J.M. Smucker Isn't A Company You Want Right Now

Summary

• J.M. Smucker is a company I've been following for some time. I like the company's overall fundamentals and potential future returns at the right valuation.
• Those valuations are, however, too high at this time - and combined with a muted growth prospect, Smucker's isn't as appealing as it once was, especially in the market context.
• The J.M. Smucker Company is a "HOLD", despite some fundamental undervaluation.

Context is crucial. You'll often hear me talking about only buying undervalued companies, and this is true. I try to focus strictly on undervalued businesses. However, all undervalued businesses are certainly not the same. In times of general overvaluation, deals are rare and good companies at cheap value are few and far between.

This is not the case now, however. Being that it's what we're seeing, I thought it an excellent time to update on one of my portfolio positions - the J.M. Smucker Company (NYSE:SJM).

The J.M. Smucker Company - How as the company been doing?

Investing in SJM for me has, over the course of my owning stock in the company, been an excellent investment. The company has even held up fairly against the overall coronavirus scare we're currently seeing, to where the stock is up 5% compared to the S&P's 5.5% drop (a 10%+ difference), looking to my last article about the company.

(Photo Source)

We also have a new quarterly report - so let's go through that one real quick before moving on.

The company's softness in sales continued to rear its head during 3Q20:

• Net sales drop of 2%, as well as a drop in the gross profit margins.
• Declines in operating income and income margins.

There were plenty of positives too, however, mainly:

• Significantly higher FCF, coming in at south of $0.5B for the quarter.
• Significant lowering of gross debt/EBITDA, from a 3.8X to a 3.3X YoY, with corresponding improvements (up from $1560 to $1618M) in quarterly EBITDA.
• Volume improvements in coffee and consumer foods, profit growth in coffee, with improving margins in pet foods and coffee.

(Photo Source)

Looking over the whole company, however, the turnaround we're looking for as investors continue to be an elusive one indeed. SJM is still struggling with margins and competition along some of its key segments, and volume mix in pet foods, as well as net price realizations, remain negative trends - meaning the company isn't selling its product as expensively as they would like to be doing, affecting SJM margins (or as they argue, lowering prices due to commodity costs). This last one is especially true for coffee and consumer foods, which are up in terms of volumes, but down in terms of price realization.

In terms of adjusted EPS, SJM actually delivered a 4% improvement. However, this was marred by the aforementioned margin problems and drops in organic sales growth - primarily coming down from the dog food business (and here specifically its private label and Natural Balance brands).

Cat food, on the other hand, performed well enough, coming in at low single-digit growth YoY. While dog food as a whole was down, select products/brands such as Milk-Bone performed quite well. The company also anticipated and guided for most of the Nutrish decline. The company intends to combat these negative trends in pet foods/dog foods through new marketing campaigns.

(Photo Source)

Some real impressive results were found in the company's "Uncrustables" brands, which saw YoY 23% growth, with similar double-digit growth being expected in 4Q20. This is one of the company's current best-performing high growth new brands - unfortunately, it's not enough to lift results as a whole.

Another positive was found in coffee which, while not exactly performing well in sales due to retail sales contraction, saw volume growth across the board due to its extremely strong market position. The company continues to hold Folgers, Dunkin', Café Bustelo, and K-Cups, which increased household penetration and market share during the quarter.

The company decided to discontinue the Jif Power Up brand due to a reallocation of resources and poor results.

Outlook for FY20 remains maintained, even if the face of coronavirus anxiety. Expectations are a 3% net sales decline YoY, as well as 2% down organically, with a full-year EPS of $8.10-$8.30/share. Gross margins are set to be maintained at around 38.2% and expected FY FCF stands at $850M.

Much of the negativity was expected, but prior to investing in SJM, you should consider the following.

The J.M. Smucker Company - What are the risks?

The risks for SJM have remained the same for much of the time since I started investing.

• Difficult, high-competition segments (some of them). This goes mostly for pet food. Several food companies, including General Mills (GIS) aside from SJM, have attempted to recapture growth by entering new segments, and for others, this also includes pet foods. However, this is a highly competitive segment, and while SJM has excellent brands, the company is hardly alone in this. What's more, results over the past few years do nothing to inspire confidence in this turnaround following the M&A of Big Heart Pet Brands in 2015 and later Ainsworth.
• The company has become less diversified as a result of this refocus. While endless diversification is never a good thing, the company's segmentation in terms of sales was something I actually considered appealing back in 2015. Now, it's a 35/30 split in terms of sales between pet food and coffee, with the company's traditional rich segments being relegated to a 20% net sales share - altogether.
• Total debt remains high. While a 3X gross debt/EBITDA multiple isn't that worrying for a company this conservative, it's nonetheless a fact that it's high from a historical perspective. A company with a great degree of debt is never a positive, regardless of how conservative it is.

To be clear, the bear thesis when it comes to J.M. Smucker seems to be predicated upon the fact that it M&A'ed two massive businesses for billions worth in cash upon the expectation that these businesses would then become the new growth engine for SJM. This hasn't occurred - instead, these new business segments are, in part, struggling heavily. This is affecting growth prospects and has caused the company to revise guidance here. Growth prospects are limited, and this makes SJM a tricky value proposition in today's market.

The J.M. Smucker Company - What is the valuation?

The valuation, in a word, is good.

(Source: F.A.S.T Graphs)

Offering a 7.47% earnings yield at a 3.2% dividend yield in the current market climate where overvaluation still haunts most qualitative companies is, in itself, excellent. The company which typically trades at P/E valuations closer to 17X is currently trading at 13.4X.

However, a quick look at the earnings trend as well as expectations shows us what people mindful of SJM's risks are talking about. For the past few years, SJM's growth has stalled, and analysts aren't expecting an improvement. Even the company itself is guiding for sales drop and an at-best flat EPS development.

(Source: F.A.S.T Graphs)

Longer-term developments are centered around a negative 1% earnings growth, largely due to a 2023 earnings drop expectation. Even if this does not materialize and we go flat in 2023, your potential upside at an investment today given a historical baseline valuation of P/E 15X, you're looking at a 6-8% CAGR, which is well below what other more undervalued, qualitative businesses offer you when looking at today's market climate.

So, one could actually go ahead and call SJM to be somewhat undervalued in terms of historical valuation, but insofar as growth prospects go, these are muted or even negative during the upcoming years.

What exactly does this mean for the current thesis?

Thesis

J.M. Smucker is, as I see it, a pretty simple play.

At current valuations and in this market situation, I don't view the company as all that appealing to invest in. The combination of segment-related margin pressures and competition, guided for net sales drops and an overall poor track record makes the company, in this market, an investment easily outperformed by other investments simply on the basis of valuation.

This does not mean that J.M. Smucker is a bad company. It's an excellent company, which owns some of the most loved coffee, consumer goods, and pet food brands across the USA. It's just that given what the company is actually going through and what sort of discounts we're seeing as a result of coronavirus, SJM shouldn't really be on your shopping list at this time. There are far better alternatives offering better yields and more appealing upsides with a higher likelihood of materializing.

Buying the company to hold it should be done at a P/E of 9-11 given the company's very limited current growth prospects. This comes to a share price of about ~$90/share for an 11X P/E ratio based on upper-end 2020E EPS, and that's where I would consider adding more. It is, coincidentally, also close to my YoC/previous buy price. At this level, the company has an appealing upside based on a simple long-term return to fair value, as well as a yield of nearly 4% for a conservative consumer staples company.

With that, J.M. Smucker is currently a "HOLD".

Thank you for reading.

Stance

Due to segment-related profitability issues coupled with an overall market pressure from the coronavirus, SJM is currently not investable and should be considered a "HOLD".

Analyst’s Disclosure: I am/we are long SJM, GIS. 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.

While this article may sound like financial advice, please observe that the author is not a CFA or in any way licensed to give financial advice. It may be structured as such, but it is not financial advice. Investors are required and expected to do their own due diligence and research prior to any investment. I own the European/Scandinavian tickers (not the ADRs) of all European/Scandinavian companies listed in my articles.