COT:

COT is the largest manufacturer of private label carbonated soft drink and private label shelf-stable fruit juices.

At current levels Cott Corporation presents a compelling risk/reward profile. At ≈$8.50/share, COTT trades at 14%-15%% levered FCF yield. I believe that is too cheap for a business of COT's relatively fair quality and stability. A more reasonable 10x FCF multiple would imply a ≈$12+ share price over the next 6-12 months, implying a 40%+ return.  More significant upside will be a function of two factors: 1) continued stability in business operations; 2) substantial FCF generation enabling highly accretive deleveraging and eventual cash returns to shareholders. Again, given the relatively fair quality and stability of COT's business, I believe downside is limited so the risk/reward is quite attractive.

This is a fairly conventional long idea where I'd be hard pressed to identify the situational/structural angle for the mispricing. That said, I do believe the market is overly concerned about nearer term issues relating to commodity price increases, and the myopia is preventing proper evaluation of COT's long term strategic position and fundamental earnings power.

The crux of the thesis, therefore, is as follows: 1) COT is a better business than the market gives it credit for; 2) COT will prove capable of dealing with the extremely well telegraphed commodity cost headwinds it faces; 3) Solid FCF generation even in a stressed scenario enables meaningful accretion to equity as COT deleverages.

Business overview:

Cott dominates two business lines:

• 1) Private Label Carbonated Soft Drink (CSDs) - this is COT's legacy business, and the company commands a ≈60% market share in the US. Of non-captive capacity (i.e. KR, SWY, and WINN all produce their own PL CSDs), COT's market share is ≈80%.
• 2) Private Label Shelf Stable Juice - COT entered this business through the acquisition of Dunkirk, NY based Cliffstar in July 2010 (acquisition closed August 2010)

In addition to their US operations, COT has three other businesses:

• 1) UK - substantial in revenue and profitable
• 2) Mexico - small in revenue and currently loss making; COT is trying to get this business to breakeven
• 3) RCI - this is basically a licensing business for COT's RC Cola syrup formula; very little capital required and nicely profitable, albeit quite small

I recommend perusing recent company presentations to gain additional detail about COT's operations.

A key assumption underlying my view on COT is that COT's business is better than a mediocre one. I won't go so far as to call it a great business - ultimately, this is a commodity like product manufacturing and distribution operation. However, based on extensive discussions with industry participants, I believe that both Cott and Cliffstar occupy integral positions in the private label landscape, and ones from which potential competitors would have an incredibly difficult time displacing Cott and Cliffstar. Simply, to the extent national retailers are committed to outsourced PL beverage categories, they essentially have no choice but to use COT.

Moreover, COT is regarded as a highly professional and reliable PL supplier, very important points of recognition. The feedback I received was universally positive in this regards - i.e. retailers like to work with COT.

COT has fundamentally refocused itself over the last two years: its leadership has never been stronger and the company's recent acquisition of Cliffstar has further solidified the company as the absolutely unrivaled leader in the PL beverage space.

On a secular basis, I believe the general trends remain pro-PL. I believe CSD's are likely in very slow secular decline (which will eventually stabilize), and shelf-stable juices are likely to exhibit GDP or population like growth. However, alterative drink categories (vitamin waters, energy drinks, teas, etc.) provide meaningful expansion opportunities.

If one accepts the view that COT is a fundamentally sound business with reasonable growth prospects, then <7x guided FCF appears to cheap for a consumer staples company - notwithstanding the moderate leverage and potential for commodity headwinds (discussed later).

Background on Key Issues:

In February 2009, COT's current CEO, Jerry Fowden, was appointed to the role. At the time of his appointment Cott stock stood at ≈$.80. Jerry had joined Cott in 2007 to lead their UK business. Based on COT's result in that region and based on discussions with industry participants, I believe he executed extremely well.

At the time Jerry became CEO, COT found itself facing significant business and financial risk as a result of mismanagement under previous CEO Brent Willis. Willis came to COT from InBev in May of 2006, and remained there until March of 2008. Under Willis, relationships with retailers became incredibly strained. Additionally, during his tenure COT began facing massive commodity headwinds which Willis had thoroughly unprepared the company for. More specifically, there were two primary mismanagement issues:

• 1) Willis devoted excessive resources to growing COT's branded business. Besides being a poor decision in-and-of-itself, pursuing such a course weakened COT's relationships with retailers. Simply, a PL supplier that also sells branded products is perceived by retailers as having conflicted interests and not being entirely committed to the PL supplier / retail customer partnership.
• 2) Willis implemented no commodity hedging strategies at a time when commodities were increasing dramatically in price. The lack of any hedging strategy severely underprepared the company to deal with rising input costs. Additionally, due to soured relationships with retail partners, COT was in a weak position to request price increases.

Under Willis, COT's gross margins stagnated (2007 vs. 2006) and then declined (2008 vs. 2007). More significantly, gross margins declined significantly.

Under Willis, COT's  relationship with WMT severely deteriorated. Background: in the early 1990's, COT came to the US with a plan to substantially increase US manufacturing capacity for PL CSDs. In order to justify building the plants, COT was able to convince WMT to grant it an exclusive contract for the entirety of WMT's PL CSD supply. Such a contract is essentially unheard of for WMT.

Willis was replaced in March of 2008 by interim CEO n March David Gibbons. In June of 2008, Gibbons outlined his plans to refocus COT's efforts on PL, to pursue cost reductions, and to repair damaged customer relationships. These changes were meant to address to the major failings of the company under Willis:

In January 2009, COT announced that WMT had decided to phase-out the exclusive supply agreement with COT. Per the phase out, WMT would be permitted to move up to one third of their supply in the first year following notification and two thirds in the second year following notification. The termination of the contract is effective on the third anniversary of the announcement.

As mentioned, present CEO Jerry Fowden joined Cott in 2007 to lead the company's UK business. In April of 2008, Fowden was appointed President of International, and in June of 2008 he was asked by David Gibbons to assist in rebuilding relationships with Cott's customers in the U.S., while also taking on leadership of the Canadian business.

Based on my discussion with industry participants, since taking the helm at COT, Fowden has completely rehabilitated the relationship with customers - most significantly WMT. Multiple sources have stated that the relationship between COT and WMT is stronger than it has ever been.

The reality is this: While COT's substantial reliance on WMT may appear disconcerting, so long as WMT is committed to the PL CSD space, it has no alternative but to rely essentially wholly on COT. A high level industry source I spoke with communicated to me the following:  when WMT cancelled their contract with COT, they came to this man and asked him to provide them with advisory on alternative sourcing. The man came back to WMT and told them that they had no alternative - no other supplier had the national capacity and distribution capabilities to service them.

In reality, the only viable competitor to COT is the national branded beverage producers such as KO, PEP, and DPS. However, all of those companies are highly reluctant to use even excess capacity for PL products, as doing so would depress overall margins. Additionally, that prospect has been rendered almost moot as a result of the vertical integration strategy PEP and KO have pursued (i.e. buying in their bottlers).

In addition to repairing customer relationship, Fowden has accomplished 3 other key items:

• 1) Entirely refocused the company towards PL
• 2) Implemented a comprehensive commodity hedging strategy
• 3) Reduced all lineaments of SG&A related to Willis' push into branded products

Under Fowden, COT is a much more focused, lean, and stable company than it has ever been.

Financial Considerations and Valuations:

I believe there are two focal points of the bear thesis against COT:

• 1) COT will prove unable to manage the headwinds posed by commodity cost increase
• 2) Cliffstar will materially underperform expectations

Commodity Costs:

The primary risk to this investment is that unabated commodity price escalation cripples COT should the company prove unable to effectively hedge input cost increases and push through price increases.

Per the company, ≈80% of total COGS are variable in nature and 50%-60% of COGS are commodity driven.