Description

Coca-Cola Bottling Company Consolidated (CCBCC) is undergoing a business transformation, is misunderstood by the Street and is trading at a low multiple of its Pro Forma earnings power.  I think the shares may be trading at under 12.5x PF Cash EPS, once the dust settles from all of the announced transactions.

The company is the largest independent Coca-Cola bottler in the United States.  Pro Forma for its announced transactions, CCBCC will have gone from distributing ~7% of Coke’s volumes in the US in 2010 to ~20%.  The company has a $1.3 billion market cap ($2.2bn EV), though The Coca-Cola Company owns 34.8% of the shares and there is a dual-class structure (the B shares have 20:1 voting rights and the Chairman/CEO J Frank Harrison, III controls 86% of the voting rights).

For those not following, The Coca-Cola Company (TCCC) acquired a large portion of its system’s North American bottling assets from Coca-Cola Enterprises (CCE) in 2010 for $12.2bn, following a very contentious and underperforming period for CCE in 2008, and following PepsiCo’s acquisition of its two large US bottlers in 2009.  Coke attempted to “fix” the North American bottler and extract cost synergies to reinvest in the business.  In April 2013, TCCC announced its intention to refranchise pieces of its US bottling operations back to its bottling partners by the end of 2020.  In September 2015, TCCC announced plans to sell off its manufacturing facilities in addition to distribution assets, and in February 2016, TCCC announced an accelerated timeline to the refranchising process, committing to refranchising 100% of the US (including all cold-fill manufacturing facilities) by the end of 2017.

For CCCBC, there are three reasons why I think the acquisition of these bottling assets will prove to be very attractive:

·         The company is acquiring the assets at very low valuations

·         It is funding the transactions with cheap debt

·         There is a sizeable opportunity to run the assets better

The market has realized that this refranchising process will be beneficial to CCBCC (its share price increased 107% in 2015).  Still, the complexity of the transactions, the lack of analyzable numbers, the partially blanked-out contracts filed with the SEC, the quiet management team (no conference calls and very difficult to get ahold of) and the lack of sell-side coverage (1 analyst) lead me to believe that the PF earnings power is still misunderstood.

Potential for Operational Improvement

I’ll start with the third reason first, as it is a bit more qualitative.  If you speak with other US Coke bottlers, they’ll tell you that TCCC is getting out of bottling “because they suck at it”.  Under TCCC ownership, less capital was invested in the distribution assets and management was more focused just on the product.  They figured they could just distribute nationally, and really strayed from the local focus.

As an example: if you go into a local supermarket, the shelf-space in the beverage aisle is pre-defined (national contracts, product placement, slotting fees).  But, if you keep walking around the store, you can find spots for additional placements (e.g. bottles of Coca-Cola by the Tortilla chips, Vitamin Water by the pharmacy, end caps, meal-deal coupons with CSDs and meats by the deli, etc.).  All of these additional placement spots are negotiated locally.  Plus, you are not paying for that space so it’s more profitable.  What basically seems to have happened under TCCC ownership is that Coke lost the local relationships and as a result- in some markets- lost market share and loss margins from less scale.  Despite hundreds of millions of dollars of announced synergies, TCCC’s owned US bottling operations margins are supposedly below where they were when they acquired the business in 2010.

While it’s early days, every bottler that has acquired new territory from Coke, has outperformed initial expectations (except for one smaller bottler).

I’ve also heard in conversations that Coke made a lot of questionable investment decision in production facilities and have a liberal pay schedule (pay more than they need to).

All of this should translate into a large opportunity for the incentivized local bottling partners.  CCBCC itself cites the benefits from acquiring the contiguous geographies in their shareholder letter:

·         Increased scale

·         Revenue synergies

·         Operating efficiencies

·         Local market knowledge

·         Expansion of adjacency business

Background

CCBCC is the largest independent Coca-Cola bottler in the United States.  Historically, the company’s footprint included markets in North Carolina, South Carolina, south Alabama, south Georgia, central Tennessee, western Virginia and West Virginia.  After signing a Letter of Intent with TCCC to acquire distribution rights to a number of territories, the Company has entered into 11 transactions/exchanges (detailed below) for Distribution rights and Manufacturing facilities in various geographies.  The company is expected to enter into 6 more transactions/exchanges in the next ~6-12 months.

The Distribution transactions include 3 components: 1) Distribution Assets (warehouses, delivery trucks, etc.), 2) Distribution rights for Coca-Cola products, 3) Distribution rights for cross-licensed brands (rights to distribute certain brands not owned or licensed by TCCC).  As part of the transactions, the Company entered into Comprehensive Beverage Agreements (CBAs) with TCCC that dictate rights/obligations.  The CBAs are for a term of ten years and are automatically renewed for another ten years at the end of the term.  Notably, for the Distribution Rights for the Coca-Cola brands, the transactions are structured so that TCCC is just granting territorial rights (CCBCC is not acquiring them).  The accounting is funny (see below), but CCBCC makes quarterly sub-bottling payments back to TCCC. 

The manufacturing facility transactions are slightly more recent.  CCBCC, along with other large bottlers Coke UNITED and Swire Coca-Cola have been named regional producing bottlers.  Along with TCCC, they have formed a National Product Supply Group, which is intended to optimize system infrastructure and lead to the lowest optimal delivered cost.

As you can see, many of the closed transactions have closed recently.  The company provides a good breakdown of the contribution of sales/earnings from the “Expansion Territories”, but given that most of the transactions are recent and we don’t know the multiples of the transactions, it’s tough to get a sense of current run-rate earnings power.

Below, I will attempt to sketch out what I think is the pro forma earnings power.  However, I will caveat that these estimates are highly uncertain, and are more illustrative to attempt to quantify the return the company will be receiving on ~$600m-worth of M&A.  If anyone has estimates they think are more accurate, I am all ears.

What we do know is that CCBCC did $860 million in Pro Forma Net Sales in 2Q16 (PF for the completed transactions) and $1.613 billion in PF Net Sales for 1H16.  Given typical seasonality, this translates to $3.2 billion in run-rate Net Sales.  Assuming a 5.5% EBITA Margin (the company is targeting 5-6% EBIT margins PF for the announced transactions) gets to ~$177 million of EBITA (CCBC’s consolidated Adjusted EBITA Margins were 5.8% in 2014 and 5.3% in 2015…excluding Expansion territories which were a drag, Adjusted EBITA margins were above 6% in 2015).

Next, we know the size of two of the upcoming transactions per the 8-K filed on September 6^th (the 3 manufacturing facilities in Cincinnati and Indiana and the Distribution Rights for Central/Southern Ohio, Northern Kentucky and Indiana).  I make an assumption for the multiple paid, though this is highly guarded information.  The company pays book value for the manufacturing facilities and a multiple of EBITDA for the Distribution rights…I have heard low-single-digit blended EV/EBITDA multiples from several sources, and, if you look at the prices paid for the 2015 and YTD 2016 acquisitions and compare to the Q2 EBITDA from these acquisitions of ~$22m, this looks feasible.  It is worth noting that, given TCCC currently does not operate these businesses standalone the EBITDA being sold off is subjective, based on Coke’s cost allocation.  I think it is likely that TCCC is telling inquiring investors it is selling these assets for a higher earnings multiple than it actually is.

I also make an assumption for the multiple and size of the Northern Ohio and Northern West Virginia transaction (based on estimated population size). 

All in, this gets me to an incremental ~$55 million in EBITA.  So Net, Net I think with the PF asset base the company does ~$230 million in EBITA, before any operational improvements or synergies.  After deducting interest expense (I have PF debt at ~$1.1bn- after a payment from TCCC equal to 0.5x Legacy territory EBITDA as part of the final CBA), sub-bottling payments, taxes and non-controlling interests, this gets me to ~$11.60 in Cash EPS (EPS Plus Amortization of Intangibles, implying a valuation of roughly 12.4x P/E

Quarterly Sub-Bottling Payments

To incentivize capable bottling partners to participate in the refranchising, TCCC is offering the assets at relatively low valuations.  The company has written-down billions of dollars of intangible assets related to the original CCE transaction ($1bn in 2014, $800m in 2015, $560m in 2016) and is receiving tax-benefits as a result.  TCCC is keeping the territorial rights on their balance sheet, but intends to recoup some of the losses through quarterly sub-bottling payments from bottlers acquiring distribution territories.  Because the payments are dependent on the bottlers’ future gross profit (% of gross profit), the SEC is forcing TCCC and CCBCC to account for these payments as contingent consideration.  As such, the NPV of the payments over 40 years is represented as a liability on the CCBCC’s balance sheet.  The payments flow through in Cash Flows from Financing, but the change in the Fair Value of the liability (which incorporates both the payments and change in the estimated PV of the liability) flows through in “Other Expenses” on the Income Statement.

I have heard through my diligence that some of these sub-bottling payments may go away once the manufacturing facilities are up and running, but I haven’t been able to confirm this. The Regional Manufacturing Agreements and CBAs filed with the SEC have a fair bit of detail excluded from them.  For the transactions already closed, the company currently expects $10-$18m of sub-bottling payments per annum.

Other Opportunities

·         The Coca-Cola Company currently has a $3 billion cost savings program in place.  As a result of the announced selling off of the manufacturing facilities, TCCC management has said that roughly $500 million of supply chain savings will not be recognized by the company but rather the bottling partners acquiring the plants.  Given that CCBCC has committed to acquiring (so far) 8 of the 48 announced cold-fill production facilities, it’s “share” of the savings in theory could be worth somewhere in the ~$83 million range.  I have no idea if any of this will be recognized (or flow-through to the bottom-line), but it is worth noting

·         Monster – On April 6, 2015, CCBCC entered a new distribution agreement with Monster that substantially expanded the territory where the company has rights to distribute its energy products.  Monster was responsible for the majority of the Company’s 6% volume growth in 2015.  Even over one-year after the expanded distribution, energy drinks are likely driving the growth (4.5% volume growth in legacy/2014 territories in 2Q16).  Energy drinks are particularly profitable as they are represent a higher % of the company’s revenue vs. volumes and a higher % of the company’s Gross Profit vs. revenue

·         The refranchising partners for the tri-state region have not yet been announced and it’s conceivable that CCBCC could go after it

State of The Red System

There are signs that The Coca-Cola Company is pursuing a path that is much more favorable for its bottlers than in times past.  For the first time in 116 years, TCCC is no longer chasing volume as its top operating priority (executive compensation is no longer tied to volume growth, the 2020 volume target has been dropped).  The bottling models in North America no longer charges a fixed rate per gallon, or percentage of revenue, but a percentage of gross profit.  TCCC is encouraging consolidation of its bottlers in Africa, China and Europe.  There is a relatively new management (President/COO, CMO, CFO), new board members and rumors that Muhtar Kent may step down as CEO (to just Chairman) at some point in the near future.

Much has been written over the years about the problems inherent in Coke’s problematic push-volume model in the US, the dilution to the brand from 2L bottles at Wal-Mart and super-sized fountain drinks.  Coke analysts have pointed to the Mexican bottlers as examples where clear rules and aligned incentives have led to a superior distribution model (“up and down the street”), dominant market share and intelligent price/package architecture.  The model is finally changing in the US, with Coke better positioned to capture the value of its core brands and the US bottlers should see outsized economic benefits as a result.

Current Trends

Per the Nielsen data, CSD sales for the industry are down 0.5% in the past 52 weeks through August (with volumes down 2.5% and pricing up 2%) with Low-Calorie options declining and Regular CSDs more flattish.  Coke’s aggregate performance (CSDs + Juices + Water + Isotonics) sales are up 1.5% in the past 52 weeks (volumes +0.7%, pricing +0.8%).  The current CSD environment can be viewed as price-rational, and slow secular decline.  Low-calorie and Diet CSDs are still stuck in a tailspin that has lasted for a few years now.

For CCBCC Organic volumes grew 6% in 2015 (price/mix grew 4.9%), 2.7% in 2014 (price/mix grew 1.4%) and declined 0.9% in 2013 (price/mix up 1.0%)

Notes on CCBCC

The company is not exactly the most attractive Coke bottler on the planet.  68% of sales are for “future consumption” (vs. immediate), 20% of sales are to Wal-Mart (and 8% more are to Food-Lion).  54% of sales are in bottles, 45% are cans.  Sparking beverage represents ~66% of Bottle/Can sales to retail customers (Energy sales are now counted as “still” as of 2Q16). Margins are low (~6% EBIT Margins on legacy business) driven by high SD&A/Sales (sales management labor, distribution costs, depreciation on trucks and fridges), with CapEx currently pacing ahead of depreciation.  Asset turns have improved over the years: from below 1.0x in 2004 to above 1.3x by 2013.

Risks

·         Health and wellness trends

·         Commodity Prices (aluminum, corn, PET, oil)

·         Higher-than-expected capital spend (“pink trucks” acquired from TCCC)

·         Funding future territory transactions with Equity vs. Debt (though management has stated it intends to finance all the transactions with debt)

·         Higher-than-anticipated transaction multiples, lower-than-anticipated margins on acquired businesses

Catalyst

Continued integration of announced transactions