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Company Hormel Foods Corp. (NYSE:HRL)

Rating Change from Neutral to Sell

Price $42.61

Target Range $26.78 - $42.08

Market Cap $11,695

52 Week High/Low$27.28 - $43.17

*All numbers presented in this report are provided by Hormel's annual reports, quarterly reports, and presentations unless otherwise noted

COMPANY OVERVIEW

Hormel Foods Corp.

Hormel Foods Corp. is divided into five operating segments. The grocery products segment consists primarily of shelf-stable food products. These products consists of brands such as SPAM, Stagg's chili, Wholly Guacamole and the recently acquired Skippy Peanut Butter. The refrigerated foods segment focuses on the processing and sale of pork and beef products. Brands include Black Label Bacon, Farmer John's, Llyod's, and Saag's Specialty Sausage. The Jennie-O Turkey Store segment specializes in the processing and sale of turkey products. The Specialty Foods segment consists of three various operating segments; Diamond Crystal Brands, Century Foods International, and Hormel Specialty Products. This segment focuses on products such as sugar substitutes, sports nutrition products and dessert mixes. A focus of this segment is the sale of nutritional food products to hospitals and nursing homes. The All Other segment is considered Hormel's international operating segment. Hormel has six joint ventures, three licenses, and two wholly owned subsidiaries. They have operations in the Americas, Asia-Pacific, China and Europe. Currently, SPAM and Stagg's chili have the number one market share in the United Kingdom.

STRENGHTS

  1. Hormel is currently in a leadership position in refrigerated pork and turkey. This leadership position has allowed Hormel to tolerate increases in production costs related to regulatory burdens, flawed political policies such as the use of ethanol, and increased feed costs. Larger companies can absorb these costs while smaller companies/farms either go bankrupt or merge with larger companies. This provides a strong barrier to entry as well as a decrease in competition. An example of this can be seen in hog farms. In 1977 the average head per operation was 87.39, there were 504,000 farms that had between one and ninety-nine heads, and there were no farms with five thousand plus heads. As of 2011, the average head per operation rose to 960.36, there are only 49,000 farms that had between one and ninety-nine heads, and there are 3,300 farms that have five thousand plus heads. (source: Pork Facts 2012)
  2. Product diversification; proteins vary in price and respond differently to the business cycle. Hormel has operations in turkey and pork. Coupling these operations with their grocery and specialty segment has allowed them to have relatively stable earnings as compared to companies that operate in a single segment such as Smithfield Foods. This stability has lead to the ability of Hormel to increase dividends for forty-seven consecutive years.
  3. Hormel's Jennie-O Turkey segment is one of the largest turkey producers in the United States. Turkey demand should consistently improve as the push for healthier food continues.
  4. Financial Strength; based on our off balance sheet adjustments total debt to capitalization is roughly nine percent. This conservative approach has allowed Hormel to make strategic acquisitions and continue to grow internally.

WEAKNESSES

  1. Based on my research, Hormel does not have any market share in the organic segment of the industry.
  2. 13.2% of sales come from Wal-Mart (NYSE:WMT). If something detrimental happens to them it could drastically affect the profitability of Hormel.
  3. Hormel's profitability, like others in this industry, will always be susceptible to volatile feed costs.
  4. The Environmental Protection Agency as well other regulatory bodies/regulation will continue to hinder growth. Flawed regulation regarding the use of ethanol has driven the price of feed higher. The USDA recently published a report stating that 42% of corn production in the United States is used for ethanol.
  5. The food industry as a whole will suffer from low job growth.
  6. As a whole, the food industry is facing headwinds as supermarkets have seen a large number of consolidations resulting in larger but fewer number or grocers. This has lead to increased buyer power which allows grocers to negotiate lower prices for products from suppliers such as Hormel.

COMPETITORS

Large domestic competitors of Hormel are Smithfield Foods (NYSE:SFD), Hillshire (NYSE:HSH), Tyson (NYSE:TSN), Sanderson Farms (NASDAQ:SAFM), and Pilgrim's Pride (PPC, parent company JBS S.A). In addition, Hormel faces competition from unbranded private label competitors. The advantage of barriers to entry is shared by many of the larger constituents as well as the weaknesses such as passing through inflation to input costs, consolidating grocery stores and limited shelf space.

FINANCIAL OVERVIEW

I believe revenue momentum will continue to be positive as the number of users increase. This stems from the constant increase in global protein consumption since 1960 as well as Hormel's recent joint ventures and strategic acquisitions. I believe that hog prices will slightly rebound over the coming years and that turkey prices will also continue to increase although at a slower pace relative to the recent past. Hormel will also be able to scale by increasing users, therefore increasing current capacity utilization. Also, I believe revenue per customer will continue to increase. As the global economy rebounds and other nations build their middle class this will increase the affordability of Hormel's products. As Hormel continues to grow internationally, this will make them more accessible to a greater number of customers.

Margins are strongly influenced by commodity prices which are a function of supply and demand. I have had the view since July 2012 that feed prices would drop which would lead to increased margins for Hormel. In recent weeks I have changed my outlook on feed prices to neutral.

Hormel currently has a relatively low amount of debt to their peers. They also do not own their farms. These two points are made to express that Hormel has a low amount of operating and financial leverage which should reduce the volatility of their earnings and cash flow.

Hormel has had dividend increases for forty-seven consecutive years.

MANAGEMENT REVIEW

As of today, I have been able to find minimal information in regards to employee turnover and work related injuries regarding Hormel employees. I believe management has done a superb job of managing the finances of Hormel. They have been effective at creating organic growth as well as making strategic acquisitions/joint ventures. The last announced acquisition was Skippy Peanut Butter which should have an effect by the end of the second quarter. Some have criticized Hormel for this purchase because Skippy has been losing market share. However, I believe this to be the case because of management neglect at Unilever (Skippy was not a core product at Unilever).

There are items that I must point out in regards to Hormel's financials that relate to management. The first item is the management of their pension (when I refer to pension I am referring to both the pension plan and post-retirement benefits). Other Comprehensive Income dropped by a large amount in 2012 which is mostly attributed to the increase in the unfunded status of the pension plan which went from being underfunded by roughly $394mn in 2011 to roughly underfunded by $615mn in 2012. I attribute this to the decrease in the discount rate used to calculate the benefit obligation which dropped from 5.33% to 4.05%. As interest rates rise the discount rate will rise which will help decrease the underfunded status of the plan. Therefore, I do not view this drastic increase in unfunded status to be detrimental at this time.

Other characteristics regarding the pension plan are the expected return being used, the use of the ALM (asset-liability matching) approach and investment into Hormel Stock. The expected return used to calculate the pension asset's return is eight percent. Currently, thirty-six percent of the fund is in fixed income and sixty-four percent in equities. I used the assumption that the fixed income portion is returning four percent which means management is assuming the equity portion will return 10.28%. Based on the limited disclosure of holdings I view this as aggressive. I would normally say this will have a negative affect on future earnings of the company as the Company is forced to contribute more to the plan. However, Hormel uses the ALM approach to manage their plan which I view as superior and a conservative way of managing the plan.

Over the next five years, Hormel has estimated roughly $357mn will be paid out or thirty-eight percent of the plans assets. Currently, thirty-six percent of the plans assets are in fixed income investments which I am assuming will be used to help meet these distributions (again, I have to make assumptions because of the limited disclosures). The area that I view as a concern is that 5.2% of the pension is invested in shares of Hormel. I would like to see this exposure reduced to zero. I have contacted Hormel's investor relations department and they have stated that they are currently in the process of reducing this exposure with the goal of zero percent.

The second item I want to point out is the use of lower of cost or market inventory reserve. I give credit to management because this is considered a conservative approach. However, the exact wording from the annual report says, "A decrease in lower of cost or market inventory reserve caused a notable expense decrease in the forth quarter." Two areas to highlight in this statement are the word notable and forth quarter. The company included this same disclosure in the 2011 annual report but did not use the word notable. Also, this decrease seems to consistently happen in the forth quarter. Using this accounting method thus far seems non-material. I present it in this report as an area that needs to be consistently monitored because this type of approach has been considered "conservative" but may also be used to manipulate earnings.

PROJECTED FINANCIAL METRICS

Key metrics used to derive value are free cash flow, enterprise value, and EBITDA. Key assumptions are listed below:

  1. Top line revenue is expected to grow. Gross margins slightly expanding this year with greater increases in FY14 and FY15.
  2. Volume is expected to grow in the grocery segment. The acquisition of Skippy has been modeled to add roughly $370mn. These results have been modeled to take affect this year. The Asian acquisition of Skippy is expected to close at the end of FY2013. Sales of $40mn from this acquisition have been modeled for FY2014. Also, Hormel has a strong position in Mexico. Many analyst have stated that Mexico should be towards the upper end of GDP growth in the near future.
  3. Volume in the refrigerated foods segment is expected to drop in FY2013 and slightly rise in FY2014 and FY2015. We currently have modeled a decrease of 2%.
  4. Volume in the Jennie-O Turkey segment is modeled to consistently rise each year as global demand increases.
  5. Volume in the specialty segment is modeled to consistently increase. Increasing population age in the United States as well as the governments push towards healthier foods should provide a tailwind for this segment. I believe it to be foolish if management chooses not to focus their efforts on this segment.
  6. Volume in the Other segment is modeled to rise as international demand increases.
  7. Feed prices were modeled to have a slight decrease in FY2013 with moderate decreases in FY2014 and FY2015.
  8. Operating Margin is modeled to decrease in FY2013 then rise in FY2014 and FY2015. In 2012 Hormel decided to accrue advertising expense which caused SG&A to be lower. I believe SG&A will rise in the future.
  9. Management has stated that they expect PP&E to be between $130-140mn. A conservative amount of $145mn was modeled.
  10. Subtraction to 2011 and 2012 net income where made to elevate the effect of hedged gains.
  11. No information regarding the purchase price allocation of Skippy has been provided. I have taken account of this acquisition on the balance sheet in the following categories; cash, short-term marketable securities, goodwill, other assets, and long-term debt.
  12. Pension assets and liabilities have been added to the balance sheet. The unfunded portion is considered as debt for the calculation of enterprise value and debt ratios. Also added to debt are the $43.9mn of off balance sheet letters of credit and capitalized leases.
  13. Dividends are modeled at $.68 per share for 2013 while rising $.015 per share in FY2014 and FY2015.

VALUATION CONCLUSION

When I value companies I use a range that is divided into five categories based on comps and sensitivity analysis. These five categories are min value, 25th quartile, median value, 75th quartile and max value. I consider Hormel a leader in their industry, therefore I focus my valuations on the 75th quartile thru max value range. For the comparable market multiples approach I used the TEV/FCFF multiple which was applied to my forecast for FY13 and FY14. The values provided by this approach were $35.09 and $42.09 per share. In my discounted cash flow model I used exit multiples for free cash flow ranging between eight and twelve times. The discount rate used was 5.1%. I use a proprietary model I developed for relative comparisons to provide this discount rate which often times leads to lower discount rates than what the conventional market uses. The max value provided by my DCF model was $26.78. The last metrics used to value Hormel came from the Company's historical P/EBITDA multiple. I applied this to my forecast for FY13 and FY14. The values provided were $40.04 and $33.55 per share. These valuations provide a target range of $26.78 - $42.08.

INVESTMENT THESIS

I currently have a neutral rating on Hormel which I am changing to sell. I believe there is low to negative return potential with moderate risk. However, I do not recommend simply shorting the stock because I have a bias towards only shorting stocks when I feel the business model is flawed and believe there will be a drastic fall in value. This is not the case with Hormel. The investment I recommend making is to execute a long-short trade or enter into a short position while limiting your risk. The long-short trade I recommend making is going short Hormel and long Tyson or Hillshire Brands. You may also enter a short position and limit your risk by entering bear spreads or a short position combined with a long call option.

FINACIAL PROJECTIONS AND SUMMARY

Hormel Foods

($ in millions, except for EPS)

Fiscal year ending October

INCOME STATEMENT

2010A

2011A

2012A

2013P

2014P

2015P

Grocery Products

$1,040

$1,065

$1,171

$1,314

$1,648

$1,748

Refrigerated Foods

$3,819

$4,189

$4,223

$4,180

$4,348

$4,657

Jennie-O-Turkey

$1,310

$1,467

$1,549

$1,643

$1,726

$1,813

Specialty

$783

$836

$924

$952

$986

$1,031

All Other

$268

$339

$363

$378

$393

$409

Total Sales

$7,221

$7,895

$8,231

$8,467

$9,102

$9,659

Cost of Sales

5,982

6,561

6,899

7,059

7,480

7,857

Gross Profit

$1,239

$1,334

$1,332

$1,408

$1,621

$1,802

Gross Margin

17%

17%

16%

16.6%

17.8%

18.7%

SG&A

$605

$619

$606

$643

$692

$734

Equity Earnings in Affiliates

13

27

39

13

13

13

Operating Profits (loss)

$647

$742

$765

$752

$917

$1,055

Operating Margin

9.0%

9.4%

9.3%

8.9%

10.1%

10.9%

Interest Income

($5)

$1

($7)

($7)

($11)

($28)

Interest Expense

$27

$23

$13

$10

$10

$10

Income (loss) from cont. operations B4 income tax

$625

$719

$758

$748

$918

$1,073

Income tax expense (benefit)

$225

$240

$253

258

317

370

Income (loss) from Cont. Operations

$400

$479

$505

$490

$601

$703

Less:Net Loss Attributable to Noncontrolling Interest

$4

$5

$5

$5

$5

$5

Net Income

$396

$453

$488

$495

$606

$708

EBIT

$647

$742

$765

$752

$917

$1,055

EBIT Margin

9.0%

9.4%

9.3%

8.9%

10.1%

10.9%

EBITDA Reconciliation

Depreciation

$115

$115

$111

$111

$115

$116

Amortization

11

9

9

7

6

3

EBITDA

$772

$866

$884

$870

$1,038

$1,173

EBITDA Margin

10.7%

11.0%

10.7%

10.3%

11.4%

12.1%

EBITDA Growth

#DIV/0!

12.2%

2.0%

-1.6%

19.3%

13.0%

Pretax Income

$625

$719

$758

$748

$918

$1,073

Taxes

$225

$240

$253

$258

$317

$370

Tax Rate

36.0%

33.3%

33.4%

34.5%

34.5%

34.5%

Net Income

$396

$453

$488

$495

$606

$708

Net Margin

5.5%

5.7%

5.9%

5.8%

6.7%

7.3%

Net Income Growth

14.6%

7.7%

1.4%

22.4%

16.8%

Fully-Diluted Shares Outstanding

271

272

269

274

274

274

EPS

$1.46

$1.67

$1.82

$1.80

$2.21

$2.58

Enterprise Value Calculation

Basic Shares

265

Plus: Dilutive Shares - Options

9.60

Plus: Dilutive Shares - Convertible Bonds

0.0

Fully-Diluted Shares

274

Multiplied by: Share Price

$42.61

Market Value of Equity (MVE)

$11,695

Plus: Preferred Equity

0

Plus: Debt

1,060

Plus: Minority Interest

5

Less: Cash and Cash Equivalents

(760)

Enterprise Value

$12,001

Hormel Foods

(in millions)

Fiscal Year Ending

10/30/2013

10/30/2014

10/30/2015

DCF Assumptions

EBIT

$752

$917

$1,055

Discount Rate

5.1%

Less: Taxes

$258

$317

$370

Tax Rate

34.5%

EBI

$494

$600

$685

Terminal Value Assumptions

Plus: Depreciation & Amortization

$118

$122

$119

Free Cash Flow - 2015

$627

Valuation Multiple

12

EBIDA (EBI + DA)

$612

$722

$803

Terminal Value at 2015

$7,527.92

Less: Changes in NOA

$34

($57)

($51)

Discount Period

2.48

Less: Capitalized Investments

($146)

($118)

($126)

Discount Factor @ 5.1%

0.88

PV of Terminal Value

$6,659

Free Cash Flow

$500

$546

$627

Discount Period (1)

0.45

1.46

2.48

Total Enterprise Value

Discount Factor @ 5.1%

0.98

0.93

0.88

PV of Cash Flows through 2014

$997

PV of Cash Flows through 2014

$489

$508

$555

PV of Terminal Value

$6,659

Total Enterprise Value

$7,656

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in HRL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Hormel Valuation Update: Overvalued