Watch out for Falling Spices!

By Chad Henage - July 3, 2012 | Tickers: CAG, IFF, MKC, SWY, KR | 0 Comments

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Dividend aristocrats are more of a rare breed than they were just a few years ago. Investors expect a company that has increased its dividend for over 25 years to continue this streak. At least, that was the thought process before 2008–2009. During these years, investors saw such dividend stalwarts as General Electric and Dow Chemical cut their dividends for the first time in many years. This has left some investors gun shy of who's next to drop off this list. I'm worried that the spice company McCormick & Co (NYSE: MKC) might lose its status unless things change.

When most people think of McCormick, they immediately flash to a little bottle of spices with the signature red label. However, McCormick competes not only with large diversified corporations, but also against private label brands. With nearly 200 years of operating history, International Flavors & Fragrances (NYSE: IFF) is a direct competitor, as well as newer entrants like ConAgra Food's (NYSE: CAG) Spicetec division. In addition, stores like Safeway (NYSE: SWY) and Kroger (NYSE: KR) have expanded their private label brands to compete directly with McCormick's profitable spices. To get an idea of the relative strength of McCormick versus these competitors, look at how the company compares on a few metrics:

You can tell that it has been a tough few years for any company tied to the general health of the economy. The fact that only one of these four companies has shown positive free cash flow growth shows very clearly the challenges of the last three years. Beyond the free cash flow comparison, McCormick looks the most overvalued based on its P/E relative to its growth rate. The fact that Kroger is selling for a P/E that's less than half McCormick's, and that Kroger is growing faster shows that there is something wrong here. While they are not in the exact same business, it seems likely that either McCormick is far overvalued or Kroger is undervalued. I'm sure that part of McCormick's valuation has to do with the company's long string of dividend increases, but these increases are going to become more difficult in the future.

In no small part due to the 27% overall decrease in free cash flow over the last three years, McCormick's free cash flow payout ratio has risen to a current payout of over 61%. While it's impressive that the company has been able to continue its dividend increases, the increase in the payout ratio is not sustainable. Three years ago, the payout ratio was just 37.6% so an increase to over 61% today shows the problems the company has had in the last few years. While this isn't an immediate problem, if the company continues on its current direction, the payout will soon become unsustainable. So what about dividend growth?

The direction of dividend growth at McCormick in the last few years is fairly straightforward. Prior to the 2012 increase, McCormick clocked in with seven straight years of decreased dividend growth. From 2004 to 2011, the rate of dividend increase slowed dramatically from over 20% to under 8%. The upturn in 2012 should be encouraging to investors, but I am not encouraged. The first quarter of 2012 shows $7.4 million in free cash flow, but $41.4 million in dividend payments. To make these dividend payments, the company borrowed $60 million. When a company has to borrow money to make its dividend payments, investors should be worried. So what should investors expect in the future?

McCormick has a great brand and used to have a virtual license to print money because of this. However, the Great Recession caused customers to make choices they weren't forced to make before. Many consumers decided to try out store brand foods, diapers, cleaners, and more importantly spices. When the average consumer realizes they can buy the same spice from a Safeway store brand for less money than buying the McCormick spice, they may not switch back. The increase in competition from store brands is permanent, and some of these customers won't come back to, even once their economic situation improves.

Given the trends, I would be concerned for McCormick's dividend sustainability, much less any dividend growth. With over $1 billion in long-term debt, the company also carries about 20% more debt than just three years ago. McCormick might leave a bad taste in investors' mouths if the dividend growth stops. You don't want to be caught holding this stock if this occurs. With just a 2% dividend, and selling for nearly 20 times earnings, the fall could be ugly.

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