Description

We believe The J.M. Smucker Company (“Smucker” or “SJM”) represents a compelling short opportunity with downside of roughly -40% to our fair value target.

Thesis

Smucker is a food and beverage company with a portfolio of brands across three categories: (1) consumer foods, (2) pet foods, and (3) coffee.  Each category contributes roughly equally to SJM’s P&L.  Our investment thesis is that the market considers both the pet foods and coffee operations to be organically “growing” businesses, whereas we see both as in structural decline due to competition and/or channel shifts.

The COVID-19 pandemic (and the resulting consumer “pantry loading”) has served to buoy Smucker’s business and mask the underlying issues.  Our variant view is that the negative underlying secular trends are real and enduring.  As the economy normalizes, we see earnings falling to <$8 per share and the stock below $90 vs. a current share price of $140+.  This represents downside of close to -40%.

Consumer Foods

SJM’s legacy consumer foods business consists primarily of peanut butter (JIF) and fruit spreads (Smucker’s).  These are structurally no-growth businesses that have faced increasing competitive pressure over time in both price and volume from (1) private label and (2) more “premium” D2C brands that have entered the space and taken share.

Recognizing the structural issues and that this is a low-quality business, in the middle part of last decade Smucker made the strategic decision to diversify its portfolio away from consumer foods and towards pet foods and coffee.

While Smucker correctly identified two growth categories in pet foods and coffee, its execution of the strategy has been poor.  Smucker gambled on inorganic growth by paying hefty multiples to purchase sub-par brands that subsequently have faced competitive threats and channel issues (more below).

At the same time, Smucker has sought to accelerate the transition by selling legacy consumer foods businesses in transactions that have been meaningfully dilutive to earnings per share, including the sale of Crisco to B&G Foods in 2020.  Selling cheap and buying dear is generally not a good strategy to create value, but that is the path chosen in recent years by SJM.

Pet Foods

Though Smucker had a small pet foods division, SJM management decided to go after the category in a big way in 2015 by entering the space inorganically.

SJM’s first large acquisition was Big Heart Pet Brands in 2015.  Smucker followed this up with the purchase of Ainsworth Pet Nutrition (the owner of Rachel Ray Nutrish) in 2018.  In aggregate, SJM forked out $7.3 billion for both companies for ~13x EBITDA.

The company reasoned at the time that these acquisitions would “increase the scale and further accelerate the growth profile of the company’s pet food business.”  However, up until the COVID-19 pandemic, growth meaningfully underwhelmed.

In 2018, pet foods grew just +1.6% organically, with volume growth of +2.3% partially offset by negative pricing of -0.7%.  In 2019, the trends stepped down hard, with organic growth of roughly -5% the quarter immediately prior to the start of the pandemic.  See Exhibit A.

Why was growth in pet foods so poor, even when Smucker had expected this would be the company’s growth engine?  In a word: competition.

In April 2018, General Mills (“GIS”) acquired pet foods competitor Blue Buffalo (“BUFF”) for $8 billion.  BUFF was an “indie” pet food brand that had amassed a loyal customer base by using all-organic ingredients and only selling its products in American specialty stores.  To make Blue Buffalo more widely available, GIS’s strategy was to shift the pet food sales channel from Specialty to the Food, Drug, and Mass channel (“FDM”).  See Exhibit B.

Unfortunately for Smucker, this channel also happened to be where SJM sold the majority of its pet foods products.  The killer blow came when Blue Buffalo launched into Walmart stores nationwide.  This coincided with SJM’s 2019 Q1.  Smucker simply wasn’t able to compete.

The underperformance has continued during the pandemic.  SJM’s pet food business received a modest bump once COVID-19 hit, and has been growing mid-single-digits organically since.  But this pales in comparison to BUFF.  During the two quarters covering peak “pantry loading”, SJM reported +6% organic growth.  Over the same two quarters, BUFF reported +27% growth.

At the same time, SJM has been forced to resort to being overly promotional.  This can be clearly seen in business margins.  While GIS has been able to keep margins steady in pet foods, SJM has experienced a meaningful degradation.  See Exhibit C.

We see these numbers as evidence of continued structural issues in SJM’s pet foods business.  Revenues are underperforming peers.  Margins are suffering, even in an industry boom.

In a more normal environment without the same tailwinds, we believe SJM’s pet foods business will once again reveal itself to be in notable structural decline.

Coffee

SJM is unfortunately experiencing similar issues in its coffee business.

Smucker manufactures and markets three key brands of coffee: Folgers, Café Bustelo, and Dunkin Coffee.  These are considered “mainstream” brands.  In coffee, “mainstream” has historically been declining mid-single-digits, whereas “premium” has been in growth.  SJM is exposed to the wrong part of the coffee ecosystem.

In 2015, SJM signed a partnership with Dunkin to distribute and market K-Cup packs for FDM distribution.  From our channel checks, we have concluded that the Dunkin’ coffee partnership has masked the significant deterioration in the Folgers brands (which represents the bulk of SJM’s coffee category).  We estimate the K-Cups business contributed roughly 30% of the category’s EBIT pre-pandemic.

The problem faced by SJM is that we think the K-Cups business now faces a similar competitive threat to what SJM has suffered in its pet foods business.  In 2018, Nestle paid $7.2 billion for the right to market Starbucks brands worldwide in perpetuity.  In February 2020, Keurig and Nestle USA announced a long-term partnership for Starbucks K-Cup pods in North America.  See here: https://news.keurigdrpepper.com/2020-02-27-Keurig-Dr-Pepper-and-Nestle-USA-Announce-Long-term-Partnership-for-Starbucks-K-Cup-Pods-in-North-America

The announcement came just before peak pantry loading…but we think it is bad news for SJM’s K-Cup business.  SJM’s coffee “crown jewel” now faces a meaningful step-up in competition and is under attack.  In our view, it won’t be able to offset the continued declines in Folgers and may itself stagnate.  SJM’s coffee business, in our view, is also a prime candidate to experience renewed structural deterioration as the COVID-19 pandemic abates.

Conclusion

As with all investments, there is risk to our short sell thesis in SJM.

First, the Omicron wave is likely to have continued to buoy near-term sales for Smucker.  Future waves could prolong a positive business environment for the company.  It is unclear how soon post-pandemic “normal” returns, or even what “normal” looks like.

Second, even after some of the air has come out of the “everything bubble”, there are plenty of stocks trading at egregious valuations.  At ~16x earnings, SJM doesn’t look so expensive by comparison.

Third, we could be wrong on our thesis and SJM’s growth in pet foods and coffee could prove to be more than just transient.

These are the risks.  In our view, however, they are outweighed by the conclusions of our fundamental business analysis.

SJM’s brands are sub-par.  They face increasing competition, alongside channel issues.  There is no clear path out of the strategic trap.

We see earnings per share falling from above $9/share to well below $8/share over the next 24 months.  As structural headwinds re-emerge, we believe the shares may trade closer to 11x earnings (where they have traded in the past) at a level below $90/share vs. $140+/share today, representing downside of -40%.

Disclaimer

The author of this posting and related persons or entities ("Author") currently holds a short position in this security.  Author may short additional shares, or cover some or all of Author's shares, at any time.  Author has no obligation to inform anyone of any changes to Author's view of SJM US.  Please consult your financial, legal, and/or tax advisors before making any investment decisions.  While the Author has tried to present facts it believes are accurate, the Author makes no representation as to the accuracy or completeness of any information contained in this note.  The reader agrees not to invest based on this note, and to perform his or her own due diligence and research before taking a position in SJM US.  READER AGREES TO HOLD AUTHOR HARMLESS AND HEREBY WAIVES ANY CAUSES OF ACTION AGAINST AUTHOR RELATED TO THE NOTE ABOVE.  As with all investments, caveat emptor.

Catalyst

-Pet Foods -> goes back into structural decline

-Coffee -> goes back into structural decline