By Alex Gavrish, Etalon Investment Research; author of “Wall Street: Back To Basics

DSS Group transaction

On November 6th, 2014, Cott Corporation (NYSE:COT) announced that it will acquire DSS Group, Inc., parent company to DS Services of America, Inc. (“DSS”), a leading water and coffee direct-to-consumer services provider in the United States, for approximately $1.25 billion, or approximately 7.1x 2014E adjusted DSS EBITDA, including the assumption of debt and the issuance of preferred shares to Crestview Partners and other selling shareholders. According to company’s press release, the acquisition will extend Cott’s beverage portfolio into new and growing markets, including water and coffee home and office delivery services, water filtration services, and retail services, while creating cost synergies as well as portfolio expansion. In addition, the acquisition is expected to broaden the distribution platform of Cott by adding a national direct-to-consumer distribution channel with the 2,100 customer routes operated by DSS.

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DS Services company profile

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DS Services is a national direct-to-consumer provider of bottled water, office coffee and water filtration services. DS Services offers a comprehensive portfolio of beverage products, equipment and supplies to approximately 1.5 million customers through its network of over 210 sales and distribution facilities and daily operation of over 2,100 routes. With one of the broadest distribution networks in the country, DS Services can provide service to approximately 90 percent of U.S. households and efficiently services homes and national, regional and local offices.

Valuation

As of November 21st, 2014 close, Cott Corporation (NYSE:COT) had a market capitalization of $623 million and an enterprise value of $1,184 million. As the DS Services transaction will be funded by debt only, adding purchase price of $1,250 makes enterprise value equal to $2,434 million. According to company’s presentation, the new company’s EBITDA will equal approximately $350 million, which means that the combined company is currently valued at an EV/EBITDA multiple of x7. However, the free cash flow generation profile will not look as favorable as it looked before the transaction. According to Cott’s presentation, DS Services capex will be about $70 million, while company’s own capex can be reasonably estimated by using FY 2013 capex, which was $56 million. In addition to this, interest expenses will grow significantly: Cott’s own annual interest expense of about $36 million plus new additional interest of $96 million (estimated average rate of 7.7% on $1,250 million). Earnings before taxes are therefore estimated to be $92 million only (without synergies), leaving very little free cash flow that could be distributed to shareholders.

Conclusion and change in outlook

We recommended shares of Cott Corporation (NYSE:COT) back in February 2014 and added the company to our High-Impact Equities Portfolio. The main reason for recommendation was attractive valuation, high free cash flow yield, and possibility for an LBO with a meaningful premium to then-current share price. We believe that although reasonable in terms of valuation, and with certain merits to it, recently announced DS Services transaction significantly alters company’s free cash flow generation profile and increases uncertainty for equity shareholders. LBO possibility is also not on the horizon anymore. We therefore remove shares of Cott Corporation from our model portfolio and no longer view them as attractive.

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