My Latest Thoughts on JM Smucker ("SJM")

It has been about a year since I initiated a purchase in JM Smucker (“SJM”) and, as such, wanted to do a quick health check-up on the position. At the time of writing SJM is the 10th largest position in the Satellite Portfolio at about 4.5%.

You can find my initial analysis here.

In a nutshell, the thesis goes that SJM is a historically well-run company that delivers consistent returns on capital and produces significant cash flow. The company is at an inflection point in which its top-line growth has decelerated, margins have compressed, and management has needed to reinvest in the company to restore growth by optimizing their product portfolio. My belief was that investors have been overly pessimistic about the stock and have projected negative trends to continue well into the future. Given the successful track record of the management team, I found this as an opportunity to add a quality compounder and dividend grower to the portfolio.

So where are we at a year later?

With a cost basis of about $105, the stock is now sitting at $108.50 at the time of writing. This is a dismal 3% return (6% including the dividend). However, as a long-term investor, I care more about the outlook over the next decade as opposed just one year. Has anything changed with the business?

Leadership Changes

On the Q2 2020 earnings call it was announced that after nearly 35 years at SJM and 15 years as the Chief Financial Officer, Mark Belgya, will retire on September 1st, 2020. He will be succeeded by Tucker Marshall, the current Vice President of Finance. Tucker has been with SJM for seven years and, in my opinion, this should be a natural succession for the position.

The other material announcement was the search for new leadership of the Pet Food business, which in the interim will be led by Rob Ferguson, an Officer of the Company with 14 years of management experience in the Pet category. He previously worked at Big Heart Pet Brands and has been instrumental “to the integration of both Pet business acquisitions and the delivery of over $250 million of synergies.” Jeff Watters, the former President and CEO of Ainsworth Pet Nutrition will serve as a strategic advisor. According to Mark Smucker, the idea here is to “ensure the alignment of a team that has a deep knowledge of the Smucker businesses and our industry.” This is important given the SJM acquisition of Ainsworth and the efforts to integrate the business into the product portfolio. The acquisition of Ainsworth was thought to be a natural fit with the current business that would provide both cost synergies and growth to the company. This will be important to monitor given the weakness in the financial results, specifically related to Pet Food. There’s always potential that this deal could be another classic case of value-destroying M&A, but the Pet Industry has been seeing decades worth of growth in household ownership of pets- providing a nice long-term tailwind to the product.

Business Update

When compared to the prior year, SJM was able to increase earnings by 4% to $2.26/share. This was mainly attributable to an increase in margins considering that sales growth was -3%. The increase in margins over the year is a good sign considering the prior trend had been in the opposite direction. The firm’s operating margin increased from 14.5% to about 17.0% last quarter. This is mostly due to the firm’s product portfolio consisting of higher margin products (i.e. pet food). Excluding the prior year’s sales related to the US baking business ($370MM), net sales were down about -1%. Here is a look at the YoY product sales as of the end of Q2 (October 31, 2019).

Category20192018Change
Coffee $    627.10 $    635.50-1.3%
Dog Food $    302.60 $    334.90-9.6%
Cat Food $    213.80 $    207.303.1%
Pet Snacks $    210.00 $    201.904.0%
Peanut Butter $    175.40 $    186.90-6.2%
Fruit Spreads $      86.50 $      83.004.2%
Frozen Handheld $      93.40 $      78.7018.7%
Shortening and Oils $      71.80 $      79.30-9.5%
Portion Control $      42.50 $      41.602.2%
Juices and Beverages $      32.40 $      33.90-4.4%
Baking Mixes and Ingredients* $      26.00 $      58.40-55.5%
Other $      76.30 $      80.10-4.7%
Total $ 1,957.80 $ 2,021.50-3.2%
* Divested Baking Business

Mark Smucker had this to say about the company’s results. “While pleased with our earnings results, our aggregate net sales performance does not reflect the potential of our brands or the progress we are making toward our strategic growth imperatives.” In the quarterly report, SJM attributed the declines to lower pricing in coffee and peanut butter, and higher-than-expected competition in Dog Food. Management stated that volume/mix had a neutral impact on net sales and that decreases in Dog Food and Shortening and Oils declines were mainly offset by an increase in Smucker’s Uncrustables (+25%).

As mentioned, I find it particularly worrisome is that the Dog Food segment is down -9.6%. Even though SJM’s revenue mix is very diversified, the poor results in this segment were not good considering its significantly increased position within the product portfolio. The Ainsworth acquisition was supposed to be a growth segment for the business moving forward. As the second largest product (Coffee #1), Dog Food generates about 16% of total revenues. This is likely why management is looking for new pet food leadership and why, in my opinion, that initiative will be important to monitor moving forward. Management did not anticipate the competition it was going to see in this segment and, as a result, continually revised estimates downward throughout 2019. The company originally said it expected sales growth of 1%-2% for the fiscal year. When it last reported in August, it revised this to a 0%-1% decline. Now Management expects sales to fall 3%. It also lowered guidance for earnings per share ($8.20) and free cash flow ($850M) in FY 2020.

Has my thesis changed or proved to be incorrect?

The short answer is no. This is still a quality, shareholder-friendly company in a defensive, albeit sluggish consumer product sector. From a financial perspective, nothing material has changed that alters my thoughts on the business prospects moving forward. I don’t expect the negative trend in Dog Food to continue indefinitely and lack-luster performance from time-to-time can create a buying opportunity. The company’s quest to boost growth may take longer than investors are willing to wait. Investors are impatient, but I’m really looking for predictable cash flows and growing dividends with this investment. Long-term, I expect that to continue. However, at the end of the day, the most important thing is how much you pay for those future cash flows and dividends.

Free-Cash-Flow (“FCF”)

Over the past six months, SJM generated $309.1M in FCF.

Six months ending Q2 2020 (millions)
Cash From Operations (CFO) $  445.50
Capital Expenditures $ (136.40)
FCF $  309.10
Interest $  (98.50)
FCFE excl. debt borrow/repay $  210.60
Dividends $(196.60)

The firm’s FCF easily covers interest costs, the dividend is safe, and the remaining cash flow means that Management can continue invest in the company to fix the top line issues while simultaneously paying down debt. As the Ainsworth synergies are realized, integration costs are finalized, and interest costs decrease, the cash flow will be accretive to shareholders allowing plenty of run-way for future dividend increases.

FCF Valuation

My first stop in valuing shares is a FCF valuation. Given that the product portfolio is increasingly built on higher margin products, I have set my base case FCF assumptions slightly higher than top-line growth. This is a two-stage FCF model that also assumes the long-term, weighted average cost-of-capital (“WACC”) increases as management continues to pay down debt. I believe the assumptions are conservative, yet reasonable given the current business outlook and stress on the general retail environment.

Base Case Assumptions
ST FCF Growth3.0%
LT FCF Growth2.0%
ST WACC4.5%
LT WACC6.5%

I used management’s guidance to determine a starting point with 2020 FCF of $850M.

Year (10yr Period) FCF Discounted
2020 $          850.00 $          813.40
2021 $          875.50 $          837.80
2022 $          901.77 $          790.21
2023 $          928.82 $          778.87
2024 $          956.68 $          767.69
2025 $          985.38 $          756.67
2026 $       1,014.94 $          745.81
2027 $       1,045.39 $          735.10
2028 $       1,076.75 $          724.55
Terminal $     24,406.44 $     13,001.94
Firm Operating Value (Sum of discounted FCF above) $     19,952.05
Cash $            48.80
(Total Liabilities) $      (8,740.80)
Equity Value $     11,260.05
Shares O/S $          114.00
  Fair Value $            98.77

The results are a fair value per share of $98.77. Assuming I require a target margin of safety of 10%, this would result in a target price of $88.90 – about 18% below the current share price. Given that this is a defensive company with a predictable business, strong dividend and quality balance sheet, I don’t require a significant margin of safety. This is a good business that I am okay purchasing close to fair value.

The Dividend

SJM currently pays $0.88 quarterly dividend, or $3.52 per year. The 1yr, 3yr, and 5yr growth rates are 9%, 8%, and 8%, respectively. The current dividend yield is 3.4%. This is very close to the highest the dividend yield has been dating back to 1996. The yield has only reached these levels previously in 2000, 2009, and the end of 2018 (when I initiated a position). I really like the current dividend yield coupled with high single digit growth rates, however, the payout ratio is a bit high after the acquisition and, as a result, I expect dividend growth to slow in the near term.

Dividend Discount Model (“DDM”)

Again, I used a two-stage DDM model to determine fair value.  I assume a short-term growth rate of 7% (lower than the 1yr, 3yr, and 5yr growth rates) and assume a long-term growth rate of 4% given that there is plenty of room to payout free cash flow, especially as debt is paid down and interest costs decrease. The required return of 8% reflects the stable and predictable cash flows of the business and the defensive nature of the holding.

Base Case Assumptions  
Current Dividend

$3.52
ST Growth7.0%
LT Growth4.0%
Req. Return8.0%
YearDividendDiscounted
2020 $                3.77 $                3.49
2021 $                4.03 $                3.46
2022 $                4.31 $                3.42
2023 $                4.61 $                3.39
2024 $                4.94 $                3.36
(Terminal) $            128.36 $              87.36
Fair Value $            104.48

The result is a fair value of $104.48 – about 3.7% below the current stock price of $108.50. If we take the FCF assumptions from above, we end up with a FCF payout ratio of roughly 55% in year 5 assuming no share buy-backs.

Multiples Analysis

Lastly, I did a multiples analysis based on 10-year historical numbers to account for a full business cycle, as well as a comparison to four of SJM’s major competitors.

CompanyMarket Cap ($M)Forward PE RatioPS RatioPrice-to-Free-Cash-FlowPrice-to-Operating-Cash-FlowEV-to-EBITDA
JM Smucker$12,193.7713.21.614.610.613.1
10yr Hist. Avg20.91.819.413.312.5
Discount/ (Premium)58%15%33%25%(4%)
Target Price$171.38$125.19$144.65$136.14$103.77
CompanyMarket Cap ($M)Forward PE RatioPS RatioPrice-to-Free-Cash-FlowPrice-to-Operating-Cash-FlowEV-to-EBITDA
The Kraft Heinz$37,220.9811.71.513.010.10.0
General Mills$32,153.7515.81.914.211.714.0
Conagra Brands$14,103.2314.01.316.011.215.5
Campbell Soup$14,101.5518.71.713.910.121.4
Comp. Average15.11.614.310.812.7
Discount/ (Premium)13.8%2.2%(2.0%)1.4%(2.6%)
Target Price$123.49$110.93$106.31$110.04$105.68
       

The result is a wide range of stock prices from a low of $103.77 to a high of $171.38. Taking the average of the outputs I get a fair value of $123.76, or a 14% margin of safety at the stocks current price.

Conclusion

After the Q2 earnings release I expected shares to fall, instead they rose about 4%. This was likely due to the increase in margins. At this point, I think SJM’s stock is slightly overvalued. Perhaps Investors are assigning the stock a small premium given that it is a defensive holding with consistent FCF and dividends. Historically, the company has traded at a premium to the market. I don’t view the stock as overvalued to the point where I want to cash-in my shares, but I will not be adding to my position at these levels. The price of the stock has been pretty range bound between $103-$109 over the past year. I will let the Ainsworth acquisition play-out and continue to hold. If the stock drops to about $95 I will re-assess my valuation and see if adding to my position makes sense. On the contrary, I will do the same if we see the stock moves significantly to the upside without significant improvements in fundamentals.

-Pennybags


 

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