McCormick & Co. – case study #3

Business description: McCormick & Company, Inc. (MKC) was founded in 1889 and today is a global leader in the manufacturing, marketing and distribution of flavor products, including spices, herbs, extracts, seasonings and flavorings, and other specialty food products to the entire food industry. Its major sales, distribution and production facilities are located in North America and Europe and operate in two business segments: consumer and industrial. The consumer segment sells spices, herbs, extracts, seasoning blends, sauces, marinades and specialty foods to the consumer food market under a variety of brands worldwide; it is the primary driver of their business representing approximately 58% of sales, 80% of FY08 EBIT profits. The industrial segment sells seasoning blends, natural spices and herbs, wet flavors, coating systems and compound flavors to food manufacturers and the food service industry, both directly and indirectly through distributors and represents 42% of sales and 20% of FY08 EBIT profits.

MKC’s products are sold directly to customers and also through brokers, wholesalers and distributors. In the consumer segment, products are resold to consumers through retail outlets, including grocery, mass merchandise, warehouse clubs, discount and drug stores under a variety of brands. In the industrial segment, products are used by food and beverage manufacturers as ingredients for their finished goods and by food service customers as ingredients for menu items. Customers for the industrial segment include food manufacturers and the food service industry, which are supplied both directly and indirectly through distributors. For a detailed summary of their history read this profile here.

Competitive advantages: So what exactly are underlying advantages McCormick possesses that enable them to earn very good margins while growing sales reliably and earning solid returns on its invested capital year-over-year?

1. Scale & size
   Being a large spice player that has a global presence provides MKC with purchasing & pricing benefits and provides it a high degree of economies of scale. This allows it to leverage its fixed cost base and command some degree of clout with its customers. Additionally it has an ability to run its operation with a high level of sophistication. According to management they have resources to maintain global sourcing teams who opportunistically work with farmers to increase yield and help forecast/evaluate crop conditions ahead of harvest which can help MKC to opportunistically make strategic purchases for some of their input materials which partially offsets some of the volatility of raw material costs. Additionally, from a customer service point of view, they offer customer-friendly web offerings such as 30 minute meal recipes and educational information on the benefits of spices. They even offer their customers the ability to age-check their old spice bottles. It is unlikely that new entrants could replicate such abilities on a short-term, start-up basis. It equally unlikely that smaller/less profitable players and/or competing store brands could match or replicate such offerings to the same degree, if at all.
2. Large portfolio of trustworthy, well-known brands
   Many of their spice brands have been around for decades (Lawry’s, Old Bay, Zatarain’s and Schwartz-UK) which affords MKC a high level of loyalty and brand equity from customers. MKC profits from this brand equity through pricing power over store brand substitutes. See article for recent example highlighting their pricing power over brands based at Walmart.
3. Large breadth of products Their product offering is wide and includes traditional herbs & spices, flavor/seasoning packets, wet marinades, extracts/colorings and grill & seafood specific products. In particular their spice selection is so wide that often times they are the only provider of non-mainstream spices such as dillweed, alum, ground cumin, etc
4. Large producer of private-label offerings They are one of the largest producers of private label in North America. This serves to limit the private label threat by preventing other competing players from gaining enough scale to significantly affect the pricing of McCormick’s branded offerings.
5. Demonstrated success of fighting off a new entrant
   As mentioned here previously one of the best ways I like to identify companies that have enduring competitive advantages is to seek out historical examples of a new entrant/competitor failing in its attempt to gain & take market share from an established player. In regards to MKC, one of its most fierce business challenges transpired in the mid to late 1990’s when Burns Philp & Co. of Australia attempted to directly challenge it.

Here are the relevant bullet points:
-In the late 80’s and early-to-mid 90’s Burns began acquiring a portfolio of spice brands (Spice Island in 1988, Durkee-French in 1992, Ostmann in 1994, Tone Brothers in 1995) with an emphasis on European markets, such as Germany, The Netherlands, France, and the United Kingdom.

-It then initiated a price-war strategy with McCormick that was reliant on heavy spending and promotion to take away shelf space from McCormick. Specifically the idea was to pay higher slotting fees to stores, which carried a single brand, to replace McCormick in favor of Burns.

-The price war carried on to around late 1996 when Burns abruptly decided to abandon the spice business and sell its herbs & spices operations due to negative profitability. However Burns encountered problems even in the sale of these business and was forced to write the associated assets down materially before ultimately being sold.

-The price war did temporarily erode profitability for MKC; it had particularly tough years in 1994 & 1996, earning unusually low EBIT margins of around 5.5%. Once Burns Philp exited the spice market EBIT margins recovered promptly recovered to 9.5% in 1997 and thereafter. (link to 35 yr summary of MKC EBIT profits)

-Based on my research I estimate that at the peak of the price war Burns peaked at gaining 15% market share compared to MKC’s +30% share.

The key reasons for Burns ultimate failure
– Burns Philp naively entered into a head-on competition with a savvy, established player and underestimated their ability/willingness to defend their #1 position. Specifically McCormick aggressively fought back by offering various discounts to grocers that gave McCormick better position on the shelves, that is shelf space and position, which are most critical for packaged-food competitors.

-Not to be overlooked, one of the key reasons McCormick was able to survive a period of depressed profitability, while Burns Philp was not, was due to Burns high debt load that was incurred as a result of its quick expansion into the herbs & spice business. As Burns, Philp moved to build up its international herbs and spices offerings it invested rapidly to acquire a number of regional players around the world and paid handsomely for its acquisitions, driving up its debt. In an attempt to reduce its debt Burns was forced to sell some of its non-spice businesses at inopportune times which resulted in low recoveries for its profitable non-spice businesses and in effect served as a ‘double-down’ type bet on their entrance into the spice business.

-While not central to their failure it is still worth noting that Burns apparently was not able to innovate on its own and there are accounts that Burns simply mimicked product designs and package redesigns of McCormick. In hindsight perhaps this can regarded as anecdotal evidence that Burns, Philp was simply operating out of its league and did not adequately assess the high ability of McCormick to defend its turf.

Quick financial history: MKC has demonstrated a long history of sales growth and profitability. I have summarized the past 30 years of Reported Sales and EBIT margins. In my opinion the results are very impressive, even more so when the growth rates of Sales & EBIT are analyzed on 10, 20, and 30 year time increments. The following are the relevant CAGR rates associated with Reported Sales growth and Reported EBIT $ growth:
It is worth noting that in 2002 MKC implemented EITF 01-09, which altered the way Net Sales are reported. The rule required the Company reclassify certain marketing expenses as a reduction of Net Sales, instead of as a component of Costs of Sales and/or Operating Expenses; the conceptual impact of this change results in a reduction to Net Sales and Operating expenses equivalently, which mechanically would raises EBIT margin % by a slight amount despite EBIT dollars not being impacted. Due to impossibility of reclassifying such amounts going back to 1979 please take a mental note to interpret the following in context.

10 yrs: Sales 4.7%; EBIT 7.8% (1999-2008)
20 yrs: Sales 4.8%; EBIT 6.7% (1989-2008)
30 yrs: Sales 6.8%; EBIT 8.4% (1979-2008)

For the past 5 years MKC has earned annual operational ROIC’s in the healthy 29-33% range. I define operational ROIC calculated using an Invested Capital amount that excludes Goodwill & Intangible assets, as they are not assets that require reinvestment to grow the business. However since MKC relies modestly on acquisitions to drive growth it is helpful to understand ROIC calculated using Goodwill & Intangible assets as part of the Invested Capital base; under such an approach ROIC is around 13-15%. The main difference between the two ROIC’s are the Goodwill generated by the acquisitive nature of MKC over the past 10 years.

Competitive Threats: The gist of existing competitive threats to McCormick boil down to a) a handful of branded competitors and b) private label products. It helps to understand the spice market is comprised of 4 major sub-categories, in order from largest to smallest: i) Spices ii) Salt seasonings & substitutes iii) Extracts, food flavorings & colorings and iv) Pepper.

According to the market researcher Packaged Facts, which compiles data primarily from Information Resources, Inc (IRI), as of 2005 MKC was #1 in all categories except for Salt where it was #2; however taking into account their 2007 acquisition of Lawry’s they should now be considered the #1 player in the salt category as well. (Editor’s note: Due to the limitations of available market research the above #s exclude data from Walmart and also do not contemplate any impact from sauces, gravy/soup mixes, wet marinades and salad dressings)

Here is a quick summary of their branded counterparts, starting with the most competitive:

Associated British Foods – Through Tone Brothers, Inc., the North American Division of ABF plc, they are the second largest spice and seasonings retail marketer, with a market share of 4.6%. Within the US they are considered a rational competitor who is unlikely to gain market share without triggering a price war however due to their large global size and portfolio of brands they are considered a legit long-term threat to MKC outside of the US.

Goya Foods – New Jersey-based Goya Foods, Inc. is the #5 player in the Spice sub-category and one of the largest Hispanic-owned producers and distributors of food products in the U.S., with presence in beverages, frozen foods, and condiments. Goya Foods has long catered to the needs of the Hispanic consumers in the Northeast and Florida, population centers for Hispanics of Cuban, Dominican, and Puerto Rican origin. Recently, it has begun focusing on Hispanic consumers in California and the Southwest. Has shown a modest degree of an ability to innovate and compete in new ways. The company’s brand, Sazon Goya, is among the top brands in the spices category. Goya has worked on increasing sales through an online e-store, which was launched in early 2006. Due to large exposure to the fast growing hispanic market they are considered a legit long-term threat to MKC.

Badia Spices – Badia Spices began as a humble family business in Miami in the 1960s. It has had a comparatively high growth of 12.8%, from $22.9 million in 2004 to $25.8 million in 2005, driven in part by tremendous support from Hispanic consumers and is considered one of the top marketers of spices and seasonings in the U.S. Badia Spices has its presence in many areas of the food market. Based on available research the key areas of business for the company lie in blends, extracts, marinades, hot sauces, and tea. Due to large exposure to the fast growing hispanic market they are considered a legit long-term threat to MKC.

Alberto-Culver Co. – Owner of 2 niche spice brands (Mrs. Dash & Molly McButter) and 2 niche non-spice food products (Bakers Joy & Sugar Twin). They do not appear to be gaining market share and do not appear to be threatening to innovate as a way to gain share. The company focuses mostly on personal beauty products. Considered a niche-player with a tiny portfolio and limited ability/desire to challenge MKC.

Morton Salt – #2 branded player in salt sub-category of overall spice market. Formerly owned by Rohm & Hass and currently owned by Germany fertilizer maker K+S AG they appear poised to maintain their narrow focused primarily on salts; nothing in recent history suggest that are innovating and/or acquiring outside of that market.Considered a niche-player with a narrow portfolio and limited ability/desire to challenge MKC.

Market research:
Based on market research for 2005 published by Packaged Facts, a division of marketresearch.com, McCormick had market share of 39.9% in the US spices & seasonings market, followed by Tone Brothers (owned by Associated British Foods plc) with 4.6%, Morton Salt with 4.2% , Unilever’s Bestfoods North America ~3-4%(note in 2007 MKC acquired Lawry’s & Adolph’s from Unilever which accounted for a significant portion of this data point) and several smaller private players including as Goya Foods and Badia spices with below 4% share each. Non-MKC based private label accounted for 15%.

Supplementing the above my personal quick-n-dirty analysis of McCormick products showed there is high degree of customer satisfaction with their best selling products. See link to their 24 most popular items on Amazon and note that most of their product receive between 4 & 5 stars. While it is not conclusive by any stretch at the very least it very suggestive that MKC products are well liked by their customers.

Additionally based on my personal visits to several supermarkets, a Walmart and a national pharmacy I was able to observe that McCormick products, including non-spice products such as marinades, flavor packs and seafood products, are ubiquitous and typically their custom designed spice racks have the best shelf space and visibility for the consumer.

Major Risks:

Recent shift in Wal-mart spice approach, which could lead to further overall shifts in how spices are sold by mass-merchandisers in the US

The evolution of Wal-mart’s approach to marketing spices & herbs and McCormick spices in particular is currently up in the air. Currently in a limited number of stores, Wal-Mart is testing a category solution which expands private label to core spices with no duplication by McCormick or other regional brands for these items. In a similar number of stores, Wal-Mart will test a total McCormick solution with no private label and a third set of stores will test a set primarily with McCormick and very limited private label. Over the next 6-18 months we will begin to understand how, if at all, Wal-mart may alter their approach marketing McCormick spices. Given the clout of Walmart as a customer this is clearly the biggest threat in the short term.

Evolution of US retailing into more of a UK/French hard discounter model
Historically speaking McCormick has always kicked the ass of store brands, particularly in the US, due in some combination to the superiority of their product quality and their savvy marketing ability; see nice discussion in this article. In Europe, specifically the UK and France, the evolution of store brands at hard discounters (aka dollar type stores) such as Aldi’s and large national retailers such as Carrefour, Sainsbury and Tesco have presented a worthy competitor to McCormick; currently McCormick has some of its strongest competition in those countries and their brands do not enjoy the dominance of their products the way they do in the US. Based on my research it comes down the following:

i) The ability for new retail entrants to compete with established retailers is higher in Europe, primarily due to scarcity of land, which drives up start-ups costs. As a result retailers are more concentrated and competition, insofar as pricing is concerned, is not as fierce, and overall its arguably a more rational environment.
ii) Consequently the largest European retailers, while relying on low prices, are not irrationally focused on price and have made great strides developing store branded products that balance price & quality well and compete strongly with branded products. Anecdotally stores are generally smaller in Europe and thus shelf space is less which in turn reduces the amounts of brands & sub-brands stores can carry; the strength of McCormick’s product breadth is somewhat handcuffed by their inability to market their full offerings as they routinely can in the US.
iii) Consumers are more price sensitive in Europe and less compelled to always favor branded products against store brands.
See great article describing this European trend.

Growth of current day ethnic-focused/niche players such as Goya Foods and Badia Spices
More of a long-term threat than an immediate concern, the growth of Badia and Goya Foods, is something to keep an eye on. Badia products and their distribution appear to be growing reliably year after year. In addition Badia and Goya both have strong following from a mostly Hispanic customer base which is also growing rapidly in the US. As both Badia and Goya are private companies financial information on them is slim but they may in fact pose the greatest long-term threat to MKC in the branded segment. Time will tell on this one but I like McCormick’s chances to remain very competitive. They have been targeting that market in ads & promotions since 2002 and appear to be keenly aware of the Hispanic demographic as demonstrated by their product La Cocina de McCormick, introduced in 2006, which is a bag containing 64 authentic Hispanic spices & seasonings.

Continued evolution of private label: As mentioned previously McCormick is one of the largest producers of private label in the US, thus they are partially hedged against consumer shifts to cheaper and unbranded spices. Additionally McCormick is typically a leader in innovations and new brand launches which should help it maintain a lead when consumer preferences & tastes shift as they are destined to do; I note MKC introduced the highest number of brands (i.e., 19) between January 2005 and July 2006. Given their strong current market position, knowledgeable management and deep pockets I believe McCormick is positioned extremely well to face continued challenges from the private label market which continues to make strides in terms of quality and product breadth.

Less than major risks:
o Loss or reduction of Pepsico as a key customer
o Raw material fluctuations
o Reliance on acquisitions to drive growth

Conclusion: McCormick has a strong moat, a very defensible position and has had tremendous staying power (120+ years in business) thus far; it appears poised to handle the challenges currently in front of it as it continues to build its global presence.