Soft drink maker Cott Corp., having taken shareholders on a couple of runs of rags-to-riches-to-rags over the last decade or so, is due for another fall. At least, that's what a significant amount of smart money thinks, as Cott's stock is among the most heavily shorted on the TSX.
Past (under)performance, however, is no guarantee of future results. And with another solid quarter behind it, it's entirely possible that Cott is now capable of beating expectations – and rewarding investors who take the long side of the trade.
First, some history: After an excellent debut in the early 1990s, the stock collapsed thanks to a restructuring and a cloud over its accounting. It rebounded, but a decade later, executive turnover, strategic missteps and a liquidity crunch wiped out 97 per cent of the stock's value from 2005 to early 2009. Since then, yes, it's up more than 1,000 per cent.
So it's easy to see why the short-sellers, who bet on a stock's price to fall, are tempted by Cott. The number of shares shorted has topped 13 million in the last two reporting periods; that's about 20 per cent of the company's float (its readily available shares). The short shares represent 134 days of Cott trading based on the stock's recent average daily volume.
The bear case is easily stated: Cott, as a maker of generic or store-brand beverages, doesn't have the pricing power of a Coca-Cola or Pepsi; at the same time, the worldwide surge in commodity prices will jack up costs, crushing profits.
Except that Cott has managed its challenges better than many expected. True, in the second quarter, gross margins declined 3.5 percentage points from the year-prior period. But revenue and cases of beverage sold increased 9 per cent, and earnings per share of 32 cents (U.S.) bested the prior year's 28 cents, and also exceeded analyst expectations. (Mississauga-based Cott reports in U.S. dollars and also trades on the New York Stock Exchange.)
Those numbers exclude the effects of Cott's third-quarter 2010 deal to acquire Cliffstar, a maker of "shelf-stable" (unrefrigerated) juices. By adding Cliffstar, JPMorgan's Neal Rudowitz noted last fall, Cott became a leader in a category that has growth potential yet is fragmented, has no dominant branded player and has a higher share of private-label sales.
Carbonated soft drinks, which Mr. Rudowitz said "are in a secular decline," shrank to 45 per cent of Cott's sales from 60 per cent. (He has an "overweight" rating and $10 price target on Cott stock.)
Perry Caicco of CIBC World Markets, who has a "sector performer" rating (but also a $10 price target) suggests that 9-per-cent sales gains "seem mostly unsustainable," but that "even maintaining volumes at 2 per cent to 3 per cent [growth] which we believe is possible, would be a substantial achievement."
Indeed, there are signs that the market will give Cott room to make those numbers. Analyst Mark Swartzberg of Stifel Nicolaus says that Coca-Cola Co.'s plans to raise prices by 3 per cent to 4 per cent in the second half of this year – after a 1-per-cent to 2-per-cent boost in the first half – bodes well for Cott. "We think this creates a favourable and improving price umbrella for private label soft drinks," he says.
Cott gets about one-third of its revenue from Wal-Mart Stores Inc. because it makes the giant retailer's Sam's Choice pop. Mr. Swartzberg, who has a "buy" and a $12 target price, says Sam's Choice did fine in the second quarter because Wal-Mart ran brief, limited price promotions on national brands that "did not have a material adverse impact" on its own label.
Analysts were somewhat disappointed that Cott management made a downward tweak last month in its free cash flow guidance for 2011. There's another way of looking at that, however: Cott is being careful not to over-promise and under-deliver.
If it does the opposite – under-promise, then over-deliver – it might provide another quarter or two of earnings surprises. That, in turn, might force short sellers to cover their positions by buying the share – putting upward, not downward, pressure on Cott's stock price.
That's the kind of pop investors are looking for.