McCormick: A Flavorful Dividend Growth Investment

| About: McCormick & (MKC)

Summary

MKC has increased its dividend for 30 consecutive years.

The company has strong brands and long-standing relationships in the slow-changing spices and herbs industry.

MKC generates excellent free cash flow, strong returns on invested capital, and consistent earnings growth.

Is the stock a buy?

McCormick & Company (NYSE:MKC) has increased its dividend for 30 consecutive years and paid uninterrupted dividends since 1925.

While the stock's current dividend yield is just 2%, it has recorded a double-digit total return over each of the last 1-, 5-, 10- and 20-year periods. Very few companies have managed to create such consistent value for shareholders.

We are evaluating this excellent business for potential inclusion in our Top 20 Dividend Stocks portfolio.

Business Overview

MCK manufactures and distributes spices, seasoning mixes, condiments, and other flavorful products to the entire food industry - retail outlets, food manufacturers, and foodservice businesses. The company was established in 1889 and incorporated in 1915. Some of MCK's leading brands include McCormick, Lawry's, Club House, Zatarain's, Thai Kitchen, and Simply Asia.

MKC has two business segments - consumer (60% of sales, 80% of operating income) and industrial (40% of sales, 20% of operating income).

The consumer business sells spice, herb and regional favorite brands. The industrial business sells to nine of the top 10 global food and beverage companies and nine of the top 10 foodservice and restaurant chains. Its flavor solutions include snack seasonings, sandwich sauces, and branded foodservice products.

By geography, the U.S. is MKC's largest market (55% of sales), followed by China (including joint ventures, 22% of MKC's sales are from emerging markets). The company has brands in more than 135 countries around the world.

Business Analysis

MKC's business is driven by its strong portfolio of brands, continuous product innovation, marketing investments, and gradual expansion into new product categories and geographies with organic growth and acquisitions.

The company's history dates back to the 19th century, building up over 100 years of customer recognition of its iconic brands. Today, MKC is four times the size of its next largest global competitor and approximately 60% of MKC's consumer sales are from brands that have number one market share positions in their categories. The McCormick brand is also ranked fifth overall on the Digital IQ Index of 114 food brands.

To reinforce its dominant market position, MKC invests heavily in branding. The company spent over $225 million on brand marketing support costs (over 5% of sales) and $100 million on advertising (2.3% of sales) in 2014. Smaller players or new entrants have a hard time competing for mindshare with consumers because of the substantial investments MKC makes to maintain its brand image.

Beyond branding, MKC invests in product innovation to keep its lineup fresh and relevant. Many of its products are prepared from confidential formulas developed by its research laboratories and product development teams. MKC spent over $60 million on R&D in 2014 and has 18 innovation centers around the world.

As a result of its focus on innovation, approximately 8-10% of MKC's annual sales are from products launched over the last three years. The company is also staying relevant with e-commerce distribution and was named supplier of the year for "Grocery" by Amazon.

Thanks to its strengths in branding and product innovation, many of MKC's customer relationships have been active for decades. The company's range of products is one of the broadest in the industry and also covers practically every price point, keeping MKC relevant regardless of the customer's needs. Breaking up these relationships is no small feat for new entrants.

MKC is also able to harness its global distribution network to efficiently leverage its acquisitions. Some of the major acquisitions MKC has made over the last 15 years include Stubb's barbeque (2015), Lawry's (2008), Simply Asia (2006), and Zatarain's (2003). These deals provide MKC with new products and markets to continue the company's growth.

With almost an endless number of flavor categories, MKC can continue building its global growth platforms through acquisitions over the years.

Altogether, MKC targets long-term sales growth of 4-6%, including acquisitions, and earnings per share growth of 9-11% per year. The company has been remarkably consistent in achieving these goals throughout history, and we expect more of the same going forward.

McCormick's Key Risks

From time to time, MKC's business must put up with currency headwinds and raw material cost volatility (e.g. the price of agricultural products is impacted by weather and harvest conditions), but we don't view these issues as threats to the company's long term earnings power.

Issues that could structurally impact MKC's future are changes in consumer tastes, increased competition from private label and smaller brands, a botched acquisition, or the loss of a large customer (Wal-Mart and Pepsi accounted for 22% of MKC's 2014 sales).

Regarding consumer health trends, it's no new news that organic, natural, and healthier products are taking more shelf space at almost every retailer. Consumers are reading more labels and want to know what exactly they are putting in their bodies.

MKC seems to face less risk than other incumbents because spices and herbs are not generally perceived to be health concerns with consumers. If anything, they are viewed as good things to consume and can even serve as substitutes for sodium.

MKC is also investing to combat this risk and expects over 70% of McCormick brand spices, herbs, and extracts in the U.S. will be non-GMO. About 80% of its premium gourmet lines will be organic in 2016 as well.

The threat posed from lower-priced private label products and new brands is likely a bigger concern. MKC has demonstrated excellent pricing power over time, but this has also created a sizable gap in price between its spices and herbs and those sold under private labels. MKC does have its own private label line of products, but it is a small proportion of overall sales. Hopefully the company's brand recognition and predictable flavor tastes are enough to hold market share against lower-priced options, but we will keep our eye on volume trends.

McCormick's Dividend Analysis

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Dividend Safety Score

Our Safety Score answers the question, "Is the current dividend payment safe?" We look at factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

MKC's dividend is about as safe as they come with a Safety Score of 99. The company has paid dividends every year since 1925 and has many attractive characteristics, starting with its payout ratios.

As seen below, MKC's earnings payout ratio has remained around 40% over the last decade, and its free cash flow payout ratio has hovered around a similar level. These are very healthy figures that provide MKC plenty of flexible to continue paying and growing its dividend over the years.

McCormick MKC Dividend Stock

Source: Simply Safe Dividends

McCormick MKC Dividend Stock

Source: Simply Safe Dividends

Beyond payout ratios, understanding how a business performed during the last recession is also helpful in assessing the safety of its dividend. Operating in the consumer staples industry, it's not surprising to see a strong performance by MKC. The company's sales were about flat in fiscal year 2009, and its free cash flow actually grew. MKC's stock also outperformed the S&P 500 by 23% in 2008. This is clearly a recession-resistant business.

McCormick MKC Dividend Stock

Source: Simply Safe Dividends

Like other high quality dividend growth stocks, we can see that MKC has been a free cash flow machine. Rising free cash flow lets MKC steadily raise its dividend and pursue acquisitions to expand its product line and geographical reach. MKC was even able to grow its free cash flow per share each year during the financial crisis. It doesn't get much safer than that!

McCormick MKC Dividend Stock

Source: Simply Safe Dividends

MKC has created significant value for shareholders, earning a double-digit return on invested capital each of its last 10 fiscal years. Its profitability was also very stable throughout the last recession. These are often the signs of a blue chip dividend stock that enjoys several competitive advantages, which we believe MKC does.

McCormick MKC Dividend Stock

Source: Simply Safe Dividends

Looking at the balance sheet, MCK carries a significant amount of debt ($1 billion) compared to its cash on hand ($108 million). However, the consistency of the company's free cash flow generation and slow-changing nature of its end markets reduces MKC's balance sheet risk. The company also received a nice "A2" credit rating from Moody's in 2015.

Click to enlarge

Source: Simply Safe Dividends

Dividend Growth Score

Our Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

MKC's dividend growth potential is very strong with a Growth Score of 73. The company is a dividend aristocrat and has raised its dividend for 30 consecutive years, including an 8% boost in November 2015. As seen below, MKC has grown its dividend at about a 9% annual rate over the last 5- and 10-year periods.

McCormick MKC Dividend Growth

Source: Simply Safe Dividends

Going forward, we expect dividend growth to continue at a similar pace. MKC's objective is to maintain an earnings payout ratio of 40%, which is about where the company is at today. In other words, future dividend growth needs to align with earnings growth, which management expects to be 9-11% per year, to keep the payout ratio constant.

Valuation

MKC trades at about 23x forward earnings and has a dividend yield of 2%, which is about in line with its five year average dividend yield.

However, this is a wonderful business that has increased its total shareholder return at a double-digit rate over the past 1-, 5-, 10-, and 20-year periods, an amazing accomplishment.

While currency headwinds and raw material cost volatility could impact earnings over the near term, we believe the company is capable of growing its earnings at a high-single digit rate for at least the next five years. If this scenario plays out, MKC appears to offer 9-11% annual total return potential.

Conclusion

Few companies have demonstrated the consistency that MKC has over the last 100 years. The company's dividend safety and growth prospects are excellent, and the business should benefit over time from competing in slow-changing, steadily-growing markets. There's really not much to dislike about MKC, other than its valuation.

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. I have no business relationship with any company whose stock is mentioned in this article.