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Morningstar | McCormick's Competitive Edge on Display as Sales and Margin Gains Persist in 3Q; Shares Still Heated

Tepid sales have dogged operators throughout the packaged food landscape (resulting from heightened competition, compounded by a stream of lackluster innovation), but these headwinds have failed to constrain McCormick’s trajectory. As evidence, the wide-moat firm chalked up 4% underlying sales growth in the third quarter, on top of more than 4% growth a year ago, reflecting a 3.5% benefit from increased volumes and favorable mix. But management doesn’t appear to be opting for growth at any cost, as adjusted gross margins shot up 280 basis points to 44.2% and adjusted operating margins expanded by 80 basis points to 18%. We would argue that these profit gains are even more impressive, given that McCormick ratcheted up advertising and promotional spending by a whopping 36% in the quarter. From our vantage point, these resources support the firm’s standing with retailers, as well as its portfolio of leading brands.

With one quarter remaining in its fiscal year, management revised its full-year expectations, now calling for 12%-14% reported sales growth (down from 13%-15% prior, reflecting a lower benefit from favorable foreign exchange rates) and adjusted earnings per share of $4.95-$5.00 (up from $4.85-$4.95, due to a lower effective tax). However, this revised outlook aligns with our forecast (13.6% sales growth and adjusted earnings of $5.02 per share). As such, we see little to warrant a material change to our $102 fair value estimate, outside of a modest increase to account for the time value of money. Despite the mid-single-digit retreat in shares (which we believe is stemming from the sizable uptick in marketing investment and concerns surrounding the extent to which this spend will need to persist at such elevated levels to offset the pressures ensuing from other branded operators, low-priced private-label fare, and small, niche peers), we view the stock as inflated and would suggest investors await a more attractive entry point than current levels provide.

In our view, the market’s concerns are unfounded. Rather, we’re encouraged that unlike others, McCormick has refrained from pulling back on its brand investments (with our forecast for 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). Despite the hit to profits, we view this spending as a plus and supportive of its leading competitive edge, enhancing the stickiness of its retail relationships. In our view, this standing 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. Moreover, we believe efforts to leverage its entrenched retail, packaged food, and quick-service restaurant relationships are aiding both its consumer (60% of sales, up 3.5%) and flavor solutions (40% of sales, up 4.7%) segments.

From a capital allocation perspective, we posit that debt paydown will remain a top priority (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), but we don’t believe the firm has abandoned its commitment to returning excess cash to shareholders. 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.