Description

In a market starved for growth, the market is paying “priced for perfection” type multiples for growth (though moderating over the last couple of weeks for some growth stocks) and that appears to be regardless of whether a company is generating organic growth or through acquisitions.  The market has become somewhat enamored with platform-driven acquisition vehicles and by going against that favorable trend, there is of course risk if one chooses to challenge it by shorting a stock having those favorable dynamics.   Nevertheless, I am advocating a short of Middleby (“MIDD” or the “Company”) because I believe the quality of growth is questionable as evidenced by an erosion in returns on capital coupled with the absence of free cash flow when including acquisitions, the pattern of promotional-oriented comments by the Company’s CEO raises numerous red flags, and it appears that management might be using spring-loaded accounting to bolster the appearance of the Company’s results which further calls into question the quality of growth. 

While returns on invested capital at Middleby were extremely attractive from 2005-2008 at 19.4-26.4% (averaging 23.6%), the past five years have significantly deteriorated, ranging from 11.0-13.0% (averaging 11.6%).  The Company’s ROIC was above only one peer (Manitowoc) last year and that pattern is consistent when comparing MIDD to the peer group over a three year average.  MIDD’s average ROIC during the past three years was ~12% compared to the peer average and median of ~13%.  According to management and partially based on the pending closing of MIDD’s acquisition of AGA Rangemaster Group, ROIC is expected to reach mid-teens by 2018. 

Although ROIC is well-above the Company’s cost of capital and it possible that returns on incremental capital might grow if one believes management, at 28x 2015E EPS, 23x 2016E EPS and 19x LTM EBITDA, MIDD’s premium valuation to its peers is substantial, at more than a 50% premium P/E on both a 2015E and 2016E basis and ~90% premium LTM EBITDA multiple.  On a reported FCF basis, MIDD’s premium is ~30% although I believe FCF is overstated by the exclusion of the numerous acquisitions MIDD annually completes as a core strategy. 

When shorting a stock, one certainly knows that valuation is never the primary reason to be short but I believe that deteriorating ROIC in the past several years and a longer-term mid-teens ROIC target is inconsistent with the valuation being accorded to MIDD by “Mr. Market” and is a source of some protection.  That said, valuation can go higher and is among the inherent risks.  To buffer part of that, I am long one of MIDD’s peers.  MIDD has become a stock market darling, building momentum in spite of recent quarterly misses.  Investors are somewhat enamored with the CEO’s promotional commentary and dismissive of promises made that have not yet materialized but continue to garner attention as the next leg of potential organic growth.  Middleby is the closest to a pure play if an investor wants to gain exposure to the food service equipment industry and I think part of the premium valuation is rationalized accordingly.  That might change pursuant to the notable changes occurring at MIDD’s peer Manitowoc.  Although it is impossible to time when the market’s appetite for MIDD will become more reasonable from a valuation perspective, I aim to highlight numerous red flags that I believe those long the stock are not adequately incorporating in their evaluation of MIDD and especially at the current valuation.  Before elaborating on some core tenets of the short thesis, I provide a summary of the business below.  

Middleby is a leading manufacturer of equipment for the commercial food service, food processing and residential kitchen industries.  The Company’s addressable market, as described in a presentation made at a Jefferies conference in 2014, is approximately $10B based on $4B from food service, $5B from food processing, and $1B from residential. 

In food service, the Company has historically focused on the cooking and warming equipment segment but has recently pursued acquisitions in other parts of the commercial kitchen in an effort to gain share of the broader $20B global market.  However, in the past, management was not keen on the attractiveness of the “cold” segment of the market but MIDD recently acquired companies focused on the “cold” segment (e.g., Celfrost in India, Desmon in Italy).  In the cooking equipment category, restaurants are seeking more energy efficient equipment and Middleby is well-positioned in providing an energy efficient oven solution though its brands Blodgett, Lang, No-Vu, Southbend, and Wells but in contrast to the Company’s assertion that “Middleby has the most rated ovens than anybody else in the Energy Star industry,” competitor Illinois Tool Works has an equal number of Energy Star-rated ovens through its brands Hobart, Wolf, and Vulcan.

Industry forecast for equipment growth is ~3% and is primarily derived from the development of new restaurant concepts in the U.S. and the expansion of U.S. and foreign chains into international markets, the replacement and upgrade of existing equipment and new equipment requirements resulting from menu changes.  Middleby’s organic growth in food service, based on what management reports, has exceeded the industry each year since 2011; they underperformed in 2009-2010.  Including 2009 and 2010, organic growth in food service has averaged 4% at MIDD.  The Company’s organic growth averaged more than 9% in food service from 2011-2014.

The Company has been a beneficiary of the substantial unit-driven growth across the chain restaurant landscape but it should be noted that Middleby does not generate much after-market revenue from its equipment sales and the equipment being sold is durable and expected to last for at least ten years.  In the pizza category where Middleby is dominant, management has noted there are more than 150,000 Middleby Marshall-pizza ovens in the marketplace that are more than fifteen years old.  Although there’s a favorable replacement cycle that Middleby should expect for pizza ovens in the next 5-10 years, it’s also critical to recognize the life of most food service equipment is at least ten years (with minimal aftermarket revenue) and given the strong recent growth trends across the restaurant chain landscape, the trajectory of new unit growth could moderate in the coming years.  During 2014, the top 100 chains grew units by 2.1%.  Growth in units is higher from outside the U.S. and the Company has been well-positioned to capitalize upon such growth.

In food processing, the Company has mainly focused on thermal processing.  A large portion of the Company’s processing mix has been generated from producers of pre-cooked meat products such as hot dogs, dinner sausages, and poultry, and producers of baked goods such as muffins, cookies, and bread.  One should expect the Company to continue its pursuit of acquisitions across the processing segment since management has said, “A huge opportunity within that segment for Middleby is how fragmented this industry is.  The seven largest companies have a combined market share of less than 15%.” 

During the Q4’14 call, the CEO noted that the Freedonia Group forecasted that global sales of food processing machinery would grow ~7% within the next 18 months.  Management also said that “we’ll outpace the industry growth similar to the commercial foodservice this year (i.e., 2015) and the years coming.”  That bold prediction has yet to materialize in food processing this year.  In the past quarter, organic growth for MIDD’s food processing segment was negative 27% (negative 22.5% on a constant currency basis).  This was subsequent to the negative 13.2% posted in the first quarter.  Management has neutralized the concern with an expectation of the timing of large orders since order rates of 20% over the first half of 2014 should favorably impact the second half.  The CFO said we’re going to see higher single-digit to lower double-digit revenue growth in the back half of the year.  The third quarter comp is low since Q3’14 was an organic increase of just 1.4%; food processing grew by 4.6% during Q4’14.  With approximately half of food processing revenues generated from international markets, it should be noted that the strengthening dollar has a significant impact on the food processing segment.  For the overall company, international growth has represented almost 30% of total company growth in the past two years.      

From a mix perspective, in 2014 Foodservice comprised 63.6% of revenue, 74% of EBITDA (before corporate allocations), and 77% of EBIT; Food Processing comprised 19.7% of revenue, 19% of EBITDA, and 19% of EBIT; Residential Equipment comprised 16. 7% of revenue, 7% of EBITDA, and 4% of EBIT.  In 2014, U.S. and Canada comprised 70% of revenue; Europe and the Middle East comprised 14%; Asia comprised over 10%; and Latin America comprised 6%.  A financial summary by segment follows below:

Note that the unallocated corporate expenses are quite substantial for a company that states there are only 31 people employed at the corporate office. 

There are approximately thirty-five categories of product offered by the Commercial Foodservice Equipment Group which include conveyor ovens, combi-ovens, convection ovens, fryers, warming equipment, charbroilers, ventless cooking systems, kitchen ventilation, ice machines, freezers and beverage dispensing equipment.  The Company has approximately forty foodservice brands which include Blodgett, Bloomfield, Carter-Hoffman, CTX, Holman, Jade, Lang, Lincat, Market Forge, Middleby Marshall, Nieco, Nu-Vu, Perfect Fry, Pitco, Toastmaster, TurboChef, Wells, and Wunder-Bar. 

The products offered by the Food Processing Equipment Group include batch ovens, frying systems and automated thermal processing, emulsifiers, battering equipment, breading equipment, food presses, and forming equipment.  The Company’s food processing brands include Alkar, Armor Inox, Baker Thermal Solutions, Cozzini, Danfotech, Drake, Maurer-Atmos, MP Equipment, and Stewart Systems. 

The Residential Kitchen Equipment Group primarily focuses on ranges, ovens, refrigerators, dishwashers, microwaves, and cooktops.  The Company’s residential equipment brands include Brigade, U-Line, and Viking. 

Similar to all the major competitors in commercial foodservice, Middleby sells to an impressive array of customers including Chili’s, Chipotle, Denny’s, Domino’s, Dunkin Donuts, IHOP, KFC, McDonald’s (though primarily internationally), Olive Garden, Papa John’s, Starbucks, Subway, Taco Bell, and Wendy’s.  Approximately 60-65% of the sales are generated from chains.  The food processing segment also sells to an impressive array of customers including ConAgra, Costco, Hormel, Kraft, Nabisco, Perdue, Sara Lee, Smithfield, and Tyson.  No customer in either segment accounts for more than 10% of net sales.

There are several major competitors across each segment.  In Commercial Foodservice, competition includes the Ali Group, Dover, Electrolux AB, Illinois Tool Works, Marmon Group (owned by Berkshire Hathaway), Manitowoc, Rational AG, and Standex International.  In Food Processing, competition includes AMF Bakery Systems, Convenience Food Systems, GEA Group, IMA Industries, JBT FoodTech, the Krones Group, Multivac, Marel, Formax, and Heat and Control.  In Residential Kitchen, there are very large competitors including Whirlpool, Electrolux, LG and Samsung but Middleby has mainly focused on the premium luxury segment where its primary competition includes Bosch, Dacor, Gaggenau, Miele, Subzero, Thermador, and Wolf.  Thermador is part of BSH Hausgerate GmbH, the third largest global appliance manufacturer. 

The Residential Kitchen group is the most recent addition to Middleby, through ~$575M in acquisitions, and often garners disproportionate attention from sell-side analysts during earnings calls despite the relatively small contribution to the Company’s overall results.  Middleby announced its acquisition of Viking Range Corporation (“Viking”) for $380M in cash (the Company’s largest thus far) on December 31, 2012 after the market closed (one accounting expert characterized the timing of the move as “classic serial acquirer”).  The Viking brand has strong recognition within the luxury residential market and was the industry’s first restaurant-type range tailored to the residential market. 

Regarding the Viking investment, as found in the Company’s presentation made on January 2, 2013, one will note an “expectation to expand profitability to more than 20% EBITDA margins within three years.”  The world’s leading global manufacturer of home appliances is Whirlpool and their highest EBITDA margin in the past three years was 10.6%.  For context, note that Whirlpool’s ROIC in 2014 was substantially higher than MIDD’s and yet MIDD trades at more than a 100% premium to WHR (11x 2016E EPS and 8.5x LTM EBITDA).  Whirlpool is targeting 9.5-10.5% in EBIT margin as a 2018 goal (12+% in North America).  Viking historically sourced some product from Whirlpool but Whirlpool decided they did not want to supply Viking anymore which caused Viking “to scramble to find another source” and is now working with Electrolux. 

Although one can understand that premium brands will typically have a higher margin structure, the differential from the world’s largest appliance manufacturer and the aspirational goals from MIDD are substantial and I believe unlikely to be attained by the Company, at least not without accounting tricks.  The LTM EBITDA margin for MIDD’s Residential Equipment is less than 13% and there are less than six months for Middleby to achieve its “expectation to expand profitability to more than 20% EBITDA margins.”  I should note that during the most recent earnings call, when the CEO was defending the Company in response to a question from Baird’s research analyst that “I think your organic growth in that business probably surprised people the most”, the CEO goes on and on promoting Viking and acknowledges the single-digit EBTIDA margin results among several appliance industry participants and then he prompts the CFO of Middleby to address the Company’s EBITDA margins for the quarter.  MIDD’s CFO said, “Well for the first half, we were running right at 20%.”  MIDD’s CEO continues “and we will continue pushing to what Middleby is.  We would like to hit 30%.”  I don’t know where the CFO gets 20% as I calculate 13.6% for the first half of 2015 from the Company’s recent 10Q.       

When it was acquired, the financial overview presented by the Company for Viking highlighted ~$200M in annual revenue and a run-rate EBITDA margin of 10-12%.  At the mid-point, Middleby had agreed to pay over 17x run-rate EBITDA for Viking.  My primary research identified the likely cover bid being closer to 10x (“maybe willing to stretch to 11x”) and that potential buyer was a strategic that had purchased their premium household appliance brand for ~8x EBITDA.  The ultimate amount that Middleby paid for the Viking Corporation was $362M but that still represented close to 16.5x run-rate EBITDA, at least the run-rate as characterized by MIDD’s management, but notably less than 19x LTM EBITDA where the public market is currently willing to buy all of Middleby.  For additional valuation context, a review of the 2013K highlights Viking generated just $11.1M of EBIT during 2013, thereby implying that MIDD paid 32.6x forward year EBIT. 

In an effort to improve Viking’s profile and results, the Company acquired the assets of six Viking distributors for another $68M.  Management also added to the Residential Kitchen group with the $142M acquisition of U-Line in November 2014 for ~11.8x EBITDA.  U-Line is a leading manufacturer of premium residential built-in modular ice making, refrigeration and wine preservation.  Note that U-Line is rated the worse by Consumer Reports, at an overall score of 21, versus all under counter wine chiller alternatives.     

Although the Viking brand is strong, a review of Consumer Reports does not rate Viking highly in an overall score comparison to other pro-style ranges which is Viking’s most important product category.  The pro-style gas and dual-fuel 30-inch model was ranked below KitchenAid (manufactured by Whirlpool), Wolf, Dacor, GE, Kenmore, Jenn-Air (also manufactured by Whirlpool), DCS, NXR, and Miele.  The pro-style gas and dual-fuel 36-inch model was ranked below KitchenAid, GE, and Thermador.  Viking’s 36-inch model is highlighted as having a “recall notice” on the Consumer Reports website.  Based on a sampling by Consumer Reports of 19 Viking appliance models, only two scored 80 or better and only eight scored 75 or better.  Across 19 appliance models manufactured by competitor Thermador, twelve scored 75 or better.  Viking averaged 69 versus premium category competitors Thermador at 75, Miele at 74, Sub-Zero at 71, and Wolf at 57. 

Viking has confronted a couple of recent recall challenges including the recall of over 60,000 ranges that can turn on by themselves and the recall of almost 20,000 dishwashers that pose a fire hazard through an electrical component that can overheat.  Management claims to have taken ample reserves but time will tell.  During Q2, revenue for the residential equipment group declined by 14.4% (negative 13.3% constant currency), and during Q1 revenue declined by 5.7% (negative 4.9% constant currency).  Management makes numerous excuses, some of them plausible (including inheriting some legacy problems and a transition to new refrigeration products), but there could be more structural and ongoing execution issues than discounted by the market. 

To further bolster the residential kitchen segment, the Company announced on July 15^th that Middleby would be acquiring AGA Rangemaster Group Plc (“AGA”) for ~$200M.  Headquarted in the U.K., AGA sells over 100,000 cooking ranges and refrigeration appliances annually.  Based on 2014 revenue, 66% was generated from the U.K., 19% from Europe, 13% from North America, and 2% from the rest of the world.   On a pension adjusted enterprise value basis, the acquisition is valued at ~9x EBITDA, according to management.  The deal is expected to close in Q3 and MIDD’s pro forma debt will exceed $850M with a leverage ratio of ~2.2x (as of March 2015 per July 2015 investor presentation).  Management asserts there is significant opportunity to improve the ~5% margin at AGA to be brought in-line with the Company’s residential kitchen segment.               

Industry-leading margins too good to be true?

It should be noted that Middleby’s reported margins for Foodservice are exceptional but industry participants with whom I have spoken question the veracity of such and this is especially when compared to Illinois Tool Works which generates more than double the revenue from Food Service versus Middleby.  In Food Service over the past three years, Middleby reported an average EBITDA margin of 27.7% and an EBIT margin of 25.6%.  Over the same period, Illinois Tool Works, more than double the size of MIDD’s food service segment, reported an average EBITDA margin of 21.3% and an EBIT margin of 18.9%.  Even when including MIDD’s lower margin food processing segment to compare total MIDD food equipment, the average margin is substantially higher, at almost 26%.  I think there’s something fishy about the margin differential. 

Middleby management has referenced their industry-leading margin being largely ascribed to more pricing discipline; management at MIDD asserts that competitors choose to discount and Middleby does not.  Manitowoc’s food service business is also larger than Middleby’s, more than 50% the size in revenue last year, but average EBITDA margin of 17.1% and average EBIT margin of 15.7% at Manitowoc is almost 40% below that generated by Middleby.  There are well-documented challenges that Manitowoc has confronted being part of a company that also manufactures cranes and it’s therefore not surprising that Manitowoc is not operating as efficiently.  In fact, a new CEO of Manitowoc Foodservice started on August 3^rd to improve margins and to lead Foodservice through its planned separation from Manitowoc.  I believe some margin differential is simply a mix issue given MIDD’s historical emphasis on higher-margin ovens but I am not convinced that all of the margin differential is real.  I believe that part of it could be derived from the benefits of spring-loaded accounting practices as described more below.   

Highly-acquisitive strategy masking quality of growth?

Since 2009, Middleby has completed 29 acquisitions.  The Company’s acquisitive strategy has generated reported compounded revenue growth of 20.4% and reported EBITDA growth of 19.5%.  Over that period, on an organic basis, the Company’s reported organic growth has averaged 7.7% (organic growth averaged less than 4% if one were to include 2009). 

I believe that Middleby’s strategy which entails pursuing acquisitions of companies having an innovative technology and of companies providing a stronger geographical platform and of companies enabling MIDD to offer its customers an important new product category makes lots of sense and especially given the fragmentation of the industry.  However, the quality of some recent acquisitions by MIDD’s management appear of lesser quality and some are contradictory to past comments by management regarding a different focus.  Although their transactions are still strategic, I believe some transactions being done are indicative of the Company’s need for acquisitions to maintain the appearance of certain growth metrics and to feed the “cookie jar” that enables such appearance.  I believe the perception of Middleby’s results are inflated and much of my belief is related to the Company’s acquisitive-driven focused strategy. 

When a company engages in numerous acquisitions as the primary source of growth and the acquisitions are frequently smaller without historical information of the target available to investors to evaluate the target’s historical results, it can be difficult to discern what a “normalized” set of results are for the highly-acquisitive company.  Some companies that are serial acquirers are known to have engaged in an accounting practice called “spring-loading.”  I believe Middleby’s results are inflated by spring-loading accounting.  Although the practice is not illegal, spring-loading can mislead investors and masks the quality of earnings.

The notion that Middleby engages in spring-loading is a hypothesis of mine although confirmed as being likely by a couple of accounting experts.  For context and notably one extreme example, it should be noted that the old Tyco engaged in spring-loading that ultimately evidenced a substantial magnitude of large restructuring reserves taken for numerous acquisitions.  In regards to Tyco, as asserted by short seller Jim Chanos of Kynikos Associates, “Tyco plays games during the stub period—the weeks just before an acquisition closes—to make the purchased company look worse that it is.  The result is that after the merger the new Tyco unit’s growth, profitability, and cash flow are stronger than would otherwise be the case.”

To benefit from the art of spring-loading, a company might do such things as accelerate the payment of expenses, hold back the posting of payments received until after an acquisition closes, and overstate reserves.  All of this is done to help boost an acquirer’s post-acquisition net income and cash flow growth but the sustainability of such will typically require more acquisitions to reinforce a growth trajectory pattern. 

One approach to discern the possibility of spring-loading is looking at goodwill and non-amortizing intangible assets.  Total goodwill and other intangibles comprised over 85% of the acquisitions completed by MIDD for the period 2012-2014.  The Company characterized ~68% of other intangibles booked for its 2012-2014 as non-amortizing.  Moreover, the sum of goodwill and intangibles increased by ~$26M from the original estimate.  Although management is applying the provisions of ASC-350 in classifying non-amortizing assets, there’s of course much subjectivity in doing such and substantial benefit to bolster earnings by avoiding amortization.  As of Q2’15, the sum of goodwill and other intangibles represented 62% of total assets at MIDD.  Compared to MIDD’s peer group, this is more than 70% of the average ratio and more than 80% of the median ratio.  Based on management’s ongoing assertions, MIDD is innovative and since R&D is relatively insignificant as described more below, many of the acquired companies were presumably completed for the technology and such should be amortized accordingly.  Based on the abundance of goodwill and non-amortizing intangibles, it is my hypothesis that spring-loading is happening at Middleby but since all acquired companies were privately-held, it is impossible to compare acquired companies’ post and pre acquisition performances, determine if there were asset write-downs in the stub period or preceding year (though there are some changes as noted during the measurement period), and infer whether the acquired company might have delayed recording stub period sales until after the deal closed.    

As one example to frame whether management might be acquiring businesses to bolster the appearance of growth, I highlight the Company’s acquisition of Market Forge, announced January 7, 2014.  Market Forge makes steamers.  It should be noted that MIDD already owned three subsidiaries with a steamer line but management acquired ~$15M revenue-generating Market Forge which makes steamers.  The Company paid a total of $11.7M for Market Forge.  When an analyst inquired with management during the Q1’14 call as to why the Company would acquire another steamer company when “you’re pretty well-represented in that segment already”, management said the Company did not manufacture steamers and was outsourcing from three suppliers (which incidentally begs the question of why MIDD wasn’t consolidating its vendors and if they aren’t pursuing what would seem to be obvious efficiencies, then how can this company generate industry-leading margins).  Management then said, “Market Forge allows us to be our own manufacturer.”  If that’s the case, then presumably there’s some PP&E involved to conduct the manufacturing and also some technology that validates the CEO’s comment in the press release regarding the acquisition of Market Forge.  “The steam cooking category is a large and growing sector in the commercial foodservice industry.  Through the acquisition of Market Forge, we add an industry-leading brand focused on steam cooking to our portfolio…Market Forge is well-known for quality and innovation.  Recent innovations such as the Eco-Tech and TurboSteam countertop steamers are eco-friendly, energy efficient products providing our customers with flexible and cost-efficient steam cooking solutions.”  That sounds promising and it’s notable that Market Forge won a Kitchens Innovations Award in 2009 which validates being innovative.  Since management asserts that Market Forge is a manufacturer and known for its technology prowess, one would expect a meaningful part of the purchase price would be allocated to PP&E and to technology.  Instead of what one might expect, only $120,000 of the purchase price was allocated to PP&E and only $200,000 was allocated to developed technology.  $10M was allocated to goodwill and other intangibles, $8.8M of which was noted as being non-amortizing.

It’s worth noting that on May 10, 2012, the Company changed auditors, from Deloitte & Touche to Ernst & Young.

What is Middleby’s Free Cash Flow?

During the Q4’14 earnings call, the CFO said, “As a company we obviously generate a lot of free cash flow, it’s part of the machine here at Middleby.  We’re able to acquire the companies integrating quickly and pay down the debt quickly.”  Although the CFO asserts the Company is able to pay down the debt quickly, it’s clearly not part of the current mandate.  Total debt at MIDD increased from $214M at the end of 2010 to $598M at the end of 2014 and pro forma for the pending transaction for AGA, debt will be going higher.  The Company’s leverage ratios are currently fine and there is little likelihood of a covenant breach, at least in the near-term.  The majority of debt is through a senior secured revolver (maturing August 2017) at LIBOR plus 1.5%; as of Q2, the average interest rate was only 2%.

On the surface, using the conventional approach of cash flow from operations less capital spending, MIDD generates a lot of FCF, over $220M in 2014 and over $263 during the LTM.  Based on LTM FCF, the conversion of revenue to FCF was 15.6%, much higher than the 12.4% average conversion from 2010-2014.  However, FCF by the conventional approach overstates MIDD’s FCF since the Company pursues acquisitions in a serial manner and those acquisitions, approximately $950M from 2010-2014 and $1.4B from 2005-2014, serve as a substitute for organic R&D and capital spending.  When a company’s growth is largely driven by acquisitions, the acquisition costs should be incorporated into the FCF calculation.  Otherwise, FCF growth is being overstated. 

Middleby’s roll-up strategy boosts the impression that FCF is growing.  Pursuant to an acquisition, MIDD gets the short-term benefit of reducing the acquired company’s working capital in the normal course of business (i.e., collecting receivables, selling inventory).  Middleby’s internal R&D has not generated the innovation that the CEO gloats about so frequently.  The Company acquires it and that cost in addition to the numerous manufacturing facilities that come with MIDD’s acquisitions (as opposed to building capacity internally that gets deducted as capital spending by the conventional approach) should be incorporated when calibrating free cash flow. 

Based on the inclusion of acquisitions, MIDD’s FCF looks very different as shown below during the past decade.  In looking at FCF with acquisitions included, perhaps it’s not a coincidence that the Company’s ROIC started to deteriorate in 2008 from the mid-20% level towards the lower-teen level.  During the past decade, debt has grown substantially to fund acquisition growth.

Pattern of promotional management commentary raises red flags

Selim Bassoul, Middleby’s CEO since 2000, is known for his unbridled enthusiasm.  Through numerous acquisitions, he has led the Company from doing $100M in revenue to ~$1.7B.  He has sold almost $110M of stock at an average price of $51.34 in the past four years; most of his sales have occurred in the past three years at an average of $56.67 for over $93M.  He continues to own more than 500,000 shares. 

Middleby’s CEO likes to assert that the Company is a “technology company.”  During the Q3 2013, he said, “Middleby is not an ordinary industrial company.  We are a high-tech firm with focus on energy, speed, ventless and water saving.”  In a company investor presentation, MIDD claims to offer “consistent market disrupting product introductions” and that same presentation highlights “innovation is in our DNA.”  Middleby’s CEO has made mention of Apple several times to frame Middleby’s innovation and technology prowess as being like Apple in the restaurant equipment industry.  I think that’s an absurd comparison!  Selim insists that Middleby is the most innovative within the industry.  “We’re basically the biggest generator of innovation and speed.” 

During the Q1’15 earnings call, Selim said, “The difference between us and most probably most of our competitors is emotional connection that people have to our innovation…the biggest thing that we’ve done in my honest opinion that made us unique is the fact that we have an emotional connection to our customers…if you can get me a touch to improve my food, you give me some labor saving, I love you.  If you give me speed on top of that, I adore you and if you give me on top of that energy efficiency in auto saving all together, I worship you...I don’t play in the same business model as my competitor.”  When I mention these comments to selected competitors and customers, they almost immediately laugh and almost all of them frown. 

Hubris can make a company vulnerable and I think there’s much exhibited at Middleby as particularly reinforced by the CEO’s comment, “I don’t play in the same business model as my competitor.”  Selim is admirably an enthusiastic person but I think his pattern of promotional comments are often lacking in truth. 

As described in the report (p. 41), written by Michel Magnan, Denis Cormier, and Pascale Lapointe-Antunes, called Like Moths Attracted to Flames:  Managerial Hubris and Financial Reporting Frauds, “Red flags can be proximate sources that create a context that is auspicious for impropriety....Moreover, as executives engage into the slippery slope of deception that accompanies…impropriety or deception, their hubris can be fed or enhanced by positive or fawning external exposure as well as by precedent obscure or forgotten events that comfort them into their likelihood of success at avoiding detection.”  As also described in their report (p. 42), “Managerial hubris…is more likely to be transparent when asking executives about their plans, realizations, future strategies, coups, etc.  Inconsistencies between executives’ statements and observable facts or realities, outlandish claims, and a lack of concern for operational details, can be signals that managerial hubris has set in, creating further risk for auditors and regulators.”  I have tried to share some commentary from the CEO which I believe is demonstrative of managerial hubris but I encourage anyone who is really interested in the short thesis to listen to at least the last couple of years of earnings calls in developing or reinforcing your own perspective.       

Innovation requires spending on R&D

Although I have not found an objective source that qualifies what equipment manufacturer is “the most innovative”, I think the Kitchen Innovations Awards presented annually at the National Restaurant Association (“NRA”) is a good barometer towards highlighting industry innovation.  The NRA show is the largest in the world and I have attended it approximately twenty times.  This past year, Middleby was not among the recipients but the Company has been recognized in past years which is demonstrative of their innovation, but to characterize Middleby as being like Apple to the food service industry and communicate that the Company is the most innovative and disruptive is simply not true, especially since most of MIDD’s innovative products were derived through acquired businesses. 

I have reviewed ten years of Kitchen Innovations Awards and it should be noted that Middleby has received recognition for a variety of innovations as demonstrated from its twenty-three Kitchen Innovations awards (206 issued overall in the past decade by Kitchen Innovations).  However, six of the twenty-three awards were issued to companies that Middleby acquired subsequent to those current subsidiaries receiving the Kitchen Innovations Award.  Since MIDD is now equipped with such innovative technologies, I am ascribing them with the award, even if MIDD didn’t own the subsidiary at the time of the award being issued.  This is also why I view those acquisitions by MIDD as being deducted in the calculation of FCF. 

Middleby won a lot of Kitchen Innovations Awards but if innovation is qualified by the most awards received at the NRA show during the past decade, then Manitowoc should be characterized as being “most innovative.”  Manitowoc’s food equipment brands won twenty-six Kitchen Innovations Awards.  Manitowoc doesn’t engage in the promotional hype though and certainly has never said, “I don’t play in the same business model as my competitor.” 

To achieve innovation, the Company has done an admirable job at acquiring companies which developed innovative approaches to address ongoing trends and issues within the restaurant industry.  It’s possible that management has used the Kitchen Innovations Awards as one approach to smartly explore potential acquisition candidates.  Among the trends and issues sought to be addressed by Middleby and also by many food equipment companies include labor cost reduction, energy efficiency, reduction in water usage, food waste disposal, and food safety.  MIDD’s CEO is simply the most visible and vocal within the public equity markets promoting these trends to investors who have embraced the “story” and his buzzwords with fanfare.  The fact is that a discussion with almost any food equipment manufacturer will include the same customer issues and end-market trends that MIDD is seeking to address.  Middleby is appropriately focused on creating solutions for its customers but that is not different than the objective being pursued by almost all their competitors. 

The notion of “innovation is in our DNA” is hardly evidenced by R&D expenditures, at less than 1.4% of revenue in 2014 (1.5% in 2013 and less than 1.4% in 2012).  In a 2012 report, Booz & Co highlighted that the top ten global innovative companies spent an average of 6.2% of revenue (median 5.6%) for research and development.  No company among the top ten incurred less than 2.2% of revenue for R&D.  When compared to its peer group, all but one publicly-traded U.S. peer (that being Standex International) spent more on R&D versus MIDD at 1.5-2.3% of revenue.  MIDD might be innovative but such is largely derived from the Company’s acquisition strategy and those acquisitions might not be adequately reflecting what should be amortized for developed technology.          

In my opinion, the true test of innovation comes from the field (i.e., customer landscape).  A discussion with more than fifty restaurant owners confirms that Middleby does own several brands that can be characterized as being “innovative” but few restaurant owners said that Middleby is the most innovative.  As perhaps best summarized by one comment, “Our industry is constantly evolving and with so many new costs, primarily driven by regulatory issues, all of the equipment guys are focused on improved productivity to help us improve our bottom-line or at the very least stay even.  No one company has all the solutions and most of the innovative solutions are similar across several companies so we typically have more than one choice which is good for us of course.” 

Kitchen of the Future:  Overpromise and under-deliver but keep the hyperboles coming

Since 2012, management has said that the Company’s “Kitchen of the Future” (or “KOTF”) can revolutionize industrial restaurants and would quickly be adopted by numerous customers, and could generate hundreds of millions in revenue for MIDD.  Despite the ongoing promotional commentary (some recent comments highlighted below) regarding the KOTF, there hasn’t been any meaningful sales from it since Chili’s installation of 1,200-1,500 units from 2011-2013.  The reason that KOTF is worth highlighting is because the CEO has communicated enormous expectations for its potential that have yet to materialize.  Management praises the customer response to the KOTF and has been predicting major roll-outs in addition to Chili’s since 2012 but the date when the substantial revenue is expected keeps getting pushed back.  

The KOTF supposedly offers “easier preparation—more repeatable—less opportunity for error—ease of use.”  As described by KeyBanc’s Brad Ludington in Nation’s Restaurant News during December 2011, “the centerpiece of the kitchen initiative is an oven that uses convection, steam and a combination of the two to replace both a smoker and a tilt skillet that previously were used to prepare products such as ribs, mashed potatoes and pasta.  The combi oven provides a higher quality product at a more consistent pace by cutting much of the human error that previously resulted from preparing multiple products at multiple stations.  The second major piece of equipment in the first phase is a rethermalizer food warmer which is essentially a large fryer that uses water to more evenly heat products such as soups.  This took the place of up to six microwave ovens per unit and allows prep cooks to focus on other tasks versus having to manage the microwaves.”  People with experience working industrial kitchens say the KOTF is just multiple cooking devices combined in one machine so there’s one less station in the kitchen and space is more effectively optimized.  One prospective customer said, “It is not revolutionary or intelligent as claimed to be.”

Analysts ask questions about the KOTF on every call and the CEO responds consistently with enthusiasm but the commentary is quite inconsistent for what was said from what has been achieved.  I think this communication pattern is among the red flags that should concern those invested in MIDD.  Below I highlight some of the comments from least recent to more recent.

During the Q3’12 earnings call in response to a question regarding having something of a similar magnitude in the pipeline in terms of number of stores and revenue opportunities, the CEO said, “Yes.  We’ve had other companies that have been interested in a very similar solution to their needs in terms of looking at what Brinker has done…so we are working in tests with several of those restaurant chains at this moment that we believe will come to fruition sometime in the latter part of 2013.”

During the Q1’13 earnings call, the CEO said, “And the Kitchen of the Future, I think, we’ll see that and other large customers coming in, starting in the first quarter of 2014.  So that gives you a timeline of where our innovation is taking place.”

During the Q2’13 earnings call, the CEO said, “1 or 2 will most probably sign up for us sometime in the fourth quarter.  And I think we’ll accelerate the rollout in…the first or second half of 2014…Yes, the Kitchen of the Future is successful for us…so a total of 17 chains are in the pipeline of the Kitchen of the Future as we speak.”   

During the Q4’13 earnings call, the CEO said, “we’re going most probably start seeing the impact of the Kitchen of the Future coming in…so we finally, basically now are working with the second chain that has the same potential as Chili’s comes through with our Kitchen of the Future.  So that’s in the works.  And that’s going to start ramping up in the second half of the year, and that will offset some of the rollout of 2013…so the Kitchen of the Future could be hundreds and hundreds of billions for us” [this is noted in the transcript but I assume he meant millions] 

During the Q1’14 earnings call, the CEO said, “I have 16 chains in field test, not in lab test, not in pre-lab visit.  They are in field test.”

During the Q2’14 earnings call, the CEO said, “So we’re having many, many 20 to 50 store outlet adopting the Kitchen of the Future so they are rolling it out.  So we’re getting most probably we’ve installed literally close to 300 Kitchen of the Future in the past few quarters.” 

During the Q3’14 earnings call, the CEO said, “We have so far, which is fantastic, we’ve had this year 300 stores installed and they have been installed not at one chain, but at several chains.  So total right now, we’ve gone from 24 chains to 25 chains testing that system representing around roughly 10,000 stores…I think we’re feeling very, very good now to those 25 chains that we will end up landing a couple, two them in 2015.”

During the Q4 ’14 earnings call, the CEO said, “So the Kitchen of the Future…Other than Chili’s, we just did fully completed 330 kitchens outside Chili’s that have Kitchen of the Future.  Today the number is, if I’m correct, it’s over 1500—between 1500-1800 kitchens that have Kitchen of the Future here in the U.S.”

During the Q1’15 earnings call, the CEO said, “We have so far seven of the top ten casual dining chains have kitchen of the future in field test…We have over 500 stores installed outside the Chili system.”

During the most recent earnings call, the CEO said, “The last year, I’ve been like you, struggling to understand why the Kitchen of the Future, which is a no-brainer, has not taken off as fast.  Because the payback is less than a year, it is extremely fantastic for over now I think there are, oh I don’t know, 3,000-4,000 restaurants that are using it.  They love it...Every test that we’ve done with those 22 chains have been nothing but raving reviews, but then the CFO wouldn’t pull the trigger…Maybe it’s another quarter or two, but I’m looking forward to saying 2016 will be a big one for our Kitchen of the Future.”

In my opinion, little will materialize in the near future from the KOTF (which incidentally provided only an estimated $30-40M from the Chili’s installation) to boost the Company’s results.  The story-line or “spin” has served management well as the KOTF concept provided a thematic growth story for them to promote and now that they are increasing their focus on the residential kitchen group coupled with more acquisitions likely in food processing, analysts will presumably soon move onto other topics of potential growth and MIDD’s management will not be held accountable for their favorable outlook that was repeatedly communicated for the Kitchen of the Future.

So what is MIDD worth?

As described, I view MIDD’s results as unreliable as a real barometer of the Company’s normalized earnings and free cash flow potential for determining intrinsic value.  I believe earnings are inflated by purchase accounting, I believe there is spring-loaded accounting being used that might distort organic growth and partially be the source of industry-leading margins.  I think trends in ROIC are inconsistent with the market’s valuation. 

When using historical and forecast results, I deem MIDD as being more than “priced for perfection”.  I don’t know when nor if the market might embrace my bearish perspective but I firmly believe there’s more downside to the stock than upside.  I envision that the Company’s pending acquisition of AGA will enable management to focus analysts on the attractive current prospects of the housing market as management drives the potential margin story within residential equipment but I don’t think Viking will achieve management’s more than 20% margin this year and the market might begin to discount lower margin prospects accordingly.  In the past month, consensus earnings estimates for 2015 and 2016 have been reduced slightly and additional reductions could foster some multiple compression. 

If my thesis is accurate, then management has been playing this game for a while and timing when the market will care is impossible to discern.  I do think the pending spin of Manitowoc is likely to drive more market participants to frame MTW versus MIDD and to recognize differences (like valuation) that might not be sustainable at MIDD. 

On an LTM EBITDA basis, MIDD generated $361M.  Peers trade at ~8-11x.  At ~12-13.5x LTM EBITDA, MIDD would be valued at ~$65-75, implying a 2016E P/E of 14-16x.  I believe the EBITDA metric is more meaningful given my impression that earnings are over-stated by non-amortization.           

Selected risk considerations

Over the past ten years, the Company’s total stockholder return was 1,073%, an impressive achievement and placing MIDD in the top 1% of all publicly-traded companies in the U.S.  Momentum begets momentum in the current market which is of course another risk to the short.  Middleby is well-positioned within most of its markets and will likely continue to effectively compete within industry segments that are growing and this market loves thematic growth stories and MIDD’s CEO is quick to promote them.  During the most recent earnings call, he said “it’s the first time ever that sales, food sales at bars and restaurants surpassed sales at grocery stores according to the U.S. Department of Commerce.”  Furthermore, in his closing remarks, when he typically has prepared a variety of promotional-oriented comments, he said “premium fast casual remains hot, hot, hot, where Middleby is extremely well positioned.”  The notion that MIDD is a derivative to Chipotle and other fast casual growth attracts investment flow and those favorable dynamics might continue, even in the current market.  AGA and other likely acquisitions will add to the cookie jar to portray healthy metrics.  If and when the market cares about valuation is impossible to know but I do think the MTW spin (expected Q1’16) is a catalyst for increased scrutiny.  I think the big risk here is that, assuming my thesis is accurate, these games can go on for much longer without the market caring so I manage the timing risk by sizing accordingly.

Catalyst

Increased accounting scrutiny

Goodwill write-offs

Moderating organic growth

Currency headwinds

Valuation premium