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Over the past few years, the food sector has experienced volatile commodity prices, which have led to fluctuating margins and profitability. In spite of these challenges, overall cash flows throughout the industry have remained strong, leading to healthy mergers and acquisitions [M&A] activity in various sections of the supply chain. Companies are continually working on cost cutting, acquisitions and divestitures to optimize operations for higher both top and bottom line growth. With the ability to produce strong free-cash-flow [FCF] and liquidity, entities in this industry are able to navigate difficult operating cycles without affecting their ratings.

In this article, I pick one of the best operating companies in the packaged food industry, McCormick & Company (NYSE:MKC). Let's dig into this company's business model, business strategy and financial statements to see how well it fits with high ratings for this industry. Additionally, I'll look at its ability to sustain returns for investors to identify whether it is a decent stock to hold for steady gains.

Business Model

McCormick & Company is an international leader in flavor. The company is engaged in the manufacturing, marketing and distribution of condiments, seasoning mixes, spices and many additional flavorful products in the food industry. Its customers vary from retail outlets and food manufacturers to food service companies. The company has considerable global exposure, as roughly 40% of its revenues are coming from outside of the United States. McCormick operates in two business segments: industrial and consumer.

Business Strategy

McCormick is operating under a straightforward strategy. The company invests in the business to drive sales and earnings, and supports these investments with cost-cutting measures from its Comprehensive Continuous Improvement [CCI] program. With this strategy, their long-term goal is to grow their top line by 4% to 6%, operating income by 7% to 9% and earnings per share by 9% to 11%.

Digging further into their strategy, sales growth targets are projected with one-third from category growth, new distribution and share gains, another one-third from acquisitions and, finally, one-third from product innovation. In 2014, the company is set to make advancements with each of these growth measures. McCormick is consistently looking to increase brand marketing to support rising digital marketing activity, as well as other support programs designed to build consumer awareness and drive volume. Between 2005 and 2012, the company doubled brand marketing support and looks to reach spending of around $13 million for this in 2013.

Further, McCormick is launching a number of new product innovations that include grilling products, new varieties of seasonings blends, authentic ethnic meals and dessert items, and snack seasonings. The company has established itself as a source of innovative ideas, which distinguishes its brands from private label and other competition. Its recent acquisition of Wuhan Asia Pacific Condiments Co. (WAPC) is a step towards its growth strategy. With acquisitions, McCormick is adding top brands to extend its reach into new geographic regions to capture new growth markets.

Financial Situation

As previously mentioned, McCormick is operating under two business segments: consumer business and industrial business and its consumer business has higher profit margin than its industrial business. In fiscal 2012, consumer business accounted for 60% of sales and 79% of operating income, while the industrial business accounted for 40% of sales and 21% of operating income. In the past three years, on average, the company's revenue growth is standing at 7.9%. In the recent quarter, its top line increased by 4% led largely by its latest acquisition of WAPC. Operating income has grown by 3% over the last year quarter, led mostly by CCI cost saving initiatives. Lastly, for the full year fiscal 2013, the company is projected to increase revenues by 4% to 6% and operating income by 5%-7%.

Top and bottom line growth enhances McCormick's potential to generate strong cash flows, resulting in free cash flows that are absolutely protecting its dividend payments. In TTM, its free cash flows are $324 million while its dividend accounts for only $176 million. McCormick's price to cash flow ratio of 21 also reveals this trend. Additionally, the company is working on a buyback program. In the last twelve months, it returned about $126 million to shareholders in the form buybacks. With the ability to produce enormous cash flows and a payout ratio of 46%, it has a lot of room for dividend raises.

Where Other Players Stand

McCormick & Company is among those companies who compete with private labels and does not have direct competition. However, Danone (OTCQX:DANOY) and Nestle SA (OTCPK:NSRGY) have some products that compete with McCormick & Company.

Danone operates in the global food and beverages industry across four markets: fresh dairy products, waters, baby nutrition and medical nutrition. Danone is struggling to generate growth in its top line and margin expansion, and, recently, has had soft quarter results, which put its stock under pressure. However, the company is building strong momentum in fresh dairy products. With its Greek yogurt line, for instance, Danone is consolidating its number one position in this popular market. Its waters division is also generating remarkable performance, especially in emerging countries and in aquadrinks. Further, the company is seeking to cut costs in order to reach $200 million in savings between now and the end of 2014. At the same time, Danone continues to expand its product categories and build its brand's profitably and sustainably.

Nestle SA manufactures and markets food products. The company's product line includes milk, chocolate, creamer, confectionery, coffee, food seasoning, bottled water and pet foods, among others. In the current challenging economic environment, Nestlé is driving growth with distribution, innovation and consumer engagement, while also strengthening its portfolio, improving its resource allocation and increasing its structural efficiency. This plan seems to be working so far, and the company has been gaining organic growth at around 5% over the past nine months. Nestle is offering dividends on a yearly basis, which looks safe given their consistent growth levels. Additionally, its valuation suggests upside potential, as its stock looks undervalued when compared to that of competitors. However, there is always an opportunity to capitalize on gains when shares are trading at their highest level, and Nestlé's shares are now trading at their highest level over the past three years, which suggests an attractive opportunity to capitalize on gains.

In Conclusion

Companies operating in this industry will continue acquisitions, divestitures and cost cuttings to optimize operations for higher top and bottom line growth. In possession of a diversified business model, McCormick is utilizing a smart business strategy, working to invest in the business to drive sales and earnings while supporting these investments with cost-cutting measures from its Comprehensive Continuous Improvement program. Overall, McCormick's aggressive marketing and innovations are paving the path for mid-single digit top line growth.

Source: Prospects Look Bright For McCormick & Company