A few weeks ago, I learned about Phil Town and what he is teaching with his Rule #1 style of investing.

I like Phil’s approach and his emphasis on minimizing risk, and I know a lot of his readers do too. Although I haven’t gotten my hands on his book Rule #1 (it comes out in March), I have been studying the Rule #1 style of investing through articles Phil has written on his blog.

Phil has been kind enough to offer mentoring to anyone that wants it. I’m not a billionaire yet, so I can definitely still learn a thing or two; I took him up on the offer.

A few weeks ago I wrote up a case study on whether or not to buy shares of spice maker McCormick & Co’s stock, MKC. I sent the case study to Phil and he sent it back with his comments. I am posting it here.

Incidentally, the stock was $30.45 then, and has barely moved in the month or so since I started running the numbers.

What follows is a series of answers, notes, and data points that I have put together (and Phil Town has been kind enough to provide feedback on) based on the method of analysis he talks about in his upcoming book, Rule #1. I put this case study together based on Phil’s discussion here and here.

To learn more about Rule #1 investing, a good place to start is Phil Town’s blog.

*** BEGIN CASE STUDY ***

1. Do I want to own the stock? Yes. McCormick is the world’s largest spice manufacturer. We use their products, and nearly all of the spices at my local Wal-Mart happen to be made by them. So I like the company from an ethical point of view.

Phil says: Good reason to own a business.

2. Do I understand the business? It seems simple enough. They buy spices in bulk as commodities, put it in tiny jars and charge prices that make me cringe. They also sell to restaurants and many other companies in the foodservice industry.

Phil says: Okay. That works.

3. Moat? They have a 40% market share. They are eight times the size of their closest competitor, and are clearly the market leader. Spices are used for virtually every food, and if they raise the price by a few cents it doesn’t seem like it will matter. In that sense, they have both the brand and the pricing power.

   But here’s the kicker about that– I hate buying spices because they are so expensive. So my wife and I tend to buy the cheaper $1 spices we can find at dollar stores and what-not. So there is competition out there. But since they are the big fish I believe they have a wide moat.

Phil says: Best of Breed is always a good thing. But lets dig in on the Moat question and look at the Big Five Numbers plus debt to confirm the moat so we’re not just guessing. First, ROIC. Above 17% and growing. Excellent. But Sales growth kind of sucks at 4%. Red flag. EPS is okay at 16%-18% but it dropped off this year. Cash growth is all over the map. Red flag. And equity growth - the most important one — BVPS is bouncy and less than 10% over the last 10 years but better lately. Pink flag. And debt is high. Hard to conclude this business has a wide moat with these numbers. To buy this I would need to really understand the business since the numbers are not a slam dunk.

And do people need to buy spices like they need to buy razor blades?

Excellent question that goes hand in hand with the confused (but not terrible) numbers.

4. Management? Yahoo says that their corporate governance is better than 5% of the S&P 500, and 48% of Food and Beverage companies. Morningstar gives them a B for stewardship.

Phil says: Meaning they are either in the lowest 5 percentile or the lowest 50%. Either way… uhhh. That said, did you read the management letters
to shareholders to get a sense of whether they are driven and owner-oriented? I couldn’t get them to download off their website. (Note: I haven’t read the shareholder letters. I didn’t take this part any further. Management’s rating isn’t stellar, though.)

5. Margin of Safety? Morningstar says McCormick is worth $33, assuming a 7% annual growth rate. At this rate, their earnings will double in ten years. EPS estimates are $1.60 now, so should be $3.20 in ten years. Therefore, at the current P/E ratio, it will be worth about $64 per share in ten years.

   ==> when I do a present value calculation at a 15% rate of return (i.e. =PV(15%,10,,-64)), Excel tells me that McCormick’s stock is worth $15.82 today, based on my assumptions.

   ==> therefore, there is no margin of safety on McCormick and it appears to be overpriced

Phil says: Morningstar thinks 7%. Analysts think (on average) 10%. What do you think? With Equity growth rate as the best proxy for growth rates we’ve got to go with that 7-10% range, I think. Since ROIC is so strong let’s use 10%. (Note: 10% sounds like a good number to me.)

Since the historical PE is about 20 and if we use 10% growth the default PE is 20, lets use 20!

Current earnings $1.52 growing at 10% with a 20 PE gives us a Future Value of $78 ( a bit higher than your $64 - and yours is the more conservative #. I just don’t know where Morningstar is getting its projection of 7% or I’d use it, too.) Sticker of $20. MOS of $10. (a bit higher than your MOS of $8.).

Stock is selling for $31. Not sure why, but if the analysts are right, the ROI on this one isn’t going to be pretty for today’s buyers at that price.

MY QUESTION FOR PHIL: Buffett defines “intrinsic value” as the present value of all of a company’s future free cash flow. Morningstar says TTM Free Cash Flow for McCormick is $277 million, however the 10 year numbers seem to be all over the place and there does not appear to be a consistent upward trend. Should I use this data in computing the sticker price somehow as a comparison?

Phil’s answer: Sure. Take a look. Morningstar guys aren’t stupid and its interesting. But what does that mean? That its only worth $1.70 per share today? ($227 million / 134 million shares)

6. Mr. Market? The stock recently announced a lower earnings forecast and is hovering near its 52-week low. However, based on the valuation and growth numbers (para 5) it does not seem to be a good enough price. The company should be announcing their earnings on the 28th of September, and the stock could tumble in conjunction with it. It looks to me like Mr. Market has been a bit apprehensive (shares are down 20% this year)– but could the worst be yet to come?

Phil says: Nice call. I agree that there is more bad news. This stock price seems to be way ahead of the business.

7. Yield = Annual EPS/Price = $1.60/$30 = 5.3%. If 7% annual EPS growth, EPS will be $3.14, therefore yield will be $3.14/$30 = 10.4%.
8. What is the history of EPS Growth? EPS has grown 250% in the last ten years. Current EPS estimates for this year are $1.60. Yahoo is saying their year over year quarterly earnings growth are - 0.1%.
9. Return on Equity? TTM ROE 26%. They have had more than 20% return on equity each year since 2000, possibly longer (I couldn’t find the data before 2000 on Morningstar). Overall, shareholder’s equity has increased by 60% in the last ten years.
10. Dividend? Shares pay 16 cents per quarter. This has increased each year for the last 16.

Phil says: I get very nervous about businesses with bouncy numbers that have nice steady dividends. That is designed to mislead investors, in my opinion.

11. Stock repurchase plan? Diluted shares have decreased by 30 million over the past ten years.

Phil says: Considering how overvalued they are, this is a sign that management may not be on our side at all since, if they are buying back overvalued stock they are throwing good money after bad.

12. Debt to equity ratio? .859

Phil says: Oh oh. That’s where they’re getting the money for dividends and stock buy backs. Both are bs in this case.

13. Book value per share is $6.02, so the shares seem to be selling at five times book value.

Phil says: By itself not too revealing. But growth of BV, now that’s a good thing to know.

My Conclusion: Avoid

This company is a wide moat company that is a dominant force in its industry. It is the kind of stock I would buy if I could get it at a good price. However, the industry has a relatively low growth rate (2-3%) and the company seems to be cutting costs and making some changes.

Based on my margin of safety calculation, and my calculated “sticker price” of $15.85, this stock is not worth buying. I will keep an eye on it, though, because it could tumble in the upcoming months if earnings remain below the street’s estimates.

Phil says: Nice job. Excellent conclusion that I agree with.

*** END OF CASE STUDY ***

While I was putting this post together, I came across two opposite takes on McCormick. Kiplingers has written that McCormick’s stock “may be one to add to your cupboard for the long haul.” At the same time, The Motley Fool shuns McCormick, saying “if you’re looking to invest in a spice company, read on.”

Obviously, they both can’t be right.

Very many thanks to Phil Town for taking the time to help mentor me and many others. I can’t wait to get my hands on his book!