Description

McCormick & Company, Inc. (MKC) has never before been written up on VIC.  It is not a particularly exciting business, although its share price performance has been pretty exciting over time.  But today it seems overvalued, and I think the stock represents a good risk/reward proposition on the short side.

The company sells spices, seasonings, etc. as well as some specialty food products into the Consumer (grocers, etc.) and Industrial (food producers) channels.  The Consumer segment is most important at 60% of sales and 70% of EBIT.

The bull case revolves around a long-term secular shift toward a spicier palate, solid supply chain characteristics, #1 market share and the benefits of scale, a potentially accretive acquisition strategy, as well as the generally defensive nature of the business.  If willing to accept valuation around 17-18x forward EBITDA, over 3x Sales, a mid-20's P/E and a < 2% dividend yield, then one can participate as an owner of a business with exposure to these potentially positive long-term trends.

However, I see a few problems.  First, they may no longer be growing the business, at least not organically.  I don't doubt that the world is getting spicier, but the world is also increasingly discovering the joys of private label, particularly as lesser brands are converted to private label and promoted more aggressively by retailers.

MKC’s organic growth has dropped to near zero:

… while organic growth in the profitable Consumer segment just dipped negative:

Underlying data follows in the table below – skip if the above charts are enough:

This year-old photo from Trader Joe's, admittedly a private label monster and outlier, shows just how much variety is now available without the McCormick (or any branded) label:

Market share is certainly being lost.  While management will admit this, they have understandably altered disclosure to make it more difficult to track.  

The chart below was included up until Q2 2016 to show MKC’s improving share trends but was removed in Q3 2016 ahead of the market share loss in reported channels widening in Q4 2016.

Management still speaks to share trends on earnings calls.

• Q1 2017: “Taking a closer look at the first quarter, our customized IRI consumption data, indicated strong category dollar growth for spices and seasonings at 6%. During the same period, retail sales for McCormick branded spices and seasonings grew 4%. The IRI data showed pricing was 4% for both the category, and McCormick with underlying volume growth of 2% for the category and flat for McCormick. Both of these growth rates for McCormick and the category, were lower than in past quarters, and coincide with the general weakness in center-of-store food categories.”

• Q4 2016: The category grew 5% while MKC only grew 2% in measured channels (implying a 3% share loss in measured channels). Management believes that unmeasured channels contributed 2% to growth, implying a 100bps true market share loss in Q4.

• Q2 2016: Category growth for spices & seasonings was 8% yoy vs. +7% for MKC in reported channels (implying a share loss of 100bps in reported channels).

Nothing scandalous here, but also not the sort of consistency in disclosure you would expect from a company with a world-beating valuation.

These characteristics are not supportive of the stock's premium valuation, even as compared to a universally expensive set of peers whose shareholders increasingly seem to crave perceived defensive safety and/or yield at almost any price.

MKC has not always been so expensive, and waiting for a return to a more sober landscape seems to present little risk given modest growth expectations:

Finally, their accounting has been modestly suspect for some time.  No smoking guns, but accrued expenses less prepaid expenses have declined considerably over the years with poor explanations from the company as to why.

Within accrueds, drivers of the trend are declining sales allowances and declines in “other” liabilities.  Explaining the decline in sales allowances, the company suggests that this trend is driven by the shift to international business.  Yet with US business down only from 62% of total to 58% over the past decade, this doesn’t seem to explain a 37% drop in sales allowances as a % of revenue.  As for the “other” bucket, the company explains that tax and restructuring accruals are volatile and might explain the shift… maybe, but the downtrend has been fairly consistent for much of the past 15 years.  Potentially refuting this, the “other” line jumped in Q4 2016, although accrueds dropped again in Q1 2017 (we only see sub-accounts at year-end).

I don’t want to overstate the accounting and disclosure issues – they are relatively minor – but they aren’t nothing, either.

In sum, MKC is probably not a fraud, nor is the company likely to buckle under the weight of its modest leverage.  There is no massive competitive threat looming in the shadows... just a medium-sized headwind from the ongoing shift to private label and ongoing conversions of lesser brands to store brands.  But when we measure the risks of shorting an extremely expensive stock with low growth prospects and slipping market share, a stock with low short interest and ample trading liquidity, vs. the reward of a potential re-rating toward a more reasonable P/E in the mid/high teens, the contrast seems highly compelling.  In a bear market, you should make money.  In a bull market, you should make alpha.  In a flat market, I am betting you'll make both.

Catalyst

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