Description

Overview:  McCormick (MKC) is a global manufacturer of spices, seasonings, condiments, and other flavor products. In late 2017, the company completed the acquisition of Reckitt Benckiser’s food products portfolio consisting primarily of French’s mustard and Frank’s RedHot sauce. As a result of this large acquisition, MKC is now leveraged at ~4.0x Net Debt/EBITDA with tepid organic growth and a margin profile that has already been enhanced over the last several years.

Investment Thesis:  MKC is one of the only remaining global Household & Personal Care/Food & Beverage peers yet to be fully hit by increasing private label penetration and the resulting lack of pricing power due to weakening brand relevance. While other peers have seen growth slow and trading multiples collapse over the last two years, MKC still trades at a premium multiple of 18x Fwd. EBITDA and ~25x FY2019 EPS. I believe that the reported growth from the Reckitt Food’s acquisition has masked weak underlying trends. Now that this deal has fully annualized, MKC looks similar to its peers with low to no organic growth, high leverage, and a few remaining levers to pull to juice growth (such as M&A or further cost cutting). I believe the thesis has started to play out with weak guidance provided on the most recent earnings call. Management expects 1-3% reported sales growth (3-5% constant currency) and 4-6% Adj. EPS growth in 2019. For this exciting growth profile, you can purchase shares for ~25x FY2019 EPS.

Investment Considerations

1.       Private Label Penetration Should Increase in MKC’s categories

• MKC has held up pretty well against PL competition but this trend appears to be changing. Management removed their market share data from their presentation in 2016 but Nielsen data shows share loss:

• Hard-discount grocers like Aldi, Lidl, and Trader Joe’s don’t sell name brand spices/seasonings and they continue to take grocery market share in MKC’s largest market.

• Small, non-perishable items are perfect for ecommerce/home delivery where brands are not as important (see batteries, cleaning products, electronic components, etc.). The shift to online, recurring grocery orders further commoditizes branded products.
  • French’s is the 31st result on Amazon when you search for Mustard and is also far from the best value:  Cheapest French’s is $0.52/ounce vs. $0.10/oz Heinz Mustard, $0.25/oz WFM Dijon, $0.19/oz WFM Organic mustard.
  • Spices and seasonings are still heavily skewed to MKC products but the PL Whole Foods and Amazon Basics products are all priced at a significant discount.
• In Q4 2017, Walmart chose to convert MKC branded seasonings (5th Season’s) to PL.
• Volumes for most MKC categories are only GDP-like so any market share loss severely retards growth.

2.    Pricing makes up a large portion of revenue gains, value proposition is weakening

• Organic growth has been anemic for some time (LSD) driven by a mix of pricing and volume growth. In recent quarters, volume growth has not picked up even with management pulling back slightly on the pricing lever. Even though organic growth has averaged ~3% for the last two years, management continues to guide to long term revenue growth of 4-6%.

3.       Margins have already increased significantly and further improvement may exacerbate growth trends

• Increasing margins (via underinvestment in either R&D, Marketing, or G&A) ultimately results in slower top-line growth. This inverse relationship has been proven out at other F&B peers like Kraft Heinz. MKC will not be an exception to this rule.
• Commodity inflation has been benign the last few years. Price increases have been able to outpace commodity cost increases leading to slightly increased gross margins.
• Industry margins are now at LT peaks and growth has slowed as a result.

4.       MKC Industrial division has been main driver of historical margin improvement

• MKC renamed their industrial foods segment to Flavor Solutions (FS) in 2018 and are trying to focus on less commoditized flavors and ingredients. Historically, MKC has had less pricing power in this division than the consumer segment. Typically, FS has been a 6-8% op margin business (since 2000) and only in last three years have margins increased to ~12%+. This was partially done by pruning lower margin products from the portfolio as well as the addition of some high margin Reckitt Foods sales to this segment. This margin improvement has been one of the key drivers of operating income growth and now that this transformation is largely complete, it will no longer be a tailwind.

5.       Capital allocation is mediocre

• MKC has progressively been paying higher multiples over the last few years to acquire growth:
• The largest deal was the 2017 acquisition of the Reckitt Foods portfolio where MKC paid a higher multiple than where their own stock trades for a slower growing business (~19.6x Fwd EBITDA /15.9x synergized and 7.2x Sales).
• The primary brands acquired were French’s Mustard and Frank’s RedHot Sauce which are now the #2 and #3 largest brands in the MKC portfolio, respectively.
• MKC declined to break out growth of French’s (since it is declining MSD in tracked channels). Frank’s RH had been growing at an 8% CAGR but has subsequently declined to MSD growth in late 2017. On a combined basis, management expects RB Food’s portfolio to grow in line with MKC’s long term targets of 4-6%. With the majority of Reckitt Foods portfolio made up no growth French’s mustard, I find this target hard to justify.
• Reckitt Food’s profit margins are already extremely high compared to the existing MKC portfolio
  • This portfolio was earning 37% EBITDA margins pre-synergies and nearly 46% if you attribute all the announced synergies to the RB Foods portfolio (compared to <20% margins for legacy MKC). This leaves limited room for further margin improvement.

6.       Balance Sheet is Already Fully Optimized

• MKC levered up to over 4.5x ND/EBITDA when they acquired the Reckitt Foods portfolio, effectively making the company a low growth, public LBO. Today, the company is down to 4.0x ND/EBITDA but management does not expect to get back to their target leverage of <3.0x until the end of 2020. With growth slowing since leverage guidance was first provided, I expect it will take slightly longer to achieve this target. While management de-leverages over the next 2-2.5 years, they have suspended their M&A and share repurchase activities. These activities were the primary drivers of EPS growth. Now, all FCF will be used to pay down debt at an after-tax ROIC of under 4%. This means the only remaining drivers of EPS going forward will be organic growth (likely LSD at best), potential margin improvement (limited), and debt pay-down (<4% ROIC). Since EPS growth should slow in 2019 (from 17% in FY2018 to 4-6% in FY2019), it makes sense for MKC’s multiple to also decline. Management has been fairly brazen about their LT goals to grow EPS at 9-11% so a deviation from this guidance for more than a year or two should cause a significant multiple re-rating.
• Even if MKC choses to perpetually maintain leverage at the edge of investment grade, the size deals they can currently finance without issuing equity will not move the growth needle.
• I believe the strategy of acquiring brands at nosebleed valuations is not a sustainable path to value creation.

7.       Other aspects of the business nearly optimized

• Borrowing costs are at all-time lows (but are locked in for several more years).
• Working capital / cash conversion cycle has already improved dramatically over the last few years, which freed up additional cash in excess of earnings. Management has mentioned on calls their customers are starting to push back since they are also trying to optimize their WC in a tough retail environment.
• Management has been working on a $400mm cost cutting program for several years. Each year, they present the costs to achieve these savings as one-time costs, even though they are likely perpetually recurring. In 2019 management expects to achieve another $110mm of cost savings with ~$10mm of additional costs required to achieve these savings ($0.08 addback to EPS).
  
  

Valuation and Price Targets

• As growth has slowed, most of MKC’s peers have seen 10-25% EBITDA multiple contraction since the start of 2017. Unlike its peers, MKC's multiple has actually expanded by over 10% and still trades at over 18x EBITDA.
• I believe an EBITDA multiple is the most appropriate way to compare peers due to the variability of capital structures. Applying an above peer 14x EBITDA multiple would cause MKC shares to decline ~28%. This is equivalent to ~18x FY2019 EPS, using management’s guidance. Given MKC’s still elevated leverage of ~3.7x ND/EBITDA at the end of FY2019, MKC deserves to trade at a lower P/E than its peers. Other low growth, heavily indebted consumer staple companies trade at low teens EPS multiples (or even single digit multiples).

Risks

• 3G/Kraft Heinz (KHC) pays extreme price for MKC in order to keep their M&A machine humming
  • Seems like interest may be limited since KHC already passed (or were outbid) on French’s/Red Hots which would have made a lot of sense in their portfolio.
  • Margins are already on the higher end of peers and MKC is near the tail end of a $400mm cost cutting program. Margins at RB Foods have already been optimized which makes it less attractive to a cost cutter like 3G.
  • MKC has less incremental debt capacity for a takeover compared to other peers.
• MKC uses their expensive equity currency to acquire a cheaper peer
• MKC doesn’t lose market share as expected
  • Consumers don’t care enough to switch (brand loyalty) due to relative infrequency of purchase compared to other FMCG products (like cereal or yogurt) and small ticket size.
• Industrial/Flavor Solutions segment continue to enhance its margin profile without stunting growth
• MKC is trying to move from more commoditized products like coatings, ingredients, and custom condiments to branded foodservice and flavors. Flavor peers like IFF, Symrise, and Givaudan earn even higher margins than MKC so they could theoretically increase margins further (but their portfolios are much more technical). Since margins have already increased by 50-100% over historical levels it is unlikely this transition could take place any time soon or without dramatic M&A.
• The Flavor Solutions segment makes up ~30% of profits so it is not the largest driver of performance.
• Short term trading dynamics
  • MKC is viewed as very defensive and recently has performed well when the broader market is turbulent (one of the best performers in the S&P 500 in 2018)
• Short squeeze – short interest is currently 7% but there is decent liquidity (>$150mm ADTV)
• Interest rates remain persistently low
• When MKC can borrow at 4%, even paying 20x EBITDA for deals is accretive
• Since MKC has bond-like financial characteristics it may continue to trade at elevated multiples
• No refinancing risk/interest expense headwind (next major maturity not occurring until July 2021)

Disclaimer: The information contained herein reflects the views of the author as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. The author has an economic interest in the price movement of the securities discussed in this presentation, but the author’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trademarks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from the author.

Catalyst

• Weakening fundamentals throughout 2019 and lack of upward earnings guidance