McCormick Inc. (MKC) is one of my favorite companies to follow. Throughout 2011 and 2012, I was an absolute bull on the stock and the company. The company has its own niche in the spice world, competing on both brand and private label. Its market share blows away the next competitor. Through 2010 and 2011, MKC struggled with rising costs hurting gross profit margins. The question is whether the 16.4% gain since the fiscal year results were announced on January 24 is justifiable given the prospects moving forward. I've been quite bearish on the stock since it crossed above my price target of $67.50. Am I being overly conservative on MKC?
Institutional investors have increased their positions in aggregate over the last few months in the non-voting shares category. Insiders have also increased their positions by approximately 1.6% over the last few months due to exercisable options. Most of this would be a bullish sign for MKC. However, insiders only own 1.41% of the non-voting shares. The voting shares (MKC.V), are mainly controlled by the 401K plan and the current management team. Institutions only own about 36% of the voting shares. It appears management is bullish on the company with the increased positions but no updated information.
There is room for margin expansion according to management on the last earnings call. With the Continuous Comprehensive Improvement (CCI) program, MKC is targeting cost improvements of at least $45M annually. Over the last three years, MKC has over-achieved its CCI estimates. Raw material costs went up over the past few years, especially for pepper as supply was limited. With prices increasing, basic economics would have spice farmers flocking back to planting new pepper fields to take advantage of the higher prices.
MKC does not hedge its raw material costs but does purchase forward contracts on it. Management commented that "Moving to gross profit margin, we anticipate about a 50-basis point increase due in part to our goal to achieve at least $45 million in cost savings from our CCI program." Raw materials are a risk to margins for MKC. "The most significant raw materials used in our business are dairy products, pepper, rice, capsicums (red peppers and paprika), onion, soybean oil and wheat (Source: MKC 10-K 2012.)" By using soybeans as a measure of commodity costs for MKC, one can see that there is room for margin expansion already (Source: Bloomberg Terminal):
Soybeans declined in price since the highs in 2011. Towards the end of 2012 however, these goods increased back to the 2011 levels. Management is forecasting 3% commodity expansion. With the most recent soybean trend turning negative, MKC could see gross profit margin improvement.
Management highlighted that MKC is facing two headwinds to EPS: a tax rate increase (-$0.12/share) and a retirement benefit expense (-$0.11). Including these items, management forecasted EPS of $3.15 to $3.23, excluding the Wuhan acquisition that is supposed to close towards the end of the first half. It is possible management is sand-bagging and setting it up for multiple positive surprises on the year. By adding back in the -$0.23 from the items, EPS would be $3.38 to $3.46 for an estimate. This doesn't even take into account Wuhan, but acquisitions in the past have shown to be a negative item to the bottom-line at the origination but accretive over-time. I wanted to look at three multiples that have justifiable measures: P/S (compared to Net Profit Margin), P/B (compared to ROE), and P/E (compared to EPS growth). The comparisons are able to justify the multiples.
MKC looks to grow sales 4-6% over the long-term but has had strong sales growth in the past due to acquisitions and price increases. In the graph below, the P/S multiple contracted as NPM contracted downward. In the fall of 2008, P/S crossed the NPM in the graph, due to the recession. The P/S multiple may increase with NPM increasing because the sales are healthier and more profitable. With NPM expected to continuously improve as management looks to grow the bottom line 9-11% long-term, the P/S multiple should be fairly stable over the long-haul. It would appear that at these levels, MKC is fairly valued on the basis that the P/S multiple has surpassed the ttm NPM. Stock prices are supposed to be forward looking, but NPM would have to greatly expand to reach the levels the market is forecasting (Source: Capital IQ):
P/B can be compared to ROE to justify it. MKC's P/B and ROE are correlated, as shown below. With stronger NPM and total asset turnover since the end of 2011, MKC's ROE has rebounded slightly. An ROE of 24% is nothing to laugh at in the food manufacturing business. It is one of the highest due to the higher profitability of MKC. The graph below shows once again that it is best to purchase MKC shares when the P/B is below the ROE level. This may be coincidence but it would show once again that MKC appears fairly valued on a P/B basis given this correlation (Source: Capital IQ):
Perhaps the strongest argument for MKC being overvalued is the P/E to EPS growth on a normalized basis (Source: Capital IQ):
The red diamond above shows the current normalized P/E compared to an 11% EPS growth rate for FY2013. The higher the expected growth rate, the higher the P/E multiple should be on a forward looking basis. If EPS were to grow 15% based on the formula, the justified multiple should be 22.87. This 15% rate is well-beyond what MKC is projected to grow, even excluding the tax rate and pension expense items. If EPS were to grow 11% based on the formula, the justified multiple would be 22.26x. With the current multiple above 24x, it would appear that valuation is getting stretched for MKC.
MKC is a great company with a strong niche. It is the spice market. When HJ Heinz (HNZ) was acquired, many consumer staples stocks took off on speculation that they could be next. MKC has some corporate governance items that get in the way of it being acquired, but that does not mean it can't get acquired. It would also make sense that former HNZ investors went to MKC for the similarities between the two. MKC is a great long-term play but valuation appears to be fairly valued to overvalued at this point. With earnings to be released on April 2, 2013, I would look for a pullback in shares. MKC is notoriously famous for issuing even great results and having shares pullback. On January 24, 2013, MKC announced results that missed expectations and pulled back over 5%. I would expect history to repeat itself again, unless management provides meaningful upside guidance. With a pullback in shares, it may be an opportune time for long-term investors to add to their positions. At this point though, MKC shares don't look too spicy.
Additional disclosure: I used to own MKC shares and am looking to get back into them over the long-term. I also manage a fund that owns MKC shares currently.