McCormick Is Too Spicy

 | Sep 25, 2012 | 11:30 AM EDT
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Have you been watching the shares of spice maker McCormick (MKC)? With investors focused on consistent dividend payers, the shares have been muy caliente! But can a company that just makes spices really support a parabolic stock price? I mean, these are spices, not iPhones!

Yet the shares of McCormick have been red-hot. Year-to-date, the stock has returned 26%, not including dividends. In 2006, the company decided to aggressively ramp up its research-and-development (R&D) and deal-making machines. By 2012, this strategy has begun to pay off. For example, McCormick will introduce over 225 new products this year. Two-thirds of McCormick's sales are composed of branded products that are No. 1 in their category. The company's enviable position has produced a consistent 10-year annualized revenue growth rate of 6.7%. Over this time, earnings per share (EPS) have grown at an 11% rate.

On Thursday, McCormick is expected to report third-quarter earnings per share of $0.76 on $990 million in revenue. In the last quarter, the company's revenue grew 11.4% to $984 million. Management reaffirmed the previous guidance of $3.96 billion to $4.03 billion in revenue and EPS between $3.01 and $3.05. Long term, the company expects annual growth of 4%-6% in sales, 7%-9% operating income and 9%-11% earnings per share.

Management is targeting the emerging markets for growth. The company expects 20% of revenue to come from overseas by 2015. Management believes sales will be powered by a growing middle class and more people consuming proteins flavored by packaged spices.

While that's all well and good, margins in the short term have been ground down to the size of a peppercorn. The costs of raw materials, such as dairy, pepper, wheat, onion, capsicums, soybean oil and garlic have soared. The company posted a second-quarter gross margin of 40.47%, down 196 basis points from last year's 42.43%. And it doesn't seem like there's a let up in sight. Management was able to hold operating margins steady at 15.44% only because of aggressive cost cutting. But one has to wonder how many quarters they can keep cutting.

To me, trading at 21x the midpoint of guidance and with margins under pressure, McCormick is too spicy.

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