McCormick: Year-Long Pullback Finally Has Shares Looking Attractive

Summary

• McCormick is a Dividend Champion with 35 consecutive years of dividend growth. Shares currently yield 1.69%.
• McCormick free cash flow generation has improved substantially over the last 10 years.
• McCormick's debt ratios are higher than I'd like due to various acquisitions over the last several years; however, I believe that management will follow through with de-levering.
• McCormick's share price got ahead of itself due to COVID and has since pulled back nearly 20% over the last year.

Justin Sullivan/Getty Images News

McCormick (NYSE:MKC) is the largest spice and flavoring business sector with over 20% market share. The majority of sales comes from everyday consumers with restaurants and other businesses accounting for the remainder.

McCormick has always appeared to be expensive and rarely offers opportunities where shares are undeniably cheap. Rather the share price typically flirts with fair value and spends the rest of the time being quite expensive. That's for good reason though as the business is very strong and offers stability in most environments. Take the craziness of 2020, while some companies were facing the very real threat of $0 revenue quarters which put a serious strain on the business, McCormick was able to thrive due to the "everyday need" for their products.

My wife and I both love to cook and while it gets difficult at times with 3 kids 5 and under, we still try to take the time to cook most meals throughout the week.

Data by YCharts

McCormick's share price is off nearly 20% over the last year while the S&P 500, via SPDR S&P 500 Trust ETF (SPY), is down just over 4%. That underperformance hurts in the short term; however, it could offer an opportunity for patient long-term investors to add this great company to their portfolio.

Dividend History

Dividend growth investing resonated with me when I was searching for strategies to employ. For starters, the idea is very straightforward: find good companies with a history of paying dividends and don't pay too much for them. Eventually, you can use the dividends to fund or support your lifestyle without having to cut down the equity tree.

Data Source: McCormick Investor Relations

According to the CCC list, McCormick has raised its annual dividend payout for 35 consecutive years giving them the title of Dividend Champion. Their streak began in 1987 and has continued on every year since through the tech bubble of the late '90s, the great financial crisis of the 2000s, and the most recent COVID issues 2020.

During McCormick's dividend growth streak year-over-year, dividend growth has ranged from 5.0% to 35.7% with an average of 12.0% and a median of 9.5%.

There have been 31 rolling 5-year periods during McCormick's streak with annualized dividend growth ranging from 7.0% to 27.1% with an average of 11.8% and a median of 9.2%.

Additionally, there have been 26 rolling 10-year periods with annualized dividend growth ranging from 7.7% to 17.7% with an average of 11.0% and a median of 10.3%.

The rolling 1-, 3-, 5- and 10-year period annualized dividend growth rates from McCormick can be found in the following table.

Year	Annual Dividend	1 Year	3 year	5 Year	10 Year
1985	$0.0275
1986	$0.0275	0.00%
1987	$0.0313	13.64%
1988	$0.0331	6.00%
1989	$0.0425	28.30%	15.62%
1990	$0.0575	35.29%	22.54%
1991	$0.0700	21.74%	28.33%	20.55%
1992	$0.0950	35.71%	30.75%	24.90%
1993	$0.1100	15.79%	24.14%	27.13%
1994	$0.1200	9.09%	19.68%	23.07%
1995	$0.1300	8.33%	11.02%	17.72%
1996	$0.1400	7.69%	8.37%	14.87%	17.67%
1997	$0.1500	7.14%	7.72%	9.57%	16.98%
1998	$0.1600	6.67%	7.17%	7.78%	17.06%
1999	$0.1700	6.25%	6.69%	7.21%	14.87%
2000	$0.1900	11.76%	8.20%	7.89%	12.70%
2001	$0.2000	5.26%	7.72%	7.39%	11.07%
2002	$0.2100	5.00%	7.30%	6.96%	8.26%
2003	$0.2300	9.52%	6.58%	7.53%	7.65%
2004	$0.2800	21.74%	11.87%	10.49%	8.84%
2005	$0.3200	14.29%	15.07%	10.99%	9.43%
2006	$0.3600	12.50%	16.11%	12.47%	9.90%
2007	$0.4000	11.11%	12.62%	13.75%	10.31%
2008	$0.4400	10.00%	11.20%	13.85%	10.65%
2009	$0.4800	9.09%	10.06%	11.38%	10.94%
2010	$0.5200	8.33%	9.14%	10.20%	10.59%
2011	$0.5600	7.69%	8.37%	9.24%	10.84%
2012	$0.6200	10.71%	8.91%	9.16%	11.43%
2013	$0.6800	9.68%	9.35%	9.10%	11.45%
2014	$0.7400	8.82%	9.74%	9.04%	10.21%
2015	$0.8000	8.11%	8.87%	9.00%	9.60%
2016	$0.8600	7.50%	8.14%	8.96%	9.10%
2017	$0.9400	9.30%	8.30%	8.68%	8.92%
2018	$1.0400	10.64%	9.14%	8.87%	8.98%
2019	$1.1400	9.62%	9.85%	9.03%	9.04%
2020	$1.2400	8.77%	9.67%	9.16%	9.08%
2021	$1.3600	9.68%	9.35%	9.60%	9.28%

Click to enlarge

Table Source: Author; Data Source: McCormick Investor Relations

As a dividend growth investor, I want to see that the dividend is not unnecessarily high in relation to earnings or cash flow. The reason being that the higher proportion of profits the business pays out, the more potential risk of a dividend cut should the business stumble for a few years. Additionally, a lower payout ratio allows management to grow its dividend faster than the growth of the underlying business.

Data Source: McCormick SEC filings

McCormick's net income and free cash flow payout ratios show no real risks at this time. Dividends have typically used ~40-45% of net income or free cash flow leaving the rest for reinvestment opportunities.

The 10-year average net income payout ratio is 43% with the 5-year average at 42%. Meanwhile, the average free cash flow payout ratios are 46% and 40%, respectively.

Quantitative Quality

A dividend growth streak can be useful to narrow down the list of investment candidates. While useful in likely limiting yourself to higher-quality companies, there's much more to examine before making an investment.

Data Source: McCormick SEC filings

Through a combination of growth in the underlying business as well as acquisitions over the last decade, McCormick has grown revenues by 52% in total or ~4.7% annually. Gross profits have tracked right along with revenues, rising 51% in total or ~4.7% annualized.

Operating profits outperformed revenue growth, increasing 89% in total or ~7.3% annualized, with operating cash flow far outpacing revenue growth climbing 206% in total or ~13.2% annualized. Likewise, McCormick's free cash flow grew 235% in total or ~14.4% annualized.

The following chart shows the rolling 5-year CAGRs McCormick has achieved for revenue, gross and operating profit, and operating and free cash flow.

Data Source: McCormick SEC filings

My expectation is that great companies will find ways to generate more cash per dollar of revenue over time as evidenced by a higher free cash flow margin. My preference is to see a free cash flow margin greater than 10%; however, that's not a hard and fast rule.

Data Source: McCormick SEC filings

McCormick's gross margins have been very consistent over the last decade with an average of 41.1% and a 5-year average of 41.6%. Meanwhile, McCormick's free cash flow margin has been steadily improving over that time with year-over-year improvement in all but two years. The 10-year average free cash flow margin is 10.9% with the 5-year average at 13.1%.

The free cash flow return on invested capital, "FCF ROIC" is my preferred profitability metric. The FCF ROIC represents the annual return of cash the business is generating based on all of the capital invested in the business. My expectation is that great businesses will have stable or rising FCF ROICs over time and preferably greater than 10%.

Data Source: McCormick SEC filings

Prior to FY 2017, McCormick has routinely shown improving FCF ROICs with it climbing from 8.5% for FY 2011 up to 16.4% for FY 2016. However, the acquisition of Reckitt Benckiser's Foods increased the capital base significantly due to additional debt which hurt McCormick's FCF ROIC. The 10-year average FCF ROIC is 11.1%; however, the 5-year average is 10.4%.

To understand how McCormick uses its free cash flow, I calculate three variations of the metric, defined below:

1. Free Cash Flow, FCF: Operating cash flow less capital expenditures
2. Free Cash Flow after Dividend, FCFaD: FCF less total cash dividend payments
3. Free Cash Flow after Dividend and Buybacks, FCFaDB: FCFaD less net cash spent on share buybacks

Great businesses should generate more cash than they can use, some of which they can then send out to shareholders via dividend payments. After that, depending on the stage of the business or other factors such as debt load or acquisition opportunity set, share repurchases should be considered as well as a means to return additional cash to shareholders by increasing their ownership stake.

Data Source: McCormick SEC filings

Over the last decade, McCormick has grown FCF each year generating a cumulative FCF of $5.2 B. They've sent $2.3 B back to shareholders via dividend payments putting the cumulative FCFaD at $2.9 B.

Management also spent a net $1.1 B on share buybacks putting the 10-year cumulative FCFaDB at $1.8 B. Prior to FY 2017, McCormick used a good amount of FCFaD to repurchase shares but since then have been retaining a more significant portion of their cash flow.

From FY 2011 through FY 2016, the McCormick's share count was steadily, although not swiftly, reduced falling 4.7%. However, since the Reckitt Benckiser acquisition in FY 2017, the share count has risen every year.

Data Source: McCormick SEC filings

Over the last decade, the share count has been effectively flat rising 0.2% in total or ~0.02% annually.

McCormick's debt-to-capitalization ratio has risen over the last decade primarily due to the aforementioned acquisition. Since then, the debt-to-capitalization ratio has been coming down. The 10-year average debt-to-capitalization ratio is 50% with the 5-year average at 57%.

Data Source: McCormick SEC filings

I place more emphasis on the debt ratios when determining how leveraged the business is. The net debt ratios look at the total debt less cash divided by some form of income or cash flow metric and represent how quickly the business could deleverage their balance sheet if need be.

Data Source: McCormick SEC filings

McCormick's debt ratios took a big jump higher with the acquisition. The 10-year average net debt-to-EBITDA, net debt-to-operating income, and net debt-to-FCF ratios are 2.8x, 3.2x, and 4.6x, respectively, with 5-year averages of 3.8x, 4.4x, and 5.7x.

Valuation

Valuation is definitely more art than science, and as such, I like to use multiple valuation methods in order to hone in on a fair valuation range. The valuation methods that I use are the minimum acceptable rate of return, MARR, analysis, dividend yield theory, the dividend discount model, and a reverse discounted cash flow analysis.

The MARR analysis requires you to estimate the future earnings and dividends that a business will produce. You then apply a reasonable exit multiple to determine the future share price compared to the estimated earnings and then calculate what the expected return that investment would provide.

Analysts expect McCormick to have FY 2021 EPS of $3.02 and FY 2022 EPS of $3.16. Analysts also expect McCormick to be able to grow EPS 6.5% annually over the next 5 years. I then assumed that McCormick would be able to grow EPS 5.0% annually for the following 5 years. Dividends are assumed to target a 45% payout ratio.

For the expected future multiple, I like to see how market participants have historically valued McCormick's EPS. As you can see in the following YChart, McCormick has typically traded between ~15x and ~30x, which I'll use for the MARR analysis.

Data by YCharts

The following table shows the potential internal rates of return that an investment in McCormick could produce if the assumptions laid out above are reasonable estimates of how the future plays out. Returns assume that dividends are taken in cash and that shares are purchased at $80.71, Friday's closing price.

	IRR
P/E Level	5 Year	10 Year
30	11.1%	8.7%
25	6.6%	6.8%
22.5	4.1%	5.7%
20	1.4%	4.4%
17.5	1.6%	3.1%
15	-5.0%	1.6%

Click to enlarge

Source: Author

Alternatively, I've used the MARR analysis forecasts to determine what price I could pay today in order to generate the returns that I desire from my investments. My base hurdle rate is a 10% IRR and for McCormick. I'll also examine 8% and 9% required returns.

	Purchase Price Targets
	10% Return Target		9% Return Target		8% Return Target
P/E Level	5 Year	10 Year	5 Year	10 Year	5 Year	10 Year
30	$84	$73	$87	$79	$91	$86
25	$71	$63	$74	$68	$77	$73
22.5	$65	$58	$67	$62	$70	$67
20	$58	$52	$60	$57	$63	$61
17.5	$52	$47	$53	$51	$55	$55
15	$45	$42	$47	$45	$48	$49

Click to enlarge

Source: Author

Dividend yield theory is a valuation method built on reversion to the mean. The method assumes that a business that hasn't undergone significant changes to its fundamentals and will trade around a normal dividend yield level.

Data Source: McCormick Investor Relations and Yahoo Finance

McCormick shares currently offer a 1.69% dividend yield compared to the 5-year average forward yield of 1.66%.

The dividend discount model is a simple method that uses the current annual dividend, an estimate for the long-term dividend growth rate, and your required return. It's a simple valuation method that can be used to get a rough idea of the value of the business.

Data Source: McCormick Investor Relations and Yahoo Finance

For McCormick, I used a constant growth rate of 6.0% and a discount rate of 8%. Under those assumptions, the current value of McCormick is ~$72 per share.

A reverse discounted cash flow analysis can be used to figure out what current share price implies about the collective expectation for the cash flows the business will produce. I use a simplified DCF model built on revenue growth, a tax rate of 22%, and an initial EBIT margin of 18% that increases by 10% over the forecast period to 19.8%.

With those assumptions and a 10% required return, McCormick would need to grow revenues by 8.9% annually across the forecast period, or increase EBIT margin to higher levels to account for slower revenue growth, in order to justify the current market valuation. Dropping the required return down to 8% lowers the required revenue growth rate to 6.2% across the forecast period.

Conclusion

McCormick is a high-quality business and one that I'm glad to own as I use their products nearly every day when I cook. McCormick has improved free cash flow margins significantly over the last decade and they now sit in the mid-teens. Their free cash flow ROIC is a bit lower than I'd like; however, I expect as they digest the acquisitions from the last few years that level should improve and the ROIC is still adequate in the high-single digits.

Dividend yield theory suggests a fair value range between $75 and $91. My expectation is that McCormick will announce a dividend increase in November to at least $0.36 per quarter, at an annual rate of $1.44, the fair value range increases to $79 to $97.

The MARR analysis based on a 10% IRR 5 years out with an exit multiple between 20x and 25x puts the fair value range between $58 and $71 suggesting shares are still overvalued by roughly 10% to the upper end of the range. Using an 8% IRR raises the fair value range to $63 to $77.

I wish there was less debt on the balance sheet namely in regards to the debt ratios that are quite high, although manageable, due to the multiple acquisitions completed in the last few years. In FY 2017, McCormick bought Reckitt Benckiser Foods, and late in 2020, they acquired Cholula, and earlier this year, they acquired FONA International.

I'll continue to hold my shares of McCormick and the valuation is now looking much better than it has been over the last year. The share price has pulled back 21% since I last examined McCormick while the S&P 500 is up nearly 27% over that same time. That decline has made McCormick much more attractive for investment dollars and I'll be looking to add shares on any pullback into the mid-$70s or lower.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of MKC either through stock ownership, options, or other derivatives. 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.

I am not a financial professional. Please consult an investment advisor and do your own due diligence prior to investing. Investing involves risks. All thoughts/ideas presented in this article are the opinions of the author and should not be taken as investment advice.