2023-10-03 13:22:56 ET
Summary
- McCormick & Company, Incorporated bounced right after our last article and then slowly gave back all those gains.
- The company's Q3 2023 results were in line with estimates, but a significant decline in consumer sales in the Asia-Pacific region raises concerns about future growth.
- We expect earnings to actually stay flat for the next year and valuation compression should pick up speed in that environment.
You often regret making unequivocal statements in the capital markets. You also tend to regret pushing for fundamental changes in the face of conflicting technicals. We got a dose of the two in our last article on McCormick & Company, Incorporated (MKC) .
We would not be surprised to see this at even a 16X earnings multiple in 3-4 years. That would be a very unpleasant journey even discounting above average growth rates for the company. At present the stock looks oversold and perhaps you get a bounce here. Longer term, we don't see this as an ideal buy point. We think we will get that though within the next 12 months and it likely will be at least 30% lower. We rate this as a Sell.
Source: Bubble Valuations Have Not Deflated, But The Thyme Is Cumin .
While we did cover the posterior with the "bounce" part, it was still not the best time to issue a Sell rating in the face of such an oversold stock. The stock promptly went up 25% and rubbed red chili pepper right into our wounds.
But of course, the fundamentals came back to haunt eventually.
Fiscal Q3 2023
MKC has an off-year end, with November being the last month. The recently released results were for fiscal Q3 2023 for the quarter ended August 31, 2023.
At first blush, everything appeared to be in order. Sales increased 6% in the third quarter from a year ago, and that was the same when you removed currency effects. Operating income was up about 4% and adjusted operating income was up 5%. Despite that, adjusted earnings per share were actually down and came in at just 65 cents versus 69 cents. Everything, including that drop, was in line with estimates, though you could argue that the revenue number was a tiny miss. But nothing here that should warrant a 10% drop, or should it? Well, there was one possible orange flag in their primary growth region.
Consumer sales in the Asia-Pacific region (aka APAC) decreased 16% compared to the year-ago period. In constant currency, sales declined 11% with a 15% volume decline partially offset by a 4% increase from pricing actions. The volume decline was driven by a 15% unfavorable impact from China due primarily to lower consumption in the current period related to a slower than anticipated economic recovery as well as lapping strong demand in the prior year.
Source: MKC Press Release .
If you look at MKC's estimates, sales are expected to grow at a sluggish 3.5% pace in the next fiscal year.
We would wage that that would be hard if APAC looked like what it did in this quarter. This will be even harder if U.S. Dollar strength continues unabated. Of course, the bulls may hang on to "price increases." That might be true, but we saw the disastrous results this quarter despite some favorable pricing.
That small sales increase is supposed to power a 10% growth rate.
Our estimates here line up with the lowest ones on the Street, and we think MKC will struggle on all fronts.
Keep in mind that MKC is not growing volumes overall. It has been all about pushing prices to make up for those lost volumes.
Now, they did do that, but we don't see them managing as well in the next fiscal. So we see sales flat in volume terms, perhaps even a small decline as consumer shift more to Non-MKC store brands. Pricing will be flattish as well as the consumer is close to being tapped out. If we see a move towards more of MKC's store brands and away from the premium segment, you could see some serious margin compression. That would mean an earnings contraction and one that should not be ruled out if we hit a recession.
Valuation
The biggest problem with MKC is that is really, really badly priced. Even after the drop today, the 26X P/E multiple is one that you could only love in the heart of quantitative easing and ZIRP (zero interest rate policy).
For a slow grower, and dare we say it, possibly declining earnings next year, what do you realistically want to pay? 16X would be the upper end of that range with 5.5% risk-free rates. So your risk-reward is not just bad, it is terrible. Yes, it is still terrible after this 10% drop. We would look for a minimum of a 2X price to sales ratio and a 16X earnings multiple to even begin to open our pocket books and give this the thyme of the day.
Verdict
You can ignore valuations for a period of time and sometimes the consequences seem to be trivial. But eventually it comes to bite with a vengeance. In the consumer staples sector, one name that traded at such silly valuations (30X earnings) was The Clorox Company ( CLX ) right at the height of the pandemic madness.
In more recent times, we have seen Hormel ( HRL ) hit 34X earnings in 2022.
Boring, staple names trading at such ridiculous valuations are probably the easiest setups to avoid in today's interest rate climate. While investors are quick to jump on the pricing power bandwagon, MKC showed this quarter that they are on the receiving end of inflationary pressures too.
With a tight labor market, you can expect this to continue. You can also expect significant increases in interest rates as the company refinances its maturing debt over the next few years.
We reiterate our sell on McCormick & Company, Incorporated stock and once again caution that these kind of sagas play out over months and sometimes years. Valuation compression is often designed to frustrate the bears more than the bulls.
For further details see:
McCormick: Take Our Sage Advice And Tread Gingerly