Brands drive performance at the biggest consumer staples companies. Although McCormick (MKC 0.44%) is a bit unique in the food space because of its focus on spices, it has been increasingly building out its brand portfolio to fuel growth. But there's a cost to such efforts, and the company is now dealing with the earnings headwinds caused by its recent acquisition spree.
McCormick is more than just spices
Most consumers probably know McCormick as the dominant brand name in the spice aisle of the grocery store. While it also has a business selling spices to food makers and other business entities, the main focus has long been ingredients. That started to change in a big way in 2017 when the consumer staples giant agreed to buy the French's mustard business for $4.2 billion. The acquisition also included Frank's RedHot Sauce.
Image source: Getty Images.
McCormick followed this acquisition with the purchase of Cholula hot sauce in 2020. This was a smaller deal at just $800 million. That said, management believed it could grow sales in the mid to high single digits by adding it to the company's distribution system, which was already capably handling Frank's RedHot. Basically, McCormick was using acquisitions to build a solid condiment business with material growth potential.
There's only one problem: The two deals together cost $5 billion, which is not exactly a small number. McCormick's debt load and leverage, looking at price-to-EBITDA (earnings before interest, taxes, depreciation, and amortization), spiked dramatically after the first purchase. After the company started to pay down debt, the second acquisition pushed debt and leverage right back up again, as the chart below shows.
MKC Total Long Term Debt (Quarterly) data by YCharts.
Time for McCormick to pay the piper
These acquisitions were made during a time of very low interest rates, so that added debt wasn't the heaviest burden to lift -- at least when the deals were inked. Over the past year or so, however, fast-growing inflation has caused the Federal Reserve to hike interest rates, which changes the debt equation in a big way. For example, McCormick now expects interest expense to be an 8% earnings headwind in 2023. That's not shocking given the company's elevated leverage and rising rates, but it clearly isn't ideal from an earnings perspective.
Which is why McCormick is focusing more on mending its balance sheet. During the company's first-quarter conference call, when asked about acquisitions, management made it very clear that paying down debt was a higher priority. The goal, according to CFO Mike Smith, is to get the debt-to-EBITDA ratio back down toward 3 times by the end of 2024. So this goal will bleed over into 2024 as well, likely keeping McCormick out of the acquisition market over that span.
That's not inherently a bad thing, since McCormick's business is fundamentally strong. However, it highlights the big change in the business environment, at least from a capital markets perspective. Indeed, the more the company can trim its leverage, the less it has to worry about the headwinds from rising interest costs. Adding even more debt to fund an acquisition would simply make life harder.
McCormick has more work to do
McCormick is a very well-run company, and the strategic acquisitions appear to be performing fairly well. The shift to dealing with the debt left behind is the right move, even though it will likely be a multiyear effort. Investors who own or are watching this spice giant will probably want to monitor the balance sheet progress, however, since there are unlikely to be any big portfolio changes until the debt-to-EBITDA ratio is brought back down.
