Contents
Summary
- SJM is a company undergoing a transformation. Short-term results can, therefore, occasionally fall short of projections.
- Other well known names in the Consumer Goods, Processed and Packaged Goods space have performed poorly over the past year.
- SJM is attractively valued. Its forward adjusted PE has not been this low since the Financial Crisis.
- I am employing a conservative option strategy to generate additional income while I wait for SJM’s stock price to recover.
- While attractively valued I suggest you pass on SJM.
Introduction
In previous The J.M. Smucker Company (NYSE: SJM) articles (August 21, 2018) and (August 22, 2018) I indicated I was employing the use of a short-term out of the money covered call option strategy to generate some additional income. The option contracts discussed in those articles all expired worthless which means I retained the option premium and the underlying shares.
To date this option strategy has generated a few thousand dollars in option premium which has helped offset the decline in the value of the underlying shares held in the FFJ Portfolio.
On November 15 I once again employed a covered call option strategy to generate additional income and wrote about it here.
Today (November 28), SJM released its Q2 and YTD results. These results were not well received and SJM shares took another hit. In this article I discuss the option transactions I initiated subsequent to the announcement of the Q2 results.
SJM is certainly not alone when it comes to name brand Consumer Goods (Processed and Packaged Goods) companies whose stock price has been under pressure. One look at the stock charts for the following companies in this space will attest to this.
- General Mills (GIS)
- ConAgra (CAG)
- Campbell Soup (CPB)
- The Kraft Heinz Company (KHC)
- Kellogg Company (K)
Being a relatively patient investor with a long-term outlook I am not about to liquidate my SJM position. I will, however, continue to employ my conservative option strategy which provides me with the opportunity to generate additional income/cash flow while I wait for business conditions to improve.
Warren Buffett on Branded Packaged Goods Companies
Toward the end of a recent interview, Warren Buffett made a comment that branded packaged goods are a very good business in terms of return on tangible assets. They are not, however, a sensational business in terms of where you can be 5 – 10 years from now.
This is certainly an interesting comment given that Berkshire Hathaway has such a large stake in KHC.
Source: Dataroma
Q2 and YTD Financial Results
SJM’s November 28th Earnings Results and Earnings Presentation can be accessed here. It is important to remember that Q2 and 6 months results include the contribution from Ainsworth Pet Nutrition, LLC which was acquired on May 14, 2018 and reflect the divestiture of SJM’s U.S. baking business on August 31, 2018.
Lower pricing and competitive activity across SJM’s broader coffee business impacted sales performance for the Folgers and Dunkin' Donuts brands.
On the pet food front, the Meow Mix brand grew 8% but this growth was offset by the planned discontinuation of certain Gravy Train products and weakness for Natural Balance in the pet specialty channel.
Gross margin dropped 170 bps for the first half of the year relative to FY2017. Adjusted operating income (non GAAP) increased 8% but on a GAAP basis, operating income actually dropped 120 bps.
On a positive note, cash provided from operating activities for the first 6 months of FY2019 amounted to $445.9 million versus $434.6 million over the same timeframe in the prior fiscal year.
In Q2, SJM repaid $140 million of short-term borrowings and $300 million was applied toward long-term debt; proceeds for this repayment came from proceeds received from the sale of the U.S. baking business and cash provided by operating activities.
Each segment’s profit margin improved versus prior year with the exception of the U.S. Retail Pet Foods segment where profit margin dropped 520 bps versus the prior year period. This was due to higher raw material and freight costs.
I like the Days Sales Outstanding and Days Inventory trends. I note the Payables Period has increased by more than 10 days since FY2014 which is great if you are SJM. I question to what extent SJM can stretch its payables even longer before suppliers push back. Please refer to the Efficiency Ratios tab under Key Ratios.
Source: Morningstar
2019 Guidance
Guidance on some line items has been revised lower. The reasoning for the changes can be found on page 3 of SJM’s Q2 Earnings Release.
On the November 28th conference call with analysts, management indicated that the downward revision is its sales forecast is primarily due to competitive activity in coffee; lower green costs are being passed through to consumers.
There has also been incremental promotional spend in peanut butter and fruit spreads and on the pet food front. There has been a shift in timing of shelf reset at key retailers which has resulted in a slight delay in the benefit of innovation launches.
In a nutshell, adjusted EPS guidance reflects the impact of the revised sales forecast, a higher tax rate related to the baking divestiture, freight costs, unplanned legal expenses, and a shift in timing of synergy realization.
SJM views e-commerce as a key opportunity for growth and has indicated it is of the opinion it has strategic advantages in that coffee and pet food are two of the fastest growing online categories; these two categories drove a 40% increase in SJM’s e-commerce sales in Q2.
Over 33% of SJM’s pet food and ~25% of SJM’s coffee online sales are on a subscription basis. Further growth is anticipated.
On the Free Cash Flow front, the reduction in the projected range reflects income taxes associated with the recent divestiture and a decrease in earnings guidance. This is partially offset by working capital benefit. CAPEX projections remain unchanged.
Source: SJM – Q2 FY2019 Earnings Supplementary Information – November 28 2018
Credit Ratings
Moody’s continues to rate SJM’s long-term unsecured debt Baa2 (middle tier of the lower medium grade category). S&P Global continues to rate it BBB (the middle tier of the lower medium grade category); this is one tier lower than Moody’s rating. Neither rating is under review.
Valuation
At the time of my August 21st article, projected FY2019 adjusted EPS was in the range of $8.40 - $8.65. With SJM trading at ~$109.50 I arrived at a forward adjust PE range of ~12.66 - ~13.04. I indicated at the time that since SJM is undergoing a significant transformation I was reluctant to compare this forward PE range with SJM’s 5 year historical PE of ~24.
SJM’s projected FY2019 adjusted EPS range has now been lowered to of $8.00 - $8.20. With SJM now trading at ~$101, the forward adjusted PE is in the range of 12.32 – 12.63.
Clearly, the investment community s not happy with SJM and this has resulted in the deterioration of SJM’s forward valuation. This valuation is even lower than the valuation in 2008 at which time we were experiencing a Financial Crisis!
Dividend and Dividend Yield
SJM’s dividend history can be found here.
I do not see a risk with SJM continuing to distribute its $0.85 quarterly dividend ($3.40/annually).
Based on the current $101.28 stock price, investors are receiving a ~3.36% dividend yield. The ~24% drop from SJM’s 52 week high stock price has resulted in SJM’s dividend yield being well above its historical norm which is sub 2.5%.
Option Strategy
While I patiently wait for SJM to turn around its performance I am employing the use of a conservative covered call option strategy to extract additional income from my SJM holdings.
I provided links earlier in this article to previous articles in which I covered the option contracts into which I had entered.
In my November 15th article I indicated I wrote 4 December 21 2018 $125 covered calls (refer this article) for which I received $445 net of commission.
Subsequent to the release of SJM’s Q2 results on November 28, SJM’s stock price tanked. I, therefore, took the opportunity to close out my 4 December 21 2018 $125 covered calls at a cost of ~$34 ($0.05/share plus commission).
I then turned around and wrote 4 January 18 2019 $110 covered calls for which I received ~$330 ($0.90/share minus commission).
I do not envision SJM’s stock price rising to the $110 level by expiry but should SJM approach this strike price I will likely close out my position and write new later dated contracts.
My game plan continues to be to write short duration covered calls to generate additional income which can then be deployed to acquire shares in attractively valued companies.
Final Thoughts
The title of this article includes the term ‘patience’ which is what I typically employ with all my investments. I just think I might require a bit more than the norm when it comes to SJM.
In hindsight the funds used to invest in SJM should have been allocated to Mastercard (MA) or Microsoft (MSFT); I invested in these two companies right around the same time as I initiated my SJM position in mid 2017.
I fully recognize an argument can be made for me to take my SJM hit and to move on. I do not, however, invest for the short-term and bail when companies fall short of projections.
In my August 21st article I indicated that I hoped to generate ~$6,000/year in option income and ~$1,390/year in dividend income. If I can generate this on my initial ~$49,250 investment I would be generating a ~15% annual return. I don’t think this is entirely unrealistic but at the same time I recognize that option income is far more unpredictable than dividend income. The plan at this stage, however, is to continue to employ the conservative option strategy described in this article when deemed appropriate.
Before you find yourself in my predicament I suggest you heed Warren Buffett’s advice (see interview for which I provided a link earlier in this article). In my opinion, the funds you might want to invest in SJM could very likely be put to far greater use by investing in such companies as Visa (V), MA or MSFT.
I hope you enjoyed this post and I wish you much success on your journey to financial freedom.
Thanks for reading!
Note: I sincerely appreciate the time you took to read this article. Please send any feedback, corrections, or questions to [email protected].
Disclaimer: I have no knowledge of your individual circumstances and am not providing individualized advice or recommendations. I encourage you not to make any investment decision without conducting your own research and due diligence. You should also consult your financial advisor about your specific situation.
Disclosure: I am long SJM, V, MA, and MSFT.
I wrote this article myself and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.
