As a supplement to my previous article about Cott Corporation (COT), this article updates recent company news including the 2013Q4/FY earnings report. Due to a focus primarily on new information, some relevant topics are not revisited here at all, or are only touched on briefly. Investors who are learning about the company for the first time may also want to have a look at my article Cott Corporation: Juicy Turnaround Story.
Cott Corporation, founded in the 1950s, is a producer of beverages on behalf of retailers, brand owners and distributors. The company's product lines include carbonated soft drinks [CSDs], shelf-stable juices and juice products, flavored waters, energy drink products, sports products, new-age beverages, ready-to-drink teas, and alcoholic beverages. Cott has three operating segments: North America, U.K./Europe and All Other, which includes Mexico and Royal Crown International. Cott markets or supplies over five hundred retailer, licensed and company-owned brands in over fifty countries. For more information, see the corporate website.
Cott released 2013 Q4/FY earnings data [pdf] before the opening bell on February 12, and held its conference call later that morning. Despite COT trading over seven times its average daily volume, the final share price didn't move much at all. After rising to an intraday high of $8.42 (+6.3%) by midday, the shares closed for the day at only $8.04 (+1.5%).
COT reported 2013Q4 EPS of $0.03, which missed the consensus estimate by $0.01. 2013Q4 revenue was $482 million, which missed the consensus estimate by $11.2 million and represents a 7% year-over-year decline.
A bright spot is that 2013 was the fifth straight year of strong free cash flow for COT, with free cash flow for the fiscal year totaling $100 million, or $108 million excluding an $8 million cash cost for early redemption of $200 million of 2017 senior debt notes. Management attributes the strong free cash flow to tight control of capital expenditures and working capital.
CEO Jerry Fowden summarized the company's performance as follows:
"The fourth quarter of 2013 and the year as a whole were challenging for Cott. The overall carbonated soft drink market and the shelf stable juice market declined during the year, which alongside increased national brand promotional activity and deep price discounting adversely affected our volumes. Despite these pressures we continued to run our business tightly, reducing our SG&A costs and delivering $100 million of free cash flow."
My take is that I was too optimistic with my October comment that "while 2013Q2 results weren't great, they did improve and the outlook indicates that 2013Q1 would be the trough." That was factually correct, but I didn't adequately factor in that COT could languish in that trough for some time before turning to actual improvement. I did describe COT as a speculative turnaround story, but it has been slow going as national brands increased pressure on small rivals due to continued CSD market weakness. It's not particularly surprising that a turnaround is elusive for COT when industry leaders like Coca-Cola (KO) are struggling with the same headwinds.
Call Performance Summary
Cott Corporation 10/10/2013 article
[+6% from published call / +15% at peak / +6% from initial buy/call]
My 10/10/2013 call on COT was: "consider buying COT in the $7.20-$7.40 range, but if that range isn't reached before the end of the calendar year, I don't think it will be. My target price is $10 (32% above $7.60), based primarily on the last DCF valuation above, with a small discount added." Since COT didn't reach the $7.20-$7.40 range, call performance is tracked from the $7.60 of the day the article was written, which is also my price.
As the chart below indicates, COT topped at $8.74 in late November, for a peak gain of 15%, and came within a few cents of that price again in mid-December. That's not a bad return for a couple of months, especially with the 2.7% dividend paid in that time, but I don't make short-term trading calls so a quick flip wasn't my intent. In fact, I described COT as a "long-term value play," and probably should have left it at that.
Upon closing at $8.06 yesterday (2/18), COT is currently up only 6% from my $7.60 buy price, making it one of my worst performing calls. Although there are five months remaining on the timeline for my $10 price target, I now think that timeline may have been too optimistic. In other words, the target is still achievable, but I also may have just been wrong on this one.
(click to enlarge)Source: Yahoo Finance
Company Updates & Catalysts
Some readers may not be fully familiar with the COT turnaround story so I'll touch on a couple of recent items, as well a couple of points about the investment case, then offer my opinions on a potential new development that is thickening the plot of the turnaround story.
On January 2, COT announced [pdf] that it would redeem the remaining $15 million worth of its senior debt notes that were originally due in 2017. COT initially issued the notes in 2009 to pay off a portion of debt that was due in 2011. The redemption date is today, February 19, 2014.
On January 31, hedge fund firm Levin Capital Strategies filed an SEC form 13G to disclose that it owns a 5.4% stake in Cott Corporation. A 13G is a "Statement of Beneficial Ownership" the SEC requires of any investor with an ownership stake over 5% as a "passive investor," meaning the investor has no intent to exert control over the company (as "activist investors"). I only mention this to share information, not to imply any hidden meaning.
The overall CSD market continued to weaken in 2013 with a four percent volume decline. Deep discounting by national brands significantly reduced the price gap between national brands and private label, which negatively impacted COT sales and margins. I concede that my first article on COT was too optimistic about a "leveling off" of the CSDs market, but that was only one of, and the lesser of, several bases for the investment case.
As detailed in that first article on COT, the company has been diversifying its business beyond traditional carbonated soft drinks [CSDs] to products like juices, flavored water and teas. COT has been doing that with deals such as the 2010 merger with Cliffstar [pdf], the 2013 acquisition [pdf] of Calypso Soft Drinks, and a partnership with SodaStream (SODA) in 2013. Since Cliffstar was a juice company that was not in the CSDs business at all, that was the most significant step in diversification away from CSDs.
The reason I mention that background is twofold. First, to reiterate that, while December 2010 may seem a long time ago, three years is not much time to integrate two companies and overcome major industry challenges. In fact, COT made clear from day one that the initial "anticipated phasing" of the companies would last throughout 2013 and "longer-term synergies" would happen 2013 through 2015. The stated goal of the merger was to "increase portfolio diversification, help shift away from reliance on declining CSDs and open up opportunities in the growing juice market."
The second reason I mention some background information about COT is to support the point that the company has a long history of deal making and surviving when no one thought it would. In fact, when any company has Coca-Cola and PepsiCo (PEP) among its competitors, having its ability to survive constantly questioned becomes standard procedure.
Mergers and acquisitions [M&A] have always been a large part of the COT strategy so it is not new territory for the company. For example, M&A activity at COT goes back decades to numerous acquisitions such as Vess Beverages, Concord Beverages, Benjamin Shaw & Sons and Hero Drinks Group. In fact, M&A is the very reason COT was able to compete against much bigger producers. Most notable among these deals was the company's 2001 purchase of its retail brand CSD formulations, the RC International business (RC Cola outside of the U.S.) and its concentrate manufacturing and research and development operations from Cadbury Schweppes.
It's important for COT shareholders to remember that the company was built on M&A so that the current situation is evaluated in proper context. In recent months, there have been rumors that COT may be up for sale. In response, the company released a statement [pdf] on February 5 to state the facts. COT confirmed that it has engaged Credit Suisse to assist with evaluating "strategic alternatives" and attempted to make clear that "strategic alternatives" does not necessarily mean a sale. In fact, CEO Jerry Fowden points out that the company has engaged consultants to assist with its strategic review process in three of the past five years:
"Each year, we undertake one of these full strategic reviews or strategic planning exercises. During that, we do look at everything that surrounds the market and segments and geographies that we're in. We also look at the segments and opportunity areas where we don't currently operate and we try and look out over a 3- to 10-year time frame, factoring in how we see the markets and segments and landscape changing. Over the last five years, we've done this each year. And on three of those occasions, over the last five years, we have engaged external advisors to assist us in kind of doing the various analysis of the multiple number of scenarios and alternatives that come out of those kind of exercises. Because we had received a couple of inbound calls from the media that had become aware of our engagement at Credit Suisse -- but from what they were saying, they appear to be a long way off of the mark as to the reasons why we'd engage them -- on the advice of the TSX, we issued a press release."
"What it means at the moment is our view towards the importance of diversifying our business through this combination of organic and acquisition-based activity is probably even more critical now as we look forward then perhaps it would have been two to three years ago. But the exercise itself is pretty much the same as that we've performed each year over the last five years. And as I mentioned, we have used advisors to assist us on that, on three of those occasions."
So, despite any speculation, there is actually no indication that anything has changed. We've known for many years that COT is not only exploring "strategic alternatives" like acquisitions and partnerships, but has been acting on some of them. The strategic alternatives COT is exploring likely include a potential sale of the company since it would be a dereliction of duty if the board didn't consider the option. However, while a sale may be the most headline-worthy possibility, that doesn't make it true. Despite its challenges, COT is larger and stronger than most direct competitors, which are mostly smaller private companies. For that reason, COT would be hard to buy and is just as likely to engage Credit Suisse to assist with any combination of many other options like acquisitions or divestitures.
For example, one option COT has not taken a lot of action on yet is large reductions to its manufacturing footprint. Manufacturing facilities carry high fixed costs so further streamlining the geographic footprint could significantly impact profitability. CEO Jerry Fowden discusses the option:
"We do undertake an annual footprint exercise. We are currently in the midst of that work now. Obviously, within that, we have to look at the landed cost to the individual distribution centers of our customers because we don't want to save on the production side and put it all back in to extra freight. And we expect to have that footprint review complete by the end of this quarter and we will, of course, update everyone accordingly on the outcome of that."
Another option COT is already pursuing is converting some of its facilities for contract manufacturing of products that are more profitable than CSDs such as alcohol, energy and specialty beverages. CEO Jerry Fowden has described the associated costs as "quite a small adaptation or conversion cost to an existing line" so this could be a big part of the future for COT. Here are other comments from Mr. Fowden on contract manufacturing:
"We see that as a significant scale opportunity ... and there's probably some 30 million to 50 million cases of business that over the next three years we could win in that area, with more than 10 million of those cases coming in 2014 from contract wins we've already signed up or we're in the process of signing up. We see that business as equally attractive as our private label business."
"That will be a good offset to the CSD market decline. But at this point in time, I don't see it as sufficient to stabilize where we are on the top line in 2014, albeit I do think we can get to that stability over time."
Finally, if the company is to be sold, I actually think the most likely buyer would be private equity. The entire beverage industry is challenged so the companies large enough to buy COT are streamlining their own operations just like COT is doing, rather than taking on acquisitions that require more streamlining. Consolidation is likely to continue among the smaller players in the industry, but COT is among the largest of the small players ("small" relative to KO, PEP, etc.) so any deal would likely be more of a merger for a comparably-sized company. The only independent that comes to mind is National Beverage (FIZZ) and that just seems unlikely.
If a sale is in the cards for COT, perhaps a PE firm extracts value in any or all of the ways that PE firms typically do so. That could be selling off less attractive assets and investing in more bolt-on acquisitions to strengthen the growth areas of the business. Perhaps it would be by divesting pieces of the business until only a small and narrowly focused piece remains. In either case, perhaps the result remains a PE firm holding indefinitely for its strong cash flow generating properties, or perhaps it gets taken public again years later. With that said, I've opined enough about what the fate of COT might be so I'll move on to what matters -- valuation.
(click to enlarge)Source: company presentation
Upside Potential, Time Frame, Downside Risk
Since I never buy a stock on speculation that it may become a takeover target or get sold in bankruptcy, I rarely use the valuation measures that are typically reserved for those scenarios such as Enterprise Value [EV] and Enterprise Multiple [EV/EBITDA].
However, there are two reasons I use those measures to offer a possible valuation scenario to consider for COT. First, in my previous article about COT, I used completely different valuation methods and got similar results so I am not changing the resulting fair value estimate of $10. Second, the speculation that COT will be sold is fairly prevalent and Enterprise Multiple is among the most common valuation methods for buyouts so I think it is helpful to at least consider that type of valuation. However, my intent is only to offer readers information to consider, it is not to validate rumors.
Based on COT fiscal 2013 data of a ~$750 million market capitalization, ~$820 million in total liabilities, ~$47 million in cash and ~$197 million of EBITDA (earnings before interest, taxes, depreciation and amortization); my calculations return a ~7.75x Enterprise Multiple for COT.
The beverage industry 2013 average Enterprise Multiple is ~12x, but that is skewed high since it includes companies like Coca-Cola with an EV/EBITDA that hovers in the mid-teens, and Monster Beverage (MNST) with an Enterprise Multiple in the mid-twenties. Valuing COT with a 12x Enterprise Multiple would put its share price in the mid-teens, which I do not consider reasonable. If COT were valued in the 9x EV/EBITDA range that is more typical of its peers, that would put the share price at right about $10. If COT were to be sold, I believe it would demand a decent premium above $10, largely due to its strong cash flow generation.
In combination with the valuation provided in my first article on COT, the calculations above make me comfortable with my $10 price target so I am not changing it at this time. However, I do believe my original timeline of 6-9 months was too aggressive. The $10 price target is 31.6% above my initial $7.60 suggested buy and 24.1% above the current $8.06 price.
However, I do not suggest that investors commit new cash to COT at this time except in very select circumstances. Until there are more and better signs of progress toward a turnaround, the stock remains too risky for me to recommend it other than as a small speculative position.
Currently, two Wall Street analysts rate COT a Buy, six rate it a Hold and zero rate it a Sell. That is about the same as when I wrote my first article on COT in October, except a few more firms have since initiated coverage. The consensus price target is now $10.33. At the time I posted my $10 price target, most analyst price targets were in the $11-$13 range so the consensus price target was higher than it is now. So far, we're all wrong.
Again, I do not recommend that investors put new money into COT based on speculation about a possible buyout or a speedy turnaround. However, I still believe there is long-term value potential in COT, but only as a small speculative position. As such, my current plan is to continue holding my COT shares and I think other investors are justified in doing so, as long as we understand the risks and don't expect too much too soon.
This article is spun off from my 2013 Performance & 2014 Updates article, which supplements my company-specific update articles like this one. For more in-depth coverage of COT and its industry, perhaps consider reading my article Cott Corporation: Juicy Turnaround Story.
I researched and wrote this article 1/12-1/18. Thank you for reading.
Additional disclosure: I may buy additional COT shares at any time.