Primo Water (NASDAQ:PRMW) sells water equipment as well as exchange and refill containers. The company has seen a few difficult years but has finally become profitable amidst continued topline sales growth.
Amidst these improvements, which are to be applauded, Primo Water announced a major move. It announced the purchase of Glacier Water Services, in a transaction which will more than double its revenues. The relative discount at which this transaction takes place, as well as anticipated synergies, are major drivers behind investor's enthusiasm regarding the deal.
While I understand this optimism, I note that Primo will become very leveraged following the deal as the high valuation multiples in absolute terms, as well as high cost of debt, prevents real accretion in terms of earnings. The high valuation and leverage concerns outweigh the benefit of potential synergies and solid organic growth performance of the combined business, at least in my eyes.
A Look At The Business
Primo Water sells water dispensers under the ¨razor-razorblade¨ principle. After selling the equipment at relative low cost, it makes money by exchanging and refilling water containers. Dispensers can be bought at over 26,000 home improvement stores and large retailers. After the equipment is installed, Primo aims to make money by providing lucrative exchange and refills.
According to the company, water makes up 32% of total beverage consumption. Bottled water makes up 18% of the overall beverage consumption, being even more dominant than tap water which has a near 14% market share. The company enjoys two tailwinds in its business. Sales of hydrocarbonated drinks are down as consumers become more health conscious. At the same time, environmental awareness is growing as well, thereby not favoring the sale of smaller water bottles.
Recent stories regarding unsafe tap water in Flint creates tailwinds as well as a lot of municipal water infrastructure is outdated.
The company has been founded in 2004 and went public in 2010. Shares were sold to the public at $12 apiece that year, but quickly fell to levels below a dollar in 2012, as investors lost faith amidst mounting losses. Ever since, shares have seen a decent recovery, having risen all the way back towards $12 per share again.
Reporting Growth And Finally Some Earnings
Primo has reported decent growth over the past five years. Revenues rose from $83 million in 2011, towards $127 million in 2015. The company reversed a $9 million operating loss into profits of $4 million, allowing for some small after-tax profits in 2015, after posting years of big losses.
Based on solid results for the first half of this year, Primo sees sales of $132 to $134 million in 2016. Adjusted EBITDA is seen around $22 million. This guidance pretty much suggests that operating profits could double towards $7 million this year. After taking into account interest costs on a net debt load of $18 million, and assuming statutory tax rates, net earnings are quite limited, given that there are 30 million shares outstanding.
Based on this outstanding float, a share price of $12, and a net debt load of $18 million, the enterprise valuation comes in at $378 million. That is equivalent to 2.8 times sales, 17 times EBITDA as equity trades at over 50 times operating earnings.
Making A Huge Move
Primo Water out of the blue announced a huge deal, as it is looking to buy Glacier Water Services. Glacier provides high quality drinking water as well, dispensed through self-service refill water machines, essentially being a similar business as Primo.
With the deal Primo's products (including those offered by Glacier), will be available at some 46,000 retail locations in the US and Canada. The company will acquire Glacier for $263 million, of which $36 million will be financed with the issuance of Primo's stock, as the deal value excludes nearly 2 million warrants, which will be issued with an exercise price of nearly $12 per share.
The deal looks relatively appealing. Primo suggests that pro forma revenues are seen at $273 million, adjusted EBITDA comes in at $45 million, and operating earnings are seen at $14 million.
Primo generated revenues of $132 million on a trailing basis, $21 million in adjusted EBITDA and $8 million in operating earnings. The $378 million valuation of Primo implies that it is valued at 2.9 times sales, 18 times EBITDA and over 50 times operating earnings.
Based on the pro forma numbers, Glacier posts sales of $141 million, EBITDA of $24 million and operating earnings of $7 million. The $273 million price tag values Glacier at a little less than 2.0 times sales and 11 times EBITDA. Based on these metrics, the transaction takes place at a 30-40% discount compared to Primo's own valuation.
Not only is this discount relatively appealing, Primo anticipates to realize $6 to $7 million in annual synergies as well, although that will take three years' time to materialize.
Pro Forma Impact
Primo will become quite leveraged, given the structure of the deal. The company operated with a net debt load of $18 million ahead of the deal. The $227 million cash & debt component of the deal will result in a pro forma net debt load of $245 million.
The company will issue some 3 million shares, diluting the shareholder base to 33 million shares. At $12 per share, equity is thereby valued at nearly $400 million, as the company is valued at $640 million including debt.
Leverage is a real concern with pro forma EBITDA running at $45 million, a number which will increase towards $52 million following a full realization of synergies. That suggests a 4.7 to 5.4 times leverage ratio, whether you include synergies or not.
The pro forma operating earnings number of $14 million could increase towards $21 million if synergies are fully realized. The trouble is that debt does not come cheap, given the elevated leverage ratio. If we assume a 6% cost of debt on $240 million in net debt, interest expenses will come in at $15 million per annum. With operating earnings running at $21 million, if we include synergies, it is obvious that little is left for common shareholders.
Investors Act Upbeat
Primo is adding scale and that is important. It is buying a competitor at a 30-40% discount compared to its own valuation, while it benefits from relatively large synergies as well. So far the good news. The bad news is that the company uses a lot of debt to finance the deal and very little equity while it is relatively expensive. For that reason, equity holders will invest in a much more leveraged business, as additional interest expenses will eat up most of the pro forma earnings and projected synergies.
While leverage is very high, the company targets a 3 times leverage ratio by 2018. Unfortunately, management does not specify by just how much debt will come down, or EBITDA will increase by 2018. Of course, the company will gain scale, benefit from synergies, have better diversification and obtain cross-selling opportunities.
Despite the leverage concerns, investors act upbeat on the back of the projected synergies, relative cheap multiples and accretive impact once leverage comes down. Shares jumped 15% in response to the deal, adding roughly $50 million in shareholder value.
While I understand the rationale for the deal, the overall business is too leveraged to my taste. This makes it an easy one to avoid, even as I like the relative appeal of the deal, as investors not only have to fear leverage, but lack of substantial earnings as well. Despite this negative stance, I will continue to monitor the progress as both businesses show growth, interest costs may come down following deleveraging of the balance sheet, and synergies might come in higher than expected.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.