2023-03-28 10:29:43 ET
Summary
- Consumer staples stocks have bifurcated; ones with rising margins are at new highs, while firms with sliding margins have slumped to near 52-week lows.
- McCormick was in the latter category as investors thumped shares due to weak operating results in 2022.
- The company just delivered a huge earnings beat on Tuesday. The earnings dip has ended, and now shares are set for take-off.
It's been a tale of two categories in consumer staples. We've seen firms that have had a favorable position on input costs and supply chain concerns see their shares blast off to new all-time highs. Hershey ( HSY ) would be the quintessential example of that with its shares running up 50% over the past two years.
On the other hand, the market has shown no mercy for consumer staples companies facing any sort of margin pressure, with many of them trading at or near 52-week lows.
As often, investors are overreacting to short-term factors. It makes no sense to think that chocolate makers have never been more valuable, whereas producers of, say, peanut butter or spices should be at 52-week lows. But, for whatever reason, people have lost sight of any long-term view of franchise value or business outlook, it's all just about short-term changes in profit margins. Which, so be it, if that's how we're trading consumer staples stocks at the moment, we can take advantage of that too.
The good news, for investors in spice giant McCormick ( MKC ), is that it has passed through the worst of its margin issues and is now back to an improving outlook. This comes after the company smashed its Q1 earnings estimates on Tuesday.
Given the market's monomaniacal obsession with short-term earnings results in the consumer staples sector right now, McCormick's surprisingly large earnings beat could set off a major rally in the shares.
It made little sense that the stock was trading below January 2020 levels, and yet here we were heading into this earnings report:
With McCormick stock down 30% from last year's peak, here's why shares are a strong buy today.
Q1 Results Hit All The Right Notes
On Tuesday, McCormick delivered Q1 results of $0.59 per share in profits. The analyst consensus was for merely $0.50. Some folks were predicting results as low as $0.44. Meanwhile, the actual result of $0.59 topped all analyst forecasts for the quarter.
The earnings beat came about from both pricing moves and cost-cutting. McCormick's revenues of $1.56 billion rose only 3% year-over-year, sure, but it's been up against hard comps from the pandemic era when people were cooking more at home. McCormick also exited its Russian business over the past year and sales are growing once again in spite of that additional complication.
So, the company's revenue growth topped expectations. Now that the disruption in usual sales patterns is winding down, McCormick should get back toward its typical 6-8% year in and year out revenue growth in a normal consumer market.
In any case, revenues are back to growth and exceeding analyst expectations.
Arguably more importantly, the company dramatically outperformed analyst forecasts on the bottom line. McCormick had said it would deliver meaningful cost efficiencies to address the current inflationary problem, but it seems folks were skeptical on whether they could deliver.
In any case, they did. Starting with the top-line, gross margin is now back up to 36.0%, after bottoming at 34.0% last May.
Traditionally, McCormick earns a 40% gross margin, give or take 1%, so 36% still isn't good enough. But it's a strong and swift recovery from the worst levels we saw at the height of the inflationary problems last year.
I'd also note that we're up against that dismal May 2022 quarter for the upcoming Q2 '23 results, so this next quarter should deliver sizzling year-over-year growth. Something for shorter-term traders to salivate over.
And it wasn't just gross margin making the difference. McCormick has made moves to contain SG&A spending, leading to an overall boost in net income even as it works through this complex operating environment.
To that point, McCormick is guiding for 10% to 12% operating income growth for full-year 2023. It expects to get there while growing revenues at 6% for the full-year. This is what we want to see. Sales growth will accelerate in the back-half of 2023 while the company sees income growing faster thanks to margins moving back toward their traditional levels.
Analysts, by contrast, were expecting a weak result in 2023, and bizarrely enough, all 11 recent earnings revisions were to the downside heading into this report:
Looks like a lot of folks are going to have to recheck their models following Tuesday's upbeat numbers. In any case, even off the Street's overly pessimistic outlook, MKC stock is trading for 26x next year's earnings. It's probably closer to 24x in reality given the pace of McCormick's margin recovery.
Given that MKC stock has tended to trade closer to 30x earnings in recent years and there is currently high demand for defensive stocks that are showing strong operational results, McCormick is attractively priced here and well-positioned for multiple expansion as analysts revise their numbers upward.
Diving deeper into the numbers, we see things are stronger than they first appear. For example, McCormick's sales volumes fell 15% in the Asia/Pacific market. Sounds bad, right?
This came about primarily due to problems in China thanks to lingering COVID-19 restrictions, along with McCormick's decision to exit low-margin commodity businesses in India. We've seen numerous prestigious consumer products companies hit with issues in the Chinese market over the past year; there's no reason to assign any special blame to McCormick's management here.
And, it's a sign of strength when a company is voluntarily willing to give up low-profitability business, as it did in India, in order to drive margin growth.
So much of McCormick's recent acquisitions have been about reshaping the firm's portfolio toward fast-growing, higher-margin, higher-status products.
Bears will look at McCormick and compare its valuation to that of, say, twenty years ago and say the stock is overvalued. But McCormick didn't own the likes of Frank's or Cholula back then. It should go without saying that selling a bottle of Cholula is worth more than selling some generic black pepper or oregano at low margins in a country where McCormick doesn't have branding or scale advantages.
Across the consumer staples space, luxury and premiumization have been key trends. Alcohol companies that can sell high-end spirits, for example, have seen their multiples expand while beer companies selling generic macrobrews at low prices have seen their valuations tumble.
McCormick's moves to improve the portfolio's quality and resonance with consumers has paid off to date, and investors can look forward to further improvements on this front going forward. Remember, you can't look at consumer staples companies in a vacuum. Brand quality is key. And McCormick's acquisitions in high-growth high-margin areas such as hot sauces are fundamental to the long-term valuation creation here.
Enough about bigger-picture strategy, though. Let's turn back to this earnings report.
It appears some analysts were caught flat-footed. UBS, for example, just initiated coverage of McCormick stock with a sell rating earlier in March due to valuation and concerns about a post-COVID pullback. It seems weird to warn of a post-pandemic pullback after shares had already dropped more than 25% from their recent highs. UBS' analyst worried about McCormick's ability to balance demand and price in the current inflationary environment.
Well, it's fair to say that we can consider this concern addressed following these latest quarterly results.
And, as always, the good news is that when analysts were too bearish on a company, they typically have to upgrade the stock and raise their price targets once it is clear that momentum has turned. With McCormick trading near 52-week lows while guiding to double-digit operating income growth this year, it seems a lot of folks were offsides here.
MKC Stock Verdict
I've been puzzled watching shares of high-quality consumer staples companies like Hormel Foods ( HRL ) and McCormick trade lower and lower in recent months. Their long-term franchise value doesn't move 25% downward simply due to having some profit margin jitters for a quarter or two. These are Dividend Kings that have put up market-beating growth and shareholder returns dating back to before when I was born. But, apparently, wars and banking crises also mean folks are going to dump companies with decades of proven success due to some transitory margin erosion.
For McCormick, anyway, they've reached the end of the down cycle with this quarter's results and are now set for a sharp rebound as analysts put it back in the outperforming category of consumer firms. Is McCormick set to blast off to new all-time highs later this year a la Hershey? Hard to say.
Based on earnings growth, I see McCormick shares being worth $100+ and trading to new highs in 2025.
That said, I never would have imagined Hershey would run up this far, this fast either. The market is really rewarding multiple expansion in defensive stocks right now. And McCormick is showing you it's going to get double-digit income growth this year even off a rather modest sales increase. That's as good of a sign as you're going to see when it comes to inflationary issues being put in the rearview mirror.
Ultimately, McCormick is the world's largest spice company. And it also has huge market share in private label, so you can either buy spices from McCormick, or from an unmarked bottle made from McCormick. Assuming people keep eating (generally a safe bet), McCormick's sales and profits will keep growing over time, just as they've done for the past century.
McCormick is the archetypal defensive stock. People have to buy the product. Its prices are so low most people don't notice or care about price increases. And it has monopolistic market share in many of its major categories and geographies. Now that McCormick has resolved the margin pressure problem -- and further help is coming on that front as the economy slows down -- the skies are clearing and McCormick should be set to run back up towards its prior highs.
Investors may complain that McCormick shares aren't "cheap enough". I'd note that the stock never once traded below a 20x P/E multiple over the entire past decade. It only rarely traded below 24x.
You don't get to buy high-quality monopoly defensive companies at the S&P 500 multiple. In a world racked with war, inflation, and now bank failures, people are willing to pay high multiples for companies with decades of consistent earnings and dividend growth in recession-proof industries. Just look at Hershey's wild rally over the past two years. McCormick, now that it has solved its margin issue, isn't going to be staying at 52-week-lows for long.
For further details see:
McCormick Q1 Results: Slump Is Over, Shares Are A Strong Buy