McCormick: Let It Pull Back

Prepared by Chris, CEO Quad 7 Capital and Team Leader At BAD BEAT Investing

McCormick & Co. (NYSE:MKC) is a name that we have traded a number of times in the past. Earlier this year, we recommended the name at the beginning of April. We felt there was potential for strong returns during the market turmoil under the thesis that “people need to eat.” We had highlighted a few defensive food names at that time, all of which fell less during the crisis and saw businesses boom with stay-at-home trends. The company took a hit from restaurant closures, or restaurants only being available for takeout/delivery, during the COVID-19 crisis, but more people were cooking at home.

Some abatement has been seen in the commercial space but there is much more to go. So we started buying at $130, $135, and started taking profit in the high $170s. Make no mistake, it was not because we were bearish, although there was a stretched valuation, but it was more so because that is prudent portfolio management. We kept a position. That said, we think you should wait for the name to drop at least 10 points before considering buying again. The company continues to be a beneficiary of the eat at home trend, as evidenced by the just reported Q3 which we will discuss.

Our take on Q3 sales

The stay at home thesis continues to play out here. Sales in Q3 were impacted by COVID-19 which turned consumption patterns upside down versus a year ago. Business sales got hit hard, while the everyday consumer drove sales. The company delivered some decent results. McCormick’s third quarter sales were up 8% compared to the year-ago period. In constant dollars, sales grew 9%.

The consumer segment saw a 15% benefit, while currency impacted things slightly. Regionally, sales we pretty bifurcated. In Asia/Pacific consumer sales fell 9%. They rose in the Americas and EMEA. Consumer sales in the Americas jumped 17%. In EMEA they spiked 23%. This was a result of the stay-at-home trend that we discussed in April.

We also talked about how the Flavor Solutions segment would see pressure from lockdowns and forced restaurant closures, or takeout only. Flavor Solutions saw sales fall 3%. Once again we will reiterate that the company continues to see growth because each year it comes out with new and exciting products that are usually well-received, and the company continues to effectively market its classic products, but this year, the declines were entirely driven by closures.

Flavor Solutions continues to have strength if we back out COVID-19 impacts. The company has pricing power and continues to innovate. COVID-19 was an issue, but be mindful competition remains tough. Restaurants are going to start to come back. Sales in the Americas were down 4.7%, while EMEA saw a 1% drop. Despite the perceived impact of COVID-19, Flavor Solutions rose 4.9% in Asia/Pacific. Restaurants are largely reopened, but at less capacity. The lower indoor capacity, advent of outdoor dining, and takeout has only done so much for restaurant volume, and by extensions sales of McCormick products to said restaurants.

Margins rose

Expenses have been kept in check, thanks to cost savings initiatives. Margins jumped 70 basis points versus the year-ago period. This expansion was driven by the favorable product mix on top of the cost savings. Operating income increased to $273 million compared to $254 million in the year-ago period. This increase was primarily driven by the impact of higher sales and gross margin expansion. Excluding special charges, adjusted operating income increased 5% to $273 million compared to $261 million in the year-ago period. From an EPS standpoint, the company missed our expectation by $0.02 but surpassed consensus by $0.01. It was a good quarter, but the stock is expensive.

Valued for more growth but wait for a pull back

The stock is still pricey even at nearly $200 per share. However, it’s not the same value we once saw. Not all valuation metrics are created equal. You see we are actually seeing some meaningful EPS growth now. Before COVID-19, we were looking at EPS for the year of $5.10 to $5.40. With outperformance in the last two quarters, we think EPS now hits $5.55-$5.65 depending on Q4. That puts valuation at nearly 35X-36X FWD EPS at $180. The stock has always had a stretched valuation, but this is pretty high. While shares have declined from their highs of $211, under $190 would be a good price to enter. We also think the 2 for 1 stock split could attract some lower dollar investment. Even though splits have no real impact on value, there is a perceived benefit often noted by investors.

In the consumer segment, we think we see an overall increase in consumer demand during periods of pantry stocking like we saw with our defensive food stock plays, and we think we see increased cooking at home continue in 2020, but maybe wane slightly. In the Flavor Solutions segment, we also expect to see slowly increasing customer demand from packaged food companies and expect still reduced but improving demand from restaurant and other foodservice customers as the year goes on.

Overall, we think it is best to let the stock pull back before doing more buying.

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Disclosure: I am/we are long MKC. 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.

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