McCormick Looks Premium-Priced Even With Premium Performance

By Stephen D. Simpson, CFA | June 27, 2013 AAA

I appreciate why McCormick (NYSE:MKC) has almost always carried a premium valuation in the packaged food sector. The company holds effectively two-thirds of the U.S. market for spices, and has multiple opportunities to generate above-average growth in areas like dry dinners and frozen foods, and not just in North America. Even so, there is a fair price for every asset and McCormick's valuation seems well more than “fair” these days.Sluggish Performance In The Second QuarterRevenue rose just 2% this quarter, coming in slightly below sell-side expectations, with 3% organic growth. The consumer business was fairly solid, as revenue rose 5% in organic terms on growth in both volume and price. Relative to what we've seen very recently from General Mills (NYSE:GIS) and ConAgra (NYSE:CAG), that's a fine performance. Industrial revenue was not as strong, though, as sales were down about 1% as reported. SEE: How To Evaluate The Quality Of EPSMargins were also not so impressive this time around. Gross margin declined slightly (about 20bp) from last year, and missed the sell-side target by half a point. Operating income was down 1% on a reported basis, and more or less flat on an adjusted basis, with adjusted consumer segment earnings up about 3%.Sluggish Restaurant Traffic Hits IndustrialI have long believed the McCormick's industrial business doesn't get quite the attention it should. McCormick provides a variety of flavorings, seasonings, and other ingredients for restaurants, food service companies, and packaged food manufacturers. PepsiCo (NYSE:PEP) alone accounts for nearly 10% of the company's revenue, and McCormick is responsible for most of the flavorings that go on/into Pepsi's chips (including Doritos).McCormick is also a major supplier to restaurants like Yum! Brands (NYSE:YUM), McDonald's (NYSE:MCD), and Subway, and that exposure isn't helping the company right now. Traffic patterns at quick service restaurants in the U.S. have been fairly soft lately, and likewise McCormick is seeing the impact of significant declines in same-store sales in China (particularly at Yum! Brands' KFC chain).Rome Wasn't Built In A DayInvestors are also right to value McCormick for the emphasis management has placed on growing the business globally. It's not practical to assume that McCormick is going to establish the same sort of dominance in spices and seasonings in markets like Brazil, India, and China, but the company has already invested considerable resources in local/regional packaged meal brands – brands that can be expanded over time and used to leverage other McCormick brands over time.Still, this is going to take time. International growth in categories like dry dinners has been better than in the U.S. recently (almost flat over the last quarter, and not all that strong over the past year), but this is a multi-year project.The Bottom LineI realize that McCormick posts solid margins and returns on capital, and has likewise posted very good growth over the past decade (whether you measure that growth in sales, earnings, cash flow, owner earnings, et al). That alone merits some premium to the sector, particularly as McCormick looks like a share gainer against less dynamic rivals like Kraft (Nasdaq:KRFT). Still, there's a big difference between “some premium” and the premium McCormick gets.I don't think McCormick should trade at an EV/EBITDA almost 40% higher than General Mills. Likewise, a free cash flow analysis based on an estimated growth rate in the high single digits suggests fair value is closer to $60 than the going price of around $70. While I do believe McCormick will continue to show itself to be one of the better-run packaged food companies in the sector, my concern that the stock's valuation is way too high limits my enthusiasm for the shares today.

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