Smucker’s (SJM): A Future Dividend Aristocrat Trading at a Historically High Yield

There’s a school of thought popularized by Peter Lynch that investors should “invest in what you know.”

 

In other words, buy companies that make products that you use and understand well.

 

This is one reason why food and beverage companies are popular, especially those that produce household brands that consumers buy on a frequent basis.

 

In addition, food companies are usually defensive, meaning recession-resistant (everyone’s got to eat), and often have strong dividend growth track records thanks to their resilient cash flows.

 

Unfortunately, because of their stability and strong brand values, many of the most well-known food and beverage companies, such as Coca-Cola (KO), and Hormel Foods (HRL), usually trade at a premium, especially in today’s market.

 

Let’s take a look at J.M. Smucker’s (SJM), a well-known blue chip food company who has grown its dividend by 8.3% a year since 1994, and whose valuation is near a multi-year low, to see if might make a reasonable choice for a conservative dividend growth portfolio.

 

Business Overview

Founded in 1897 by Jerome Monroe Smucker in Orrville, Ohio, Smuckers has grown into a leading purveyor of various consumer food products and specialty pet snack foods that can be found in an estimated 93% of US households. The company’s iconic brands include:

 

 

Smucker’s obtains about 93% of its sales in the US and has four main business segments that generate over $7 billion in annual revenue:

 

 

Business Analysis

Smucker’s has done an admirable job of achieving some of the packaged food industry’s best overall growth in the past few years.

 

 

This growth has come from a combination of factors, including maintaining leading market share in its core brands. For example, Smucker’s owns the #1 or #2 brands in segments that make up 75% of its total revenue.

 

Smucker’s is especially strong in mainstream coffee, where Folgers (acquired for $3.8 billion in 2008) leads its nearest competitor by 30% in market share.

 

 

The economies of scale that Smucker’s is able to generate (from low cost supplies and efficient distributions and logistics), combined with a long-term $250 million cost savings program ($140 million of which is expected in 2017), has helped the company obtain above average profitability and a healthy free cash flow margin.

 

Smucker’s Trailing 12-Month Profitability

 

Smuckers has also been consistent with its efforts to adapt to changing consumer preferences. For example, the US coffee market is becoming increasingly dominated by single serve K-cups, which has impacted the company’s coffee volume growth (one reason the stock performed so poorly last year).

 

 

To adapt, Smucker’s has made strategic acquisitions such as its $360 million purchase of Hispanic coffee brands Cafe Pilon and Cafe Bustelo in 2010. The Bustelo acquisition in particular has been a big success, with sales growing 12% a year since 2012.

 

In addition, Smucker’s has been successfully introducing new product categories under its strong brands, which give it an edge on center store shelf space (which is notoriously difficult to obtain). This includes the Uncrustables line of snack products, which has seen 17% annual sales growth over the past 15 years and 12% over the past five years.

 

 

Smucker’s believes that it can more than double uncrustable sales in the coming half decade, which is why it’s building a new dedicated factory in Longmont Colorado, scheduled to come online in 2020.

 

 

This new factory is just part of a larger and more aggressive investment plan, which is boosting the company’s capital expenditures thanks to new categories such as nut butter offerings, snack bars, and plant-based protein products (currently highly in demand).

 

 

Despite the company’s increased capital spending (about 4.4% of sales), Smucker’s is still generating large amounts of free cash flow which is going to paying its dividend, investing in the business (new products and strategic acquisitions), and paying down debt taken on in previous acquisitions.

 

 

Acquisitions have been the largest source of Smucker’s growth historically, with the company having done 24 deals (including one that’s pending) since 1963.

 

Most of these have been highly successful, including the 2008 Folgers deal, which boosted sales by 50%, and the recent Big Heart Pet Brands purchase for a whopping $5.8 billion in 2015, which allowed Smuckers to enter the large and fast-growing premium pet food and pet snack market.

 

This strategic shift demonstrates Smucker’s long-term efforts to adapt its business as pets appear to be a booming industry due to two large trends in America. Specifically, aging boomers are looking for increased companionship as their children leave the home. Meanwhile, Millennials, due to a slower career start thanks to the Great Recession (and record amounts of student loan debt), are waiting to start families, and pets are increasingly popular stand-ins for children.

 

Furthermore, Millennials are increasingly focused on health and natural food products, showing a greater propensity for paying a premium for healthier pet foods. As a result, brand loyalty in the pet food market has shown to be fairly high. For example, private label (store brands) pet food commands 12% of the market, compared to 20% market share in human foods.

 

By acquiring Big Heart, Smucker’s achieved instant market leadership since Milk Bone is the dominant market leader in pet snacks, which is a very high margin business (people are willing to pay a lot to keep their pets happy).

 

 

Smucker’s pet food R&D facility in Orrville, Ohio, is constantly working on new product offerings it can launch to further capitalize on the pet food and snacks industry, including launching new premium biscuits and low calorie pet snacks.

 

The bottom line is that Smucker’s has shown itself to be a thoughtful acquirer and grower of strong consumer brands over the past 120 years, and more importantly for income investors, it’s also been very generous with its dividend growth as well.

 

That being said, as with all packaged food companies, there are several key risks to keep in mind.

 

Key Risks

There are three main risks for almost any food company.

 

The first risk is an increasingly fast pace of change in consumer preferences as spending power gradually shifts from older gen X and boomers to Millennials. Specifically, this means that packaged food companies are struggling with consumers’ increasing preference for fresh foods over packaged offerings.

 

This is making the center of the store (where Smucker’s dominates) highly competitive. Constant innovation and new product launches are required to compete for market share in several market segments that are in decline, such as baked goods and certain oils.

 

In fairness to Smucker’s, evolving consumer tastes and preferences isn’t a new risk to the industry, and the company has proven itself adept at responding to a rapidly evolving consumer market over its 120-year history.

 

However, this brings up another major risk, which is that the way most food companies grow is through acquisitions, a strategy that brings several challenges.

 

The first is the potential to overpay, especially to gain entrance into faster-growing markets, such as pet food.

 

In fact, in 2015 Smucker’s got into a bidding war with Church & Dwight (CHD) over Big Heart, the maker of Meow Mix and Milk Bone. Smucker’s ultimately bought Big Heart for $5.8 billion (including debt assumption) in a deal that included 17.9 million shares of Smuckers and $1.3 billion in cash, most of which was borrowed.

 

While the deal made some strategic sense in that it diversified Smucker’s into a fast-growing and premium market, paying 13 times EBITDA is highly questionable, even assuming management can obtain all $200 million in synergistic cost savings (far from guaranteed), which would lower the multiple to 9.0.

 

In addition, Smucker’s most recent acquisition, a $285 million deal for Wesson Oil, is potentially questionable as well. Wesson Oil is meant to shore up Smucker’s Crisco oil segment; however, the entire oil market is facing declining sales due to an increased consumer focus on healthier foods.

 

The deal is expected to boost sales by $230 million a year (about 3%) and increase adjusted EPS by $0.10 after the first year (about 1.3%), meaning that it’s far from a needle-mover and one that might ultimately prove unwise given the shrinking oil market.

 

In other words, food companies, while defensive, also face real challenges in maintaining and growing market share in their low-growth product categories over time, which is why often the only way to achieve the kind of earnings (and dividend) growth investors expect requires acquisitions that can ultimately hurt shareholders.

 

Another risk faced by smuckers is commodity prices, especially in volatile goods such as coffee. A major component of packaged food earnings growth is cost cutting, but rising commodity prices can easily offset several years of hard earned cost savings over the short-term.

 

Smucker’s Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

 

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

 

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

 

 

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

 

Smucker’s has a Dividend Safety Score of 94, indicating a very safe and dependable dividend. This is what one would expect from a dividend achiever like Smucker’s, which has a good history of steadily rising payouts (20 straight years of dividend increases). In fact, in 2023 Smucker’s is very likely to join the dividend aristocrats list here.

 

The key to Smucker’s solid payout safety safety is management’s conservative approach to growing the dividend at a moderate pace, thus ensuring a low payout ratio which provides the dividend with a strong safety buffer. As you can see below, Smucker’s earnings payout ratio has remained below 40% throughout most of the last decade.

 

 

The other important factor is a strong balance sheet, because a company with too much debt can have a tough time either funding further growth or its payout.

 

At first glance, Smucker’s has a lot of debt, especially relative to its small cash position. However, keep in mind that this is due to the acquisition-heavy nature of the business model, which is why we need to put the debt levels in context with those of its peers.

 

 

When we look at the industry as a whole, we find that while Smucker’s has a slightly higher-than-average leverage ratio (Debt/EBITDA), its overall debt burden is actually lower than average, (debt/capital) and its strong interest coverage ratio give it a solidly investment grade credit rating that allows it to borrow very cheaply (3.1% average interest rate).

 

 

In other words, while Smucker’s does need to deleverage over time (which management is doing), its balance sheet is still strong enough to support ongoing business growth while rewarding investors with a very safe and steadily rising dividend.

 

Smucker’s Dividend Growth

Smucker’s track for dividend growth is both impressive in its duration, and by its steady, high single-digit rate over time.

 

 

Over the long-term, investors can expect the company’s payout to grow in line with earnings and free cash flow, which analysts expect to increase by about 9% annually, assuming continued strong execution by management and plenty of acquisition-fueled growth.

 

However, dividend growth over the short-term seems likely to occur at a somewhat lower pace as Smucker’s works on restoring its balance sheet. In fact, management’s most recent dividend increase in 2017 was only 4%.

 

Valuation

Concerns over relatively flat sales and earnings growth in 2017 and 2018, coupled with the company’s relatively high debt load, have caused Smucker’s shares to underperform the S&P 500 by more than 20% over the past year. As a result, the company’s valuation looks interesting for investors who believe in Smucker’s long-term earnings power and growth potential.

 

For example, SJM’s forward P/E ratio of 15.9 is not only much lower than the S&P 500’s 18.5, but also significantly below the industry median of 19.7 and the stock’s own historical norm of 19.0.

 

More importantly for income investors, Smucker’s dividend yield of 2.5% is above its five-year average yield of 2.2%and remains near one of its highest levels since the financial crisis.

 

 

Smucker’s stock has potential to deliver long-term total returns of about 9.5% to 11.5% (2.5% yield + 7% to 9% annual earnings growth). If the company’s efforts to improve its positioning in competitive, legacy product categories (e.g. coffee, oils) are successful and management continues making timely acquisitions, a double-digit annualized return isn’t out of the question from this likely future dividend aristocrat.

 

Conclusion

While the packaged foods industry is extremely competitive and fraught with numerous needs to adapt to rapidly changing consumer tastes, Smucker’s has proven itself more than up to the task to stay relevant over the past 120 years.

 

With an impressive 20-year track record of annual dividend increases and a very safe payout whose yield is not far from multi-year highs, today could be a reasonable time for investors to give Smucker’s a closer look, assuming one is comfortable with the industry’s overall risk profile and management’s ability to conservatively allocate capital and improve profitability.

 

Investors seeking more yield with equally impressive safety can review some of the top high dividend stocks here.