Description

Cott (COT) is a misunderstood, undervalued, and high FCF business, which thanks to savvy deal making offers a stable double-digit free cash flow yield at its current stock price. COT also offers some additional free out-year optionality on contract manufacturing-driven margin expansion and growth from utilizing DS’ route capacity to pass many more doors with COT products, which collectively could drive a 30-35% CAGR in FCF (‘15E-‘18E) in a bull scenario vs. ~13% in our base case, from what is already an attractive double-digit FCF yield base.  

COT manufactures and sells carbonated soft drinks, sparkling water, energy drinks, and juices. They also deliver water and coffee to offices. Our long thesis rests on the following points:

• COT’s recent transformative acquisition of sticky home and office water delivery (HOD) and office coffee services (OCS) businesses has fundamentally changed the growth profile and competitive moat of their overall business to a greater degree than is broadly appreciated.

• With the HOD water DSS and Aquaterra deals, Cott is now a far more diversified, robust company with low capex requirements, coupled with high asset turnover and ROIC. COT is now less susceptible to the secular challenges of carbonated soft drinks, and it can reinvest in more structurally attractive and higher return businesses.

• COT still trades like it is a purely private-label carbonated soft drink company, as its current multiples - 6.7x EV/2016E EBITDA and 9.8 EV/2015E EBITDA less Cap Ex - are trading at only a 0.6-1.2x turn premium to their respective 5-year medians. COT’s 2016E FCF yield currently trades at a slight discount (13% vs. 15%) to its 5-year NTM median - despite COT’s recent transformation and improved outlook. This valuation provides ample margin of safety against any continued declines in soft drink sales.

• We expect COT will surprise positively in coming years regarding two value drivers (growth from utilizing DS’ route capacity to pass 1.5mm+ DS and Aquaterra customer doors with COT products, and building the co-pack business). Our bull case shows the shares trading at a 29% FCF-yield on our 2018E FCF.

DS Services Deal

Cott’s purchase of DS Services from the PE firm Crestview Partners was a true coup. Crestview was planning an imminent IPO exit of their DS Services stake, when Cott convinced Crestview to sell the business instead, at a multiple (~7x EV/EBITDA) below what DS would likely have captured in the IPO market (8x+). Crestview sold to eliminate IPO execution risk, and to get more cash upfront.  

DS Service’s core business is the sale and distribution of “water coolers” to offices and homes around the country. They also have a growing coffee business. The appeal of the deal, beyond acquiring an attractive business and potential M&A platform at a good price, is that it lowered COT's product exposure to:

• Soft drinks (from ~30% of sales to less than 20% of New Cott);

• Walmart (from 30% to less than 20%), and;

• The private label channel (from ~75% to less than 50%).

Also, DS balances Cott better. The HOD and OCS businesses are a more cyclical, faster growing yin to the counter-cyclical, flattish growth yang of Cott’s legacy business. Finally, the deal will be FCF-accretive, despite being dilutive on a GAAP EPS basis. Part of the optics here is the substantial amount of D&A that came over with the DS deal (~$113mm vs. ~$105mm at COT legacy business), which widened further the gap between COT’s GAAP and Cash EPS.

HOD Past and Future Tuck-ins

Back on their second quarter 2015 earnings call, COT announced two other asset purchase agreements in the DSS business, which together will add ~$9mm in revenue. While not a huge amount of revenue, there is a steady flow of these opportunities of $10-20mm per year in acquired revenue, and these businesses are purchased at attractive post-synergies multiples of 3-4x EV/EBITDA, and 5-6x pre-synergies; and so, they are highly-accretive. COT is able to achieve such attractive pre and post-synergy multiples on these tuck-in deals, because the sellers are typically highly-motivated. They are more often than not mom-and-pop operators that are retiring, and looking for an exit. COT is getting inbound calls for these deals. The logical buyer in these instances is one of the two biggest and best capitalized players in the space (COT or Nestle). COT is able to realize synergies from plugging these mom-and-pop operations on to their platform by achieving more efficient procurement, garnering significant distribution cost savings due to the greater density of their network, and from lower customer churn due to DS’s superior customer service.

In January 2016, COT announced another, more sizeable water HOD deal. They purchased Aquaterra, Canada's oldest and largest direct-to-consumer home and office water delivery business for approximately C$62 million (approximately $45 million USD on the closing date). The acquisition was funded using cash on hand as well as borrowings under Cott's asset based lending facility, and adds to COT’s diversification efforts that began with the transformational DSS deal. While these deals will slow-down ever so slightly COT’s debt pay down efforts, given the accretive nature of these transactions, it is for good reason.  If we assume that COT purchased Aquaterra for a similar multiple as their other deals back in Q215, and the same level of synergies as what DS has been able to achieve in their other acquisitions historically (we will find out more about the multiple likely on next earnings call) – i.e. 5.5x pre and 3.5x EV/EBITDA post – this deal will add nearly $13mm in additional EBITDA once the full synergies are realized. We believe there is a pipeline for similar highly-accretive deals in the future.

Also, some speculate that Nestle may eventually consider a sale of their HOD water business. Nestlé’s HOD business, after COT de-levers some more, is an ideal future takeout candidate, as Nestlé’s business is primarily concentrated along the I-95 corridor, where it has very little overlap with DSS’s footprint. This deal would consolidate the number 1 and 2 players in the market, creating an even more formidable platform from which to roll up the other mom and pops at extremely accretive post-synergy multiples. Also, such a deal would likely have no anti-trust concerns, given the alternative ways for offices to stock their fridges and kitchens with beverages. While an attractive business for Nestle, its HOD business is still a very small part of their overall pie – and may provide a logical business for them to shed in an effort to refocus on their core business.

Why it is being overlooked?

Cott’s pre-DS exposure to Walmart, CSD, and private label (and the conservatism bias this corporate history engenders in the minds of investors), its moderate amount of sell-side coverage, its Canadian domicile, its minimal GAAP EPS despite high Cash EPS and FCF, the secular trends of its core CSD business, the market’s extrapolation of recent pricing trends for branded soft drinks, and a lack of appreciation for the quality of the DSS business all contribute to making Cott an orphaned, unloved security. Of the 11 analysts that cover Cott, there are 4 holds and 7 buys. Analysts have only started to appreciate the full potential of the DS Services deal; as of summer 2015, there were 5 holds and 3 buys.

Sentiment has slowly been shifting in the right direction, as the market digests the DS deal and the immense potential before the new, consolidated Cott. But the recent sell-off in the stock from $11.25 on January 7. 2016th to under $9.50 more recently seemed more related to hedge fund “risk off” deleveraging (stock has 12% HF ownership) and even more so to mutual fund outflows (MF ownership 20%), as both groups have been recent net sellers of the stock, rather than any fundamental factors related to the company. If anything, over this time the outlook has improved, given the Aquaterra deal for one.

Also, promotional activity for branded sodas continues to show signs of stabilizing. On their Feb. 11th earnings call, Pepsi said, “North American Beverages had its best financial performance in recent memory benefiting from the continuation of improved industry pricing dynamics, a broad product portfolio and continued positive innovation performance.” Just two days earlier, Coke reported, “For the full year, organic growth of revenues was 4% and, importantly, we delivered 2% global price/mix. This was stronger price realization than we have generated in several years, reflecting our segmented revenue growth management strategies and enabled by our increased investments in media.” Because of the inefficiencies related to COT mentioned above, we have seen the stock be sluggish and slow to respond in the past to such positive announcements from KO and PEP, only to pop after COT reports and cites benefits from the improved price realization announced by the big two. Continued declines in CSD promotional activity from Coke and Pepsi is unequivocally good for COT, as greater-than-expected private label CSD declines on the heels of heightened branded price competition is a major risk facing the company.

Business Overview: The New Cott

Products: Market leader in HOD Water (32% of 2015 YTD EBITDA) and Coffee (6%) home and office delivery services; co-packer of branded consumer drink products; and manufacturer of private label and own-branded: soft drinks (16%); juices (11%); other (25%); and Sparkling water/Mixers/New age (10%).

Segment mix: DS Services (51% 2015 YTD EBITDA); Cott North America and UK (41%); Aimia (5%); and other (3%).

For DS Services, HOD is the better business of the two. DS’s market share of ~30% rivals that of Nestle. In the Office Coffee Services (“OCS”) business, things are more fragmented. For coffee, DS only boasts <5% market share, but end-market growth is ~2.5x faster: 5% versus 2% for HOD. Here were the historical results for DSS provided at the time the deal was announced:

Consensus is calling for -0.5% sales CAGR at New Cott from 2014-18; our base case is for -1% CAGR for the consolidated enterprise. In our base case, we assume -5% CAGR for CSD and juices at legacy Cott, and 0% for the other legacy Cott segments. We assume 0% growth for DS Services beyond 2015.  

Contract Manufacturing – an underappreciated opportunity

Post the DSS deal, management outlined detailed guidance for New Cott, in which they stated that growth within contract manufacturing in the legacy business would offset declines in CSD and juices, resulting in 1% CAGR in sales through 2018 for the legacy business. With our modeled base case revenue declines of -5% in CSD and Juices, and 0% in other legacy business modeled, there is significant unappreciated upside potential from the realization of the contract manufacturing opportunity in front of Cott, particularly on the gross margin line.

Cott’s value proposition as a co-packer is crystal clear to brand owners: because of Cott’s scale and plant footprint, they can save brand owners real money versus the competition, namely through high service level (98%+) and low freight costs. Cott’s processing facility footprint is a substantial competitive advantage to service national and super-regional accounts. As national brands lose CSD volume, and look to replace that lost volume with sparkling water and other capacity, it makes sense for them to initially outsource this volume to a co-packer like Cott, rather than investing in new production lines, so that they can experiment and test customer acceptance before committing tons of capital to new capacity, especially in instances where old CSD lines cannot be repurposed for new growth initiatives It works similarly for the many upstart beverage brands who now compete for the shelf space vacated by CSD’s.

Based on our channel checks of the potential CSD capacity likely to be transitioning to co-pack volumes of sparkling waters and the like, we estimate that COT only needs to capture ~10% of the addressable market of the new co-pack business expected to come online industry-wide in the coming years, in order to hit their stated 2016 co-pack volume targets.

Source: May 2014 IR Presentation

Also, as of mid-2015 Cott’s plants were currently operating well below full capacity: 70% for hot-fill (i.e. juice plants) and 88% for cold-fill (i.e. carbonated drink plants).

Given the slack at their plants, Cott can take on new Co-pack business at attractive incremental margins, driving up to $30mm in further EBITDA, or $0.24 in Adj. FCF per share – which at a 14x multiple is 34% of the 2/16/16 closing share price. North American co-pack sales were $80mm in 2014.

Management expects co-pack volumes to triple by the end of 2016E. Some of this new co-pack business will replace lost private label, but the majority will utilize the spare capacity at existing plants.

Based on our estimates, New Cott can service their entire expected co-pack sales growth through the current spare capacity in their plants. Because of this, we estimate the incremental gross margins on these co-pack sales should be 21% versus ~12% gross margins firm-wide.

Management said they could expand gross margins by 50 basis points per year over the next two years, citing contract manufacturing wins among a few other opportunities.  The increased EBITDA we estimate from just the co-pack sales utilizing spare capacity can achieve about 1/2 of that 50 bps per year margin improvement on its own.

Using Spare Capacity on DS Services Trucks

DS Service as a market-leading HOD service in the United States, matched only by Nestle in size and scope, has an expansive delivery/distribution network. The scale of DS Services distribution network has allowed DS Services to make very accretive roll-up acquisitions through the years of “mom & pop” delivery operators. DS Services contends their customer acquisition costs are actually cheaper through M&A than through other means. Through M&A, management believes customers cost them on average less than 6-months of subscription revenue. The average customer stays more than 4 years. Also, the combo with Cott brings a new suite of products that New Cott is able to sell to DS Services sticky customer base.  

Despite its scale, though, DS trucks are still operating at only 85% capacity utilization. Another underappreciated aspect of the DS Services acquisition, one that was not even considered in the M&A model, but outlined by Cott’s management, is the uplift expected from pushing Cott’s own branded products through the spare capacity in DS’s trucks:  

“Not within our model is an opportunity that we see as part of this transaction, that the DS route trucks have about 15% of excess capacity that we could place Cott products on, either to be distributed to current DS customers or use to distribute to a channel that Cott currently doesn't have access (being corner delis, local and convenience stores and sorts like that). 

And if we use up that 15% excess space, we feel we could generate another $100 million to $150 million of revenue, again which is not in our current model…at a 50% margin and the 11% commission that gets paid to the route truck sales rep, really see about a 40% of that fall into the bottom-line, therefore creating a $40 million to $60 million profit opportunity.”

Management has said that it will take 3 years to add Cott juices and other products to DS trucks; they do not want to overwhelm the route drivers by pushing these initiatives too soon at the expense of their integration and synergy targets.

They have already announced, however, the addition of Cott’s sparkling water brand (“Sparkletts”) on to DS trucks (the $7mm “revenue” synergy guidance – that is really a forecasted EBITDA amount). Our channel checks suggest early customer uptake of Sparkletts has been strong. But it is the inclusion of juices, energy drinks, and other products that will really generate the healthier $50mm in incremental EBITDA starting in 2017, but possibly sooner. With ~40% of sales dropping to profit, COT has far greater incentive to make this push than DS ever had with the thin margins of distributing third-party branded products. At the mid-point, we estimate this initiative could bring 40c in Free-cash-flow per share, worth 57% of the Feb. 16, 2016 closing share price at the same 14x multiple.

Balance Sheet Considerations

At the end of Q2 2015, COT announced plans to issue up to 16.2mm shares through a bought equity offering, the proceeds of which will be used to redeem all of Cott’s Series B nonconvertible preferred shares, and a portion of Cott’s Series A convertible preferred shares. This deal will importantly speed the pace of COT’s debt pay down.

While we are never crazy about equity offerings using an underpriced stock or the dilution that results (the share count in this case went from from 93.3mm shares up to 110.5mm shares currently), the funds raised in this offering relieved COT of up to $13mm in dividends related to the preferreds they redeemed, and will allow COT to dedicate more future free cash flow to paying down high cost debt both assumed from DS Services and issued at time of the DS deal (first the $350mm 10% callable notes and then the $625mm 6.75% of new senior debt), versus paying down the preferreds.

We believe Cott, barring any new acquisitions, will be able to pay down ~$80-140mm per annum in 2016-18 of the DSS debt principal using FCF after dividends, while also funding their recent $42mm purchase of Aquaterra, bringing interest expense on this DSS debt from $77mm in 2015 down to $63mm by 2018 (with the added opportunity of potentially refinancing some of their debt at a lower rate in the future, possibly at rates 100 bps+ lower).

Finally, it was this recap that created the opportunity for attractive roll-up acquisitions in the HOD water space like Aquaterra (and potentially future similar deals), “Cott believes that this application of the proceeds of this offering will assist with the elimination of certain restrictions on its ability to pursue its strategic objectives, including from time to time pursuing acquisition or expansion opportunities.”

The timing of this equity offerings came shortly after Cott announced an increase in the expected synergies from the DSS deal; and we suspect, this is because with ample time to get under the hood of the DSS business, Cott was in a better position to see the potential for further small and medium-sized roll-up acquisition opportunities in this new, higher growing market segment, deals that covenants on the preferreds would prevent them from pursuing.

Valuation

Current multiples; Historical Median (last 5 years)

• EV/EBITDA ‘16E:                              6.7x; 6x

• EV/(EBITDA less cap ex) ‘16E:          9.8x; 8.5x

• P/’16E FCF:                                        6.8x; 7.5x

Scenario Analysis

Base case (8x; 12x; 12x): ’18 Target Price $16.84; IRR 34%.  

We believe that investors are missing the FCF growth potential of the new, transformed COT – and not assigning proper value to out-year optionality associated with successful contract manufacturing and DS services growth initiatives. COT is trading at its historical median FCF multiple – one which historically has represented the structural issues facing COT’s legacy business (fraught as it was with high private label, CSD, and Walmart exposures). But with some savvy capital allocation, COT used the high levels of FCF the company generated even through the challenged environment of recent years, along with some debt, to finance the transformational acquisition of DS’s HOD business. Since the DS deal at the end of 2014, however, not only did this transformational acquisition change the combined company’s FCF profile, the legacy CSD business has also stabilized over this time. Despite this, arguably due to a heavy dose of conservatism bias (whereby the market has been unwilling to process new information, and instead has clung to historical perceptions about COT’s business), COT’s NTM FCF multiple still trades at a slight discount to its 5-year median, despite the greater diversity of FCF and the higher quality and higher competitive moat outlet to invest for growth. Not only do we believe COT has the potential to grow FCF double-digits between now and 2018, but we also believe the market will come to re-rate COT as they realize the ways in which the DS deal has diversified and strengthened their overall business.

Assumptions: CSD and juice (-5% rev growth 2015-19). Other legacy products: 0%. DSS rev. growth 0% beyond '15. COT maintains low non-strategic SG&A, guided synergies of $30mm by '17. Uses FCF to rapidly de-lever. COT does not achieve stated contract manufacturing growth goals. Assume Aquaterra was purchased for 5.5x pre synergies; 3.5x post, and that it achieves comparable EBITDA margins as DSS. Cash tax rate 10%.

Bear case (6x; 9x; 9x): ’18 Target Price $6.58; IRR -19%.

Assumptions: CSD, juices (-8% per annum), and sparkling and other -2%, contract manufacturing disappoints, and DSS organic growth (0% beyond '15). Excess capacity in COT’s legacy biz and the DS distribution network remain. Half of guided synergies are not realized. Assume Aquaterra was purchased for 5.5x pre synergies; 3.5x post, and that it achieves comparable EBITDA margins as DSS. Cash tax rate 10%.

Bull case (10x; 13x; 15x): ’18 Target Price $38.85; IRR 109%.

Assumptions: Both Cott-branded juices and sparkling water sold using spare capacity in DSS's trucks, adding $50mm of incremental EBITDA by '18.  Co-packing on plan, and uses spare capacity at their existing manufacturing plants to service this demand ($30mm EBITDA). 1.5% rev growth for legacy COT, and 2.5% for DS services post '15. Assume Aquaterra was purchased for 5.5x pre synergies; 3.5x post, and that it achieves comparable EBITDA margins as DSS. Cash tax rate 10%.

Summary

On the M&A call related to the DS Services deal in Q414, COT management guided to $1.65 in Adjusted FCF per share for 2018E (our base case for 2018E is for $1.52 2018E FCF per share). COT’s closing price of $9.75 on February 16, 2016 trades at only 5.9x this stated 2018E Adjusted FCF per share guidance, and 6.4x our estimate.

Risks

1. Price competitiveness in branded soft drinks persists;

2. Inability to win meaningful co-pack business;

3. Cyclical slowdown in HOD business;

4. Convertible Preferreds are exercised (if COT fails to delever), resulting in significant dilution to equity holders.

5. Continued weakness in UK business.

This report (this “Report”) on Cott Corporation (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold long positions tied to the securities of the Company described herein and stand to benefit from an increase in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their long exposure to the Company’s securities or establish short positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

1. Continued stabilization in CSD business – on heels of less promotional activity at Coke and Pepsi

2. Further small tuck-in deal announcements for DS business

3. Announcement of further co-pack business wins

4. Successful product launches and customer adoption in the HOD business

5. Stabilization of UK segment