Description

(Figures in Canadian dollars unless noted otherwise)

I. SERVING UP DESSERT – COOLBRANDS INTERNATIONAL
Due to the announced loss (though not irreplaceable in our minds) of CoolBrands’ Weight Watchers SmartOnes (WWSO) low-fat brand (14% of FYE August 2005 revenues, 28% of earnings), we feel there is an extraordinary opportunity to buy a world class package of dessert brands and distribution assets at 40% to 50% of what we feel is fair value.

What You Get
* #1 seller of frozen dessert Better-For-You (BFY) novelty brands (far and away the fastest growing component of the ice cream market) with total projected ’04 revenues of $665mm (vs. $340mm in ’03)
* North America’s 3rd largest ice cream company (and most profitable one to our knowledge)
* Owner of the 2nd largest Direct-Store-Delivery (DSD) network covering 68% of US retailers (All Commodities Value or ACV) in a duopoly competitive situation (3rd largest distributor, Blue Bell, distributes to 14 southern states)
* An extremely strong balance sheet (projected ’04 cash net of debt at $69.2mm or $1.24 per share), low capex requirements (~$5mm-$10mm/year), and high quality of earnings (FCF = 95% of Net Income)
* A business model that has high barriers to entry (brands, distribution) and a company that has strong organic growth trends year over year (Q1 growth 19%, Q2 growth 27%, Q3 growth 14%)

What You Pay
* P/E ’04-‘06: Downside Scenario: 8.0x, 7.9x, 7.4x vs. 18.3x and 16.4x (’04 and ’05) for the consumer packaged goods comps (Note: Excess cash of $69.2mm subtracted from market capitalization)
* P/E ’04-‘06: Base Case Scenario: 8.0x, 7.0x, 6.3x vs. 18.3x and 16.4x (’04 and ’05) for the comps
* EV/EBITDA ’04-‘06: Downside Scenario: 4.7x, 4.7x, 4.5x vs. 11.7x (LTM) for the comps
* EV/EBITDA ’04-‘06: Base Case Scenario: 4.7x, 4.2x, 3.8x vs. 11.7x (LTM) for the comps
* Acquisition Multiples: 63% discount on a multiple of ’06 sales (normalized) compared to what Nestle paid for Dreyers (90% discount on a multiple of EBITDA)

II. THE BASICS
Price (8/11/04): $10.30
A Shares (mm): 49.7
B Shares (mm): 6.2
Market Cap (mm): $563.6
Cash (Net of Debt, mm): $69.2
Enterprise Value (mm): $494.2
Options: 3.8mm outstanding at 5/31/04 which we believe are at a weighted average strike prices above $15

III. LOSS OF THE WEIGHT WATCHERS SMARTONES LICENSE – THE SCOOP

On Thursday July 29th, CoolBrands announced that it was losing its license to manufacture, market and distribute the WWSO low-fat ice cream novelty. According to management estimates, WWSO was projected to comprise 16% and 14% of revenues in FYE August 2004 and 2005, respectively, and 32% and 28% of net income. The WWSO license ceases at the end of September 2004, but the Company is entitled to continue producing and selling WWSO until the earlier of 1) inventories running out (estimated between March and May 2005) or, 2) the end of September 2005. In response, the stock declined 38.8% from $16.90 (7/28) to $10.35 (8/5), a $365mm drop in the fully diluted market value of the company.

Downside Scenario

So what are you left with in a downside scenario? A downside scenario is one where CoolBrands is unable to replace any of the lost WWSO low-fat business, starting in January of 2005 (start of shelf space resets in supermarkets) and in parallel experiences a reduction of gross margin by 2% for ’05 and 3% for ’06 for the pre-packaged segment of their business. Based upon these assumption, earnings for FY 2004 through 2006 would be $1.11, $1.12, and $1.19, respectively. This represents a 21% and 27% reduction in earnings from our ’05 and ’06 estimates assuming they had retained the WWSO license. We see the likelihood of this scenario coming to pass as highly unlikely (discussed below). Extracting the projected net cash (net of all debt) of $69.2mm at August 2004 from the market capitalization (this cash is excess in our minds), we see the following multiples as posted below:

Downside Scenario Multiples
Multiple -- 2003 -- 2004 -- 2005 -- 2006
EV/Revenues -- 1.4x -- 0.7x -- 0.8x -- 0.7x
EV/EBITDA -- 9.1x -- 4.7x -- 4.7x -- 4.5x
Price/Earnings -- 15.6x -- 8.0x -- 7.9x -- 7.4x
Price/Cash Flow from Operations -- 49.6x -- 6.0x -- 7.6x -- 6.8x

Base Case Scenario

The base case scenario (in our minds the most likely outcome) assumes that in March of 2005 CoolBrands replaces its WWSO branding on its low-fat products with an alternate Better-For-You (BFY) brand. The two primary options are as follows (listed in our estimated order of probability):

1. Silhouette Brands “Skinny Cow” – Dreyers has tentatively agreed to license the Skinny Cow brand (#2 brand behind WWSO) for products that are not overlapping with their existing Skinny Cow line (approximately 60%-70% of CoolBrands existing WWSO sales do not overlap). The SKUs making up the remaining 30% to 40% of WWSO volume could potentially then be rebranded under an alternative brand either already existing in CoolBrands’ brand portfolio or another 3rd party licensed brand.
2. SmartOnes (without Weight Watchers branding) – H.J. Heinz owns the SmartOnes brand, which is by far the dominant branding on WWSO ice cream products (28.75sq cm for SmartOnes vs. 0.81sq cm for Weight Watchers). It is uncertain whether or not Heinz is precluded from licensing the SmartOnes brand in ice cream without the Weight Watchers brand attached. If CoolBrands is able to license the brand, we anticipate a minimal loss of revenues and earnings to the Company as compared to a scenario under which they had retained the WWSO brand.

Under the base case scenario (placing more weight on the less attractive “Skinny Cow” outcome), we project earnings for FY 2004 through 2006 would be $1.11, $1.27, and $1.41, respectively, which assumes a 40% loss of the WWSO business post March of 2005 and a reduction of gross margin by 1% for ’05 and 2% for ‘06 for the pre-packaged segment of their business. Extracting the projected net cash at August 2004 from the market capitalization, we calculate the multiples below:

Base Case Multiples
Multiple -- 2003 -- 2004 -- 2005 -- 2006
EV/Revenues -- 1.4x -- 0.7x -- 0.7x -- 0.6x
EV/EBITDA -- 9.1x -- 4.7x -- 4.2x -- 3.8x
Price/Earnings -- 15.6x -- 8.0x -- 7.0x -- 6.3x
Price/Cash Flow from Operations -- 49.6x -- 6.0x -- 7.2x -- 6.0x

So are these multiples cheap given that the comps trade at 16.4x calendar ’05 P/E (a 134% premium to our base case and 108% to our downside scenario) and that the company traded at similar multiples 2 months ago??? We certainly think so.

IV. THE COMPANY & INDUSTRY – A BRIEF OVERVIEW

Packaged Goods – Concentration in the High Growth Segments

CoolBrands has positioned itself in the fastest growing and most profitable segment of the frozen desserts market. The US$20bn frozen dessert industry is primarily comprised of regional and private label ice cream brands, while CoolBrands’ business is focused in the frozen novelty (US$2.5bn) and super-premium and sorbet (US$1bn) segments. These segments are growing much faster than the overall frozen dessert markets, and within them, CoolBrands has focused on the most rapidly growing sub-segment, the BFY frozen snacks category. Industry-wide the BFY component grew from US$374mm in 1998 to US$706mm in 2003 (13.6% CAGR) vs. regular frozen snack growth from US$1.5bn to US$1.8bn (3.9% CAGR).

CoolBrands has built one of the strongest brand portfolios in the BFY frozen novelties segment through its licensing of the WWSO brand (discussed above), the Atkins Endulge brand (20 year license and the company’s most successful roll-out ever), and the Yoplait brand and ownership of the Whole Fruit Sorbet brand. The Yoplait Breakfast Bar and Sandwich are being rolled out nationwide currently and preliminary sales results (Baltimore/Washington, DC) suggest that it will be a strong addition to CoolBrands BFY portfolio. CoolBrands brand portfolio is as follows:

Owned Brands:
* The Original Chipwich
* Eskimo Pie
* Fruit-a-Freeze
* Whole Fruit (excl. stick bars)
* Dreamery

Licensed Brands:
* Weight Watchers SmartOnes
* Atkins Endulge
* Carb Solutions
* Yoplait
* Welches
* Godiva
* Trix Pops
* Tropicana

Distribution – An Irreplicable Advantage

Through CoolBrands’ acquisition of the Nestle DSD assets, the company now owns the 2nd largest frozen desserts DSD system in North America, behind Dreyers. There is no third national DSD system so competitors must either work with Dreyers/Nestles (with whom many have intense rivalries), CoolBrands, or piece together groupings of smaller regional distributors. The DSD system provides CoolBrands and potential acquirers with the following competitive advantages:

1. Expand Distribution for its Existing Products – Historically CoolBrands has distributed its product primarily through grocery stores. Its acquired DSD system covers Washington, Oregon, Florida, California, Pennsylvania, New Jersey, Utah, Minnesota, Georgia, Maryland, Alabama, South Carolina and the District of Columbia and allows it to penetrate convenience stores in these markets as well as distribute super premium brands in super market channels. To this end, CoolBrands recently agreed to distribute five products across 3,000 7-Eleven stores though it’s DSD system. We expect further similar agreements to be forthcoming.
2. Improve the Quality and Display of Product – Control of the means of distribution allows the company to manage the quality of delivered product (important for frozen foods) and the in-house display, ultimately increasing the velocity of sales.
3. Add Incremental Revenues through 3rd Party Distribution – Both Unilever and Mars cancelled contracts with Dreyer’s upon its acquisition by Nestle due to their intense rivalry and contracted with CoolBrands. In light of Ben & Jerry’s (Unilever) particularly poor 2004 sell through performance, we believe it is likely that CoolBrands will receive additional volume into its DSD system over the next few quarters.

CoolBrands also has a number of related businesses (foodservice, raw materials, and franchising) which represent less than 10% of sales and are declining in importance.

V. REVALUATION CATALYSTS
Near-Term Catalysts (1 to 2 months)

We believe the most imminent catalysts for CoolBrands include:

1. Replacement of WWSO Brand – We feel the company will find a solution that will preserve the majority of CoolBrands low-fat business (“Skinny Cow” is already tentatively agreed).
2. Stock Buyback – The company has announced a buyback of 1.1% of its stock (550,000 shares). We see this as a minimum and understand that management is considering a more aggressive buyback program of potentially 5% or more of outstanding shares).
3. Additional Brand Licenses – We understand that the company is currently in negotiations to license a number of well-known consumer brands. While the brands may turn out to be significant contributors to the company’s business in future years, we feel the more important (and immediate) message to investors is that the company continues to be open for business as usual, despite the loss of the WWSO brand.

Longer-Term Catalysts (1 to 2 years)

Longer term catalysts for the company’s valuation include:

1. Results of the New Low-Fat Brand – We believe that the new low-fat brand will likely be rolled out between March and June of 2005. As the replacement brand is able to capture the shelf-space currently occupied by WWSO brand and corresponding revenue amounts, investors will rethink the over zealous valuation haircut that they have given the company.
2. Additional Manufacturing Business – Dreyers recently purchased Silhouette Brands, approximately 80% of whose products (low-fat ice cream sandwiches) were being made by hand, exposing the company to serious health and quality hazards. Given that CoolBrands already manufactures the majority of Silhouette’s other products, and has ample sandwich capacity, there is a significant chance that CoolBrands will capture a large portion of this business. Given Silhouettes sales of approximately $62mm in sandwich sales last year, this could comprise a significant win for CoolBrands.
3. Accretive Acquisitions – CoolBrands management has been extremely disciplined in its acquisition strategy to date and has proven itself a savvy buyer of mispriced assets. In 2003 the company purchased 50.1% of its Americana facility (one of top leading manufacturing facilities in the US) for US$1 and a combination of Nestle/Dreyers assets for $13.4mm that included the nations second largest DSD system and brands that represented US$135mm in sales.
4. Time – CoolBrands currently trades at a 9.0x ’05 P/E based on downside scenario earnings, vs. comparable consumer goods companies which trade at 108% premiums to this valuation. In part, this valuation is a reflection of investor’s disappointment that they were blind-sided by the loss of a major portion of the company’s business. We believe that the discounted multiple will expand over time as it becomes apparent that there are no other immediate risks to the business, management executes on its plan, and investors come to realize that management was at no fault in the loss of WWSO.
5. Sale to Strategic Buyer – Management has been quite clear about its exit strategy for the business – sale to a strategic buyer. While we believe that management will wait to make solid strides in the execution of its revised growth plan, and wait for the market to appreciate the company’s underlying value, it is not unreasonable to believe that the company could be sold within an 18 to 36 month time frame. The multiples below illustrate what Dreyers was purchased for and what the implied valuation would be in both a downside and base case scenario for the company.

Multiple --- Dreyers Multiples --- Downside Scenario 2006E Results --- Implied Price Upside
Revenue --- 1.9x --- $680.9 --- 131.0%
Gross Margin --- 8.4x --- 300.7 --- 336.9%
EBITDA --- 44.2x --- 118.2 --- 776.1%
EBIT --- 111.3x --- 110.8 --- 1980.3%
Net Income --- 284.1x --- 66.6 --- 3069.5%

Multiple --- Dreyers Multiples --- Base Case Scenario 2006E Results --- Implied Price Upside
Revenue --- 1.9x --- $775.7 --- 161.3%
Gross Margin --- 8.4x --- 345.0 --- 399.2%
EBITDA --- 44.2x --- 136.9 --- 914.7%
EBIT --- 111.3x --- 129.5 --- 2329.1%
Net Income --- 284.1x --- 78.8 --- 3650.1%

The most likely acquirors of the company would be firms that could leverage CoolBrands DSD distribution system and have deep experience in managing a brand portfolio. Candidates include Unilever (owner of Ben & Jerry’s), ConAgra (owner of Healthy Choice), Mars (owner of a variety of frozen novelties), Kraft (owner of a variety of frozen novelties and DSD assets for frozen pizzas), Heinz (owner of SmartOnes brand), among others.

VI. MANAGEMENT

Corporate Governance – Low Marks but Improving

CoolBrands management historically has not won awards for its corporate governance policies and structure. In fact, in a report conducted by The Globe and Mail on 207 companies in the benchmark S&P/TSX, the company ranked lowest on 30 corporate governance metrics. Primary negatives regarding the company include that five members of the six member board are members of management, and that the compensation and audit committees are dominated by management. Furthermore, the company has common A shares (1 vote, 49.7mm shares) and super voting B shares (10 votes, 6.0mm shares), with the B shares controlled by management. Importantly in the past, this led to large and unchecked issuance of options (3.9mm outstanding currently), though the company agreed to limit grants to 2.5% per year of the outstanding equity of the company. Furthermore, there are significant related party transactions in the form of a distribution agreement for the New York metro area and a management services fee in the sum of US $1.3mm due to Calip Dairies (owned by Richard Smith, Co-Chairman and Co-CEO).

Looks bad, right?? The lack of independent directors, one of the most significant corporate governance weaknesses, will be remedied at the latest by January of 2005 due to new laws that bring Canadian regulations in line with US regulations under Sarbanes Oxley. With this change, the audit and compensation committees will also have a minimum of 3 independent board members.

The super voting share structure, while not ideal in our minds, is not atypical for the ice cream industry. Both Dreyers (pre-acquisition by Nestle), Ben & Jerry’s (pre-acquisition by Unilever) and Silhouette Brands had super voting structures which allowed management to control the company and avoid selling during the low points in the ice cream cycle (typically when butterfat prices were high). While CoolBrands is less exposed to butterfat prices due to its large proportion of low-fat products (Whole Fruit Sorbet, WWSO), for Dreyers, Ben & Jerry’s and Silhouette the super voting structure allowed them to sell out near all-time highs.

Acquisition and Operational Prowess – Top Marks

The corporate governance issues highlighted above would be of more concern to us if management team hadn’t proven themselves to be such shrewd acquirors and operators. CoolBrands’ 2003 acquisition of the Dreyers/Nestle assets (required by the FTC to approve the merger of Dreyers and Nestle) was a steal based on any metric. The $13mm deal included brands selling approximately US$135mm per annum (Whole Fruit Sorbet, Dreamery & Godiva) and Nestle’s DSD system (60% ACV, 520 trucks), and inventory valued at approximately US$9mm. Upon acquisition of the DSD network, CoolBrands quickly cut warehouse and employment costs and optimized routes, cutting employment costs by 1/3 and quickly making the DSD network profitable (something we believe was never achieved by Nestle). Regarding the acquired brands, our understanding is that the company is managing these for profitability which will likely mean a decline in sales, but improved net income.

Skilled Acquiror
Dreyer’s/Nestle-US$10mm-Acquired distribution assets including 520 trucks and 8 warehouses in 11 states (est. $26mm in asset value). Acquired Dreamery, Godiva and Whole Fruit Sorbet franchise ($US135mm in revenues) and $8.6mm in inventory.
Americana Foods-US$1-Acquired 50.1% of 240,000 sqft manufacturing facility in Dallas, TX to produce soft serve ice creams and yogurts, Atkins, Weight Watchers and super premium brands. Pending $14mm investment, facility will produce approximately $140mm of the company’s products.
Fruit-A-Freeze-Trade Debt and Earn Out-#1 frozen fruit bar brand in Southern California. DSD assets in market and manufacturing facility.

In its second acquisition last year, CoolBrands acquired a 50.1% stake in Americana Foods, a plant previously owned, and unprofitably run, by TCBY. CoolBrands purchased its stake for US$1, quickly increased volumes (now 80% higher than in January of 2003) and now runs the plant profitably. The combination of CoolBrands’ DSD and manufacturing assets allows the company to innovate and rapidly roll-out new products. This is illustrated by its successful Atkins roll-out to 50% of retailers within a 12 week period, and currently the roll-out of the Yoplait breakfast bar and sandwich. Both the Dreyers/Nestle and Americana acquisitions, and their subsequent operation, show management to be extremely adept stewards of capital.

VII. MAIN RISKS

So what we have thus far in the story is a company that is priced at 50% of the consumer packaged goods comps, with strong growth, in a growing segment, with a defendable strategic advantage (strong brands and DSD distribution). The main risks we believe investors perceive are follows:

1. Inability to Replace Weight Watchers Brands – While this would be a dramatic loss if it were to occur, we feel that the company is pursuing many options, some certain (licensing of Silhouette Brands) and some less certain (licensing of SmartOnes) as discussed above. Even if these revenues are not replaced (highly unlikely), with the stock trading at a 2006 7.4x P/E (downside scenario) it is still a bargain in our minds.
2. Lower Atkins Sell Through – The Atkins Endulge roll-out (launched at the end of calendar 2003) began with very successful retail penetration and sell-through, but was then limited by manufacturing constraints (on the stick lines in particular). As a result, some retailers released shelf space that CoolBrands was unable to fill (the company now has adequate manufacturing capacity), and management recently intimated that sales in Q4 on the Atkins product would be lighter than expected (a reduction in Q4 guidance is expected). This coupled with a reported slowing in the growth of low-carb as a diet plan nationwide makes it difficult to assign proportionate cause for the Q4 weakness to short-term phenomenon (a loss of shelf space) vs. long-term phenomenon (a slow down in Atkins dieters), the latter being the great risk for the long-term investor. Given CoolBrands license of the most recognizable brand in low-carb (Atkins), we feel that if anyone is going to succeed in this market, it will be CoolBrands.
3. Loss of Further Brands – Given that the WWSO license was an unexpected loss (investors had been reassured on the latest conference call that there were no licenses in jeopardy), one does have to wonder what other licenses could be lost. To address these fears, management stated that over the next 18 months there are only $9mm of revenues in jeopardy for renewal (1.8% of packaged goods sales). Post this renewal, the next license renewal date is in 9.5 years. Given the peculiarity of the WWSO license (a co-license from Heinz and Weight Watchers), we feel the unexpected nature of the loss is a one-off occurrence. We are comfortable with this re-licensing risk.
4. Lawsuit Risk – Weight Watchers has sued CoolBrands for anticipatory breach of contract, arguing that they believed CoolBrands was planning to breach its master license agreement for WWSO. Damages were unspecified and no preliminary injunction was requested (a signal that Weight Watchers does not have a high degree of confidence in their own case). Alternately, the company filed a 23 page countersuit against Weight Watchers on August 11 with plenty of detail regarding how Weight Watchers breached multiple clauses of the contract. While there is risk of a ruling in favor of Weight Watchers, we believe the net effect of the above court motions will likely benefit CoolBrands both monetarily and in negotiating new licenses, in particular a SmartOnes license.
5. Head to Head Competition in Super Premium – Through the acquisition of the Dreamery, Godiva and Whole Fruit Sorbet brands, CoolBrands is competing head to head with the much larger marketing and product development budgets of Unilever (Ben & Jerry’s) and Nestle (Haagen-Dazs). Dreamery and Godiva in particular are sub-scale brands and will need to be managed for profitability as opposed to growth. Our understanding is that CoolBrands is pursuing this profit maximizing strategy and we expect a 10% net margin on this business.
6. Corporate Governance/Dual Class Share Structure – The super voting class of shares controlled by the Co-Chairman could lead to abuses by management. A 20% expansion of the stock option pool in 2002 caused significant controversy (though grants are limited to 2.5% of outstanding stock per year). Management’s significant ownership, however, aligns their interest with shareholders. Dreyers, Silhouette and Ben & Jerry’s all had dual class structures prior to their acquisitions. Additionally, the company is expected to add two additional independent directors (for a total of three) to their board within the next two quarters.

VIII. IN SUMMARY – SECONDS PLEASE

Based on ’05 P/E multiples vs. the comps, the stock has 108% upside (downside scenario) or 134% upside if you believe as we do that the base case is more likely. Given the catalysts we outlined above, we believe this upside will likely be realized within the next 12 months. When this performance potential is married with the security of strong cash flows ($1.23/share ’04E), balance sheet ($1.24/share net cash ’04E) and a stable base business, we feel the risk reward is compelling.

Catalyst

* Replacement of WWSO Brand – We feel the company will find a solution that will preserve the majority of CoolBrands low-fat business (a viable option is already tentatively agreed).
* Stock Buyback – The company has already announced a buyback of 1.1% of its stock (550,000 shares) and is considering expanding it to 5% or more of outstanding shares.
* Additional Brand Licenses – The company is currently in negotiations to license a number of well-known consumer brands that will drive incremental revenues.
* Additional Manufacturing Business –CoolBrands and/or 3rd parties will likely bring additional production into the Americana facility, increasing efficiency and profitability.
* Accretive Acquisitions – CoolBrands management has been extremely disciplined in its acquisition strategy to date and has proven itself a savvy buyer of mispriced assets – we expect this to continue.
* Time – We believe that the penalty box multiple (half the P/E the stock was trading at just a few months ago) will expand over time as it becomes apparent that there are no other immediate risks to the business and management executes on its plan.
* Sale to Strategic Buyer – Management has been quite clear about its exit strategy for the business – sale to a strategic buyer. Given the multiples at which Dreyers was sold (1.9x revenues), CoolBrands (0.7x revenues) has dramatic upside.
* Upside Scenario – If results bear out that the low-fat business (WWSO) will decline only slightly, if at all, with an alternate brand, and that Atkins will continue to grow, albeit at a slower rate, we see significant upside above our base case scenario.