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Smucker Experiencing Near-Term Pandemic-Related Boost, but Long-Term Competitive Headwinds PersistSmucker Experiencing Near-Term Pandemic-Related Boost, but Long-Term Competitive Headwinds Persist Rebecca Scheuneman Equity Analyst Business Strategy and Outlook | by Rebecca Scheuneman Updated Dec 09, 2020 Given persistent secular headwinds and a loss of pricing power, we believe Smucker does not possess a moat, either via its brand intangible assets or entrenched retail relationships. Our analysis shows that over the past few years, Smucker has lost relative pricing power in categories that represent most of its revenue. While Smucker does have leading positions in some categories (fruit spreads, peanut butter, coffee, dog treats, cat food), they represent only a mid-single-digit percentage of total food sales, which we believe is insufficient for a competitive edge. While Smucker is currently benefiting from COVID-19-related pantry stocking, the firm faces long-term revenue headwinds. Its food segment (22% of fiscal 2020 operating profit) is under pressure as consumer preferences shift to fresh, unprocessed fare. While the company is attempting to offset this pressure with new products more aligned with consumer trends, such as on-the-go snacking, it will take a few years for these smaller brands to be large enough to offset the 70% of the segment that is under pressure, by our estimate. The coffee (38% of operating profit) and pet (31% of operating profit) segments have more attractive growth profiles, but Smucker’s high exposure to mainstream and value segments in these categories has resulted in market share losses over the past few years as consumers have traded up to premium price points. We believe 60% of the coffee segment and 65% of the pet segment are exposed to off-trend products and are therefore losing share. However, the firm recently acquired the Rachael Ray Nutrish brand, which is in the high-growth premium segment and has significant growth potential as it expands from dog food to cat food. In time, this may help the firm stabilize the pet segment, although the brand has stumbled in recent quarters. Despite these pressures, we’re encouraged that management has committed to a significant step-up in marketing spending to modernize its capabilities, from 5.8% of 2018 revenue to over 7% long term. We believe the firm will focus these investments on the small pockets of growth in its portfolio to offset the headwinds facing most of the portfolio. Economic Moat | by Rebecca Scheuneman Updated Dec 09, 2020 We believe that Smucker does not maintain a competitive edge based on a brand intangible asset (brand equity or entrenched retailer relationships) or a cost advantage, and we thus rate the firm as no-moat. Recent data shows that the company’s brands have lost pricing power, and although Smucker holds dominant share in a few categories, we deem them as too small (only a mid-single-digit percentage of total food and beverage sales) to elevate the company to a strategic partner status with retailers, which could give it a competitive advantage. Returns on invested capital that are only marginally above the firm’s cost of capital on average are further evidence supporting our no-moat rating. In fact, the company reported economic losses (ROIC that is less than the firm's weighted average cost of capital) in three of the past six years. To assess whether a firm has a brand intangible asset, we like to see evidence of pricing power, which we believe has proved elusive for Smucker in the last few years. Pricing has declined across all of Smucker’s segments at a surprising consistency. In the past four years, its prices have fallen an average of 0.9% annually compared with an average annual increase of 1.1% for the CPI’s food-at-home average. We believe the company has lost pricing power in pet food and treats (38% of revenue) as well. Since Smucker acquired this business in 2015, it has reported price declines nearly every year. Competitors that release price data for their pet food businesses (Colgate-Palmolive and General Mills) have shown consistent price increases over this time frame. However, the comparison is not entirely apples-to-apples, as the competitors primarily participate in the natural, organics, and prescription pet food channel. Despite its mix of leading brands, we don’t believe Smucker is entrenched in retailer supply chains. According to Euromonitor, in the U.S. (94% of fiscal 2020 sales) the company has the top brand in jams and preserves (Smucker’s), peanut butter (Jif), frozen handheld foods (Uncrustables), and dog treats (Milk-Bone) and the number-two brand in coffee (Folgers) and economy dry cat food (Meow Mix). We believe that companies with leading brands in many important categories can be strategically important partners to retailers, giving these companies a competitive advantage. However, we don’t believe Smucker’s dominant categories are large or attractive enough for retailers to warrant a competitive advantage. We estimate that the categories in which Smucker holds a top brand cover a mid-single-digit percent of total food and beverage sales. Although coffee is a larger category, at about 2% of food and beverage sales, and has grown faster than most center-store categories, we still don’t believe it’s large enough to warrant an economic moat. In addition, Folgers has been losing market share to first-place Starbucks. In the past 10 years, Folgers’ share has dropped from 19.2% to 10.1% while Starbucks’ has increased from 8.5% to 13.6%, providing additional evidence for Folgers’ lack of a competitive advantage. Due to the lackluster growth and cachet in its legacy categories, Smucker has attempted to improve its positioning by acquiring on-trend businesses, such as pet food, given outsize growth opportunities relative to other areas of the grocery store and because consumers have tended to prove more brand loyal in this category. In the past four years (2015-19), per Euromonitor, dog food, cat food, and dog treats have reported compound annual growth rates of 5.0%, 4.4%, and 7.4%, respectively, above the 2.2% grocery store average. However, organic growth has proved elusive for Smucker, with the segment reporting organic revenue of down 5.3%, up 1.6%, down 1.5%, and down 1.2% in 2017 through 2020, respectively. We believe this weakness is because Smucker is heavily exposed to the value and mainstream segments, which have lost share as consumers shift purchases to the premium and superpremium segments, suggesting that Smucker has failed to amass pricing power in this niche. Furthermore, Smucker's premium pet food brand, Natural Balance, has been steadily losing market share to narrow-moat General Mills' Blue Buffalo, as the latter brand expands its presence into food, drug, and mass channels. We don’t think that the firm’s weak organic consolidated revenue growth heading into the pandemic (with flat volume over the past four years and a 1% erosion in pricing on average) is the byproduct of insufficient brand spending. In the past five years, the company spent 6.1% of revenue on marketing and advertising on average, above the 4.6% peer average, while its research and development spending of 0.8% was only slightly lower than the 1.0% of peers. We attribute this tepid performance to the lagging categories in which it plays, being overexposed to the underperforming subsegments within its categories, combined with product innovation that has failed to make a meaningful impact against these headwinds. We believe that the company will continue to struggle to reaccelerate products that are off-trend, although the company has had success with some new products developed to capture secular trends. For example, Uncrustables sandwiches meet consumers’ needs for convenient on-the-go snacks, and the product has grown 15% on average in the past five years. However, the small pockets of growth from a few new products have been insufficient to offset the pressures in the rest of its portfolio. Another possible moat source could stem from a cost advantage, which would typically manifest itself as a scale advantage (buying power, manufacturing processes, advertising, for example). We do not believe Smucker has secured a scale advantage through procurement, as the vast majority of raw materials (which make up two thirds of its cost of goods sold) are commodity ingredients, such as coffee, meats, nuts, and resin, where prices are largely dictated by supply and demand. While we believe the company probably maintains certain scale advantages in manufacturing and marketing, we lack confidence that they could not be overcome by other large-scale competitors over the next 10 years. In the past 10 years, Smucker has reported ROICs including goodwill of 2.4%-9.8% compared with our 6.7% weighted average cost of capital estimate. We believe it is appropriate to include goodwill, as acquisitions are a core part of the company’s growth strategy. In the past five years, the firm has reported a cumulative economic loss of $569 million, supporting our no-moat rating. Fair Value and Profit Drivers | by Rebecca Scheuneman Updated Dec 09, 2020 We’re increasing our per share fair value estimate for Smucker to $112 from $108 to account for stronger-than-expected first-half performance and a 1% increase in long-term sales growth in the coffee segment as more employees are likely to work from home after the pandemic, partially offset by a drop in profits due to the divestitures of the Crisco and Natural Balance brands. Our valuation implies a fiscal 2021 price/reported earnings (including amortization) of 17 times. Smucker's organic sales were down in three of the past five years, but stepped up brand investments should gradually improve Smucker's underlying sale trajectory, improving long-term organic growth to 2% in 2023 and beyond. We maintain our long-term expectations for 37%-38% gross margins (compared with its 38% three-year average), as we believe Smucker has lost relative pricing power over the past few years. We expect the competitive environment will remain intense and that pricing power will continue to be elusive for Smucker, given its outsize exposure to categories facing secular headwinds as consumers switch to fresh, natural, and organic selections. As such, we forecast gradual gross margin degradation over the next several years, which will only be partially offset by efficiency improvements. In the face of lackluster revenue growth, the firm is now attempting to modernize its marketing model. Before fiscal 2019, Smucker spent less than 6% of revenue on marketing, but beginning in fiscal 2019, these investments are set to increase, rising to 7% by 2022. We expect these investments will be concentrated on pockets of growth that Smucker has identified in its current categories, opportunities that benefit from consumer trends such as demand for on-the-go foods, trade up to premium offerings, snacking, increased consumption of protein, and natural and organic foods and beverages (such as Uncrustables, Sahale natural trail mixes, Nutrish premium pet food). However, we estimate that combined they currently account for just 20% of revenue, and as such, are unlikely to move the needle on its performance in the near term. Risk and Uncertainty | by Rebecca Scheuneman Updated Dec 09, 2020 The primary risks affecting Smucker are the secular headwinds faced by its brands, the volatile nature of cost inputs, and the risks associated with buying, integrating, and managing acquired businesses. Many of the company’s brands face secular headwinds, resulting in declining revenue or lost market share as consumer trends move away from its products. We estimate that 60% of the coffee segment, 70% of foods, and 65% of pet is facing such headwinds, which Smucker is addressing by significantly stepping up marketing investments beginning in fiscal 2019. However, there is no guarantee that these investments will return the business to growth, particularly if its product mix fails to align with evolving consumer trends. A significant portion of Smucker’s cost of goods sold (64% in fiscal 2020) consists of raw materials that can be quite volatile in price, such as coffee, peanuts, and the meat used in pet food. This volatility can, and often does, have a significant impact on the company’s margins. For example, we estimate that higher green coffee prices in fiscal 2018 resulted in a 500-basis-point hit to the segment’s operating margins. Reported margins fell 300 basis points even though there was a nearly 200-basis-point benefit from a more favorable K-cup contract. Acquiring businesses has been an important part of Smucker’s strategy, and we expect it will continue to be. Integrating companies can be difficult, as there is usually significant risk in maintaining key personnel and managing disruption as the business transfers ownership. It is also crucial for management to be disciplined purchasers, ensuring that the price they pay allows for appropriate risk-adjusted returns. We believe that management has not been consistent in this discipline, as the Big Heart Pet Brands acquisition ultimately destroyed shareholder value; we view this as a persistent risk. Stewardship | by Rebecca Scheuneman Updated Dec 09, 2020 We assign Smucker a stewardship rating of Poor, primarily because we believe that it has overpaid and failed to integrate and leverage acquisitions. For one, we think Smucker paid an excess premium for the 2015 acquisition of Big Heart Pet Brands ($5.9 billion, or 13 times on an enterprise value/EBITDA basis), a deal that we believe has ultimately destroyed shareholder value; the company has realized $465 million in impairment charges for goodwill and trademarks in the past four years. Furthermore, the performance of the business has been disappointing, as the brands are primarily positioned in the value and mainstream segments, which have been losing share to premium and superpremium products. The acquisition has pressured ROICs, as well. In the two years before the acquisition, ROICs averaged 9.7%; in the two years following, they averaged 6.9%. We think the strategy to enter the pet category is sound, as it boasts more attractive growth rates than Smucker’s legacy categories, but we believe the price paid for Big Heart was too steep in light of the poorly positioned brands. In 2018, Smucker acquired a second pet food company, Ainsworth. About two thirds of revenue stems from the high-growth premium brand Rachael Ray Nutrish, while the remaining third comes from regional brands and private label. The price Smucker paid for this acquisition could prove rich as well, but it will largely depend on the company’s ability to grow the Nutrish brand and expand the brand (which is primarily dog food) into the cat food market. Smucker paid 22 times adjusted EBITDA, the same multiple that General Mills paid for the Blue Buffalo acquisition a few weeks earlier, although Blue Buffalo is more profitable, with a 25% EBITDA margin compared with 14% for Ainsworth. However, we applaud Smucker for selling two noncore businesses (canned milk in 2015 and baking in 2018) to free up capital to accelerate the paydown of debt, which had risen after acquisitions. Mark Smucker, great-great-grandson of founder Jerome Smucker, has served as CEO since May 2016. The shares have performed fairly well under his leadership, averaging a 2% annual total return over the past three years as of December 2020, compared with a 1% decline for the Morningstar packaged food index. Although the firm's brands appear to have lost pricing power in the past few years (a factor that underpins our no-moat rating), we think his strategy to increase marketing investments on the firm's highest potential brands should help to accelerate organic sales growth, which has stalled in recent years. We also have a favorable view of the creation of a chief operating officer role in March 2020, which should enhance execution and free up the CEO to focus on strategy. Smucker has 12 annually elected board members, nine of whom are independent; the remaining three are Smucker family members and current or former company executives. The family continues to hold significant power on the board, with family members holding the titles chairman emeritus, executive chairman, and chief executive officer. We grant that the family members have deep knowledge of the company, which is beneficial, but the family’s board representation seems heavy, given that it only owns about 4% of the shares. While the CEO and chairman roles are separated, we believe having both roles filled by family members minimizes independence. And although the board is diverse in terms of gender, age, race, and tenure, we believe it’s light on directors with experience at large consumer packaged goods companies. Of the nine independent directors, only one has worked at a CPG firm. We believe that executive compensation effectively aligns the interest of the executive officers with that of shareholders. Performance-based pay makes up 67%-83% of the named executive officers’ compensation, with a greater portion allocated to long-term incentives (stock-based, vests after four years) than short-term (cash-based). Furthermore, named executive officers are required to own a minimum amount of stock (6 times their annual base salary for the executive chairman and CEO and 2 times for the other executive officers). Performance targets are primarily based on adjusted operating income, earnings per share, free cash flow, ROIC, and, in some cases, strategic business area performance. We believe these metrics appropriately balance shareholder interest with factors under the executive officers’ control. |
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