It’s been a long, long time since the packaged foods category, was really thought of as a growth opportunity, but with COVID-19 leading to major changes in consumer behavior, that’s what we have … at least for the moment. Therein lies one of the key issues for McCormick & Company (MKC) (“McCormick”) as an investment idea – how much of the shift from paying others to make food for you to doing it yourself will persist once COVID-19 has faded from view?
It always fascinates me when analysts more or less agree on the financial outlook for a company but come up with significantly different fair values, and that’s the case here. The spreads between expectations for revenue, EBITDA, and free cash flow aren’t all that wide over the next three years, but the spread between the Street-low price target ($134) and Street-high price target ($205) is wide indeed, with most of the analysts on the higher end basing their price targets on what the market is already paying for other packaged food companies.
Strong Consumer Demand, But Weaker Margins
McCormick had a mixed fiscal third quarter and guidance for the next quarter came up a little disappointing too. Revenue grew by almost 9% in the quarter, around 3% better than expected, but operating earnings came up about $0.03/share short of expectations on higher costs tied to COVID-19 and incentive compensation.
Within that 9% revenue growth, the Consumer business grew 15%, with business in the Americas up more than 17% and business in the EMEA region up almost 23%. The Asia-Pacific region was the notable outlier, falling 6%, though the year-over-year declines are shrinking sequentially (from down 28% in FQ1’20 to this 6% contraction). The restaurant-and-packaged food-driven Flavor Solutions business reported a 1% revenue decline, with Americas down 3%, EMEA up 1%, and Asia-Pacific up 7%.
Gross margin improved 70bp in the quarter, while EBITDA rose 5% and operating income rose 5%, with margin down 60bp. By segment, the Consumer business saw 18% profit growth (margin up 70bp to 22.9%), while Flavor Solutions declined 24% with margin down 350bp to 12.3%. Management called out COVID-19 mitigation efforts and incentive comp as margin headwinds, but with the company also pushing to expand capacity, I have to believe that played some role as well – McCormick is increasing its blending capacity both internally and via contracted third parties, and the capacity increase is equivalent to a new standalone plant.
Will Consumer Demand Stay This Strong?
Multiple surveys, including surveys conducted by McCormick, have indicated significant changes in consumer behavior during the pandemic. A large majority of consumers have reported changing their food habits (85% according to McCormick’s surveys), with 60% cooking more and many reluctant to go to restaurants.
This corroborates what a range of consumer products companies have reported through their own earnings cycles, including names like Grupo Bimbo (OTCPK:BMBOY) and Gruma (OTC:GMKKY) which I wrote about recently here and here. With many restaurants operating on a more limited basis (and some going out of business altogether), and many people sick of takeout/drive-through and/or finding some comfort in cooking for themselves, there’s been a significant increase in retail sales across a range of food categories, including seasonings, condiments, and meal “kits” offered by McCormick.
The question is how long this will last. McCormick management, and some analysts, seem to believe it will be an enduring trend, but I’m skeptical. While I don’t doubt that a meaningful chunk of people will continue to avoid restaurants while the pandemic remains and there is no effective COVID-19 vaccine, I am very skeptical about the extent to which adults really change their behavior patterns. Will some people continue to cook for themselves more often? Absolutely. Will it be enough to drive a meaningful change in McCormick’s revenue trajectory? I don’t think so.
One item of note over the next 12 months or so is the impact of restocking. With the surge in FIY food prep, retailer and wholesaler food stocks are thin, and I believe growth will stay elevated in calendar 2021 even if sell-through slows. I’d also note that McCormick has been seeing strong trends lately in household penetration (up 8% in the third quarter) and repeat business (up 7%). McCormick has also been gaining share across most of its categories, at least temporarily pushing back on the argument that the company is at elevated risk from private label growth and increased sales of smaller brands through online channels (where McCormick’s ability to dominate retail shelf space doesn’t matter).
Flavor Solutions Will Be Back… Eventually
On the flip side, I expect improvement in Flavor Solutions results from here. Other packaged food companies will see that same restock trend, and I expect McCormick’s sales to customers like PepsiCo (PEP) will improve. I also see a recovery in the restaurant/food service sector, though I believe that will be more of a 2H’21/2022 effect, with a lot depending upon the availability of a vaccine and/or meaningful progress in herd immunity.
McCormick management said that it’s “open for business” for M&A, and I view that as a mixed blessing. While McCormick has generally done a good job with M&A over the years, reaching or exceeding return goals more often than not, the increase in multiples is unmistakable – the company paid about 8x EBITDA for Zatarain’s and Lawry’s in 2003 and 2008, 12x for Gourmet Garden and Giotti in 2016, and almost 20x for RB Food in 2017.
I’ll grant that RB Food was a special opportunity in many respects, including offering multiple category-leading products like French’s mustard and Frank’s hot sauce, but I think “multiple creep” is a real issue in the current environment. If McCormick is going to get more active again on M&A, I’d like to see it look more at some emerging market opportunities; China is already the company’s second-largest market (around 10% of sales), and while American brands enjoy a premium reputation, I believe acquiring some local emerging market brands could also be worthwhile.
I’m looking for McCormick to generate long-term revenue growth of a little less than 4%. I believe margins and asset efficiency can improve further from here, driving long-term FCF margins from the low-double digits to the mid-teens, and pushing long-term FCF growth solidly into the mid-single digits. These estimates don’t include any large-scale M&A.
Unfortunately, neither the cash flows nor the company’s healthy margins and returns (ROIC, ROA, et al) support an attractive fair value in my analysis. Using my free cash flow estimates, I have to ratchet the discount rate down to about 4.75% to get today’s price, and 4.75% is only about 250bp above corporate AAA bond yields today.
The Bottom Line
Valuation arguments predicated on “A, B, and C are trading for 32x earnings, so McCormick should too” can work for a while, but I’ve seen what happens when the music stops for that approach and everybody scrambles for the exits. I’m not predicting imminent doom and gloom for McCormick, and I won’t be that surprised if the shares are higher still in six months, but this valuation/investment approach doesn’t work for me and I won’t be buying McCormick’s today.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.