Has McCormick Become A Bargain After Its Recent Correction?

| About: McCormick & (MKC)

Summary

MKC enjoys a premium valuation, thanks to its wide moat.

However, due to its rich valuation, the stock is very sensitive to any shift in the policy of Fed on interest rates.

The implied volatility in its put options is remarkable.

McCormick (NYSE:MKC) has pronouncedly outperformed S&P (NYSEARCA:SPY) in the last two years, with a 42% rally vs. 15% of S&P. The stock reached a new all-time high of $107 in July, but has incurred an 11% correction since then. Nevertheless, as the stock is still trading at a markedly rich valuation, the big question is whether the recent correction has now presented a bargain or investors should wait for a deeper correction.

First of all, McCormick, the largest producer of spices, condiments and mixes, is one of the few companies of the consumer goods sector that still enjoys a wide moat. While many stalwarts used to enjoy a wide moat in the past, the technological advances have eliminated that moat in the last few years. For instance, while Wal-Mart (NYSE:WMT) and Target (NYSE:TGT) enjoyed uninterrupted growth for more than a decade, they are now facing extremely intense competition from Amazon (NASDAQ:AMZN) and other retailers, and hence their moat has almost disappeared.

Fortunately for McCormick, its business cannot be attacked by technological advancement, and hence its moat is likely to remain in place for decades. The only threat to its business model is the expansion of private label products, which have become more appealing to consumers over time, as the latter have become more price conscious. However, McCormick produces some of these private label products, so their impact is limited on the results of the company. In addition, the total sales of the company do not show any signs of fatigue. Therefore, while the sales of private label products of McCormick have much lower margins than the rest of its sales, the expansion of private label goods has hardly affected the results of the company and does not seem likely to affect them for the foreseeable future.

The business moat of McCormick is also secured by the fact that the company does not rest on its laurels. More specifically, it has several research centers around the world, which continuously try to come up with new products, as well as enhance the existing ones. The extensive research of the company makes it even harder for its peers to compete and thus strengthens its business moat even further. When a company enjoys such a wide moat, it certainly deserves a premium valuation.

The company has also posted excellent results lately. More specifically, despite an unfavorable currency impact and reduced share repurchases in its fiscal Q3, it exceeded the analysts' EPS estimates by 10%, while it also raised its guidance by about 2%. Moreover, due to its recent acquisition activity, it reduced its previously announced plans for share repurchases this year in order to keep its leverage within its desired limits. This shows that the management is prudent in the cash flow management and is in contrast to other stalwarts, such as Coca-Cola (NYSE:KO) and General Mills (NYSE:GIS), which have stopped growing and try to mask their poor performance by share repurchases funded by new debt.

McCormick is also firing on all cylinders in China. More specifically, it enjoyed double-digit, constant-currency revenue growth in its consumer segment in the country. It is remarkable that a large corporate customer in China recently started to diversify to a second supplier, other than McCormick, so it will be interesting to keep monitoring the results of the company in China. Nevertheless, this diversification has hardly affected the results of McCormick so far, which is likely to continue to grow at a high pace in China.

The company is also reactivating its purity campaign in the running quarter. This campaign seems to be particularly successful with millennials, as the company measured an increase in millennial consumption by 200 basis points. In addition, retail sales increased 9% while the advertisement was on the screens. Therefore, the company is likely to easily keep growing at the recent pace or more in the running quarter.

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The only problem with the stock is its particularly rich valuation. To be sure, despite the recent correction, the stock is still trading at a forward P/E of 23. Given that the company is expected to grow its EPS by 8% next year, this valuation is certainly not a bargain. It has essentially resulted from the prolonged environment of record-low rates, which has led investors starve for yield. As the company has raised its dividend for 30 consecutive years and currently offers a 1.8% dividend yield, the stock is highly attractive to many yield-starved investors, particularly those who are also looking for safe and growing dividends.

However, if the Fed changes course and starts to raise rates at a meaningful pace, the stock will adjust violently to the downside, as its dividend will become much less attractive than it is now, at near-zero rates. Therefore, investors who purchase the stock at its current price should be well aware of the significant potential short-term downside if interest rates rise. Of course, the consistent EPS growth of the company will partly offset the P/E compression in such an adverse scenario, but still the returns are not likely to be satisfactory.

The high sensitivity of the stock to the interest rates became apparent recently, when the Fed adopted a more hawkish tone. That shift significantly contributed to the recent 11% correction of the stock. Moreover, the implied volatility of the options of McCormick is remarkable. Last month, I was able to sell monthly put options with a strike price 30% below the stock price at a 0.15% monthly profit. This is extraordinary for a stalwart whose stock price is characterized by markedly low historical volatility and a beta of 0.58. The high implied volatility of the stock options confirms its sensitivity to the underlying conditions, most notably the path of interest rates.

To sum up, McCormick is a great stock that is likely to keep growing its earnings at the recent pace for the foreseeable future. However, the market has already baked its great consistency in its stock price. Therefore, if the Fed raises rates at a meaningful pace, the stock will experience P/E compression, which will probably offset its EPS growth, at least in part. On the other hand, if the interest rates remain around their current levels, the stock is likely to provide returns in line with its high single-digit EPS growth rate, as there is little room for P/E expansion.

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.