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Middleby Corp. Conference Call Notes



August 08, 2014 – Comments (0) | RELATED TICKERS: MIDD

Board: Middleby Corp.

Author: ultimatespinach

One of the subtler aspects of Selim Bassoul's brilliant 14-year tenure as Middleby CEO was on display in Q2 -- the ability to continue producing strong results for owners even as the company devotes significant resources to digesting major acquisitions.

You would hardly know from its earnings performance over the past six quarters that this period included major expenses and integration efforts for its expansion into the residential market. The Viking integration is now largely done with only the continued development and culling of dealers to be completed.

The largest Q2 sales advance in percentage terms was in that new residential equipment segment -- 20.6 percent year over year, or $12.1 million, to $70.9 million. This came from a combination of improved margins after taking the entire distribution network in-house and the first indications of market enthusiasm for the portfolio of 50 new products, which includes major steps forward into the internet of things -- smart appliances remotely operable through smart phones and tablets.

Keep in mind this gain was achieved during a period that Selim described as "very disruptive" for Viking because of the simultaneous overhauls of the distribution and dealer networks, not to mention working through old inventory in the hands of the formerly independent distributors. Selim expressed some of that old-time passion for the future of this business, pointing to 2015 as the beginning of a major growth cycle.

Under its former management, Viking had deteriorated from a $400 million annual revenue run rate to about $200 million. When the acquisition was made at the end of 2012, Selim said it could easily get back to its previous level. This quarter's results reflect significant progress toward that goal and I got the feeling the goal will move considerably higher as time goes on. More on Selim's vision for this business in just a minute.

First, the basics. Quarterly sales moved over the $400 million mark for the first time. It took Middleby more than 100 years to reach $1 billion in annual sales, which happened in 2012. It looks like it might take only three from there (2015) to get to $2 billion.

Net sales were up 16.8 percent year over year to $424.8 million, Middleby's first $400 million quarter, 11 percent of it organic. The growth was 18.3 percent in the commercial food service equipment segment, 10.2 percent of it organic. The rest came from the acquisitions of Wunder-Bar, Celfrost and Market Forge. Growth was 9.8 percent in the food processing equipment segment, 6.2 percent of it organic, the rest from the acquisition of Process Equipment Solutions.

The commercial food service segment represented 62 percent of sales in Q2. Food processing was 21 percent. Residential was 17 percent. Gross margins improved from 37.5 percent to 39.1. The improvement came from both the food processing segment, where Middleby technology is earning more pricing power; and residential, where the integration of the distribution network and drawdown of old inventory are producing the gradual improvement Selim predicted at the time of the acquisition. Gross margins at Viking improved from 30.7 percent a year ago to 33 percent in Q2. This number will continue to improve as the company works through the remainder of old inventory in the distribution network.

Operating margins were 28 percent in food service, consistent with the past; 21 percent in food processing, up 2 percent from 2013; and around 15 percent at Viking including the impact of lower gross margins on the acquired distributor inventory. CFO Tim FitzGerald said they are on track to reach 20 percent operating margins at Viking by year-end. Originally, this was a three-year goal. It was revised to a two-year goal after one year.

Much of the company's strong Q2 cash flow was devoted to paying down debt, which declined from $655.4 million at the end of Q1 to $592.7 million. That's a net debt to EBITDA ratio of about 1.8 times, toward the lower end of their historical range of 1.5-3 times EBITDA. It's also consistent with Selim's history of expanding debt to finance major acquisitions, in this case Viking, and then aggressively paying it down to make room for new ones.

Middleby has a $1 billion revolving line of credit at very favorable interest rates (LIBOR plus 1.75 percent). Roughly half the debt is hedged to fix the rate and half is variable. There is now room on the credit card for an acquisition roughly the size of Viking.

Net income was up 30 percent, almost double net sales, from $37.2 million a year ago to $48.4 million. This has been Selim's secret sauce of late, growing earnings much faster than sales.

[See Post for Tables]

You can see that since the great recession, Selim has consistently grown profits faster than sales with the exception of 2013, when the addition of Viking produced that 38 percent balloon in the top line. For the first six months of 2014, sales have grown 15.3 percent and earnings 29.8 percent.

Demanding high margins for high-quality products is at the core of Selim's business plan, which brings us to the final phase of the Viking integration. Selim disclosed that a significant number of Viking's old dealers protested that they could not keep their doors open if they had to deliver the margins Middleby requires. So Selim thanked them and removed them from the network. The 1,500 original dealers have been weaned to fewer than 1,000, and Selim predicted the number will be down to 700 by the time they're through. Among the requirements placed on dealers is that they display Viking exclusively, not among competing products. He said there is a core group of 250 dealers that has enthusiastically embraced the new requirements. "You have to be a true partner with us," Selim said.

His vision for Viking is aimed at three markets: baby boomers, who want machines that are easy to operate, easy to clean and work fast; millenials, who want smart appliances operable from remote electronic devices; and city dwellers, including high-rise dwellers in emerging markets, who need radical new space-saving designs. This latter initiative represents an entirely new line of products for Viking. Selim is excited about all three opportunities, but I got the sense he feels that latter market could be enormous. In his closing remarks (below) he specifically mentions a number of emerging markets as targets.

"We want to be more democratic about who can afford Viking," Selim said. Middleby R&D is focused on expanding the brand. It is also focused on outdoor cooking, an area of growth among both boomers and millenials.

The new Viking range series and wall ovens are already on the market. New refrigerator models will be launched in September, new cooktops and that new urban line in October.

Just a few notes on other stuff before we get to Selim's closing comments on the call this morning. One of the analysts expressed some impatience with the continued status of the kitchen of the future in field tests with the major restaurant chains. Selim explained that smaller chains are now adopting the KOF on a regular basis and will continue buying it as they grow, but the larger chains are adopting it more slowly than he expected because of the hefty aggregate price tag.

To illustrate, he said Brinker wrote a check for more than $50 million to outfit all of its more than 1,200 Chili's stores. That comes to a per-store cost of more than $40,000. A year or so ago, my notes indicate he estimated the per-store cost at Chili's at closer to $30,000, but no matter. The fully automated KOF is custom-configured for each customer, so this gives us a general range of the per-store cost.

With all the attention on Viking and the KOF, one analyst wanted to know what else was going on, which gave Selim a chance to talk about ongoing rollouts of the dry well (waterless steam table) with a major Asian chain; the waterless steamer; next generation combi-ovens (wet and dry); the next generation WOW (pizza conveyor) oven; the new low-oil-volume fryers from Pitco; and the burgeoning growth of ventless cooking technology, which allows food service in non-traditional spaces without restaurant duct work.

He also bragged on the new Middleby-Marshall ventless fire oven, which cooks a wood-fire pizza in 90 seconds and launches in September.

"I've never seen in any introduction of any product like this that people lined up (to see it at trade shows)," he said. "We've had orders from people who just saw it at a trade show."

On the international front, the tainted food scandal that stalled KFC's growth in China is over and the buildout of new restaurants has resumed. FitzGerald reported 16 percent year-over-year growth in international sales overall with double-digit gains in Europe, the Middle East and Asia. The latest China tainted food scandal did not hit KFC, which is Middleby's major growth engine in China. They believe international growth is back on track going forward.

Selim returned to his custom of finishing the call with some closing remarks, which historically has been a sign of his optimism. This is my own transcription, so it might vary slightly from the automated call transcript when it comes out on Seeking Alpha. As always, the syntax is uniquely Selim's:

On the commercial side, restaurants are looking at (growing) sales by extending menu items and extending their hours of operation, starting from breakfast to late-night day parts. What is the impact of this for Middleby? More equipment to accommodate new items that differ from just lunch and dinner.

The second impact in the commercial food service is to lower labor costs. With more chains open longer hours, cost of labor is higher. In addition, the impact of raising minimum wage will force operator to look for automation, such as kitchen of the future, such as conveyors, such as introduction of equipment that allows less cleaning, less training.

No. 3, cost of energy continues to be a big impact and we are the leader in energy efficiency, water savings -- our waterless steamer, our dry well, our combi-ovens that use less water than our competitors, reduced oil volume. We continue to look at reducing the lifetime cost of ownership. I think we've done a great job going back and looking at payback that are less than two years.

What's happening to the future capital spending on commercial appliances? It looks very good. According to a survey by the National Restaurant Association, 62 percent of restaurant operators plan to make a capital expenditure for equipment expansion or remodeling in the next nine months.

Nearly two thirds of restaurant operators reported that their same store sales rose above year-ago levels. Most important, restaurant operators are increasingly optimistic about continued sales gains in the months ahead, a sentiment that is also showing up in their capital expenditures.

Looking at Viking, despite some headwinds, such as the economy improving slower than expected and home sales struggling to keep up with last year's pace, remodeling spending is expected to still be significant, which is a big important factor for Viking because Viking is the longest established brand in that high end and we benefit from remodeling more than our competitors.

International will add growth to Viking in 2015 and 2016. We are launching in the fourth quarter of 2014 cooking appliances specifically designed for city dwellers and high-rises, a product basically needed in the international market and in urban cities, in China and Brazil, in India, in Dubai, in Malaysia, and in cities in Europe.

We have started shipping our best range ever, the 7-series. This range has the fastest boil time and the fastest preheat oven time. In addition, it's the first cloud-based home range that allows you to monitor your oven using a tablet, a smart phone, away from the appliance. It is a true smart appliance that's also easy to use, easy to program. It also syncs very easily. You don't have to be an IT expert to figure out how to sync it. It's the largest cooking surface and the ability to heat up quickly.

We will be launching our new energy-efficient refrigeration . . . in September, and the most easy-to-clean refrigerator and, in the same space, the most cubic feet than our competitor and our previous model.

Most important, we are spending our R&D on beefing up the quality of construction of our appliances across the board by taking products and features and parts from our commercial use which are being eaten up by our customers who are open and use those appliances almost 20 hours a day, which integrated many of our features and our parts in our residential appliances, whether it's in the convection fan from Blodgett, whether it's our range burner, whether it's our door hinges, everything is being eaten up and the fit and finish is getting much, much better. That will affect down the road our warranty rates and the consumer confidence in our equipment.

Let's talk a little bit about builder confidence. Builder confidence has been in a holding pattern for the past three months. Looking ahead, I predict 2015 to be a strong builder year for homes above $800,000 as homes below that price will have difficulty. Why? Because builders will have a hard time finding well-priced lots for that price range. The competition for lots and lot sizes has increased and they are becoming a lot more difficult for houses that are in the $200,000 price range. Which bodes well for Viking, because people who are buying or building above $800,000 home are putting the high-end appliances, the stainless steel appliances, in those homes.

We are very excited about what's happening in our dealer and distribution strategy. The early sign of the commitment of over 250 dealers to us has been fantastic. They like what's happening. We've started shipping the new products and the reception of those new products has been very, very well received. To that extent, we are very optimistic about our second (half of 2014) and the next three years of how we continue building our innovation and getting closer to our customers, both in food processing and commercial, and now with Viking.

He concluded by mentioning that Middleby will hold two investor days to show off the new Viking products at Viking headquarters in Greenwood, Mississippi on Nov. 18 and 19.

Finally, let's have a quick look at value. Middleby beat analyst estimates on both revenue ($424.8 million actual, $408 million consensus estimate) and earnings per share ($0.85 actual, $0.75 consensus estimate) and the market responded enthusiastically. Shares closed today at $82.69, up 14.6 percent from yesterday's close of $72.16.

Yesterday, trailing split-adjusted earnings were $2.86, giving the shares a P/E of 25 at $72. Today, as I calculate them (feel free to check me), trailing split-adjusted 12-month earnings are $3.05, giving the shares a P/E of 27 at $82.69. This seems to me a much healthier, more sustainable gain than the 13 percent bump after Q4 that took the multiple to 36. That's mainly because today's bump merely takes the shares back to a pre-split price of $248, which is about where they were a quarter ago. So the slide of the past three months has been wiped out without taking the multiple into the stratosphere.

FitzGerald cautioned that the second half of the year will include increased spending to promote the new Viking line, including "investments made to distribute these products in dealer showrooms and training of our dealer sales representatives." So some of the improvement in Viking sales and margins the company expects will be offset by these expenses. It's always hard to know with Middleby how seriously to take these warnings because they so routinely under-promise and over-deliver. For shareholders, of course, this is a very endearing trait.

The multiple remains at the high end of the historical range, but so does the earnings growth. Selim is on top of his game, cooking with gas, as it were, like an athlete who keeps getting better entering the prime of his career. He is signaling that 2015 could be a year of dramatic growth in the residential equipment segment. Middleby may be the best unknown company in America. This year of share price consolidation is probably a good time to get on board.


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