Description

We were initially long COT, for many of the same reasons from yarak775‘s write-up in March (we refer you to that write-up for background on the company). However, our diligence into the customer acquisition process at COT’s DS Services (water distribution segment) led us to accumulate a sizeable short position, as we see substantial risk to the company’s prospects.

(For purposes of this write-up, we will use COT and DS Services, COT’s water distribution business, interchangeably).

Thesis

In its 2Q18 conference call, COT management emphasized a subtle shift in its go-to-market strategy during prepared remarks:

“As we noted earlier in the year, in conjunction with the expansion of our commercial sales force, we have also redesigned our approach to residential marketing, including our retail booth program. In essence, we are taking the high-density area, or HDA, approach that our European operation is implementing, and we are applying this to our U.S. based residential marketing efforts, where we are focusing on the regions that were able to provide the best customer service in return on investment, which are tied to the distribution centers, where we have the greatest routes and customer density. As a result, we are concentrating our residential marketing activity within HDAs and in turn reducing our cost in certain regions that we do not find as attractive.”

While this sounds innocuous, we believe this change in strategy to further emphasize commercial customers over residential customers is in response to a major competitive threat to COT’s business: the re-emergence of Nestle’s Ready Refresh as a viable competitor. Our checks indicate that Nestle has recently partnered with COT’s largest retail partner, Costco, in several markets. (We describe our diligence in the section labeled “Nestle and Costco” below).

We believe the Nestle threat impacts COT in three major ways, which we elaborate on further below:

1. Customer acquisition will be more difficult

2. Margins could come under pressure as cost increases will be harder to offset

3. COT’s acquisition strategy is less likely to be successful

The combination of these issues, the threat of further Nestle growth and COT’s balance sheet leverage results in downside potential of more than 50%.

Customer Growth

Nestle’s entry into Costco impacts COT’s ability to acquire customers. While not disclosed as a 10% customer (because customers technically sign up with COT), we believe Costco is the major retail booth partner often discussed by COT. There are references to a contract between DS and Costco in the 2014 10K (filed 3/4/15), references to Costco in the DS Services Modeling call in January 2015 and numerous sell-side analysts have mentioned Costco by name.

The booth program is relatively simple. COT can set up a booth at the front of a Costco store and customers can sign up with COT at a discounted rate. Customers can also access this discounted rate online, but the relative mix has not been disclosed.

When COT reported 1Q16 results, they announced an extension of this partnership through 2021:

CEO Jerry Fowden further expanded on this program at the Goldman Sachs Staples Forum in May of 2017:

“So we have exclusive long-term multi-year retail booth program with a large club store, whereby we have the exclusive rights to mine their customer base for people interested in home and office water services. And that probably drives some 1/4 to 1/3 of all our new customer sign-ups.” (Emphasis ours)

Our research shows this “exclusive partnership” is at best exaggerated. Nestle is now a preferred partner for water delivery in several geographies through Costco’s website, penetrating the partnership representing 25-33% of COT’s new customers.

COT has guided for organic revenue growth of 2-3% overall, and 2%+ in the route business (figures below from Sept 2017 “New COT Modeling Presentation”), so any impact to this customer acquisition channel is meaningful to growth. This is also a route density business, so if it becomes harder to replace churning customers efficiently, it should have a meaningful effect on margins.

The churn of this business is significant, as shown in this chart from the investor day in March. In fact, ~18% of customers churn each year. So to grow revenue 2%+ organically, COT must sign up 20% new customers. Any impact on their single largest customer acquisition channel has a significant effect on their ability to grow.

Margin Impact

This is a route-based business, where incremental margins from route density are significant. COT is

claiming that they are only de-emphasizing low density geographies, but we find two issues with this:

1. If they don’t target new markets, what will be the future high density areas to drive growth?

2. Nestle appears to be infiltrating geographies with a significant COT presence, and presumably high density and therefore margins. We expand on this in the “Nestle and Costco” section.

Acquisition Strategy

Finally, we believe there will be a significant impact on COT’s acquisition strategy.

One of the biggest growth levers for COT is its capital allocation strategy as it reduces leverage through EBITDA growth. If EBITDA growth slows or even declines, this will obviously impact that deleveraging story, and impact the ability to acquire other businesses. Acquisitions in route-based businesses are quite accretive, as synergies are relatively simple. COT has been vocal about this opportunity.

Nestle’s emergence as a Costco partner impacts COT’s acquisition strategy in multiple ways:

• As COT’s share price declines, deals become less accretive.

• COT may no longer be the only national player pursuing these tuck-ins, resulting in lost deals or more expensive acquisitions

• A potential Nestle merger (one of the most bullish options for COT long-term) may be less likely.

One of the most compelling parts of the COT long pitch is that they are the only way to play water distribution. We would summarize the bull thesis around competition as: Nestle is the only other national player, but the presence of an activist investor and the relatively small size of the market has kept Nestle from making water distribution a priority. Therefore, Nestle won’t pursue acquisitions of other local water distribution businesses, leaving COT as the only player for highly accretive bolt-on acquisitions. In fact, bulls believe Nestle may ultimately decide to shutter this business entirely and COT is the logical acquirer. Recent events suggest all of this may need to be questioned.

Nestle and Costco

Up until July 20, it appeared that COT was the exclusive water distribution partner for Costco. This url (https://www.costcowater.com/costco/index-get-started.jsf) takes you to COT’s DS Services “Costco Services” website, which looks like this:

When you click “Order now” you can type in zip codes to see Costco locations where DS Services is active.

You used to reach this site by visiting Costco’s Member Services website (https://www.costco.com/services.html?EXTID=ps_GM2_mov_services2) and clicking on “Bottled Water Delivery,” which looks like this:

However, beginning on July 20, that link now directs you to a different website (https://www.costcowaterdelivery.com/):

Note the “third party” label. When you enter a zip code, you are either redirected to the original DS Services website, or shown a phone number:

When you call this number, you will be speaking with a Nestle representative, and they state that they are Costco’s Preferred Partner in that zip code. We have not seen any Nestle booths yet, but the website just went live a few weeks ago, and on the phone the Nestle operators state that there is an active booth program.

While COT still controls many geographies, Nestle has made a sizeable entry into Costco since we noticed the website change on July 20th. We haven’t checked every zip code in the country, but have identified a few areas with a significant Nestle presence. Here are a few examples of zip codes where the Costco website directs you to call Nestle (there are many more as you play around on the website):

*NW Atlanta, GA – the same zip code as DS Services headquarters

**Orange County, FL – the same zip code as the COT production facility toured on the March investor day

The map below shows Nestle’s Costco presence near Atlanta. The blue shaded areas represent zip codes where the Costco website directs you to Nestle as its preferred partner, while pink shows areas where the website still directs you to COT (DS Services). While COT claims that they are de-emphasizing low density areas, it seems unlikely that Atlanta is low density. This is especially surprising considering that the black marker on the map indicates a COT production facility (which is now right in the middle of Nestle’s service area).

The maps in the appendix show other zip codes where Nestle is now an online partner for Costco. As you can see, these are not isolated areas, and Nestle’s presence already spans major cities in the Northeast, Florida, Texas and Northern California.

In some of these regions it appears that you can choose either Nestle or COT – these maps only show where Costco’s website directs you.

Additional Considerations

• COT has recently discussed increasing prices to offset freight, wages and healthcare cost pressure, in addition to potential tariff issues. They discussed on the 2Q18 conference call that they would phase these increases in between August and December. Given Nestle is entering their largest customer acquisition channel, the ability to take price may be more difficult. Nestle appears to be offering the same price per bottle as COT (at least in the zip codes we’ve checked), which could also make raising price more difficult. It may be difficult to increase price with a customer like Costco who has been focused historically on offering special deals to its customers. Finally, as we will show, any increase in churn caused by these pricing measures could severely impact COT’s growth algorithm.

• COT announced a management transition with Q2 results. The head of DS Services, Tom Harrington, will be taking over as CEO. Jerry Fowden will become Executive Chairman. The timing of a management transition, right after Nestle gained entry to Costco, seems interesting.

Financials

We don’t know if Nestle will fully displace COT. But even a small dent in new customer acquisition is likely to make achieving guidance very difficult. With incremental margins quite high for route-based businesses, and customer acquisition costs increasing as COT invests in its commercial sales force, EBITDA margins should decline without revenue growth. The loss of Costco business may also force COT to make additional investments in its infrastructure, which would further impact cash flow. COT has already slightly increased CAPEX guidance for 2018.

The basic impact can be summarized below:

Note this analysis ignores that COT puts annual price increases through for its customers, so the churn rate has a greater impact on revenue than we show here. Conversely, pricing measures could help growth if they come in higher than expected.

You can make your own assumptions for incremental margins, but assuming SG&A still needs to grow given the current inflationary environment, detrimental margins in this route-based services business resemble others and the company’s balance sheet leverage, you could paint a picture where FCF is closer to $100m than the $150M COT has guided to for 2019, and ~$80m in 2020 if they are unable to find credible M&A targets. At a 7% FCF yield (potentially rich for a business with shrinking EBITDA and a much lessened competitive position), that implies ~$8.50/share, or ~50% downside.

But what if we back out Eden?

We also thought it would be interesting to attempt to strip out Eden, COT’s European water distribution business, from this analysis. COT has stated that Eden’s customer base is more commercial-centric, and therefore should be lower churn – meaning US churn is likely higher than we’ve shown here.

At a Cannacord conference in August 2016, COT showed the following slide, pegging Eden’s average customer tenure at 7.5 years.  

We know from the Investor Day that DS overall had customer tenure of 4.6 years.

While we don’t know exactly how much revenue Eden will make up this year, if we assume it grew 2%/year off its base of $408m in 2015 (see slide below), it implies it makes up almost 30% of DS revenue.

For Eden’s average customer tenure to be 7.5 years and overall tenure to be 4.6 years, it implies almost 29% churn for the DS Services business. Even assuming our analysis is too dire, just using 25% churn for DS services results in a much more significant impact on organic growth:

Again, you can make your own assumptions, but if organic revenue growth is (2%) in 2019 and cost pressures continue, FCF could end up less than $100m in 2019. If growth continued to decline in 2020, some investors may start to question the company’s debt load.

Risks

• It may take time to see the Nestle impact now that we are past the seasonal peak in volumes driven by warmer weather

• COT may be able to offset some of the SG&A pressure due to its drivers largely being compensated on commission. A potential offset to this risk is that those drivers would likely seek to be paid more in base salary if volumes decline.

• This could be a short-term issue and COT could reclaim Costco

• COT could make a value accretive acquisition that mitigates the Costco risk

Appendix

       Baltimore & Philadelphia Dallas/Fort Worth

Florida         New York

San Francisco

Disclaimer:

The views and opinions stated are the personal views of the author. Do not rely on the information set forth in this write-up as the basis upon which you make an investment decision – please do your own work. The author and funds in which the author manages hold positions in and trade, from time to time, securities issued by COT and options on such securities.  This write-up does not purport to be complete on the topics addressed, and the author takes no responsibility to update this write-up in the future.  This is not a recommendation to buy or sell any securities.

Catalyst

- Customer growth slows

- Margins contract

- Fewer acquisitions

- Nestle continues expansion