McCormick & Company, Inc. (MKC) is a high profit margin spice company with a consistent record of growth.
-Seven-Year Average Revenue Growth Rate: 5.6%
-Seven-Year Average EPS Growth Rate: 9.0%
-Seven-Year Average Dividend Growth Rate: 10.4%
-Current Dividend Yield: 2.02%
-Balance Sheet Strength: Moderately Strong
During the last two years when I published reports on McCormick, I stated that it has been a fairly appealing stock, and the results for those that invested have been quite good. This time, however, I believe that the stock is a bit ahead of itself, and even though it's a great business, the stock would have to come down a bit to be a good value choice.
McCormick and Company is a 120-year-old spice business. It produces and sells spices, herbs, and seasonings the world-over to both individual buyers and businesses. The company grows both organically, and through acquisitions, and sources product material from 40 countries and sells its products in over 100 countries.
The company derives 59% of its revenue from consumer sales, and the other 41% from industrial sales. Geographically, 71% of sales come from the Americas, 21% come from Europe, the Middle East, and Africa, and the remaining 8% comes from the Asia/Pacific region.
Consumer brands include McCormick, Old Bay Seasoning, Lawry's, Simply Asia, and many others. In addition to owning by-far the dominant market position in branded spices and herbs (50%+ market share in terms of sales), McCormick is also a leading provider of private label spices and herbs.
- Price to Earnings: 21.8
- Price to Free Cash Flow: 23.5
- Price to Book: 5
- Return on Equity: 23%
Over this period, revenue grew by an annualized rate of 5.6%. The sales are up by an additional 6% over the trailing twelve-month period compared to the 2011 figures shown on the chart.
According to the 2011 Chairman's letter, they're looking to grow sales by 4-6% going forward. This would be a decent result, but since much of this growth has come from and will likely continue to come from acquisitions, this takes away from the free cash that's available for dividends or stock buybacks.
Earnings and Dividends
Over the same period, earnings grew by a solid 9% annualized rate. When combined with the dividend yield, it leads to respectable low double-digit returns. The dividend has grown at slightly higher than 10% per year.
McCormick stock has 26 years of consecutive dividend growth, but currently yields only 2.02%. The dividend payout ratio from earnings is very comfortable, at a bit over 40%. The company makes mild use of share repurchases, and has a total shareholder yield of under 3%.
Approximate Historical Dividend Yield at Beginning of Each Year:
As can be seen, McCormick's current yield of only 2.02% is below the recent average, and comparable to how it was back in 2004 or 2005. (And returns were pretty poor for this stock between 2004 and 2009 even though fundamental performance was pretty good, mainly because the valuation got ahead of itself.)
Total debt/equity is around 80%, and all of the equity consists of goodwill due to their large acquisitions from a few years ago. Total debt/income is between 3 and 4, which is solid, and the interest coverage ratio is over 10, which is quite solid.
So while the company does make use of leverage, and does have a considerable amount of goodwill from acquisitions, the overall balance sheet strength is rather solid for the defensive food industry.
Developed countries are becoming increasingly health aware, and due to this, people will be looking for healthy yet flavorful foods more than in the past. Spices and herbs are a great way to add taste to food, while keeping the meal healthy, or even increasing the healthiness of the meal with antioxidants.
The company is also aggressively expanding into China and India, and has also completed its largest acquisition in company history a couple of years ago. Asia/Pacific currently accounts for only 8% of McCormick revenue, but it's growing at a rate that exceeds overall company growth, so there is a tremendous growth opportunity there and they are very keen on tapping into it.
McCormick announced plans in late August to make an acquisition of Wuhan Asia-Pacific Condiments Co. for approximately $141 million. The company has leading market share in central China with approximately $115 million in annual sales, and according to the press release, McCormick expects the sales of this company to increase by at least 10% annually going forward, after having increased a substantial 25% annually between 2007 and 2011. It's a fairly small acquisition, but paying 12x EBITDA for an expectation of 10% annualized sales growth would be quite reasonable. McCormick has a target of having 20% of its revenue come from emerging markets in 2015, which would be double the 10% of total sales that emerging markets provided in 2011.
I regard McCormick above most other food companies because its products are rather expensive per unit of weight and volume. Spices and herbs only make up a tiny part of a meal. Like most of the food industry, the company faces headwinds from commodity costs, transportation costs, packaging costs, and so forth, but I believe the company's operations in the spice business may buffer them to some extent from these problems, compared with companies that sell cheaper, larger, heavier foods in bigger packaging. The result of this is that McCormick has fairly solid net profit margins of around 10%. The company also has private-label products to capture some of the lower-margin spice purchases. I'm not too excited about investment opportunities in the food industry overall, but McCormick's core business is more attractive than most others, in my opinion.
Like any company, McCormick has risks. McCormick is a large global company and is subject to international political and currency risks. The entire food industry including McCormick is facing very high cost of goods (food, transportation, packaging), and this may be a substantial long-term trend.
I believe a key risk is that of low returns over the next few years. I can't predict what the market will do, but I believe the stock valuation is on the high side. The last time it was at this level, returns weren't particularly appealing over the next five-year period.
Conclusion and Valuation
By basically all metrics, McCormick is an appealing company. I think spices and herbs is an excellent space to operate in, and McCormick dominates the market share of this industry. You have to go back nine years to find a time when annual revenue didn't increase year-over-year, and McCormick has considerable international expansion opportunities even though almost three quarters of their business comes from the Americas.
That being said, the valuation is higher than I think is prudent. Using the dividend discount model (more info on the DDM here), and taking into account the expectation of 8% long-term EPS/dividend growth and a 10% discount rate, the fair value comes out to around $65, which is a bit higher than the current price of around $61.
Instead, using a two-stage dividend discount model, with 9% EPS/dividend growth over the next 10 years and 7% after that, and using the same 10% discount rate, I calculate that the fair value would be under $51.
Taking these estimates into account, it appears pretty clear that while McCormick may not be substantially overvalued, there just isn't any margin of safety to get decent returns of 10%+. I'd be interested in buying on a sizable stock price dip, but at the current price of over $61, I view the company as a hold.
Full Disclosure: As of this writing, I have no position in MKC. You can see my dividend portfolio here.