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McCormick: Large Moat Around Leading Seasoning Supplier

October 04, 2011 | About:
McCormick (MKC), founded in 1889 and incorporated in 1915 in Maryland, is the global leader in the flavor business, involved in manufacturing, marketing and distribution of spices, seasonings, specialty foods and flavorings to food industry. The company operates in two business segments: consumer and industrial. Consumer segment is involved with selling spices, herbs, etc. to consumers’ food market under MKC’s own brands. And industrial segment is to sell seasoning blends, natural spices, herbs, etc to multinational food manufacturers and foodservice customers in both direct and indirect way through distributors.

MKC’s raw materials are mainly agricultural products such as dairy products, pepper, onion, wheat, soybean oil, garlic. So they are subject to weather conditions and the market price. And for customers, MKC got a large number of customers for its own products. But the level of customers’ concentration increased over time in the last three years. In 2008, sales to Pepsi accounted for 10% of total sales. In 2009, sales to Pepsi and Walmart accounted for 10% and 11% respectively. And in 2010, five largest customers took 34% of total revenue of MKC.

In the recent conference call discussing third-quarter 2011 earnings, Alan Wilson, the chairman, president and CEO has pointed out the strong top line growth and solid profit result. In the local currency term, the sales grew 11%, a step up from a 5% sales increase in the first half of 2011. The positive drivers for the third quarter were higher sales, cost savings from comprehensive continuous Improvement program (CCI) and discrete tax items.

Negative factors are investment in brand marketing support, up 27% for the quarter, and the higher cost for raw and packaging materials. With those costs going up and anticipated to keep going up, how is MKC managing efficiently under this cost pressure? First, it was discussed to be strategic inventory. The inventory is up throughout 2011 because of higher strategic inventories initiatives. Second is the CCI cost savings program, and the third is the pricing. It seems like MKC can increase prices in the consumer business to pass on the cost inflation to consumers. With the industrial business, MKC has the pricing protocol to pass the higher costs to customers. However, these protocols only work with dairy, wheat and soybean oil, not spices and herbs.

The total business performance with operating income rose 2% year-on-year and operating income margin was below the previous year, staying at 14%. Operating income has risen 7% and the operating margin has been down 30 basis point year-to-date. Earning per share was 69 cents compared to 76 cents in the third quarter last year. However, the EPS figure last year included the tax reversal impact. If we exclude that, the EPS this quarter has increased 3 cents from last year.

If we step back and look at the business over the last 10 years, MKC has done quite well both fundamentally and in share price. Fundamentally, MKC has had positive EPS consistently and it has been growing, from $1.05 in 2011 to $2.87 in 2010, achieving the growth of 10.6% per annum. The return on equity always stays at a very high number, around 23-35%. And it consistently generates positive and growing operating free cash flow as well as free cash flow as well. The CFO and the FCF are at $360 million and $270 million respectively.

For the financial health, the goodwill item is the main in its asset, accounted for more than 41%. The D/A ratio is 54.5%, whereas around 28% comes from short and long-term debt. The debt in absolute number in May 2011 is $990 million. So the cash flow to debt ratio is currently at 36%, it’s not very healthy figure, but ample.

Along with the consistent in the operating performance, the valuation in the market place goes along with that. The earnings multiple stays in the range of 16x – 25x and the cash flow multiples stays in the range of 11x – 25x. And the shareholders of MKC have got the benefits if they stayed in the company for the long-time.

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The share was $1 in 1978 and is now around $45 in 2011, so for the period of 33 years, long-term investors in MKC realized an annual compounded rate of 12.23%, not counting the dividend reinvested.

In the business of seasoning, size really does matter for economies of scale. MKC is considered to have a large economic moat. It is more than twice the size of its next largest competitor. The business is having consistent profits, return on equity in the double digits, and it is generating growing consistent positive operating cash flow and free cash flow. It can be the predictable business that long-term investors might want to own for the very long term for the reasonable, not too low, not too high return.

This is the subjective viewpoint of the author, and it is not the recommendation to buy, hold or sell the stocks mentioned in this analysis. Anyone who wishes to buy, hold or sell the stocks has to do his/her own analysis at his/her own risk.

About the author:

Anh Hoang
Money manager into global equities, especially with US and Vietnam markets. CFA level 3 candidate. Lecturer for Stalla - CFA course in Vietnam

Visit Anh Hoang's Website


Rating: 3.3/5 (20 votes)

Comments

Adib Motiwala
Adib Motiwala - 3 years ago
Do you feel current valuation (12x EBIT or 20x FCF) provides good returns in future?
kfh227
Kfh227 premium member - 3 years ago
Thing often missed:

They also make generics that go on shelves as "store branded". If you buy a generic, there is a 50% cahnce that it is a McCormick generic.

MKC's problem has been valaution. It's never been at an attractive buy in price except for maybe 5-10 years ago.
ken_hoang
Ken_hoang - 3 years ago
@Adib: Yes, the current valuation is left alone would seem to be very high, however, it's around the average valuation it is trading for the last 05 years. so it would provide reasonable returns, not so good, but not so low one. "not too low, not too high return" as I mentioned.

@Kfh: Thanks for the info on its business of generics. For 5-10 years ago, the earning multiple was around 20-25x, sometimes 16x. Left alone, it seemed never to be cheap. Everything is relative..
batbeer2
Batbeer2 premium member - 3 years ago
Everything is relative.

Absolutely ;-)
kfh227
Kfh227 premium member - 3 years ago
McCormick,

I'll say this.

1) Monopoly

2) best of breed

If it ever gets undervalued I would stomp on it.

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