Smucker A Relatively Interesting Play In Food

By Stephen D. Simpson, CFA | June 08, 2012 AAA

As I've mentioned often in recent weeks and months, investors have reacted to the uncertain global growth outlook by bidding up the shares of those stocks and sectors seen as safe and relatively inelastic, and food has been one of the primary targets. While Smucker (NYSE:SJM) does have some challenges from private label competition, and the long-run returns on capital have not been good, the combination of growth, share and valuation makes this a relatively interesting stock to consider today.

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Not a Bad End to the Year, But There Were Some Spots
Investors who want to believe that any beat is a good beat will like Smucker's fiscal fourth quarter, and it was largely a decent quarter from a profit perspective. That said, there were a few issues that investors shouldn't ignore.

Revenue rose 14% as reported, and that was just a touch below the average of sell-side analyst estimates. Organic revenue growth was only 5%, though, as a double-digit average increase in prices was weighed down by a significant volume decline (the fourth straight quarterly volume decline). In particular, U.S. coffee volume was down about 8%.

Smucker did better than expected on its profit lines, but here too there are some reasons to pause. Gross margin declined a better-than-expected three points, as input costs (especially peanuts and green coffee) took their toll. Operating income rose 12% on a reported basis, but rose 8% on an adjusted basis; operating margin was better than expected, but due in significant part to lower-than-expected ad and promotion spending.

SEE: A Look At Corporate Profit Margins

Coffee Market Still Evolving
With about half of the company's business revolving around coffee, there's no point in pretending it's not a major factor for the company. Smucker has excellent share (it's far and away the largest branded company), but Kraft (NYSE:KFT) and Starbucks (Nasdaq:SBUX) are both trying to build their share. It will be interesting to see what happens when Green Mountain's (Nasdaq:GMCR) K-cup patents expire later this year. Treehouse (NYSE:THS) has already talked about its plans to get into this market and I suspect that there will be a land-grab for a few quarters.

At the same time, input costs are always going to be a big variable. Those who have followed the coffee commodity markets know what I mean; weather can have a huge impact on yields and drive major swings in prices from one year to the next.

Leading Brands, but Lagging Returns
One of the curious dichotomies about Smucker is that it boasts an impressive stable of brands; seven of the company's brands are category leaders, and about three-quarters of sales come from these brands. That brand strength, as well as an aggressive acquisition program, has led to above-average sales growth. However, for all of that growth, the company's returns on capital just haven't been all that good.

Where companies like Unilever (NYSE:UL), Kellogg (NYSE:K) and General Mills (NYSE:GIS) post double-digit returns on capital (or close to), Smucker is stuck in the mid-single-digits. As Smucker has a very good operating margin, this underperformance comes down to lower asset turnover. This suggests that Smucker has more assets than it can effectively use, those assets are obsolete and/or management just isn't taking advantage of them. Improving this metric would go a long way towards improving shareholder returns and producing outsized share returns.

SEE: How To Evaluate A Company's Balance Sheet

The Bottom Line
Stressed-out consumers are likely going to continue to seek out private label options when they can, and that's a threat to coffee, spreads, oil and pretty much every category at Smucker. Likewise, the long-run trend in asset turnover is not a good one.

Still, relative to the sector, Smucker may actually be just a little undervalued. While the company's balance sheet carries a lot of debt, interest coverage isn't a problem. With fair value in the low $80s, Smucker is a decent option within the food sector, though truly impressive long-term performance is likely to be tied to the company's ability to more effectively utilize its assets.

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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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