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After many years of flat returns, Cott sees sales pop

The private-label soft-drink maker’s move to diversify into water and coffee is producing some effervescent returns for shareholders

Brands like RC Cola, Red Rain and Harvest Classic juice are probably not top of mind when you’re preparing a shopping list.

These products are lurking on store shelves, overshadowed by the likes of Coca-Cola, Red Bull and Tropicana. But for Cott Corp., low-profile names such as these—and dozens of others—constitute a multibillion-dollar business.

Cott is the world’s largest manufacturer and supplier of private-label carbonated soft drinks, a title that would be more impressive if not for the fact that sales peaked more than a decade ago. Since 2005, soda sales have dropped steadily, as more and more evidence points to sugar as the leading culprit in North America’s obesity and diabetes epidemics.

Meanwhile, Cott has struggled to find its place in the rapidly changing beverage industry, and it’s proven highly vulnerable to commodity prices, which affect its manufacturing costs and make earnings erratic.

At the moment, Cott is enjoying an episode of apparent strength. The past two quarters beat analysts’ expectations in terms of revenue, sales, and earnings per share. That’s the result of a growth plan put in place by CEO Jerry Fowden when he stepped into the role seven years ago.

A key element of the plan is to diversify beyond soft drinks into water and coffee, and there are signs that strategy is starting to pay off. But the question remains: Is this actually the start of long-term growth and sustainability or just another glimmer of light that’s bound to be extinguished again?

READ: Pepsi opening NYC hipster joint to make soda cool

“The important thing to note is that this is an entirely different Cott than what people have known for years,” says Mark Petrie, an equity research analyst with CIBC. Petrie is referring to Cott renouncing its identity as exclusively a soda-bottling outfit—something it’s arguably held onto for far too long.

According to Petrie, the company is poised for an unusually long period of success, driven primarily by its purchase of private U.S. water distributor DS Services (DSS). Acquired by Cott in December 2014 for US$1.25 billion, DSS delivers water filtration and coffee systems to homes and offices across the United States.

The deal gives Cott exposure to a growing market—bottled water is poised to surpass carbonated soft drinks as the largest beverage category in America next year and hit $280 billion in sales by 2020.

“People aren’t consuming more pop,” says Petrie. “They’re drinking more water or coffee or tea or sparkling water—all the areas Cott is trying to grow in.”

This isn’t the first time Cott has tried move its business away from soda. In the late ’90s, for instance, Cott was almost manic in its efforts to diversify and nearly went bankrupt. “The company had been focusing on too many projects and initiatives at one time instead of driving a few key strategic initiatives,” says Fowden.

Cott tried breaking into the Chinese market and set up satellite companies in Israel, South Africa, Norway and Australia. It tried making frozen food, snack food and pet food, and entered the beer space.

“This wasn’t only stretching manpower,” Fowden adds, “but the efforts all drove increased costs and investments with a payoff that, if successful, would take multiple years to deliver.” The payoff never came, and a hike in commodity prices in 2005 further imperiled Cott’s finances.

According to Petrie, price changes for raw materials—plastic, high-fructose corn syrup, and aluminium—is one of two major threats to Cott’s bottom line.

“The issue with Cott’s business is there aren’t a lot of costs to cut, so they can be very exposed to movement in commodity prices,” he says. “If those prices move, Coke and Pepsi have a lot of ways to offset the impact of that, but because Cott is such a stripped-down business with no pricing power, it doesn’t have as many levers.”

READ: Coke’s namesake sodas see declines in key markets

But analysts covering the beverage sector now largely agree that Cott’s recent diversification efforts insulate the business from the industry’s volatilities.

The commodity risk for water and coffee, for example, is much lower than it is for soda manufacturing, which now represents just 20% of Cott’s sales. The company has also added more than 30,000 new customers in its DSS division so far this year, 42% above the average growth rate, which will give revenue a boost.

There’s reason to believe the DSS deal may just be the first of many acquisitions that will see Cott’s customer base—and profit—grow.

“One of the interesting and attractive things about the home and office water delivery business is that it’s a highly fragmented industry,” says Petrie. “There’s lots of opportunity and pretty significant synergies and benefits to operating as a bigger entity.”

Cott has made clear its intentions to snap up small companies and secure its place as the world’s largest home and office beverage delivery business. Right now, Nestlé is the only other big player, controlling 30% of the market, versus Cott’s 31%.

“It’s an industry where companies can be bought and integrated at attractive valuations,” says Fowden.

In January, Cott acquired AquaTerra, a Canadian company similar to DSS, to expand its presence north of the border. And in June, it entered into an agreement to purchase Eden Springs, another water and coffee delivery company with 800,000 home and office clients across Europe.

While home and office beverage distribution is expected to drive Cott’s growth over the next few years, the company is not abandoning its private-label manufacturing business. Increased sales in what Fowden calls the “good-for-you” drink categories, like tea and sparkling water, offset the drop in juice and soda sales (5% and 3.7% respectively) last quarter. In fact, the delivery business and the manufacturing arm can assist each other: Cott can deliver new and existing private-label products through the DSS division (it’s already done so for a brand of water known as Sparkletts), potentially providing another sales bump.

These efforts pushed Cott’s share price up more than 50% over the past year. Some of those gains, however, are due to investors favouring consumer stocks lately.

“I think money is trying to find a place to go in the sector, in both Canada and the United States,” says one analyst who follows Cott but is not authorized to speak on the record. “Consumer stocks have had a good run, and there’s only so much you can buy of Loblaw or other stocks that have run up to valuations that are quite high.”

Still, there are promising developments with Cott’s balance sheet. Derek Dley, an analyst with Canaccord Genuity, points out that Cott’s new strategy doesn’t just improve its earnings profile but also boosts its free cash flow, ability to pay down debt and overall stability.

“We’re starting to see stable cash flow, which, in my view, reduces the volatility we saw in the company’s profitability in the past. This, to me, is becoming a completely different company than it was a decade ago,” Dley says.

READ: Good things come in small batches

Cott’s latest financial results are nothing to get excited about on their own, indicating progress will be slow. Cash flow, for example, is only expected to increase 1% this year over 2015.

The number of Buy ratings on the stock—four compared with five Holds, according to data from Bloomberg—shows analysts have confidence in finances down the road, while others would rather wait and see if Cott can move past its erratic history.

“It’s growing in exactly the types of areas you’d want it to be growing ,” Petrie says. That means the volatility that has characterized Cott’s earnings may finally be tempering. There might be no saving the soda business from fizzling out, but for once, that shouldn’t worry Cott.

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