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Commercial kitchens and food processors are eager to increase capacity and contain (if not reduce) costs, and automation is a key part of that process. That’s very good news for Middleby (NASDAQ:MIDD), but strong demand from restaurants and foodservice customers is being offset by intense cost pressure, as well as emerging weakness in the residential business.
The valuation wasn’t great, but I thought Middleby was setting up as a “buy the dip” opportunity back in early March. That was absolutely the wrong call, as the shares have remained weak ever since, dropping around 17% and underperforming the market. There aren’t many good comps anymore, as most of Middleby’s competitors are part of larger conglomerates, but neither Marel (OTCPK:MRRLF) or Rational (OTCPK:RATIY) have been all that strong of late either.
Residential Drives A Third Quarter Miss
Core commercial growth remained strong for Middleby in the third quarter, but results were undermined by a downturn in the Residential Kitchen (or RK) business, and I would expect worse trends here in the quarters to come.
Revenue rose 14% in organic terms, coming in 3% short of sell-side expectations at $993M. Commercial Foodservice (or CF) revenue rose 17% in organic terms to $624M, basically in line, while Food Processing (or FP) revenue rose 22% organically to $148M, beating by around 5%. RK saw 2% organic growth (to $221M), missing by more than 10%, as strong domestic demand (up 11%) was offset by weaker overseas results (down 10%).
Gross margin improved 20bp yoy and 120bp qoq to 36.8%, which was good for an inline performance. EBITDA rose 23% to $212M, missing by about 3%, with margin down 10bp to 21.3% (or up 120bp to 22.6% on an organic basis). Operating income rose 31% to $162M, missing by 10%, with margin up 120bp to 16.3%.
At the segment EBITDA level, CF profits were 33% to $166M, with margin up 230bp to 26.7%, while FP profits rose 34% to $33M, with margin up 40bp to 22.2%. RK profits fell 14% to $35M, with margin down 510bp to 15.8%. Relative to expectations, CF EBITDA was a little higher than expected, while FP beat by a wide margin and RK missed by a wide margin.
Costs Prove Hard To Overcome, And Residential Is Likely To Get Worse
Management noted that price/cost was still negative in the quarter. This comes after aggressive pricing actions; cumulative pricing increases of over 30% in the CF business over the last two years and price increases in FP and RK as well. Even with another price hike set for January, management is only looking for around 100bp-200bp of price/cost margin leverage over the next three years.
I believe the residential business is only going to add to these challenges in the near future. As I mentioned in that last article, I thought that the renovation/remodeling wave that had helped push strong RK sales during the pandemic was going to fade, and that seems to be the case. With interest rates much higher now and a slowing housing market, I think Middleby’s residential business is in for a couple of tough years – keep in mind, too, that RK sales are currently about one-third above their pre-pandemic level.
Healthy Trends In The Core Commercial Operations
The serious cost pressure notwithstanding, the commercial operations are doing well. Commercial kitchens are more receptive than ever before to new technologies that reduce labor and utility inputs without compromising service times. Likewise, food processors and packaged food companies have been scrambling to add capacity while also navigating a more challenging labor market.
Still, I wouldn’t say that Middleby’s results are “can’t miss” good. Growth rates of 17% and 22% in CF and FP aren’t that special next to the 23% growth reported by Illinois Tool Works (ITW) in its Food Equipment business this quarter (with 28% growth in equipment). Likewise with Marel and Rational, which reported 36% and 33% growth, respectively, albeit with forex tailwinds that weren’t quantified. John Bean (JBT) was the laggard here, with 11% organic growth in this last quarter.
Looking ahead, I expect Middleby to continue to leverage its core technologies. The company stepped up its R&D spending a few years ago and should start reaping some benefits with new innovative equipment that reduces hands-on time, total turnaround time, and operating/production costs. While a weaker labor market in 2023 could ease some of the urgency to invest in labor-saving equipment, I think this is nevertheless a long-term trend working in the company’s favor.
The Outlook
Between management’s commentary with third quarter earnings and the recent Analyst Day, I think the commercial business remains on track and is being run with realistic expectations. I think the 30% EBITDA margin target for Foodservice within three years is credible (the prior peak was 29%), though management also indicated that they won’t turn away from strategically useful deals just because of near-term margin dilution. Likewise, I found the 25% margin target for FP to be realistic (against a prior peak of 27%).
Residential remains a sticking point. I don’t think I’ve ever been on the same page with Middleby management with respect to the RK business, and that’s no exception. I think margin erosion in the near term could well be worse than management expects and I think a 25% margin target over four years could be too optimistic.
I’m still looking for around 5% long-term revenue growth from Middleby, and I think the company is well-placed with respect to increasing adoption of automation across food/beverage and food service. I’m turning less bullish on margins. I think it may be hard for the company to break out of low-20%’s EBITDA margins for several years, and I’ve cut back my long-term FCF margin expectations from the high teens to the mid-teens, but that does still support a long-term FCF growth rate in the high single-digits.
The Bottom Line
Middleby wasn’t exactly cheap before, and that remains the case now. Discounted free cash flow should support a mid-to-high single-digit long-term annualized total return, but weaker near-term margins and returns argue for a lower EBITDA multiple (12.75x versus 14.5x previously) that drives a not-so-exciting near-term fair value in the mid-$150’s.
Just as I was too positive too soon back in Middleby, maybe I’m too negative at this point. I do think Middleby should benefit from easing cost pressures next year, and I’m a big believer in automation adoption. Were the share to rerate back toward that older 14.5x multiple, the fair value would shoot up into the $180’s. It’s tempting to double down here, but I was concerned that commercial orders could start to soften and this is more of a “wait another quarter and check again” idea for me now.
Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
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