Business context and reporting period
The J. M. Smucker Company’s Form 10-Q covers the quarter and six months ended October 31, 2018, the second quarter and first half of fiscal 2019. The company manufactures and markets food and beverage products across U.S. Retail Coffee, U.S. Retail Consumer Foods, U.S. Retail Pet Foods, and International and Away From Home.
In May 2018, Smucker acquired Ainsworth Pet Nutrition for approximately $1.9 billion. In August, it sold its U.S. baking business, receiving $372.1 million in net proceeds and recording a $26.6 million pretax gain. Prior-period comparisons are affected by both transactions.
Financial performance and position
- Second-quarter revenue: Net sales were $2.02 billion, up 5%. Excluding acquisition, divestiture, and foreign exchange effects, sales declined $7.2 million, approximately flat. Ainsworth added $184.2 million; lower pricing weighed on sales.
- Second-quarter earnings: Gross profit was $771.3 million, with a 38.2% margin versus 39.2%. Operating income was $330.5 million, essentially unchanged, and net income was $188.5 million versus $194.6 million. Diluted EPS was $1.66 versus $1.71. Adjusted diluted EPS was $2.17 versus $2.02.
- First-half results: Net sales were $3.92 billion, up 7%; sales excluding acquisition, divestiture, and foreign exchange declined $17.2 million. Operating income was $557.4 million, down 2%; net income was $321.5 million, essentially unchanged. Diluted EPS was $2.83, unchanged, while adjusted diluted EPS rose 12% to $3.95.
- Margins and adjusted results: First-half GAAP gross margin declined to 36.9% from 38.6%, and operating margin to 14.2% from 15.4%. Adjusted operating income increased 8% in the quarter to $415.7 million and 7% in the first half to $732.8 million. Adjusted measures exclude items including amortization, integration and restructuring costs, and unallocated derivative gains and losses.
- Segments: First-half U.S. Retail Pet Foods sales rose 31%, largely from Ainsworth; excluding Ainsworth, they declined 2%. U.S. Retail Consumer Foods sales fell 7%, mainly reflecting the baking divestiture; excluding it, sales increased slightly. Coffee sales were broadly flat, while International and Away From Home sales fell 2%.
- Cash flow: First-half operating cash flow was $445.9 million, compared with $434.6 million. Capital expenditures were $179.1 million, leaving reported free cash flow of $266.8 million, down from $304.6 million. Investing cash outflow was $1.72 billion, including the acquisition, partly offset by divestiture proceeds.
- Liquidity and debt: Cash was $171.2 million at October 31, versus $192.6 million at fiscal year-end. Total debt rose to $6.28 billion from $4.83 billion, principally to finance Ainsworth. The company had $390 million of commercial paper outstanding and no revolver borrowings; its revolving facility provides $1.8 billion of capacity, subject to commercial paper usage. The company reported compliance with debt covenants and said available cash, operating cash flow, borrowing capacity, and capital-market access should meet requirements for the next 12 months.
- Dividends: Dividends declared were $0.85 per share for the quarter and $1.70 for the first half, compared with $0.78 and $1.56, respectively, in the prior-year periods.
Changes, outlook, and risks
- Management expects Ainsworth to contribute nearly $800 million of net sales in fiscal 2019 and anticipates approximately $55 million in annual cost synergies, fully realized within three years; about $20 million is expected in fiscal 2019. Approximately $50 million of one-time Ainsworth integration costs are anticipated, most expected to be cash costs.
- The organization optimization program is expected to cost approximately $75 million and reduce headcount by about 450 positions; roughly 75% of the reductions were complete by October 31. Most remaining restructuring costs are expected through the end of 2019.
- Management forecast a fiscal 2019 effective tax rate of approximately 25.5%–26.0%. A $765.8 million provisional tax-reform benefit was recorded in fiscal 2018; the estimate remained subject to refinement, with accounting completion expected in fiscal 2019’s third quarter.
- Management cited lower net pricing and higher costs in several categories. Pet Foods faced higher raw-material and freight costs and brand-specific volume pressures; coffee benefited from lower input costs. The company also noted exposure to commodity, energy, interest-rate, foreign-exchange, transportation, competition, and integration risks.
- Goodwill and indefinite-lived trademarks in U.S. Retail Pet Foods were described as susceptible to impairment, with carrying values near estimated fair values. Significant adverse changes in projections or macroeconomic conditions could trigger impairment charges.
- A California Proposition 65 coffee-warning lawsuit remained unresolved. The remedies trial was stayed while a state agency considered a proposed regulation that could exempt coffee warnings. No loss was accrued because the potential loss was not considered probable or estimable; significant penalties or warning requirements could adversely affect costs and sales.
- The company expects adoption of the new lease standard in May 2019 to materially increase recognized lease assets and liabilities, though it had not quantified the impact. Management said disclosure controls were effective; Ainsworth had not yet been included in the internal-control effectiveness assessment.
Most important facts for investors to verify
- How much reported sales and profit growth reflects Ainsworth, the baking divestiture, and other non-comparable items, versus underlying performance.
- Whether Ainsworth delivers expected sales and synergies, and whether integration costs or acquired-asset valuations change as purchase accounting is finalized.
- Whether pricing, input costs, and Pet Foods brand performance improve, and how these affect GAAP margins and cash generation.
- Debt reduction capacity, interest expense, and covenant headroom following the acquisition financing.
- Potential impairment exposure, Proposition 65 developments, and the final tax-reform accounting and lease-standard impact.