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Morningstar | McCormick Shares Slide as It Chalks Up Modest Q4 Sales and Eroding Profits; Shares Not a Bargain

Despite the low-double-digit retraction in McCormick’s shares following a fair end to fiscal 2018 (with 2% organic sales growth in the fourth quarter, a 30-basis-point erosion in adjusted gross margins to 45.5%, and 70 basis points of degradation in adjusted operating margins to 19.9%), we continue to view the stock as overheated. As evidenced by the significant appreciation in shares (which popped from less than $100 to start calendar 2018 to a peak of $155 in mid-December), we think the market found favor with McCormick (which was trading at a 30% premium to our estimated intrinsic value prior to the fourth-quarter release). We attribute this to the fact that McCormick has consistently bucked the industry trend of sluggish sales gains (with organic sales growth holding in the midsingle digits over the last several quarters). Even though we posit the firm has carved out a competitive edge due to its solid retail relationships, leading brand mix, and cost advantage, we don’t believe this performance warranted such a premium valuation (of more than 25 times forward earnings).

As it relates to the most recent quarter, management suggested the pullback in sales and profits primarily stemmed from an inventory replenishment issue at a leading domestic retailer (accounting for a 3% negative hit to volumes on its home turf and the main constraint on gross margins). However, because this issue was a technological problem at the retailer (and failed to evidence a reduction in consumer consumption trends), we don’t believe the modest step down in underlying sales is cause for concern. Rather, we view this performance as solid, given it came on top of more than 5% organic growth in the year-ago period. In this vein, we don’t intend to materially alter our $107 fair value estimate or our long-term assumptions (around 4% sales growth annually with operating margins averaging 19% over our 10-year explicit forecast).

While we don’t expect the competitive angst that has ensued from other branded operators, low-priced private-label fare, and small, niche peers stands to subside, we believe McCormick is investing to shore up its competitive edge. For one, it maintains a stringent eye on eliminating excess costs (with plans to shed more than $400 million in costs over the next few years). We view this effort as prudent, particularly in light of management’s aim to elevate its level of brand spend and ultimately support its retail relationships. This was evident in the fourth quarter, as McCormick increased its spend behind advertising and promotions by more than 7% over the prior year’s quarter to 6.6% of sales (up 40 basis points). And we don’t anticipate it will back down in these efforts; we forecast research and development and marketing to approximate 9% of sales, or nearly $600 million annually in aggregate, up from 7% on average over the past five years. From our vantage point, its standing as a leading operator in the space creates a virtuous cycle, starting with scale, affording manufacturers a mutually beneficial relationship with retailers through which the vendor is an important retail partner, developing sales strategies to maximize volumes and retailers’ margins while also prioritizing its own brands.

From a capital allocation perspective, we surmise that McCormick will continue to funnel its excess free cash flow (which approximated 12% of sales in fiscal 2018) to lower its debt load (with management targeting a leverage ratio approaching 3 times by fiscal 2020, down from 5.5 times pro forma for the tie-up in fiscal 2017 and 4.3 times in fiscal 2018). Despite this, we don’t believe the firm has abandoned its commitment to returning excess cash to shareholders, as evidenced by its recent 10% quarterly dividend increase. In this vein, we forecast the firm will raise its dividend at a high-single-digit clip each year over our 10-year explicit forecast (maintaining a 40%-50% payout ratio over the longer term) and will resume repurchasing around 1%-2% of shares outstanding annually beginning in fiscal 2020. Further, we think that upon reaching leverage targets, acquisitions could again be in the cards. However, McCormick has been a prudent capital allocator in the past--returns on invested capital have exceeded our cost of capital estimates for each of the past 10 years--and we doubt it will pursue a deal merely to drive growth.