Jamba Inc.: Q1 First Impressions

Jamba Inc. (JMBA) announced its first quarter 2009 results, and issued its 10-Q, after the market’s close yesterday. Management has made solid progress on its “BLEND” plan to reduce costs, expand its in-store food offerings, license the brand for packaged food items, and shift its mix of company-owned versus franchised stores. Sales were in-line with expectations.  Costs were better than expected.

The headline same-store sales number of -13.8% was consistent with my March 27th forecast, and with management’s prior guidance, after adjusting for a reduction in store hours. It was somewhat disappointing to hear that there was no positive trend toward the end of the quarter.

The good news was on the cost side, with COGS significantly lower than I had anticipated. The company appears to be making good progress on its goal of reducing store-level costs by $25 million annually (in 2009, with more reductions in 2010). Management expects positive free cash flow in 2009 after capital expenditures.

Given the first quarter results, I plan to reduce my sales forecast for the rest of the year, but increase projected EBITDA and cash levels significantly:

  • For Q2, I expect to reduce my sales forecast by about $4 million, to $86 million (mainly to account for the shorter store hours), but increase store level EBITDA by roughly $1 million, to just under $20 million, and increase total adjusted EBITDA by roughly $0.5 million, to $11 million.
  • For 2009, I expect to revise my sales forecast to $300-$305 million from $317 (assuming 50 more stores refranchised in H2); to revise store-level EBITDA to $48-$50 million from $42.5 million; and to revise total adjusted EBITDA to $13-$15 million from $7.6 million. These figures do not include any impact from the potential sale of development agreements in connection with the company’s refranchising efforts.
  • I now expect non-restricted cash – before the impact of any refranchising – to be approximately $26 million at the end of Q2, $29 million at the end of Q3, and $20 million at year-end. Management has consistently exceeded my expectations for cash balances, so these figures may be conservative.

Of course, Jamba cannot cost-cut its way to success. To increase sales, the company needs to expand its menu, and the company was very bullish on its early results. Oatmeal has performed beyond management’s expectations, and the limited test of salads, sandwiches, wraps and cold teas went well enough that they plan to expand the test into 200 stores this summer. (I would not be surprised to hear about soups and other items as we move into fall.)

CEO James White said on the call that he thought it would not be unreasonable for food to be 20% of Jamba’s sales mix at some point. This makes sense, given that food is 17% of sales at Starbucks stores. I estimate that food is roughly 5-6% of Jamba’s sales today, so an increase to 20% would drive an increase of over 15% in same-store sales (since food not only adds incremental sales, but also increases store traffic, helping to drive blended beverage sales as well). This is roughly double the 6-9% increase in same-store sales that I had previously estimated for food (but consistent with my longer term expectations).

Revising Price Target Upward

Given my new estimates of 2009 store-level EBITDA and adjusted EBITDA, I am increasing my near-term share price target to $1.50 from $0.95. I am targeting $1.75 per share in the second half of 2009. The $1.50 price target implies an enterprise value of approximately 6.5x 2009 forecast EBITDA. The $1.75 price target implies an enterprise value of approximately 7.5x 2009 forecast EBITDA.  I would expect this discount versus comparable company multiples to persist until the company’s menu expansion efforts begin to translate into improvements in same-store sales.

Catalysts for share appreciation include: meaningful Q2 profits; positive results from the 200-store expanded food test; significant additional brand licensing deals; the refranchising of a considerable number of stores (for a reasonable amount of cash); and a comprehensive balance sheet fix. The company stated on the earnings call that it is still exploring options for the latter. Positive surprises on any of these fronts could generate upside for the stock beyond my price targets.

Disclosure: (Author is long JMBA)

Copyright © 2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

Jamba Inc. – New CEO Gives Company a Boost

The market’s valuation of Jamba Inc. (JMBA) seems to reflect a consensus view that this chain of 729 smoothie stores will not survive.  After a review of JMBA’s fourth quarter and full-year 2008 results, and several calls with management, I disagree. I predict that this company will not only survive but thrive.

The company still faces extremely weak retail sales traffic, and a consumer that is cutting back on discretionary, premium-priced items.  However, the company’s new CEO, James White, has a good understanding of what it takes to succeed in this environment, and is quickly reorienting the company’s offerings to deliver what today’s consumer wants – healthy, convenient, fun food at an affordable price.  His vision and passion, combined with intense focus and a sense of urgency, are exactly what the company needs right now.

In the analysis below, I discuss (click to skip to section):

  1. Current Valuation and Consensus View
  2. New CEO: Focused and Results-Oriented
  3. Strategy and Execution
  4. Risks and Opportunities
  5. Financial Projections
  6. Potential Future Valuation and Catalysts

Current Valuation & Consensus View

jmba-value-jpg3A recent share price of $0.47 implies an enterprise value (equity + debt – unrestricted cash) of $25 million – approximately 0.6x store-level EBITDA and about 3.3x adjusted EBITDA, based on my 2009 forecast.  For comparison, PEET trades at about 7.9x EBITDA, and SBUX trades at approximately 7.6x EBITDA.  QSR concepts SONC and JACK trade at about 6.7x EBITDA.

The common viewpoint seems to be that: (a) JMBA’s business model is not viable, and (b) the company will run out of money before management has time to figure things out.

In 2006 and 2007, the business model was indeed broken outside of California, and deteriorating in California.  A smoothie may provide a boost of energy, but it is not a cup of coffee.  Coffee drinking is a habit, often repeated several times a day.  Even regular smoothie drinkers are unlikely to average one per day, let alone several.  Yet prior management acted as if a smoothie could replace coffee and JMBA could be the next Starbucks.  They opened stores too close to each other, and in suboptimal locations.  New stores outside of California had AUVs well under $600,000 and even CA store AUVs were dropping (especially for stores not included in comp store figures at the time), but JMBA’s cost structure, at both the store level and at corporate, was geared toward a system with $800,000 to $1 million AUVs.  Cash flow margins for stores outside of CA were in the single digits.  California store margins were still over 20% for seasoned stores, but newer store margins were only in the teens.  New stores in general were not even getting close to management’s target of 20% store-level EBITDA and 40% cash-on-cash returns.  Meanwhile, comp stores in 2006 and 2007 were flat.

This broken business model and a flawed growth strategy – along with the purchase of stores from franchisees – caused JMBA to blow through its $100 million in post-IPO cash reserves and get in trouble, or at least too close for comfort, with its banks.  This forced the company into an extremely costly debt financing – with $25 million coming due in less than 18 months.

Looking back over the last year, what we see is a company that:

  • Is suffering double-digit declines in comp store sales because it sells the sort of expensive indulgence on which consumers are cutting back;
  • Has not been able to articulate a strategy to fix the store-level business model;
  • Cannot afford to build new stores;
  • Might not have a profitable enough business model to attract new franchisees; and
  • Has less unrestricted cash on hand than necessary to repay its debt, and no proven ability to generate cash from operations.

Yes; this is pretty scary stuff.  However, over the last several months, the company has reduced its costs, store labor and SG&A in particular, and closed a number of underperforming stores.  Under James White, who joined JMBA last November, the company has developed a more focused strategic plan, and will further reduce costs while growing its product offering and franchise system.  The combination of a store model that now works better at lower AUVs, and an increase in AUVs through menu expansion, should be effective.  The picture looking ahead shows promise.

New CEO: Focused and Results-Oriented

JMBA’s new CEO, James White, is an experienced brand builder, product developer, and foodservice operator.  He came from Safeway, where he ran an $8 billion retail brand P&L, which included responsibility for brand strategy, R&D, product development, and manufacturing (prior experience includes Gillette, Purina and Minute Maid). He built the “O Organics” line of products for Safeway, through which he developed an extensive rolodex of organic food contract manufacturers.  The line was so successful that Safeway began offering it to other grocery retailers last fall.  He also knows multi-unit foodservice.  Safeway’s in-store foodservice business – essentially a restaurant chain within a grocery store chain – is bigger than Quiznos.

He sees that the brand equity of Jamba Juice is more in the “Jamba” than the “Juice” and that Jamba can grow to be a leading healthy lifestyle brand with broad application and appeal.  But he is not letting these big ideas distract him from the necessary task of creating the maximum positive impact in the least amount of time.  To this end, he has the team focused mainly on four key initiatives:  retail food, franchising, wholesale food/licensing, and local store marketing.

Strategy and Execution

Retail Food – JMBA wants to build a retail food capability across all four day parts (breakfast, lunch, afternoon, and dinner).  Oatmeal has exceeded management’s expectations.  In the coming months, the company will begin rolling out items for other day parts, likely focusing on high-traffic metro area stores where oatmeal has had the greatest uptake.  The company is focused on food items that, like its smoothies and now its oatmeal, are superior to the offerings of competitors, have high margins, are relatively simple to execute in the stores, and are consistent with the Jamba brand’s promise of great tasting, healthy, convenient, fun, on-the-go foods.

I estimate that breakfast and lunch could add $45,000 to $75,000 of annual sales per store ($30-50k of food sales plus an additional $15-25k of blended drink sales from the incremental customer base).  Since food will probably not work equally well in all locations, I would assume that perhaps 75% of stores benefit.  Thus, the overall impact on company-wide same-store sales would be in the range of 6-9%.  I expect minimal impact in the first half of 2009, and very little impact until 2010.

Franchising – JMBA has halted new company-owned store development for now, focusing its current efforts on improving the performance of its existing stores and growing its franchise system.  As of December 31, 2008, 511 stores (70%) were company-owned and 218 (30%) were franchisee-owned.  The company is now targeting something closer to a 50/50 mix. As part of this effort, JMBA is seeking to “refranchise,” or sell back, certain stores to franchisees (so far, ~30 stores have been identified for refranchising, of which the first 10 were sold this month).  For new franchised locations, JMBA is increasing its focus on “non-traditional” locations such as airports, which have been very successful to date.  This shift to a more balanced company-owned/franchised mix will help preserve capital, and lead to higher overall profit margins.

I made some rough estimates of the economics of a new store for each of three types of locations: suburban strip centers, urban metro areas, and airports.  The figures show that the economics of airport locations probably work very well today, which explains why JMBA is focusing on these now.  The suburban and urban metro “traditional” stores are probably adequate for an existing franchisee who can share some labor among stores, but probably fall slightly short of the return required to attract significant numbers of new franchisees.  With food, these locations should provide sufficient returns for a robust franchising model (once franchise capital is generally available again).

jmba-store-model

Wholesale Food/Licensing – White wants to capitalize on one of the things prior management did well: build a strong brand.  JMBA has now hired a senior executive, Susan Shields, to lead a branded CPG effort.  It is focused on licensing, but could include products that are contract manufactured for, and sold by, JMBA or through a JV.  The company has had discussions with potential partners regarding fruit teas, fruit yogurt and parfaits, frozen smoothie bars and sorbets, breakfast and energy bars and packaged boosts.

A successful offering in any one of these packaged food categories could be a $50-$100+ million business, so it is conceivable that a wholesale food effort could deliver $3-5 million per year, or more, of incremental cash flow.  Also, while Nestlé has shelved the licensed RTD smoothie line launched last year, JMBA’s 2008 10-K states, “We believe Nestlé is fully committed to re-launching a Jamba ready-to-drink beverage proposition.”

Local Store Marketing – The company believes that it can reduce spending on traditional advertising and marketing, and more efficiently build store traffic by focusing on “owning the two-mile radius” around each of its stores.  This effort includes off-premise sales such as at schools, and community and sporting events.  It also includes store-level sales incentives, and a greater emphasis on working with non-profit groups for fundraising.

In the short term, this will probably only serve to reduce the decline in same-store sales.  Assuming that retail sales are only just now beginning to bottom-out, without a food program and any enhanced efforts to drive traffic, same-store sales would be negative at least through year-end.  A successful local marketing program should mitigate the decline this year and help drive positive comps next year.

This seems like a lot for a small company to accomplish at once, but according to management, the team is actually focused on doing fewer things, but doing them better, and with a stronger sense of responsibility and accountability.  For example, in the past, development of new food items and licensing opportunities were projects added to somebody’s “normal” work schedule.  Now these initiatives are being driven by people who’s jobs are at stake if these initiatives are not successful.  My sense is that this greater focus and accountability has created a sense of urgency, and a level of positive energy at the “support center” (i.e., corporate office), that has not existed in years.

Risks and Opportunities

A lot could still go wrong, and, as shown in my financial projections, management does not have a lot of cushion.  Some of the many risks to a turnaround include:

  • Higher unemployment rates expected this year could potentially drive overall retail sales and consumer spending significantly lower.
  • The roll-out of lunch items into certain retail stores, which should kick off this spring, might not go smoothly.  Management is making decisions quickly and will recalibrate in the field if/as necessary.
  • Competitors could respond to the food launch with enhanced promotions and other tactics.
  • Costs for fruits, juice concentrates, dairy and other food ingredients are volatile and could spike up due to demand or supply shocks.
  • Weather could have a negative impact on sales and food costs.
  • Gas prices could have a negative impact on sales and food costs.

Of course, there are many other risks, from food-borne illnesses to increased labor and benefits costs.  One can pick up the latest 10-K for the usual laundry list.

However, I believe that with its new leadership, this team can navigate through the current economic environment and execute a successful turnaround.  The current store-level business model works better than one might think, and the strategic shift from a smoothie chain to healthy lifestyle brand will add to both sales and profits.  At a minimum, things should get better.  If management delivers completely on both the tactical turnaround and the strategic changes, the growth will be dramatic:  The strategic shift will not only add to the sales and profits of existing stores, but also (a) substantially increase the number of potential retail sites, and (b) create significant interest in the franchise community.

Financial Projections

Below is a summary of the company’s financial performance in 2007 and 2008, as well as a forecast for 2009.  In the first table, I show annual sales dropping 7.5% to $317 million in 2009.  I assume that food costs average 26.5% of sales versus management’s target of 26%, and labor costs average 36% of sales versus a target of 34%.  The second table shows the 2009 quarterly forecast, and assumptions for same-store sales.  It also shows the resulting trailing 12-month store-level EBITDA and projected unrestricted cash levels.

Same-store sales are modeled assuming two-year cumulative comps, before any impact of new food items and other initiatives, down 15% in Q1’09, and down 14% for the rest of the year.  The new retail food initiative is assumed to add just slightly to comp stores later in ’09.  No sales are included for wholesale/licensed food.  Store growth assumes no new company-owned stores and 50 new franchised locations, per management’s guidance.  The pro forma impact of refranchising 10 Arizona stores is included, but no additional store sales are included.  There is no specific impact for local store marketing, although one could assume this is reflected in the 1-point improvement in compound comps after Q1’09.

These projections show JMBA with a seasonal loss in Q1 but significant positive cash flow in Q2 and Q3 this year.  Store-level EBITDA remains comfortably above the $35 million covenant level.  Unrestricted cash rises to roughly the amount of the company’s outstanding debt in Q3 of this year, then falls to $14.7 million in Q4 after seasonal losses.  Even if comps are roughly 5% down in 2010, the company should still generate enough additional cash to repay the debt when it comes due in September 2010 (although it would be tight).  Successful implementation of the company’s current growth initiatives should provide substantial upside beyond this scenario.

jmba-projection-is-jpg

Quarterly projections are shown below:

jmba-projection-qtr-jpg

Potential Future Valuation and Catalysts

It will be hard to get excited about Q1 results, but a performance in Q2 like that projected above should demonstrate that the company is on the road to recovery.  This could be a catalyst for a significant improvement in the company’s valuation.  Growth in enterprise value to 1.2x ’09 projected store-level EBITDA, or 6.7x ’09 projected EBITDA, would bring the equity market cap to $55 million, or $0.95 per share.  This is my six-month price target. My 12-month target is $1.30 per share (unchanged from December).

Short covering could accelerate this adjustment.  At current prices, there is very little volume.  With short interest of 2.3 million shares as of 3/31/09, “days to cover” was over 31 (see chart here).

An increase in market cap could create an virtuous upward cycle.  Currently, investors who want to own less than 5% of the company are capped at an investment of just over $1 million, which is just not meaningful for many institutional investors.  As JMBA’s valuation improves, the stock will become more relevant.

Another potential catalyst would be coverage by a major sell-side analyst.  Recent investments in JMBA by PE group CIC Advantage and value fund manager Royce & Associates may help renew interest in the analyst community.  A restaurant industry analyst from Piper Jaffray was on the last earnings call.  I would not be surprised to see them pick up coverage again once the company demonstrates more progress on its turnaround.

(Disclosure: The author is long JMBA)

Copyright © 2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.
www.aptacapital.com John Appel

XL Capital: Short Interest Poised to Drop – Will the Stock Pop?

XL Capital (XL) is a company that the market loves to hate. Its stock price has plummeted by 94% over the last twelve months, mainly over concerns about its investment portfolio.  (For a more in-depth discussion of XL’s past troubles, please see my article from November 25th, “Reinsurer Stocks: A Fear-Driven Market Creates Opportunity.”)  The stock could tick up a bit in connection with the unwinding of hedges related to forward share purchase contracts that settle on February 17th.  The company’s fourth quarter earnings call on February 11th could also bring positive news that lifts share prices, perhaps accelerating the hedge unwinds, and potentially leading to further short covering.

Short interest in XL stock is the highest of all commercial lines insurance companies as a percentage of float, at 9.3%, according to a recent Credit Suisse report. One might be tempted to view this as a sign that many investors believe the stock is headed to zero soon.  However, there is more to this story.

Most of these short sales are likely to be hedges rather than speculative plays.  XL has entered into forward sale agreements on up to 47.4 million common shares.  Much of the current short interest of 30.5 million shares is probably related to hedges of these agreements.

Equity Security Units

The forward purchase/sale agreements are part of $1.32 billion of outstanding “Equity Security Units” comprised of:

•    $745 million of 7% Equity Security Units sold on December 9, 2005 (prospectus), and
•    $575 million of 10.75% Equity Security Units sold on August 5, 2008 (prospectus).

Each unit consists of a portion of a note and a contract to purchase a like amount of common shares at a minimum price.  The minimum price to be paid by holders of the 7% units is $65 per share.  Quite a premium compared to today’s price of under $3 per share!

The Equity Security Units are a bit complicated, but essentially what happens is that on the “settlement date,” the unit holders are required to purchase shares of common stock at some price between the minimum price and a maximum threshold price.  At the same time, the related notes are remarketed.  That is, they are reoffered for sale at a new interest rate intended to bring the price (net of a small remarketing fee) back to par.  If the notes are successfully remarketed, the unit holders use the proceeds of the remarketing to fulfill their common stock purchase obligations.  If the notes are not successfully remarketed, XL can use the notes to fund the common stock purchases.  Thus, from XL’s perspective, the worst case is that the units act like convertible debt that converts on the settlement date.  The best case is that the notes remain outstanding after a successful remarketing, and the purchased common stock is incremental new capital.

Partial Hedge Unwind Coming

The settlement date for the 7% units is February 17, 2009.  The unit holders will be required to purchase an aggregate of 11.46 million common shares for $65.00 per share, or $745 million in total. (XL hired Goldman Sachs to remarket the notes.  To the extent they are successful, the common share purchase will constitute incremental capital.  If Goldman is not successful, the notes will effectively “convert” into common at $65 per share – adding to common equity but not total capital.)

The chart below shows that less than half of the 7% units were hedged while the common stock was trading well above the minimum forward price.  As the stock price broke through $65 per share, short interest grew, reaching about 12 million shares as the price passed through $40 per share.  At that point, the 7% units were probably fully hedged.  Short interest popped up by over 10 million shares, to approximately 25 million shares, when the 10.75% units were issued.  Short interest approached its current level of 30.5 million shares last October, as the stock price fell below $10 per share.

xl-shorts-since-05

If all $745 million of stock purchase obligations related to the 7% units are hedged with short sales, short interest should decline by at least 11.5 million shares near the contract settlement date of February 17th.  The stock could see some upward pressure as these short sales are covered, although the impact would be small, as the covered shorts would represent just over 1x average daily trading volume.

Earnings Call

The impact from short covering could be eclipsed by reactions to the company’s fourth quarter earnings announcement on February 10th and analyst call on February 11th.

XL’s shares reached a low closing price of $2.68 last December after the company announced that mark-to-market and impairment losses on its investment portfolio as of December 10th would be consistent with amounts for the prior quarter, or approximately $1.1 billion, and, as a result (i) analysts cut prices targets significantly, and (ii) S&P, Moody’s, and Fitch cut XL’s ratings again.

The main reason for the negative action by sell-side analysts was concern that additional investment losses could lead to a need to raise dilutive capital.  As for the ratings cuts, these actually seemed to be driven less by potential balance sheet issues (although these were cited, of course) than by a concern that the company’s financial problems could have damaged its reputation to the point that it could lose a meaningful amount of business at January 1 renewals and beyond, or that it would need to under-price business to retain it, or both.

After rising to $4.69 per share on January 9th, the stock has retested its $2.68 December low.  At this price, which is only about 0.15x book value, the bad news is once again priced in.  It would take a large negative surprise to drive shares down significantly, and anything short of disastrous news should send shares higher.

It does not seem likely that investment losses will exceed last December’s guidance.  Market prices for many classes of securities held by XL – such as high-grade corporates and securities backed by subprime loans and commercial real estate loans – were higher at year-end than at the time XL provided guidance.  Thus, investment losses might come in slightly better than expected.  However, it is more likely that any benefits from lower rates and tighter spreads are offset by additional marks on other asset classes, such as investments in hedge funds.

It is difficult to predict XL’s Q4 revenue and operating profit, and to know how well XL fared in January renewals.  However, there is no indication that XL’s business has fallen off substantially. According to Business Insurance (article), XL’s policyholders are not abandoning the company (although they are watching things carefully), and XL is being offered the opportunity to bid on new business.  However, Business Insurance implied that D&O coverage could be one area where XL may be more vulnerable.

This is consistent with what other insurers have been saying on recent earnings calls.  Some companies have mentioned that risk managers have not been as willing to move business as they had expected.  However, ACE Ltd. (ACE) said that its D&O business has benefited from a significant “flight to quality.”  It is not clear if this has come at the expense of AIG, XL or both.

So far, financial results announced by competitors have been mixed.  However, 2009 guidance has been consistently positive.  Pricing appears to be more rational overall, and has firmed slightly in most lines of business.  Expectations are for further improvement throughout the year.

According to the company’s website, the median analyst estimate for Q4 EPS is $0.35 and the median estimate of book value per share is $21.65, about flat with the prior quarter.  Bloomberg shows consensus estimates of $0.43 for adjusted EPS and $19.36 for BV/shr.  The latter BV/shr figure is more consistent with management’s December guidance on investment losses.  Book value could be reduced further by the impact of a stronger dollar.

On the February 11th call, management should be able to make a convincing argument that the franchise is still very much alive, and that profitable growth will be forthcoming in 2009.  If the company surprises on the upside, positive movement in the stock could be enhanced by some short covering beyond the unwinding of hedges on the 7% Equity Security Units.

(Disclosure: the author is long XL, as well as ACE, AXS, PRE and VR)

Copyright © 2008-2009 by John G. Appel. All rights reserved. You may link to any Content on this website. You may not republish, upload, post, transmit or distribute any Content without prior written permission. If you are interested in reprinting, republishing or distributing Content, please contact John Appel via the e-mail address shown on this website to obtain written consent. Modification of Content or use of Content for any purpose other than your own personal, noncommercial use is a violation of our copyright and other proprietary rights, and can subject you to legal liability. Disclaimer: This website is provided for informational purposes only. Nothing on this website is intended to provide personally tailored advice concerning the nature, potential, value or suitability of any particular security, portfolio or securities, transaction, investment strategy or other matter. You are solely responsible for any investment decisions that you make. Terms of Use: By using the site, you agree to abide by the Terms of Use, which includes further copyright information and disclaimers.

Cott Corp. – Could go Far, But Somebody Needs to Grab the Wheel

Cott Corp. is the world’s largest supplier of retailer brand soft drinks, and the fourth largest nonalcoholic beverage maker.  Given the recent growth trends in private label, Cott should be doing well.  Unfortunately, in 2006, when faced with slowing growth and shrinking margins, instead of striving to become a better and more efficient producer, the company abandoned its historical business plan and entered the uncharted territory of enhanced waters and energy drinks – with its own brands.  This plan failed miserably: Cott alienated its core retail customers; healthy profits turned to losses; and debt mounted to the point that the company can barely service it.

In May 2006, Cott’s board pushed out its CEO, John Sheppard, who had built EBITDA to roughly $200 million through acquisitions and a focus on efficient manufacturing, and brought in a new CEO, Brent Willis, to execute the new plan.  From then until March 2008 when Willis departed, Cott’s stock dropped from $15 to $2 per share, wiping out nearly $1 billion of equity value.  Today, it trades at around $1.00 per share, less than tangible book value.  As I explain below, this could be an $8.00 stock if the company successfully implements its plan to cut costs and return to its roots.  But it is a long, long way from here to there.  If the company does not get capable leadership soon, it may never get there.

Crescendo Shakes Things Up

Activist investor Crescendo Partners must have seen the upside opportunity when it purchased 8.7% of the company’s stock between March and May of this year.  Crescendo installed four new directors and proposed that the former VP of Canadian Operations and Global Sourcing for Cott, Csaba Reider, become CEO.  Crescendo then pushed the company to slash costs and get back to basics.  On June 19th, the company announced its plan to increase cash flow by $39-43 million by refocusing on its core business, cutting G&A expense, and improving the efficiency of its bottled water operations.  The cost cuts started with the elimination of several senior executives.

Unfortunately, the damage done by Cott’s management may have been worse than even Crescendo realized, and the path to profitability looks pretty long and bumpy.  It may take complete board control, not just the influence of an activist investor, to steer this company back into the clear.

Highly Leveraged – The Natives Must Be Restless

With debt approaching 5x run-rate EBITDA – and 8x run-rate EBITDA less normalized CapEx[1] – the company’s balance sheet may force some sort of recapitalization, or reorganization, before the company is able to execute this plan.  Cott’s $269 million of 8% Senior Subordinated Notes are due in just over three years.  Its new ABL facility ($131 million drawn as of 6/28/08 ) also comes due at that time if the 8% Notes are not refinanced before then. The 8% Notes, which were recently downgraded by both S&P and Moody’s and trade at a significant discount, will not be easy to refinance.

A patient lender, with confidence in management, would give the team the runway to execute a turnaround.  But who would trust this team?  The quality, consistency and transparency of its financial reporting, the reliability of its communications to investors, and the execution of its current turnaround plan have all been disappointing.

Crisis of Confidence

It’s hard to believe in a company when you can’t rely on its financial statements.  Cott’s auditors have sited significant internal control issues affecting the accuracy of its financial statements, and state that “management oversight… could not be relied on to mitigate [these issues].”[2]   Recent events indicate that despite management changes earlier this year, things have not gotten better.

In its second quarter earnings call on July 31st, management said that it expected “adjusted operating profit” for 2008 to be 50% to 70% above 2007’s figure of $36.3 million.  On the call, an analyst challenged this assertion, stating that given that adjusted operating profit for the first six months was approximately zero, “something fairly heroic has to happen in the next six months” to meet those projections.  Management defended its position.  However, less than a month later, on August 26th, the company said it would not hit these targets and revised its 2008 guidance downward dramatically, saying that adjusted operating profit would range from down 5% to up 28% versus 2007. I think this is still optimistic.[3]

On July 31, management said that the reduction in shelf space at Wal-Mart didn’t seem to be having a material negative impact on sales; that they were on track to deliver their cost savings plan; that their “water project,” which was to deliver over half[4] of the roughly $40 million in cash flow increase from the turnaround plan, was going smoothly; and that they and a commodity cost advantage over their competition this year.  By August 26th, they said that the sales decline was more severe than anticipated due to heavy promotional activity by competitors; their savings targets for this year would not be met; the water project was hampered by cost overruns and delays; and commodity costs were squeezing margins.

If management gives us positive news on the October 25th Q3 conference call, will they retract it a few weeks later? [Update – I have been told the call will now be in November]

The Clock is Ticking – With Lenders And Customers

Cott needs to move immediately to assure its customers that it is a capable, long-term partner, and assure its lenders and investors that it has a handle on its business.  This means hiring a CEO who will inspire confidence, and making the other management changes necessary to insure that the company can provide some reliable visibility into its future performance.  It is not clear that Crescendo’s CEO candidate is the right person for this situation.  Rather than somebody with no prior CEO experience, I would like to see a seasoned company leader with real turnaround experience at the helm.

If the company does not act quickly, its customers and lenders will lose confidence completely, taking the company into a downward spiral from which it may not be able to recover.  Its retailer customers need a manufacturer for their store brand beverages, but Cott is not their only choice for private label production.  Dr Pepper Snapple Group (NYSE: DPS) and National Beverage (Nasdaq: FIZZ)[5] also have meaningful private label operations and capacity.  It is not clear if they have enough capacity to service Wal-Mart and all of Cott’s other customers, but if Cott were to lose Wal-Mart, DPS and National Beverage could buy whatever additional capacity they needed from Cott’s lenders for pennies on the dollar.

Low Stock Price Does Not Mean Good Value

At $1.00 per share, Cott’s total equity value is about $72MM and the enterprise value is approximately $500MM, as shown below.  (This value assumes that any discount one could get on the company’s 8% subordinated notes is offset by non-debt liabilities not included in this enterprise value calculation.)

Enterprise Value at $1.00 Share based on 6/30/08 Balance Sheet ($MM):


At this price, the enterprise value is 5.4x my estimate of adjusted EBITDA for the twelve months ended 6/28/08, and 5.7x my estimate of run-rate adjusted EBITDA (see “Financial Summary” below for EBITDA calculations). If one believes in the turnaround, the price is low, because it is only about 4x pro forma adjusted EBITDA after turnaround savings.  If one has completely lost faith in management, the price is high and does not reflect negative sales trends and significant default risk.  The current market price seems to suggest that the turnaround upside and default risk downside roughly offset each other.

Current Stock Price Still has Big Downside Risk

If confidence is not restored soon, default risk may become the dominant issue, in which case the stock price should go below $0.50 per share.  At $0.50 per share, the company would be valued at about 5x adjusted EBITDA.  One could argue that even this multiple is high, and that the company is not worth more than its debt, but I won’t go that far.  The replacement value of its manufacturing assets and the value of its rights to the RC Cola brand internationally should put a floor on the equity value.

G&A Needs Further Cuts

Cott needs $40-$50 million of additional EBITDA right away just to get its leverage down to a comfortable level.  Thus, the maximum $40+MM of savings from the turnaround plan MUST be achieved ASAP.  To make success more certain, Cott should target deeper cuts in the primary controllable cost: G&A.  Instead of sizing G&A to where the company wants to be, it should size it to where it is headed today.  The planned G&A cuts should be $30MM, not $20MM.  This will provide more certainty that the total savings can be achieved soon even if the operational/COGS fixes take longer than planned.

The company needs to adjust not only head-count, but also salaries and board fees.  Last year, the board of directors paid itself a whopping $1.8 million in cash director’s fees.  The interim CEO, David Gibbons, is being paid at a rate of $850,000 per year (including directors fees), plus a grant of 720,000 shares of stock.  Their current CFO made $800,000 in total comp for 2007. How can this be justified?

Crescendo’s CEO candidate has agreed to work for a salary of $625,000 and a bonus of up to 100% of salary.  How about a salary of about $400,000 and a performance-based bonus plus stock options to make up the difference?  Cott needs a leader who will bet his paycheck on his performance.

The Upside – Possibility or Pipe Dream?

With $40-$50MM of additional cash flow – initially driven by G&A cuts and later by the “water project” and improvements in the company’s business model – EBITDA could get to $120-130MM and debt would be reduced to below 3.5x EBITDA (see “Financial Summary” below).  With a return to growth and profitability taking the EBITDA multiple up to 8x, the company’s stock could be worth $8.00.

But without new leadership, this seems like a pipe dream.  The way things are going, it seems more likely that weak revenues and cost overruns lead to a cash crunch, which could lead to a death spiral.

Great Meal for a Vulture

Now is the time for action by an industry acquirer, or a private equity group with the ability to capitalize Cott properly.  Several other firms have circled Cott in recent years, but now this deal may have gotten too small for them.  Likely strategic buyers are National Beverage and Dr Pepper Snapple Group.  DPS is still highly leveraged after its “demerger” with Cadbury and has a number its own issues to deal with, so FIZZ, which has no debt, is probably the better acquirer at the moment.  Cott would also be a great fit with Polar Beverages, which has a strong position in the Northeast.  Ralph Crowley, Polar’s CEO, has a good eye for a bargain.

The Numbers

Below is a summary of historical income statement data, along with my estimate of run rates as of 6/30/08, including adjusted operating profit, and my view on adjusted EBITDA.  I have added a pro forma run rate adjusted EBITDA figure, factoring in management’s expected savings from the turnaround plan. The market seems to be anticipating adjusted EBITDA in the mid-$80MM range, but an EBITDA of $125MM or more seems to be within reach.  If Cott had the right leader, it would be a lot easier to imagine that possibility.  At the moment, it seems easier to imagine a restructuring.

______________________

(a) Annualized by applying 6-month growth rate to 2007 full year figure.
(b) Annualized revenue multiplied by the ratio of LTM COGS to LTM revenue.
(c) Equal to LTM figure.

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[1] In the Q2 earnings call, management said that capital expenditures should be $30-$35 million next year, excluding the “water project.”  I assume this is “normalized” capex.

[2] In its 10-K filing for 2007, the company states that it had “material weaknesses” in its internal controls, “… affecting the financial statement balances of cost of sales; selling, general and administrative expenses; accounts receivable; amortization; income tax (benefit) expense; accounts payable; intangible assets; deferred income tax assets and shareowners equity recorded in the financial statements as of December 29, 2007.”  It also said that, ”… management oversight within the financial close process … could not be relied on to mitigate the segregation of duties internal control deficiencies.”

[3] In my Financial Summary, I estimate the run-rate adjusted operating profit to be approximately zero as of 6/30 based on year-on-year trends.  Given the lack of progress on operational improvements and continued deterioration in revenue, I think that 2008 adjusted operating profit is more likely to be down 100% than down 5% as predicted by management.

[4] Cott management said that the “water project” would take their water business, equal to 17% of North American revenue, from a zero gross margin to a “fair” gross margin.

[5] If one wants to be long in this sector but does not have the stomach for Cott, National Beverage could be an interesting pick.  It has steady cash flow and no debt, and trades at about 7x EBITDA….

(Disclosure: the author is long COT stock)

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