Activist investor explains decision to go public with performance concerns

Whether publicly traded or privately held, companies that accept funding from investors don’t always agree with their financial backers and vice versa. The process of growing a successful business that can withstand long-term challenges can be a bumpy road, and disagreements are bound to occur.

Many investor-investee conflicts remain out of public view. Investors often have representatives on the board of a company they’ve funded — giving them a voice who can influence business decisions and long-term strategy.

Sometimes, however, disagreements can’t be resolved behind closed doors. That’s what happened recently with Primo Water Corp. (NYSE: PRMW), a publicly traded company headquartered in Tampa.

Via brands such as AquaTerra, PureFlo and Mountain Valley Spring Water, Primo is a leading provider of water and related products — what it calls hydration solutions — throughout North America, Europe and Israel, manufacturing water dispensers and delivering bottled water to millions of homes and businesses. According to its website, Primo sells more than one billion gallons of water every year. It reported gross revenue of $2.07 billion in 2022, up from $1.95 billion in 2021 — an increase of more than 6%, though it posted a loss of $3.2 million. 

One of Primo’s investors, Los Angeles-based Legion Partners Asset Management LLC, has been less than thrilled with the company’s performance, and it expressed that displeasure in a public letter, sent March 6, to the company's board. The letter was accompanied by a detailed financial analysis and recommendations for four new board members. (Primo Water officials, in a brief statement, generally addressed the letter but declined to comment specifically on it.)

“Legion Partners believes its case for meaningful change is validated by Primo’s perpetual underperformance — over several time periods — relative to its various peer groups, the Russell 2000 Index and the S&P 500 Index,” the letter reads.

In a rare move, Legion Partners Managing Director Chris Kiper agreed to speak with the Business Observer about his firm’s decision to go public with its concerns about Primo, and what it hopes to gain from doing so. The ensuing conversation revealed some compelling insights about how so-called “activist investors” view their roles and responsibilities.

Constructive criticism

Kiper says Legion Partners isn’t interested in trying to oust Primo CEO Thomas Harrington or any other member of the firm’s executive leadership team. (Pushing for leadership change is sometimes a component of activist investor campaigns.) 

“We can talk about the things that have gone wrong with the company, but the overall macro backdrop story is very positive,” he says, adding Primo’s business model aligns nicely with several consumer trends, such as the decline of consumption and sales of carbonated, sugary beverages.

“Consumers are interested in getting higher-quality drinking water,” Kiper says. “A number of years ago, carbonated soft drinks, on a per capita basis, had a higher consumption rate than water. And what we've seen over time is that carbonated soft drink [consumption] has continued to go down, while water consumption has continued to go up. We think that will continue. Consumers are generally interested in healthier living.”

One of Legion Partners’ primary issues with Primo’s performance and management pertains to the company’s return on invested capital (ROIC). The letter quotes Harrington’s November 2022 prediction that ROIC would jump from below 5% to 12% by 2024. As a highly capital-intensive business, Primo, Legion's letter states, “has been a prolific destroyer of value for years given that its ROIC has not once exceeded its weighted average cost of capital (WACC), which we calculate at 7%.”

Kiper says ROIC growth has been sluggish, to say the least, rising from 3.1% in 2018 to 4.5% in 2022.

“ROIC needs to be above 7% for them to be creating value for shareholders,” he says, “and it’s not been over that in any period.”

It should be noted, though, that with just 1.5% of the company’s outstanding shares, Legion Partners doesn't have a large stake in Primo. However, Legion Partners manages the funds of the California State Teachers’ Retirement System, which is part of the reason why it felt compelled to call attention to what it sees as subpar performance and management at Primo.

“We want to see companies do sustainably better,” Kiper says. “Our largest investor, the California State Teachers’ Retirement System, they’re going to be invested in [Primo] basically forever. They're going to own all these companies long after we've finished our activist campaigns at any of the companies in our portfolio.”

He adds, “What they would like to see, and what we would like to see, is putting these companies into a place where they succeed as public companies, long after we're done being invested in them.”

Legion Partners’ other concern with Primo revolves around customer retention and growth. According to the letter, Primo has spent about $220 million since 2018 to grow its Water Direct home and office delivery division inorganically through acquisition of more than 120 smaller companies. Legion Partners refers to these deals as “tuck-in acquisitions” but says the strategy has “translated into near zero customer growth … we are concerned that Primo has been using its tuck-in acquisition program to cover up how awful its real organic customer count growth metrics look for Water Direct.”

The Water Direct line of business, Kiper says, accounts for about 60% of Primo’s total revenue, “and that customer count has gone from 2.5 million to 2.2 million.” Some of the customer losses, he explains, can be attributed to a stepdown of activity in certain areas, such as Russia, which Primo exited entirely in 2022.

Kiper believes Primo’s aggressive acquisition strategy should have resulted in a net gain of Water Direct customers Instead, growth has been flat.

“The business isn't growing, even though they've spent $220 million to buy things, which is very ugly,” he says. “It means that the base business is losing customers or the acquisitions that they've made aren't keeping their customers — one thing or another is going on, but we're not growing customers.”

Primo has taken steps to kickstart customer growth, Kiper says, and he praises the company for striking a five-year exclusive deal with Costco that will see Primo water dispensers sold in Costco stores nationwide. The deal will also allow Primo representatives to sell home water delivery service “across the entire network of Costcos,” he says. “I think that's going to help them with customer growth, but it's not the only answer to this problem. This is a service problem and a focus problem, and they need to do a better job.”

Ideal outcomes

In advance of the Primo's annual meeting, Legion Partners has put forward four nominations for the water company's board of directors. Kiper says the board is desperately in need of fresh faces and ideas.

“The average tenure of the directors is nine years, which is very long, especially over a period where the stock hasn't performed well,” he says. “So, it's certainly time for change, and the question is, ‘How much change can we drive here?’ Hopefully, it's enough that we can ultimately put the company in a better place to perform. You need changes at the board level to drive performance.”

As an activist investor, Legion Partners, Kiper says, has gotten more than 60 of its preferred candidates placed in company board seats over the past decade. The firm puts a lot of thought, time and effort into its nominations, and he would like to see Primo take seriously the four names it has put forward. He refers to the current board as “stale” and Legion Partners’ letter criticizes directors for undermining investor confidence.

“Since November 4, 2021, the board members have, in total, been net sellers of stock totaling over $5.7 million in total proceeds,” the letter reads. “We believe this speaks volumes, demonstrating a lack of conviction and confidence in Primo and its long-range plan and leaving the board woefully misaligned with shareholders.”

A refreshed board of directors, according to Kiper, would help Primo’s leadership focus on reversing some concerning customer service trends that he and his colleagues have identified. He says they researched Primo’s Better Business Bureau ratings and discovered numerous complaints about service quality and billing issues.

“It’s important that the company get its head around those service issues and begin to delight the customers in a way that keeps more of them with the business than what's been going on here,” he says, “because we need to see the customer count start to grow.”