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Spice Up Your Portfolio

|Includes: BGS, IFF, KHC, McCormick & Company, Incorporated (MKC)

Imagine this: It's winter time, you're either at your favorite football stadium or sitting at home watching the game. You're having load of food and beer with your buddies. Now, imagine its summer and you're outside grilling up burgers, steak, chicken, ribs, and the sort. Did you notice that your spices cabinet or drawer is most likely stocked with products made by one company? Even if it's not, chances are McCormick, Inc. (NYSE: MKC) manufactures that brand or generic product. MKC is the dominant leader in manufacturing, marketing, and distribution of spices in the world with a large variety of brands. If one were to venture down to the Baltimore, they can see and smell the impact MKC has on the community.

I've been following McCormick, Inc. for over a year now, and it does not appear that its strategy and strength are letting up anytime soon. MKC really has no true competitor that can keep pace with it. It has comparable companies like H.J Heinz (NYSE: HNZ), International Flavors and Fragrances (NYSE: IFF), J.M Smucker (NYSE: SJM), and B&G Foods (NYSE: BGS). BGS and IFF are the only two publicly traded companies that come close as competitors, but they have greater product diversity than MKC's spices. Private-labels are the main competition. In this analysis, I will give a brief overview of an extensive report I have written on MKC already that shows the true value for shareholders to own MKC for the long-term. The fundamental analysis will be done using 2011's annual values.

Segments - MKC restructured itself back in 2005 in order to improve its processes. It used to consist of 3 segments: Consumer, Industrial, and Packaging. In 2003, it sold off its Packaging segment for a variety of reasons, including the SEC mandating it due to anti-trust laws. The Consumer segment accounts for 60% of revenue, and sells to merchandisers and grocery chains. It is typically the main growth segment of the Company, with the exception of 2011. The other 40% of revenue comes from the Industrial segment which sells to other food manufacturers, like PepsiCo (NYSE: PEP). As shown in the accompanying charts, MKC has had solid growth for a food manufacturer over the last 5 years. MKC is 'recession-proof' as all people need food. Growth has come from acquisitions, organic growth, and a one-time price increase to offset input costs. Geographically, MKC's sales are 60% from the US, 21% from EMEA, and 19% from the Asian/Pacific area. The strategy is three-pronged approach: 1) Increasing the organic business through brand marketing support, merchandising, and expanded distribution 2) Product Innovation 3) Acquisitions.

Year 2007 2008 2009 2010 2011
Consumer 7.38% 10.74% 3.26% 4.59% 10.05%
Industrial 7.32% 6.50% -3.39% 4.44% 11.95%

Industry - Recently, the global world has gone through economic shocks and skeptical times: Greece, the euro, the European continent, China's potential hard-landing, the US elections in November, and the potential US fiscal cliff at the end of the year. End of the day - people will still buy their spices and seasonings, even if Greece leaves the euro, the US goes into a recession (just look at 2009's Consumer segment sales growth), or if Romney or Obama win the election. It doesn't matter to this company.

The industry itself is made up of MKC and many private/generic producers. MKC actually makes 50% of the US generic brands. "Private-label products still cost an average of 29% less than their nationally branded counterparts. But they are rising faster in price, at a rate of 5.3% last year [2011] compared with the industry average of 1.9%, and can sometimes be the most expensive product in a category" [WSJ, January 31, 2012]. Many food producers like H.J Heinz, Hormel Foods, Tyson Foods, and McCormick quietly produce the private-label brands though. This gives them a competitive advantage.

Food consumption is on the rise as other nations are growing. India is the fastest growing nation as the middle class is growing, and consumes five times more spices than the US. The US has the highest amount of pounds consumed per capita. European countries follow the US in this development, but second and third-world countries are in the distance. Many citizens in emerging markets are malnourished and will require more food. Brazil and India especially will have to import or grow more food with its fast growing populations. Consumption of spices has grown three times as fast as population growth throughout the world. Regardless of the environment, MKC is well position given increasing spices consumption. On top of that, the more people there are, the more there will be consuming spices. As shown (data from Capital IQ and Bloomberg), emerging markets and the US have the fastest growing populations:

Population (NYSE:M) 2011 2010 2009 2008 2007 CAGR
US 313.20 310.20 307.00 304.40 301.60 0.76%
UK 62.70 62.35 61.99 61.64 61.25 0.47%
France 63.13 62.79 62.47 62.13 61.80 0.43%
Germany 81.78 81.76 81.88 82.12 82.26 -0.12%
India 1,189.20 1,173.10 1,156.90 1,140.60 1,124.10 1.13%
China 1,336.70 1,330.10 1,323.60 1,317.10 1,310.60 0.40%
Indonesia 237.64 234.18 231.37 228.52 225.64 1.04%
Russia 138.70 139.40 140.00 140.70 141.40 -0.38%
Brazil 203.40 201.10 198.70 196.30 193.90 0.96%
Mexico 113.70 112.50 111.20 110.00 108.70 0.90%

Producers' food costs have been on the rise and saw record highs in 2011. This includes the spices sub-sector as spices like pepper, reached historic highs. This is due to supply shortages and increasing transportation costs. Pepper prices are starting to show stability though, and should see a decline as farmers flock to produce this higher margin spice. This will lower costs long-term. Prices have come down from their historic highs but are still plaguing food companies and other industries that incorporate food, such as restaurants. The current estimate is that costs for food companies will increase anywhere from high-single digits to even low-double digits! Attempting to offset this, companies have either purchased raw materials when management believed it was strategic to, implemented efficiency gain measures, or raised prices for consumers.

Dual-Class Share and Corporate Governance - MKC has a dual-class share system: MKC ('Non-Voting') and MKC-V ('Voting' or 'Common Stock'). Both are entitled to a dividend and both actually have forms of voting. MKC-V is meant for employees to hold and is rarely publicly traded. MKC has had 2 classes of shares for over 50 years. 10% of the shares outstanding (about 12M) are 'voting shares' and the other 90% (about 120M) are 'non-voting' shares. As of the end of 2011, 12.4M MKC-V shares and 120.5M MKC (non-voting) shares were outstanding, with 320M authorized. Joyce Brooks, Head of Investor Relations, outlines the differences in the classes as both do have voting rights, such as the sale of the majority of assets, ownership matters, reverse mergers, statutory share exchanges where capital stock is converted into other securities or property, and dissolution of MKC. Non-voting shareholders lack the ability to vote on the board or other matters. The Board of Directors reviewed this voting procedure but decided to keep this structure in place. The voting shares are infrequently traded as many are held in the pension plan. Holders of MKC-V are restricted to 10% of the total vote if they own more than 10% of the Company, such as the pension plan and Harry Wells. If there is a 50% voting power held by one party or person, all holders of MKC (non-voting) will be automatically converted into shares of voting stock.

MKC has frequently been rated one of the top 100 best places to work by Forbes. It offered employees many benefits, including a pension plan. It is both a domestic and international pension plan, but is currently underfunded in both segments by $187.6M and $39.2M, respectively. This was closed in the beginning of 2012 to new employees however. The major holder of MKC-V shares is the pension plan itself, thus the employees own the largest share of the Company at 21.93%. Their retirement benefits and pensions are correlated and tied to the benefit of the Company long-term. This adds extreme value to the Company as all shareholders' interests are aligned. (Source: Analyst & Bloomberg)

Morningstar and other credit agencies believe that MKC has solid corporate governance, but with a few issues such as Alan Wilson as the CEO and Chairman. Since his time as CEO and Chairman, the stock price has increased significantly and the firm has produced strong EVA. Directors are also elected annually and 9 of 11 are independent. The Company has a Clawback policy (such as in 2005 when the firm underperformed), and compensation is variable and fixed based on a number of factors.

Supply Chain - By controlling a larger part of a supply chain, a company is able to increase its margins and be more profitable. This gives the company a competitive advantage. McCormick controls a large portion of its supply chain, leading to power over suppliers and a barrier to entry for potential competitors. McCormick also has over 250 suppliers across the globe and can shift production. For example, due to the turmoil in Egypt in recent years, management shifted towards other countries and increased inventory for strategic purposes. Management is seeking to lower inventory and is implementing a new Vendor Managed Inventory (NYSE:VMI) System. By using VMI, MKC will improve customer service and retention, and reduce demand uncertainty, inventory requirements, reliance on forecasting, and costs. Global reach is important for many companies. MKC immersed itself in developed, emerging, and frontier markets. Its facilities stretch across the globe, which gives it production flexibility. For example, if a disaster were to happen in the US at its Hunt Valley facilities, management could shift production to another country. MKC also has the opportunity to expand still, including into South America.

Acquisitions - MKC's management team firmly believes that it is in a strong growth stage as a company, despite being in a mature industry. Management targets emerging markets like India and Eastern Europe, and 'tuck-in' acquisitions. Major acquisitions before 2011 include Ducros and Lawry's. In 2011, MKC acquired Kitchen Basics and Kamis S.A. It also launched into a joint-venture, Kohinoor JV, with Kohinoor Specialty Foods in India. If Kamis, the Kohinoor JV, and Kitchen Basics were included from the beginning of 2011, EPS would have been $2.85, over the reported $2.79! Management has hinted at acquiring another firm in 2012, specifically in South America (first one) and in China. Acquisitions over the last decade cost on average $192.5M or 5.49% of sales each year.

Financials - McCormick is very sound financially. It likes to reward shareholders (which include its employees) by product innovation, geographic growth, and acquisitions to increase sales.

  • COGS increased in 2011 due to rising raw material costs for items like pepper. This is expected to decrease with material costs normalizing and a new inventory system.
  • SG&A is declining with CCI Program and R&D is seeing breakthroughs in the study of spices and health benefits. Net income and EPS are on the rise.
  • Management uses its cash to encourage growth, pay down debt, and reward shareholders. Inventory increased in recent years, mainly in raw material form due to strategic purchases.
  • PPE increased due to the new acquisitions and leases.
  • Goodwill and intangible assets are a caution for MKC due to the amount they constitute. Because of management's history of creating value and making quality acquisitions that turn into profit generators, goodwill and intangibles are not a high-concern but something that should be monitored in case of needed write-downs.
  • Long-term debt increased recently with financing the new acquisitions, especially Kamis. Management expects to pay down long term debt in the near future.
  • MKC rewards employees with a pension plan and many other benefits.
  • Management rewards shareholders and has created a 'dividend aristocrat'. A concern with this is if investors assume an increase each year forever, although MKC is positioned and committed to do so for a long-time.
  • Shares outstanding are expected to decline in the near-future due to its repurchase plan. Share repurchases may be put on hold due to another acquisition, especially as competitor IFF is divesting some of its flavor businesses.
  • McCormick is fundamentally sound, a safe company to invest in, and one that is maximizing shareholders' returns for the long-term.
  • Restatements done in this analysis were operating leases and purchase obligations, removing un-ordinary items, and including pension obligations as long-term debt

Fundamentals and Market Multiples- MKC is one of the most profitable firms in the industry and has above average ROE, despite the short-term decline in both NPM and ROE. It typically trades at a slight premium to the industry due to measures like these. For example, EV/EBITDA increased gradually since 2007, which is justified as MKC is in an expansion mode. Also, it has taken on more debt due to acquisitions in order to grow long-term. Large acquisitions like Lawry's and Kamis are the key to the rise in EV. Acquisitions typically take some time to implement. Thus, it makes sense that MKC's EV increased faster than EBITDA. Compared to its peers, MKC appears overvalued. This measure is historically higher due to the increase in debt with the Kamis acquisition, but will return to normal in the coming year as EBITDA will increase due to the addition. (Source: Analyst)

Economic Value Added (NYSE:EVA) - EVA (and ROIC) are the two measures management focuses on for company performance. Looking at MKC's Investor Relations page, one will notice the EVA and ROIC section. Displayed below is the EVA calculation management provides on its Investor Relations website:

Year 2007 2008 2009 2010 2011
EVA ($M) 136.00 130.80 150.30 219.80 202.00

Management focuses on being EVA positive. The reason for the decline in 2011 compared to 2010 is due to the timing of the acquisitions. In the EVA valuation (not shown), management uses an 8% WACC. Looking at MKC from either a BV or MV WACC, leads to a WACC lower than 8% anyways. Bloomberg has a WACC between 5% - 7% historically. Thus, this measure is highly conservative, and shows management is truly creating value for shareholders.

Valuation - Probably what you care about most when reading this. Many analysts have price targets in the mid-50s with only one or two having above $60 for a PT. They aren't seeing the value and it shows as MKC typically beats estimates. The buyback program should continue to help MKC beat expectations or at least meet expectations again. The last time it missed was 2009, and not by a significant amount.

# Scenario: Likelihood
1 Base Likely
2 Worst Unlikely
3 Best Unlikely
4 Management's Low Sales Estimates Possible
5 Management's High Sales Estimates Possible
6 Management's Mid Sales Estimates Likely
7 Recession Unlikely
8 "2000 CAGRs" - 12 Year CAGRs Possible
9 5 Yr Average Growth Rates Likely
10 "2007 CAGR" - 5 Year CAGRs Likely
11 FY 2012 Acquisition Possible
12 5 Years of Acquisitions Unlikely
13 Base Case (1) with High Costs Unlikely
14 Base Case (1) with Low Costs Possible
15 Base Case (1) with Flat Costs Likely

I did a DCF (FCFF) Model, Dividend Discount Model, and two market multiples (P/E and P/CF) to value MKC. Also, I used 15 different scenarios for each method (shown in the chart above) that could potentially happen. MKC is a consistent company, so using percentage of revenue for line items was simple and consistent. Management also gives guidance in terms of percentage of revenue. In the valuation process, I used three WACCs: BV (5.64%), Mid-Level (6.82%), and Management's WACC (8%). Also, I looked at the terminal value, specifically in the DCF Model using 2 standard deviations out for both the EV/EBITDA and NOPAT approach to test sensitivity. I looked at the median, average, and weighted average for each method and came up with approximately the same valuation. For the DCF method, which I believe better values a company like MKC better than other methods, I arrived at a PT of $66. Using a synergy of all four methods, I arrive at still a conservative PT of $62.

Method Aggressive Price Target Conservative
DCF 5 Year 70.41 66.24 62.32
DDM 64.27 60.92 57.78
P/E 64.74 59.19 52.91
P/CF 66.54 61.95 55.14
Total 66.49 62.08 57.04

Overall, MKC is creating strong value. This is not your high growth story like that of Chipotle (NYSE: CMG) or Monster Beverage (NYSE: MNST). Management targets double-digit returns annually. Would a rationale investor pass up +10% return almost every year? Right now, the stock is relatively expensive to its 5 year P/E average of 18. Looking at it long-term though, it traded an average 10 year P/E of 20.5, and average P/E multiple of 22 dating back to 1994. Multiples are depressed right now. It would appear that MKC is fairly valued right now with trading around $56 to $57. It wouldn't be wrong to initiate a position now, but an investor would have to be patient with it. I would expect management to increase the dividend for the 28th year in a row in the fall (Q3). If MKC falls back this summer to anywhere south of $55, I will initiate another position in it and hold it for the long-term. Get money, get paid.

Disclosure: I am long MKC, HNZ.