Sun. Jul 3rd, 2022
Jars of spices

Jars of spices

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Over the last twelve months, ingredients producer McCormick (NYSE:MKC) outperformed both its peer group and the broader market. While Unilever (UL), Conagra Brands (CAG), and the S&P 500 were all in negative territory, McCormick actually provided a nice defensive play with a total return of ~14%. However, at a forward PE multiple of 29.3x and a dividend yield of 1.5%, plus a mature growth position, the stock doesn’t exactly look priced for upside. You would expect these kinds of multiples for a company that was growing rapidly; not a 130-year old+ maker of ingredients. With the S&P 500 hovering around 20x, McCormick appears plain overvalued. Add in a challenging supply chain environment, a tight labor market, and competition from alternative private label spices, there’s material downside on a macro standpoint too.

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Data by YCharts

According to Seeking Alpha data, 11 of 13 analysts rate the stock a “hold” or worse. 3 even rate the stock a “sell”, and 1 rates it a “strong sell”. Not exactly a rosy picture from Wall Street’s experts. While this sentiment has roughly held the same since the pandemic began, it is also corroborated by Seeking Alpha’s internal quant ratings which have the stock’s valuation rated as an “F” and growth as a “C”. From my perspective, this stock offers operating margins of 15.5% but trades at 29.3x forward earnings; by contrast, Conagra trades at 14.2x and has only slightly smaller operating margins at 13.1%. With minimal room for product innovation and generally increasing competition, McCormick, at least on the surface, looks significantly overvalued

DCF Analysis Indicates Meaningful Overvaluation

To get a sense of the company’s intrinsic value, I ran a DCF analysis. No DCF analysis can provide a perfect picture of future returns for shareholders; however, they can provide an illustrative “story” of the likelihood of different scenarios. I forecast revenue growing at a 5% clip into 2026. For a company that is 130+ years old and has grown at roughly that rate in recent years, this is reasonable. I assumed EBIT margins expanding around 300 bps to 20%. Capex, increase in net working capital, depreciation, and taxes were flat-lined for simplicity. By 2026, I have EBITDA at nearly $1.8 billion.

dcf

Source: Created by author using data from Yahoo! Finance

Assuming a terminal EBITDA multiple of 17x and a discount rate of 7%, the stock has more than 20% downside. Historically, over the last two decades, McCormick has traded in more of the 11-15x region, so I find my assumptions, if anything fairly generous. Conagra currently trades at 14x EBITDA and has also traded in the 11-15x region over the last two decades. Where McCormick justifies its high growth style multiple is beyond me.

dcf

Source: Created by author using data from Yahoo! Finance

Looking at the sensitivity analysis, there are minimal pathways to upside here. Even if the stock were to see its multiple at 19x and growth hits an impressive 7% clip for a very mature company, the stock would only just be fairly valued. By contrast, if the company were to return to the high-end of its historical multiple, 15x, and grow at 5%, there’s 30% downside here. On the positive side, my model isn’t too sensitive to changes in margins. A 100 bps swing in EBIT margins yields less than a 500 bps change in returns. At a beta of under 0.5, the stock will be relatively defensive against a recession, notwithstanding a correction in the valuation.

Downside Catalysts

Although McCormick looks overvalued to me, the stock could continue to trade at high multiples if investors want to move to defensive names. On the other hand, there are numerous factors that could cause a downward price correction. McCormick is the largest producer of private label spices in North America, and it has used this position to build solid retail relationships to push out its higher margin branded products. As inflation rattles grocery shoppers, consumers are likely to continue to shift towards cheaper private labels, and there is likely to be an increase in private label competition to McCormick during this environment. There’s particularly likely to be an increase in tiers to private branded products that, in my view, will eat share away from McCormick’s spice position. At the same time, McCormick is also vulnerable to continued shocks in the supply chain. Pepper costs have soared, and consumers are not likely to accept an increase in prices for relatively less essential food products. I am also not encouraged by the broader trends of the company, where consumer sales declined 2% in the first quarter despite pricing actions across all regions. On the flip side, flavor solutions grew 12%, and it was a tough comparison against the previous year, but a dip anywhere in such a favorable environment isn’t exactly what you need when you have a growth stock-like valuation multiple.

I am also concerned about the company’s debt load. It stepped up materially following the string of recent acquisitions, and the leverage ratio is now at 4.2x. This is particularly concerning, because if the economy contracts and management is unable to pay down debt, it will be unable to double down in the high growth categories it has been focusing on. Thus, I believe the company is even more exposed to a downturn than one would otherwise expect. Continued worsening in the freight environment could also catalyze a price correction.

Upside Factors

McCormick may look overvalued, but there are several reasons to like the stock. In addition to its low 0.5 beta, it has industry-leading gross margins of 39% and a relatively predictable business model. The appointment of Brandan Foley to COO and President on June 1st also has me hopeful for the company. Foley comes equipped with a deep industry background, having served nearly 15 years at Kraft Heinz, where he rose from Brand Manager to Zone President of North America. He previously focused on building out McCormick’s global consumer products division since 2014, and is exactly what the company needs to revitalize sales in a challenging environment.

It is also true that the company generally benefits from a secular tailwind towards increased home cooking. Since the pandemic hit, consumers have been stocking pantry shelves like never before. With a heavy legacy position in condiments and spices, the company’s recent acquisition of Frank’s Hot Sauce and Cholula have demonstrated that it is meaningfully diversifying category count. Hot sauce sales have taken off well beyond peer seasoning, sauce & condiments, reflecting that there is room to further shift towards higher returning categories. If McCormick can continue to strike upon the right categories, I may revise my investment thesis.

Conclusion

With the recent sell-off in the broader stock market, I am no longer as bearish as I once was. The S&P 500 is now at roughly 20x, and, while this is material above the 15x rule of thumb, the market has evolved materially since pre-1980. With that said, there are still a significant number of overvalued names. McCormick easily falls in this mix. Although it has done well picking out the right acquisition targets, a high debt load, inflation, increased private-label competition, and an anticipated economic downturn are all poised to produce a perfect storm that will cause the premium valuation to contract to at least the high-end of its historical 11-15x EBITDA multiple. I struggle to see the upside story here, and I think investors that are looking for defensive names would be better off seeking companies with cleaner balance sheets and higher dividend yields.

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By Samy

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