Business context and reporting period
The J. M. Smucker Company’s Form 10-Q covers the quarter and six months ended October 31, 2015, the second quarter of fiscal 2016. Results include Big Heart Pet Brands from its March 23, 2015 acquisition; therefore, reported year-over-year growth is not directly comparable. Big Heart contributed $576.7 million of quarterly sales and $1.1 billion for the six months. The company reports U.S. Retail Coffee, U.S. Retail Consumer Foods, U.S. Retail Pet Foods, and International and Foodservice.
Key financial results
| Metric | Three months ended October 31 | Six months ended October 31 |
|---|---|---|
| Net sales | $2,077.7 million, up 40% | $4,029.7 million, up 44% |
| Gross profit / margin | $787.3 million / 37.9% (36.2% prior year) | $1,516.0 million / 37.6% (36.2% prior year) |
| Operating income / margin | $313.8 million / 15.1% (17.2% prior year) | $580.9 million / 14.4% (15.9% prior year) |
| Net income | $176.0 million, up from $158.3 million | $312.4 million, up from $274.3 million |
| Diluted EPS | $1.47, versus $1.55 | $2.61, versus $2.69 |
| Net interest expense | $42.6 million, versus $16.2 million | $87.0 million, versus $33.6 million |
Excluding acquisitions and foreign exchange, sales increased 2% for the quarter and 4% for the six months. Management’s non-GAAP diluted EPS was $1.62 for the quarter and $2.95 for the six months, up 6% and 3%, respectively; these measures exclude specified special project costs and derivative gains or losses. Higher GAAP operating expenses, acquisition-related amortization and integration costs reduced operating margins. Increased share count and acquisition financing costs contributed to lower GAAP EPS despite higher net income.
For the six months, operating cash flow was $580.5 million, compared with $83.9 million a year earlier; capital expenditures were $117.4 million, resulting in reported free cash flow of $463.1 million versus negative $29.8 million. Management attributed the operating cash increase mainly to lower working capital, particularly reduced inventory, and higher net income. Cash was $139.0 million at October 31. Total debt was $5,864.5 million, comprising $370.0 million of short-term borrowings and $5,494.5 million of long-term debt. The company had a $1.5 billion revolving facility with no balance outstanding and was in compliance with debt covenants. Current assets were $2,006.0 million and current liabilities $1,132.7 million.
Material changes and management commentary
- Big Heart drove most of the reported sales increase. Organic performance was led by coffee, particularly Dunkin’ Donuts K-Cup pods. Coffee sales rose 10% in the quarter; Consumer Foods sales fell 3%, while Pet Foods sales were $566.7 million. Pet Foods growth included Milk-Bone and Natural Balance, partly offset by Kibbles ’n Bits declines.
- Management expects approximately $200 million of annual net Big Heart synergies by the end of 2018. It expects $25 million of savings in fiscal 2016, of which $7.9 million had been realized in the first half. Big Heart-related costs are expected to total about $225 million, with roughly half anticipated in fiscal 2016.
- Management expects fiscal 2016 capital expenditures of about $220 million and a full-year effective tax rate of approximately 35%. It said available cash, operating cash flow, and borrowing capacity should cover requirements for the next 12 months, absent further material acquisitions or investments. It intends to use some future cash generation for debt reduction while maintaining its dividend policy and investing in the business.
- On November 2, 2015, the company agreed to sell its U.S. canned milk brands and operations, with annual sales of about $200 million. It expected approximately $200 million in proceeds and a pre-tax gain of $20–$30 million, subject to closing and a working capital adjustment. The Canadian canned milk business is excluded.
Risks, contingencies and unusual items
- Integration, retention, and delivery of Big Heart’s anticipated cost savings remain execution risks; acquisition-related debt and higher interest expense increase financial obligations.
- A dispute with Del Monte Foods over the working-capital adjustment from Big Heart’s 2013 sale of its consumer-products business remains unresolved. An independent accountant ruled in Del Monte’s favor on the calculation method; the company said the adjustment could be materially different and could significantly affect cash flows. No receivable or liability had been recorded for the matter.
- Commodity and foreign-exchange movements affect costs and reported results. Management expected foreign-exchange effects to remain unfavorable in the second half of fiscal 2016 and into the next fiscal year. Risks also include competitive pricing, input-cost volatility, and the successful completion of the canned milk sale.
- The company reported $53.5 million of other special project costs for the six months, primarily related to restructuring and Big Heart integration. It also disclosed that Big Heart’s preliminary acquisition-date fair-value allocations, including goodwill and certain intangible assets and liabilities, remained subject to finalization.
Important facts for investors to verify
- How much of future sales and earnings growth is organic versus attributable to Big Heart, and whether expected synergies are achieved on schedule.
- Progress on debt reduction, interest costs, cash conversion, and the $200 million working-capital reduction initiative.
- The final outcome and cash impact of the Del Monte working-capital dispute.
- Completion terms and realized proceeds and gain from the canned milk divestiture.
- Whether Pet Foods brand trends, commodity costs, and foreign-exchange conditions develop as management anticipated.