Published by Nicholas McCullum on May 29th, 2017
Hormel Foods (HRL) recently reported its second-quarter financial results.
The company’s earnings were below market expectations, particularly in its turkey segment, and Hormel’s stock price was pummeled as a result. Hormel closed down 6.4% on the trading day following the announcement.
Investors should be pleased to see this lower stock price. It presents a stellar opportunity to accumulate shares in this exceptionally high-quality business. One quarter of slightly lower earnings does not mean that Hormel’s overall business is in decline.
Hormel has weathered through many market cycles already. The company was founded all the way back in 1891 and has been rewarding shareholders handsomely ever since.
Hormel is also a very shareholder-friendly stock. In fact, the company’s long streak of consecutive dividend increases qualifies it to be a member of the Dividend Aristocrats, a group of elite stocks with 25+ years of consecutive dividend increases.
Hormel’s dividend history goes well beyond the requirement to be a Dividend Aristocrat. Hormel has raised its dividend for 51 consecutive years (including 2017’s increase).
This makes Hormel a member of the Dividend Kings, stocks with 50+ years of consecutive dividend increases – twice the requirement to be a Dividend Aristocrat.
Clearly, Hormel is a high-quality dividend stock.
This article will discuss why Hormel’s recent price decline presents a compelling buying opportunity for investors.
Hormel can trace its roots to 1891, when it was founded by George Hormel as George A. Hormel & Company. The corporation changed its name to Hormel Foods Corporation in 1993.
The company has grown meaningfully over this long period of time. Hormel generated $9.5 billion of net sales in 2016 and owns well-known brands like Jennie-O turkey, SPAM, Muscle Milk, Dinty Moore, and Skippy peanut butter.
Hormel has a current market capitalization of $16.4 billion and is headquartered in Austin, Minnesota.
Hormel is well-known among most self-directed investors because of its very strong performance.
Along with its remarkable 51 consecutive years of dividend increases, Hormel has delivered total returns well in excess of the broader stock market (as measured by the S&P 500) and its peer group (as measured by the S&P 500 Packaged Food & Meats Index).
These impressive total returns can be seen below.
Hormel is currently divided into 5 diversified operating segments for reporting purposes:
- Refrigerated Foods (49% of 2016’s net sales)
- Jennie-O Turkey Store (18% of 2016’s net sales)
- Grocery Products (18% of 2016’s net sales)
- Specialty Foods (10% of 2016’s net sales)
- International & Other (5% of 2016’s net sales)
Product snapshots from each operating segment can be seen below.
Hormel buys raw ingredients – pork and turkey, primarily – and processes these ingredients into products that we find on the shelves of our grocery stores. A small proportion of Hormel’s raw ingredients are produced at Hormel-owned farms.
To understand the Hormel business (as well as its current troubles in its turkey segment), it is imperative to understand the relationship between the company and its suppliers. This is best understood by reading the following passage from Hormel’s most recent 10-K:
“The majority of the hogs harvested by the Company are purchased under supply contracts from producers located principally in Minnesota, Iowa, Utah, Nebraska, Kansas, and Colorado. The cost of hogs and the utilization of the Company’s facilities are affected by both the level and the methods of pork production in the United States. The Company uses supply contracts to ensure a stable supply of raw materials. The Company’s contracts are based on market-based formulas and/or the cost of production, to better balance input costs with customer pricing, and all contract costs are fully reflected in the Company’s reported financial statements. In fiscal 2016, the Company purchased 94 percent of its hogs under supply contracts. The Company also procures a portion of its hogs through farms that it either owns or operates in Arizona, California, Colorado, and Wyoming.
In fiscal 2016, JOTS raised turkeys representing approximately 76 percent of the volume needed to meet its raw material requirements for whole bird and branded turkey products. Turkeys not sourced within the Company are contracted with independent turkey growers. JOTS’ turkey-raising farms are located throughout Minnesota and Wisconsin.” – Hormel 2016 10-K, page 4
Keep in mind that the company’s turkey segment grows the majority (76% in 2016) of the raw turkey needed to produce its end goods. This is a key fact to understand Hormel’s current turkey troubles.
It should also be noted that Hormel Foods has a rather unique ownership structure that is reminiscent of Hershey (HSY).
48.5% of Hormel’s common stock is owned by the Hormel Foundation, which has no intent to ever sell this stock.
The foundation’s permanence of capital encourages long-term thinking among Hormel’s management team, which is a positive for Hormel shareholders.
Moving on, the next section will discuss the negative news in Hormel’s second quarter earnings release that sent the stock plunging by ~6%.
Current Events & Second Quarter Financial Results
As mentioned, the reason why Hormel’s stock dropped 6% when their second quarter earnings release was announced is the company’s weakness in its turkey segment, the Jennie-O Turkey Store (or JOTS, for short). Raw turkey prices are at 7-year-lows, which has reduced the segment’s sales and profitability.
On the surface, it might not be clear why low raw turkey prices would impair the profitability of the Jennie-O Turkey Store. Cheap turkey should reduce the company’s cost of goods sold and increase profits, right?
While that might be true over short periods of time, the current prolonged low turkey price environment has created a supply glut of turkey products and turkey derivatives, meaning Hormel has to sell its end products at lower prices to food retailers.
The impact of low turkey prices on the short-term financial performance of Hormel’s turkey segment is profound.
The JOTS segment experienced a decline on both the top and bottom line during the second quarter. On the top line, Hormel’s turkey segment saw an 8.3% decline in quarterly net sales over the same period one year ago.
The company’s turkey performance was even worse on the bottom line. Hormel’s turkey segment saw a 28.9% decrease in quarterly operating profit compared to the same period a year ago.
So why is Hormel’s turkey segment performing so poorly?
Here’s is management statement on the recent performance of the Jennie-O Turkey Store, as per their second quarter earnings conference call:
“Three main issues affected Jennie-O Turkey Store’s profitability this quarter versus the same time last year: Declining turkey prices; increased competition; and increased expenses.
First, turkey prices such as breast meat have maintained their seven year lows and in some cases declined further since the first quarter as the industry continues to be in an oversupply situation. History suggests that turkey industry will balance supply and demand and market conditions will improve in the coming months. In turn, we have made additional adjustments to our production levels and would expect volumes slightly under 2014 levels.
The impact to our business continues as commodity sales pricing and whole bird pricing is much lower than last year. Lower turkey prices are also pressuring prices in Jennie-O Turkey Store’s three sales divisions: retail, deli, and foodservice.
Second, increased competitive activity from other turkey suppliers and competing proteins such as beef continue to pressure Jennie-O’s results.
Third, we incurred higher operating expenses primarily related to bird performance issues with both our conventional flocks and those raised without antibiotics. We continue to make investments into consumer trends such as our raised-without-antibiotics products.”
While management cites three reasons why JOTS has performed poorly lately, I believe the first (low turkey prices) is the most important.
While performance has been weak, Hormel’s turkey problems should be seen as a buying opportunity, not a reason to be fearful of this stock. There are three main reasons why.
First of all, the overall company is still performing quite well. The company’s year-to-date non-GAAP net sales in its turkey segment are actually up by 1.7% – while not fantastic growth, the segment certainly is not in systemic decline. The overall Hormel business has been growing at a similarly satisfactory rate on a year-to-date basis, with overall net sales up by 2.8% over the same period a year ago.
So, while JOTS is under pressure recently, the overall business continues to perform well.
Hormel’s management stated the following on their second quarter conference call:
“Looking to the balance of fiscal 2017, the only change to our outlook is for Jennie-O Turkey Store. We now expect percentage declines in earnings for Jennie-O Turkey Store to be in the high-teens for the second half of the year with the pressure not abating until the entire industry starts to reduce production levels…
…Based on our updated outlook for Jennie-O Turkey Store, we are maintaining our full year earnings per share guidance of $1.65 to $1.71, and expect earnings to be at the lower end of the range.”
The strong performance of Hormel’s other segments means that management has not adjusted its earnings guidance even though JOTS has experienced poor performance. This is a testament to the strength of Hormel’s diversified business model.
Secondly, turkey continues to be a larger and larger component of the ground meat industry.
This slide indicates that turkey demand has been growing in recent years – a trend that is likely to continue. Rising demand for turkey products will help to reduce the current supply glut caused by low raw turkey prices, boosting the profits of the JOTS over time.
Third, low turkey prices are a temporary phenomenon. Buying Hormel right now is similar to buying oil & gas companies when oil prices were at rock-bottoms in 2014 – it is a bet on the mean reversion of commodity prices.
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” – Warren Buffett
While Hormel Foods is far from being ‘on the operating table’, it certainly is a great company and the above quote is very applicable.
To sum up, I believe that Hormel’s turkey problems are temporary in nature, and the company’s diversified business model will help it to continue growing through this difficult operating environment.
Moving on, the next section will discuss the growth prospects of Hormel Foods in detail.
Hormel’s track record indicates that its management team is highly capable of compounding earnings-per-share at high rates over long periods of time.
The company devotes its generated cash to either drive organic growth or fund accretive bolt-on acquisitions.
From the organic growth side of the business, Hormel recently announced the intention to build a new $130 million turkey production facility in Melrose, Minnesota that will improve the efficiency of its ailing Jennie-O Turkey Store.
More details on the new production facility, courtesy of Hormel’s second quarter conference call, can be seen below.
“This week we announced plans to build a new production facility in Melrose, Minnesota primarily to process whole birds. This new facility will replace the current aged Melrose facility and is expected to cost over $130 million. While our emphasis at Jennie-O Turkey Store is on value added products, whole birds are an important part of the turkey supply chain. The new plant will increase operational efficiency through an improved layout and will also automate some of the most difficult production jobs. Construction begins this year and we expect the plant to be operational in early 2019.”
While this $130 million production facility is certainly a significant step in improving the Jennie-O Turkey Store and the company has strong organic growth opportunities, Hormel has historically derived most of its growth from acquisitions.
Looking at recent history, $2.2 billion of Hormel’s $3.9 billion of cash from operations since 2012 has been spent on acquisitions – including Skippy, Muscle Milk, and Applegate Farms.
The company has very specific characteristics for its acquisition targets.
Hormel’s potential acquisitions should have leading brands, be immediately accretive to the company’s earnings-per-share, and bring ‘more than cash’ – Hormel is looking to bring on board talented management teams and strong operational facilities when it acquires smaller food businesses.
Hormel has been very active on the M&A front in recent years. In the past two years alone, Hormel has executed the following important transactions:
- July 13, 2015: Hormel acquired Applegate Farms for $774.1 million
- May 26, 2016: Hormel acquired Justin’s LLC for $280.9 million
- May 9, 2016: Hormel sold Diamond Crystal Brands for $110.1 million
The last major driver of growth for Hormel will be its international expansion efforts. The company’s International & Other segments reported 19.0% growth in second quarter net sales over the second period a year ago, and it shows no sign of slowing down.
For example, Hormel began producing SPAM in China in 2015 and tripled its in-country production in the middle of 2016. Exposure to the world’s largest population will be a significant tailwind to Hormel’s future growth.
Competitive Advantage & Recession Performance
Hormel’s largest competitive advantage comes from its strong portfolio of leading food brands.
The company’s products have a remarkable #1 or #2 market share in over 35 food categories, with selected categories shown below.
Hormel also spends a significant amount of money on marketing and advertising, ensuring that new consumers are exposed to Hormel brands on a daily basis.
The company’s advertising investment over the past 4 complete fiscal years can be seen below. Note that Hormel has increased its advertising budget by double-digit percentages over the past four years.
I would expect Hormel to perform exceptionally well during a recession for three reasons.
First, Hormel has a recession-resistant business model. The company sells a nice mix of premium and cheap products, and its cheap food products (like SPAM) experience stable or growing demand when disposable income becomes constrained.
Secondly, Hormel has a pristine balance sheet.
At the end of the second quarter, Hormel reported cash and cash equivalents of $548 million, and long-term debt of only $250 million. Further, the company had a reasonable amount of current liabilities – ~$825 million.
Third, Hormel has historically performed admirably when recessions hit.
During the last recession – the global financial crisis of 2007-2009 – Hormel experienced only a very minor decrease in earnings-per-share and resumed rapid growth during the following year.
Hormel’s adjusted earnings-per-share during the last recession can be seen below.
- 2007 adjusted earnings-per-share: $0.54
- 2008 adjusted earnings-per-share: $0.52 (3.7% decrease)
- 2009 adjusted earnings-per-share: $0.63 (21.2% increase)
- 2010 adjusted earnings-per-share: $0.87 (38.1% increase)
The company’s history of compounding its bottom line goes well beyond its performance during the last recession.
Hormel has seen its earnings-per-share increase in 28 out of the past 31 years – a streak matched by only 4 companies in the S&P 500 (another Dividend Aristocrat and Dividend King to achieve this feat is Johnson & Johnson (JNJ)).
It should also be noted that Hormel has a very low stock price volatility, driven by its fundamentally recession-proof business model.
Valuation & Expected Total Returns
Hormel’s future shareholder returns will be composed of valuation changes, earnings-per-share growth, and the company’s current dividend yield.
Hormel is trading at a more attractive valuation than it has in recent times, as it’s second quarter earnings release lowered the company’s stock price and created a buying opportunity for long-term investors.
The company reported diluted earnings-per-share of $1.64 for full-year fiscal 2016. Hormel’s current stock price of $33.12 is trading at a price-to-earnings ratio of 20.2 base on 2016’s earnings.
Looking ahead, Hormel expects its 2017 earnings-per-share to be ‘at the low end’ of its previous guidance of $1.65-$1.71. Thus, the company’s look-ahead valuation is not meaningfully different than its valuation using last year’s earnings.
The following diagram compares Hormel’s current valuation to its historical averages.
Source: Value Line
Looking at the diagram, it appears that Hormel’s current valuation is higher than its long-term historical average.
However, it looks as though the markets have revised Hormel’s ‘normal’ valuation upwards, and the company is actually trading at a discount to its valuation in recent years.
Thus, I believe that Hormel is trading at somewhere close to fair value, and the company’s current stock price represents an attractive opportunity to pick up shares of this high-quality stock at a reasonable price. I do not expect valuation changes to have a meaningful effect on the long-term future returns for Hormel shareholders.
Rather than valuation changes, I would expect the majority of Hormel’s returns to come from profit growth. The company’s management has a publicly communicated goal of 10% annual earnings-per-share growth over full economic cycles helped along by 5% annual increases in net sales.
While this rate of growth seems quite high for some companies, Hormel has managed to successfully achieve this rate of return in recent years. Hormel has compounded its earnings-per-shares at 12% per year over the past decade.
Taking Hormel’s past performance and management expectations into account, I believe long-term investors can expect 9%-11% annual growth in earnings-per-share for Hormel in the long term.
It should be noted that share repurchases will not be a notable boost to Hormel’s earnings-per-share growth.
While the company is shareholder-friendly in many other ways, Hormel avoids large stock buyback programs and prefers to retain earnings to fund acquisitions, build new plants, and streamline its operations. Hormel does repurchase enough stock to offset the dilution associated with its stock option compensation programs.
Occasionally, Hormel might accelerate its stock repurchases when its share become attractively priced. This was seen in the recent quarter, as Hormel has declined significantly off its past high among the fears surrounding low turkey prices.
The ‘Financing Activities’ section of Hormel’s statement of cash flows indicates that Hormel deployed $49.6 million of capital towards share repurchases in the most recent quartered, up significantly from $6.4 million in the same period a year ago.
Even in this accelerated buyback environment, Hormel preferred to return capital to its shareholders through dividend payments rather than share repurchases ($166.5 million compared to $49.6 million).
Lastly, Hormel’s total returns will be boosted by the company’s quarterly dividend. Hormel generally trades with a low dividend yield, but its yield has been driven up by its recent stock price decline.
Hormel currently pays a quarterly dividend of $0.17 per share which yields 2.1% on the company’s current stock price of $33.12. Hormel’s recent stock price decline has pushed the yield above 2%, making it a more attractive stock for income investors.
To sum up, Hormel’s expected total returns will be composed of:
- 9%-11% earnings-per-share growth
- 2.1% dividend yield
For expected total returns of 11.1%-13.1% before the effects of valuation changes.
Hormel’s stock has been under pressure since its earnings release, but low turkey prices do not materially affect its long-term growth outlook.
Derek Getz, a contributor on Seeking Alpha, summed up my opinion perfectly in his recent article Hormel Drops 5% – What You Need To Know:
“The company has virtually no debt, operates in a recession resistant industry, maintains a low payout ratio and has been raising dividends for over 50 years. What’s not to like?”
Hormel’s low stock price volatility and exceptionally long dividend increase streak help it to rank favorably using The 8 Rules of Dividend Investing. Hormel has also ranked as a Top 10 Stock in past editions of the Sure Dividend Newsletter, as recently as the April edition.
Thus, investors would do well to accumulate shares of this outstanding company at the recently lower stock price.
If you’re interested in reading more Sure Dividend analysis on Hormel Foods, the following articles may be of interest: