McCormick Continues To Defy Gravity

By Stephen D. Simpson, CFA | Updated April 05, 2013 AAA

When I last wrote on McCormick (NYSE:MKC) in October of 2012, I liked almost everything about the company except the valuation on the stock. However, as I've mentioned repeatedly in the past, valuation is no impediment to further appreciation in the short term and McCormick shares have climbed a further 15% from that point (beating the market by more than 7% over that time).

Accordingly, the story on McCormick largely remains the same. While some investors will argue that the valuation of Berkshire Hathaway's (NYSE:BRK.A) and 3G Capital's deal for Heinz (NYSE:HNZ) “proves” that packaged food stocks are undervalued, I don't share that sentiment. The strong volume growth at McCormick is certainly positive, and I like both the company's commanding U.S. share and growth prospects, but today's share price suggests future appreciation potential more suited to bonds than an equity.

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Mixed Results To Start The Fiscal Year
McCormick's fiscal first quarter results certainly don't suggest a “pay any price” level of performance. While I would expect these results to set a very high bar for volume growth across the sector, there's more to the story than top-line performance.

Revenue rose 3% this quarter, and beat the average growth expectation by 1%, as both volume and price contributed positively. In the consumer business, revenue rose 7% on strong 5% volume growth, while the industrial business declined 3%. The industrial business was undermined by weak volume (down 5%) tied to sluggish performance in quick service restaurants, as McCormick is a major supplier of seasonings and flavor mixes to restaurant operators like Yum! Brands (NYSE:YUM).

While the top-line performance was solid, McCormick did give some of that away in margins. Gross margin actually declined 50bp year-on-year, against a sell-side average estimate of 150bp improvement. Operating income was down very slightly (and operating margin declined 40bp) as the company shuffled around some marketing expenses (promotions versus advertising) and absorbed some cost inflation.

SEE: Analyzing Operating Margins

These Are Still Not The Best Of Times
Investors have certainly gotten themselves excited by the prospect of lower input cost inflation and a valuation reset brought on by the Heinz deal. While those are both positives, let's not overlook a few challenging realities about the market today.

First, consumers are still feeling a pinch in their wallets and overall branded packaged food volume growth has been tracking below 1% as per Neilsen data. While a few names have been notably stronger than that – including McCormick, Hershey (NYSE:HSY), and Mondelez (Nasdaq:MDLZ), I'd be careful about assuming that consumers are back to the habit of buying up the brands they like irrespective of price.

Second, two of the company's targeted growth areas, dry dinners and frozen foods, are seeing a lot of turbulence. Companies like Nestle (OTC:NSRGY), ConAgra (NYSE:CAG), Heinz, and Kraft (Nasdaq:KRFT) have intensified their marketing efforts to gain/maintain share and volumes here have generally been weaker than the overall branded packaged food trends.

Last and not least, McCormick arguably still lacks ideal scale for its operations. It takes quite a lot of money and resources to compete globally (as well as to enter new categories), and it takes time to leverage those costs effectively. This doesn't make McCormick a bad company as it's return on capital and free cash flow (FCF) conversion are both pretty solid by industry standards, but it does mean margin leverage could be more distant than the bulls hope.

The Bottom Line
I have a hard time paying multiples more akin to stocks like Whitewave (NYSE:WWAV), Hain Celestial (Nasdaq:HAIN), and Annie's (Nasdaq:BNNY) for a company with McCormick's growth profile. True, the company's long history of solid cash flow generation and high market share do merit a premium, but we're now talking about valuations on par with (or in excess of) Hershey and Coca-Cola (NYSE:KO).

SEE: America’s Biggest Food Companies

I'm just not willing to bid that high for these shares, particularly when my discounted cash flow model (which assumes better than 5% long-term revenue growth and 8% free cash flow growth) suggests an expected annual return more on par with bonds than stocks. By no means does this mean that the shares can't go still higher, but today's valuation just looks much too rich for this investor.

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