Prepared by Chris, CEO Quad 7 Capital and Team Leader At BAD BEAT Investing

McCormick & Co. (NYSE:MKC) is a name that we have traded a number of times in the past, and most recently, we got behind the name at the very beginning of April. We told you that there was potential for strong returns during the market turmoil under the thesis that “people need to eat.” We had highlighted a few defensive food names at that time, all of which fell less during the crisis and saw business boom with stay-at-home trends. Fantastic returns have been had in the last two months. That is winning. Interestingly, we note that MKC took a hit from restaurant closures, or restaurants only being available for takeout/delivery, during the COVID-19 crisis, but more people were cooking at home. So we started buying at $130, $135. We think that this trade has played out well, as evidenced by the just reported Q2 which we will discuss. Ultimately, we think it is prudent to take some profit here, buy yourself something nice, but let the rest run. While valuation is still a bit stretched, sales are likely to remain elevated as families stay home and cook meals, but the Flavor Solutions segment should start seeing improvement in the back half of 2020 as things reopen.

Our take on Q2 sales

So our thesis played out to perfection here. Sales in Q2 were adversely impacted by COVID-19 which turned consumption patterns upside down. Business sales got hit hard, while the everyday consumer drove sales. The company delivered some decent results. McCormick’s second-quarter sales were up 7.7% compared to the year-ago period. In constant dollars, sales grew 10%. COVID-19 was a headwind, particularly in Asia/Pacific, thanks to extended lockdowns. That is still strong, all things considered. The consumer segment saw a 26% benefit, while currency impacted things slightly. Regionally, sales we pretty bifurcated. In Asia/Pacific consumer sales fell 18%. They rose in the Americas and EMEA. Consumer sales in the Americas jumped 36%. In EMEA they spiked 22%. This was a result of the stay-at-home trend that we discussed in April.

We also talked about how the Flavor Solutions segment would see pressure from lockdowns and forced restaurant closures, or takeout only. Flavor Solutions saw sales crater 18%, with a slight positive currency impact. Once again we will reiterate that the company continues to see growth because each year it comes out with new and exciting products that are usually well received, and the company continues to effectively market its classic products, but this year the declines were entirely driven by closures. Flavor Solutions continues to have strength if we back out COVID impacts. The company has pricing power and continues to innovate. Additionally, well-timed acquisitions have continued to help the company and segment grow. In addition, the company continues to build brand equity internationally, and performance was particularly strong in its emerging markets. However, the segment was simply pressured.

COVID was an issue, but be mindful competition remains tough. Over the years, the company continues its slow and reliable growth here, but now things are tough. It will rebound, which is why we feel good about holding some of this stock despite taking some profit. Restaurants are going to start to come back. Sales in the Americas were down 15%, while EMEA saw a 34% drop. Despite the perceived carnage of COVID-19, Flavor Solutions was only down 6% in constant currency in Asia/Pacific. That lower decline is a reflection of life getting a bit back to normal in the east, at least ahead of the Americas.

Margins rose

Expenses have been kept in check, thanks to cost savings initiatives. Margins jumped 230 basis points versus the year-ago period. This expansion was driven by favorable product mix on top of the cost savings. Operating income increased to $257 million compared to $208 million in the year-ago period. This increase was primarily driven by the impact of higher sales and gross margin expansion. Excluding special charges, adjusted operating income increased 21% to $260 million compared to $215 million in the year-ago period. From an EPS standpoint, the company crushed our bullish expectations by $0.20, and surpassed consensus by $0.28. Fantastic quarter.

Valued for more growth

The stock is pricey still even at nearly $180 per share. However, it’s not the same value we once saw. Not all valuation metrics are created equal. You see we are actually seeing meaningful EPS growth now. Of course, the company pulled guidance because no one knows how bad the COVID-19 will impact things, but we surmise we will see slowly recovering Flavor Solution sales, and perhaps some slight tailing off, but continued elevation in consumer demand.

Before COVID-19, we were looking EPS for the year of $5.10 to $5.40. When it landed, we thought earnings could see as a high as a 25% haircut. Now, it looks like we might be back to seeing EPS within our original range. That is pretty solid. So let’s call it $5.10 to low ball it. That puts valuation at nearly 36X FWD EPS at $180. The stock has always had a stretched valuation, but this is pretty high. So, we are comfortable with our decision to take some profit, and let house money run.

Taking some profit

In the consumer segment, we think we see an overall increase in consumer demand during periods of pantry stocking like we saw with our defensive food stock plays, and we think we see increased cooking at home continue in 2020, but maybe wane slightly. In the Flavor Solutions segment, we also expect to see slowly increasing customer demand from packaged food companies and expect still reduced but improving demand from restaurant and other foodservice customers as the year goes on.

So we think you should consider doing what we do at our professional trading team. We are going to sell about 60% of the position, enough to back out the initial buying costs, plus some profit, and let the rest run, collecting all future growth and dividend on house money. That is how you win.

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Disclosure: I am/we are long MKC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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