Shares of McCormick (MKC 0.40%) stock significantly lagged the S&P 500 in 2021. McCormick only gained 1% last year, whereas the S&P 500 ripped 26.9% higher during that time. This raises the question: Does this recent underperformance make the stock a buy, or should investors wait for a correction?
Let's take a look at three reasons why the stock of this manufacturer and distributor of spices, seasoning mixes, condiments, and other flavoring products may be a buy and one reason that could make it a sell.
1. McCormick boasts robust operating fundamentals
McCormick turned out an impressive third quarter (finishing Aug. 31) on behalf of its shareholders, topping analysts' forecasts for net sales and non-GAAP (adjusted) diluted earnings per share (EPS). The company's fourth-quarter report comes out Jan. 27.
The company reported $1.55 billion in revenue during the third quarter, an 8.3% growth rate against the year-ago period. McCormick narrowly beat the average analyst estimate of $1.54 billion for the quarter. So, how did the company make this better-than-expected revenue a reality in the quarter?
McCormick derived four of those percentage points -- or half of its sales growth -- during the quarter from Cholula Hot Sauce and flavor company FONA International, which were respectively acquired in November and December 2020. Another three percentage points of McCormick's revenue growth was due to favorable currency translations, since the company sells its products in many international markets. Finally, consumer segment sales contributed to the remaining percentage point of McCormick's sales growth. This was driven by more consumers cooking at home during the COVID-19 pandemic and preferring the company's products to its competitors.
Since the U.S. is currently experiencing its highest inflation rate in nearly 40 years, McCormick's gross profit margin dropped 260 basis points compared to the year-ago period. This was partially offset by the company's cost-savings program, which explains how McCormick was still able to grow its non-GAAP diluted EPS 5.3% year over year to $0.80 in the third quarter. This handily surpassed analysts' expectations of $0.72 in non-GAAP diluted EPS during the quarter.
Given McCormick's strong third quarter, the company expects that its net sales will grow 12.5% at its midpoint during the current fiscal year. It will lean on a combination of its aforementioned acquisitions, new product launches, and price hikes to achieve this growth. Moving to the bottom line, McCormick is anticipating 7% non-GAAP diluted EPS growth to a midpoint figure of $3 for the fiscal year.
This is in line with the 7% annual earnings growth that analysts are predicting over the next five years, which makes McCormick's guidance for the year seem reasonable.
2. McCormick's business is financially sound
McCormick is consistently growing its sales and earnings. But is the company backed by sturdy financial positioning?
McCormick's interest coverage ratio through the first nine months of this fiscal year was 7.3 ($751 million in earnings before interest and taxes/$103 million in interest costs). This is up slightly from the year-ago period interest coverage ratio of 7.1 ($737 million in EBIT/$103 million in interest expenses). For context, McCormick's EBIT would need to plunge more than 85% before it would be unable to cover its interest expenses from earnings. This signals that the company is in decent financial health and in no immediate danger of going out of business.
3. McCormick has a dividend with room to grow
McCormick is fundamentally solid. However, it's equally important to consider whether its payout is safe.
McCormick has paid $1.36 in dividends per share over the past 12 months. Stacked up against the guidance for $3 in midpoint non-GAAP diluted EPS for the fiscal year, this is a dividend payout ratio around 45%. This gives the company the flexibility to build on its reputation as a Dividend Aristocrat, with 35 straight years of annual payout hikes under its belt.
And in light of its 7% annual earnings growth potential in the medium term, McCormick should continue to hand out raises like its most recent 8.8% raise. Pairing that dividend growth potential with a 1.5% yield is an attractive proposition.
A reason to sell (or at least not buy right now): The valuation is too rich
McCormick is a stock that I believe all dividend growth investors should want to own for the long haul. However, the one reason I am not interested in buying the stock has to do with its arguably stretched valuation.
McCormick is trading at a forward P/E ratio of 31.3 at its $98 share price, nearly double the packaged foods industry average of 17.6. And the analyst forecast of 7% annual earnings growth for McCormick is only slightly higher than the industry average of 6.5%.
McCormick's quality certainly warrants a premium to its industry peers, but the current premium is too much, in my opinion. That's why I'm planning on buying McCormick during the next correction instead of doing so at this time.