in search of Value

Cott Corporation (COT) announced that Wal-Mart (WMT) has decided to terminate its existing 10-year old exclusive supply agreement for carbonated soft drinks.  This action gives Wal-Mart the option to transition to other suppliers over time: up to one third of its requirements can be moved this year and up to two thirds can be moved next year.

While the ultimate outcome is unclear and discussions between Cott and Wal-Mart are reported to be ongoing, this is certainly not good news for Cott.  Wal-Mart represents 35%-40% of Cott’s sales.  If Wal-Mart were to move its business to other suppliers, Cott could have difficulty servicing its debt.

This risk was highlighted in my previous articles on Cott.  The last article, entitled “Mysterious Silence from Cott Corporation,” argued that Cott’s silence was an indication that something was up.  It raised the potential that the company had received an acquisition offer, but also focused on the risks associated with Wal-Mart, saying, “Wal-Mart’s reduction of Cott’s shelf space last year may have been the first step toward reducing its exposure to Cott.  The next logical step would be to split the business, or maybe even go all the way and switch suppliers….”

It does not seem likely that Wal-Mart would transition all of its Cott business to other suppliers.  It is more plausible that this action will result in some split of the business, a reduction in pricing, or both. (The most likely beneficiaries are DPS and FIZZ.) This move by Wal-Mart enhances Wal-Mart’s bargaining leverage by introducing greater competition among suppliers.  It would not be in Wal-Mart’s best interest for Cott to go out of business.

This situation is complicated by Cott’s high leverage.  Debt plus other long-term liabilities totaled $430.6 million as of September 27, 2008, which was approximately 4.6x LTM adjusted EBITDA, and over 7x adjusted EBITDA less normalized capital expenditures.  Sales to Wal-Mart were 35.8% of Cott’s total sales for the nine months ended September 27th.  This implies that Wal-Mart represents approximately $600 million of Cott’s annual sales.  Products not covered by the exclusive supply agreement comprise some of this amount.  The annual sales covered by the agreement might be approximately $500 million.  If Cott were to lose 25% of this business, the impact on EBITDA would be $25 million, assuming a contribution margin of 20% (just a “swag”).  This would be nearly 50% of adjusted EBITDA less normalized capital expenditures.

I have previously estimated the fair value of the company’s stock to be in the range of $1.00 to $1.50 per share, based on EBITDA multiples and discounted cash flow analysis.  Until we have better visibility into the status of Cott’s relationship with Wal-Mart, it will be difficult to develop a revised cash flow forecast and fair value estimate.  As a placeholder, I have cut my previous range in half to $0.50 to $0.75 per share.

(Disclosure: The author has no positions in Cott Corp. stock as of this writing)