McCormick & Company (MKC) Equity Research

McCormick & Company  (NYSE: MKC  ) delivered a good set of fourth-quarter earnings that came in slightly ahead of estimates. However, investors will be equally interested in management's guidance. Let's take a look at the underlying trends in the earnings report that came out Jan. 28 and management's outlook for 2015.


READ THE FULL EQUITY RESEARCH ARTICLE LINKED

What You Need to Know About Yum Brands in China

Another set of earnings from Yum! Brands (NYSE: YUM  ) , and another setback for its plans to recover KFC sales growth in China. Yum! continues to struggle to recover from adverse publicity due to chicken quality supply issues in China. With the share price now flat on the year, is now the time to be picking up some shares? 

What's going wrong?

There were two main disappointments in the last quarter.  First, KFC's Chinese sales were lower than expected, and the new product launched at KFC in September (a beef burger) failed to generate sales in line with expectations.  Consequently, Yum! no longer expects positive same-store sales in the fourth quarter. Listening to the conference call, it's clear that management feels this is mainly a question of reestablishing credibility in China:

"our overall trust and reliability and safety measures are below what they were the previous year. And we think we really need to get those back at least level."

The question is whether the decline in same-store sales is totally due to the chicken quality/avian flu double whammy, or whether it is a function of hyper-competition in China, or even a macro issue. Indeed, Yum!'s major quick service restaurant (QSR) rival McDonalds (NYSE: MCD  ) has also seen declining same-store sales growth in its Asia-Pacific, Middle East and Africa (APMEA) markets.

source: company presentations

In fact, last quarter's comparable sales were negative in McDonald's big three APMEA markets of China (-6.1%), Australia and Japan. By way of comparison, KFC same-store sales declined 14% in China. Both companies blamed a bout of avian flu in China during the spring, but same-store sales growth has been declining since the end of 2011.  In other words, the trend was in place before KFC's chicken quality issues, and the avian flu issue.

The second disappointment was the $258 million impairment charge taken on Little Sheep (a hot pot restaurant chain acquired in China), and Yum! declared itself 'deeply disappointed' with the results achieved from Little Sheep so far. While the impairment charge is a non-cash item, the ongoing performance at Little Sheep is a concern.

What's going right

There are three good things going for Yum!. First, Yum!'s casual dining outlets are performing relatively better, and Yum! has growth opportunities thanks to innovation. Yum!'s overall US same-store sales were flat, but Taco Bell contributes 60% of US profits and its same-store sales were up 2%. In comparison, Pizza Hut's US number was down 1%. In a confirmation that the quick serve restaurant category is tough globally, KFC's US same-store sales were down 4%. For the immediate future, the good news is that Yum!'s efforts in the US will focus on advertising Wing Street (a chicken wing QSR co-located with Pizza Hut), and developing its breakfast menu at Taco Bell.

Incidentally, many of these trends in the US are confirmed by the National Restaurant Association Restaurant Performance Index (it declined for the third consecutive month to August), or in what QSR suppliers like spice and seasonings company McCormick (NYSE: MKC  ) are saying about the market. In particular, McCormick's QSR-based sales in the US are likely to remain weak, especially because the company is not particularly strong in the breakfast market.

The second positive point is that despite the double-digit decline in Yum!'s China division's same-store sales, restaurant margins only declined 1.9% in the quarter (and by less than 1.5% if you exclude Little Sheep). Hopefully, if and when sales growth turns positive again next year, these underlying productivity improvements should feed into substantial profit improvements for Yum! in China.

Positive indications from sales trends

The third positive indicator may appear esoteric, but bear with me! With regard to third quarter sales trends in China, Yum! said this on the conference call "No real meaningful variances across the city tiers by day part, or any other occasion. Pretty consistent, pretty balanced across the market."

Thinking laterally, different cities will have different levels of competition. Some variance in performance might be expected if the weakness was due to excess competitiveness. In other words, its probably a combination of macro and KFC-specific weakness.

Yum! also stated that the second quarter saw some disparity in performance by city; Shanghai was weaker thanks to its greater concentration of avian flu cases. However, this didn't feed through into the third quarter, which indicates that avian flu fears are receding.

What to do with Yum! Brands?

A bullish case sees a much brighter outlook in 2014. China's sales will turn positive, underlying margin improvements will lead to a massive increase in profitability, and US performance will remain solid on the back of innovation at Taco Bell and Pizza Hut.

On the other hand, the US QSR category remains weak, and so far Yum! has underestimated how long it will take to recover its reputation in China.

In conclusion, a piecemeal approach probably works best here. Investors can monitor three interesting inputs. First, you can look at McDonald's third quarter results (due on Oct. 21, 2013) in order to see if its Chinese sales are turning around. Second, keep an eye out for what McCormick is saying about the QSR environment. Third, Yum! has promised to provide the market with monthly updates on China same-store sales, with the next report due on Nov. 12, 2013.

McCormick Not Looking Such Good Value Right Now

Food company McCormick (NYSE: MKC  ) is down over 13% from its high of the year as disappointing sales in some of its markets dragged the stock lower. The spice and seasoning maker has long been attractive thanks to its defensive-growth prospects, demographic appeal and long-term potential within emerging markets. However, its valuation has also looked a bit too spicy for a while. Is the recent weakness a chance to buy in?

What happened?

The recent third quarter results were disappointing, and McCormick indicated that its full-year earnings per share would come in at the lower end of its $3.13 to $3.19 range. Similarly, its full-year adjusted operating income is now forecast to grow 3% to 5% versus a prior forecast of 5% to 7%. What went wrong?

McCormick reported three weak points in the quarter. First, its industrial division saw weak demand from its quick service restaurant customers in the quarter. Essentially, the fast food companies are seeing lower demand, and they are also tailoring their products and promotions toward the kinds of items (breakfast, coffee, etc) that McCormick doesn't sell into. On a more positive note, McCormick argued that China was a bit better than expected.

We had weak demand from quick service restaurants in the U.S. and China, although China was better than we expected as sales begin to recover from consumer concerns about bird flu earlier this year.

Given that Yum! Brands (NYSE: YUM  ) is a key customer of McCormick (it's almost certainly being referred to in the above statement), then this is relatively good news for Yum!'s plans to return to growth in China. Over the last year, Yum! has been hit by food safety scares, and an outbreak of bird flu has kept customers worried. With McCormick indicating that China was relatively positive, it can be seen as a good portent for Yum!'s next results.

source: company accounts

Second, McCormick outlined that its US consumer sales were lower at the start of the quarter. They did come back up toward the end of the quarter, but it wasn't enough to counteract the earlier weakness. Furthermore, there was a pull-forward in consumer sales in the third quarter. This was due to retailers aggressively taking up McCormick's holiday display program (an initiative that McCormick does to encourage early season sales), and this induced customers to buy early for the holiday season.

In fact, if overall consumer sales are adjusted for currency, the pull-forward effect and the sales contribution from its WAPC acquisition mean that its consumer sales actually declined by 2%. It wasn't a strong set of results for McCormick.

source: company accounts

And finally, McCormick's underlying international consumer sales were not strong either. Sales in Europe, the Middle East and Africa, or EMEA, were flat (constant currency) with a year ago. It wasn't much better in Asia-Pacific, or APAC, either. Sales in China were down 5% (constant currency) on a comparable basis, but they rose 54% on the back of a 59% contribution from WAPC. Furthermore, the company's sales in India declined. This must have come as a disappointment, because only two years ago it formed a joint venture with Kohinoor Specialty foods in India.

A reason to be cheerful

The good news is that McCormick guided toward a better outcome in the next quarter, and in particular, from the part of the company's sales that really matters. After the quarter started off weakly in regard to US consumer sales, McCormick saw a stronger trend at the end of the quarter. Its management predicted that the trend would continue into the fourth quarter, and ultimately lead to a 7% sales increase in the quarter.

While industrial sales are likely to remain weak, remember that McCormick generates around 80% of segment income from its consumer sales. Moreover, WAPC will contribute to sales growth in the quarter as well, even if the underlying picture in China isn't that strong.

Going forward, if McCormick can get US consumer sales back on track and make some more acquisitions, then it may be able to ride through this difficult period.

Where next for McCormick?

In conclusion, McCormick's valuation still looks a little stretched for the risks involved. With a current share price of around $64.80 it still trades at a P/E ratio around 21 times its forecast earnings for 2013. The company has good long-term prospects, but it needs to start delivering.

MKC Price to Earnings Less Cash TTM data by YCharts

McCormick's current performance isn't great, and the positive forecast for the next quarter is yet to be delivered. Despite the pull-back in the share price, it still isn't a good value yet.

ConAgra Foods Earnings Analysis

ConAgra Foods(NYSE: CAG) stands out as a winner in the food industry over the last few years. Its mix of value brands in the consumer division, expanding private label business and, a commercial foods division (which has been expanding profits strongly over the last few years) has stood it in good stead to deal with a challenging environment.

In summary, I think the company is well-positioned to do well, but a lot of its prospects depend on believing the management can execute successfully.

How ConAgra makes its money

I’ve broken out the recent fourth-quarter numbers, because private-label manufacturer Ralcorp hasn’t been part of ConAgra for a full year yet.

In order to properly reflect its performance ConAgra will change the way it reports by splitting the commercial foods division into a private-label segment (to reflect the addition of Ralcorp to its existing private-label business) and, a food service segment which will contain its Lamb Weston potato operations.

The three things its management needs to execute

The first question is it can continue to generate volume growth in its consumer foods division. ConAgra increased prices last year; in common with so many other companies in this slow economy, it then saw volume decreases. Consequently, it’s taken a while for ConAgra to get back to organic volume growth. Indeed, it only did so in the recent fourth-quarter results with a 3% gain. Overall, consumer foods sales were up 7%, with acquisitions contributing 5%.

ConAgra sees the organic sales growth as a turning point, but it has come at the expense of increasing advertising and promotion expenditure by 15%. Margins were up slightly thanks to strong cost savings which may not be repeated this year. This is fine but,note that the company has had to increase marketing costs in order to get volume growth. It is also spending more on supporting the launch of some new products in areas like desserts and frozen breakfasts. It is not a given that the new products will work and/or that operating margins won’t suffer next year thanks to increased marketing spending.

The second question relates to the Ralcorp acquisition. The good news was that It raised its synergy projections to $300 million by 2017, as opposed to the initial target of $225 million. Moreover Ralcorp’s profits were in line with expectations, but its sales performance was softer than ConAgra expects to see in the future. The subsequent restructuring activity was described as short term and fixable in the conference call.This is fine, but it still needs to be done.

Looking at the wider question of private label manufacturing I would issue caution. As investors in TreeHouse Foods (NYSE: THS) will tell you, manufacturing private-label foods can be a volatile business. Industry trends may be favorable right now, but Treehouse has had to deal with difficult conditions in recent years. Its customers' sales channels have changed along with the trend towards trading down.

Private-label companies are subject to the sales patterns of their customers, and while Treehouse is currently doing well with things like single-serve coffee and refrigerated dressings, it has also suffered before with categories like soup and pickles. It’s a business that requires a constant adjustment to the end market conditions of customers. Don’t be surprised if Ralcorp faces similar issues in future. Treehouse is on a forward PE of over 20 and is hardly cheap for such an uncertain business.

The third issue is that its commercial foods segment saw its potato operations (Lamb Weston) lose a major long-term customer. This will reduce EPS by $0.10 next year.The contract loss will also hit margins, but ConAgra expressed confidence that it would make up for it. Again, the management needs to deliver.

In addition, ConAgra talked of "short term challenges in Asia," which caused profits to decline for its potato operations for the quarter. Frankly, I don’t believe in coincidences, and anyone looking at McCormick’s (NYSE: MKC) latest results would note that it reported weakness from its quick service restaurant customers in both China and the Americas. Yum! Brands is a major customer of McCormick and much of its problems are company specific but the truth is that it’s Chinese same store sales growth has been falling since the first quarter of 2012.

In addition McCormick’s industrial growth has been negative for the last two quarters. Is this a short term issue or is it a deeper one relating to slowing quick-service restaurant sales growth? These types of restaurants are major customers of ConAgra's potato operations.

The bottom line

In conclusion, I think these three concerns require you to express a fair amount of confidence in the management to execute over the next year. This might be okay if the stock traded on a more attractive valuation. A forward PE of around 13 may look attractive, but recall that the company has to pay off significant amounts of debt.

Looking at these companies' current enterprise values (EV) in relation to their earnings before interest, depreciation and amortization (EBITDA) reveals that none of them are cheap. The measure helps to account for debt levels in evaluating a stock.

CAG EV / EBITDA TTM data by YCharts

ConAgra is the most expensive of the three companies above, and it's not cheap enough to compensate for the execution risk. It's a stock for the monitor list. The market may be in love with food stocks, but there is no excuse for not sticking to your valuation principles.

McCormick's Evaluation is Looking a bit Rich

There is a lot to like about the long-term prospects for spice and seasoning company McCormick (NYSE: MKC)Consumers are demanding ever more flavor in their cooking, and food companies are being forced to innovate by using flavorings in order to compete in difficult end markets. With these positive trends in place, the company is doing well. But what of its near-term prospects? Moreover, is the stock good value right now?

McCormick delivers mixed results

It was an underwhelming set of second-quarter (Q2) results for McCormick, as reported sales rose a paltry 2%. Its top line growth has been slowing in recent quarters as it laps some difficult comparables. In addition, Yum! Brands (NYSE: YUM), is one of its major clients and it's having some well documented difficulties in China with its KFC stores. First it was a scare over its chicken suppliers, and now it has to deal with fears over bird flu. The issue is hurting Yum!, and McCormick's industrial sales are being hit because it supplies spices and seasonings to KFC.

I’ve broken out the progression of McCormick's divisional sales growth below.

The problems in the industrial division aren’t just about quick-service restaurants in China, because McCormick's industrial sales in the Americas declined 1%. McCormick cited strength in its snack seasonings and food flavorings, but it wasn’t enough to offset declines in demand from quick service restaurants in the Americas. The eating out category has faced some weaker growth and, the areas that are growing within it are not favoring McCormick.

All of which is not to be too negative on the stock because it’s the consumer side that makes the majority of profits. And it is still doing quite well.

A breakout of Q2 operating income here.

Consumer segment sales grew 5% in constant currency. Within developed markets, McCormick is benefiting from a increased willingness among consumers to eat at home and, to utilize more flavors in their cooking. The latter trend is also being driven by an increasingly ethnically diverse population in many developed countries.

Within emerging markets, McCormick is seeing good results via a mix of organic and acquisition-led growth. For example, in India its acquisition of spice company Kohinoor is giving McCormick long-term opportunities in an important growth market. India makes up less that 5% of sales, so there is plenty of scale for this figure to increase in future years. Similarly, the WAPC acquisition in China is believed to bring its Chinese sales up to 7% of the company total.

Two concerns

The first relates to the disappointing performance within China and the Americas on the industrial side. The hope with Yum! is that it will be able to recover from its company specific issues but I think there might be some macro factors at play here too. Yum! Brands' same-store sales in China were getting weaker even before the media scare stories and bird flu worries hit.

It was a similar story with McDonald’s (NYSE: MCD).

The outlook for the quick service restaurant sector is important to McCormick, since much of its industrial demand goes to this industry. The signs are that it is not just a Yum! issue. McDonalds’s could be facing a tough year this year, and Yum! investors need to take note.

McDonald’s management was very clear on its last earnings call that it intends to retain and even grow market share. This as a sign that it will be willing to sacrifice margins and cash flow in order to secure long term positioning. McDonald's and Yum! are likely to increase competitive efforts in North America in order to try and make up weakness elsewhere. McCormick investors will be hoping that Yum! wins out.

The second concern is that even though the consumer division is doing well, its growth is still slowing. The company announced it was increasing incremental marketing on its consumer brands to $15 million but, it did not raise revenue expectations. The weakness on the industrial side is increasing the pressure on the consumer side.Is this marketing increase a sign that it is having to work harder to hit its numbers?

The bottom line

I don’t want to appear too negative here, because this company has plenty of good long-term drivers, and its acquisition strategy makes perfect sense. However, if you are going to add this stock to your portfolio, you will need to assess it on a risk/reward basis. This is a stock that trades at 22 times its November 2013 earnings, which looks pricey when compared to International Flavors & Fragrances' forward PE of nearly 18, and German rival Symrise at 20 estimated 2013 earnings.

McCormick is hardly cheap, and its underlying growth is slowing while its end-market customers (on the industrial side) are facing some difficult market conditions. This stock is worth monitoring for a long-term buy, but an entry point might only come should it miss estimates this year.