Remaining faithful to a value-oriented philosophy sometimes leaves you feeling like you're rooting for certain companies to stumble. Take the case of Middleby (Nasdaq:MIDD). While acquisitions have clearly played a major role in building the company, management has done pretty well in sustaining that growth on an organic basis and developing new equipment to improve the efficiency and profitability of restaurants. Unfortunately, as a very good growth stock, these shares seldom get to a valuation where value or GARP investors can feel comfortable loading up.
With another quarter in the books, Middleby continues to grow at a rate well above its peers and the industry as a whole. What's more, with the restaurant industry apparently feeling more comfortable about near-term trends, it doesn't sound like a stumble in demand is coming. Nevertheless, Middleby is a good stock to keep on watchlists just in case, and more growth-oriented (and less valuation-sensitive) investors may find there's nothing wrong with buying in today.
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First Quarter Earnings Roll On
Middleby reported another solid quarter of growth, though acquisitions are once again pressuring margins.
Revenue rose 43% as reported, good for a better than 6% beat relative to sell-side expectations. Acquisitions (particularly Viking) had a big impact this quarter, but the overall organic growth rate of nearly 11% was still very good. Organic growth was led by the food processing segment (up 18%), but the commercial foodservice business (up 9%) was hardly struggling. In its first quarter as a separate segment, residential sales were almost 20% of sales, and Viking's sales were up almost 18% on a standalone basis.
Gross margin declined more than a point as reported, due in large part to the incorporation of the lower-margin Viking business. Ex-Viking, gross margin would have been up about 70bp. Deals also hit the operating line, where operating income rose only 15% largely on integration expenses and inefficiencies tied to the newly-acquired operations. It's also worth noting that the residential operations reported a loss for the quarter; stripping out the various acquisition items, operating income would have been up more than 33%.
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Restaurants Feeling Better, And Middleby Is Driving Home The Value Proposition
In contrast to the uninspiring report earlier this week from Sysco (NYSE:SYY) and lackluster same-store sales trends, Middleby's management spoke of increasing confidence among its restaurant customers and an expectation that business is past the worst.
Either way, Middleby has more to offer than just a ride-along with the restaurant industry. Middleby has focused a lot of attention (and capital) on the acquisition and development of new foodservice technology, and this is giving the company a strong sales edge. Their “Kitchen of the Future” concept can not only reduce prep time and improve service quality, but enhance store profitability – one of the driving factors for a big order from Brinker's (NYSE:EAT) Chili's that the company has nearly completed.
It's also true that restaurants continue to expand their product offerings in an attempt to grab more revenue and better expense leverage. Starbucks (Nasdaq:SBUX), Dunkin' Brands (Nasdaq:DNKN), and Tim Horton's (NYSE:THI) are all looking to expand their breakfast food offerings, and restaurants like Dunkin' and Sonic (Nasdaq:SONC) have both talked about trying to improve weaker dayparts (lunch/dinner for Dunkin', breakfast for Sonic).
Is Middleby Doing Too Much Too Soon?
Investors should note that acquisitions are a major component of this story – the recent 10-Q refers to 11 specific deals. It's worth asking, then, just how much growth Middleby can achieve on a long-term organic basis. The company is doing quite a bit better than the single-digit growth at Dover (NYSE:DOV) and Manitowoc (NYSE:MTW), let alone the single-digit decline at Illinois Tool Works (NYSE:ITW), and gaining share, but can this go on forever?
I also noted one interesting detail in the 10-Q – the company's warranty expense has increased significant. Warranty claims climbed 75% from the year-ago period. Now, this isn't a large item (about 3% of sales) and no sell-side analysts seem to be talking about it, but I find that increase to be interesting. Maybe it's a byproduct of the company's rapid acquisition history, or maybe the company has been experiencing problems with new equipment. Either way, it's worth monitoring – disproportionate warranty claim growth could mean there's a quality issue, and that could alienate customers.
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The Bottom Line
It feels aggressive, but I do believe Middleby could grow its revenue at a long-term rate in the high single-digits, and its free cash flow at a low-to-mid teens rate. That's well ahead of the restaurant industry growth rate, but there's a lot of room for Middleby to grow/gain share overseas, and more restaurant conversion deals like Chili's would certainly lead to meaningful domestic growth.
If Middleby can grow like that, a fair value close to $160 isn't unreasonable. That's a pretty narrow margin of error, though, and with a double-digit EV/EBITDA and over 50% appreciation in the past year, these shares would likely get hit hard if there's an earnings disappointment. I'm still very interested in this story, and wish I'd bought the stock a long time ago, but it's hard for me to get comfortable chasing these shares today.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.