Analysis: MKC

This morning AAP holding McCormick & Co. (MKC) reported very disappointing quarterly results that reflect many if not all of the challenges of the June quarter. Yet, the shares are down modestly following the earnings report being published and the earnings conference call, which suggests much of the damage was already priced into MKC shares. More than likely there is also some realization about the tough comparisons McCormick faced due to the reopening strength in the year ago quarter.

While some of the challenges of the May quarter will remain, including higher interest rates, a stronger dollar, and the ongoing impact of the Russia-Ukraine war, mostly related to input costs, walking away from the company's earnings call several of the items that plagued McCormick will fade and or be offset by additional pricing actions.

On the earnings call, McCormick shared its EPS in the May quarter was hit by $0.14 per share by China, Russia-Ukraine, and FX, with FX roughly pegged at $0.03. There was also the impact of higher fuel and transport costs, which added together accounted for the $0.17 per share EPS miss relative to expectations.

We have two thoughts. First, it confirms the suspected impact for the confluence of these events, and second, there is a high probability McCormick won't be the only company whose upcoming earnings report and guidance will be impacted.

Second Half of 2022

But as we said, some of those factors will fade, most notably with China, which is McCormick's second largest geography but a distant second compared to the U.S. McCormick's current quarter kicked off on June 1, which means it will feel the lingering effects of China's lockdowns in the current quarter but as those lockdowns fade, its Shanghai facility, which produces 40% of its product for China should rebound. That means that some of the $0.14 per share pain in the May quarter will be removed.

Also pointing to a better second half of 2022 for McCormick is incremental pricing to be taken in August for its Consumer business, which builds on pricing action this past April and in the company's November 2021 quarter. This latest increase is aimed at pushing back on higher input costs, and should be in full force as we march into the strongest demand period for McCormick's Consumer business - the holiday laden period between October and January.

We may see some margin improvement in the current quarter as supply chains continue to improve, but the totality of those pricing actions points more toward McCormick's November quarter. Here's the thing, we are witnessing some roll over in various commodity inputs, and as we start to think about 2023 if that rollover continues, it means McCormick's pricing action to combat inflation this year are likely to become margin generators in 2023.

After reflecting on the what McCormick has reported for its February and May 2022 quarters - its first half of 2022 - what we found rather interesting in parsing McCormick's updated 2022 EPS guidance that now calls for $3.03-$3.08 per share vs. it's  prior $3.17-$3.22 is what's implied for its EPS in the second half of 2022.

For its February quarter, McCormick reported EPS of $0.63 and heading into the May earnings report, the consensus was for $0.65, but as we now know it reported $0.48 for that quarter. That adds up to $1.11, which based on its new guidance for 2022 implies $1.95 in EPS during the second half of 2022. Not only is that a few pennies higher than its original second half of 2022 guidance that was $1.92, it also points to much stronger EPS growth in the second half of 2022 ($1.95/$1.11) than was expected previously ($1.92/$1.28).

That is an eye-catching expectation for the second half of the year vs. the first half, and it is a good deal stronger than we've seen in recent years, but 2020 and 2021 were also impacted by the pandemic and the reopening. If we go back before the pandemic, the average range of EPS growth in the second half of the year for McCormick was 50% over the 2016-2019 period. With pricing action taken by McCormick expected to be in the low double digits and the 2Q impact of China fading as we move through the second half of 2022, its implied 2022 EPS guidance doesn't look all that outlandish. However, there are several pieces to the input cost puzzle that could make or break that guidance, including oil and gas prices as well as other input costs.

2023 Expectations

The next few months will be ones to watch for McCormick and its business even as the Wall Street heard likely comes to the same conclusion we did. Odds are we will see some 2022 EPS revisions to the pre-May earnings report consensus of $3.16, and we would be surprised if they come in below McCormick's $3.03-$3.08 view. Those revisions will likely be joined by price target cuts as well, but it will be what Wall Street does with its 2023 EPS expectations that we will be watching far more closely.

With the bulk of the pricing action benefits to be had in the company's November quarter, it sets up the time between now and when it reports its August quarter results as a bit of a No Man's Land. When that report comes in September, we'll have a much better feel for not only the size of its pricing action but also how sticky it will be, not to mention we'll have a much better sense as to whether inflationary pressures have indeed peaked.

We'll also be that much closer to the time of year when McCormick announces its dividend changes for the company year, and its comments on capital allocation and the balance sheet will set the tone for what we'll hear around Thanksgiving on the dividend front.

We continue to see McCormick as a high-quality company, but for now we'll step back to a Two rating with the shares even as we keep our longer-term price target intact. If the conditions surrounding its business improve, particularly on the input cost side, we'll look to round up to a fuller position size as we move through the summer.