McCormick &, Incorporated Management Discusses Q4 2012 Results – Earnings … – Seeking Alpha

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Alexia Howard of Sanford Bernstein.

Alexia Howard – Sanford C. Bernstein & Co., LLC., Research Division

Can I ask about the consumer takeaway dates in the U.S.? It looks as though the volumes have fallen off a bit in the recent months. And it’s kind of hard for us to tell how much of this is supply chain related or the timing of the Nielsen cutoff dates or maybe Hurricane Sandy and so on. Maybe you could just go through how much these supply chain issues affected the Americas, maybe both consumer and industrial volumes this last quarter. And then, as we look out to 2013, how confident are you in the volume outlook in the North American Consumer business given that consumer takeaway dates that we’re seeing?

Alan D. Wilson

Yes, a couple of things, Alexia. The Nielsen data cutoff, I think, on the 22nd or 23rd, so — I think it was 22nd. So we missed 2 pretty important days of sales for our products. And as we look at the more longer-term based on IRI, which is what we measure, we saw a pretty good recovery, and we’re encouraged by what we saw in consumer takeaway in the Thanksgiving and Christmas holiday periods for our products. So that’s part of the reason why we are displaying more confidence in our outlook in the U.S. business. We think there may be some impact, but not a lot of impact of actual consumer takeaway in — from Hurricane Sandy. There’s certainly an area of the country that is extremely important for us, where we have very high shares, was impacted but we think the bigger impact was on our supply chain in the quarter.

Alexia Howard – Sanford C. Bernstein & Co., LLC., Research Division

Okay. And then maybe as a follow-up. There were a number of mentions at the negative mix effect this quarter, and I’m thinking more globally now. I’m trying to get a sense for the company-wide margin outlook as you continue to push for growth in the emerging markets. So I mean, have you got to a point where you’re profitable in places like the Middle East and Africa or China on the Consumer business, for example? And if you’re not at a level of profitability there yet, how are you managing that transition as you really balance growth in emerging markets versus profitability?

Gordon M. Stetz

Alexia, this is Gordon. We are profitable in those markets. The particular issue within the fourth quarter that we were pointing to relates to the relative mix of the business of the U.S. versus those foreign markets. And given the skewing of our results and the importance of the holiday period within the fourth quarter to the extent the U.S. market doesn’t perform to the expectations that we have had, that can have negative relative mix on both the gross and operating margin lines. So that’s the near-term impact that we saw within the quarter. On a longer-term basis, we fully expect the Americas businesses to continue to grow. We’ve talked about the Americas margin structure being a strong line as it is, so our desires for that business to continue to grow over time. And the emerging markets, as we gain scale and share and expand our presence there, we would expect those to start to approximate overall corporate margins as well. And the margin story really does differ by which emerging market we talk about. We’ve been in certain areas for quite some time, China in particular. That would be a better relative margin to, say, India where we’re still establishing an infrastructure and then versus Poland, where we have an established business there that’s being integrated into the European team, where they have margins comparable to the overall company structure.

Operator

Our next question comes from the line of Thilo Wrede of Jefferies.

Thilo Wrede – Jefferies & Company, Inc., Research Division

Gordon, you indicated that the Wuhan acquisition could add about 1 point of incremental sales growth. That’s not included in your guidance right now. Is there any reason to assume that the income benefit would be at similar range?

Gordon M. Stetz

It’s more than likely would be flat to slightly dilutive, and that’s primarily a function of the transaction cost that we would expense at the time we close the transaction, which we’ve indicated previously are about $4 million.

Thilo Wrede – Jefferies & Company, Inc., Research Division

Okay, fair enough. And then the China Industrial business, what impact do you expect from the troubles that Yama’s [ph] having in China or just had in China?

Alan D. Wilson

Well, certainly, when our customers in China are not growing their sales, it does impact us in a couple of ways, and we’re not giving the specifics on a particular customer. I think our larger customers there, our quick service customers, have reported challenges in their current sales as a result to this chicken issue. Most of it, the quick service business there is chicken, although we do a lot of other kinds of things like dessert toppings and drink mixes. But if their traffic’s down, then our sales are under some level of pressure.

Thilo Wrede – Jefferies & Company, Inc., Research Division

Do you see a corresponding uptick in your Consumer business then if Chinese consumers don’t go to quick service?

Alan D. Wilson

Our Consumer business grew very strong in China through the year, and we’ve continued with that momentum.

Thilo Wrede – Jefferies & Company, Inc., Research Division

Okay. And then last question I had is for the Industrial business overall, is the target still to get to about 10% EBIT margin and kind of what’s the time frame you’re looking at right now?

Gordon M. Stetz

Well, what obviously impacts that and many of you heard us talked about this is the material cost environment to the extent it’s inflationary, which is what we have seen through to — from 2011 to 2012. Our pricing mechanisms are pass-throughs as we’ve talked about, and those pass-throughs do not allow for a margin expansion. In fact, it’s passing dollar for dollar through on the raw material cost and actually has margin — gross margin points compression on it. So what we point to in those periods is year-on-year operating income growth. We’ve seen consistent year-on-year operating income growth out of that Industrial business, and we’ve seen margins stuck pretty much in that 7.5% to 8% range. So underneath this period of cost inflation, there actually is margin improvement. But in terms of the timing of when we continue to believe we can get to that, say, 8% to 10% range is going to be very much a function of the cost outlook.

Operator

Our next question comes from the line of Akshay Jagdale of KeyBanc Capital Markets.

Akshay S. Jagdale – KeyBanc Capital Markets Inc., Research Division

My first question is on gross margins. You’ve talked a lot about mix. So based on your comments, my interpretation is that because of the softness in the Americas business, your gross margins came in below even your plans. So if I’m wrong on that, please correct me. But my broader question on gross margins is your long-term goal has been to increase gross margins, I believe, roughly by 50 basis points every year. You’ve had now 2 or 3 years of — 2 years, at least, of significant margin compression, and now commodity cost seemed to be easing. So at some point, shouldn’t we start to see gross margins increase higher than the 50% rate that you typically expect? And if you can give us the answer, so when that might happen, that’s my first question.

Gordon M. Stetz

Akshay, this is Gordon. Your first assumption is correct. The gross margin impact was very much a function of the geographic mix of the business, as we’ve said in the call that, and that’s the primarily, the Americas region softness we pointed to. As we have indicated in the call, we expect — because of a more benign environment, improvement in our gross margin this year, and that follows 2 years of material cost inflation, which we’ve had that compression on now. In those periods of material cost inflation, we want to make sure that we’re still able to deliver operating income dollar growth, and certainly our teams primarily in the industrial group but also in the consumer group have been focused on delivering those operating income growth targets. It’s difficult to give you an exact time frame as to where we will be on the gross profit margin in the long term. I can tell you in a benign environment, we would expect this nice steady improvement that we had seen over time, and that would be a function of the Consumer business growth outpacing the Industrial business growth. Our Industrial business margin structure is getting better through their CCI and portfolio mix, and that’s still the strategy that we have adhered to.

Akshay S. Jagdale – KeyBanc Capital Markets Inc., Research Division

Okay, great. And just one follow-up on the pension expense issues. So it’s a little bit hard to judge that from an analyst perspective. So I mean, it’s been a bit frustrating because your underlying performance has been very solid. So to glean into that, I’m trying to understand, I mean, when you set your management compensation plans, are you excluding those type of issues as onetime? I mean, I’m just trying to understand, I mean, if the interest rate environment reverses, how would you deal with some positive tailwinds from this type of item?

Alan D. Wilson

Just — our philosophy is that we’re all in. So when we have a negative like we did in 2012, we take the hit on that. When we have a negative like we expect in 2013, we’ve got to figure out how to overcome it from a compensation standpoint. And when it’s positive, we expect that there will be some level of benefit to our growth rate. Obviously, every year is unique as we set our compensation plans, so we will adjust targets and goals based on that. But our basic philosophy is we’re all in and we’re measuring ourselves against top-tier performance.

Operator

Our next question comes from the line of Chris Growe of Stifel, Nicolaus.

Christopher R. Growe – Stifel, Nicolaus & Co., Inc., Research Division

I just had 2 questions for you. The first one I want to be clear on was in your discussion with — to Alexia’s question about product — or about mix. I want to make sure I also understood the product mix within businesses. I’m not sure if you were addressing that, if you’re addressing the business mix between industrial and consumer. Can you speak to the product mix within each division, and how that was a factor? In particular, it sounds like it was a negative industrial in the quarter.

Gordon M. Stetz

Yes, on the consumer side, it was mostly the volume issue as it relates to the entire portfolio mix in the Americas softness. But within the industrial business, I would agree that we did have some negative mix, in particular, in the U.S. Industrial business within the quarter.

Christopher R. Growe – Stifel, Nicolaus & Co., Inc., Research Division

And that would be related to weaker QSR performance? Is that the main factor there?

Gordon M. Stetz

Yes, that’s certainly a part of it,yes.

Christopher R. Growe – Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then I want to ask just a bigger picture question about, I guess, the cash flow but more importantly like how you expect to use the cash in 2013? You got some share repurchase authorization available. And I guess, along those lines, can you also talk about maybe acquisition pipeline and how that — it looks for the company from here?

Alan D. Wilson

Yes, I’d say, as always our priorities on the use of cash are dividend is extremely important. Acquisitions, because we believe investing in growth is important. We have some CapEx as we’re expanding our facilities in China and Poland specifically, and investing in a new flavor technology in the U.S., which we’re very keen on, and we think we’ll have a positive impact long term on margins in that business. But we have room as we do acquisitions for cash repurchases with, at least, the Wuhan acquisition that we have on the table right now, we’ll continue to buy back shares. We are always on the market. We see some level of activity. I would say it’s not as robust as we’ve seen in some years, but we still have — we have some good targets and continued conversations at expanding our footprint.

Gordon M. Stetz

Chris, I would just add that’s given where we are with our targeted debt level and the amount of cash we generate, depending on the acquisition size, we’ve historically been able to do both share repurchase and acquisitions, and that’s our intention as we go into this year.

Operator

Our next question comes from the line of Rob Dickerson of Consumer Edge Research.

Robert Dickerson – Consumer Edge Research, LLC

I guess, first question is just I’ve heard you say, I guess, on the Q3 call and also this morning that overall you would expect that consumers would increasingly become a little bit more comfortable spending on flavors because it’s such an attractive category, and flavor matters at current prices. But then, at the same time, it seems like your couponing and retail takeaway in the IRI data, which if it includes the full holiday, does seem to improve a little bit on the margin and volume, part of that could be from the increased couponing. So I’m just curious, I guess, what studies, one, have you done not on flavor being a great category, but on consumers willing to pay current prices for that flavor; and then two, if the couponing seems to be working, would there be a point such that you would consider lowering your pricing to actually get volume growth?

Alan D. Wilson

Thanks. We do a tremendous amount of work on price elasticity. And we have, as we’ve gone in this aggressive pricing environment, as I said on the call, we’ve had about a 45% increase in commodity cost over the last 4 years and have taken about 25% pricing and we’ve taken a number of different actions along the way, and we are always evaluating the impact of that on volume. The consumer is looking at 2 things. One is we’re a fairly low-frequency purchase, and there has traditionally been less price sensitivity on some of our items than there is in a number of other categories. All that said, though, on the shelf, when you’ve got a range of price points ranging everything from $1 up to about $8 in gourmet, we want to get the promoted price right when the consumer is there to buy. Our business is largely a base business, which means that a small percentage is sold on promotion. But as we get into some of these key periods, we want to make sure that we’re incenting customers to buy our brand and not let them have a reason to walk away. Coupons are always a part of our mix, as our price promotions at certain times of the year, that really hasn’t changed. We did view that we needed to make sure that we were driving positive volume consumption in the fourth quarter, and so we shifted some of our spending and we’ll keep evaluating what the right mix to get to consumers are. We’ve taken some price reductions on shelf on a couple of key items that we talked about like vanilla and grinders, and we’re measuring the impact of that. We think it’s — the results have been generally positive in terms of that, and we’ll continue to evaluate certain items to get to the right price points. And this — and by the way, what we have seen as our pricing has gone up, we have seen those price gaps close now as competition, largely private label, has also taken place increases to either catch up or improve their margins. So we’re seeing that situation moderate a bit. All that, we — it’s fairly complex because of a number of items and we’ve got different elasticities with different items. So we may be trying to be sharper on things like dry seasoning mixes and evaluating what we do on certain spice items, but we do a tremendous amount of work in really understanding that dynamic.

Operator

Our next question comes from the line of Robert Moskow of Crédit Suisse Group.

Robert Moskow – Crédit Suisse AG, Research Division

I think you’re not the only food company or CPG company that’s kind of entered the year thinking that they could increase brand marketing and then have to adjust that expectation down, but I wanted to get to a final number for you for the year. Were you still up about $10 million in terms of increasing your brand marketing for the year, and — I’ll leave it at that.

Gordon M. Stetz

Yes, Rob. We were up $11 million and a significant portion of that was also up in the advertising. So we were up year-over-year. We also — as mentioned, we had a significant portion in digital that we’re spending behind. So yes, we were up.

Robert Moskow – Crédit Suisse AG, Research Division

And was that kind of in line with sales growth, or was it kind of below sales growth? And how would we compare that to your guidance for 2013, which is to be in line with sales growth?

Gordon M. Stetz

It was just ever so slightly below sales growth if we do the math.

Operator

The next question comes from the line of Andrew Lazar of Barclays Capital.

Andrew Lazar – Barclays Capital, Research Division

With respect to some of your comments about industrial sales in the Americas, I think, you were — and actually the organic side of that were actually pretty good, and I think you said it was driven by increased sales of branded products to food service as opposed to the QSR. So that’s fairly consistent, I think, with some of your comments in the third quarter where you said you were a bit more optimistic that as pricing was starting to wane, volumes for the — just the branded sort of packaged food companies, many of which you supply, were starting to improve a bit. So I was hoping to get a bit of an update from you on just kind of how you see the landscape around the branded packaged food guys and if that trend has continued in a way that keeps you somewhat maybe cautiously optimistic from an industry standpoint.

Alan D. Wilson

Yes, we’re encouraged by what we’re seeing in that part of the business. Obviously, different companies have different philosophies and challenges. I’d say the one thing that we didn’t see as we went into last year is the amount of actual new product launches that we’d typically expect to see. A lot of our customers are going through restructurings and have focused on some level of reorganization. We do see a pretty strong pipeline of new product activity among the consumer food customers that we have, that does encourages as we go into the second half of the year.

Andrew Lazar – Barclays Capital, Research Division

Got it. Okay, that’s helpful. And then, I know that from time to time, not just in your business, but in others, there can be these quarter-to-quarter shifts in kind of inventory management in key customers, particularly, in the ends of key retailers fiscal years, and we’ve seen that from time to time. Is — I guess, I’m trying to get a sense of how your capabilities or systems allows you to have some visibility to what your inventories are at the customer level. Has your ability or capabilities there changed at all in the last couple of years to where you have a better sense of how that tracks, because it still seems like a lot of companies in this space get blindsided every so often by some of these shifts? And admittedly, maybe that’s just the reality of the customer shifting things kind of quickly in a given period that you can’t read. But I’m trying to get a sense of what your level of visibility is to that.

Alan D. Wilson

Yes, we have a level of visibility to about half our U.S. volume because of things like vendor managed inventory or data that we can purchase to evaluate consumption versus their factory sales. So we have that level of visibility. It doesn’t — even in the case of our BMI customers, though, it doesn’t change the fact that they decide on a short term that they’re going to aggressively manage inventory that, that won’t happen. I would say we did miss this a bit in terms of laying out what we thought was going to happen relative to prior periods because of the amount of pricing that we’ve taken. I’d say there’s probably a little bit of an underlying caution by a number of our customers because of some softness in December and January of last year. Now we’re seeing the volumes pick up, so we’re encouraged by that. But I think, in terms of their inventory management, there was a level of caution around what they thought they needed to bring in, in that period.

Andrew Lazar – Barclays Capital, Research Division

Got it. And I think Gordon said that you felt like separate from the supply chain issues from Sandy, that these issues, as well around the inventory side seem like they’re pretty well behind you, or is some of that bleed into the first quarter, I wasn’t clear on that piece.

Gordon M. Stetz

No. We think it’s — just based on what we’ve seen so far since we closed the year, we’re cautiously optimistic and encouraged by what we’re seeing in the U.S. business.

Operator

[Operator Instructions] Our next question comes from the line of Eric Katzman of Deutsche Bank.

Eric R. Katzman – Deutsche Bank AG, Research Division

Still a couple of questions. I guess, first, Gordon, a number of companies have changed their pension accounting and have offset having to take a pension expense hit. Obviously, yours is pretty significant. Did you look into that, and why didn’t you use this mark-to-market methodology or maybe Hershey’s IFRS approach to offset some of this $22 million in expense?

Gordon M. Stetz

Our philosophy, Eric, has been to disclose the amount, the underlying economics whether — based on whatever accounting you’re using doesn’t really change. So from our standpoint, we felt certainly it’s important for our investment community to know what the amount is and for you to evaluate the impact to us. We’ve given you the cash impact associated with some of the funding as well, but we do look at those things. However, we finally landed that the best way to disclose this was purely to give you the amount that was the impact. And as Alan said, we’re challenged as a management team to overcome this and move on.

Eric R. Katzman – Deutsche Bank AG, Research Division

Okay. And then, I guess, on Slide 15, maybe you answered this question, but you — Alan, you talked about retail price points. And maybe you could expand on that a little bit. I don’t recall for a long time you talking about retail price points. I assume you mean sharpening those to drive consumption higher because you weren’t talking about higher pricing in the business. So…

Alan D. Wilson

No, there’s a couple of initiatives. One is making sure we got the right prices on items that are price sensitive. So things like dry seasoning mixes and pepper and vanilla and that sort of thing, and so we’ve got some initiatives on that. We’re not talking about higher prices. We’re talking generally about how we apply our promotion funds to make sure we’re hitting the items that are really volume — that are really price sensitive.

Eric R. Katzman – Deutsche Bank AG, Research Division

Okay. And then, last question back to Gordon. You — right, the pension expenses noncash, although, you are making a contribution. I guess, you have your tax rate going up, and I’m not really sure what that means for actual cash taxes paid. But I guess, my point is if EBIT is up 6% to 8%, and excluding the pension expense, it’s up close to 10%, and then you’ve also got the JV income up 10%. Is your free cash flow in fiscal ’13 up double digit, especially, if inflation and working capital aren’t much of a challenge?

Gordon M. Stetz

We have a specific number out there, Eric, but I don’t disagree with your math and that certainly could be an outcome as we progress through the year.

Alan D. Wilson

Yes, we do expect a year of strong cash flow, and built into that assumption is that commodity costs are fairly moderate.

Operator

Our next question comes from the line of Ann Gurkin of Davenport & Company.

Ann H. Gurkin – Davenport & Company, LLC, Research Division

I have 2 questions. One, you’ve commented about the outlook for the Industrial business in the first quarter, but can I get some more detail on your outlook for the overall QSR segment of your business for the year, and as the year progresses the outlook for that QSR segment?

Alan D. Wilson

We think it’s going to be fairly challenged. We have some positives in certain markets. And then, as we get into the back half of the year, some easier comparisons. But we do think through the year that, that — and I’m following our customers’ releases as closely as — probably closer than you are because they really impact us. But I would say that we think that it’s going to be fairly challenged.

Ann H. Gurkin – Davenport & Company, LLC, Research Division

Great. And then, Alan, in Australia, can you comment on the environment and how you’re approaching the consolidating retailer environment and your strategy to address that changing marketplace?

Alan D. Wilson

Yes. Australia has been a tough market for McCormick. As you all know, we’re not the brand leader there, and so what we have done is we kind of use this as a laboratory in terms of how a second place supplier challenges a market leader. And so we’ve been pretty innovative with new products. We’ve been very targeted on the kinds of things that we’re doing and — outside our core spice and seasoning line, and we’ve seen some pretty positive results over the last 2 years as we’ve done that, but it is a challenging market.

Operator

Our next question comes from the line of Erin Lash of Morningstar.

Erin Swanson Lash – Morningstar Inc., Research Division

I apologize if I missed this, but I was curious, the fourth quarter tends to be a quarter where there’s more of a — branded sales are more emphasized just because of the holiday cooking season and that sort of things. So I was wondering if you could comment between the mix of branded versus private label sales, if there was an increase in private label sales relative to branded in the fourth quarter?

Alan D. Wilson

I don’t have the actual comparative data between branded and private label in the fourth quarter, but typically we do see an increase in branded shares for a couple of reasons. One is consumers are less willing to take chances on their meals. The second is private label is pretty prevalent in really popular items, but a lot of the items that are purchased at the holiday like nutmeg and pumpkin pie spice and apple pie spice and things like that aren’t necessarily replicated in private label because they are onetime purchase. So I’m afraid I don’t have the data specific to private label in this period on these items in front of me, but typically what we’ve seen is our branded shares were at the highest in the fourth quarter of the year. I would expect they still are.

Erin Swanson Lash – Morningstar Inc., Research Division

All right. That’s helpful. And then just one other question. When — with the retailer inventory adjustments that were occurring in the quarter that you just discussed, was that concentrated in any one channel, or was that across all channels?

Alan D. Wilson

It was pretty concentrated with a limited number of customers.

Operator

Our final question of the day comes from the line of Leigh Ferst of Wellington Shields & Co.

Leigh Ferst – Wellington Shields & Co., LLC, Research Division

I was wondering if you could comment on your digital marketing spending of 12%. Give us some background on how you spent that in different categories and geographies, and how you’re evaluating the impact of that.

Alan D. Wilson

Sure. Our focus is in a couple of areas. The main spending is in our larger consumer markets like the U.S. and EMEA, and we’re doing a number of things everything from digital recipes to promotions that we work with on search to really target where consumers are at — on their mobile phones. So as they’re searching for things like chicken, we’re working with the retailers on driving specific purchases of specific McCormick items to a retailer, and we’re seeing some really great results with that. As we continue to expand, we have some technologies, which allow for individual flavor selection, and we’ve been talking to a number of retailers around tying that to their programs. But we’re very encouraged by what we’re seeing in terms of returns, how consumers are responding. The digital consumer is a very engaged consumer, and so it’s one that increasingly we’re reaching out to.

Leigh Ferst – Wellington Shields & Co., LLC, Research Division

And on your CCI, is there any evolution or change in the focus of the spending this year or in the savings this year?

Alan D. Wilson

I wouldn’t say specifically. I think, it’s been a pretty balanced approach to everything from SG&A to productivity in our manufacturing plants, as well as looking at saving within our procurement channels. So it’s pretty balanced, and I don’t expect that, that’s going to change. We’re not going to be heavier this year in one versus the other, different than we’ve been in the past.

Operator

At this time, I would like to turn the floor back over to management for any concluding remarks.

Alan D. Wilson

Thanks for your questions and for participating in the call today. We do believe interesting flavor continues to grow, and McCormick is well positioned to meet this through our growth initiative, our increased global presence and our passion for flavor. While today’s environment remains challenging, we’re staying close to the market, we’re going to be agile, and we’re going to adapt our business to drive sales and profit. McCormick’s leaders and all its employees are committed to building shareholder values. So thank you very much.

Joyce L. Brooks

Thanks, Alan. I’d like to add my thank you to those that participated on today’s call. Through January 31, you may access the telephone replay of the call by dialing (877) 660-6853. The conference ID number is 403908. You can also listen to a replay on our website later today. If anyone has additional questions regarding today’s information, I would welcome your call at (410) 771-7244. This concludes this morning’s conference.