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Morningstar | Grill Season Off to Wet Start, but McCormick's Results Not Dampened; Shares Don’t Offer Upside

We’ve long attested McCormick is poised to withstand intense competitive angst because of its entrenched relationships with leading retailers, dominant share position (controlling 20% of the global spices and seasoning market, 4 times the size of the next closest competitor), and the cost edge that has ensued from its economies of scale, the combination of which underpins are wide moat rating. And we posit that second-quarter results (2.8% organic sales growth and 80 basis points of adjusted operating margin expansion to 16.5%) pay credence to our stance.

Despite recent performance (which came in the face of a wet spring across much of the U.S.), we don’t believe the firm is resting on its laurels. In this vein, McCormick announced its intentions to invest in an ERP modernization over the course of the next three years (with the total project set to cost $150 million-$200 million) to provide the capabilities to support its future growth. Further, we think McCormick is committed to bringing value-added new products to market, in line with our forecast, which calls for aggregate spending behind R&D and marketing to approximate 9% of sales over the next 10 years, or nearly $600 million annually, up from 7% on average the past five years.

Although management edged up its fiscal 2019 adjusted earnings outlook to $5.20-$5.30 per share (from $5.17-$5.27), this still aligns with our $5.28 mark. Results through the first half of the year are pacing our expectations, and we see little to warrant altering our $107 fair value estimate, beyond a $1-$2 bump to reflect the time value of money. However, shares continue to trade at a lofty premium of nearly 40% (and more than 28 times our fiscal 2019 earnings estimate) to our assessment of the firm’s intrinsic value (which we attribute to the firm’s ability to consistently chalk up top-line gains in an industry where similar metrics have proven elusive); we’d suggest investors refrain from building a position at current levels.

Breaking down McCormick’s sales performance, growth was again fairly balanced between its consumer (2% underlying top-line growth, around 60% of sales) and flavor solutions (4% organic sales growth, about 40% of sales) segments. Further, we’re encouraged that these gains came on top of comparable growth levels in the year-ago period. Management attributed this to new product and distribution wins across its geographic regions, particularly for its recently acquired French’s and Frank’s lineups.

However, we don’t surmise that the firm has tapped the well dry from this acquisition, even after nearly two years post close. From our vantage point, the Frank’s RedHot, French’s mustard, and Cattleman’s barbeque sauce brands (which we estimate account for 10%-20% of consolidated sales at present) were essentially orphaned under its prior owner (wide-moat RB), given the lack of overlap these offerings maintained with its core home, health, and hygiene operations. As such, we believe McCormick stands to leverage its retail relationships and R&D and marketing prowess centered on the spice, seasoning, and flavor categories to spur further product innovation and ultimately support its sales trajectory. This underlies our long-term expectations that call for 3%-4% average annual consolidated sales growth and 19% average operating margins over our 10-year explicit forecast.