sanguine outlook for the business and expect challenges in the Commercial Foodservice to persist for many years and note that MIDD has struggled to grow organic sales for many years before the disruption caused by COVID-19.  In addition, we don’t believe that MIDD’s products are particularly differentiated in the highly competitive and fragmented markets that MIDD competes in.  MIDD has been reliant on acquisitions to drive revenue growth and the company has a mixed acquisition track record over the last several years.  We note that ROIC has declined meaningfully over the last decade as acquisition activity has accelerated.  We believe that the market is not fully incorporating these long-term challenges into MIDD’s current valuation (23x NTM P/E) and shares are an attractive short opportunity.  

Industry Challenges

The Commercial Foodservice segment is likely to face lasting headwinds (end market exposure is shown below).  We expect a challenging operating environment to persist for Independent Restaurants, Travel & Leisure, Casual Dining and some franchisees.  These end markets represent over 25% of total segment revenue and other end markets could also feel pressure as unit growth slows and owners delay capital projects as they repair damaged balance sheets.  According to a November 2020 restaurant survey by the National Restaurant Association, around 100,000 units (~17% of the U.S. total), are either permanently closed or expected to be closed for an extended period.  In addition, Rabobank, estimated that there will be 50,000 to 60,000 eventual permanent closures in the independent restaurant sector alone, representing 15% to 20% of the entire group.  MIDD’s management states that ~74% of the company’s revenue is related to replacements/upgrades, parts and menu driven changes and is therefore is less cyclical.  We believe that capital projects will be delayed as foodservice operators look to strengthen balance sheets and new openings will likely be depressed over the next several years.  In addition, a restaurant equipment distributor noted that he is seeing more used equipment availability and pricing pressure.  We believe used equipment will be attractive to struggling operators.  The pandemic has likely changed the commercial foodservice industry permanently and we expect a challenge macro environment for MIDD’s Commercial Foodservice segment. 

Commercial Foodservice Revenue Mix by Customer Type

Organic Growth

MIDD wasn’t performing well before COVID-19 and organic revenue growth over the past five years has been roughly flat.  The company has also grown slower than its end markets over the past several years and has lost market share.  There were several execution related headwinds including a salesforce reorganization, distribution channel disruptions and acquisition challenges.  There has also been some slowing in restaurant demand.  We believe it will be challenging for MIDD to generate consistent organic growth over the long-term and don’t believe that COIVD-19 improves the long-term commercial foodservice outlook in any way.  Margins were ~flat from 2010 to 2019 and we while there will be some cost savings related to COVID-19 (less travel and entertainment), we don’t believe there is a significant long-term margin expansion opportunity at MIDD.

Technology & Innovation

MIDD typically charges a premium for its products and believes that it is the technology and innovation leader in many of its end markets.  While the company has some quality products and has won some innovation awards, we don’t believe that the portfolio is particularly differentiated and this is evidenced by the company’s inability to consistently maintain or grow market share.  We also note that the company’s end markets are fragments with the top three competitors typically holding less than 20% cumulative market share.  When looking at R&D expense, MIDD’s 2019 R&D expense was just 1.4% of sales and this lags well behind many of its competitors, including WBT and WHR, which spent 2.6% of 2019 sales on R&D.  It’s hard to make the case that MIDD is the innovation leader when its R&D spending lags well behind many of its peers.  In 2020, MIDD launched its Open Kitchen (Internet of Things) platform and we don’t have a lot of confidence that will help the company reverse years of lackluster organic revenue performance.

Acquisitions

Management has pursued an aggressive acquisition strategy with 32 acquisitions completed from 2015 to 2019.  Selim Bassoul, the company’s CEO from 2000 to 2019, led the acquisition strategy until his retirement with MIDD’s then CFO, Timothy Fitzgerald, assuming the CEO position in 2019.  The new CEO views the industry as fragmented and ripe with opportunities and I expect more acquisitions.  The largest and most notable acquisitions over the past few years include Taylor for $1.0 bil. in 2018 and Viking for $380 mil. in 2012.  The acquisition track record is mixed with Viking notably encountering significant early challenges.  We also note that ROIC has declined as acquisition activity accelerated with 2012 ROIC of 14% declining to 10% in 2019 and 7% in 2020E.    

There aren’t any compensation metrics at MIDD tied to organic revenue, organic EBIT growth or ROIC and management is incented to make acquisitions to hit comp targets.  Short term targets are based on a 50%/50% mix of EBITDA and EPS targets while long-term incentives are based on three year compounded EBITDA growth.  We should continue to expect management to focus on acquisitions and less on driving organic growth or effectively integrating acquisitions.

We also believe that after many years of acquisitions, there are now fewer attractive targets that can significantly impact growth and achieve attractive returns for shareholders.  MIDD may need to look outside of its core segments for M&A opportunities and this could lead to more integration risks.

Inventory Days Growth

Inventory days have grown meaningfully over the last five years and MIDD may not be effectively integrating acquisitions and could have inventory that is significantly aged or obsolete.  At the least, this is a sign of poor management and should be closely watched by investors.  

Valuation

Despite the industry challenges that MIDD faces, it trades near its all-time highs on an absolute and relative basis.  We believe that the company will continue to encounter challenges consistently growing its organic growth over the long-term and acquisitions could also be detrimental to shareholder value.  We also note that the company has significant leverage with over $1.6 bil. of net debt at the end of Q3 and ~$1.9 bil. if unfunded pension liabilities are included in debt.  This translates into ~4.2x net debt to 2021 EBITDA.  We believe the consensus expectations for over 27% 2021 EPS growth and 21% 2022 EPS growth are aggressive and expect downward revisions.  With problematic end markets and lack of organic growth, we believe MIDD should trade no higher than a mid to high teens P/E multiple, in line with the five year average.  A 17x multiple on our 2022E EPS leads to a price target of $106, representing downside of over 20%.