McCormick Stock: Dividend Growth And Expenses Reduction Imply Undervaluation (NYSE:MKC)

McCormick & Company, Incorporated (NYSE:MKC) recently delivered better than expected EPS, continues to pay dividends, and reports a 5 year dividend growth rate of 8.35%. Given recent successful pricing strategies and the global operating efficiency savings programs, I believe that we can expect operating profit margin growth and profit margin growth. In addition, further divestitures of low margin business units like the Giotti canning business unit could accelerate gross profit margin growth. There are some risks coming from failed introduction of products or goodwill impairments, however I believe that MKC could trade at higher price marks.

McCormick & Company, Inc

McCormick is a manufacturer, marketer, and distributor of spices, condiments, seasoning mixes, and other flavor-related products for food, with clients from various areas within the food industry, both manufacturers and retail distributors.

Although it also has production facilities in Australia, Central America, Thailand, and South Africa, the bulk of the company’s operations are in the United States, China, and Europe. In addition to its core operations, the company has business partnerships and an active acquisition strategy, demonstrated by the purchase of FONA International and Cholula Hot Sauce in 2020.

The organization functions via two segments, consumers and flavor solutions. The first of these segments has higher operating margins. The wide number of end markets offered by this type of industry means that the company has the possibility of introducing its products on a large number of dietary options, offering consumers products with specific conditions such as organic products, reduced in sodium, and without genetic modifications among others.

I believe that the importance of the consumer segment is given by the participation of products in more than 160 countries, including products with an international scope and others that respond to the ethnic or geographic preferences of each region besides being marketed in specific territories.

Besides, McCormick stands out as one of the global leaders in the spices market. It is a market leader in sauces and condiments in the United States. The products are distributed via varied sales channels, mainly through retail stores. The flavor solutions segment responds to the company’s activities in its services to companies in the food sector.

In the last quarterly report, McCormick reported better than expected EPS GAAP and better than expected quarterly revenue. Given the reaction of market participants, which push the price up to more than $76 per share, I think that having a look at the valuation of the company makes a lot of sense right now.

I believe that investors out there appear quite optimistic about the incoming EPS expected for 2024 and 2025. Consensus estimates include an increase in EPS in Q3, Q4 2024 and Q1 2025. In my view, with better than expected EPS again released in 2024, the stock price may trend higher.

Balance Sheet

As of February 29, 2024, the company reported a significant amount of cash worth $178 million. McCormick also reports goodwill worth $5.2 billion and intangibles of $3.3 billion. Given the total amount of goodwill and cash in hand, I believe that a new acquisition could be announced soon. In this regard, it is worth noting that the company mentioned possible future acquisitions in the last quarter.

Those balances are generally available without legal restrictions to fund ordinary business operations, capital projects and any possible future acquisitions. Source: 10-Q

I dislike the fact that the current ratio is lower than 1x. However, given the company’s brands and intangible assets accumulated, I believe that bankers would give financing when necessary. The asset/liability ratio is larger than 1x, so I think that the balance sheet appears healthy.

In 2024, McCormick & Company reported long-term debt lower than that in 2023. In this regard, management noted that it used some cash to reduce short-term debt in the U.S. I believe that further reduction in the total amount of debt may lead to higher EV/EBITDA or PE ratio.

At February 29, 2024 and February 28, 2023, we temporarily used $539.3 million and $150.1 million, respectively, of cash from our non-U.S. subsidiaries to pay down short-term debt in the U.S. During a quarter, our short-term borrowings vary, but are typically lower at the end of a quarter. Source: 10-Q

Assumption 1: Further Reduction In Expenses Could Lead To Operating Margin Growth Under My Base Case Scenario

According to the last press release, during 2023, the company’s objective was to carry out a considerable reduction in general expenses, largely tied to complications in global supply and distribution chains and the change in fuel prices. If we analyze the results of the first quarter of 2024, we find positive statistics including operating income growth and net income growth.

The forecast for 2024 includes adjusted EPS of 5%-7%, income per share close to $2.80-$2.85, and adjusted operating income increase of about 4%-6%. Under my base case scenario, I assumed that the efforts made in 2024 and 2023 will most likely continue in the coming years. As a result, under my base case scenario, I assumed 2033 operating profit of 20%.

Assumption 2: Net Sales Increases Thanks To Pricing Strategies, M&A, And Volume Sold

In the last quarterly presentation, McCormick noted improvements in volume performance in the Consumer and Flavor Solutions business segments. Besides, the company noted improvements in terms of pricing. According to management, recent investments were successful. As a result, McCormick believes that unit share gains could also build through 2024.

I also believe that the company could deliver gross margin improvements thanks to the comprehensive continuous improvement and global operating efficiency savings programs. Under my base case scenario, I assumed further net sales growth driven by the same pricing strategies. I included net sales growth close to 3.4%, which I believe is quite conservative.

Assumption 3: Working Capital Initiatives, And Debt Reduction Lead To Net Income Growth Under My Base Case Scenario

McCormick continues to return cash to shareholders. I believe that further increases in the CFO thanks to working capital improvements and capacity improvements could lead to higher dividend payments. In addition, McCormick expects to reduce its debt obligations, which may enhance net income growth and lower interest expenses. In this regard, I invite investors to have a look at the following slide.

Assumption 4: Discontinuation Of Certain Business Units Accelerates Net Profit Margin Under My Base Case Scenario

I believe that the company’s discontinuation of certain low margin businesses may bear fruit throughout 2024, impacting merchandise volume growth during the year. In this regard, the company noted the divestiture of the Giotti canning business, among other business models. I believe that further strategies could bring net income growth. Under my base case scenario, I assumed that the net profit margin could increase to up to 17%.

Unfavorable volume and product mix in our consumer segment exceeded the favorable volume and product mix in our flavor solutions segment. Our decisions to discontinue certain low margin businesses contributed approximately 0.6% to the unfavorable impact of volume and product mix. Also, the divestiture of our Giotti canning business unfavorably impacted sales by 0.2% as compared to the prior year period. Source: 10-Q

My Base Case Scenario Based On Successful Execution Of Previous Initiatives And My Assumptions

I assumed 2033 revenues of close to $9507 million and 2033 revenue growth with a median revenue growth of close to 3.4%. With the cost of goods and services sold of $5529 million, I obtained a gross profit of $3977 million and a gross margin of 41%. The margin is a bit better than that reported in 2021, 2022, and 2023.

In addition, with selling, general, and administrative expenses worth $1932 million and special charges of about $135 million, I obtained operating income of close to $1909 million and 2033 operating profit of 20%.

With interest expense of close to $33 million, I obtained income from consolidated operations before income taxes worth $1936 million, 2033 net income of $1633 million, and profit margin of 17%.

In my dividend discount model, I used a payout ratio of 58%, which is close to the current payout. In addition, I included a PE ratio of 29x, which is significantly lower than the multiple seen in 2022, when McCormick reported a PE ratio of more than 36x.

Finally, I also used a WACC of 5.7%, which is close to the median reported by other competitors and peers. The maximum WACC is close to 8%. Under my worst case scenario, I assumed a cost of capital of 6.5%. The results include an implied fair price of $117.

Under My Worst Case Scenario, Some Of My Assumptions And Initiatives Of McCormick Fail

Under my worst case scenario, my previous assumptions and initiatives communicated by McCormick may not lead to net sales growth. Besides, profit margin growth may not increase as much as expected in the previous case scenario.

Under this scenario, I assumed 2033 revenue of $6182 million, with revenue growth of -3.4% and median revenue growth of -0.6%. In addition, with the cost of goods and services sold worth $3837 million, I obtained 2033 gross profit of $2345 million and a gross margin of close to 37%.

Besides, I also took into account selling, general, and administrative expenses of $1344 million, special charges of $102 million, and operating income close to $898 million. I also assumed net income of about $789 million, which implied a profit margin of 12%.

Lower net sales than expected may lead to lower demand for the stock, which may lead to higher cost of capital, and higher WACC, and lower PE ratio. Under this case scenario, I also used a payout ratio of close to 58%, a PE ratio of 27x, and cost of capital of 6.5%, which implied a fair price of $55 per share.

Competitors

Both operating segments coexist in highly competitive markets, and McCormick’s strategy within these markets is focused on generating closer contact with customers, through insights about preferences and active promotional campaigns for its products as well as an expanded offering for its customers in the flavor solutions segment.

In any case, it is difficult even for the company to do a fine analysis regarding competing products since in many cases the spices are purchased in bulk and at retail. In some cases, they are distributed without reference brands, especially in the Asian market, where the company maintains a considerable bulk in its operations. Seeking Alpha gives the following list of competitors. However, finding peers is difficult because some of these companies report very different business units.

Risks

In terms of the market in general, especially that of end consumers, going through the current economic crisis, the consolidation of customer preferences, and the company’s ability to introduce its products into the markets and generate brand recognition play a fundamental role in the competitive environment and the commercial success of these products. In this same sense, the pricing strategy that allows establishing positive margins in the growing inflationary context and the company’s ability to practice it are relevant data in the risk analysis.

Specifically, the two major points of risk for the company are linked to exchange rates in international trade and the possible increase in interest rates in different regions. Although neither of these two factors means situations of high conflict, added together and in the worst case scenario, they can mean a significant part of the company’s income margins.

Given the total amount of goodwill, McCormick & Company, Inc. could also suffer from goodwill impairments and declines in the book value per share. As a result, investors may also believe that the company does not correctly integrate new brands, or does not select targets appropriately. In the worst case scenario, lower demand for the stock could lead to lower stock price declines.

Conclusion

McCormick recently delivered better than expected EPS, and many analysts are expecting EPS to increase in 2024 and the first part of 2025. I believe that recent pricing strategies and divestiture of low margin business units like the Giotti canning business unit could bring an increase in the operating profit margin. In addition, the company’s comprehensive continuous improvement and global operating efficiency savings programs could also accelerate net profit margin growth. There are risks coming from changing consumer preferences, goodwill impairments, or failed branding efforts. However, I believe that McCormick’s future dividends imply a valuation that is higher than the current price mark.