Have you noticed that, during the 2015 through 2019 stretch, McCormick has traded at an elevated valuation of approximately 25x earnings? From 1975 through 2014, the average P/E ratio of the stock was 18.7x earnings. The profit margins during the 1975 through 2014 stretch were 8.7%. During the 2015 through 2019 stretch, profit margins have improved to 12.1%. That is a staggering 39% increase in the amount of each dollar of revenue that flows through to shareholders as net profits.
It is worth examining what McCormick is doing now that explains why its profit margins have increased substantially in the past four years after holding steady for four decades. After all, the business hasn’t changed–it is the manufacturer, market, and distributor of spices, seasonings, flavorings, mixes, condiments for the consumer, industrial, and foodservice markets. These businesses are remarkably consistent sources of profits over time, and that is why shareholders have reaped 14.5% annual returns since 1975.
The answer is on page 4 of McCormick’s 2018 year-end 10-K, where the seasoning manufacturer mentions that it is now licenses its brand names out to other manufacturers (my emphasis in bold added):
We own a number of trademark registrations. Although in the aggregate these trademarks are material to our business, the loss of any one of those trademarks, with the exception of our “McCormick,” “French’s ,” “Frank’s RedHot,” “Lawry’s,” “Zatarain’s,” “Stubb’s,” “Club House,” “Ducros,” “Schwartz,” “Vahiné,” “OLD BAY,” “Simply Asia,” “Thai Kitchen,” “Kitchen Basics,” “Kamis,” “Drogheria & Alimentari,” “DaQiao,” “Kohinoor” and “Gourmet Garden” trademarks, would not have a material adverse effect on our business. The “Mc – McCormick” trademark is extensively used by us in connection with the sale of our food products in the U.S. and certain non-U.S. markets. The terms of the trademark registrations are as prescribed by law, and the registrations will be renewed for as long as we deem them to be useful. We have entered into a number of license agreements authorizing the use of our trademarks by affiliated and non-affiliated entities. The loss of these license agreements would not have a material adverse effect on our business. The term of the license agreements is generally three to five years.
McCormick has been largely silent about the licensing agreements to non-affiliated entities, but essentially, what is going on here is that McCormick not only continues to say, manufacture and sell French’s mustard, but it also lets other mustard manufacturers (presumably in parts of the world where McCormick’s distribution of the product is non-existent or small) use the French’s name to market their products in exchange for a fee, which is often around 5% (though could be anywhere between 3% and 15% depending upon the bargaining power of the licensee and the desirability of the particular licensor trademark).
For various companies, companies are usually very quiet about disclosures concerning their licensing agreements. This is because McCormick does not want you to think that you are getting some inferior product if it is mustard sold by a licensee, nor does a licensee selling under the trademark name want to call your attention to the fact that your purchase is not McCormick-manufactured.
Plus, the terms are usually competitive–McCormick could be charging an Argentinian condiment manufacturer more to use the French’s name than, it say, charges a Mexican manufacturer to use the Old Bay name. Likewise, if a manufacturer receives favorable terms licensing a McCormick brand, it may know that if the favorable terms were disclosed McCormick may strike a harder bargain during the next round of negotiating lest other licensees complain about paying more.
The reason why a company moves toward licensing when it can is because the money is almost entirely profit–McCormick sits back and collects a cash override on the capital provided by the licensee manufacturer and distributor. If McCormick licenses the French’s name and they licensee sells $25 million under the license agreement, assuming a 5% fee, McCormick would just collect $1.2 million without having to tie up capital and produce anything. Under these circumstances, it would be passively collecting profits that flow from its intellectual property without any accompanying tangible asset.
My guess is that McCormick is generating around $60 million per year from these licensing arrangements (I base this calculation on the fact that Culver’s is selling around $5.5 billion in condiments per year, is earning around $550 million or so from this, but is earning annual profits of $665 million in total profits, with recent pension accounting changes amounting to another $50-$60 million).
Although I do think the incorporation of licensing agreements into the McCormick overall profit pie does make the company more attractive as it brings in more cash while requiring less capital, I am not crazy about the company’s leveraging of its cash flows. Ten years ago, it was earning $379 million in profits while carrying $1 billion in debt. Today, it is earning $665 million in profits but is carrying $5 billion in debt (and only $73 million in cash).
My guess is that, with the licensing agreement, McCormick will grow profits by 11% annually over the next five years. If profits per share rise from $5 now to somewhere around $8.50 or so, I think the stock will trade at around 21x earnings at the high end of fair value, which would put the stock at $178 per share from the current price of $126. A valuation of 17x earnings is not even out of the question, which would place the stock at $144 per share. I think the licensing agreements in place might be a good reason to suck it up and pay 20x earnings for shares of the stock. I am unconvinced that 25x earnings should be an acceptable price, even though I do have a favorable view of the earnings per share growth characteristics that will be partially enhanced by these licensing agreements. A high price is hard to overcome.