Oct 31, 2013
Executives
Robert Meyer Jerry S. G.
Fowden - Chief Executive Officer and Director Jay Wells - Chief Financial Officer and Vice President
Analysts
Eric Balshin - CIBC World Markets Inc., Research Division Carla Casella - JP Morgan Chase & Co, Research Division Amit Sharma - BMO Capital Markets U.S.
Operator
Welcome to Cott Corporation's Third Quarter 2013 Earnings Conference Call. [Operator Instructions] The call is being webcast live on Cott's website at www.cott.com, and will be available for playback there until November 15, 2013.
We remind you that this conference call contains certain forward-looking statements reflecting management's current expectations regarding future results of operations, economic performance and financial condition. Such statements include, but are not limited to, statements that relate to estimated revenues, volumes and free cash flow.
This conference call also includes forward-looking statements reflecting the company's business strategy and include statements related to the company's capital deployment strategy, the payment of future dividends, share repurchases under our share repurchase program, the redemption of our 2017 senior notes and the refinancing of our 2018 senior notes, the reduction of interest expense and the investment in organic and bolt-on opportunities and goals and expectations concerning our market position, future operations and estimated capital expenditures and commodity costs. Forward-looking statements are subject to certain risks and uncertainties, which could cause actual results to materially differ from current expectations.
These risks and uncertainties are detailed from time to time in the company's Securities filings. The information set forth herein should be considered in light of such risks and uncertainties.
Certain material factors or assumptions were applied in drawing conclusions or making forecasts or projections reflected in the forward-looking information. Additional information about the material factors or assumptions applied in drawing conclusions or making forecasts or projections reflected in the forward-looking information is available in the company's press release issued earlier this morning and its annual report on Form 10-K for the year ended December 29, 2012, which are available on the Investors section of the company's website.
The company does not, except as expressly required by applicable law, assume any obligation to update the information contained in this conference call. A reconciliation of any non-GAAP financial measures discussed during the call with the most comparable measures in accordance with GAAP is available on the company's third quarter 2013 earnings announcement released earlier this morning, as well as on the Investor Relations section of the company's website at www.cott.com.
I'll now turn the call over to Robert Meyer, Cott's Director of Investor Relations.
Robert Meyer
Hello, and thank you for joining our call. Today, I'm accompanied by Jerry Fowden, our Chief Executive Officer; and Jay Wells, our Chief Financial Officer.
Jerry will start this morning's call with some introductory remarks before turning the call over to Jay for a discussion of our third quarter 2013 financial performance. Jay will then turn the call back to Jerry who will complete the call with his perspective on our third quarter 2013 performance, as well as a discussion of business drivers and expectations for the remainder of 2013.
Following our prepared remarks, we will open the call up for questions. With that, let me now turn the call over to Jerry.
Jerry S. G. Fowden
Thank you, Rob. Before Jay reviews our financial results, I wanted to offer a few introductory comments.
While we did see improved performance trends in the third quarter relative to the second quarter of 2013 for volume, revenue, EBITDA and cash flow, it's fair to say we did not see the level of improvement we've been hoping for when we spoke after our second quarter results. Our volume in the third quarter declined by 5% in raw cases sold, or 8% in 8-ounce equivalent cases when compared to the same quarter in 2012.
While this volume performance does show improvement from our second quarter, it's still indicative of a very challenging market. Approximately half of the volume reduction relates to our continued movement away from low margin case pack water and the ongoing decline in non-North American CSD market.
The remaining shortfall was primarily attributable to the highly competitive national brand pricing and promotional activity that started in early August and ran right through to the back end of September, with 1 national brand player continuing at the $1 or below price point for 2-liter CSDs through October. This lowering of the national brand pricing significantly reduced the typical 35% to 40% price gap between private label products and national brands on 2-liter CSDs to around the 15% to 16% level.
We estimate that this price gap reduction negatively impacted our sales to the tune of plus or minus 3 million raw cases or 8 million 8-ounce equivalent cases during the third quarter. Nielsen data for the third quarter showed that U.S.
private label CSD volumes fell at over twice the rate of U.S. CSD market sales as a whole.
This loss of volume and its associated revenue trickled down the rest of our financial metrics. However, we continue to control SG&A costs and cash tightly and managed to deliver SG&A savings alongside strong cash flow for the quarter.
We will remain focused on the areas that we can control within our business. And as you would expect, manage our business as tightly as possible.
Also as you are aware, quarter 3 was our first full quarter to include our small Calypso Soft Drink acquisition in the U.K., which is off to a good start. But more on that later.
Importantly, and in line with our capital deployment strategy, the quarter saw us announce our intention to redeem $200 million of our 2017 senior notes in a couple of weeks time, which is expected to reduce our 2014 interest expense by approximately $14 million. Additionally, we repurchased $4 million worth of shares during the quarter and announced our CAD 0.06 quarterly dividend.
All of these actions show that even in such a challenging environment, we are making progress in the execution of our capital deployment strategy and financial plan. On this note, let me hand the call over to Jay to cover our financial metrics in more detail and I will then return to cover our trading in each business segment.
Jay Wells
Thank you, Jerry. Total sale of beverage case volume, excluding concentrate sales and 8-ounce equivalent cases, was lower by 8% at 208 million cases versus the third quarter of 2012.
The volume decline was from a combination of factors, including increased promotional activity from the national brands, lower case pack water sales and the general CSD market decline. Revenue was lower by 7%, 6% excluding the impact of foreign exchange, due primarily to lower global volumes, slightly offset by an increase in average price per case on a global basis.
Average price per case increased primarily as a result of product mix. For example, selling higher revenue products such as apple juice compared to lower revenue products, such as case pack water.
Gross margin was 12.0% compared to 12.5% last year, due primarily to lower volumes that resulted in unfavorable fixed cost absorption that was not offset by pricing or operational efficiencies. SG&A was lower by 13% at $38 million versus the prior year due to a combination of factors, including lower employee-related costs compared to a higher annual incentive accrual in the prior year, cost savings from the SG&A restructuring announced in the second quarter of this year and reduced costs associated with our information technology strategy.
We have been able to lower our information technology costs by moving from a series of legacy platforms to a company-wide SAP system. We will continue to carefully look at our costs and we'll make appropriate reductions in line with our volume performance and operational requirements.
Excluding purchase accounting adjustments, integration expenses, restructuring expenses and certain regulatory adjustments, net income was $14 million, adjusted net income was $14 million compared to $16 million in the third quarter of 2012. Adjusted earnings per share on a diluted basis was $0.14 compared to $0.17 in the prior year, and adjusted EBITDA was $54 million compared to $56 million in the third quarter of 2012.
Turning to our balance sheet. Cash on hand at the end of the third quarter was $126 million.
Net debt was $481 million and our unused borrowing availability was $239 million. Free cash flow for the quarter was higher than the prior year as a result of timing of payment of accounts payable at the end of the quarter and lower CapEx within the quarter.
With respect to CapEx, we currently anticipate 2013 CapEx to be around $65 million, as we have completed our U.S. investment and vertical integration of bottle-blowing.
With this project complete, we expect 2014 CapEx to be below $60 million. With respect to our capital deployment strategy that returns approximately 30% of our free cash flow to shareholders, we believe the most effective means of doing so is through our quarterly dividend, supplemented by our discretionary share repurchase program.
I am pleased to report our Board of Directors approved the dividend of $0.06 per share in Canadian currency payable on December 12, 2013. Also during the quarter, we repurchased approximately 550,000 shares at an average price of $8.09, totaling approximately $4 million.
As always, we will manage the share repurchase program opportunistically, in line with the objectives outlined in our overall capital deployment strategy. Lastly, we announced our intention to redeem $200 million of our 2017 senior notes in November of this year.
The amount of the redemption was conservatively calculated to ensure that adequate liquidity would be available for all areas of our capital deployment plan through 2014, including bolt-on acquisitions. The redemption will strengthen our balance sheet and reduce our interest expense by approximately $14 million in 2014.
This $200 million redemption does not preclude us from redeeming the residual $15 million at any point in the future and we will look at this opportunity and the redemption and refinancing of our 2018 senior notes during 2014. The final approach to this refinancing and what level of interest reduction we achieve is dependent upon market conditions at that time.
With that, I will now turn the call back to Jerry.
Jerry S. G. Fowden
Thanks, Jay. I'll now review the performance in each of our reporting segments.
In North America, revenue was lower by 13% for the quarter, and 8-ounce case volume was lower by 12%. The decrease in volume was the result of a combination of factors.
We had lower case pack water sales as we continue to minimize our participation in this category. We believe case pack water is not an attractive category from a gross margin and overall profitability standpoint.
Next, during the quarter, the CSD category continued to decline around 3.5% in volume. Finally, as previously mentioned, the highly competitive national brand pricing and promotional activity during the quarter adversely impacted our volume performance.
As best we can estimate, the adverse volume implications from this activity was around 3 million raw or 8 million 8-ounce equivalent cases. Let me just expand on this national brand pricing and promotional activity for a moment.
At the beginning of August, a major national brand reduced its 2-liter retail price by some 35% to 40%. Within a week, all 3 national brands were selling their entire 2-liter product portfolios for $1 or less per bottle.
This retail price point reduced the national brand to private label price gap from around 35% to 40%, to 15% to 16%. This activity was not just a short Labor Day promotion, as often occurs, it ran for 7 weeks right through to the latter part of September, with 1 major player holding those prices through October.
As we stand back and review the impact of this activity, it seemed to bring little benefit to the overall CSD category, which continued to decline by 3.5% in volume, and a higher 4.3% in value across the quarter as a whole. This type of promotional activity reinforces our need to execute against our diversification strategy, which is designed over time to help offset market conditions and activity like this.
We must also maintain our focus on the 4 C's and continuing to run our business tightly, scrutinizing both our cost structure and our capacity utilization closely. Returning to North America trading, we continue to experience a slight increase in average price per filled case as we sold more apple-based products within our mix versus lower revenue products such as case pack water during the quarter.
In general, our hot-filled business performed better than our cold-filled business within the quarter and benefited from the start of a new juice contract manufacturing agreement that will expand slowly as we go through 2014 and into 2015. Continuing on contract manufacturing.
This week saw us undertake the first test production run of a new 24-ounce cold-filled canned product, which we will start shipping this quarter. During the third quarter, we also began production on our water enhancer line in Columbus, Georgia, for products to be sold both in Canada and the United States.
We also undertook our first full U.S. alcohol test production run in Dallas that went well and expect to begin commercial production in quarter 1 2014.
Turning to the U.K. Operating trends improved during the quarter.
Raw case volumes were up 15%, and 8-ounce equivalent beverage volumes, excluding all concentrates, were up 11%, with revenues up 14% in dollar terms but 16% in local currency. These results were assisted by a strong start to the quarter with excellent summer weather in July, which drove high double-digit sales increases of traditional CSDs through both the retail and wholesale channels.
The quarter, however, continued to see a narrowing of the energy and sports price gap between private label and national brands, causing our energy and sports volumes to decline just over 10% during the quarter. Quarter 3 revenues in the U.K.
also included the first full quarter's contribution from our Calypso Soft Drink acquisition where both integration and synergies are progressing well. The improved weather in July boosted the freezables part of Calypso's portfolio in particular, with Mr.
Freeze ice pops and the Jubbly freezables brand, driving Calypso's total quarterly revenues up 35% as compared to quarter 3 in 2012. In RCI, revenues in the quarter were up 2% over the prior year and operating income was up 7%, which was driven by both an improved and different mix of business with higher finished good sales more than fully offsetting lower concentrate sales.
Finished good sales consisted of both the export of finished goods from the U.S., predominantly juice products, to overseas markets, as well as production in the U.S. of syrups for in-home dispense systems for a contract manufacturer customer.
Concentrate case volumes were down in the quarter due primarily to timing of shipments. However, the mix of concentrate sales was positive.
Turning to Mexico. Volumes and revenue were down in Mexico, and earnings were down due to a regulatory-related accrual within SG&A.
We are watching as legislation is being put forward to impose a sales tax in Mexico on sweetened beverages. While we believe the final version of this legislation will have less effect on Cott than our competitors due to our high participation in contract manufacturing and the diverse product mix in Mexico, we remain concerned about the effect any such legislation may have on the overall beverage market.
As we summarize the third quarter, we have seen improving trends in many of our metrics as compared to quarter 2 but not to the degree we were hoping for when we released last quarter's results. The overall market continues to be challenging.
CSD and juice market volumes continue to decline at a rate that was not expected by most people a year ago. And private label CSD declines are being exacerbated by a narrowing of the price gap to national brands.
While there has been some recent public commentary by the national brands not engaging in battles over volume at the expense of profits, we continue to see a deeply discounted promotional activity taking place in the market. I believe we're likely to continue to see a highly competitive beverage marketplace where deep cut pricing and promotional activity becomes an increasing part of the business landscape rather than an occasional exception.
We thus believe competitive pricing activity will continue in one form or another. While we will take the appropriate steps to run our business tightly and best function in such an environment, it's clear that recent market declines and the result of excess capacity is causing a shift in both manufacturer and retailer behavior that we do not see abating as we look out over the next 12 to 18 months.
To combat these challenges, we'll continue in our efforts to be a low cost, high service level partner to our retailers and focus on shareholder value by improving our capital structure, continuing to monitor and minimize our costs, and seeking opportunities to progress our diversification, both organically and through bolt-on acquisitions. Our balanced capital deployment strategy sees us allocating some 30% of free cash flow for the return of funds to shareholders in the form of dividends and our opportunistic share repurchase plan.
We will reduce our interest expense from the redemption of our 2017 notes and expect further reductions in 2014 from the redemption of the remainder of these notes, as well as refinancing of our senior notes due in 2018. It's still a bit too early to comment on 2014 commodities but we see aluminum and PET remaining relatively stable, and we currently see this continuing into 2014.
Overall, we expect apple concentrate to remain around the current price, which is below 2012 but above the spot pricing we were seeing right across the middle of this year. It appears that corn will experience a good harvest.
And as such, we are unlikely to see any increases in the cost of goods in this area, despite many converters trying to increase their corn to high fructose corn syrup conversion costs. We'll update you more on our overall view of 2014 commodities next quarter.
In summary, despite the challenging market conditions, our goal continues for us to be a tightly run, cash-generative, high service, low-cost producer, while implementing our capital deployment strategy, which includes investing behind the diversification of our product, package and channel mix, alongside the return of funds to shareholders and continued debt and interest reduction. The third quarter showed slightly improving trends over the preceding quarter, but not to the degree we would have hoped.
As mentioned, the fourth quarter of 2013 and 2014 as a whole is likely to see these same challenging market conditions and dynamics continue. Our cash flow continues to be strong and was up significantly from the quarterly performance of last year.
We believe our full year positive free cash flow will allow us to comfortably redeem the $200 million of our 2017 senior notes and we'll revisit the appropriate action for the balance of these notes and our 2018 senior notes next year. I'd now like to turn the call back to Rob.
Robert Meyer
Thank you, Jay and Jerry. [Operator Instructions] Thank you for your time.
Operator, please open up the line for questions.
Operator
[Operator Instructions] Our first question is coming from the line of Eric Balshin with CIBC World Markets.
Eric Balshin - CIBC World Markets Inc., Research Division
It's obviously become quite competitive out there and you make it sound as if that's going to continue over the next 12 to 18 months. I know previously, you talked about getting more active on the promotional side of things while keeping an EDLP strategy.
Can you maybe talk about some of the strategies you're taking in regards to that and what you saw in the quarter and how you see that playing out over Thanksgiving and Christmas?
Jerry S. G. Fowden
Yes. I mean, I think the large piece of new news in the quarter which everyone, I believe, was previously aware of and we highlighted when we were in a public forum in September, is the significant increase in national brand promotional activity isn't the normal 3, 5, 7 days around a major high day and holiday, but ran for 7-plus weeks, it's continuing with some players, started in one big retailer, but as always, in these kinds of situations, copycat activity meant really most people had that same kind of pricing.
And I know there's been a lot of commentary around perhaps this moving back to a more rational scenario. Even since that commentary, we have seen some further deep cut activity within 1 case major national brand can promotional activity, actually below the price of our EDLP private label.
So our approach is very much to control our cost tightly, focus on the diversification of our business product pack and channel. We started one piece of juice contract manufacturing in the quarter, just started our first production run of our new 24-ounce can product.
First shipments going out of our plants, I think, literally this week. And we're working on other stuff in that area in the pipeline.
Back to your question, more around promotional activity, it's pretty clear as we look forward, while our business model is EDLP, on some of the obvious and easy packs around 24 packs of cans, 12 packs of cans, we need to make sure we have some greater feature activity. We ran some of that in Canada during this quarter and it did produce a positive result in September.
But that's not the kind of thing our business model is built to do on a day in and day out basis. So we'll increase our core kind of 24-pack promotional activity, contain our cost tightly and continue to push this diversification of our business, whether organically like those 2 contract pack agreements I mentioned, or our pouch line startup, alcohol startup at the early part of next year, or through bolt-ons, such as Calypso, which as mentioned in our remarks, was obviously off to a good start.
Operator
[Operator Instructions] Our next question is coming from the line of Carla Casella with JPMorgan.
Carla Casella - JP Morgan Chase & Co, Research Division
You mentioned -- you talked a bit about your share buybacks and the debt pay down as well, do you have a target leverage ratio?
Jay Wells
Yes. When you look at our business and the business that we're in, we say that our main target is to get down to gross 2x debt to EBITDA ratio and that will give us the flexibility, one, to diversify the business when opportunities come up, will allow us the optionality to return more funds to shareholders and just give us the diversification and the solid balance sheet we need.
So 2x debt to EBITDA on a gross basis is what we're targeting. We really believe, by calling the 2017 notes, will give us the debt we need to pay down to get to that level.
And we're funding that pay down through cash and our ABL and by funding it through ABL, that's how we'll have the additional debt to pay down in order to get to gross 2x debt to EBITDA.
Jerry S. G. Fowden
And Jay, just on that comment -- sorry, I was just going to ask Jay to expand on that. There was an email we got in earlier on asking us to clarify the $14 million calculation for next year.
So if you could just expand on that. And then, we'll pick up on your follow-up as well.
Jay Wells
So Jerry is giving me follow-ups here. But I mean, before we actually announced our -- the amount of bonds that we were going to redeem, we were not sure of the exact amount, so we were saying $12 million to $15 million, depending if we were going to redeem a lower amount or a higher amount.
But looking at redeeming $200 million through cash and ABL and looking at our liquidity forecast on what we're going to have to draw down on our ABL and pay interest at the -- about 2.5% rate versus 8 3/8, we feel that next year, just by doing that, we will generate $15 million of interest savings without paying -- sorry, $14 million of interest savings, without paying off any additional debt. Now if we pay off the remaining $15 million, that will gave us that extra $1 million, and that's why we were at the $12 million to $15 million, but right now, I would model out $15 million benefit just from that for next year.
Carla Casella - JP Morgan Chase & Co, Research Division
Okay. Great.
My second question was actually on that. The 200 -- why $200 million instead of $215 million of takeout and then how that gets done.
I mean, I think, that's what typically happened in our market where each holder gets their pro rata share taken out, so that would leave everybody with a very small step piece of bonds and may complicate some of the trading of them. Just curious how -- if it's managed a different way?
Jay Wells
Yes, let me turn to managed first and then go back to why the $200 million, it's managed more as a lottery type system. It's how it's going to be redeemed, so not on a pro rata basis.
And why we're doing $200 million versus $215 million, we have received several questions on why not just do the other $15 million. And as a management team, we take a conservative approach to managing the business.
And therefore, a disciplined approach to managing liquidity and the application of our free cash flow. And based on our models and wanting to make sure we have the adequate cash flow and borrowing capacity for working capital needs, for funding dividends, for funding stock buybacks and for doing potential bolt-on acquisitions in 2014, we felt comfortable only doing the $200 million, and we will go get the remaining $15 million as soon as our liquidity forecast in 2014 makes me comfortable that we can do that and fund all these other activities that I mentioned.
Operator
The next question is coming from the line of Amit Sharma with BMO Capital Markets.
Amit Sharma - BMO Capital Markets U.S.
I'm sorry if you had already addressed this question. Can you give us a little bit more color on what the coal manufacturing contract wins here in U.S.
are, what the scale of that is, and is there a potential for those to get larger as we go down the line?
Jerry S. G. Fowden
Yes. I'll provide a bit of color around there.
I won't obviously mention any brand names. We have started and signed up both contractually and started the production of a hot-filled juice contract manufacturing agreement.
We believe that will be around 4 or so, plus or minus, raw cases, filled cases in the first 12-month period, growing to around double that in the second 12-month period. And to give you a rough conversion, 1 raw case of a juice product turns into about 2.5, 2.7 8-ounce equivalent cases.
So that gives you some scale of that. And in the other contract, we believe that will be somewhere around 3 million raw or 8 million to 9 million 8-ounce equivalent cases over the first full 12 months.
And then, we are looking at other contract manufacturing are in discussions where the other known pieces, the startup of our first alcohol product for quarter 1 of next year, our first U.S. alcohol product, we already do alcohol in Mexico, Canada or in the U.K.
And the volumes there will be smaller, up to something like 0.5 million cases or so but there's other alcohol discussions in the pipeline.
Amit Sharma - BMO Capital Markets U.S.
And then, can you talk about the margin structure for the Coal Manufacturing business, is it in line with your consolidated margins or is it better than that?
Jerry S. G. Fowden
As I mentioned once before, contract manufacturing comes with a number of distinct pluses and some minuses. But overall, we believe it's equivalently attractive business.
Let me just expand on that. Obviously, for contract manufacturing, it's a conversion cost for all the elements of manufacturing a product from a brand owner's own ingredients, and in some cases, packaging.
Therefore, dependent on the kind of product it is, the production line it's on, the efficiencies of it, it could be anywhere from $1 to $3 conversion cost per case, on which the gross margins are pretty similar to normal traditional private label business. But at the same time, you don't have the working capital associated with that and all of the costs and complexities of holding and buying the raw materials.
So the cash contribution per case is less. But the percentage contribution per case is at least the same as that of private label, and it doesn't use up the same working capital.
Therefore, you don't have the same commodity exposure when ingredients are either increasing or declining.
Amit Sharma - BMO Capital Markets U.S.
Great. And if I may ask one more.
We talked about last quarter about cutting SG&A costs and bringing in line with where volumes are. As we, given the Coal Manufacturing business coming in and perhaps their volume improvement next year as well.
But when you look at your overall manufacturing network, given where volumes are or maybe where volume may be headed, is there a potential or opportunity for you to maybe rightsize that a little bit or you're pretty content with where it is today?
Jerry S. G. Fowden
Well, we go through a process about once a year, normally in the early part of the year of really looking in detail at our footprint and plant utilization. So last time we did that, there were a couple of plants around the world whereby, they were relatively close, and I think we highlighted this in a public forum in September, to a decision as to whether that capacity was still needed or not.
Obviously, you have to offset fixed cost savings from the reduction of our plant footprint against the increased transport cost of that product to our customers' DC. We did say very clearly in this call that we continue to keep a close eye on cost and footprint.
We are in the process of redoing that footprint analysis. And the real question is do we get to the position that 2 or 3 of our smaller plants no longer justify staying in place with the fixed cost versus the transport cost.
So we'll go through that exercise again, and communicate as soon as we finish that exercise with all our shareholders, as well as our employees as to the outcome of that. But what I do want to say is, rest assured, we've been doing it for the last few years, we'll continue to stay focused as a low-cost, lean, high service company.
Operator
[Operator Instructions] It appears we have no further questions at this time. I would now like to turn the floor back over to management for any concluding comments.
Robert Meyer
Thank you very much for joining today's call. This will conclude Cott Corporation's Third Quarter Call.
Thank you for attending.
Operator
Thank you. Ladies and gentlemen, this does conclude today's teleconference.
You may disconnect your lines at this time and thank you for your participation.