Sunday, November 18, 2012

McCormick Offers Good Long Term Growth

The same old story. Another good set of results and another new set of admirers for McCormick & Company (NYSE: MKC). You can count me in the list but while I like company, I don’t like the valuation. The market has woken up to the favorable profit drivers here and it is hard to argue that the stock is a value anymore. In addition, I have some concerns about the underlying growth not being what the market may be expecting it to be. That said, I am not the final word on valuation and other investors will find a lot to like in these results.

McCormick’s Growth Trends

McCormick reports in two business segments of which consumer contributes over 75% of income. Consumer margins are typically double those in the industrial segment and the recent acquisitions have been made on this side of the business.

A graphical depiction of margins and revenues below.

Consumer revenues have been growing faster than industrial but this partly has to do with contributions from acquisitions.

In fact if you strip out the contributions from acquisitions, the growth in the consumer segment has been around 4% for the last two quarters. Similarly, industrial growth slowed to just 2.8% in this quarter. However, analysts have 4.8% revenue growth forecast for next year. Based on this quarter’s results it may find it hard to achieve this. Although part of this is due to currency effects so I don’t want to be too harsh on the company.

McCormick’s Favorable Profit Drivers

There are few industry specific trends which are favorable for McCormick.

First, food companies like say Campbell Soup (NYSE: CPB) are being forced into a huge amount of innovation in flavors and taste offerings in order to retain market share in the face of high costs and reluctant consumer spending. Whenever a Campbell or a H.J. Heinz (NYSE: HNZ) tries to increase pricing in the US it is usually greeted with a drop in volumes. Subsequently both these companies have aimed for growth from emerging markets while trying to hold market share domestically. For Campbell the international challenge is to grow categories like snacking but I think overall it has a weak mix of product categories. Prospects look a little brighter at Heinz. It has a fast growing nutrition business and core products with strong emerging market appeal.

Turning back to these companies domestic situation the main way to retain market share (without cutting prices) is to increase marketing or try and innovate on flavoring. The latter is obviously favorable to McCormick’s industrial sales.

Second, as consumers are eating more at home they will tend to carry on buying McCormick’s spices. In this sense the company is actually a beneficiary of the new age of austerity.

Third, its products are low ticket item so passing on higher input costs is relatively easier than it will be for a company like Kellogg (NYSE: K) or General Mills (NYSE: GIS). These companies find themselves locked in a game of rising input costs leading to raised prices, volume and market share losses followed by marketing initiatives and cost cuts which lead to margin decreases. Then the game begins again. It is a very tough environment and consumers are monitoring pricing and promotions very closely. Kellogg has acquired Pringles and I think the commodity price hedges it has put in place this year should benefit the company next year. Nevertheless Europe is a big market for them (and cereal in particular is struggling there) and the US retains its pricing difficulties. Fortunately, McCormick is relatively immune from such tribulations.

Fourth, soft commodity costs are falling and margin expansion should be easier in future. Indeed, General Mills pointed out that cost inflation was falling to low single digits in its last results presentation.

And finally, there is the long term story of emerging market growth to drive future sales. McCormick already generates around 14% of sales from emerging markets and despite evidence that growth is slowing in places like China, the food sector still has good growth prospects.

In summary, it is a compelling long term growth story but is it already in the price?

Is McCormick’s Price Too Spicy?

Without over indulging in the cheap food gags I do think that the evaluation is getting a little hard to swallow right now. If we accept that top line growth will be around 4-5% with some margin expansion leading to high single digit earnings growth than I don’t think that a PE of 21 or an EV/Ebitda multiple of 14.3x is screaming good value.

Throw in the lower revenue growth in the industrial side in the quarter and the vagaries of having to rely on the promotional and sales activities of its food service clients and arguably the stock is expensive on a risk/reward basis.  One for the monitor list.