Smucker's Solid Brands Should Accelerate Growth

We believe

While center-of-store competition is fierce, and we believe Smucker’s brand-based competitive advantage is deteriorating as a result, we still think the company enjoys an intangible asset edge that should leave returns on invested capital (excluding goodwill) around 380 basis points higher than its cost of capital on average over the next five years.

In addition to the market’s overreaction to what appears to be a transitory slide in coffee in the past quarter, we suspect prevailing sentiment does not adequately credit the company’s remaining brand strength, particularly in nut butters, premium at-home coffee, and higher-end pet food.

With its presence in these on-trend categories, Smucker has offset category erosion in some of its legacy businesses. Its sought-after brands and record as a proven supplier make it a valued partner for retailers, providing a platform for distributing new products. However, the company’s intangible asset is threatened by difficult market dynamics in the center of the grocery store, which continues to see brand values erode as competition rises and consumers increasingly favor fresh items.

The 2015 Big Heart Pet Brands acquisition represented a transformational shift in Smucker’s sales mix; the company’s coffee, consumer foods, and pet foods units each account for just under 30% of sales. Big Heart has benefited from customers’ increasing willingness to spend on premium pet products and snacks, driving growth and boosting margins through differentiation. Still, Smucker paid dearly for Big Heart, a 13 times EBITDA level that we believe will be difficult to justify even as the combined entity achieves synergies.

Smucker faces a fast-changing consumer landscape but has leveraged its brands to keep abreast of trends. After struggling in K-Cup coffee sales, Smucker’s introduction of Dunkin’ Donuts-branded pods (sold under license from Dunkin’ Brands) has boosted the company’s share in the sector despite slowing category growth. The Jif brand’s extension into snack bars, other nut butters, and powders has allowed Smucker to capitalize on increasing consumer demand for protein (especially plant-based). Big Heart has used innovation to extend pet snacking into pet care through vitamin and oral care-related treats, creating another avenue for growth. Still, intense center-of-store competition and retailers’ unquenchable thirst for growth have diminished the value of brands across the industry. This, combined with the rapidly evolving consumer palate, will force Smucker to negotiate fast-changing consumer tastes to offset erosion in its legacy brands and keep its privileged position with retailers.

Strong Brand Portfolio Results in Narrow Moat Historical returns on invested capital (excluding goodwill) reflect Smucker's attractive economic positioning, with the three-year historical average (9%) exceeding our 7% weighted average cost of capital estimate. Our five-year forecast corresponds to relatively stable excess returns with an average ROIC of 11%.

Smucker has built a portfolio of top brands in a variety of categories and has the leading share in segments such as coffee (Folgers, Dunkin’ Donuts), nut butters (Jif), shortening and oil (Crisco), and fruit spreads (Smucker’s). Its acquisition of Big Heart made the company the leading maker of dog snacks (Milk-Bone) and dry cat food (Meow Mix). As a result of its leading share positions and the resources it deploys to support its brands, we believe the company is a valued supplier for retailers, supporting the intangible asset source of its narrow moat.

In coffee, the recent expansion of Smucker’s relationship with Dunkin’ Brands through the introduction of Dunkin’ Donuts-branded K-Cups gives Smucker a strong, premium label to invigorate what had been a somewhat disappointing brand portfolio in single-cup coffee. Combined with Smucker’s mainstay roast and ground coffee business (and its strong Dunkin’, Folgers, and Cafe Bustelo brands), the portfolio is comprehensive and has demonstrated staying power. Furthermore, in single-cup coffee, Smucker is well positioned to benefit from any consolidation behind more popular labels as the category matures (the top 15 K-Cup brands drive 85% of sales volume) thanks to the strength of the brand portfolio and Smucker’s strong relationships with retailers that depend on the company for a wide variety of products. The fact that Smucker holds popular brands in the mainstream and premium K-Cup segments makes the company an especially valuable partner for retailers and Keurig, which depends on its partner brand portfolio to spur ongoing single-cup growth. This is exemplified by Smucker’s new arrangement with Keurig, which provides better economics as well as improved support.

The consumer foods business has been able to offset category weakness in fruit spreads and baking by expanding usage occasions for Jif, for example, through the launch of snack bars and different flavored nut butters (peanut butter accounts for around a third of unit sales, up from the mid-20s in 2012). Strong retailer relationships allow the company to quickly gain shelf space for these and other line extensions, allowing Smucker to capitalize on its innovations more quickly than smaller or less comprehensive food manufacturers. Smucker’s rapidly growing Uncrustables frozen sandwich line has especially benefited from this dynamic, with the company able to quickly capitalize on changing flavor trends in a variety of ways, such as new hazelnut varieties in both Jif spreads and Uncrustables. Food service should help build on the company’s consumer relationships, particularly Smucker’s presence in the USDA’s school lunch program with Uncrustables.

We believe Big Heart bolstered Smucker’s moat due to the overall attractiveness of the pet sector and the company’s emphasis on faster-growing subcategories such as premium and snack products. The pet food industry mirrors trends in the consumer food sector, with an increasing focus on natural and health-oriented products and a move toward more frequent snacking. However, the industry is more bifurcated, with product offerings differing significantly between conventional mass retail and specialty pet stores. Smucker’s multichannel approach has insulated its more commodity mainstream business through sales of premium, differentiated products in pet specialty shops. Additionally, the pet food sector features greater brand loyalty as consumers are hesitant to switch away from a product that their pet tolerates. Pets are increasingly treated as family members, particularly among households without children (both older individuals whose children are grown and millennials who are starting families later than their forebears). The loyalty dynamic and demographic trends have combined to limit private-label penetration in pet food to about 12% (versus around 20% private-label penetration for U.S. food and beverage in the aggregate) and have made consumers receptive to innovative products such as Milk-Bone’s brushing chews in dental care and the company’s vitamin treats. Smucker’s brand equity also allows it to market new health products under its trusted labels, expanding usage occasions. The pet acquisition has strengthened Smucker’s brand equity companywide, as the expanded product scope makes the company a more valued partner for mainstream grocery retailers whose customers demand products from Smucker’s consumer and pet portfolio. We think the company’s recent introduction of natural pet foods into the grocery channel furthers this improvement.

Smucker’s scale allows the company to spread its distribution, marketing, and management expenditures over a large base while giving the company buying power against competitors when it contracts with farmers. While we are skeptical that the Big Heart acquisition will provide meaningful procurement cost benefits due to the commodity nature of many key inputs (particularly grain), the company should still generate operating leverage as the acquisition is integrated and as the overall enterprise grows. That said, we believe these favorable dynamics are not so significant as to merit granting Smucker a cost advantage-based moat, as they could be overcome by other large-scale competitors or innovative small companies that can extract a premium for differentiation.

Competition, Consumers, and Commodities Are Risks Unfavorable center-of-store dynamics are especially salient for Smucker, though we believe conditions are relatively more favorable in coffee and pet food. Greater reliance on K-Cups, which see a less loyal customer base than mainstream, and the emerging premium and snack segments in pet food increase Smucker's dependence on unsettled categories where consumer habits are fluid and innovative new players can capture consumers' attention. Staying relevant is increasingly challenging in light of the influx of new products and grocers' need to find shelf space for growth drivers.

The pace of change is driven by a market bifurcated between traditional buyers and millennials who seek more authentic, natural, and differentiated culinary experiences. As the latter cohort’s buying power increases, Smucker will need to rely on new products to offset losses in legacy brands, such as fruit spreads, where it leads a shrinking category. The company will also have to invest to keep abreast of distribution changes, with online sales playing a larger role. While Smucker has the resources to keep pace, the emergence of a new era in food challenges incumbents to adapt products and go-to-market practices.

While the pet acquisition diversified Smucker’s raw materials exposure somewhat and the segment shows above-inflation pricing power, the company is still subject to commodity cost volatility, particularly in coffee. Supply pricing volatility can derail innovation and limit differentiation opportunities if customers trade down, while increasing processing costs as demand fluctuations reduce plant efficiency.

Our forecasts assume U.S. corporate tax reform will benefit Smucker starting in calendar 2018; deviation from our expectations (which call for a mid-single-digit reduction in the company’s effective tax rate) could lead performance astray.

After years of a conservative approach to leverage, Smucker significantly increased indebtedness to finance the Big Heart acquisition. The company has said it will aggressively reduce leverage in the near to medium term, spending 40%-45% of cash flow from operations on debt retirement over the next five years. The company plans to continue to pay 40%-45% of adjusted earnings as dividends, which we believe cash flows will be more than adequate to support, despite debt payments (we assume 45% of prior-year adjusted earnings). Even after the post-acquisition leverage increase, we expect adjusted EBITDA to cover interest expense a healthy 10 times in fiscal 2018.