Description

Summary:  

• SJM’s “mainstream” brands are poorly positioned and losing market share across all of its business segments (coffee, pet, consumer foods) driven by brand fragmentation with consumers preferring more “premium” brands at the high end of the market and private label at the low end of the market

• SJM’s coffee and pet food business are overearning driven by falling commodity costs for coffee beans and animal proteins.  Coffee commodity costs are poised higher driven by lower supply from South America. Animal protein prices are likely to increase materially from increased exports to China given the Phase 1 Trade Agreement with China as China is in desperate need of protein driven by African Swine Fever that has culled ~50% of its hog supply

• FY 2022 EPS (April 2022) of $7.45 (10% below Street) x 11.5x PE = $85 or down 20%

Background:  

• SJM’s sales and profits are essentially 1/3 coffee (company-owned Folgers brand, distribution for Dunkin’ Donuts within Food, Drug & Mass channel), 1/3 pet food (Milk Bone, Nature’s Recipe, Nutrish, Meow Mix, Kibble n’ Bits), and 1/3 consumer foods (JIF, Smucker’s).    

Investment Thesis:

• SJM’s Coffee Brands are Poorly Positioned:  SJM's “Mainstream” coffee brands are poorly positioned as premiumization is occurring in the category.  The "Premium" part of the coffee industry is growing LSD%, whereas "Mainstream" is declining MSD%-HSD%. Folgers is the dominant brand within "Mainstream."  SJM does participate in "Premium" and "Pods" through a packing and distributing agreement with Dunkin Donuts, but Folgers comprises ~2/3 of the coffee portfolio which has resulted in declining revenue as growth at Dunkin' hasn't been enough to offset declines at Folgers.  Folgers tried to market a more premium offering by introducing Folgers 1850 in 2018, but this brand has already started to decline. Private label is gaining market share and limits the ability to take price - particularly for "Mainstream" brands. Kraft Heinz has reportedly been trying to sell the Maxwell House assets since February 2019 at 10x EBITDA with no success.   

• SJM’s Coffee Business is Overearning:  Coffee prices have primarily gone down since 2014 with prices falling ~50% since that time.  If you look on an annual basis, SJM’s coffee margins have been relatively stable at 30%-33% however they fell to ~29% when coffee prices rose in late 2016.  Some of the structural pressures against SJM have been masked by the falling commodity price as SJM passes along the decline in commodity costs with a lag. Coffee prices are up ~35% in recent weeks driven by drought conditions impacting key coffee producers of Honduras, Brazil and Peru.  Additionally, Brazil’s Arabica trees are in the off-year of the biennial crop cycle.     

SJM’s Pet Brands Poorly Positioned:  Similar to coffee, premiumization is occurring in cat and dog food driven by the humanization of pets.  Smucker’s entered the pet food category with the 2015 acquisition of Big Heart Pet Brands, which consisted of “Mainstream” brands such as Meow Mix, Kibbles ‘n Bits, and Milk-Bone.  Big Heart Brands has substantially underperformed the market. In response, Smuckers’ acquired Ainsworth Pet Nutrition in 2018 to premiumize the offering through the Rachel Ray Nutrish lineup.  Nutrish is already losing market share in part driven by Blue Buffalo entering the Food, Drug and Mass channel versus previously only being in Specialty Pet Retail. Finally, 2 of SJM’s major brands (Natural Balance and Nutrish) were recently named among 16 brands in the FDA’s DCM (Dilated Cardiomyopathy) investigation that might be responsible for a higher risk of heart complications with dogs.  DCM is a disease of the heart muscle, whereby the ventricle can’t pump blood as well and has been linked to “grain free” labeled pet food.  The pet influencer community, independent pet specialty stores, and veterinarians are now increasingly not recommending these grain-free brands. 

• SJM’s Pet Food Business is Overearning:  COGS are ~65% of Pet Food sales.  Ingredients account for ~50% of COGS.  Animal proteins are the largest component of ingredients at up to 50%, skewing toward poultry.  Thus, animal proteins represent ~15% of pet food sales. China is the world’s largest market for chicken paws/feet but China has not imported these products from the US since 2014 when the US experienced the Avian Flu.  Chicken paws/feet are less popular in Western civilization and due to a lack of demand the product is typically sold to rendering plants at significantly lower prices (for use as pet food). In China, chicken feet can be sold for $1/lb. whereas feet sold into rendering plants typically fetch $0.05-$0.10/lb.  Driven by the African Swine Fever that has wiped out ~50% of China pork production and ~35% of China protein (pork, chicken, beef) production, China is looking to aggressively import protein including once again allowing US imports of chicken paws/feet. More broadly, China’s aggressive importation of protein will prove inflationary across the entire protein complex.  A 30% increase in animal protein costs would be ~500bps of margin in the Pet Food segment without price increases. The entire industry will likely raise price to offset this pressure but in the process create a more competitive category as consumers attempt to mix shift down and rely on more promotional offers. 

• Peanut Butter and Fruit Spreads is a No Growth Category with Increasing Private Label Penetration:  SJM is the category leader in Peanut Butter and Fruit Spreads, but these categories are flattish growth collectively.  There is strong private label penetration at 20% with private label becoming more aggressive.

Catalyst

Earnings