McCormick: Currency Headwinds Mask Earnings Growth

| About: McCormick & (MKC)

Summary

McCormick has been suffering from a negative currency situation, which must eventually end.

The company has still managed to post strong results.

Remember Buffett's advice and be willing to pay a fair price for a good company.

As the Dow continues to flirt with passing the 20,000 mark, many investors are wondering if the market is too overvalued to put money to work. While I believe price is a critical factor to consider when investing, I also believe it is important to reflect on one of Warren Buffett's most well-known quotes during times like this:

"It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."

I believe McCormick (NYSE:MKC) is one of those "wonderful" companies, and the recent pullback in the stock price has made it "fairly priced" for long-term investors. Additionally, I believe currency changes due to the strengthening dollar have obscured the company's strong sales and earnings growth, making it seem overvalued.

Recent Earnings Results

McCormick reported strong revenue and earnings results in its most recent quarter, growing sales, operating income and EPS at a healthy clip. Clearly this is not an isolated result, with the business delivering positive results throughout this past fiscal year, including growing profits 32% in Q1. In fact, management also raised its financial outlook for FY 2016, demonstrating its confidence in being able to continue to deliver in Q4.

What's most impressive is that the business was able to deliver these results despite significant currency headwinds, which in effect mask the true strength of the operations oversees. For example, Q3 sales grew +3% y/y, but sales growth was actually double that amount, +6%, on a constant dollar basis. McCormick is a global juggernaut in the global packaged spice and herb industry, with operations in 24 countries, controlling 22% market share and 4x larger than its next largest competitor. Furthermore, almost half of its sales coming from non-US operations and sales in emerging markets are expected to continue growing at almost double-digit rates for several years. In fact, China is McCormick's third largest country in terms of sales. Given it's global scope and geographic reach, the impact of unfavorable currency changes cannot be overlooked.

Company Strength

Another characteristic I like about McCormick is that it has done an excellent job in crushing its competition, despite being in a very simple business. Think about it: McCormick's raw materials are simple agricultural products (peppers, onions, etc.) that it processes and resells as spices and condiments. Yet despite this simple business model, the company has been able to maintain excellent margins, and was actually able to expand its gross profit margin above 40% this past quarter (41.6% vs. 39.8% Q3 2015).

As the clear market leader in seasoning and spices, the company has been very effective leveraging its leadership position to secure prime shelf space with retailers. Furthermore, being the largest player provides MKC with a high degree of economies of scale, which translates into purchasing and pricing benefits, and a higher level of operational efficiency. For example, its Comprehensive Continuous Improvement (CCI) program is expected to achieve cost savings of $100 million to $110 million in 2016. This allows the company to continue to organically grow sales by investing in brand marketing and launching differentiated new products, such as herb grinders and slow cooker sauces for its consumer segment and snack seasonings for its industrial customers. The company has invested an enormous amount of resources in developing and maintain brand equity, enabling it to charge premium prices for what are essential commodity products in the truest sense.

Further evidence of the company's continued strength is provided by its announcement of a 9.3% increase in it's dividend to $0.47 per share. McCormick has increased its quarterly dividend 31 year in a row and doubled the amount paid 10 years ago, while still maintaining a dividend payout ratio below the 50% mark.

The company also recently completed its acquisition of Enrico Giotti SpA, a leading Italian flavor manufacturer, less than a month after originally announcing the deal. The acquisition of Giotti adds greater scale to McCormick's already substantial industrial business in the Europe, Middle East and Africa region while expanding the breadth of McCormick's value-added flavor solutions. With sales expected to grow at the mid- to high-single-digit rate for the next several years, Giotti is just the latest example of how Mccormick is continuing to grow its global footprint through acquisitions as well, including significant investments into Asia.

Valuation & Conclusion

Even though McCormick is a great business, investors obviously do not want to overpay for it as that will hurt their results. However, given McCormick's long track record of strong operational performance, and the simple and predictable nature of its business, I believe investors should be willing to pay a premium to own the company. Furthermore, operating income and earnings growth have been strong, despite a negative currency impact, with Q3 operating income growing +12% y/y (+15% in constant currency) and adjusted Q3 EPS growing a blistering +21%.

Looking ahead to the full fiscal year, management is guiding for operating income to grow 7% (10% in constant currency) and adjusted EPS of $3.75 - $3.79. This would be an 8% increase compared with the previous year, and a 12-13% increase in constant currency. With the stock currently around $90 per share, this gives a forward P/E ratio just under 24. However, this includes three quarters that have already been reported, so we're really interested in FY 2017.

Assuming MKC can grow earnings 12% next year, the forward P/E ratio drops to ~21x. While still high, this seems reasonable given the company's characteristics, and it provides an earnings yield of 4.7%, double the 10-year bond yield (2.3%) and significantly higher than the 30-year bond yield (2.9%). Additionally, management has been able to skillfully allocating capital to acquisitions that strengthen the brands and expand the company's global reach and return cash to shareholders through dividends and share repurchases, while also consistently growing earnings.

Given all this, I believe McCormick is a company worth paying up for, especially for long-term investors willing to hold the stock for an extended time period.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MKC over 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.

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