McCormick: Valuation Concerns Keep Me Sidelined (NYSE:MKC)


Overall, it is hard to get more bullish on McCormick (MKC) despite a largely solid earnings result in FQ3. Admittedly, the company has executed well through the pandemic, and could even stand to gain under current conditions as consumers increasingly opt to cook at home. All of this underpins the medium- to longer-term demand outlook, and taken together, MKC is certainly a high-quality franchise. The major hurdle is the valuation, which I believe more than accounts for the upside in its premium c. 35x NTM P/E multiple and keeps me on the sidelines.

Solid Results Led by the Consumer Segment

MKC reported adjusted FQ3 ‘20 EPS of $1.53, slightly above Bloomberg consensus. Driving the beat was strong organic sales growth at +9% Y/Y. Although the adjusted EBIT of $273 million fell shy of consensus estimates, more favorable below-the-line items boosted earnings for the quarter.

Leading the way in FQ3 was Consumer segment growth, but improvement in Flavor Solutions also contributed to the consensus beat. Considering the lower margins in Flavor Solutions, however, the unfavorable mix shift also contributed to some of the EBIT margin miss.

(Source: FQ3 Presentation Slides)

Dissecting Consumer Performance

Headline sales growth in Consumer of 14.7% Y/Y was strong, but the result would have been even higher on a constant currency basis (+15.1% Y/Y). However, the margin performance was relatively disappointing at 22.9%, as a portion of the company’s holiday program was shifted into FQ4. While MKC typically begins to ship holiday-related products in FQ3 to drive “early in-store display and merchandising” of holiday products, the elevated level of demand this time is shifting the focus toward keeping core items on the shelf.

Also notable was management’s decision to invest in additional blending capacity amid a rosier consumer demand outlook. The new capacity (equivalent to an additional manufacturing facility) reflects management’s preference to bring manufacturing in-house over time – the rationale being to optimize production processes and its scheduling system.

But there is a trade-off, and I would note that the move reduces flexibility to scale down capacity should demand slow (a likely outcome if the COVID-19 boost fades). Nonetheless, the company seems confident in the need for incremental capacity to support the fiscal 2021 growth outlook.

Flavor Solutions Remain on the Decline

As expected, the Flavor Solutions segment saw ongoing declines of c. 2.9% Y/Y (including a c. 2% unfavorable currency impact). However, it is worth noting that organic sales only declined c. 1% Y/Y – a rather resilient result, reflecting a strong recovery in quick-service (c. 25% of division sales). Most of the top line strength was driven by China (convenient solutions and Condiments), while the Americas saw 3% Y/Y declines on weakness in branded foodservice.

Meanwhile, segmental operating income also declined 24% Y/Y to $64 million on the back of the top line, and an unfavorable product mix shift, manufacturing costs, along with COVID-19-related costs. On the other hand, CCI-led cost savings offered a partial offset.

While demand weakness is set to continue in the Americas, management commentary indicates demand is starting to rebound in the EMEA and APZ regions. Additionally, growth from packaged food companies and pricing actions against heightened COVID-19-related costs present potential tailwinds to the segmental performance.

A Closer Look at Guidance

MKC reinstated fiscal 2020 guidance, with sales now expected to grow at the upper end of a 4-5% Y/Y range. Adjusted operating income is also set to grow at a similar pace, driving the adjusted EPS guide to $5.64-5.72. However, it also implies FQ4 sales growth of 2-6%, operating income of $289-299 million, and EPS of $1.55-$1.63 – a below-consensus result. The underwhelming operating profit/EPS FQ4 guide is largely due to incremental cost pressures from COVID-19 (c. $40-50 million for the full ear) and a less-favorable segment mix.

Despite the FQ4 disappointment, the fiscal 2021 outlook was upbeat – a stark contrast to many food peers that are calling for sales declines in the upcoming year. According to management, the strength will be broad-based, with both the Consumer and Flavor Solutions segments set for organic growth in fiscal 2021. The positive news for margins is that no new “go-lives” are anticipated until fiscal 2022 under the ERP implementation plan, and some COVID-19 costs (initially set for fiscal 2020) will be spread out over a longer period. As a result, I think operating margins could see some Y/Y expansion as soon as next year.

Open to Acquisitions

MKC’s cash-generative model has also helped it de-lever significantly over the last few quarters, with net debt/EBITDA now down to c. 3.1x. This leaves room for either capital return or acquisitions, but as M&A has been a core part of McCormick’s strategy, I was not surprised to hear management’s preference for the latter. Notably, M&A remains a key contributor to the company’s long-term 4-6% revenue growth target.

(Source: FQ3 Presentation Slides)

Additionally, the company will also be moving forward with a 2-for-1 stock split, effective December 1. The split will not alter the underlying economics of the business, but it will double the number of outstanding shares and provide greater liquidity to individual investors., which can only be positive for valuations.

Valuation Concerns Keep Me Sidelined

MKC could well be a winner in the long run, as it has several trends (such as a potentially structural shift in preference toward cooking at home) working in its favor, and a strong M&A track record as well. Armed with a clean and well-capitalized balance sheet, there is room for more accretive acquisitions ahead, which is positive for the growth outlook. But the current valuation multiple is lofty at c. 35x earnings, and I think investors would be better served waiting for a more attractive entry point.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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