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Despite Pullback, Smucker Still Overvalued

The narrow-moat food maker's U.S. pet foods unit nicked results last quarter.

We do not plan to significantly alter our $107 per share valuation for narrow-moat Smucker (SJM) after soft first-quarter results that lend credence to our suspicions of the firm’s ability to justify the high price it paid for its pet food unit (13 times EBITDA, or $5.8 billion, in 2015). Though we intend to reduce our near-term targets slightly, our long-term outlook (3.1% sales growth and 17.8% adjusted operating margin, on average, over the next decade) is largely intact. We still believe our less optimistic take on the firm’s ability to weather rising center-store competition amid normalizing input costs is at the heart of the gap between our valuation and prevailing trading.

Smucker’s volatile U.S. Retail Pet Foods unit (29% of fiscal 2016 sales) posted a 6% quarterly sales decline, lagging as the rest of the firm mostly met expectations. Although mainstream brands drove much of the shortfall and account for almost half of segment sales, Smucker’s Natural Balance premium label also posted a double-digit pullback, and while some of the impact was due to a fiscal 2016 distribution gain, results were also hit by weakness in the pet superstore channel.

While we support Smucker’s efforts to premiumize pet food by introducing functional snacks and capitalizing on trends favoring natural and protein-rich items, the investments needed to develop and market such innovations will take time to build brand equity and meaningfully reduce reliance on lower-margin mainstream offerings. Until then, Smucker should remain especially dependent on specialty retailers for growth, as the channel is more receptive to innovative, unestablished items. Our long-term segment margin target (19.8% average over the next decade versus 17.4% in fiscal 2016) includes benefits from premiumization and innovation that we believe will outweigh higher input costs; however, continued challenges in Smucker’s premium offerings over the coming quarters may lead us to temper our expectations.

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