Smucker's (NYSE:SJM) brand strength has been a key driver behind its continued growth, and management remains committed to growing the Jif brand even further. The firm also owns the Crisco, Pillsbury, and Hungry Jack brands, which hold considerable recognition across a variety of markets. The firm's solid free cash flow generation and relatively strong balance sheet support the company's favorable Dividend Cushion ratio. Since the dividend's inception in 1997, it has never been lowered and has been increased in each of the past ~15 consecutive years.
If commodity prices on key inputs were to drastically increase, Smucker could experience headwinds, but none perhaps strong enough to put its operations or dividend in peril. We think there are very few holes in the firm's dividend, even as we highlight the possibility for cyclical pressure to come from private label brands in economic downturns. Debt repayments should be monitored as they can impact the pace of dividend growth moving forward. We are fans of Smucker's brand strength, and its largest end markets are relatively stable. Smucker currently registers a 6 on the Valuentum Buying Index -- not the worst rating, but not the best either.
Smucker's Investment Considerations
• Smucker manufactures and markets branded food products on a worldwide basis. Its key products include coffee, peanut butter, fruit spreads, shortening and oils. Sales to Walmart account for more than 25% of revenue. It completed its merger with Folgers in 2008. The J.M. Smucker Company was founded in 1897 and is headquartered in Ohio.
• Smucker's Jif brand has been a key driver behind its continued growth. Management remains committed to growing the Jif brand even further. The firm also owns the Crisco, Pillsbury, and Hungry Jack brands.
• There are a couple key risks in Smucker's operations. Though not unlike that of many of its branded peers, private label growth tends to accelerate during periods of economic recessions. Smucker owns ~30% of the at-home retail coffee category, but Green Mountain has redefined the coffee space. Though growth at Green Mountain has deteriorated, ongoing innovation in Smucker's key markets remains a threat.
• Smucker's largest brands participate in strong categories, providing its operations with a degree of stability. 75% of its annual net sales are derived from coffee, pet food, nut butters, pet snack, and fruit spreads. These categories collectively have grown at a 4.5% CAGR since 2011.
• For fiscal 2016, Smucker is expecting net sales to come in at ~$7.8 billion, while non-GAAP income per common diluted share is expected to be in a range of $5.84-$5.94. Our forecasts are in-line with these estimates.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Smucker's 3-year historical return on invested capital (without goodwill) is 15%, which is above the estimate of its cost of capital of 9.8%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Companies that have strong economic profit spreads are often also solid free cash flow generators, which also lends itself to dividend strength. Smucker's Dividend Cushion ratio, a forward-looking measure that takes into account our projections for future free cash flows along with net cash on the balance sheet and dividends expected to be paid, is 1.6 (anything above 1 is considered strong).
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Smucker's free cash flow margin has averaged about 11.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Smucker, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures expanded about 2% over the same time period.
Through the first nine months of fiscal 2016, Smucker reported cash from operations of $1.1 billion and capital expenditures of just over $160 million, resulting in free cash flow generation of more than $960 million. This is nearly triple the free cash flow generation of the comparable period of fiscal 2015.
This is the most important portion of our analysis. Below we outline our valuation assumptions and derive a fair value estimate for shares.
We think Smucker is worth $111 per share with a fair value range of $89-$133. Shares are currently trading at ~$131, near the upper bound of our fair value range. This indicates that we feel there is more downside risk than upside potential associated with shares at this time.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance.
Our top-line forecasts for fiscal 2016, for which results will be released shortly, and fiscal 2017 mirror consensus estimates. Substantial growth in fiscal 2016 is expected to be followed by flat revenue growth in fiscal 2017. Our earnings per share forecasts for the next two fiscal years are much more optimistic than consensus estimates, but are in-line with management's guidance.
Our model reflects a compound annual revenue growth rate of 7.6% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of 5.2%. Our model reflects a 5-year projected average operating margin of 16%, which is below Smucker's trailing 3-year average.
Beyond year 5, we assume free cash flow will grow at an annual rate of 2.3% for the next 15 years and 3% in perpetuity. For Smucker, we use a 9.8% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $111 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Smucker. We think the firm is attractive below $89 per share (the green line), but quite expensive above $133 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Smucker's fair value at this point in time to be about $111 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Smucker's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $143 per share in Year 3 represents our existing fair value per share of $111 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
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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.