McCormick Stock: The Good, The Bad, And The (Somewhat) Ugly (NYSE:MKC)

Introduction

McCormick & Company (NYSE:MKC), the leading supplier of spices, seasonings and flavors, is a very solid company – no question about it. Much of the company’s business is invisible to consumers, but its relationships with retailers like Walmart (WMT) and Dollar General (DG) and food and beverage manufacturers are extremely strong. As a result, McCormick also benefits from the growth of world-renowned food and beverage companies such as PepsiCo (PEP), qualifying the company as a “hidden champion”, if you will. Management is very shareholder friendly and long-term investors continue to benefit from typically high-single digit dividend growth.

However, this often-touted “no-brainer” investment comes with some caveats, which I will discuss in this column.

The Good

As mentioned above, McCormick is by far the global leader in spices and seasonings. Because of its size, MKC benefits from tremendous economies of scale and maintains close business relationships with most, if not all, major retailers. For example, Walmart is a major customer that McCormick highlights in its annual report, having accounted for 11% of consolidated net sales in 2021. Other customers include Dollar General and Family Dollar, for which MKC supplies spices and seasonings sold under the retail chains’ private brands. McCormick is the largest domestic producer of private label spices and seasonings. In addition to its namesake brand, MKC owns well-known national brands such as French’s, Frank’s RedHot, Lawry’s, Club House, OLD BAY and Stubb’s, as well as international brands such as Ducros, Schwartz and Kamis.

McCormick’s Consumer segment accounts for approximately 62% of total sales (± 1% over the past decade), while the Flavor Solutions segment typically contributes 38% to McCormick’s top-line. Through the latter segment, the company has business relationships with most of the leading food and beverage manufacturers, food service companies and restaurant chains. PepsiCo, for example, accounted for about 11% of consolidated sales in fiscal 2021. Investors in McCormick therefore indirectly participate in the success of the world’s leading food and beverage brands.

Management has been able to maintain the Consumer segment’s solid margin of 20%, but the former Industrials segment has steadily improved from an operating margin of around 8% (fiscal 2012 to 2014 average) to 13% (fiscal 2019 to 2021 average)

The company has a well-managed production and distribution network. Significant cost advantages over smaller competitors and considerable economies of scale enable McCormick to continue to build on its already leading position.

Of course, with the Consumer segment accounting for nearly two-thirds of total sales and generating a solid operating margin of over 20% in recent years, the company must be careful not to neglect its brands. However, McCormick continues to invest in advertising to maintain or further strengthen its brands. Also, both the Consumer and Flavor Solutions segments require significant R&D spending to ensure that innovation is maintained. McCormick clearly has not cut corners, as shown in Figure 1.

Income-oriented investors will certainly appreciate McCormick’s dividend history, even though the current yield is only 1.8%. Management has raised the dividend for 36 consecutive years, making the company a dividend aristocrat, and the dividend growth rate continues to be solid. The compound annual growth rate (CAGR) of 8.0% and 8.7% for the last three and ten years, respectively, confirms that the dividend remains a high priority for management. With a payout ratio of typically 40% of free cash flow, normalized for working capital movements and adjusted for share-based compensation expense and recurring (but not really significant) impairment charges, there is ample room to increase the dividend, even in years of poor cash flow, such as fiscal 2021 and 2022 (see below). MKC repurchases its own shares, but only to the extent that dilution by stock-based compensation expenses and share issuances to fund acquisitions is offset. The number of fully diluted shares has remained fairly stable since at least fiscal 2012, i.e., the number of shares has increased by only 0.6% over the entire period.

The Bad

Although McCormick is the market leader and benefits from cost advantages and economies of scale, the company is sensitive to input cost inflation. In recent earnings releases, management indicated that raw material, freight, packaging and labor costs have reached their highest levels in over a decade. Exposure to commodities such as pepper, garlic, etc., is difficult to hedge, so rising costs have impacted McCormick’s operating profitability (Figure 2). McCormick is in a superior position because of its size and the benefits of volume discounts, but it does not seem unreasonable to expect that pressure on margins will continue for some time, as it is expected that its premium products will forfeit demand to some extent as consumers shift to discount products.

In this context, McCormick’s position as a supplier of private label seasonings and condiments is certainly a positive. Like all companies facing input cost inflation, McCormick has and will continue to pass along price increases to its customers, which will also help normalize gross margin and thus operating margin going forward. Nonetheless, the extent of margin compression is indicative of the company’s dependence on commodities and certainly not infinite pricing power, and should therefore be factored in when determining the fair value of the stock.

In terms of profitability, it is also worth noting that McCormick’s cash flow conversion is not ideal, as can be seen from the negative excess cash margin (ECM, Figure 3, see my recent educational article). However, this should not be over-interpreted, as MKC’s cash flow conversion is still reasonable and the lack of a trend in ECM signals that cash flow profitability is largely stable. Of course, supply chain and inventory issues are evident in the fiscal 2020 to 2022 ECMs.

Given that McCormick’s cash flow conversion is not the best, and due to the volatility of free cash flow – especially in recent years – a look at the company’s debt service ability is warranted. Historically, MKC has been a very conservatively financed company with net debt of only about $1.2 billion to $1.4 billion, resulting in very manageable leverage of about four times net debt to normalized free cash flow. However, the acquisition of Reckitt’s (OTCPK:RBGLY, OTCPK:RBGPF) food division in 2017 for $4.2 billion (see next section) increased McCormick’s net debt to about $5 billion (Figure 4), which has remained largely unchanged to date and corresponds to a leverage ratio of between 5.5 and 10 times normalized free cash flow – not unmanageable, but certainly significant. Theoretical leverage will be even higher as fiscal 2022 draws to a close, a year in which free cash flow will be particularly weak due to lower earnings and working capital issues.

The acquisition likely played a major role in the decision by Moody’s, which downgraded McCormick’s long-term debt rating to Baa2 from A2 (three notches) in August 2017. Since then, however, the rating – which is equivalent to a BBB rating by S&P (lower medium grade) – has been left unchanged and was last affirmed in December 2020 with a stable outlook.

However, while this may all sound overly negative (and indeed I expected a better rating for an industry leader), I would like to draw your attention to Figure 5, which compares McCormick’s maturity profile to its three-year average free cash flow from fiscal 2019 to 2021 (fiscal 2022 FCF has been excluded due to significant one-time items). Importantly, the semi-transparent green bars in the chart represent after-dividend FCF, confirming that the company is in a fairly comfortable position when cash flow improves in fiscal 2023. Of course, it is unreasonable to expect a large entity to pay off its entire debt as it matures – most companies maintain some level of leverage and therefore refinance their obligations as they mature off the balance sheet. As a result, McCormick will likely have to make somewhat higher interest payments in the future, as debt maturing between 2022 and 2024 bears interest at a weighted average rate of 2.9%, and the Federal Reserve has been aggressively raising rates recently. However, with an interest coverage ratio that is typically 5-6 times normalized free cash flow (aside from the disproportionately low expected FCF for fiscal 2022), I have a hard time calling McCormick’s leverage uncontrollably high.

… And The (Somewhat) Ugly

As mentioned earlier, McCormick acquired Reckitt’s food division in 2017, which most likely played an important role in Moody’s decision to downgrade MKC’s debt by three notches. The price paid was certainly substantial at seven times 2017 sales. By comparison, McCormick is currently trading at a sales multiple of 3.5 and certainly isn’t cheap (see next section).

Reckitt is notorious for its lackluster profitability, as I explained in my analysis from earlier this year. The company has been struggling since 2017, the year it acquired baby formula manufacturer Mead Johnson for a substantial valuation, then touting the $17 billion transaction “as a significant step forward in Reckitt Benckiser’s journey as a leader in consumer health“. Last year, the company announced the sale of a portion of the assets, recording a goodwill and other intangible asset impairment charge of nearly £3.3 billion, while the remainder of that failed acquisition is expected to fetch about £5.6 billion. Net debt ballooned, the interest coverage ratio dropped dramatically, and most importantly, the company’s return on invested capital fell to a level equal to or below its weighted average cost of capital.

It appears that McCormick “inherited” Reckitt’s lackluster profitability. To be fair, however, McCormick is still able to generate excess return on invested capital (ROIC, Figure 6), but when the somewhat weak cash flow conversion is taken into account (CROIC), things look worse (Figure 7). In this context, it seems worth noting that CROIC is compared to cost of equity (COE), the “correct” determination of which is debatable, but my own estimate of 7.8% is likely not too aggressive. A COE of 7.8% represents a 4% premium to the current yield of 30-year Treasuries. Of course, the expected free cash flow for fiscal 2022 makes things look even worse, but as noted above, things are expected to normalize in 2023, so the data for that year should not be over-interpreted. Some may argue that ROIC and CROIC can or should be calculated without taking goodwill into account, but since McCormick is a company that is growing in large part through acquisitions, I don’t think this is appropriate and would paint too positive a picture of the situation.

The hypothesis that the acquisition of Reckitt’s food division has not (yet) been properly digested is underscored by McCormick’s asset turnover (Figure 8), which fell sharply in fiscal 2017 and has continued its downward trend in fiscal 2018, meaning the company is generating less revenue per dollar of assets.

Conclusion

McCormick is a great company – no question about it. As I like to invest in what I understand, I am naturally drawn to companies like McCormick. Indirectly participating in the growth of leading global food and beverage companies like PepsiCo sounds like a great investment thesis, and it is, provided the valuation is right and the company performs accordingly.

I’ve shown that McCormick still suffers from integration issues, probably largely related to its 2017 acquisition of Reckitt’s food division, and its leverage has also gotten a bit too high for my taste (underscored by the significant rating downgrade that year), although it is certainly manageable. Given McCormick’s history and the quality of its underlying business, its strong relationships with retailers on the one hand and food and beverage giants on the other, it seems likely that the company’s profitability will improve sooner or later. The near-term challenges, however, are serious and show that even industry leaders are not infallible and do suffer from input cost inflation. Nevertheless, as these problems are certainly not insurmountable, the likely very weak free cash flow in 2022 should balance out again in 2023.

Against this backdrop, however, I can’t quite understand the market’s optimism, which is best illustrated by the FAST Graphs chart in Figure 9 and the plot of normalized free cash flow per share versus share price in Figure 10. Performing a discounted cash flow analysis based on average normalized free cash flow for the fiscal 2019-2021 period, investors demanding a cost of equity of 7.8% (4% premium on the yield of 30-year Treasuries) assume that McCormick will continue to grow its free cash flow at a rate of 4.8% per year until the end of day. Past data (except for fiscal 2022) suggests that such growth is indeed possible, but I want to emphasize how sensitive discounted cash flow analyses are to such high terminal growth rates. It should also be remembered that growth over the past decade has been bought by a substantial increase in debt.

Given the quality of the underlying business, I find it difficult to rate the stock a “Sell”, but the fact that McCormick has operational issues suggests that further upside is rather limited. The substantial valuation multiples expansion in recent years also makes me a bit uneasy, knowing that the rise in equity valuations is largely due to easy money policies, especially since the Great Financial Crisis (see my recent article discussing other important consequences).

Of course, the dividend is a comfort to long-term investors who are likely sitting on a significant yield on cost, also taking into account that the dividend continues to be a high priority for management. However, if I were currently invested in the stock, I would calculate the replacement yield and see if the current bear market offered me a better opportunity. The replacement yield is equal to the current dividend yield of a new investment after selling the position in question and taking into account capital gains taxes (see the formula at the end of my recent analysis of several Big Pharma companies).

If I currently owned the stock, I would consider selling it under the following assumptions:

• I held it in a tax-deferred account or have the ability to offset capital gains taxes with losses

• I bought not too long ago or my replacement yield is achievable with another investment

• I have an otherwise good idea of how to reallocate the funds, as I am not a fan of market timing and typically only hold a small cash reserve. It is also helpful to factor opportunity cost into the equation.

Thank you very much for taking the time to read my article. In case of any questions or comments, I am very happy to read from you in the comments section below.