Middleby's Premium Is Gone, But Longer-Term Demand Destruction Is A Real Concern

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Summary

For some time now I’ve stayed away from Middleby (MIDD) because I thought the market gave too much of a growth premium to a stock where the underlying company really wasn’t a true growth story anymore. Relative performance has indeed been poor over the last three years or so, as the company has struggled to put together compelling growth and margin leverage despite restructuring initiatives and ongoing reinvestment in product development.

I no longer think that premium valuation is a problem here. In fact, the shares look undervalued if the company can manage long-term annualized free cash flow growth of just 3% (from 2019’s level). That should be an achievable/beatable target, but I don’t want to underplay the risk that Covid-19 will cause long-lasting demand destruction in its core market, nor that management will continue to make questionable strategic and capital allocation decisions.

A Challenging First Quarter, With Help From An Unreliable Source

Middleby started to feel the effects of Covid-19 in the first quarter, leading to a 6% drop in organic revenue. The largest business, Commercial Foodservice saw a 9% decline and Residential Kitchen saw a 5% decline, while the oft-disappointing Food Processing business managed 6% growth on mid-teens growth in the U.S. business.

Differing end-market mixes make comparisons to other companies a little challenging, but still informative. Illinois Tool Works (ITW) fared a little better in commercial foodservice, with 6% organic revenue erosion, but that’s helped by ITW’s greater skew towards institutions. Welbilt (WBT), with revenue down 12%, did markedly worse in commercial foodservice. In food processing, I’m even more reluctant to make head-to-head comparisons given how idiosyncratic the market can be, but I’d note that JBT (JBT) reported a 3% decline in its Food Tech segment, while Alfa Laval (OTCPK:ALFVY) reported a similar decline.

Credit where it’s due – relative to the rapid end-market erosion, I believe Middleby managed costs quite well in the quarter. Gross margin declined 60bp, but adjusted EBITDA held flat while adjusted operating income declined 5%. In Foodservice, EBITDA declined 5% (margin down 50bp, and up 40bp on an adjusted basis, on a 9% organic revenue decline), while Food Processing saw 14% growth (10bp margin expansion). Residential Kitchen was not nearly so strong, though, with EBITDA down 23% and margin down 330bp.

How the company handles what is likely to be a crushing decline in business in the second quarter remains to be seen, but the liquidity situation looks okay. Debt is higher than you’d like going into a downturn ($1.8B and around 3x trailing EBITDA), but I believe it’s manageable. At this point, I expect Middleby to remain free cash flow positive, as management is taking some pretty significant cost reduction measures and believe it can produce double-digit EBITDA margins even on a 50% revenue decline.

The Tsunami Is Coming

Restaurants have been hit hard by shutdown and stay-at-home orders driven by the global Covid-19 outbreak. While a select few takeout/delivery-oriented operations haven’t seen as much of a hit, sit-down dining has been absolutely hammered. While most of the larger chains do have the wherewithal to absorb this for a short time, smaller regional and local operators cannot. At a bare minimum, operators are slashing spending to the bone, driving a 65% decline in Foodservice orders in April and a 55% decline in May.

While many businesses are going to see sharp declines in the June quarter and likely some residual declines in third quarter as well, many industrial end-markets should recover in 2021. The restaurant industry may well be different. Management noted that order rates in China were still down 25% in April, even as that economy gets back up and running. It seems entirely plausible to me that many small restaurants will go out of business, or at least be significantly hobbled in terms of their ability to spend on equipment over the next couple of years.

I do think Middleby’s mix will help some. Quick-service chains should do comparatively better, and although management has never broken out sales by customer revenue to my knowledge, the information management has provided leads me to believe more of their revenue is more skewed towards larger operations that are better-placed to survive this downturn, including national QSR chains, national casual and fast-casual chains, pizza, retail, and convenience store chains.

Still, Middleby needs more than just customers who “survive”, and I do think the company is likely looking at a more stretched out recovery in its core business. One potential positive is that Middleby could be a beneficiary of changing consumer behaviors. If more customers decide to stick with delivery in the future, I could see more spending on so-called “ghost kitchens” designed and built to serve delivery demand.

The Food Processing business is a tougher call. I like management’s decision to expand into cured/dried meats, bacon, and pet food, but this has been an up-and-down business for a while. Some of that is just the nature of the business; as I said, trends in food/beverage equipment can be highly idiosyncratic. In terms of underlying trends, though, I don’t think consumption patterns for processed meats or baked goods are likely to change much post-Covid-19.

I remain relatively bearish on Residential. Management has certainly made some improvements to the Viking business, but the U.K.-based AGA has been an albatross ever since it was acquired, and I don’t believe the Residential business will ever earn a particularly attractive return on capital, even though I do think residential construction/remodel should recover relatively well in the U.S. in 2021/2022.

The Outlook

I believe Middleby could well be looking at a 25% or greater decline in revenue in 2020, and I wouldn’t say 30% or worse is off the table. As mentioned before, though, management has shown it can rapidly scale down costs in response to business conditions, and I believe management when they say they can produce double-digit EBITDA margins and positive FCF even on a 50% revenue decline.

At this point, I do think significant demand destruction is probable, and while I do think revenue will rebound some in 2021-2023 (more in 2022/2023), I’m looking for only low single-digit revenue growth now, with mid-single-digit growth from the trough. I’m hoping that’s an overly conservative number, but there’s a real lack of visibility with modeling now. I do still believe that mid-teens FCF margins are possible down the road, helping drive better FCF growth.

One idea I want to throw out there is the possibility that Middleby uses this downturn to be more aggressive on M&A. It seems quite likely to me that many equipment vendors are going to see serious operating pressure, and Middleby may be to acquire attractive assets at good prices. I don’t think Middleby will do anything big in 2020, but if the business seems to be stabilizing early in 2021, it’s something to watch for, and I wouldn’t rule out a larger-than-normal deal, though getting the lenders on board could prove to be a limiting issue.

The Bottom Line

With what I believe to be conservative, or at least not bullish, expectations, Middleby does look potentially undervalued now. I say “potentially” primarily because there is so much modeling uncertainty, but that’s the sort of risk investors have to accept if they want to try to buy in during ugly corrections. I’m still not the biggest fan of this business, but at the right price I think it’s a name to consider as I do expect that it will be one of the survivors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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