It’s a few months ago since I wrote my most recent article covering the food giant McCormick (MKC). Back then, I discussed that the company was still an interesting long despite a somewhat ‘high’ valuation. The company just released its third-quarter earnings and once again demonstrated its power to generate higher earnings despite seeing some global headwinds. Unfortunately, buying a high-quality company like McCormick comes with a rich valuation while debt levels are a bit elevated. I remain very confident that long-term investors should stay long while I consider it to be better for new investors to buy on larger dips. The alternatives are strong as well, and I think it is better to wait before running after this stock right now.
Source: McCormick & Company
Earnings Continue To Rise
First of all, let’s start with adjusted EPS. Even though sales growth has slowed as I will show you in this article, the company continues to deliver solid bottom line results. In the just released third quarter, McCormick generated adjusted EPS of $1.46 which is well above expectations of $1.29 and 14% higher compared to the prior-year quarter when the growth rate was at 8%. The current growth rate is one of the many double-digit quarters the company has revealed over the past few years.
Top-Line Strength Thanks To Organic Growth And New Products
So, where did growth come from? First of all, third-quarter sales improved by 1% compared to the prior-year quarter. On a constant currency basis, sales are up 2% thanks to a strong consumer segment which was supported by higher volume and product mix. This was caused by a strong base business as well as new products.
The consumer segment saw a sales increase of 3% including a 1% unfavorable impact from currency, meaning that adjusted sales would have been up 4%. The company mentions an acceleration trend from the first half. The Flavor Solutions segment saw a sales decline of 2% as a result of negative currency changes. This is the first weakness after 5% growth in the first half. This volatility is normal in this segment.
That said, both Asia-Pacific and the Americas saw strong growth. In the Americas, sales were up 4% on a constant currency basis. This growth was completely organic and a result of higher volumes and product mix. Category management initiatives, strong marketing results as well as merchandise execution all contributed to this success.
According to management, McCormick branded spices in the US grew in line with category sales and had double-digit growth in unmeasured channels. Moreover, new products like One Dish and Street Tacos dry recipe gained momentum in the third quarter.
In EMEA countries, volume/mix was down 1.1%. Prices were down 0.9% and currency headwinds accounted for 3.6%. Total net sales were down 5.6%. This was the result of unusually warm weather in Europe. Especially, in France and Italy with pressured consumption. These weather effects lingered in the second half of the third quarter which resulted in strong momentum going into the fourth quarter. McCormick also sees high potential from new products – just like in the US.
And speaking of new products. Brand awareness and e-commerce are two things the company has increasingly invested in. The third quarter saw double-digit e-commerce growth as investments in content development and e-commerce are paying off. This includes digital advertising.
Margins Are Up Thanks To Cost Management
That said, strong sales do not really matter when a company is failing to control costs. Fortunately, as I started this article by showing you EPS results, you probably already guessed that the company did not struggle with controlling costs. Gross margin improved by 100 basis points to 40.6% driven by CCI-led (Comprehensive Continuous Improvement) cost reduction and a favorable product mix. On a year-to-date basis, gross margin is up 40 basis points. On a full-year basis, gross margin is expected to be up between 50 and 75 basis points.
SG&A costs were down to 20.9% of total sales as higher sales outperformed operating costs. The bigger picture shows what I mean when I say that the company is doing so well despite sales growth weakness this year. Margins are improving, pushing operating income to new highs. Also note that sales are not down but subdued due to weather. I expect this trend to continue if the company is able to generate higher sales growth.
Updated Guidance Sees Higher EPS Growth
And speaking of higher sales growth, the company expects to grow sales between 1% and 2% this year, meaning that we should not expect a sales upswing anytime soon. However, on a constant currency basis, sales are expected to be up at least 3%. This shows that the company’s products are not the problem as organic sales growth in key markets continues to be good. And let’s not forget that this company is not a hot tech stock with a tremendous growth market.
Anyhow, adjusted operating income is expected to rise between 6% and 7%. This is slightly down from previous expectations of 6% to 8% growth. As I already said, a large driver will be a full-year gross margin improvement of 50 to 75 basis points and $110 million CCI-led savings. Adjusted earnings per share are expected to be up between 7% to 8% on a basis of 134 million outstanding shares. These expectations are up from previous guidance between 5% and 7%.
The Bottom Line
The stock continues to look good as the recent ‘market’ weakness has not been able to get this stock lower. However, the company is trading at 30x next year’s earnings with a PEG ratio of 3.5. Moreover, McCormick has a debt/equity ratio of 1.4. That’s not extremely bad, but investors prefer healthier stocks during economic downtrends. Nonetheless, even though the stock is ‘expensive’, I would not bet against it with my enemy’s money. The company is doing so well that I get why investors are paying a huge premium. However, if you are not long, I think it might make sense to wait for a bigger dip to start buying. The stock is yielding 1.4% which is way below the 3% dividend yield you get when buying the utility ETF (XLU). It’s a weird comparison I only make to show you there are low-risk places to put your money with a significantly higher yield. You don’t have to settle for a company at a high premium and somewhat unfavorable debt position.
Nonetheless, if you have been long for some time, I think you should stay long. This company has a tremendous market position and I believe that it will continue to generate strong sales and earnings in the future. I am just not too happy about the market in general.
The biggest risk investors are facing is a situation where growth slowing meets higher inflation. Such an event would be triggered by dollar weakness as a result of expected central bank dovishness. It is not very likely as an economic slowdown often tends to linger inflation, but it would be a problem as consumer weakness and higher input prices would do serious damage to margins and earnings. But as I said, this scenario is not very likely and I don’t expect it to happen.
So, all things considered, I think the stock continues to be a good place to be for long-term investors. Unfortunately, new investors should probably wait for a dip as the alternatives are good and the high valuation is not doing the risk/reward any favors.
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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.
Additional disclosure: This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.