Cott Corporation (COT) – I think not.

December 27, 2013

Like many investors, I’ve always liked used basic company statistics as a screen to identify companies worthy of more in-depth investigation. I readily admit that there are many qualitative aspects to a company that are unlikely to show up in the figures, but on the other hand, a corporation is a device that turns cash into (hopefully) more cash, and so qualitative aspects are important only to the extent that they can be expected to show up in the numbers eventually, and when it comes to stock purchases, a false positive (buying a stock that shouldn’t have been bought) strikes me as more painful than a false negative (not buying a stock that should have been bought), and at any rate, I don’t always have the patience to heed Warren Buffett’s advice to just “start with the A’s”.

However, a screener is only the first step. Although the goal of screening is to identify a company with a high free cash flow yield, the subsequent analysis and digging into the SEC filings and other useful sources is to determine whether the historical performance is likely to be repeated or whether the same is doubtful, because many companies have low multiples for a reason.
open blank soda can6636619Such a company, unfortunately, is Cott Corporation, which produces private-label sodas and other beverages. Although its free cash flow yield based on historical performance is a robust 10% when excess cash is taken into account, the company’s competitive position and the movement against sugared beverages cause me concern as to whether these cash flows will be likely to repeat themselves in future, and the performance during the current fiscal year seems to suggest that things are already beginning to unravel. I know it is a common weakness of analysts that we cannot see two points without drawing a line through them, nor three points without drawing a curve as well, but again, false positives…

Cott corporation’s produces soft drinks, juices and juice products, flavored waters, energy drinks, sports drinks, teas, and some alcoholic beverages as well. It operates in the private-label, or store-brand markets, and has operations in the United States, Canada, and the United Kingdom. The company is the largest private-label producer in the United States and the United Kingdom. Lately the firm been trying to diversify away from carbonated beverages, reducing them from 50.4% of total sales in 2010 to 39.1% in 2012, a goal that has been partially accomplished through acquisitions.

Naturally, much of Cott’s business is concentrated among the large grocery store chains that can sponsor a store brand, with over 10% of its sales coming from Wal-Mart alone. The company uses long-term supply contracts, but apparently its ability to pass increasing costs on to its customers, as the company also relies on futures contracts for aluminum, corn, and sugar, as well as forward contracts for plastics and other ingredients when available.

The company’s market cap as of this writing is $760 million, and based on its latest balance sheet there was $126 million in cash and its noncash current assets exceed its current liabilities, indicating that the cash can be treated as excess. Thus, the market value of Cott’s operating assets is $634 million.

On the free cash flow side, in 2012 sales were $2.251 billion, gross profit was $290 million for a gross margin of 12.9%. Operating income as reported was $110 million, depreciation was $101 million and capital expenditure $75 million, resulting in operating cash flow of $136 million. Interest expense was $56 million, leaving $80 million, which after estimated taxes of 15% (Cott is headquartered in Canada where corporate taxes are lower than in the United States), free cash flow was $68 million, and subtracting $4 million for noncontrolling interests gives free cash flow to shareholders of $64 million. This works out to a free cash flow yield of just above 10%.

In 2011, sales were $2.337 billion, and gross profit $277 million for a gross margin of $11.8%. Operating income as reported was $101 million, depreciation was $99 million and capital expenditures $55 million, plus $2 million in noncash impairments, producing operating cash flow of $147 million. Interest expense was $57 million, leaving $90 million, which is $77 million after estimated taxes. After subtracting noncontrolling interests of $4 million, we have free cash flow to shareholders of $73 million.

In 2010, sales were $1.803 billion, gross profit of $266 million and gross margin of 14.8%. Free cash flow to common shareholders was $64 million.

Cott claims that in 2012 it exited certain low-margin businesses, which lowered sales but expanded margins. It also explains the increased capital expenditure as being part of a vertical integration program. In 2010, Cott acquired a private-label juice company for $500 million, which explains the jump in sales between 2010 and 2011.

As I stated before, the cash flow situation at Cott seems to be unraveling somewhat already as 2013 goes on. During the first three quarters of 2013, sales were $1.612 billion versus $1.773 in 2012, gross profit $198 million versus $229 million and gross margins 12.3% versus 13.2%. Operating income was $74 million versus $93 million, and ultimately free cash flow to shareholders was $49 million versus $58 million. The fourth quarter is typically not a large contributor to earnings, as one expects during winter from a company that sells nice cold drinks.

Normally, I would warn against making too much of the results of a single quarter or year, as the information content of those results often does not explain the wild swings in prices that accompany their release. But what the results do make clear is that Cott Corporation’s margins are unstable, and this will be the case even if Cott does manage to reverse the current decline in earnings. These unstable margins are a telling symptom of Cott’s unenviable competitive position. More than half of its earnings come from only 10% of its customers, and 10% of its sales come from Wal-Mart alone, and anecdotally being a Wal-Mart supplier is said to be a highly frustrating experience. Furthermore, as stated above Cott has difficulty in transmitting changes in input costs to its customers, hence the push towards vertical integration in 2012.

Furthermore, although the company is looking to expand its range of offerings, the largest category of sales are still private-label sodas, which are currently under attack as the cause of obesity, even outside of New York City. Furthermore, sodas are a low-margin business anyway; in 2012, although they represented only 41% of Cott’s sales volume, they were 63% of its physical volume. And unfortunately for Cott, the market for private-label sodas is naturally constrained because of the presence of the leading brands, which are in a position to suck up a great deal of any rebound in the popularity of soda. As Ross Johnson, then-CEO of Nabisco and a fellow Canadian, said years ago in Barbarians at the Gate, he had to sell off Canada Dry because even if the company could walk on water, Pepsi and Coca-Cola are waiting on the other side.

For these reasons, despite the apparently attractive yields of Cott Corporation, I cannot recommend it as a candidate for portfolio inclusion.

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