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The J.M. Smucker Company (SJM) manufactures and sells food and beverage products. Some of the company's largest brands include Pillsbury baked goods, Smucker's jellies, Folgers Coffee, and Hungry Jack sausages. Smucker distributes its goods via the retail channel at supermarket, drug stores and discount stores. The company also distributes directly to food service distributors and operators that in turn sell to restaurants, schools and hospitals. In 2012, the company bought the coffee and hot beverage division of Sarah Lee for $375m. Approximately 39% of the firm's revenues in 2013 were derived from its U.S. retail coffee sales. Other U.S. retail food sales account for 38% of Smucker's revenues in 2012. The international segment comprises the remainder (23%) of the firm's revenues.

Investment Thesis

Declining consumer price elasticity. According to Deutsche Bank, the elasticity of the firm's largest product categories that collectively represent 65% Smucker's revenues (coffee, peanut butter and baking mixes) has declined by 10% since 2007, implying that the company has room for additional price increases.

Exiting low margin businesses. Smucker is exiting several low-margin businesses that will put the company on a better footing with respect to margins going forward. In the second quarter of 2013, the company is planning to exit the private label roast and ground coffee business it acquired from Sarah Lee. This action will reduce sales by $50m, but according to management will have a positive effect on the firm's overall margins.

Commodity price depreciation. In 2012, coffee prices fell over 35%. Similarly, the peanut harvest had the largest crop ever and prices have fallen from a high of $1,000 in 2012, to a low of approximately $400-450 at present. Two of the firm's largest input costs have therefore experienced substantial depreciation, which has helped the firm stabilize its gross margins at 34% despite a 6% cut in the retail prices of coffee.

K-Cup strength to offset coffee price decreases. In 2010, the company announced a multi-year sales and distribution agreement with Green Mountain Coffee Roasters (GMCR), the makers of K-Cups. Although Smucker's coffee sales are expected to be flat on a volume basis (1%) and to decrease slightly on a pricing basis, the company's move toward selling K-cups should support additional profit growth. K-Cups sales are anticipated to increase by 70% in 2013 to approximately $300m.

Possibility of an acquisition or being acquired. The company's long-term debt currently stands at 16.6% of enterprise value versus a 5-year historical average of approximately 19%. However, the company has had historical leverage as high as 29% and interest rates are at historical lows. Furthermore, the company has a weighted cost of debt of approximately 4.60% and demonstrated in 2011 that it could borrow funds for 10 years at 3.5%. The company could therefore easily fund an acquisition without raising its cost of capital substantially.

Being acquired is also a strong possibility. Heinz was recently acquired for approximately 24x 2012 earnings or a 20% premium to Smucker's current valuation. The companies have comparable net margins, but Smucker is significantly less levered. As a result of its lower leverage and because of its ability to generate approximately $855 in operating cash flow, the company is a strong leveraged buyout candidate.

Risks

Commodity price inflation. Virtually all of the firm's revenues are derived from the sale of food and beverage products. The company is therefore highly susceptible to inflationary trends in the commodities market. Coffee prices in particular have a large effect on the firm's cost of goods sold as coffee sales accounts for 39% of the firm's revenues in the company's last fiscal year. At present coffee prices are in a slight deflationary trend, but price increases have historically compressed the firm's margin as competitive pressures make it difficult to fully pass price increases onto consumers.

Ownership structure. The Smucker's family controls 55% of the firm's voting rights although it only owns 30% of the firm's shares. A would-be acquirer would therefore have to convince the family to sell. Furthermore, the possibility of more aggressive cost cutting or activist investors causing the firm to change its balance sheet structure is extremely low because of the family's ownership.

Source: Smucker Brewing Upside