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Morningstar | Wide-Moat McCormick's First-Quarter Results Are Full of Flavor, but Shares Still Spicy

We don’t expect to materially alter our $107 fair value estimate for McCormick following a solid start to the year, which included 4% organic sales growth (entirely due to increased volume and favorable mix) and 40 basis points of adjusted operating margin expansion to 16.2%. Further, management held the line on its fiscal 2019 outlook, calling for adjusted earnings of $5.17-$5.27 per share, which continues to align with our $5.19 mark.

Encouragingly, this growth was pronounced in both the firm’s consumer (60% of sales) and flavor solutions (40%) business segments, at 3% and 6%, respectively. From our vantage point, McCormick’s ability to maintain its sales momentum (posting mid-single-digit underlying quarterly gains for the better part of the past few years) stems from its commitment to bringing value-added new products to market. We view this as a means to differentiate McCormick's fare from competitors at both the value and the premium ends, while also entrenching its position with leading brick-and-mortar and e-commerce retailers. Although we don’t expect intense competitive pressures to subside, we doubt McCormick will veer from its strategic priority of investing to shore up its wide moat. In this context, we forecast R&D 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 its knack for posting underlying top-line growth in an industry that has been starved for gains, we don’t believe this performance warrants such a premium valuation (27 times forward earnings and a more than 30% premium to our assessment of the firm’s intrinsic value). In this vein, our long-term forecast still calls for around 4% annual sales growth and operating margins averaging 19% over our 10-year explicit forecast; however, the current price implies 6% sales growth and 21% average operating margins over the next decade. As such, we’d suggest investors await a more attractive entry point.

McCormick’s first-quarter sales gains were a reversal from the fourth quarter, during which it was plagued by an inventory replenishment issue at a leading domestic retailer (which accounted for a 3% negative hit to volumes on its home turf in the final quarter of fiscal 2018). However, we had surmised that because this issue was a technological problem at the retailer, it failed to evidence a reduction in consumer consumption trends or cracks in McCormick’s competitive edge. And in light of the resumption of growth, we think this stance had merit and we don’t expect similar challenges to constrain is top-line trajectory going forward.