McCormick: A Dividend Aristocrat With Double-Digit Total Return Potential

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Simply Safe Dividends
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Dividend aristocrats, S&P 500 companies that have proven to have stable and resilient enough business models to raise dividends for 25+ consecutive years, can be a great place to go looking for new income growth ideas.

Let's take a look at McCormick (NYSE:MKC), a dividend aristocrat whose wide moat business has allowed it to raise its dividend by 11% annually for the last 31 years.

Even more impressively, the company has paid an uninterrupted quarterly dividend for the past 91 years, proving its dedication to rewarding dividend investors.

Specifically, let's find out what makes McCormick such a stable blue chip, and more importantly, if it's likely to be able to continue its impressive growth record in the coming years.

Finally, learn if the company's valuation seems reasonable enough to make McCormick a potentially solid addition to a diversified dividend growth portfolio today.

Business Overview

Founded in 1889 in Sparks, Maryland, McCormick is the world's largest producer and distributor of premium spices and specialty food items.

Source: 2016 Annual Report

It operates in two segments, consumer brands, which sell numerous premium brands in over 150 countries around the world, and industrial flavors and spices, which sells to 90% of the world's top food producers and restaurant chains.

The consumer division is the company's largest sales and earnings driver, representing 60% of 2016 revenue, and 75% of operating income, respectively, thanks to higher markups on its products.

Business Analysis

McCormick's more than 100-year history of success is largely due to its high margin, wide moat business, which has allowed it to see consistent growth in both sales, margins, earnings, and cash flow.

Source: Simply Safe Dividends

The company's ability to maintain this moat is largely driven by its strong portfolio of brands, continuous product innovation, marketing investments, and gradual expansion into new product categories and geographies with organic growth and acquisitions.

The company's history dates back to the 19th century, building up over 100 years of customer recognition of its iconic brands and impressive scale.

Today, McCormick is four times the size of its next largest global competitor, and approximately 60% of the company's consumer sales are from brands that have number one market share positions in their categories.

Thanks to its strengths in branding and product innovation, many of McCormick's customer relationships have been active for decades.

The company's range of products is one of the broadest in the industry and also covers practically every price point, keeping McCormick relevant regardless of the customer's needs. Breaking up these relationships to secure shelf space is no small feat for new entrants.

McCormick's focus on innovation is also remarkable, and many of its products are prepared from confidential formulas developed by its research laboratories and product development teams.

For example, since 2000 McCormick has done a comprehensive annual flavor forecast, in which it brings together top chefs, expert culinary professionals, sensory scientists, dietitians, trend trackers, marketing experts, and food technologists to keep abreast of changing consumer preferences in spices and its specialty food products.

This is why McCormick was one of the first packaged food companies to recognize the increasing trend in healthier foods, especially of the organic variety, and as a result, 75% of its premium consumer spices are now organic.

Source: Investor Presentation

In addition, McCormick employs 400 people in its 18 global technical innovation centers, where new products and flavors with maximal regional popularity are developed.

Meanwhile, the McCormick Science Institute funds numerous (22 and counting) clinical trials at universities around the world to keep abreast of the latest scientific breakthroughs in the realm of nutrition, helping the firm stay ahead of its rivals in recognition of new dietary trends, such as increasing popularity of anti-oxidants and the benefits of a low carb, moderate protein, high fat diet (Paleo and Mediterranean diets) into which it can market its products.

All told, McCormick's long-term investments into staying at the cutting edge of spice and flavor science allows it to expand its core brands, with new product offerings representing 9% of sales in 2016.

And, in its industrial segment, McCormick custom flavor solutions works closely with major food companies such as Pepsi (PEP) and McDonald's (MCD) in order to meet their steadily evolving needs in a world where increasing concerns about obesity and a push for healthier eating means that maintaining top quality taste can be challenging.

In addition, McCormick has continued to spend aggressively on marketing to maintain its top market share in its fastest growing and most profitable brands.

In 2016, advertising spending came in at $264 million, or 6% of revenue, with 46% focused on digital marketing, specifically in order to ensure that McCormick's products continue to be well received by Millennials.

Of course, all of these strategies are just one piece of the growth puzzle, the other being highly disciplined and well executed cost cutting efforts over time, as McCormick takes advantage of its global supply chain (3,000 products from over 80 countries) and growing economies of scale.

McCormick's Comprehensive & Continuous Improvement (CCI) initiative has proven highly successful at steadily maximizing its efficiencies and allowing it to generate solidly above industry average profitability and returns on investor capital.

In fact, in addition to achieving over $400 million in cost savings since 2012, McCormick plans to cut annual expenses by another $300 million by the end of 2019, resulting in an operating margin of around 16% and over $2 billion a year in operating cash flow.

These actions will further solidify the firm's margins above most of its peers.

McCormick Trailing 12-Month Profitability

Sources: Morningstar, Gurufocus

In addition to a strong focus on organic growth and long-term cost cutting, McCormick also grows through acquisitions, which it can quickly scale by plugging new brands and product categories into its extensive distribution network.

With almost an endless number of flavor categories, McCormick can continue building its global growth platforms through acquisitions over the years.

This includes the recent $4.2 billion purchase of Reckitt Benckiser Foods, which will add well-known brands such as Frank's Red Hot sauces, French's mustard and ketchup, and Cattleman's BBQ sauce to McCormick's famous brand portfolio.

This latest purchase is expected to increase the company's sales and EBITDA by 13% and 28%, respectively. And, once management completes its projected $50 million in annual synergistic cost savings by 2020, the deal is projected to become 10% accretive to EPS.

This three-pronged strategy of steady organic growth, disciplined and well-executed acquisitions, and ongoing margin expansion is why management believes that it can achieve its impressive long-term growth and shareholder value creation goals.

And, as we'll soon see, this kind of impressive (especially for a packaged food company) and steady growth bodes very well for McCormick's future dividend growth potential, which isn't surprising given McCormick's strong dedication to payout growth in the past three decades.

Key Risks

There are three main risks that current and potential McCormick investors need to understand.

First, the company's margin expansion plans could run into headwinds if commodity prices (raw materials) increase or competition from lower-priced private label products and new brands become a real risk.

McCormick has demonstrated excellent pricing power over time, but this has also created a sizable gap in price between its spices and herbs and those sold under private labels.

The company does have its own private label line of products, but it is a small proportion of overall sales. Hopefully, the company's brand recognition and predictable flavor tastes are enough to hold market share against lower-priced options, but it's worth monitoring volume trends, especially in mature food markets such as North America.

In addition, while McCormick has historically been very good at executing on acquisitions, the Reckitt Benckiser deal is by far the company's largest, and only time will tell if the deal's hefty 19.6 times 2017 projected Adjusted EBITDA multiple means that McCormick overpaid.

Furthermore, the deal will significantly increase McCormick's leverage ratio (Debt/EBITDA) to 4.9, though management expects this to come down to 3.0 by the end of 2020.

However, that is predicated on achieving its targeted synergistic cost savings (which would lower the price paid to a far more reasonable 15.9 times 2017 Adjusted EBITDA), which isn't necessarily guaranteed.

That's especially true given that studies have shown that the vast majority of large acquisitions fail to live up to expectations and in fact destroy shareholder value.

Finally, be aware that because it operates in over 150 countries, McCormick faces a lot of currency risk; a strong dollar can result in major sales, earnings, and cash flow growth headwinds.

While currency fluctuations generally zero out over time, large short to medium-term swings can result in the company falling short of its growth expectations.

For example, management's impressive long-term growth guidance figures (9% to 11% EPS and FCF per share growth) are based on constant currency, meaning that in any given year, McCormick could fall short, resulting in dividend growth disappointing.

McCormick's Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, "Is the current dividend payment safe?" We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

McCormick has a perfect Dividend Safety Score of 100, indicating a rock solid and dependable payout.

That's not surprising given that McCormick has been paying dividends every quarter since 1925 and raising its payout for 31 consecutive years.

There are two primary keys to this kind of impressive dividend security and consistent growth.

First, management has maintained modest and highly secure EPS and FCF payout ratios, meaning that McCormick's dividend is always well protected by a large safety buffer in case of unexpected industry downturns.

You can see that the firm's EPS payout ratio has remained at or below 50% for years with remarkable stability, underscoring the resiliency of McCormick's earnings.

In fact, the company's sales were about flat during the last recession, and its free cash flow actually grew. MKC's stock also outperformed the S&P 500 by 23% in 2008. This is clearly a recession-resistant business.

The other important component is a strong balance sheet, which allows McCormick to invest in future growth, especially via large scale acquisitions without endangering the current dividend or hindering its ability to grow strongly and consistently.

In this case, McCormick's relatively small debt burden and strong free cash flow generation allowed the company to take on large amounts of debt in the short term to make potentially game-changing purchases such as Reckitt Benckiser Foods.

And, given the capital intensive nature of this industry, when we compare the company's credit metrics against its peers, we can see just how financially sound McCormick's business really is.

Sources: Morningstar, Fast Graphs

For example, McCormick's much lower-than-average leverage ratio and debt/capital ratio is why it can afford to take on substantial debt for this latest and largest ever acquisition.

Meanwhile, the very high interest coverage ratio helps it to have an investment-grade credit rating and access to low cost debt capital, all while maintaining a highly secure and steadily growing dividend.

McCormick's Dividend Growth

Our Dividend Growth Score answers the question, "How fast is the dividend likely to grow?" It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

McCormick's Dividend Growth Score of 71 indicates that investors can probably expect above average dividend growth (relative to the S&P 500's 20-year median payout growth rate of 5.9%) in the coming years.

Again, this isn't surprising since McCormick has historically had high single-digit/low double-digit dividend growth over the past decades.

Over the coming years, the payout is likely to track the company's EPS and FCF per share growth closely.

Barring substantial currency fluctuations, McCormick should be able to maintain its historical payout growth by achieving 9% to 11% dividend increases for the foreseeable future.

Valuation

Over the past year, McCormick shares have underperformed the S&P 500 by about 10% and look more reasonably valued today.

For example, MKC's forward P/E ratio of 21.8, while above the S&P 500's forward PE of 17.7, is about in line with the company's 13-year median value of 21.6 and just slightly greater than the industry median of 20.2.

Meanwhile, the current dividend yield of 1.9% matches the S&P 500's 1.9% (as well as the industry median yield) and is in line with the company's historical 2.0% yield.

All of which means that, while McCormick may not be a perfect choice for those looking to live off dividends during retirement and doesn't look like a bargain, it appears to be a high-quality, fairly valued dividend aristocrat.

If everything goes as planned, MKC's stock has potential to generate 10.9% to 12.9% long-term annual total returns (1.9% yield + 9% to 11% annual earnings growth).

Conclusion

McCormick has proven itself over the past 100+ years to have a wide moat, thanks to its well-managed brand of premium spices and strong science-based focus on keeping up with the latest dietary and health trends.

Investors can't be faulted for questioning the price McCormick paid for Reckitt Benckiser's foods business, which caused MKC's stock to drop by more than 5% on the announcement, but management has earned the benefit of doubt with its capital allocation for now.

While the company's stock may not be necessarily selling at a discount right now, its long-term, double-digit dividend growth potential makes it a solid candidate to keep on a watch list for investors looking to benefit from decades of steady income growth and healthy total returns.

This article was written by

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Simply Safe Dividends helps conservative dividend investors increase current income, make better investment decisions, and avoid risk. Brian Bollinger, a registered CPA, runs Simply Safe Dividends and previously worked as an equity research analyst at a multibillion-dollar investment firm.
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