By Mark Bern, CPA CFA
For those who have not yet read the original article that began this series, it would probably be very beneficial to take a few minutes to read that post first to get a better sense of the rules that apply to the selection process followed in this and following articles. It's more than just a defensive play! No doubt that the food processing industry is mature as people have been eating food forever, and processed foods for well over a century. But I contend that this industry may have more growth in its future than it has seen in some decades. There are more people entering the consumer market than at any other time. Many millions of people are just beginning to have disposable income and the ability to buy more protein, try more new spices, and eat more food in general. There are hundreds of millions of people around the world in emerging markets who are being pulled out of subsistence living standards into consumerism, albeit at a very limited level. But just adding a pound of meat and a few ounces of little cereal to a few hundred million weekly diets around the world have the potential to impact this industry in a big way over the coming decades.
We all think in terms of the BRIC countries when we consider emerging markets, but there is much more to this story than just Brazil, Russia, India and China. This is a theme that you'll see in my work often when it applies to the industry and the respective future growth prospects. Other nations in Asia are beginning to join the emergence trend, lifted by newly created jobs from the attraction of their cheap labor rates, low taxes and lack of regulatory reporting and associated costs. There are many nations in Africa also joining the movement with similar attractions plus abundant natural resources. Extraction of natural resources requires labor and better infrastructure; these mean more jobs and a better standard of living for millions on the continent. The Middle East is experiencing strength due to its vast oil and gas resources and high energy prices. Latin America is growing, not just Brazil, and there will be millions more consumers south of the border than ever before.
And one of the things a rising standard of living always means is more food and more processed food. I like to eat and I know that once people have the luxury of being able to eat more, a great majority will follow me in eating more than I absolutely need. And as hundreds of millions of people find that they have more money to spend, food will become one of the luxuries they will pamper themselves with first. And many of them will continue to pamper themselves this way for as long as they live. Look at Americans; we're getting fat! It's not that we don't know better, either. It is simply because we can. The world may not want to be like us in all ways but people everywhere want to have the choices we have, especially when it comes to food. Thus, I believe that the potential opportunities for geographically dispersed food processors will be significantly large and that the trend will be sustainable for many decades to come. After all, the world's population is expected to double over the next 61 years assuming the current growth rate continues. For an explanation of how this is calculated see this interesting article on population growth.
Regarding how per capita incomes transform a nation, there is a short, but informative article on the Economic Times site about India reaching a major milestone in income per capita with links to articles and information about other countries. Another link I find useful is from knoema.com with GDP growth rates per country. It also forecasts future GDP levels for each country through 2017. It appears that China will overtake the U.S. by that time, if not before. But we are talking about per capita incomes and for that reason I'd like to point out the CIA's Factbook as a good source of this information. When we take the $1,000 per capita income threshold provided in the Economic Times (ET) article and combine it with the information from the CIA Factbook we begin to see how the rise from the bottom of countries like India with huge populations will impact future consumption. The ET article was written in January of 2011 and based on 2010 data available at the time. From then to the current forecast for 2012 provided by the CIA per capita income in India has increased about three-fold. Even if the CIA is off by a year or two, the trend is still obvious. Of course, there is a huge disparity between the rich and poor, but the middle portion (those entering the consumer phase for the first time) is expanding rapidly, and not just in India but in dozens of countries around the globe. To put world progress into even better perspective, I want to show you a short clip from gapminder.com. This one is called "200 Countries, 200 Years, 4 Minutes" and comes from an amazing video, "The Joy of Statistics." If you don't click on any of the other links, I highly recommend that you take the time to check this one out as it has been one of my favorites for its visual effects and presentation.
Not that I have (hopefully) gotten your attention, I want to make sure that we remain grounded in reality. This isn't going to be an area of hyper growth. What I expect is above average growth overall, but we will find that making the best choices from within the industry to be more important here than ever as we try to identify those companies that I expect to experience the growth that will pull the averages upward. Those companies are the ones that invested in their brand recognition on a global scale and have the ability to integrate local and regional acquisitions to create synergies that result in top and bottom line growth, new market penetrations, and market share advances in an expanding global demand setting.
I only cover companies that are listed on U.S. exchanges in my research and recommendations. With that in mind, overall, I expect revenue for the industry to increase at a compound annual rate of nearly four percent over the next five years and continue along that path into the future. There will be years of higher growth and years of lower growth, but overall I look for the average annual rate to remain at below five percent. I realize that this sound pretty pedestrian to most investors. But nice and steady growth with little downside risk can be very rewarding over the longer term, and remember that when we get to the stock selection process we will be winnowing out the slower growth options and concentrating on those companies that have the potential to grow at a faster clip than the industry average. After all, who wants to buy an average stock?
I expect net profit margins for the industry to improve from the current 6.4 percent level to about 7.1 percent. That may not seem like much either, but it represents an increase of 10.4 percent in profitability. The improvements should come from better capacity utilization rates, the addition of newer, more efficient processing facilities and equipment upgrades in older facilities. That is why I expect overall industry profits to compound at an average annual rate of approximately 5.5 percent. Again, if we buy the whole industry this looks pretty mundane. But selectivity can guide us to those companies that we expect to grow at rates of ten percent or more. Add a nice dividend to that growth rate and it starts to get interesting.
I expect long-term debt for the industry to increase somewhat, but not significantly, between now and 2014, while borrowing costs remain historically low. Then I expect that the industry leaders will begin to pay down debt and buy back shares with their growing free cash flows. These moves will improve earnings per share for the industry as a whole but will show up as having much greater impacts on the industry leaders.
While we can't expect to get rich overnight with food processors, as long as we are very selective in our investment decisions, long-term investors looking for stability and steady income streams can find some interesting opportunities from within this group. And now I'll start with the companies from this industry that made my list with a highlight on my favorite from the group. I'll explain why each one made the grade with a pass/neutral/fail analysis chart on each. I'll also provide examples of a few other very good companies from the industry that didn't quite make the cut and explain why.
My overall favorite from this group in McCormick & Company (MKC), a global leader in the manufacturing, marketing and distributing spices, seasonings, flavorings, and specialty food products to the consumer, industrial and food service industries. Major brands owned by McCormick include Mc, McCormick, Aeroplane, Billy Bee, Club House, Ducros, El Guapo, Lawrys, Old Bay, Schwartz, Silvo, Simply Asia, Thai Kitchen, Vahine, and Zatarains. We should all recognize some of these brands from the shelves in grocers where we buy food, but the consumer side is only the beginning of what MKC does. It also provides seasoning blends, natural herbs and spices, wet flavors, compound flavors, and coating systems to multi-national food manufacturers and the food service industry.
Just because a company is my favorite in an industry does not make the company a buy at the time I write about it. As a matter of fact, I think MKC is a little pricey at the current level and that investors should look for ways to get the company at closer to what I consider its current fair value. The price today (Friday, May 25, 2012 at mid-day) is close to $57.00. That represents a premium of about 8.5 percent over fair value, in my opinion. It is my belief that prices of all stocks will always revert to the mean (fair value) from time to time over time. Prices will also rise above the mean for periods and drop below the mean at other times. It is when the price drops below the mean that investors need to gather their respective nerves and buy as much of their favorite stocks as possible. The alternative is dollar cost averaging, which I do believe is a good tool as well for those who want to make consistent, periodic investments.
Let's take a look at how MKC stacks up against the rules found in the first article of this series, "The Dividend Investors' Guide to Successful Investing." If you haven't read that first article I suggest you take the time to follow the link back to where this series began to understand fully why I rate companies the way I do.
5-Yr Average Annual Dividend Increase
Free Cash Flow Per Share
5-Yr Average Annual Growth in EPS
5-Yr Average Annual Growth in Rev. / Share
Return on Total Capital
Seven category passes and two neutral ratings (with the debt-to-capital ratio so close it could conceivably be consider a pass, as well) is a strong showing. Remember, I look for companies that maintain ratios at or better than the industry average, so being equal to or very close to the industry average is also a pass for me. Very few companies have come through this process with no fails in any category. For the two categories, annual dividend increase and free cash flow per share, I do not have industry averages available. I provide a pass on the 5-year annual dividend increase if it averages at least 8 percent on a compound annual basis. Free cash flow simply needs to be positive to rate a pass. From my perspective, as long as the number is positive the company is allocating its cash resources reasonably well.
Now I'd like to reference some additional supportive statements I acquired from readers of my focus article written about McCormick in February of this year. I asked readers to comment about what they had found in local markets around the world regarding what spice brands they found in the markets where they lived. This is very unscientific and purely coincidental, but I think these comments are enlightening and useful, as well.
I defer to your deeper understanding of spice usage in India, but in China, where I live, apart from super-hot chills and soya sauce, very few spices like oregano, basil, and marjoram are used much in day-to-day cuisine. However that is changing slowly, as the burgeoning middle class becomes more international in its food tastes. And when I see spices on the grocery-store shelves, it is largely McCormick bottles that I see. The company seems to have its foot in the door first.
Gillette was first into Latin America, and Schick has had a difficult time for decades dislodging Gillette products from the shelves. Being first really counts for a lot, and so in the soon-to-be-huge China market, McCormick has the edge.
Chinese spices and usage are very regional, but they are spreading rapidly. Another factor I noticed in the Philippines is that there is a lot more trust in the brand names like McCormick than in many local ones, due probably to the many stories of adulteration, and the high variability - i.e., quality control - of many local ones.
MKC is expanding into many markets and still has the ability to expand into South America, especially Brazil. Kamis will add $100-105 million in annual sales. India is the strong point for companies to expand into, and MKC with its 26% ownership of Eastern Condiments and 85% JV with Kohinoor should see strong results from that.
The nice part about them is they supply to every food company in the US and more. Go to any restaurant, I would bet MKC supplies them. Go to a grocery store, I bet their products are there. What they don't own, they buy. The launch into India is huge. Anyone else notice that the Kohinoor JV led to 83% growth in the Asian market alone? Or that the Asian growth was 109%?
There were other very positive comments on McCormick's penetrations into emerging markets around the globe, but I just wanted to include a sample for new readers to consider. McCormick is also using its entry into new markets and its experience with new blends used in those local markets to introduce new products into developed markets; yet another growth opportunity. Once again, MKC isn't a get rich quick investment. It is, however, a very solid, very well-positioned company with a great future.
The other side of the company is its relative safety. During the great recession MKC stock fell from its 2007 high of about $39.70 to a bottom of $28.10 in 2009; a fall of 29 percent. Compare that to the overall drop in the S&P 500 of nearly 57 percent. While the broader S&P 500 has yet to regain its high of about 1535, MKC is now trading about 44 percent higher than its 2007 high. Earnings at MKC did not fall year-over-year during the great recession (probably a good reason why the stock price did not fall precipitously). The company also grew its dividends in each of those years, as well. I really like the consistency that management has displayed in the results posted during the worst economic near collapse since the great depression. There are few companies that can lay claim to have delivered such an outstanding record on behalf of its shareholders. Later in the series we will discuss the others.
This article is getting a little long so I have decided to continue the discussion of the other companies such as Smuckers ((SJM), Archer Daniels Midland (ADM), Hormel (HML), Heinz (HNZ), Hershey (HSY), and Conagra (CAG) in Part III of the series. I hope you'll continue to follow along and add your comments. I find the discussions following many of the articles here at seekalpha.com to often be as informative as the articles themselves.
Wishing you all a future filled with successful investing.
Disclosure: I am long MKC.