Geoff Gannon April 8, 2020

Middleby (MIDD): A Serial Acquirer in the (Normally) Super Steady Business of Supplying Big Restaurant Chains with Kitchen Equipment

Middleby (MIDD) is a stock I was excited to write-up, because it’s rarely been cheap. I’ve seen 10-year financial type data on the company. I’ve seen it show up on screens. And now the government response to coronavirus – shutting down so many of the restaurants that Middleby supplies – looked like a once in a lifetime opportunity to buy the stock. The company also has quite a bit of debt. That can make a stock get cheap quickly in a time like this. So, I was looking forward to writing up Middleby.

I’ll spoil this write-up for you now and tell you I didn’t like what I found. The company’s investor presentation, 10-K, etc. was a disappointing read for me. And I won’t be buying Middleby stock – or even looking into it further. Why not?

Middleby is in an industry I like. The company has 3 segments. The biggest profit contributor is commercial foodservice – supplying restaurant chains like: Burger King, IHOP, Chili’s, etc. – with kitchen equipment. The company sells equipment that cooks, bakes, warms, cools, freezes, stores, dispenses, etc. It sells a very broad range of equipment. A lot of it is good equipment. A lot of the brands the company carries are well known. Plenty of them are pretty innovative. However, I think that innovation most likely happened before – not after – Middleby bought those companies. Middleby talks a lot about innovation – but, it only spends about 1-2% of its sales on research and development. That’s not a high number for a company in an industry like this. Middleby is building this stuff itself – in the U.S. and around the world (in both owned and leased facilities – and it’s making it for some pretty large scale orders. Plenty of the chains Middleby serves have thousands of locations. Gross margins in the commercial foodservice business are 40% or a bit better. Although most of this stuff is sold under just a one year warranty – some is under warranty for up to 10 years. Plenty of these products do last longer than 10 years. For a company making 40%+ gross margins on sales of key capital equipment to big business customers – Middleby doesn’t do a lot of R&D. That fact bothered me a little. It started to bother me a lot more when I looked closer at the company’s acquisitions.

Middleby has bought some leading brands. Chances are – if you’re reading this – you know more about home kitchens than commercial and industrial kitchens. You may eat at Chipotle. But, you don’t know what equipment Chipotle cooks on. You do – however – know brands you might find in home kitchens. Several years ago, Middleby bought the Viking brand and later the Aga brand (Aga is a big, premium brand in the U.K. – it’s less well known in the U.S.). In the company’s investor presentation, they show the EBITDA margins for these acquisitions at the time they were made and then as of the present (under Middleby’s restructured ownership). The point of the presentation is to show the big earnings growth Middleby can squeeze out of these brands. I wouldn’t be surprised to find improvements once Middleby owned these companies as they are strong brands that probably share a lot of overlap in turns of where and how they can be produced, what materials they are made from, how they can be distributed, etc. Middleby can also take technology it already uses in commercial kitchens and adjust it to add some sort of new feature, a brand extension, etc. to the home premium home kitchen brand. So, the fact there was improvement in EBITDA margins didn’t bother me. What bothered me was the starting number shown for both Viking and Aga. Middleby shows the before and after EBITDA margin comparison for Aga going from 0% (previous) to 17% (current). And for Viking going from 0% (previous) to 24% (current). I don’t believe these numbers. Or, at least, I don’t know what the 0% EBITDA margin number is supposed to mean exactly. Did Middleby buy two well-established brands when they were producing no EBITDA? What’s weirder about this is that Middleby gives information allowing me to see how much goodwill and identified intangibles it booked when it made each acquisition. Middleby didn’t buy Viking – which it shows as having a 0% EBITDA margin – at some sort of discount to book value or something. Almost all of Middleby’s acquisitions consist mostly of goodwill and intangibles. The acquired companies have very little tangible assets relative to the price Middleby pays. And we know that Middleby eventually wrote down some of Viking’s goodwill. So, how could Viking have been making no money – a zero percent EBITDA margin is normally a loss in terms of both reported earnings and free cash flow – when Middleby bought it and yet Middleby paid a lot more than book value for it and then Middleby had to write down the price it paid? Did Middleby pay a high price for an unprofitable business that it then turned around? I just don’t believe that Viking and Aga both didn’t have positive EBITDA before Middleby bought them. So, I can’t really make sense of that slide in the company’s presentation.

This bothers me, because the case for investing in Middleby is 100% a case for a serial acquirer. The company would – in a steady state – produce free cash flow. I estimate it averaged a traditional free cash flow figure of about $284 million over the last 3 years. That’s about $5 a share. The stock trades at $48.71. So, the price is basically 10 times free cash flow. That sounds fine till you consider debt. The company carries about $33 in debt per share. This presents two problems for investors. One, the stock price isn’t really $50 a share – it’s more like $80 a share. It’s just a leveraged $80 a share. Two, the free cash flow is about $5 per share while the debt is about $33 a share. That means the ratio of free cash flow to debt is about 6 to 1. It would take Middleby half a decade to earn enough in cash to pay down its debt.

This is the part that really bothers me – because, I’m not sure Middleby ever intends to pay down its debt. By my math, Middleby makes about a 50% after-tax return on its net tangible assets. If the company stopped acquiring stuff – it’d be a very high return business. A lot of this return would be earned in cash. Middleby is a good business.

But, Middleby isn’t investing in itself. It isn’t spending on R&D – it’s spending on acquisitions. And the return on acquisitions is not 50%. In fact, by my math, Middleby’s return on total capital employed is more like 10% after-tax. Now, that’s still a lot higher than Middleby’s cost of debt. The company borrows using a credit line that pays a reasonably small spread over the higher of like the prime rate, LIBOR, Fed Funds Rate, etc. We don’t know what that will be in all years. And we don’t know that lenders will continue to lend to Middleby on the exact same terms when that revolver matures in 2021. But, I can do some quick math and – assuming the worst – am not getting an estimated cost of borrowing of more than like 5% before tax for Middleby. After-tax, it’d be under 4% in most situations I can think of. So, there’s a natural arbitrage here. Middleby can borrow at less than 4% after-tax and make close to 10% after-tax on its acquisitions.

I’m not sure about that though. See, the 10% estimate is not an estimate of what Middleby is actually earning on these acquisitions using the more recent acquisitions. I can see that Middleby – which has been an acquirer for 20+ years and a rabid acquirer for about 10 years – does get great returns on the really old acquisitions. It seems to get good enough (like 10% type returns) on the entire company as it exists today. But, if the trend in returns on acquisitions is decreasing over time – this is problematic. It’s a problem because the newer acquisitions have to be bigger than the older acquisitions. This isn’t true for all serial acquirers – but, I honestly think it’s true for Middleby.

The company’s growth record is fantastic. This is a stock that returned more than 20% a year for more than 20 years. And it did it through continual growth in sales, EBITDA, earnings, etc. without a ton of dilution for shareholders. However, the growth in profits per share in recent years has been accompanied by high debt growth and low (sometimes shrinking) organic growth. That is not a good combination. And it makes me less sure of the free cash flow number I mentioned before.

I talked about how Hanesbrands has acquired things. But, the acquisitions made by Hanes just weren’t big enough contributors to growth so as to confuse me about the underlying free cash flow. I think the U.S. innerwear business at Hanes is declining a bit in sales and maybe more than a bit in free cash flow. But, I have a lot more faith in the free cash flow Hanes will produce if it stops buying things than I have in Middleby.

Over the last 10 years, Middleby has bought between 2 and 8 companies per year. Many of these acquisitions are pretty small. But, some aren’t. The company includes a chart in its investor presentation that is pretty disturbing. It shows that Middleby’s new acquisitions in a given year as a percent of its total revenues in that year were: 23% in 2009, 8% (2010), 22% (2011), 9% (2012), 23% (2013), 7% (2014), 31% (2015), 8% (2016), 12% (2017), 17% (2018), and 16% (2019).

A lot of this has been funded by debt. In fact, from 2004 to 2018 – Middleby never took its Debt/EBITDA ratio much below 1 or much above 3. It stayed in a constant state of 1-3 times EBITDA in leverage.

Now, some people would say that’s a more optimized capital structure than most companies use. It’s fairly safe – except in coronavirus years – for a company supplying restaurant chains with kitchen equipment to always borrow something. And the company has not taken on any really excessive amounts of debt.

But, the debt isn’t used to buyback stock or to expand the business organically. The debt is just used to make additional acquisitions. That’s the part that worries me. If you have EBITDA of $600 million now – you need to have debt of about $1.8 billion. That’s the situation Middleby finds itself in. But, as you generate free cash of say $300 million and also keep growing your EBITDA at the kind of rates Middleby has in the past (often 15%), you’d end up in a situation where your Debt/EBITDA falls. And it falls in such a way that you need to find an acquisition that’s pretty close to your existing EBITDA to go out and buy. Now, it can be a combination of smaller deals. But, if you are growing 10-15% a year solely through acquisitions – then, you need to be making 10-15% a year bigger acquisitions every year. I like to look at a ten year holding period when analyzing stocks. I don’t feel comfortable with the idea Middleby will be spending $1.5 billion or $2 billion or something on acquisitions in the year 2030. And, remember, it will be spending many billions cumulatively over the 9 years before that. I just don’t see evidence that these acquisitions have high returns. Right now, Middleby seems at the edge of what it should be borrowing. It’ll have a bad 2020 and possibly 2021 as well. It’ll then have too much debt coming out of this to acquire enough to keep the snowballing rolling.

I do like the existing businesses they own. For example, one of their biggest acquisitions was Taylor. That equipment is very common in soft serve ice cream, frozen yogurt, etc. It’s a brand that will probably be a leader in that area a decade or two from now. A lot of Middleby’s brands will prove very durable. And they’ll be consistently profitable.

But, I don’t like the serial acquisition snowball I see here. And it’s not something I want to be part of.

So, I like the industry. I like what Middleby already owns. And the stock price – on a leveraged basis – is not expensive. But, I’m not okay with the capital allocation here. So, this one is a pass.

Geoff’s Initial Interest: 20%

Revisit Price: Won’t Revisit at Any Price