Description

Welbilt combines a few negative themes which has resulted in an ugly share price trajectory – stock down over 50% from its July 2018 high and below the 1Q 2016 post-split price. Concerns include high leverage (equity dilution?), new management (vague commentary around guidance and previously articulated margin targets), cost inflation and an organic growth hiccup.

As a result, the current valuation provides a cheap option on several positive dynamics, such as the remaining 600-700 bps of potential margin improvement and organic growth initiatives. Cash generation should allow for debt reduction, which should eliminate any dilution overhang and increase earnings. Lastly, this is a potential takeout candidate considering the passage of the two-year spin-off window plus over $40 million of potential annual corporate and unallocated cost removals (on top of additional synergies).

At current prices, Welbilt trades at <10x 2019E EBITDA, ~10.5x UFCF (EBITDA-capex) and ~10x FCF. Significant replacement demand and a large installed base provides stability and a capital light business model allows the company to support leverage of ~4.5x (including AR securitization). Factoring in expected EBITDA growth and cash generation, this ratio should decline below 4x heading into 2020, with the incremental value flowing to equity.

Business Description

Welbilt was spun-off from Manitowoc in 1Q 2016 after activist pressure. The company manufactures commercial foodservice equipment* – hot-side, cold-side and beverage dispensing. End-users include full-service restaurants and QSRs (58% of total), hotels, hospitals, schools, caterers, supermarkets and convenience stores. Welbilt’s top five customers comprise approximately 8%, 4%, 3%, 2% and 2% of revenues and relationships with these customers span 28-55 years. Geographically, revenue and EBITDA are split 68%, 20% and 12% and 71%, 21% and 8% between Americas, EMEA and APAC.

*Brands: Cleveland, Convotherm, Delfield, fitkitchen, Frymaster, Garland, Kolpak, Lincoln, Manitowoc Ice, Merco, Merrychef and Multiplex.

Hot products (40%-45% of revenue) include combi, conveyor and high speed ovens, ranges, grills, induction steams, kettles and skillets and commercial fryers and hot holding equipment. The recent Crem acquisition adds a coffee offering, specifically espresso, filter machines and instant and liquid freestanding equipment. Cold products (40%-45%) captures refrigeration, including walk-ins and preparation stations, ice-cube machines and beverage stations. Aftermarket parts and service (15%-20%) via its KitchenCare brand fills out the balance.

A host of competitors exist in the space but I would call out Illinois Tool Works, Middleby, Standex, Marmon and Dover. Raw materials consist of structural and rolled steel, aluminum, copper and natural gas.

Due to a large installed base and predictable replacement cycles, much of the company’s revenue exhibits stability. 2018 expected US foodservice equipment needs are split between replacement (51%), renovations (26%), new construction (12%), site expansion / additional parts (6%) and eco-friendly applications (6%).

Global industry growth is expected to be 2.5%-3.0% (depending on restaurant capital spending), and Welbilt targets 1%-2% above this rate through innovation and other market share capture. Foodservice industry drivers include population and income growth, expansion into new markets, new concepts and an increasing focus on health and sanitation. Specific to the US, the restaurant industry has experienced few periods of year-over-year sales declines as dining-out and pick-up trends continue to drive growth. On the cost side, innovations seek to offset higher labor, energy, real estate and other costs. For example, Welbilt’s fitkitchen concept is designed to reduce footprint, improve efficiencies and automate various restaurant functions (i.e. a full connected kitchen solution).

A recent NexGen agreement is another source of potential company-specific growth, although the contribution is difficult to quantify. For background, NexGen represents 50% of US distributors serving a diverse customer base. Welbilt announced an agreement in mid-2018 to become a primary supplier of its Cleveland and Delfield brands (pans, skillets, kettles and refrigeration). Benefits started in 2H 2018 and should continue in 2019.

New Management

When the previous CEO departed for CNH Industrial, the board brought in William Johnson. He worked as CEO of several public companies but his comments about his job at Dover struck me. At Dover, he helped build out the Phoenix retail refrigeration brand. This included growing the sales from $450 million to over $1 billion (organic and inorganic growth) while also driving operational improvements (margins +200-300 bps).

Capital Structure

The capital structure is straightforward.

Revolvers                             $120

Term Loan B                         $900

Other Debt                           $92

9.5% Senior Notes                $425

Total Debt                             $1,537

Net Debt                               $1,443

Market Capitalization              $1,625

Enterprise Value                    $3,068 million

The 9.5% high yield bonds are callable in 2019. I expect these to be refinanced at a far lower rate even in the current market. Additionally, the company likely generated FCF in 4Q of over $50 million.

Financials

For 2016 and 2017, revenue of $1,457 and $1,445 million reflected flattish organic sales – small declines in Americas due to customer line simplification and culling of lower margin business, offset by growth in EMEA and APAC. EBITDA rose from $260 to $275 million as cost improvement initiatives increased margins by 120 bps.

3Q18 and YTD organic sales increased 3.8% and 4.7%, respectively. EBITDA margin declined 20 bps in each period after stripping out the negative 30 bps impact from the Crem acquisition (in April). The lower margins were a function of higher raw material costs (170 bps headwind) and mix (soft aftermarket sales and ramp-up costs for large chain rollouts). Pricing gains helped to partially offset, but these increases occurred prior to realization of the section 301 tariffs.

2018 guidance moved around a few times. Initial guidance was +1%-4% organic growth and EBITDA margins of 19.5% to 21.0%. Organic growth guidance is now +3%-5% but EBITDA margins are lower at 18.1% to 19.1%. The decline on the margin front comes from the aforementioned higher material cost inflation (tariffs – 232 + 301, freight and mix) and the Crem acquisition. The full year guidance implies a tough 4Q which management blamed on a difficult comparable period. Section 301 tariffs caused a 20 bps impact for the year (effectively a 40 bps hit in 2H).

Organic growth represents only part of the story here. Previously, management discussed a plan to move from mid-teens margins (2015) to mid-to-high 20s due to prior mismanagement. There was always a question of how much of this could be delivered since part of the gap with competitors could be structural, but the target remains. The 1,000 bps+ improvement “levers” include plant rationalization, headcount reductions, KitchenCare improvements (and growth as a % of total sales – higher margins), a more focused product line (80/20 plan), an improved purchasing and supply chain, lean manufacturing and new products and systems. A hiccup in 2018 related to higher raw material costs and Crem margin dilution raised concerns about the achievability of these targets but the new CEO recently reiterated their legitimacy.

The company is in the early stages of its purchasing and supply chain and lean manufacturing improvement initiatives, the midpoint of product line simplification and the later stages of aftermarket and pricing improvements. Capacity and labor reductions are 75%+ complete.

2019

The projected weak 4Q and a tough 1H 2019* comparable period aside, management mentioned several positives including 23 new product launches in 4Q, the removal of one-time supplier and start-up costs, normal KitchenCare inventories, expected pricing to help offset tariffs and a reiteration of its 1,000 bps margin improvement target (with 600-700 bps remaining).

*Post 3Q CC, management clarified the difficult comp related to 20% of its business versus easier comps at the remaining 80%.

For 2019, I project LSD growth mostly from catch-up pricing and some volume gains. From a margin perspective, note that at a conference after the 3Q call, the new CEO talked about expected margin improvement relative to both 2018 and 2017. Taking this into account and factoring in a lower coupon from the bond refinancing, I expect FCF/sh to exceed $1.00.

Valuation

At current prices, the shares trade at 10.5x and 11x 2018E EBITDA and EBIT. Rolling forward to this year, I calculate multiples of <10x and 10x, respectively and a FCF multiple of 10x. If the margin targets are achieved, I believe the shares could more than double. However, at these prices, the company merely needs to show progress for the stock to perform.

Similarly, private market value should be far higher than current prices. Welbilt purchased Crem for 13x and Middleby acquired Taylor for 15x EBITDA. The best comparable is Middleby which trades at 11.5x EBITDA.

Conclusion

The share price reaction post 3Q numbers appears overblown to me. Since then, the stock declined from around $20 to $11.59/sh. As such, the shares trade below its post-split 1Q 2016 price of $12 despite a streamlined portfolio, higher margins and improved earnings. I think a 10x FCF multiple is pretty cheap for a high quality and growing business with margin enhancement opportunities.

As management provides more clarity on 2019, and after margin recovery becomes apparent, I believe the market will focus less on leverage and more on Welbilt’s cash generating ability. Applying a 15x FCF multiple to my 2019 estimates results in a $17+ share price. Assuming a 21.5% margin (halfway to its target) leads to nearly $1.50 in FCF and potentially over $20/sh. And don’t forget the takeout potential as this space continues to consolidate.  

Catalyst

-Cash generation and debt paydown

-Organic growth

-Progress towards margin targets

-Takeout