Saturday, February 23, 2013

McCormick Equity Research

I confess to becoming increasingly perplexed with the markets these days. While whole swathes of the technology sector look like good value it is increasingly hard to find stocks in more defensive sectors like food and health care with which to balance a portfolio. Such thoughts came to mind when looking at McCormick’s (NYSE: MKC) latest set of results. They were disappointing, and the stock sold off only to see the value investors buying back in. Is it time to follow them in?

McCormick’s Disappointing Quarter

I previously discussed McCormick in an article linked here and made reference to some of the questions over its underlying trends. Most notably, McCormick’s underlying consumer segment revenue (which makes up nearly 79% of income) growth was only around 4% for the previous two quarters (excluding acquisitions), and industrial growth slowed to 2.8% in the last quarter. Furthermore, analysts had 4.8% revenue growth penciled in for 2013, a number I found hard to have a lot of confidence in thanks to the Q3 results.

Roll on to Q4, and company guidance is for 3-5% sales growth in 2013 with a disappointing set of earnings reported. The problem in the quarter was that US consumer performance (a high margin business) was weaker than anticipated, and a number of reasons were cited. Sandy affected some supplies, but the key issues seem to be the following:

  • Retailers lowered inventory from last year.
  • McCormick had to issue coupons and price promotions because customers were still adjusting to pricing.
  • Industrial demand in China was weak thanks to lower levels of promotions at restaurants like Yum! Brands (NYSE: YUM).

The weakness in China was somewhat presaged by slowing same store sales growth at the fast food outlets in China, in particular at YUM, and it’s not just about the recent chicken debacle. In fact, as discussed in this article, things were slowing down over the course of the year. McDonald’s too has seen slowing growth. While this is disappointing, it is the weakness in the US consumer segment that has really had an effect.

To demonstrate this, here are revenues ($millions) and operating income margins:

With regards to the Americas region, consumer pricing rose 2.6% but was offset by a 2.2% decline in volume/product mix, and there was also some negative impact from US industrial as its clients didn’t launch as many new products as usual in the quarter.

By way of comparison EMEA constant currency revenues were up 10% with particular strength on the industrial side.

A look at sales growth by segment:

What Makes McCormick Tick

McCormick is a highly rated stock, and for good reason. It’s been a key beneficiary of some favorable trends in the economy. The recovery hasn’t been kind to the mass consumer, and many food companies like Heinz or Campbell Soup Co. have found it tough going to get consumers to take pricing. There seems to be an ongoing cycle of food companies raising prices only to be met with volume declines. The main way out of this cycle is to innovate with flavoring, and this has obvious benefits for McCormick.

Moreover, more stay at home eating means increased demand for McCormick’s flavorings and fast food restaurants, which usually do okay in tough times. I also think that increasing multi-ethnicity in Western economies is encouraging consumers to adopt new flavoring as they try new food and ethnic populations increase. Putting all these things together suggests that McCormick is well placed to benefit from an ongoing weak economy.

The question is, will these conditions continue to be the same in 2013?

Where Next for McCormick?

I suspect the flavorings trend will continue, but if the economy improves (and it is slowly) then any shift in marginal behavior by consumers could have an effect. The good news is that margins are set to increase following commodity cost moderation, and McCormick must be hoping that it can ease up on couponing and promotions within the Americas in 2013 so the full benefits of margin improvements can kick in.

Frankly, I think that whenever companies engage in this sort of promotional activity, investors have a duty to question whether it is a temporary issue or the start of some end market weakness. I think it's too soon to tell.

If it is temporary then the margin improvements will drop into the bottom line, but even if this occurs McCormick is only guiding towards 4-6% EPS growth this year. On a forward PE ratio of over 20x this stock is certainly not cheap for the uncertainty. I’ll take a pass.

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