Hotter Than It Looks

Many people don't care for eggnog. But just try getting through the holidays without being offered a cup. Chances are, the spice in it will be McCormick's (MKC ), and if that leaves a bad taste in your mouth, you're probably a stock analyst: Of the 13 who track McCormick, Standard & Poor's (MHP ) lists just one who rates it a buy.

Ubiquitous as its nutmeg, cinnamon, pepper, herbs, sauces, and marinades may be, the world's No. 1 seller of flavorings comes into the holiday season this year unwelcome on Wall Street. From over 39 in January, the stock recently traded under 29. The reason is a pair of revisions last summer in the company's earnings expectations for fiscal 2005, which ends on Nov. 30. From its initial forecast of $1.72 or so in earnings per share, McCormick now expects $1.58 to $1.62. Chief Executive Robert Lawless remains undaunted. "We'll get back on track in 2006," he told me. "No one should hold the view of us that we have a damaged business strategy."

CHIEF EXECUTIVES, ESPECIALLY those scrambling to find their way back into investors' good graces, rarely say anything very different. Just the same, the steadiness of McCormick's 116-year-old business along with its sturdy financial position -- debt is 45% of capital, down from 59% in 2001 -- lead me to think that the shares represent a buying opportunity. For one thing, the way the Street is treating the stock, you would think McCormick is suddenly losing money on its $2.6 billion in revenues. Instead, growth in earnings per share has slowed abruptly, to 5% or so this year from an annual average of 11% in the five years ended Aug. 31, according to S&P's Capital IQ data-services unit.

McCormick had been able to outpace the food industry by diverting its steady excess cash flow -- $290 million after capital spending over the past four quarters -- in a variety of salutary directions. These include higher dividends; share repurchases, currently through a $400 million program that began in June right after a $300 million buyback budget was exhausted; selected acquisitions, such as 2003's $180 million deal for the Zatarain's brand of New Orleans-style foods; and development of higher-margin products, including a group of barbecue sauces, marinades, rubs, and seasonings called Grill Mates. Another new line is Grinders, which are a variety of unground peppers, salts, and herbs that come in bottles with an integrated grinding tool.

So, what went awry this year? For starters, the company saw its gross margin squeezed by holding a big inventory of high-cost vanilla beans even as competition cut the prices fetched by its vanilla products. Lawless told me the vanilla market is now stable. Then came Hurricane Katrina, which Lawless blames for 2 cents a share or so of the decline in this year's estimated earnings. The Zatarain's unit has been able to maintain production, but regaining orders from the many retailers and restaurants still reeling from Katrina will suppress demand for an unknown period of time.

A bigger problem is in McCormick's industrial-products segment, which caters to other food processors and restaurateurs (think spicy tortilla chips and hot buffalo wings). It makes up less than half of sales and about a third of operating income. Through this year's first nine months, the segment's operating income sank more than 12% on a slight rise in sales. One reason was delays in its customers' new-product introductions, which figure to push sales that McCormick had anticipated for 2005 into next year. Another was price-cutting, as competitors angled to take market share. In any case, in September Lawless outlined a plan to take $30 million to $45 million out of its annual costs over the next three years via supply-chain efficiencies and also to trim less profitable items. He figures that as McCormick consolidates its global manufacturing and distribution assets, pretax charges of up to $130 million will result.

When McCormick reports its fiscal 2005 results in late January, investors can expect Lawless to offer fresh guidance on future sales and profit growth. Will the company continue to promise the 10% to 12% in average annual earnings per share gains that the Street had come to take for granted? There's no guarantee, naturally. Yet with the stock now trading down at multiples of enterprise value (1.8 times revenue, 13 times operating income) not seen in more than two years, it's priced to benefit from any nice surprises.

By Robert Barker

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