Perhaps the most important responsibility that a company’s management team has is capital allocation. These decisions on where to place their dollars play a sizable role in how a company’s business performs. Decisions vary based on the company. Companies that are heavily indebted might choose to pay down debt with their excess cash. Other companies may feel that their stock is undervalued and authorized a large share repurchase program. Still others may decide to initiate or raise their dividend. Another way companies can improve their business is by making a large acquisition. One such company that chose to spend heavily on an acquisition is McCormick & Company (MKC, Financial).
Company Background
McCormick was founded in 1889 and is based in Maryland. The company controls roughly 20% of the $11 billion seasoning and spice market. McCormick is nearly four times as large as its nearest competitor, making it the dominate player in its sector. The company generated nearly $5 billon in sales in 2017 and has a current market cap of $17.5 billion.
McCormick operates in two segments: The Consumer division sells products to every day consumers while the Flavor Solution division, formerly known as Industrial, markets products to firms and restaurants.
Growth through acquisitions
Even with this market dominance, McCormick has attempted to improve its business through acquisitions. On July 18, 2017, it was announced that McCormick had agreed to purchase RB Foods from Reckitt Benckiser for $4.2 billion. This purchase would be funded with debt. On the day of the announcement, McCormick’s dropped more than 6% as the market deemed the price too high for package food assets.
RB Foods consisted of several brands, but the most important two are Frank’s Red Hot and French’s Mustard. Frank’s is the No. 1 hot sauce and French’s mustard is the top-selling mustard in the world. Adding these two powerhouse condiments to its portfolio has been almost immediately accretive to earnings. RB Foods has added at least 10% to both earnings and sales in each of the first three quarters of the year.
Recent Earnings Results
McCormick released third quarter earnings results on Sept. 27. The company earned $1.28 during the quarter. This represented 14.3% growth from the third quarter of 2017 and topped estimates by 1 cent. Revenue increased more than 13% to $1.4 billion, which was slightly below what analysts had been looking for.
Adjusting for currency, both the Consumer and Flavor Solutions divisions grew sales by 13.5%. Frank’s and French’s were a large driver of these increases, adding 10% to sales during the quarter. These brands also helped McCormick become more profitable, with adjusted gross margins increasing 280 basis points to 44.2%.
On the conference call, McCormick increased the midpoint for earnings per share for the year to $4.98, up from $4.90 previously. The company did lower its expected sales growth for the year to around 13%, down from approximately 14%, but this was due to slightly less favorable currency rates going forward. This slight decrease in sales expectations was the likely culprit for a 5% decline the day of the earnings release. Still, a packaged foods’ company growing earnings, sales and gross margins at impressive rates is very rare in the market. Investors seemed to take note of this, and shares now trade above the close of Sept. 27.
Dividend history and valuation
McCormick has increased its dividend for the past 32 years, making the company a Dividend Achiever. Over time, McCormick has been a very consistent dividend grower. The company has increased its dividend by:
- By an average of 8.3% annually over the past three years.
- By an average of 8.7% annually over the past five years.
- By an average of 8.9% annually over the past 10 years.
McCormick most recently raised the dividend by 10.6% on Nov. 28 of last year. This is well above the company’s growth rates above. This type of growth indicts that McCormick feels rather bullish about earnings going forward. If the company sticks to its historical pattern, shareholders should see an increase sometime in late November.
McCormick will payout just under 42% of its earnings per share in dividends this year, which is right in line with the company’s decade-long average payout ratio of 42.4%. This gives the company plenty of room to increase its dividend going forward, even in the event that earnings suffer a decline.
Shares of McCormick currently yield 1.56%. This is below the yield of both the S&P 500 (1.74%) and the 10-year Treasury bond (3.05%). From 2008 through 2017, the stock’s average yield was 2.2%. McCormick’s shares are up nearly 31% year to date and up 43% since the beginning of 2017, which helps account for the low yield.
Based off of Tuesday’s closing price ($133.40) and the expected midpoint for earnings per share for the year ($4.98), McCormick’s stock trades with a price-earnings multiple of 26.8. This is well above the stock’s 10-year average price-earnigns ratio of 19.4, but only slightly higher than the price-earnings ratio of the S&P 500 (25.3). McCormick saw earnings grow at a rate of 7% from 2008 through 2017. Given the impact RB Foods has already made on the company’s quarterly results, it is likely that this acquisition will help grow earnings at a faster rate.
Conclusion
Deciding where to allocate capital is a very important job for companies. Make the wrong choice of where to spend, and the business and stock could be adversely impacted. While the decision to pay more than $4 billion for RB Foods was a very unpopular decision at the time, the Frank’s and French’s brands have contributed heavily to McCormick’s earnings and sales growth over the last year. The company has also increased its dividend for more than three decades, proving that McCormick can weather all phases of the economic cycle and still manage to grow its payments to shareholders. While shares of McCormick are not cheap, they do offer high rates of growth, something that is very difficult to find in this space.
Disclosure: I am not long any of the stocks mentioned in this article.
