High Expectations In Place For McCormick

Spice and seasoning leader McCormick (NYSE:MKC) has some interesting challenges these days. On one hand, the company has a great franchise in its core spice and seasoning business, albeit a franchise that is challenged today with higher input costs and competition from private labels. Likewise, while the company has the potential to grow its business by expanding further into packaged food categories like boxed meals, companies like ConAgra (NYSE:CAG) and General Mills (NYSE:GIS) have demonstrated lately that success in packaged food is hardly easy.

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A Solid Second Quarter
Even if this is a tough stretch for food companies, McCormick didn't show any weakness on the top line. Helped in part by currency and pricing, McCormick delivered 11% growth this quarter (8% in constant currency) and beat the high end of the analyst range. Perhaps its a sign of McCormick's brand power that the company was able to register both a 5% boost in pricing and a 3% increase in volume - other companies like General Mills have recently found that price increases usually take a toll on volumes.


While McCormick did offer good news on the top line, profitability was less impressive. The company saw gross margin slide more than a point as input costs took their toll. McCormick captured some of this back through the operating line, and operating income rose more than 12%, but overall the bottom line performance was not so spectacular given the top line outperformance.


Another Player in Packaged Food
McCormick has been trying for some time now to become a bigger player in packaged food with products like the Zatarain's line of boxed meals. Certainly, this makes some sense - McCormick's revenue growth history is not that great and other companies in the flavor space like International Flavors and Fragrance (NYSE:IFF) have a mixed history of driving real growth from seasonings and flavor additives. Moreover, companies like Hormel (NYSE:HRL), Fresh Del Monte (NYSE:FDP) and Tyson (NYSE:TSN) have had some measure of success by finding new product lines and brands for the store shelves.


Still, this is a competitive market. If McCormick wants to play in the dry dinner space, companies like General Mills and Kraft (NYSE:KFT) are waiting for them. That leaves the company with some difficult choices. Should they pay up for established brands? Should they invest heavily in promotions? Should they just try to patiently build share and brand value? Luckily for McCormick, the company has a solidly profitable core business to underwrite these new ventures and expansion plans.


The Bottom Line
There are some solid reasons to like McCormick. After all, this is a company with valuable brands (and a pretty commanding share of the spice aisle at the supermarket) and good returns on capital. Even if the company cannot become the number one player in packaged dinners, the incremental growth should still be quite positive.

That said, expectations look pretty spicy already. The stock seems to already be pricing in strong revenue growth up into the low teens - a rate of growth that blows away McCormick's past track record - as well as steady improvement in free cash flow yield beyond prior peaks. In other words, McCormick is supposed to transform revenue into free cash flow at a record rate despite higher input costs and is supposed to grow revenue at an accelerated pace despite a great deal of competition on store shelves and already-stretched consumer budgets.

That seems like a very high hurdle to make and the odds say McCormick won't make it. Although this is a well-run company and a good story, investors should likely wait for more realistic expectations in the stock price. (For related reading, also take a look at Foods With The Biggest Price Increases.)

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