The J.M. Smucker Company (SJM) has been a disappointment for investors over the past three years, a slide that has only been amplified by a market that has moved in the opposite direction. Over this time frame, Smucker is down 20%, while the S&P 500 is up 37%. Despite such pronounced under-performance, there are still traits within J.M. Smucker that give it appeal as a long-term investment. We identify three factors behind the stock's struggles and three reasons why investors should keep J.M. Smucker on their radar.
J.M. Smucker has seen its operating margins trend lower over the past three years. Input costs such as some commodities and freight have risen and eroded profits across the sector, J.M. Smucker included among them. The highly competitive nature of the industry (a lot of pressure from generics and other tiers of brands) has made it difficult for J.M. Smucker to utilize pricing power.
Smucker has made a couple of large acquisitions over the past few years, buying itself into the pet food industry. The company will need to effectively realize synergies and cost cuts to help buoy margins over the next few years.
Source: J.M. Smucker Company
Potential margin sensitivity will remain in place with the company's revenue portfolio reliant on coffee and pet food (which features input costs on raw materials such as proteins, coffee beans, and corn). A large shift in commodity prices could have a large impact on Smucker's margin.
High Debt Load
The company's two blockbuster deals (Big Heart Pet Brands for $5.8 billion, and Ainsworth Pet Nutrition for $1.7 billion) to buy its way into the pet food industry have hampered down the balance sheet with a large debt load. While sales growth has returned to Smucker (net sales up 6% year/year last quarter, and forecasted to grow 2-3% over long term), it will take time for Smucker to dig itself out of this debt.
The company is carrying approximately $6 billion in total debt, which leverages Smucker to more than 3.8X EBITDA. This is much higher than our usual stress benchmark of 2.5X and is stifling the business as a result. Over the past 12 months, the company has paid approximately $206 million in interest expense.
This is negatively impacting the company's bottom line growth, which at low single digits is currently below management's long-term target level of 8% per year. Even reducing to just 3X EBITDA would add an entire percentage point (1.0%) to the company's bottom line EPS growth. As deleveraging continues, EPS growth will be freed up as a result.
No Short-Term Catalyst
While its challenges are fairly simple to identify, a difficult-to-find short-term catalyst is perhaps the most frustrating aspect of Smucker's situation. The company needs to grow at a faster rate before the market will elevate the stock to a higher valuation.
The company's debt position will take time to unwind. Management is targeting leverage of 3X EBITDA by 2021, so the company will be burdened with high interest expenses for a while yet. The company's top line will have to help carry water. While this past quarter was a positive sign, some of Smucker's core brands remain stagnant. In fact, Jif's peanut butter will actually see price cuts due to competitive forces and low peanut prices. With the majority of sales coming from coffee and pet food now, these segments will remain the "barometer" of how Smucker is performing in the quarters ahead.
While these headwinds are undeniable, there are still some very positive traits within J.M. Smucker that investors can hang their hat on. Smucker's brand portfolio remains very stable, and the company is still very profitable. Stocks tend to appreciate in "spurts" rather than a smooth curve over time. While Smucker has had a rough few years, there will come a time when the stock makes a strong move higher. A number of factors make J.M. Smucker attractive today.
Continued Strong Cash Flow
Despite margin compression issues, J.M. Smucker remains a strong cash flow engine. The company converts 12% of its revenue into free cash flow despite a recent surge in CAPEX. The conversion rate has risen since the Big Heart Pet Brands deal in 2015 and will continue to rise as the current CAPEX spend rate of 4.6% of revenue eventually lowers to comply with long-term goals of 3.5%.
Strong cash flow generation is key to helping the company pay its debt down and will eventually lead to increased capital for future acquisitions and dividend increases.
A Strong Dividend
Speaking of the dividend, there is a lot to like for dividend growth investors in J.M. Smucker. The company has raised its dividend for 21 consecutive years, and the current annual payout of $3.40 per share offers a 3.30% yield on the current stock price. That is more than 10-year US treasuries, currently offering a yield of 2.60%.
The dividend is very secure, consuming just 46% of cash flow. While investors can expect modest increases to the payout while deleveraging the balance sheet in the near term, the dividend has shown an ability to grow with a 10-year CAGR of 10.0%. As the balance sheet opens up in the years to come, we expect inflation-beating dividend growth. In the meantime, investors can take advantage of a very solid yield.
Priced For Upside
With the challenges that Smucker faces, investors need to be conscious of valuation. Investing at a discounted valuation can lead to PE expansion when the sentiment around a struggling company changes for the better.
While Smucker has suffered from headwinds over the past few years, the rising FCF yield and falling PE ratio indicate that the market has oversold the stock.
Management is forecasting full-year earnings at a midpoint of $8.10 per share. This results in an earnings multiple of just 12.7X, which is much lower than the company's 10-year median PE of 18.7X (a discount of 32%).
Source: J.M. Smucker Company
This is an attractive valuation, even considering the current stock price of $102 is a notch above its 52-week low point of $91. In other words, the window of value remains open. We like the stock at the current price, and as high as $121, which would result in a fair value estimation of 15X full-year earnings.
While investors shouldn't ignore the struggles that J.M. Smucker is working through, it should be noted that a whole sector is dealing with similar challenges. In a tough operating environment, quality companies will eventually rebound. We believe that Smucker's strong cash flow, dividend, and brand quality, combined with a very suppressed share price, offer investors a long-term opportunity that should include eventual PE expansion as Smucker finds top-line growth and deleverages its balance sheet.
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Disclosure: I am/we are long SJM. 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.