Description

Short MKC ($103)

We recommend shorting McCormick & Company (MKC). We acknowledge that banjo1055 wrote this idea ~11 months ago; however, we think the current food industry paradigm shift, coupled with rising interest rates makes this a uniquely interesting time to be short MKC.

Historically, in our view, consumer staples companies have been fantastic investments because of 3 attributes: 1) brands, 2) manufacturing scale, and 3) distribution. We believe that all 3 of these “moats” are reversing and will disrupt what has historically been a great industry. First, we don’t think brands are dead; however, we do believe the cost of building a brand has decreased significantly. This is because smaller companies are able to target customers on digital advertising platforms such as Facebook and Google. Manufacturing scale still exists, but we believe the growth in contract manufacturing is allowing upstart companies to source products more easily. As an example, Dollar Shave Club has become a major shaving brand by sourcing products from a company called Dorco in Korea. Finally, big staples companies have been able to take advantage of the fragmentation among food retailers to maintain fat margins. Now, consumers are more willing to buy food online (endless shelf) and experiment w/ private label products which are gaining shelf space at discount retailers. Overall, time is working against branded consumer staples companies and we think there is a lot of money to be made on the short side.

MKC is a food company with a leading position in spices, seasoning mixes, condiments, and other flavorful products. The company operates in 2 segments: Consumer Segment (~60% of sales) and Flavor Solutions (~40% of sales). The Consumer Segment includes spices, seasonings, condiments & sauces, and recipe mixes. We believe this is a collection of remotely better than average food categories that are predominantly US exposed. This is because, on average, MKC’s Consumer Segment operates in GDP+ categories (rising penetration); however, branded players are losing market share to private label and small brands. For example, searching for “hot sauce” on Amazon will provide you w/ results of several small brands and searching for “oregano” will return Whole Foods’ 365 brand. I would note that WMT is 11% of MKC’s Consumer Segment’s revenue and they are aggressively clamping down on branded food companies and promoting their own private label offerings.

In conversations with investors, bulls believe that MKC deserves to trade at an elevated multiple because of its Flavor Solutions segment. For reference, in this segment, MKC sells flavors to multinational food manufacturers and foodservice companies. For example, MKC sells flavors to Pepsi, which are subsequently used in their potato chips. We agree that MKC is uniquely positioned in this industry and has the widest assortment of flavors; however, most of MKC’s Flavor Solutions customers are the same companies facing secular headwinds across the whole food industry. At some point, Pepsi, which represents 11% of revenue in this segment, will start driving down the price of its suppliers’ products. We don’t know when but we believe its inevitable given the deflation across the value chain.

There are a lot of staples companies that are likely shorts but we find MKC the best risk/reward. During the 2^nd half of last year, the company decided to lever up to 5.1x net debt/EBITDA to buy Reckitt Benckiser’s food division. In doing so, the company has geared itself at exactly the wrong time and bought an asset with exactly the wrong characteristics (legacy food brands). We are taken aback that MKC is trading for 21x fwd P/E with 5 turns of debt when more emerging market exposed food companies such as MDLZ trade for <16x fwd P/E with 3 turns of debt. More domestically exposed food companies such as GIS/K/CPB trade for 13-14x fwd P/E though they have made recent acquisitions which have stretched their balance sheets.

Overall, we don’t have an exact price target but believe that MKC should de-rate to 16x fwd P/E given secular headwinds and its levered balance sheet (~$80/shr). What we like about this trade is that time is working for us. Everyday that goes by the industry dynamics get worse for MKC. Hence, we expect our estimate for intrinsic value to only decrease overtime.

Catalyst

Another Marlboro Monday

https://en.wikipedia.org/wiki/Marlboro_Friday