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).
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:
Customer acquisition will be more difficult
Margins could come under pressure as cost increases will be harder to offset
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%.
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 exclusivelong-term multi-year retail booth program with a large club store, whereby we have the exclusiverights 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.
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:
If they don’t target new markets, what will be the future high density areas to drive growth?
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.
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.