Smucker Does Alright, But The Street Goes Away Disappointed

By Stephen D. Simpson, CFA | June 07, 2013 AAA

I liked J.M. Smucker (NYSE:SJM) on a relative basis back in November, and the stock hasn't disappointed since – trading up about 20% and slightly outperforming peers like General Mills (NYSE:GIS), Kellogg (NYSE:K), and Kraft (Nasdaq:KRFT) in the packaged food space. I still like Smucker as a company – management is happy to run a business of relatively small, focused, market-leading brands, and run them pretty profitably. While guidance of a year-on-year decline in free cash flow (FCF) and stagnant sales may have disappointed the Street, this still remains a relatively interesting name in the food space.

SEE: Analyze Cash Flow The Easy Way

Some Good, Some Bad In Fiscal Fourth Quarter Numbers
Although Smucker posted a strong bottom-line beat, the weaker top-line performance and soft guidance seem to be siphoning off the Street's enthusiasm for the results.

Revenue fell a little more than 1% for the quarter, leading to a roughly half-point miss relative to the Street estimate for growth this quarter. Smucker continues to post positive volume (up 2%), but price/mix (down 3%) is cutting the other way. Retail coffee saw a 1% revenue decline on 6% volume growth, while consumer foods (which includes Jif peanut butter, fruit spreads, Crisco, and so on) grew 5% on a 4% volume improvement.

Margins were quite strong this quarter, supplying about half of the reported EPS beat. Adjusted gross margin improved 240bp from the year-ago level, while adjusted operating income grew 3% despite a 17% increase in marketing spending. At nearly 17%, Smucker's operating margin is very competitive within the packaged food sector. By segment, coffee earnings rose 18% while consumer earnings declined 2%.

SEE: How To Decode A Company’s Earnings Reports

Sluggish Sales Going Nowhere Fast
Not only did Smucker miss the consensus guess for the quarter on sales, but this was the first time in a while for the company to come in below where Nielsen data suggested. I wouldn't make all that much of it, but it does suggest that business has softened despite ongoing spending on marketing and promotion. That said, the coffee business has gotten increasingly competitive lately, and Hormel's (NYSE:HRL) acquisition of Skippy could mean more competition in peanut butter.

I suspect that investors were also put off by the update on the company's K-cup business. K-cup revenue rose 18%, making a sharp decline from the 50% growth in the fiscal third quarter. While Smucker has about one-third of the U.S. coffee market (more than twice as much as Kraft, and a lot more than Green Mountain (Nasdaq:GMCR) or Starbucks (Nasdaq:SBUX), the comapny's share in K-cups is a more modest 20%. Given investor fears about stagnant (or negative) growth prospects for traditional roast and ground coffees, decelerating K-cup growth seems to be a cause for concern.

Spending To Support The Business, But What About M&A?
With the company increasing its capital expenditures over the next few years to support growth in the coffee, peanut butter, and spreads businesses (two-thirds of the company's revenue base), free cash flow generation will ease off a bit. Likewise, I'm sure investors worry about margins given the company's higher cost basis in peanuts (due to locking in supply at higher prices) and commitment to support ongoing marketing.

I'm more interested in whether or not the company will pursue more M&A. Smucker management has commented in the past that they believe there's still more “shaking out” to occur in the packaged food space as companies digest large deals (like ConAgra (NYSE:CAG) and Ralcorp) and companies with non-strategic assets in food (like Unilever (NYSE:UL)) look to monetize them.

I would expect management to be on the hunt for businesses with less than $1 billion in sales, but strong market share and store shelf presence. Businesses like Clorox's (NYSE:CLX) Hidden Valley salad dressings or PepsiCo's (NYSE:PEP) Aunt Jemima syrups come immediately to mind, as well as other products like sauces (Sweet Baby Ray's in the BBQ category). With a debt to equity ratio of about 40%, I think Smucker could add some assets without too much financial stress.

SEE: Evaluating A Company’s Management

The Bottom Line
I'm looking for Smucker to grow revenue at a long-term rate of about 4% (excluding M&A), with free cash flow (FCF) growth of about 5%. That works out to a price target in the mid-$90s; not particularly compelling, but not bad in a generally over-heated and over-priced packaged foods sector. While I do like the Smucker business and the stock is relatively attractive, I'm a little concerned about the possibility of a bigger swing away from consumer staples – though this is supposed to be one of the sectors that does better in a higher rate/slower growth environment, the big move over the past year could have institutions looking to cash in profits and could make it hard for any of these stocks to continue the hot run of the past year.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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