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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.
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